Myth Busters: Bond Market Edition

In a rising rate environment, is it safer to hold individual bonds or bond funds?

Michael Rawson, CFA 1 July, 2013 | 9:00AM

Market pundits have been expecting interest rates to rise for the last several years. When rates rise, many investors seem to think that bond funds are worse than individual bonds. The thinking goes that since you can hold an individual bond until maturity, you're insulated from the effects of rising interest rates and can avoid taking any losses. A typical bond fund doesn't hold bonds until maturity, forcing it to take losses after interest rates rise.

Inverse Relationship: When Rates Rise, Bond Prices Fall

Let's walk through the maths of bond pricing. The present value of a payment to be received in the future equals the value of the payment divided by one plus the interest rate compounded over the appropriate number of periods. This process is called discounting. Since the interest rate is in the denominator, bond prices have an inverse relationship to interest rates. Bond prices are equal to the present value of future coupon payments plus the present value of the par amount or face value paid at maturity.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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