You will be able to explain why a bond fund can lose value over your holding period even if no bond defaults.
Arjun put S$15,000 into a bond fund a while ago, because he wanted something safer than his stock ETF. Then yields rose, and the fund fell about 6%. He checked: none of the bonds it held had defaulted. He also knew from module 2 that a single bond recovers to face value at maturity. So he asked the obvious question. When does my fund get back to where it was? The honest answer is that it has no date to get back to.
A single bond has a maturity date. A bond fund, including a bond ETF, holds many bonds, and it does not let them simply run off. As bonds approach maturity or mature, the manager sells them or receives the repayment and buys new, longer bonds to keep the fund in line with its mandate or the index it tracks.
The result is that the fund's average maturity, and so its duration, stays roughly the same year after year. A fund that targets a duration of about 6 today will still have a duration of about 6 in five years. It never becomes a short-term holding.
That is a deliberate design, and useful for many purposes. But it changes the way interest rate risk behaves.
With a single bond, rising yields push the price down, and then the approach of maturity drags it back up, as lesson 2.1, Price and yield move in opposite directions, showed. Hold to the end and you get 100.
A fund has no end. Because it keeps replacing bonds that would have recovered with new ones, there is no date when its price is guaranteed to return to what you paid. If yields rise and stay high, the fund's price can stay lower for a long time.
This is why lesson 2.3, Duration: how far a price moves when rates move, put it as a timing risk. A fund with a duration of 6 behaves, for price purposes, much like a single six-year bond that is always six years from maturity. If you need the money on a set date and yields have risen just before it, nothing in the fund's structure brings the price back in time.
There is a second half to the story, and it is good news. When yields rise, the fund's price falls at once. But from then on, the manager is buying new bonds at the higher yields, and the fund's income rises.
Here is a made-up example. A fund has a duration of 6 and a yield of 3%. Yields rise by one percentage point, to 4%. Using duration, the price falls by about 6%. S$10,000 becomes about S$9,400.
Compare two paths, assuming for simplicity that the fund earns its yield each year and that yields then stay where they are. If yields had stayed at 3%, the S$10,000 would grow by about 3% a year. After the rise, the S$9,400 grows by about 4% a year instead. After one year, the second path is still well behind: about S$9,776 against S$10,300. After three years it is about S$10,574 against S$10,927. After about six and a half years, the two paths meet. After that, the higher yield puts the second path ahead.
The breakeven point, about 6.4 years in this example, is close to the fund's duration. That is not a coincidence. It is a rough rule worth remembering: over a holding period near the fund's duration, the price fall from a rise in yields and the extra income from the higher yields tend to offset each other. Hold for much less than the duration and the price fall dominates. Hold for much longer and the higher income wins.
The rule is approximate. It assumes one rise and then no further change, and real funds face defaults, fees and changing yields along the way. But it gives you a sensible sense of scale.
For long-term money, a rate rise in a bond fund is painful in the short run and helpful over a long holding, because you end up earning a higher yield. A holding period well beyond the fund's duration gives that offset time to work.
For money with a date, the picture is different. If you need it 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, SSB or fixed deposit that matures before your date does not. Lesson 7.3, When owning the bond beats owning the fund, picks this up.
Arjun's fund had a duration of about 6. He did not need the money for at least a decade, so 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.
Find the duration and yield of one bond fund or ETF and write how long you would need to hold it to ride out a one point rate rise.
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