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However, the value of fixed-income investments can depreciate.
With this being said, there are many questions unanswered – are bond funds actually safe? How can investors lose money with bond funds? How can investors minimize their losses?
In order to clearly understand how bond funds work it is important for you to know how individual bond securities work. The reason behind this being that mutual funds are just pooled investments of individual bonds.
However, individual bonds and bond mutual funds do not work the same way, especially in the case of performance and pricing. But if you start to understand the basics of bonds, you can get a clear grip on the basic idea of bond mutual funds along with the similarities and differences between the two.
Bonds are considered to be fixed-income securities because the yield generated is fixed till maturity. But in case you plan to sell your bond before maturity, the alleged safety of bonds can be tricky.
It is important to know that investments never actually lose or gain money until the time comes to sell them. Upon which they either appreciate or depreciate in value on the basis of the price or NAV (Net Asset Value).
For instance, if your house decreases in value in the market you do not lose any money unless you decide to sell your house at a lower price. Similarly, if a bond you are holding decreases in value and you decide to sell it at the lower price, you will have to accept the loss.
Basically, you do not have a loss or a gain on any investment unless you decide to sell it.
Bond prices are inversely related to interest rates. The reason behind this is that lower the interest rates on old bonds the higher is the degree of flexibility of prices. For instance, today’s bonds are paying a higher interest as compared to yesterday’s, which means you would want to buy the bonds that are offering higher interest rates so that you can receive higher returns. However, if the issuer offers you a discounted price for the bonds that are paying a lower rate, you might consider buying them.
This implies that when the interest rates are rising, the prices of older bonds will fall. This reason behind this being the investors’ demand for a discount on the old bonds that are paying lower interest. This is why bond prices and interest rates move in opposite directions and this is what makes bond fund prices sensitive to interest rates.
However, bond mutual funds work in a different manner as compared to individual bonds because mutual funds contain a wide array of holdings and the portfolio managers and constantly purchasing and selling the bonds in the fund.
As said before, bond funds hold a Net Asset Value or NAV of the underlying bonds rather than having a ‘price’. A change in the price of the bond causes a change in the Net Asset Value of the fund.
In a scenario where the interest rates are rising, bond prices are usually falling. The reason behind this, as mentioned before, is that investors are not willing to purchase bonds that are paying a lower interest rate unless they are offered a good discount deal.
Also, the longer the maturity, the stronger the swing in price in relation to interest rate movements. In a period of declining prices and increasing interest rates, the long-term bonds decline in value more than the intermediate or short term bonds.
This may cause some fund managers or investors to shift their fixed-income investments or bond fund investments to investments with shorter maturities when the market is expected to face a rise in the interest rates. Similarly, when the market faces a decline in the interest rates, the investors or fund managers may consider investments with longer maturities a better bet.
To further conclude, bond mutual funds can face a decline in their value, if the fund manager decides to sell a significant number of bonds in an environment with rising interest rates. This is because the investors in the market will demand a discounted price on the older bonds that are paying lower interest rates. These falling prices will also adversely affect the Net Asset Value.
Bond mutual funds are usually less risky when compared to mutual funds. However, investors are wise enough to understand the fact that the value of a bond tends to fluctuate. The ideal option for investors is to find the bond mutual funds that are suitable as per their needs and requirements, invest in them and hold them for the long term, and try their best to avoid any fluctuations.