Is Your Bond Fund Really Losing Money?

When the yield on 10-year federal bonds spiked earlier this year—from 1.88% on May 16 all the way to 2.55% on July 5—the value of broad-based bond ETFs plummeted sharply. But I’ll wager that many investors think their bond ETFs are performing worse than they really are.

There’s a common misunderstanding about how fixed-income ETF returns are calculated. That’s understandable, because your brokerage’s account summary is highly misleading: it indicates only an ETF’s price change while ignoring all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you understand that, you might think your ETF has lost money when it’s actually logged a nice gain.

Why bond ETFs fall in price

Most investors understand that bond prices fall when yields rise. What’s less well known is that bond ETF prices will decline steadily even if interest rates don’t change. That’s because virtually all the bonds in a broad-based ETF today were purchased at a premium—in other words, for more than face value. As these bonds mature or get sold, the fund will incur a steady trickle of small capital losses. But that doesn’t necessarily mean your investment will lose money overall, because the interest payments from the bonds will offset at least some those losses.

So far in 2013, broad-based bond funds have indeed suffered negative returns—but the numbers are not as bad as you might think. Here are the year-to-date numbers for three popular bond ETFs (as of July 31). The total return of each fund is significantly better than the price change would suggest, because investors received monthly interest payments along the way:

Price on Dec 31, 2012 Price on July 31, 2013 Price change Total return
XBB $31.39 $30.31 -3.44% -1.66%
VAB $25.41 $24.48 -3.68% -1.88%
ZAG $15.88 $15.31 -3.59% -1.74%

Now have a look at the year-to-date results for some popular short-term bond ETFs. All of these funds have delivered positive returns this year despite a decline in price:

Price on Dec 31, 2012 Price on July 31, 2013 Price change Total return
XSB $28.87 $28.57 -1.04% 0.56%
VSB $24.88 $24.66 -0.87% 0.64%
CLF $19.78 $19.47 -1.57% 0.63%
CBO $20.15 $19.84 -1.54% 1.06%

When a loss is really a gain

The numbers are even more dramatic if you go back a few years with CLF and CBO. These iShares ETFs are extremely popular, at least in part because they pay unusually high yields: despite holding nothing but short-term government bonds, CLF pays almost 4%. The corporate bonds in CBO pay almost 5%. That can only happen when the underlying holdings were purchased at a steep premium, and that means these ETFs will see their prices decline steadily as the bonds are gradually sold and replaced. If you’ve held these funds in your account for a full three years, they would show a significant capital loss—and yet their total return over that period was actually quite good:

Price on July 31, 2010 Price on July 31, 2013 3-year price change Total return (annualized)
CLF $20.33 $19.47 -4.23% 2.75%
CBO $20.48 $19.84 -3.13% 3.53%

An investor who held CLF over the last three years (and reinvested all distributions) would have seen every dollar grow to $1.08, while CBO investors grew each dollar to $1.11. Yet I recently received an email from a reader who was alarmed that CLF “has been losing money for years.”

Go the source

One final note: don’t make the mistake of thinking a distribution reinvestment plan (DRIP) will eliminate this confusion. Index mutual funds don’t solve the problem either, even though all distributions are automatically reinvested. In both cases, the dollar amount of your total holding will increase over time if the fund delivers a positive return, but the gain/loss column in your account summary will show the same misleading price decline.

Here’s a simplified example to illustrate the idea:

  • At the beginning of the year you buy 1,000 shares of a fund for $20. Your holding is $20,000.
  • The fund yields 4%, or $0.80 per share annually. All of the distributions are reinvested, so you receive your $800 in the form of 32 new shares.
  • By the end of the year the fund’s price has declined $0.40 per share to $19.60. Since your purchase price for the shares was $20, the gain/loss column in your account summary now shows a capital loss of 2%.
  • However, your holding is now 1,032 shares worth $19.60, which works out to $20,227.20. That’s a total return of about 1.4% on your original investment.

The easiest way to check the total return on your bond fund is to simply visit its web page: published performance numbers always include both price changes and interest payments, which are assumed to be reinvested. To measure your personal rate of return (which factors in the dates of all your purchases and sales), you’ll need to use a calculator like this one from Justin Bender.


58 Responses to Is Your Bond Fund Really Losing Money?

  1. Canadian Couch Potato February 13, 2015 at 8:27 pm #

    @Melissa: What bond fund were you holding? Most bond funds have delivered surprisingly good returns recently, so I wonder if there is a misunderstanding.

  2. Melissa February 14, 2015 at 5:59 pm #

    Hi Spud, thanks for answering.
    It was MD Bond fund. Sold at the end of Nov, so probably I missed the turnaround.

    I’m just looking for a safer place to park some of our assets. Warren Buffet suggested keeping 10% safe. Bonds didn’t seem to be doing anything except giving worse returns, but I’ll study the math from your post to see if I was miscalculating. I’m leaning toward GIC’s, bonds, or cash, but didn’t want to get hit with too bad a tax bill just because I saved some money in my corp.

    I’m also going to pore over this article:


  3. larry wade May 18, 2015 at 10:33 pm #

    Somewhere I have seen, or heard of, a site which enables comparisons of ETFs on many topics. Please tell me where i might find such a site.

  4. Jonathan July 26, 2015 at 1:31 pm #

    “2. If by buying a bond fund, I’m making a small bet that interest rates will drop … is there a way to effectively short a bond fund? I’d prefer to make a small bet that interest rates will rise.” moi, April 2014.

    “If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it,” Warren Buffett, May 2015.

    After two further BoC rate drops, contrasted with the Greece banking crisis, Warren and I are even more dreaming of the same thing.

    PS: the implication that I might have a financial insight on par with Warren Buffett is a joke. And it’s my joke.

  5. Alexander March 21, 2017 at 12:07 am #

    Dan i recently wanted to double check BMO web page for annualized return for ZAG in 2016, taking in consideration the price in January plus all the monthly interest payment and the final price in December. I used Justin Bender 2016 modified diets method spreadsheet as well as your old spreadsheet you created while ago with Preet Banerje, both files showed a annual rate of return around -4.51% while BMO reports a positive 1.54% for 2016. What have I done wrong ?

  6. Canadian Couch Potato March 21, 2017 at 7:28 am #

    @Alexander: My guess is that you treated each interest payment like a cash flow into the portfolio. This is not correct: a cash inflow is a new contribution, not dividends or interest paid by the funds already in the portfolio. In this case, start with the price on December 31, 2015 and for the end value use the price on December 31, 2016 plus the total of all cash distributions paid in 2016. Do not enter any cash flows. You should come up with a number close to 1.54%.

    For the record, look at the return of similar bond ETFs (such as XBB and VAB) and you will see they are all in this ballpark.

  7. Alexander March 21, 2017 at 11:16 am #

    Thanks Dan. I got it now. By the way I have to discount the fund’s MER from the 1.54% right?

  8. Canadian Couch Potato March 21, 2017 at 11:59 am #

    @Alexander: Nope, fund returns are always reported net of fees. The fees are taken off the distributions before they are paid to investors.

Leave a Reply