Why can principal not be lost, if a bond fund is held for a period equal to its duration?

Question

[Source:] Which leads us to the key message for investors: as long as your time horizon is at least as long as the duration of your bond fund, you won’t lose any capital.

You’ve probably heard people say they prefer individual bonds to bond funds, because as long as they hold on until maturity, they won’t lose principal. Well, the same is true if you hold a bond fund for a period equal to its duration. You can be sure that XBB will not have a negative total return over any period longer than 6.3 years: any price decline from rising interest rates will be offset by higher coupons within that time frame. In fact, history suggests the recovery is likely to be more swift than that: even a three-year period of negative bond returns is extremely rare.

1. Are the bolded clauses true absolutely? To wit, capital loss is identically (and NOT just near) 0?

2. Why are the bolded true?

Answer 1

A bond is basically a contract between the debtor and the creditor, which roughly usually says something like

You, the creditor, agree to lend me \$10,000 today. In return, I, the debtor, will make the following payments to you (or, in the event that you sell this bond, to the new owner of the bond):

• \$500 every year for the next five years.
• An additional final payment five years from now to return your $10,000.

That the original invested principal is returned to the investor at the end of the bond's life is fundamentally written into the terms of the agreement. Thus, provided you don't sell the bond before its maturity, the terms of the bond guarantee that your original principle will be returned. This means that, under normal circumstances, capital loss will be zero if the bond is held to maturity.

Here are some reasons why capital loss might be non-zero for a bond investor:

1. The debtor defaults (for example, by declaring bankruptcy) and ceases making the payments required by the bond.

2. A minority of bonds have terms that require an amount different to the original invested principal be returned at the end of the bond's lifetime. In this case, the amount to be returned will be described in the bond, but might be less than the original investment.

3. or, of course, you sell the bond before its maturity date, and the amount for which you sell it is less than the amount you originally invested.

It is also important to remember that even if nominal capital loss is zero, inflation will erode the value of the invested capital over the lifetime of the bond. Thus, the real value of the returned principle will be lower than the value of the amount invested.

Answer 2

The duration of a bond fund changes over time, so how do you define the holding time versus a fixed start date?

Most bond funds track an index. If new long-duration bonds are added to the index and lose money, those losses could be larger than the pull-to-par effect on existing bonds. So yes, it is possible to generate capital losses. (Admittedly, the odds are low of such sequence of events.)

And as noted by Ubiquitous, credit losses will reduce returns.

Additional issues:

• The fund will have fees, and execution risks can result in returns below the index.
• Most bond indices drop bonds when they hit one year to maturity. If the curve is inverted, there could be capital losses that are only recouped after the bond leaves the index. (Once again, a unusual situation.)