Bonds vs. mutual funds/ETFs that hold bonds

[QuazyQuinton]

I'm relatively uneducated to be posting in this subforum, but I recognize that HuntTalk is the repository of all knowledge worth knowing, so here I am. My kids have a little money that I've helped them invest, and I'm always perusing the options. They currently have a small percentage of their money in a mutual fund that holds fairly conservative bonds. I was looking at a higher risk/reward bond ETF this morning and pondering how it works.

My question: I understand a bond to be essentially a loan to the issuer at a certain rate for a certain time. Short of a default, the concept is simple, and the return (interest) is predictable. I also understand that the bond can be sold to another party, and then the price and return can vary based on what makes the transaction attractive to buyer or seller. When bonds are held in a mutual fund or ETF, the complexity and variability increases even more because the fund manages many, many bonds at once. It also seems that the price of such a fund could fluctuate significantly based on investor sentiment toward the bond market as a whole. The idea of earning interest on the original bond seems like it could really be lost in the chaos. (To put it another way, if the bonds are paying interest, and there are no defaults, how does the investment lose value?) So....how much is my kids' money "invested in bonds," and how much is it "invested in sentiment toward the bond market?"

QQ

 

[SAJ-99]

I had a long post trying to explain and lost it, but it sounds like you get the basics. A single bond can change in price over time, but if you hold to maturity and it doesn't default, you won't lose money. It is a contractual obligation. A fund will hold hundreds of bonds of various types and maturities, so the daily pricing can drown out any single bond. A bond has a definite term, while a bond fund generally is expected to go on forever.

One types of exception is in the link below. These are bond funds that have targeted end dates. They still change in price during their life term with whatever interest rates do, but the prices impacts are more muted.

Build better bond ladders with iBonds® | iShares - BlackRock

iBonds ETFs are designed to mature like a bond, trade like a stock, and diversify like a fund. Start building better bond ladders with iShares® iBonds® ETFs.

www.ishares.com

 

[npaden]

One way to explain it would be that if you bought a 10 year treasury bond 3 years ago the interest rate would have been around 1%. If you hold that bond you would end up earning around $1,000 over the 10 years to maturity. If you bought a 10 year bond today the interest rate would be around 4% and you would end up earning around $4,000 over the 10 years to maturity on that bond.

Let's say you decided you weren't happy with the 1% return on the bond you bought 3 years ago and wanted to sell it. You would need to sell it at a discount to get someone to buy it. In our simple scenario you are earning about $100 per year on it. You would be earning $400 per year at the current market rate. You would need to discount it by $300 per year times 7 years remaining to get someone to buy it. So I would give you $7,900 for the $10,000 bond earning 1% interest so that I could earn and effective yield of 4% for the remaining life of the bond.

The other thing you might get into with individual bonds would be default or credit rating issues if a company is having financial difficulties you would possibly have to discount the bond due to that.

With the bond fund they are trading bonds daily and your overall exposure to one company is much less. Some bond funds are short term, some longer term so the interest rate risk is higher on the long term funds.

Even more confusing is that right now we are in an inverse yield curve where some short term bonds are earning a higher interest rate than long term bonds.

I think I started out thinking my explanation was going to help but not sure anymore. LOL.

 

[SD_Prairie_Goat]

My two cents. If they don't need the money for a while, say college fund to be used in fifteen years, stock based ETF's traditionally have higher yields but greater risk. Over a longer time frame they're usually better for gains.


Bonds are much safer but gains between 4% and 8% are massive over fifteen years

 

[RobG]

I think what npaden was trying to say is that the price of long-term bonds is much more dependent on interest rates (driven by investor sentiment) than short-term bonds. .

Generally, the reward of a long term bond fund isn’t worth the risk.

Quality corporate bonds have a higher risk/reward than government bonds. Maybe that’s what you’re looking for. Vanguard VCSH etf is a good short term one.

 

[LopeHunter]

Match your risk horizon to when you need the cash from the sale of that investment.

If don't need the investment to be converted into cash for 7 or more years then can invest today in a stock ETF which is a big bucket of stocks mimicking the whole stock market (VTI, for example has low cost to acquire and low annual cost to have the ETF managed). Or, put part of the money in the stock ETF and part in a bond ETF (BND, for example).

If instead you are wanting to use the funds in less than a couple of years (such as for a down payment on a home or to pay for college for you or your family) then you should only be holding cash or an equivalent very-low risk investment such as a CD where is just about impossible to lose any of the nest egg's value the next few months. Anything riskier than holding cash for such a pending outlay is no different than gambling in Vegas since you could lose easily if you hold stock when the stock market pulls back temporarily just when you need to sell or the bond market drops or the real estate market drops or the commodity market drops, yada yada. Just don't do something out of ignorance or exuberance. You and I are not as lucky as we think at high risk games and the big casinos in Vegas are a testament to the disconnect between how lucky we think we are vs reality.

If you want to get educated for exactly $0 then spend a couple of hours once or twice a week over at Bogelheads.org website this summer which is a website forum which promotes a simple approach to long-term investing. You simply select 3 or 5 ETFs from a list of 3-7 choices to invest money you do not need for 7 years or longer longer. This approach is not flashy but is like the tortoise rather than the hare in the children's fable. Leave your gambling for when go to Vegas and don't put your nest egg at risk. For every YouTube teenage millionaire there are many that lost it all as is very risky to make big bets that have crappy odds. Keep your feet on the ground.

You should do well with just 3 to 5 ETFs no matter if are just starting to build your nest egg or if you instead have a lot of money on hand. Same strategy applies and barely adjusts year over year as you age. Same discipline is used month and month, year after year. The more you can find ways to set aside money now to invest the easier life will be down the road. You make the money, invest with a small number of ETFs and no need to be an investment guru or MBA.