Bond Funds in Rising Rates Environment

[workathome]

What happens to a bond fund with an average duration of 5 years if yields went up 1%? My cursory understanding is that the value of your fund would immediately drop 5%, but after 5 years the fund should return to the "Face Value" of your initial investment?

[thebbqguy]

There is an inverse relationship between interest rates and bond prices. If rates go up, the older bonds with lower yield are less desireable and prices drop.

[44deagle]

@thebbqguy

Obviously the fund would drop in price but won't the distribution payment go up over time as the fund re investments principle in new debt?

[workathome]

The question is more difficult than I realized. I called a couple Fixed Income experts, but couldn't get a definite answer beyond "yes, short term funds would recover quicker." It seems a rather complicated formula would be needed with a variety of example data.

[altoid]

I have one basic question related to bond fund :

What happens when I buy, let us say 1000 shares of bond fund etf? Did I receive the current holding of the basket of bonds from an existing owner like buying stocks? Or does the fund manager use the "fresh money" to buy more individual bonds at open market? if it is the former, then how does the bond fund etf total asset change in value?

[thebbqguy]

I personally would not feel comfortable investing in bond funds right now.

I sold all my intermediate term bond funds about 8 months ago. It turned out to be a good decision.

I think back to my first year as a licensed investment representative. It's a difficult thing to explain to retirees who purchased bond funds thinking they were relatively safe investments; especially if they are used to buying individual bonds and getting their principal back when the bonds mature.

[RealPerson]

In a rising interest rate environment, you bond prices will go down as interest rates go up. If you have a bond fund, the price of the fund would drop immediately when interest rise, and then gradually go back up as the fund receives the capital of bonds kept to maturity, as well as invests in newer higher interest bonds.

Why not open a Treasury Direct account for free, and buy the bonds directly from the treasury. Yes the value of your bond will drop, but you will get 100% back upon maturity. Obviously,in the current environment, you don't want to buy the 30 year bond.

[workathome]

I guess I was hoping to find out something like: If average duration of Bond fund is 7 years, and I invest now, will it take 7 years for the Bond fund to recover to the "face value" of my initial investment? As in, does it have that same "safety" built in as do buying bonds direct?

I am looking mostly at short and intermediate term bond funds, with lots of corporate exposure.

[jacob]

Yay! Math time. (This is pretty standard stuff.)

First, if the interest rate changes, then the present value changes inversely proportionally with the duration as the scale. To see this, write the PV of the bond (sum of all cash flows), take the derivative of the sum with respect to the discount rate. You'll find that the expression is the negative of the duration.
http://en.wikipedia.org/wiki/Bond_durat ... d_duration

What happens with a bond if the interest rate goes up is that it drops in price. However, as years go by and it comes closer to maturity, the duration drops, the 5 year, say, bond becomes a 4 year bond, a 3 year bond, ... until it expires (is that the word?!) at parity so you get 100 back.

Conversely, if you buy a bond fund (mutual, closed, etf, .. doesn't matter) ... you buy a basket of bonds. They will drop in the same way... however, as the years go buy, the fund will trade away bonds which get "younger" (e.g. the 2 year bonds) and buy new 5 years to maintain the duration of the fund.

However, those new 5 years now pay a higher interest rate so all things being equal you should receive about the same interest payment throughout. Conversely, if you stick to your single bond, you will still get, say 3% on your bond ($3 a year) whereas you'd be getting $5 (on a new 5% if you switched).

There seems to be a lot of opinionating wrt losing principal and owning funds. You can certainly avoid losing principal by holding until maturity, but you would be giving up larger interest payments had you sold the old bond and bought a new one.

[KevinW]

...the 5 year, say, bond becomes a 4 year bond, a 3 year bond, ... until it expires (is that the word?!)

I think the word is "matures."

[bibacula]

Here is a simplified way to look at interest rate changes in a bond fund.

If you invest $100 in a bond fund yielding 5% with a duration of 5 years, reinvesting fund distributions, and interest rates don't fluctuate, then after 5 years you will have your principal plus five years of interest. Like this:

$100.00 + $5.00 + $5.25 + $5.51 + $5.79 + $6.08 = $127.63

If interest rates rise to 6% the day after you invest, it's like investing $95 at 6%.

$95.00 + $5.70 + $6.04 + $6.40 + $6.79 + $7.20 = $127.13

You'd roughly "break even" after holding the fund for the duration period.

In the real world, interest rates always change, and the taxman must be paid, too.

[workathome]

Interesting! So as Jacob was pointing out above, "holding to maturity" is pointless - because bonds will be priced to the point that you would come out equal either way.

[bibacula]

Sometimes there are advantages to holding individual bonds or CDs to maturity.

If you know that you'll need a certain amount of money at a definite point in time (like $20,000 in 5 years), then you should probably buy a 5-year bond or CD. Since bond funds keep a constant maturity, there is a danger that the price of the bond fund could move the wrong way right when you need to cash out.

Most people want to stabilize a portfolio, counterbalance stocks or gain income. Bond funds are good options for these tasks, because rebalancing and reinvesting are really easy.

You mentioned that you want exposure to corporate bonds, and most corporate bond funds offer diversification, which is really important with non-Treasury bonds.

[thebbqguy]

"there is a danger that the price of the bond fund could move the wrong way right when you need to cash out"

That is a very wise statement. Many retirees have been burned on this when their broker didn't fully explain the risk of principal loss; no matter how much lower the risk is than a common stock fund.

I know from first hand experience. It was ugly.

[KevinW]

Interesting! So as Jacob was pointing out above, "holding to maturity" is pointless - because bonds will be priced to the point that you would come out equal either way.

Yes. Holding to maturity can distract you from decreases in the market value of bonds, and the corresponding unrealized loss, which might be psychologically beneficial. But this is entirely a matter of psychology and perspective.