Investing Risks and Rewards - Why Do Bond Funds Go Down?

A conservative way to invest is always to make sure that a considerable portion of the portfolio is on bonds. Bonds are thought of as less risky and therefore could save your investments in cases when stocks take the plunge. It’s considered a safety net by some. But there may also come a time when bond investments take their own plunge.

I made an investment in a particular bond fund by the start of March 2012 but unfortunately the fund went south initially. I was right not to sell to a loss and was happy to see the investment value rise up again. Otherwise, I could have made a mistake and lost money in this investment. 

Bonds are Debt Instruments

When I think of bond funds I think of debt. Bonds are simply debts. Like all debts, bonds have interests paid for the benefit of using borrowed money. The only difference is that bonds have a more formal structure. 

The timing of payment of interests is clearly defined. The rate of the interest is also agreed upon. After the term of the debt has been completed for a specific period, all money borrowed is returned just as how a normal debt works.

When I invest in bond funds, I think of it as lending money. The more funds I invest, the more money I lend. The value of my investment includes the total amount I lent and all the interest payments I am assured to get. 

With this line of thought, it would seem illogical for a bond fund to lose its value. How could you lose from a debt arrangement? 

Devil in the Details

Actually, bond funds are a little more complex than this. This complexity adds to the risks and rewards of bonds. Note that bonds have considerably less risk as an investment but it is not without risk.

When you buy into a bond fund, your money becomes part of pooled amount used to acquire bonds issued by governments or companies. These bonds could be a number of different types with different interest rates and terms (tenors). So with a variety of bonds in a single pool, valuation of the bond fund can be a bit complex.

What usually happens is that these values are determined by the market. Each of the bonds in the bond fund will have a current market value. This market value, as you can imagine, is not constant. How come?

Market Forces at Work on Bonds

Bonds are actually sold in a secondary market. Meaning you can buy or sell a bond at the middle of its term. But the tricky part of this buying and selling of bonds before maturity is the price. As you may have imagined, the market interest rate is the main driving force behind how a bond price changes. 

Interest rate changes due to a number of factors. It goes down and it goes up. When it goes down, bonds bought when the interest rate was higher increases in value because people will be more willing to buy that bond for a fee rather than buy at current market interest rate. The reverse happens when interest rates go up. 

Whatever the case maybe, it's worth knowing that bond funds do have some associated risks. But overall, it offers less risk than stocks and ought to be considered in your investment portfolio.