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 the all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you appreciate 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:

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:

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:

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.