 The Longer They Are, The Harder They Fall
|
By Scott
Lummer
Chief Investment Officer, mPower
|
Editor's note: Scott Lummer is recovering from his U.S.
Open finals match (in the "long-term players" category) but he'll be back with a
new column next week. In the meantime, he asks that you please not fall asleep when
reading this column
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 -- 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
invested in bonds that paid only money (and not coupons) in 5 years would have a duration
of 5 years. A fund with 50% invested in bonds that pay money in 5 years, with the other
50% in bonds that pay money 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 a 6-year duration has triple the risk of a fund with a
2-year duration. Yet the return differences are small.
Bonds with a 2-year duration are currently yielding 6.4%,
while bonds with a 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 -- 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
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
401Kafe.com is the
premier online community resource for 401(k) participants
Copyright ý 1996 - 2000 mPower. All Rights Reserved.
|
