With interest rates at historical lows right now, the question facing bond investors is whether to buy individual bonds or bond mutual funds. Since bonds will drop in price when interest rates rise, common wisdom suggests that if you purchase an individual bond and hold it to maturity, you are guaranteed to get the full principal back regardless of how rates may change in the future as long as there is no credit risk associated with the bond issuer. By contrast, if you instead invest in a bond fund, after rates increase the value of the bonds in the fund – and consequently the price of the fund – will drop, causing you to suffer an immediate loss, at least on paper. I’ve written in the recent past about bond ladders and about active bond fund management techniques all designed to mitigate the consequences of rising rates. This time I want to address why holding an individual bond to maturity actually does not eliminate interest rate risk, contrary to most people’s understanding. Allan S. Roth, a financial planner in Colorado Springs, provided the original explanation, which I will repeat (with suitable embellishment) here.

Suppose you decided to buy a one-year U.S. treasury note with a face value of $1,000 paying 4%* interest.  How did you and the seller (in this case the U.S. government) agree on the price of the bond? The current value of any bond is always equal to the present value of the future cash to be received from it, which includes all interest payments plus the return of principal. No one would sell a bond for less than that amount or they’d be losing money. And no buyer would pay more for the very same reason. In this example you would expect to collect $1,040 when the bond matures one year from now. To calculate the present value of that income you discount it by the current prevailing interest rate for that type of bond (4% in this hypothetical example). So the calculation is $1,040 (the total income) divided by 1.04 (1 plus the current interest rate) or $1,040 / 1.04 = $1,000, which is how you and the seller came up with $1,000 as a fair price for the transaction.

Now suppose that one day later an influential economist announces in the Wall Street Journal that she expects inflation to increase. Suddenly, investors demand a 5% yield on this type of bond rather than 4%. The value of your bond will immediately decline to $990.48 ($1,040/1.05), which is a drop of $9.52. But you’re not worried because you still expect to get the $1,040 back next year. True enough. Unfortunately, you will be receiving only $40 of interest, while the market now demands $50 (a 5% return) for this type of bond at the price you paid. That means next year you will receive $10 less than you would have gotten had you purchased the same bond today. The present value of that $10 shortfall is $10.00/1.05, which is exactly equal to the $9.52 decline in the current value of your bond. This is not a coincidence. The math always works out the same irrespective of the interest rate or the maturity of the bond. In other words, you may not have lost any principal value, but you will still be receiving less money than the current market would dictate. The risk is even higher when purchasing longer maturity bonds, since you would be locking in the lower rate for a longer period of time.

If alternatively you had purchased 100 shares of a U.S. treasury bond fund priced at $10 containing lots of similar bonds, after the inflation announcement the price would have immediately dropped to $9.90. But as the fund spends the principal from the older maturing bonds to purchase higher-yielding newer bonds, over time its valuation will climb back to $10 and even beyond.

Your return on individual bond investments may also be impacted by the cost of purchasing the bonds. You can purchase U.S. treasuries at face value, but the spreads and commissions on other types of bonds can be prohibitively expensive unless you have the ability to make very large purchases (i.e. in the hundreds of thousands of dollars or higher).

In summary, while purchasing individual bonds instead of bond funds will protect against any erosion of principal, your total return will still suffer if/when interest rates rise. Unfortunately, when it comes to investing, as in life, there are rarely any guarantees.
*Note that this is hypothetical. Interest rates today for U.S. treasuries are actually much lower than 4%, but using the higher number makes the logic easier to understand.