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Myth Busters: Bond Market Edition

In a rising rate environment, is it safer to hold individual bonds or bond ETFs?

Michael Rawson, CFA 18 July, 2013 | 10:19
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Market pundits have been expecting interest rates to rise for the last several years. When rates rise, many investors seem to think that bond ETFs are worse than individual bonds. The thinking goes that since you can hold an individual bond until maturity, you're insulated from the effects of rising interest rates and can avoid taking any losses. A typical bond ETF doesn't hold bonds until maturity, forcing it to take losses after interest rates rise.

Inverse Relationship: When Rates Rise, Bond Prices Fall
Let's walk through the math of bond pricing. The present value of a payment to be received in the future equals the value of the payment divided by one plus the interest rate compounded over the appropriate number of periods. This process is called discounting. Since the interest rate is in the denominator, bond prices have an inverse relationship to interest rates. Bond prices are equal to the present value of future coupon payments plus the present value of the paramount or face value paid at maturity.

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About Author

Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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