For many investors, investing in the right bond funds can be a better option than holding a portfolio of individual bonds. Bond ETFs can provide better diversification — often for a lower cost — can offer higher liquidity, and can be easier to implement. However, there is a common misconception, especially during periods of rising interest rates, that individual bonds should outperform an otherwise similar bond ETF.

Bond ETFs vs. individual bond portfolios

 This makes sense because a bond fund is simply a portfolio of individual bonds. Assuming cash flows are reinvested, the two operate in the same way. This also holds true for bond-laddering strategies, which are bond portfolios built by staggering maturities of individual bonds and reinvesting the cash flows.

When comparing a bond fund to a bond ladder, the bond ladder must be actively managed to maintain the same risk characteristics as the bond fund over the time horizon for an accurate comparison. The simulated bond portfolio in Figure 1 creates an apples-to-apples comparison by matching duration and credit risk.

Maturity myth

There is a common misconception that if rates are rising, bond funds are forced to sell at a loss whereas an investor can instead hold an individual bond to maturity, therefore potentially avoiding losses.

In reality, regardless of whether the bond is sold for a loss with the proceeds reinvested or held to maturity, the investor is in the same position (ignoring trade costs). You can either take the loss on the principal now in exchange for higher income from reinvesting or hold until the par value recovers but receive less income. This is because the price for all bonds adjusts to current prevailing interest rates. It may feel better not to realize a loss and recoup the principal at maturity, but this is purely emotional.

This bias may further be exacerbated when bond values are not accurately reported on investor statements at their true marked-to-market value and instead are displayed at par.

Hypothetically speaking, in an environment where interest rates continued rising indefinitely year after year, an individual bond portfolio where cash flows are not being reinvested should fare better than a similar constant-maturity ETF. However, if one knew the direction of interest rates with certainty, they would either not buy bonds at all or assume an extreme-duration profile, depending on the outlook. ETFs provide a great way to manage a stable duration in a world where interest rates are volatile and tend to move in both directions.

Bonds and interest rates have an inverse relationship

Understanding the mechanics behind bonds should help this concept intuitively make more sense. Bond prices and interest rates have an inverse relationship with each other. Bonds are typically issued at par. The price of a bond fluctuates during the holding period but will eventually converge back to its par value at maturity (assuming no default risk). The coupon rate determines the income payment as a percentage of par, and it remains fixed throughout the term. Yield to maturity (YTM) is the expected return on a bond if held to maturity.

When interest rates change, bond prices adjust to keep the YTM of bonds with matching credit risk and maturity the same. Therefore, if rates rise, older bonds with lower coupon rates drop in price to compete with similar newly issued bonds with higher coupon rates, so both should offer the same expected return over the remaining period.

Duration is an important risk measure used to compare bonds and bond portfolios. Duration indicates the time it will take in years to recoup the original investment from the bond’s cash flows. It measures a bond’s (or bond portfolio’s) sensitivity to changes in interest rates. As a rule of thumb, for a 1% change in interest rates, the price of the bond will move in the opposite direction by approximately the magnitude of its duration (assuming a parallel shift in the yield curve).

Bond-market pricing example

The duration of bond A can be calculated and comes out to ~3.6, which is consistent with its price drop. A similar newly issued bond B priced at par with the same maturity and credit risk will have a coupon rate of 5% with similar duration and yield to maturity (YTM) as bond A.

Whether you sell bond A and reinvest the proceeds into bond B or hold bond B, both bonds have the same YTM and therefore offer the same expected future return if held to maturity. You still receive the same coupon payment on your lower-coupon bond, but there is also a price-appreciation component as the price converges back to par as it approaches maturity. Bond A’s total return over the four-year period will be around 5%, with ~1% coming from price appreciation and ~4% from coupon income, with bond B’s ~5% return over the same period coming from the income component. The future return of a bond will be close to its starting-period yield. Figure 3 further illustrates that an investor is no better off holding onto bond A vs. selling bond A and reinvesting the proceeds in bond B. Eventually the two converge, but the components of return for each bond differ.

*These are hypothetical depictions of bonds, not actual bond returns. The numbers used are rough estimates meant to depict a simplified example of the inverse relationship between bond prices and interest rates.

**These are hypothetical depictions, not actual bond returns. The numbers used are rough estimates for simplification purposes. Figure 3 shows the estimated initial drop in the price of bond A, assuming a 1% rise in interest rates. The comparison period starts after year one and shows the price of the bonds and the accumulation of price appreciation and coupon payments annually over the remaining period.

Summary comparing bond funds vs bond ETFs