Let’s start out with a basic question— how do most people get exposure to bonds? The answer is that they buy fixed income mutual funds.

Why do People Buy Fixed Income Mutual Funds?

It is operationally difficult to buy individual bonds. You need to do your own research and know what you want to buy. In addition, because of their yield, maturity and coupon (annual interest rate) features– people view them as less fun and more complicated to select than stocks.

As such, for the safe/low risk part of their allocation, many people opt to use Fixed Income (aka Bond) mutual funds.

Is this Bad?

In some environments, it can be.

In What Environments are Bond Funds Bad?

During times where interest rates and inflation expectations are rising—bond funds tend to lose value.

Why is This A Feature only of Bond Funds?

Think about it this way. When you buy a bond, you lock in a certain coupon (annual interest rate) payment. And you earn that coupon every year—unless the bond defaults. But during the life of the bond (the time from when you buy it until maturity), a bond’s price may fluctuate.

Bond prices will fall as interest rates rise. Bond prices will rise as interest rates fall.

OK, But What If I Just Hold to Maturity?

That’s just the problem with bond funds. You give up your right to make decisions like that. Since you are in a pool with many others—if they chose to sell their portion before maturity, and if bond prices are down when they sell, you will effectively realize a portion of that downward price movement.

So Even If I don’t Sell and A Bond Doesn’t Default, I Could Still Lose Money?

Unfortunately. Yes.

And this is not what you want because people invest in bonds to preserve their wealth.

What’s the Short Summary?

In a rising interest rate environment, Fixed Income mutual funds could be poised to lose real money. It’s something to think twice about before investing your safe assets.

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