Today's question is about that incredibly exciting topic,
bond funds.
"Dear Scott,
Could you please address the factors that affect the rise and fall of bond fund share
values
-- beyond the obvious inverse relationship between interest rates and share values? If
interest rates were to rise steadily from where they are now to say, 12% over 3 or 4
years,
what would happen to bond fund investments where the investor continued to
dollar-cost-average on a consistent basis?
I am assuming that while share prices were going down because of the interest rate rise,
there would be some positive impact from funds replacing maturing "low rate"
bonds with
new "higher rate" bonds, and that the duration of funds' new bond investments
would be a
factor."
Well in answer to your question, I would like to say z …z …z …z … oh,
I'm sorry, I dozed off
there for a minute. It tends to happen when I start talking about bonds. You see, for the
typical
long-term investor, bonds are kind of boring, and for the typical long-term analyst like
me, bonds
are very boring. It's kind of like analyzing a British-produced movie about the early
1900s ý I
challenge you do it without falling asleep, especially if it involves a relationship
between Anthony
Hopkins and Helena Bonham Cart …z …z … see, it can't be done.
However, although talking about bonds is not terribly exciting, your question is very
important. So I
will answer it, but please forgive me for resorting to some cheap ploys to hold everyone's
attention.
Bond Prices Affected by Extraterrestrials!
First the basics. As you said, when interest rates rise, bonds fall, as do bond funds.
However, not all
bond funds are created equal. The longer they are (in terms of maturity, or duration), the
harder they
fall. The longer a bond fund's duration, the farther it may plummet.
Duration is the average maturity of the fund. A fund that is 100% invested in bonds and
pays money
in five years has 5-year duration. A fund with 50% invested in bonds that pays money in 5
years,
with the other 50% in bonds that pay in 6 years would have a duration of 5 1/2 years.
(Because
most bonds pay coupons in addition to cash at maturity, a bond's duration is usually less
than the
time it takes to mature).
If interest rates rose to 12% very rapidly, what would happen over the next 4 years?
If your bond fund's duration were longer than 4 years, its value would immediately fall.
Shorter-
time-horizon bonds would mature and be replaced by newer, higher yielding bonds, yet this
gain
would not be enough to make up for the value lost in the 4-year duration bonds.
Buying Short Term Bonds is a Guaranteed Method of Losing Weight!
If, however, you owned a bond fund with a duration of less than 4 years, the situation
would be
slightly different. Yes, the bond fund would still fall in value, but not by as much as a
long-duration
fund. And there would be a larger proportion of shorter time horizon bonds that would be
replaced
with the higher yielding new bonds.
For this fund, the gain in the yields would offset the loss in bond values, and you would
make money
over the 4 years. Consequently, shorter duration bond funds are far less risky for you to
invest in
than long duration funds.
Another way of looking at risk is to ignore the fund values and simply focus on yield.
First of all, remember that the typical reason bond yields go up is because of a real or
perceived rise
in inflation. And if inflation goes up, you will need a bigger yield from the bond to keep
up with
inflation.
A shorter duration fund will see its yield rise relatively quickly, lagging inflation by
only a year or
two. If you are investing for a relatively long time period (more than 10 years), the lag
will not be
too severe and the bond fund will come close to matching inflation. However, the yield on
a longer
duration bond fund will be much more rigid as inflation rises, and it will do a very poor
job of
keeping pace with inflation, even over a 10-year period. Once again, you can see how the
longer-term bond fund is riskier.
The Path to Utopia is Paved With Bond Funds
So, which type of fund should you buy? Like most aspects of investing, risk typically
trades off
against return. With bond funds, risk is directly related to duration. A fund with 6-year
duration has
triple the risk of a fund with 2-year duration. Yet the return differences are small.
Bonds with 2-year duration are currently yielding 6.4%, while bonds with 6-year duration
are
yielding 6.6%. If that small 0.2% difference in return does not seem worth the extra risk
to you, I
agree. And that difference in return is not unusual ý it is consistent with data over the
last 30 years.
For that reason, I think it makes sense to invest in shorter duration bond funds (1 to 3
years) instead
of intermediate or long duration bond funds. If you do not have any shorter duration bond
funds in
your 401(k) plan, you should consider putting the majority of your bond investments in a
stable
value fund (they typically have shorter duration). And if you have neither a short-term
bond fund nor
a stable value fund, you might want to put a large amount of your bond investments in a
money
market fund.
Now that I have finished answering your question, I'm going out to rent Howard's End. Lummer's Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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