Explain why a bond fund can lose value over the time you hold it, even when none of its bonds default.
When yields rise, a bond fund's price falls. Many people expect it to come back the way a single bond does as it nears maturity. Most bond funds have no maturity, so nothing guarantees their price returns by any date. If you need the money by a certain date, this decides whether a fund suits you.
A single bond has a maturity date. Held to maturity, it pays back face value, which is 100. A typical bond fund, including most bond ETFs, holds many bonds and doesn't let them simply run off. As bonds approach maturity or mature, the manager sells them or receives the repayment, then buys new, longer bonds to keep the fund in line with its mandate or the index it tracks. This is called rolling forward. It keeps the fund's average maturity, and so its duration, roughly the same year after year. A fund with a duration of about 6 today will still have a duration of about 6 in five years, and it never becomes a short-term holding. The exception is a defined-maturity, or target-term, bond ETF. It holds its bonds until they mature and then winds up on a set date, paying out its net assets to shareholders, as its prospectus describes. The rolling design is deliberate and useful for many purposes, but it changes how interest rate risk behaves.
Lesson 2.1, "Price and yield move in opposite directions", showed that rising yields push a single bond's price down and the approach of maturity pulls it back up to 100. An ordinary fund keeps replacing bonds that would have recovered with new ones, so there is no date when its price is guaranteed to return to what you paid. If yields rise and stay high, its price can stay lower for a long time. For price purposes, a fund with a duration of 6 behaves much like a single six-year bond that is always six years from maturity. Lesson 2.3, "Duration: how far a price moves when rates move", framed interest rate risk as a timing risk. If you need the money on a set date and yields rose just before it, nothing in the fund's structure brings the price back in time.
Arjun ran into this. A while ago he put S$15,000 (an example figure) into a bond fund because he wanted something safer than his stock ETF. Yields rose and the fund fell about 6%. He checked and found that none of the fund's bonds had defaulted. He knew from module 2 that a single bond recovers to face value at maturity, so he asked when his fund would get back to where it was. His fund has no date to get back to.
When yields rise, the fund's price falls at once. From then on, the manager buys new bonds at the higher yields, so the fund's income rises.
Take a made-up fund with a duration of 6 and a yield of 3%, and say yields rise by one percentage point, from 3% to 4%. Estimate the price fall as duration times the rise: 6 x 1 point is about 6%, so S$10,000 becomes about S$9,400. Assume the fund earns its yield each year and yields then stay where they are, and grow each path at its own yield. On Path A, yields stay at 3% and S$10,000 grows about 3% a year. On Path B, S$9,400 grows about 4% a year.
After 1 year, Path B is about S$9,776 and Path A about S$10,300, so Path B is still well behind. After 3 years, Path B is about S$10,574 and Path A about S$10,927. The paths meet after about six and a half years (about 6.4 years worked out more exactly), and after that Path B is ahead.
The year the paths meet is the breakeven point, the holding period after which the extra income from higher yields makes up for the price fall. At about 6.4 years it lands close to the fund's duration of 6, which is not a coincidence. As a rough rule, over a holding period near the fund's duration, the price fall and the extra income tend to offset each other. If you hold for much less than the duration, the price fall dominates. If you hold for much longer, the higher income wins.
The rule is approximate. It assumes one rise in yields and then no further change, while real funds face defaults, fees and changing yields along the way. Use it only for a sensible sense of scale.
For long-term money, a rate rise in a bond fund hurts in the short run and helps over a long holding, because you end up earning a higher yield. For money needed by a set date, say in two years, a fund with a duration of 6 exposes you to a fall you may not have time to recover from. A single bond, T-bill or fixed deposit that matures before your date, held until it matures, does not carry that risk. A T-bill pays back face value only at maturity and cannot be redeemed early, so if you sell one on the market before it matures after yields have risen, you can get back less than you paid. An SSB can be redeemed at face value in any month with no capital loss. Check MAS for the current rules on each. Lesson 7.3, "When owning the bond beats owning the fund", covers when to choose one of these for money with a date.
To decide, find the fund's duration on its factsheet and compare it with when you need the money. If your holding period is well beyond the duration, the offset has time to work. If you need the money before then, consider a single bond, T-bill, SSB or fixed deposit that matures before your date.
Arjun's fund had a duration of about 6, and he did not need the money for at least a decade. He decided to stop checking the price weekly.
Find the duration and yield on one fund's factsheet, and work out roughly how long you would need to hold it to ride out a one point rise.
Look up the duration and yield of one bond fund or ETF. Write down how long you would need to hold it to recover from a one point rise in rates.
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