You have made the following argument on bond funds. 

​"In addition a bond fund has to manage duration, even in a falling market, which means bonds often cannot be held to maturity. This means investors in bond funds risk underperforming the bond market in a rising interest rate environment." 

That does not seem correct. If the fund rolls bonds in such an environment, it will take a capital loss but receive higher interest on the remaining capital. I have seen research that suggests that these effects cancel each other out.

Eoin Treacy's view

Thank you for raising this point which allows me to elaborate on yesterday’s piece focusing on bond risk. Yes, of course there is an argument that if prices go down, yield goes up and over the course of a reasonably lengthy maturity the investor will be compensated for the additional risk that has been taken on. However for this to be true in all cases would be to subscribe to the belief that one cannot lose money by investing in bonds. We have plenty of evidence that this is not the case so there must be additional factors affecting value. 

You can really only reach a goal of being fully compensated with a higher yield by assuming that inflation, default and credit risk remain constant. However they don’t and in fact we are now in a period of time where inflation has been virtually absent and default rates have been at historically low levels because interest rates are close to zero and credit freely available. 

Covenant-lite issuance is at an all-time high, that’s higher than 2007 despite the fact everyone swore they would never do it again. There is no logical leap to forecast an uptick in the default rate as interest rates rise. Even if spreads stay the same, refinance costs will rise. However it is unlikely spreads will remain as tight as they are if default rates pick up. 

Inflation is not currently a problem because commodity prices have been trending lower and expectations for global growth have been morose. However eventually commodities will stop going down and the net effects of lower food, energy and raw material prices in tandem with weaker currencies will kick start growth in the emerging markets and elsewhere. At that point inflation measures will begin to pick back up and bond risk will have to be repriced. 

As this unfolds a yield to maturity investor can wait out volatility in the reasonable hope of receiving their principal back when all the coupons have been paid. However a bond fund often does not have this luxury because it has to deal with redemptions. In the good times there is a constant flow of new money coming in so they are always buying new bonds and it is easy to manage the duration of the portfolio. However in a market where investors are pickier finding bonds that price in all of the above factors is hard to find. As a result it is much more difficult for managers to outperform and passive strategies such as ETFs are not equipped to handle this risk. 

One of the reasons the US Oil Trust underperformed the oil price was because it had no mechanism for managing contango costs. Bond ETFs run the risk or underperforming in the same manner because they have no mechanism for handling an uptick in interest rate and default risk. It is worth mentioning that stocks are often a much better hedge against inflation than bonds, because dividends tend to rise over time. 

The above considerations are medium-term in nature and there is no doubt that high yield bonds have already experienced a deep pullback so there is potential for a reversionary rally given the jump yields have experienced. However this is probably more of a trader’s opportunity than a long-term investor’s play.