This is a rant.

Yahoo Finance has this article, sponsored by Fidelity: Retirement Investors Turn to Bonds for Balance. The headline says “bonds.” The article says “Bonds Funds.” See the difference? That extra word means a world of “fuck you.”

This is important. In fact, it is one of the few times I’ve heard Suze Orman say something that made me think, “Holy shit, maybe she does belong on television.” Bond funds are not bonds. Yes, Suze Orman recommends against investing in bond funds instead of bonds. If you buy a bond, there are two kinds of risk. Interest rate risk, and default risk. The interest rate risk is that interest rates will rise, and your bond won’t be worth as much as an equivalent amount of cash invested in a savings account. The price of the bond drops as interest rates rise, reflecting this risk. However, even though the price of the bond drops, you still get paid the full value you are owed, provided they don’t default. And that’s the second risk: Default risk is the risk that the company whose debt you are buying will default (as in bankruptcy, as in Lehman), and you won’t get the money you are contractually owed. But the point here is that as long as the company doesn’t default, you don’t have to worry about your bond dropping in value. You always have the option of holding the bond to maturity and getting paid the full amount you are owed.

A bond fund has the same exposure to interest rates and to defaults (although most bond funds are better diversified than your bond portfolio ever could be). However, they strip out one key part: You no longer have the option to hold the bond to maturity. If other investors in the bond fund sell their fund holdings, the bonds are sold for face value. This impacts the value of the fund for you. You no longer can simply hold on and wait for maturity. So we have the same risks, but one less benefit. Essentially, a bond fund is a proxy bet on interest rates.

If you want to invest in bond funds, that’s fine. However, don’t be mislead into thinking it is the same thing as investing in bonds. Especially don’t think that it’s magically better because the fund offers diversification. The inability to hold to maturity is a huge strike against bond funds. Incidentally, I do trade bond funds (ETFs) on occasion as a bet on interest rates (and therefore have contributed to the problem). Trading is not investing.