Do you have the bond gene?
One of the smartest people I know—a brilliant copy editor—used to shake her head as she read articles about bonds and the bond market.
“I think you have to be born with the bond gene to understand bonds,” she would mutter.
What set Mary to muttering, as I recall, was the fact that bond prices tend to move in the opposite direction of interest rates.
“You would think,” she’d say, “that higher interest rates would be good for bond investors. Wouldn’t I earn more?”
Was she in need of a bond-gene transplant? Not really. The impact of rising or falling rates on bond returns varies depending on time horizons.
The short term
When interest rates go up, the market value, or price, of an existing bond immediately falls. This adjustment occurs because an investor wouldn’t pay full price for an existing bond with a face value of $1,000 and a yield of 4% if she could get a similar $1,000 bond yielding 5%. It’s the opposite story when interest rates fall. If prevailing interest rates go from 5% to 4%, you’d expect to pay more for the existing 5% bond than for one yielding 4%.
So in the short run, rising interest rates are bad news and falling rates are good news for an investor who holds bonds or bond funds.
The long term
But over the longer term, rising interest rates can be good for bond investors. And falling rates, although they boost bond prices at first, eventually are not so good for bond investors.
The key is what happens over time as your bond investments throw off income and as bonds mature. The income from your bonds is either spent or reinvested. If you reinvest the income, and rates have gone up, that $100 earns more than if rates fell or held steady. And when a $1,000 bond you own (directly or in a bond fund) matures, you’d rather be able to reinvest that $1,000 in principal at, say, a 6% yield than at 4%. At 6%, money doubles in roughly 12 years. At 4%, it takes about 18 years to double.
For long-term bonds, it’s the interest income—and the reinvestment of that income—that accounts for the largest portion of total returns. Over time, the impact of price fluctuations is outweighed by the impact of reinvestments of income and principal.
The table below illustrates the disparate impact of rate changes over various periods, demonstrating how important an investor’s time horizon is when thinking about the risks of interest rates. For the long-term investor, the bigger risk is lower rates, not higher rates. The reverse is true for the short-term investor.
This element of time is too often missed, I think, in commentary on bonds and in the way some investors think about bonds. For example, bond mutual funds tend to attract increased cash from investors after interest rates have fallen and prices have appreciated—as reflected in cash flows during 2009. After periods of rising interest rates—when bond prices have fallen and bond fund returns are weak or negative—it’s not unusual to see money flowing out of bond funds.
It’s as if investors have a genetic inclination to use the rear-view mirror to guide them in moving forward.
Are there terms or concepts about bonds and bond investing that you find puzzling? Yield curves? Duration? Credit risk and credit spreads?
I’d be interested in hearing about them, then asking some of our bond experts to tackle the questions in a future post or posts.
Assumptions: Rates change evenly over two years; initial yield to maturity is 4%; initial duration is 5.8 years and changes as interest rates change; and—a key assumption—the bond fund’s interest income is reinvested. Data source: Vanguard.
Note: Investments in bond funds are subject to interest rate, credit, and inflation risk.
I think I lack the bond gene. That’s why I read this blog.
All of the above questions plus what is the difference between yield and return and interest rate?
I understand the effect of changing interest rates on the value of bonds, but all the terms are confusing and make understanding any article on fixed income assets very difficult to follow.
Jeepers, I hate bonds.
Investing in bonds can be simple. Essentially, there are two basic ways to invest. One can buy and hold to maturity, or one can speculate. It is easy to speculate - just be sure to buy bonds the day before interest rates decline. Conversely, be sure to sell on the day before interest rates rise. If you believe that you have the ability to predict interest rates with certainty, then buy and sell bonds and make a load of money. If you believe that a mutual fund portfolio manager can predict interest rates with certainty, then you can speculate through owning shares in a bond mutual fund.
If you are not able to predict interest rate movements (and I contend that no one can successfully predict rates over an extended time period), then stay away from trading in bonds and bond funds.
Now, isn’t that simple? It certainly does not require a “bond gene” to understand this concept.
Doesn’t the interest rate change rapidly when the business cycle is about to bust, such as summer 2007- winter 2009? Aren’t treasury bond funds more like reverse stock funds when the business cycle is starting or ending?
I would like to know more about yield curves, duration credit risk and credit spreads. Very informative post, thank you. I’m on break at work
You stated that for a long term investor the risk is lower interest rates. So with the current interst rates at rock bottom and can’t go much lower, is this the right time for a long term investor to purchase bond mutual funds.
