Chapter 7: Bond funds vs individual bonds
In 2022 the Bloomberg US Aggregate Bond Index, the broadest standard yardstick for the US bond market, returned −13.0%. That was its worst year in records going back to 1976. Funds holding longer-term bonds did far worse: the iShares 20+ Year Treasury ETF returned about −31% the same year, per its own fact sheet.
Elaine, 63, a retired teacher with a $700,000 rollover, owned a plain aggregate bond index fund. It was the slice of her portfolio she never checked, because it was the safe slice. In October 2022 she checked. She got as far as the order screen, with "sell all shares" selected, before closing the app, more from exhaustion than conviction. This chapter is the explanation nobody gave her beforehand, and the reason closing that app turned out to be her best investing decision of the year.
A bond has an end date. A bond fund does not.
A bond is a loan you make to a government or a company. The deal is fixed on day one: you hand over, say, $1,000, you collect interest payments called coupons on a set schedule, and on a stated date, the maturity date, the $1,000 comes back. One loan, one finish line.
A bond fund holds hundreds or thousands of those loans at once and runs them like a conveyor belt. Bonds nearing the end of their life roll off the belt as they mature, and the cash they return buys new bonds at whatever interest rates are on offer that week. The belt never stops and never empties. Keep that picture, because it carries the whole chapter: every individual bond on the belt has a finish line, but the belt itself has none. A bond fund has no maturity date.
That one missing date explains what happened to Elaine's statement.
Why did "safe" bond funds fall 13% in 2022?
Because interest rates rose sharply, and a bond fund reprices everything on the belt every single day.
When rates rise, newly issued bonds pay more than older ones. Suppose the fund holds an older bond paying 2% a year while a brand-new bond, identical in every other way, pays 4%. Nobody will pay full price for the old 2% bond while the 4% one sits on the shelf beside it, so the old bond's resale price gets marked down until its deal looks fair again. The fund's NAV, the per-share value of everything inside (Chapter 1), absorbs that markdown the same day, across every bond on the belt at once. No borrower vanished and no loan defaulted in that calculation; the belt's cargo was repriced for a higher-rate world, all at once, in plain view.
How big the markdown gets depends on one number, and the number takes one sentence. Duration is the sensitivity dial: a fund with a duration of 6 falls roughly 6% in price when interest rates rise 1 point, and gains roughly 6% when rates fall 1 point. That is the whole definition. Everything else is illustration, and 2022 supplied the illustration at scale. Long-term bonds lock their rate in for decades, so they carry high duration and swing hard; short-term bonds reprice soon anyway, so they carry low duration and barely flinch. The receipts line up with the dial exactly as the sentence predicts: the aggregate index, an intermediate-length belt, returned −13.0%, while 20-plus-year Treasuries, a much longer belt with decades of payments to mark down, returned about −31%.
The half of the story the sell screen leaves out
The markdown is half of one event, and the sell screen shows only that half.
The same rise in rates that marked Elaine's fund down also raised what it earns from here. Maturing bonds keep rolling off the belt, and the cash buys replacements at the new, higher rates, month after month. Her fund showed this in plain numbers: its quoted yield roughly doubled by 2023. The price fell now precisely because the fund will pay more later. Two moves, one fact.
There is a useful approximation hiding inside the duration number, stated loosely: hold a fund for about as many years as its duration, and the higher interest payments have roughly enough time to offset the markdown that created them. An estimate rather than a guarantee, but it reframes the fall correctly. A markdown is the market pre-charging you for years of better income.
Walk Elaine's October choice with real numbers. Her bond sleeve was $100,000 at the start of 2022. Down 13%, it sat at $87,000.
- Sell: the $13,000 markdown becomes permanent. The money moves to cash, and the higher payments the fund just repriced itself to earn go to whoever buys her shares.
- Hold: the $13,000 stays a paper markdown, and the belt keeps swapping in bonds paying roughly double what the old cargo paid, working the damage back down.
Selling the dip would have locked the loss and handed the repair to a stranger.
