Bond funds and ETFs versus single bonds

What you will learn

• The key structural difference: a single bond matures, most bond funds never do
• How constant duration changes the effect of a rate rise over time
• When target-maturity ETFs can combine features of both
• How to compare costs and diversification in euros

Explanation

How bond ETFs and money-market funds work, and their interest-rate and credit risk, is covered in the ETF course. This lesson compares them directly with single bonds and ladders.

Maturity versus constant duration

A single bond has a fixed maturity date, so its duration (its price sensitivity to yield changes, measured in years) shrinks every year until it reaches zero at maturity. A typical bond ETF instead follows an index with rules such as "bonds with 1 to 10 years remaining". It sells bonds that become too short and buys new ones. Its duration therefore stays roughly constant and there is no date at which you are sure to get a known amount back.

The yield to maturity shown on an ETF fact sheet is a weighted average of the bonds it holds today. It is a useful estimate of future return before costs if yields stay unchanged, not a promise.

The duration rule after a rate rise

When yields rise, a bond fund loses value at once, roughly duration × yield change. After that, it earns the new, higher yield. A useful approximation: the time needed for the higher yield to make up for the initial price loss is roughly equal to the fund's duration. This ignores convexity, credit events and further rate changes.

Target-maturity ETFs

Some providers offer target-maturity (fixed-maturity) bond ETFs. They hold bonds that all mature in one year and then pay out the cash and close. They behave more like a single bond or one rung of a ladder, while keeping fund diversification. Their final value is still not guaranteed: defaults, reinvestment of coupons and costs affect it.

Comparison

TER (total expense ratio) is the yearly running cost of a fund as a percentage of assets. For single bonds of high-quality governments, diversification matters less because default risk is low. For corporate and high-yield bonds, one default can hurt a small portfolio badly, so a fund's diversification is a strong argument.

Rules of thumb

• For a known future expense (for example in 3 years), a single high-quality bond, a ladder or a target-maturity ETF fits better than a constant-duration fund.
• For a long-term portfolio that will be rebalanced, a broad bond ETF is simpler and well diversified.
• For credit risk (corporate, high-yield, emerging markets), prefer diversified funds over a few single bonds unless you have a large amount.

Worked example

Hypothetical example: You have €10,000. Option A: a broad euro government bond ETF with a duration of 6 years and a TER of 0.15%. Option B: a ladder of five government bonds bought with one €9.90 fee each. Taxes and spreads are excluded.

1. Yields rise by 1 percentage point right after you buy. ETF loss ≈ 6 × 1% = 6%, so the value falls to about €10,000 × 0.94 = €9,400.
2. The ETF now earns about 1 percentage point more per year than before. By the duration rule, it needs roughly 6 years to make up the €600 relative to the no-change path.
3. The ladder's market value also falls, but each rung repays its nominal at maturity; the cost shows up as lower yield than new bonds offer.
4. Costs: ETF €10,000 × 0.15% = €15 per year, so about €75 over 5 years. Ladder: 5 × €9.90 = €49.50 once, plus fees for reinvesting each rung later.

Neither option avoids the rate rise; they show it differently. The ETF shows it as a price drop, the ladder as a fixed lower yield until each rung matures.

Common mistake

Practice activity

You invest €8,000 in a bond ETF with a duration of 5 years and a TER of 0.20%. Shortly afterwards, yields rise by 1.5 percentage points. (a) Estimate the price loss in euros. (b) Roughly how many years does the higher yield need to make up for it? (c) What is the yearly TER cost?

Key takeaways

• A single bond matures and its duration falls to zero; a typical bond ETF keeps a roughly constant duration and never matures.
• After a rate rise, a bond fund needs roughly its duration in years to make up the price loss through higher yield.
• Target-maturity ETFs mature in a set year and can replace a ladder rung with more diversification.
• Use single bonds or ladders for known dates; use diversified funds for long-term allocations and credit risk.

Next step

Next, you will look at the shortest end of the market: money-market rates, deposits and the ECB deposit rate.