This blog contains some simple tips and advice from two regular guys. We're not accountants, financial advisors, or brokers, so follow, ignore, or discuss our ideas as you see fit.

Tuesday, December 11, 2007

Why Do Bond Funds Go Down?

Posted By Paul

Okay, this is one of my favorite things about Frugalize, the opportunity to have a question that I don't know the answer to, take some time to find out the answer, and then share the answer in the hope that someone else may be wondering the same thing.

So the question I had was:

"If a bond fund is a mutual fund that invests in bonds, and since bonds are essentially loans to corporations or the government that have an interest rate, then how can a bond fund go down in value?"

Is it loss from defaulting on the bonds? Money so that the fund manager can buy nice things for his or her family?

My thought was that such a fund would be conservative (that's true) and since they're just sitting there accumulating interest, that they should only go up in value (that's not true).

The part I was wrong about was that in addition to holding bonds until maturity, bond fund managers can and do trade them on a secondary market. Bonds are constantly being bought and sold on a market not unlike the stock market. The basic mechanism for bond value is the idea that if interest rates go down then older bonds become more valuable (a super simple example: if the current interest rate for bonds is 5% but you have a bond with an interest rate of 10% then people will be interested in that bond and will want to buy it). The opposite is true as well, if interest rates go up then people would rather buy a new bond than an old one with a lower interest rate so that bond becomes less valuable.

It's also true that sometimes entities default on their bonds, but this is generally rare, and it's also true that bond funds have expenses that include paying the fund manager to manage it (for more info on mutual fund expenses see the posting on 'A Few Quick Tips on Mutual Funds'), but usually these don't significantly factor into the value of the fund. Generally the fluctuations in a bond fund relate to the value of the fund change as the bonds within it fluctuate in value.

Confusing? You bet. I guess one thing to keep in mind is that even the conservative bond funds aren't a sure bet. So if you ever need to invest your money in something that has absolutely no risk, then you'll have to start looking at things like CD's, savings bonds, and savings accounts.


Anonymous said...

Bond funds also go down when its investors pull out their funds during times that force the fund management to sell bonds (before they mature) at a loss. This is what is happening currently. For example, management buys a 3-year $10k bond. If management has to sell that bond at $9.5 after having owned it for only 1 year, this causes the fund to lose money!

Matt said...

That makes sense and is similar to the feedback loop I think the banks are caught in. People are afraid the banks will fail, so they pull their money out, so then the bank goes downhill as a result!