Would individual bonds have spared her?
Partly, and the honest version of "partly" is worth spelling out.
An individual Treasury held to maturity keeps its promise no matter what rates do in between: buy a $10,000 Treasury, hold it to its date, and $10,000 comes back along with every coupon. During 2022 its resale value fell just as hard as anything on a fund's belt. The markdown was identical; the difference is that a known end date makes a falling resale price ignorable. That is a real advantage, and it is an advantage of psychology and timing rather than arithmetic.
The individual-bond route charges for that comfort in three ways.
- Chores. Every coupon and every maturity is cash that needs reinvesting, by you, at whatever rates that month happens to offer. The fund's belt does this automatically and never forgets.
- Concentration. With corporate bonds, one issuer's trouble lands on you alone, while a fund spreads it across hundreds of issuers. With Treasuries this worry falls away, since the borrower is the US government.
- Effort to diversify dates. Spreading money across many maturities takes real dollars and steady attention. A fund does it for the small annual fee Chapter 5 taught you to check.
There is also a practical point about plumbing. Bonds trade dealer to dealer, with pricing that is harder for an individual to see and compare than a stock quote, which is one reason most households hold bonds through funds in the first place. The full toolkit for going it alone, Treasury mechanics, bond ladders, the yield curve, gets its own treatment in the Cash & Bonds guide, coming next in the library. For this chapter, the decision compresses into one rule.
Match the belt to the calendar. Money you will spend within about 3 years does not belong in a long-duration fund. For everything else, pick a fund whose duration is no longer than the time until you need the money, then let the belt run.
Elaine reran 2022 holding the one sentence she had been missing: a duration of 6 means roughly −6% for every 1-point rise in rates, and rates rose hard that year. Her fund had not malfunctioned; it had behaved exactly as the dial said it would, in the worst bond year on record. She forgave herself for nearly selling, since nobody had ever shown her the dial. Then she fixed the actual problem instead of the feeling. The next 3 years of spending money moved to a short-duration fund, where the dial barely moves, and the rest of her bond sleeve stayed on the longer belt, now earning roughly twice the yield it paid her in 2021.
Where people go wrong
- Reading the fund like a broken bond. A fund never promised a fixed end value; only an individual bond makes that promise. The fund's promise is the belt itself: diversified loans, continuously refreshed at current rates.
- Selling after the markdown. The price fall and the higher future yield are one event. Selling keeps the first and gives the second away.
- Reaching for yield without reading the dial. Long funds pay a little more in calm years and returned about −31% in 2022. The extra yield was the price tag for that swing, printed in advance for anyone who looked.
- Parking near-term money on a long belt. A down payment needed in 2 years can be down 13% in the year you need it. The dial does not care about your closing date, so you have to.
- Assuming individual bonds dodged 2022. Their resale prices fell the same way. The end date makes the fall ignorable, but only if you genuinely hold to the end, and only while the borrower keeps paying.
Key takeaways
- A bond is one loan with one end date. A bond fund is a conveyor belt of hundreds of loans with no end date, continuously replacing maturing bonds at today's rates.
- Duration is the risk story in one number: a duration of 6 means roughly −6% in price per 1-point rise in rates. The 2022 receipts: the US aggregate index −13.0%, its worst year in records back to 1976; 20+ year Treasuries about −31%.
- The markdown and the higher future yield are the same event. Elaine's fund's yield roughly doubled by 2023; selling the dip locks the loss and hands the repair to someone else.
- Individual bonds held to maturity make rate swings ignorable, at the cost of reinvestment chores and, outside Treasuries, single-issuer risk.
- Match duration to horizon: money needed within about 3 years stays off the long belt. Ladders, Treasury mechanics, and the yield curve arrive in the Cash & Bonds guide, coming next in the library.
Sources: Bloomberg US Aggregate Bond Index, 2022 calendar-year return (index records to 1976) · iShares 20+ Year Treasury ETF fact sheet, 2022 return · Investor.gov on mutual funds · Investor.gov on ETFs