sdvan wrote:I think there is a difference. With the bond fund, I don't have any control over the NAV drop. The NAV will go down and the most I can hope to do is to recover that loss with increased payments by holding for the duration of the fund after the interest rate increase. This is compounded if there are multiple interest rate increases.
The nature of the NAV drop is such that you can and will recover it for the duration of the fund. Basically, it drops because there are new bonds available with higher yields, and nobody is willing to buy the older bonds without a discount that reflects the yield difference. The fund is required to mark down the value of its assets accordingly. The same exact markdown affects your bonds, except you choose to ignore it because you plan to never sell. Well, if you never sell the fund
, you don't care about its NAV either, it's gonna keep yielding $X / month *or higher* whether interest rates stay the same or go up.
I'll repost my example from another thread, viewtopic.php?f=1&t=115577
ogd wrote: Here's a simplified scenario that I played with when I was making my own version of your decision: suppose today, three of our fellow citizens hold the following assets:
Citizen A, afraid of interest rates but desiring yield, holds muni bonds maturing in 5 years.
Citizen B, being lazy, holds VCADX, with roughly 5 years duration.
Citizen C, being even more afraid of rate increases, holds cash.
Now suppose interest rates rise tomorrow. Just once, decisively and brutally, by like 5%. It hurts like hell, but it's enough to satisfy citizen A's gut instinct that there are no more rate hikes coming. What happens to the three portfolios?
Citizen A has suffered no apparent loss, but will have to wait 5 years to take advantage of the higher rates.
Citizen B has suffered about 25% NAV loss, but his depreciated fund shares are yielding more (on the depreciated basis). The effects of the rate hike will be gone after about 5 years.
Citizen C has suffered no loss and he can buy new bonds and start making the higher yield immediately.
From this it's clear to me that citizen A, although he'd like to think he's in the same boat as citizen C, is actually in the same boat as citizen B. They both suffered a loss, realized or not, whereas citizen C hasn't. To put it another way, citizen A and citizen B's assets are still interchangeable after the rate event, e.g. citizen B can sell his fund at a loss and *buy* the same depreciated bonds that A holds, on the market. By contrast, A and C's portfolios are clearly not interchangeable, there's no way that A can go back to the same amount of cash *now*.
What if the rate event takes place 1 year into the maturity period, you ask? In that case, A indeed loses less than B, but the same as B's cousin, Bprime, who was holding a bond fund with duration four years. And you can push the date further, to the point where if the rate hike happens the day before bond maturity, citizen A's holdings are indeed the same as cash, i.e. no loss.
So what matters is what duration you were holding when the interest rates rose; you take a loss at that exact moment whether it's a bond or a bond fund. As you can see from the other thread, this comes up a lot, and the truth is not intuitive. In my case it took a while to convince myself that I really really didn't need to go through the pain of managing individual bonds. Which was a great relief!