What it means
The fund's price is its net asset value per unit, calculated by taking the market value of every bond it holds, subtracting any liabilities, and dividing by the number of units in issue. This is usually recalculated daily, so investors always know what their holding is worth.
For a business or an individual investor, the appeal is diversification and convenience. Buying 200 corporate bonds directly would take a large portfolio and considerable administration, whereas a single fund purchase delivers exposure to all of them plus professional credit analysis.
The key risk measure is duration, which expresses how sensitive the fund is to interest rate movements. A fund with a duration of six years will lose roughly 6% of its value if market yields rise by one percentage point, and gain roughly the same if yields fall.
Bond funds are grouped by what they hold: government funds, investment grade corporate funds, high yield funds holding riskier issuers, and short duration funds designed to limit rate sensitivity. Each combination of credit quality and duration produces a different balance of income and price volatility.
The most misunderstood feature is that a bond fund has no maturity date. Hold an individual bond to maturity and you get your money back at par whatever happened to prices in between; hold a fund and you get whatever the units are worth on the day you sell.
In practice
Real-world examples.
Example
A charity with $3,000,000 of reserves moves from a single five-year corporate bond to a diversified investment grade bond fund. The trustees accept a slightly lower yield in exchange for daily access to the money and exposure to hundreds of issuers rather than one.
Example
A finance director parks surplus cash in a short duration bond fund with a duration of 1.5 years rather than a long dated fund. When yields jump by a full percentage point, her holding falls about 1.5% instead of the 7% a long duration fund would have suffered.
Example
A first-time investor is surprised when his bond fund loses value in a year when no issuer in it defaulted. His adviser explains that rising market yields cut the market price of existing bonds, which flows straight through to the fund's daily unit price.
Think of it
“Bond fund pools money to buy many bonds-fixed income diversification.
Formula
Calculation
Net asset value per unit = (market value of holdings - liabilities) / units in issue
Approximate price change = -duration x change in yield
A corporate bond fund holds a portfolio worth $250,000,000, owes $2,000,000 in accrued fees and pending settlements, and has 24,800,000 units in issue. Its net asset value per unit is ($250,000,000 - $2,000,000) / 24,800,000 = $248,000,000 / 24,800,000 = $10.00.
The fund reports a duration of 6.0 years and a running yield of 4%. If market yields rise by one percentage point, the price effect is approximately -6.0 x 1% = -6%, taking the unit price to $10.00 x 0.94 = $9.40. Adding the 4% of income earned across the year gives a total return of -6% + 4% = -2%, so the investor is down 2% despite the fund collecting every coupon it was owed.Case study
Seen in the real world.
The following is an illustrative and fictional story. Calderbrook Foundation, an invented endowment, held $20,000,000 in a long dated government bond fund because its previous treasurer regarded government debt as the safest option available.
When market yields rose by roughly two percentage points over eighteen months, the fictional fund's duration of eight years drove the holding down by about 16%, a paper loss of roughly $3,200,000, even though every bond in the portfolio was certain to be repaid in full. Trustees who had been told they owned a low risk asset were understandably alarmed.
The foundation's imagined investment committee restructured into a mix of a short duration fund for money needed within three years and a longer dated fund for the rest. Nothing about the credit quality changed, but matching duration to the actual spending horizon meant future rate moves affected only the portion of the portfolio that could afford to wait.
Watch out
Common mistakes.
- Assuming a bond fund is a cash substitute and cannot lose money over a twelve-month period.
- Choosing a fund on its headline yield alone while ignoring the duration that determines how far the price can fall.
- Believing the fund will return to par like an individual bond, when it has no maturity date to return to.
Questions
People also ask.
How does a bond fund differ from owning bonds directly?
The fund never matures and is priced daily, whereas a single bond repays face value on a known date if the issuer survives.
Why did my bond fund fall when no borrower defaulted?
Because market yields rose, which lowers the price of every existing bond in the portfolio.
Is a high yield bond fund just a higher paying version of a government fund?
No, it holds weaker issuers, so it carries genuine default risk alongside its higher income.
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