The Illusion of Not Losing Money by Holding a Bond to Maturity
- Not losing money by holding a bond until maturity is an illusion.
- The economic impact of market rate changes still impacts investors holding bonds until maturity.
- A bond index fund provides an investor with greater diversification and less risk.
Can bonds lose money?
This is a question we often get from investors who are seeking a safer alternative to stocks.
It’s not uncommon for people to think that if one simply buys and holds a bond to maturity, they will not lose money. This statement is most often given as the reason why they would prefer to hold individual bonds as opposed to a more diversified bond index mutual fund or exchange-traded fund (ETF). To navigate the nuances of bonds, investors need to understand concepts such as bond yield to maturity, diversification, and market rates.
Here, we explain why holding a bond to maturity doesn’t mean that you won’t lose money on it, along with helping you understand the difference between buying individual bonds versus bond index funds or bond mutual funds so you can make informed decisions with your portfolio.
What is a bond index fund?
Bond index funds have a daily price (like stocks) that fluctuates up and down daily and can sometimes show a loss; whereas an individual bond will pay its stated yield until maturity and then return your principal.
Bonds 101 & the Economics of Holding an Individual Bond to Maturity
What is a bond in the first place?
A bond is a debt security that’s issued by an entity like a corporation or a government. You, as the investor, lend the entity money in exchange for regular interest payments, with the principal typically being paid back to you at maturity. Bonds are often issued in $1,000 increments.
What is a bond’s yield to maturity?
A bond yield to maturity (YTM) is the annualized return an investor can expect to earn if a bond is held until maturity, based on the bond's current market price, future interest payments, and principal repayment.
An Example of Holding a Bond to Maturity
Let’s take the case of a single $1,000 bond you want to buy and hold to maturity. Let’s say this bond has a 4% coupon (i.e., yield or coupon rate) that is commensurate with current market rates (i.e., the rates available to investors at the time). This $1,000 bond will pay you $40 of interest per year until it matures and returns your principal of $1,000.
Since the bond’s coupon rate (4%) is equal to the market interest rate and you're buying it at par value (its face value of $1,000), the YTM is the same as the coupon rate, which is 4%. This is the return you'll earn by holding the bond to maturity, assuming no changes in market conditions.
That last part is the important piece that we need to discuss here. If market conditions change, that changes the economic impact of holding your bond.
Can Bonds Lose Money? The Illusion of Not Losing (or Making) Money
As time passes after purchasing your $1,000 4% bond, economics continue to change and play out. As this happens, the interest rates available to investors change.
Sometimes, market rates go up (meaning an investor could get a better yield on a bond similar to yours), and sometimes, they go down (meaning an investor would have to accept a lesser yield on a bond similar to yours). Since you are holding your bond to maturity, you don’t care.
You may not care if market rates go up or down, but that does not change the real economic impact of those changes.
If market interest rates rise to 5% while you're holding your bond, the bond's yield to maturity (YTM) would still remain 4%, assuming you hold the bond to maturity. However, since new bonds are now offering 5% (due to higher interest rates), how much would investors be willing to pay for your 4% bond if you were to sell it?
Your bond only pays $40 of interest per year, so the price of your $1,000 bond would have to drop to $800 so that your $40 of interest would be equivalent to the market’s new 5% yield ($40/800 = 5%).
As a result, if you try to sell the bond before maturity, its market price will fall because investors can now buy new bonds offering higher interest rates (5%). In this case, the price of your bond will drop below $1,000 to compensate for the lower interest payments compared to newer bonds.
How Do You Lose Money On Bonds That Are Held To Maturity?
Technically, you are not losing money if you hold the bond to maturity and get your $1,000 principal back. However, economically speaking, you are still receiving a below-market yield of 4% ($40) making the bond sub-optimal.
It’s important to acknowledge that there is psychological comfort in holding a bond to maturity. While this may be worth something from a mental framing standpoint, there is no economic benefit. It is akin to an ostrich sticking its head in the sand (the world is still out there).
Not losing (in the case of market rates rising) or not winning (in the case of market rates declining) is an illusion. If market rates increase, you will still lose by accepting and holding what ended up being a below-market yield. When market rates decrease, you will still win by accepting and holding what ended up being an above-market yield.
Why Not Choose a Bond Index Fund Instead?
As retirement planning specialists, we often see people turning to individual bonds to fund some of their retirement income as they seek to build an optimal investment portfolio for retirement.
However, many aren’t aware that they have another option - buying bond index funds.
As an investor, what is the difference between holding onto your $1,000 4% bond that pays you $40 or selling your $1,000 bond for $800 and buying an $800 5% bond that also pays you $40? You cannot escape the real economic loss.
So then, why should an investor take on the additional risk of buying a few individual bonds rather than a far more diversified bond index fund?
A bond index fund is just a portfolio of individual bonds, generally held to maturity. The difference is you don’t see the individual bonds that are held to maturity, but rather the “mark-to-market” price each day reflecting the aggregate value of all the bonds in the fund’s portfolio. Sure, the daily price change is in your face, but we know there is no economic difference.
The primary benefit of a bond index fund is diversification. Imagine a scenario where an investor’s portfolio comprises only a handful of bonds. If one issuer defaults or underperforms, the financial impact can be significant. In contrast, a bond index fund spreads investments across a wide range of securities, reducing the risk of individual bond failures.
For example, Vanguard’s Total Bond Market ETF (BND) has 11,314 bond holdings (and only a 0.03% expense ratio as of April 2024). BND’s SEC yield at the time of this writing in December 2024 was 4.477%. A fund’s SEC yield approximates the yearly after-expenses yield an investor would receive, assuming all the fund’s bonds are held to maturity and income is reinvested. A fund’s SEC yield would be comparable to an individual bond’s coupon (or yield).
When Holding a Bond to Maturity is a Valid Strategy
All of this said, there is a time when holding a bond or a CD to maturity is a valid strategy, whether you’re preparing for retirement or other financial planning goals. This strategy is best when you have a specific amount of funding you need at a specific time. Holding a bond to maturity can help ensure that you have the amount needed at the time needed.
As retirement planning specialists, we commonly use this strategy to build 18-month CD ladders for our clients to fund their monthly retirement distributions. It’s not so much the yield that’s important to us as is having the specific amount of money when needed.
The CD ladder is a tool to manage against a negative sequence of returns event first and an investment second. (See our Insight entitled "How we Actively Manage Sequence of Returns Risk for Clients" for more.)
If you want help transitioning out of your individual bonds or building an income ladder to meet your retirement spending needs, we are here to help. You can click here to schedule an informal, introductory Zoom call with a retirement planning specialist who will help you position your portfolio to best match your goals, needs, and objectives.