Let’s Talk About Bond Fund Redemptions

Some of the bond pickers of the world were not very happy with my recent post talking about how bond funds are generally safer than owning individual bonds.¹ The most common response I saw was similar to this comment on Seeking Alpha about the risk of redemptions:

Beyond diversification, you have the impact of potentially permanent capital impairment as a fund sells bonds in order to, say, raise money for even normal redemptions. This risk can be particularly acute if there is a run on a fund or, even worse, a bond rout. This is not to say one would not see the same mark to market effect with their directly held bonds. The difference is that in the case of directly held bonds, the investor retains the option of either selling or holding the bonds through to maturity.

First off, we should be clear that a “redemption” is just another word for selling. When you redeem shares in a bond fund you are effectively telling the bond manager to sell on your behalf. This is really no different than initiating the order on your own except that you’ve hired a bond manager who likely has more experience and better behavior implementing trades in these markets. Again, a bond fund is just the summation of all its individual holdings and orders to buy/sell a bond fund are just orders to buy and sell a whole bunch of individual bonds using a fund manager as the middleman.

Second, I would point out that bond funds do have an average effective maturity date. For instance, if you buy the Barclays Bond Aggregate you’ll note that it has an average effective maturity of about 8 years.² If you hold that fund for 8 years the average holding will have matured which means that there is a very low chance that this fund will incur principal losses over an 8 year holding period. While it is not exactly the same as holding a single 8 year bond that matures at par it is functionally the same except that you’re taking less credit risk in the case of the aggregate over the course of those 8 years.  So, if your bond fund’s holdings are under pressure you still have the option to ride out the storm and let the markets normalize. If you own high quality underlying instruments there is very little reason for long-term worry. In fact, if you own a well diversified bond fund the odds are that you’re far less exposed to risk than you would be in a similarly volatile market in which you own individual bonds. The fact that the individual bond matures in 8 years does not make it safer than the aggregate index whose average holding will mature in 8 years.