My question is directed more to bonds: the risks of bonds are many-although, provided you buy high quality bonds, you are pretty much assured of getting your money back. But what about interest rates? If interest rates rise, the value of your bond drops. There are bond funds that invest in short duration bonds (i.e. close to maturity dates). The question: are these funds significantly less risky that conventional bond funds?
As you stated, the price of a bond fluctuates as interest rates (and credit spreads) rise or fall. However, if held to maturity, you’re assured of receiving the full par value (assuming no default). Of course, there are still risks with that such as inflation risk.
Low duration funds are lower risk but also generally yield less as well. They don’t fluctuate as much relative to interest rates. Keeping convexity out of the equation, the value of a bond changes by the percentage duration for each percent change in rates. For example, if rates rise across the yield curve by exactly 1% (parallel rise), a bond with duration of 10 will fall in value by 10%, while a bond with a duration of 1 will fall by 1%.
Remember, though, the only times a value of a bond is important are on 2 dates: the day you buy it, and the day you sell it. If you never sell it and just hold it to maturity, the “value” of the bond on a day to day basis is completely irrelevant.
Bond FUNDS, on the other hand, are highly affected by interest rates, since the fund buys and sells bonds after issue and before maturity.
J.
The problem I see with bonds at the moment is that the investment grade bonds are quite popular at the moment due to their perceived low risk of default, and this has of course pushed their prices up and their yields down. So if you buy at 10% above par and hold to maturity, you get a guaranteed capital loss. This makes it hard for the overall returns to beat inflation. As such I generally prefer high-yielding shares to bonds at the moment, but if I did buy a bond fund it would be a “strategic” fund, i.e. with the ability to buy high-yield as well as investment grade or even short the market. Then again, I’m quite a risky investor so probably not very interested in bonds anyway.
The basic answer to the OP has been given in the first reply - yes, short-duration bonds are less risky, but you get lower returns. The market in most things these days is quite good at pricing risk correctly, I think. I don’t know enough about bond markets to comment on whether short-duration bonds are currently under-priced compared with longer duration bonds.
Wouldn’t the first sentence also be true for stock purchases? Stocks don’t mature the way that bonds do, but it’s also true that day to day fluctuations are less important than the purchase and sale price.
As phrased, it’s true for stock as well, but I think it was imperfectly worded.
If your intent with a bond is to get 3% interest every year and have a return of your principal at the end, you’re virtually guaranteed to get that. Furthermore, if you sell in the middle, the discount/premium on the bond’s face value will pretty much reflect its net present value as a stream of payments that are either above or below the current market average.
The only real exception to this predictable behavior is the financial health of the entity that issues the bond. (Side note: I’m sure that even my great grand kids will be sick of hearing the story of how I got a 50% gain on a bond, by buying an AIG bond at the right time in 2008.)
While the day-to-day gyrations of a stock are irrelevant as long as you hold it, many stock owners pick a price to sell and let their computer/broker execute the sale when the market price comes up to their target. Thus, the daily price is the motivator to sell, and that is a very different perspective than the typical bond investor.
Risk is mostly a function of the financial health of the entities issuing the underlying bonds and only to a much lesser extent the maturities, but that’s only if by ‘risk’ you mean default risk - which is how it would normally be used. If you mean it more colloquially to imply risk of capital loss, then there are a lot more variables to consider as others have noted. This may seem pedantic, and the average retail broker probably would have understood. Even so, if you ever plan to talk to financial-types, you’ll need to know the argot.
The other thing that should be high on your list of considerations is fees. As long as interest rates were falling, bond funds were reaping the windfall from the rise in prices. That may or may not be over, but if it’s not over, the distance left to drop isn’t at all exciting. So those fees are going be more noticeable and unpleasant.
Related to that is something called “churn.” This something you tend to see in actively managed funds which not coincidentally also tend to have higher fees. BTW, I looked up the definition in Investopedia and I really don’t think that the word is exclusively negative, but I assume that they have a better handle on common usage than I do.
Another option you might want to consider is a laddered bond fund.