Why Bond Funds Are More Dangerous Than You Think

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Rising interest rates have plagued the bond market for months, and bond-fund investors have discovered the hard way that their investments are more vulnerable than they believed. But the worst for bond-fund investors might be yet to come, even though many of them aren't even aware of the danger.

In the following video, Dan Caplinger, The Motley Fool's director of investment planning, talks about the hidden danger in bond funds that many investors don't know about. Dan notes that when interest rates rise, bond prices fall, and the longer the maturity on the bond, the bigger the price decline. That's why iShares Barclays 20+ Year Treasury (NASDAQ: TLT  ) and iShares Barclays TIPS Bond (NYSEMKT: TIP  ) have suffered such extensive losses in recent months, as they tend to own longer-dated bonds. By contrast, as Dan observes, more balanced exposure from Vanguard Total Bond (NYSEMKT: BND  ) and PIMCO Total Return (NYSEMKT: BOND  ) have limited their declines somewhat.

Dan observes that the big problem with bond funds is that they buy and sell their portfolio holdings regularly, rather than holding bonds to maturity. With individual bonds, you can hold the bond to maturity and generally get the full par value of the bond back, essentially letting you ride out interest rate fluctuations. Bond fund investors, on the other hand, might never make back their losses, showing the true danger in choosing bond funds over individual bonds.

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