With interest rates poised to rise later this year, I’m getting a lot of emails and comments from readers who are wary about investing in bonds. There seem to be a lot of myths and misunderstandings about bonds, which isn’t surprising: fixed-income investments can be difficult to get your head around.

Let’s start with the most relevant issue: when interest rates rise, the value of bonds goes down. To understand why, imagine buying a five-year bond with a face value of \$1,000 that pays 5% interest annually. Now imagine that 12 months later interest rates have risen one percentage point. Your bond now has four years left to maturity and it’s still paying \$50 a year in interest, while new four-year bonds are paying 6%, or \$60 a year. If you decide to sell your bond now, you won’t get \$1,000 for it. Why would anyone buy your bond with its 5% yield when they can get one that pays 6%?

Of course, your bond isn’t worthless: you just need to drop the price to make it more attractive. If you sell it for \$965, the buyer would still earn \$50 annually in interest, plus he’d make a \$35 capital gain when he collects the full \$1,000 at maturity. His total return over the four years would be \$235 (4 × \$50 +\$35) on a \$965 investment, or 6% annually—the same as new four-year bonds selling at par. (You can check my math with this handy yield-to-maturity calculator.)

This example illustrates why bonds lose value when interest rates rise: their market prices decline in order to bring their yield in line with those of newer bonds. The longer the term of the bond (that is, the greater the number of years until maturity), the bigger the loss in value when interest rates go up.

If you own a bond mutual fund or ETF, virtually all of its holdings will lose some value when rates move higher. That’s why so many investors are reluctant to put money in a bond fund today: the Bank of Canada has all but assured us that rates will move up in the second half of this year. Isn’t buying a bond fund now guaranteed to lose you money?

Not necessarily. Remember that the vast majority of a bond fund’s return comes from interest payments, not from changes in its net asset value (NAV). If the fund’s market price drops 2% one year, but the bonds inside the fund pay 4% in interest, the investor’s total return is still 2%. Notice what happened to the first investor in our example above: he bought a bond for \$1,000 and sold it a year later at a \$35 loss. In the meantime, however, he collected \$50 in interest. That’s a net gain of \$15, or 1.5%. Sure, he’s disappointed, because he was expecting 5%. But he didn’t lose money.

It’s not surprising that many investors don’t appreciate this. When you check your account holdings, all you see is your funds’ net asset value, not the distributions you’ve received. In my own account, I have a bond ETF that’s showing a 2.5% loss since I bought it 10 months ago. I had to use a spreadsheet to figure out that my total return, including interest received in cash, is actually slightly positive.

One reader recently noted that the NAV of the iShares Canadian Bond Index Fund (XBB) was about \$27 in late 2001, and is about \$29.50 today, which looks like an anemic return of barely 1% annually. But when you include the quarterly interest distributions, XBB’s annualized return over the last nine years is 4.8% — almost five times higher. No wonder people are so pessimistic about bonds.

So, is it smart to buy a bond fund or ETF now? Who knows. You may well be able to get in more cheaply if you wait just a few months. But if the interest rate hike is smaller or later than you planned for, you may pay in opportunity cost.

In the next post, I’ll look at the difference between buying individual bonds and investing in bond funds and ETFs.