A $300,000 investment in a fixed-income mutual fund with an average maturity of 20 years (a mix of 10-, 20- and 30-year bonds), for example, would fall to $260,000 if interest rates climb 1 percent. (Shorter-term bond funds would be less volatile.)
The drop in value makes investors nervous, which prompts more selling.That, in turn, forces the bond-fund manager to sell off some of their bonds to meet redemptions.
Depending on how significant the redemptions are, they may have to sell off their highest-yielding bonds and replace them with those offering a lower yield, or assume more risk to obtain the same return.
"What happens in the marketplace is all those bonds from the fund manager start going out to bid to be sold, and that creates more supply in the market—and more supply drives prices lower," Ghodsi said. "It's a downward cycle. It takes very little shift in the supply and demand to cause prices to shift pretty dramatically."
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Eventually, this surge in supply and subsequent price shift impacts even buy-and-hold bond fund investors.
"There are people who say, 'I'm going to hold them forever, anyway, so it doesn't matter.' But it does, because now with all the redemptions and selling, all of a sudden, all those high-income bonds are gone and the fund manager now has to cut their dividend, so your actual income goes down," Ghodsi said. "You get squeezed from both ends. Not only does the statement show a lower value, but now your income gets cut, too."
By comparison, if you own $300,000 worth of fixed-rate individual bonds with an average maturity of 20 years and interest rates go up 1 percent, the value of those bonds on your statement might be down, but your income remains unchanged and you'll still get your principal back when the bonds mature—assuming, again, that you buy and hold and the debt issuer doesn't default.