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Author: spinning Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: another bond fund post Date: 2/3/2005 7:02 PM
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Like many of us, I am trying to figure out the difference between a bond and a bond fund. This group is great and I have learned a lot from your posts and from the links you've provided -- Thanks!

To help me clarify ideas, I created a thought experiment. Suppose I buy a 10 year, $10,000 bond, paying 5% and hold to maturity. This bond pays $500 in years 1 through 10, and I get my $10,000 back in year 10.

Now let five years pass and I decide to sell my 10yr bond and use the proceeds to buy a new 5 yr bond. The amount of money I get for my 10 year bond is based on the present value (present is now year 5) of the 10 year bond. So selling the old 10 year bond and buying a new 5 year bond doesn't change the present value of my investment (ignoring transaction costs, which of course cannot really be ignored). I found a nice calculator at
http://www.hedge-hog.com/sub/applet/applet5.html

In particular, if the interest rate in year 5 has risen to 6%, my bond has dropped in value to $9579. If I sell and buy the 5yr bond, I get $575 (9579*0.06) a year in interest, or $75 a year more, but only $9579 when the bond matures. On the other hand, if the interest rate drops to 4%, then my bond is worth $10,445, but I get only $417 a year and $10,445 at the end. Either way, the new bond has the same present value as the old bond.

So selling and buying bonds vs. holding does not change the present value, only whether I get money sooner or later. Then it seems that there is no difference, apart from transaction costs, between buying individual bonds and holding until maturity vs. buying and selling bonds, ie buying a bond fund.

So whether individual bonds or a bond fund are a better deal depends on whether the transaction costs for an individual to buy bonds and hold them to maturity and then buy another one are less than those of a bond fund with its large asset base and its constant buying and selling.

I am confused now, since most posters seem to say that if you hold a bond to maturity you are better off with individual bonds, with no mention of transaction costs. If so, where did I screw up?
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