Bond Funds Are a Bad Investment

If you buy, say, $1,000 of a 10 year 4% bond at par (face value) - that is, pay $1,000 for it - you will collect $40.00 in interest annually for the next 10 years and get your $1,000 principal back at maturity.

The bond price will fluctuate (trade for more or less than the face value) depending on:

Interest rates
Bonds move in the opposite direction of interest rates: interest rates up>>> bond prices down, and vice versa, because interest, declared as a percentage of principal when the bond is issued, is fixed in dollars, $40.00 in our example. If interest rates go up and new investors can get, say, 5% elsewhere, the price of your bond, if you were to sell, will be reduced to yield 5%: $800.00 ($40.00 ÷ $800.00 = 5%). If interest rates drop to 3%, your bond will be worth $1,333.00 ($40.00 ÷ $1,333.00 = 3%) - again, if you were to sell. If you hold to maturity, you get the $1,000 back.

Credit rating
Issuers whose ability to repay is questionable pay a higher interest, like consumers. The issuer's condition can deteriorate after the bond is issued; even if interest rates remain the same, your bond price will be reduced to reflect lowered ratings. Again, it only matters if you trade; at maturity you get back the face value.

So if you hold a bond outright, you know exactly how much you will get every year in interest, when you will get your principal back, and how much.

The only time you may not get all your money back is if:

(a) you pay a premium for the bond (pay more than the face value); or

(b) if the issuer defaults and declares bankruptcy.

Now look at what happens if you buy a bond fund:

You have no assurance that you will ever get your money back because bond funds have no maturity date: they constantly buy and sell bonds for their portfolios.

1) Bond funds buy bonds when they get money from investors and sell them when investors want their money back. Retail investors are notorious for buying when they should be selling and vice versa. Panic selling will force your fund to sell bonds at a discount, causing a drop in the value of your holding. When bond prices are cheap, investors are too scared to buy, so bond funds do not have the money to buy at bargain prices. When the panic subsides and bond prices recover, investors rush in to get a "better" return on their "safe" money. It's a permanent buy high - sell low cycle.

2) As bonds in a fund's portfolio change, so will your monthly income. If interest rates drop, so will your income.