A good explanation of bonds. Thank you for taking the time to write this up. Being Boomers and in retirement, we look foreward to higher interest rates.
AS good interest paying CD’s are maturing is this a good time to switch cash into bond funds?
What is the better strategy, invest in an low-cost index bond fund or a top notch actively managed fund? What are the pros and cons of each?
Please give a series of articles on investing in bond funds and bond terminology. Most of us want a portion of our retirment money in bonds and yet do not know how to choose. Can one hold a bond fund (like a total bond fund index)for 3, 5, or 10 years and make money? Does one have to move in and out of these funds (becoming a market timer/loser)?
Great summary. This concept is important, espeially when the short term seems to be emphasized so much more in the media.
Thank you, great article
Good Article.
It’s all a matter of - to what extent not what. If you are taking income monthly from a bond fund how much does it vary not whether or not it varies. Still a good article. Finally, the bond fund manager is more in the spotlight during changing economic times. A good manager should anticipate the things you wrote and seek to off set those changes through better investments such as TIPS/IPI during periods when inflation is suspected to rise.
Good Day
I completely lack the bond gene. I use bond index funds mostly to park profits I can reinvest in the next market meltdown. I’m sure this is wrong, and short sighted, but since it had worked for me, I wish someone would explain why.
Craig,
As usual, your writing style on each topic provides much clarity and “digestibility”. In fact, your clarity, flow, and “digestibility” within your writing parallels Jack Brennan’s.
I too suffer from the defective “bond gene.” I have read other articles about bonds, which seem to stress the idea of laddering. Also, what info could you provide concerning how to incorporate tax-exempt bonds within a portfolio as well?
Could you elaborate and clarify those concepts (ie. laddering and tax-exempt bonds) for those of us who suffer with the tenaciously misaligned “bond gene”?
Thanks
Is this a good time to invest in an intermediate bond mutual fund? Interest rates are literally at zero and can only go in one direction, UP! When is the only question 1-4 year??? Investing now in a bond mutual fund will surely lead to a declining share price. Will the time value of reinvesting the bonds dividens with increased interest rates off set the reduction in share price?
A very informative article. For me the article clarified that rising interest rates is just part of the economic cycle, not something catastrophic.
You use “prevailing interest rates” to explain bond price movement without a hint of what are “prevailing rates”. Is it 10 yr treasury, prime rate, savings bond rates, mortgage rates, CD rates, money market rates, bank saving deposit rate, credit card usury rates. How about enlightening us what types of interest rates affect what types of bonds.
Thanks for the article. I’m wondering about your opinion on the weakened dollar and how you feel this
affects/has affected the bond market. And what if this trend reverses and the dollar strengthens? How in your
opinion would this affect the Treasury market and the
long bond in particular?
Thanks
Rising interest rates make your bond share value decrease in the short term but doesn’t that only affect you if you sell your bond? For example, you buy a bond for $1000 now and get say 4% for the duration of the bond. You let your bond mature and get back the full $1000 so you didn’t lose any money by selling it for less than it was worth. (Maybe $1000 is worth less due to inflation but that is another issue isn’t it?) When the bond matures you can reinvest the $1000 in bonds that will give maybe 6% since interest rates have gone up Isn’t this a good strategy or am I missing something? Do you need to reinvest the 4% you earned to be able to buy enough bonds that yield 6% or if you just keep reinvesting the principal will you hold onto the value of your investment?
Thanks,
Financially Naive
I think this topic is confusing because those who explain it have basic math abilities that average, security-minded, bond-buyers lack. Here’s what I think is a better explanation and how I explained it to my students.
Suppose you have a hole in the ground that once a year produces four dollars. If other holes that produce four dollars sell for $100 (4% interest) then that’s what the price of your money-producing hole should be, $100.
If the economy changes so that new holes that produce four dollars only sell for $80 (5% interest), then no one will buy your hole for $100. They’ll buy one of the newer, cheaper holes. Thus, is you must sell your hole; you’ll have to sell at the lower price. At the $80 you’re $100 hole produces 5% interest and will attract buyers.
So, when interest rates go up on new holes (bonds), prices on old holes (bonds) must go down. It also works the opposite way for the same reason. Thus prices of money producing holes (bonds) go in the opposite direction of interest rate trends. The price is only stable when interest rates have no up or down trend.
Thank you for the article. Now where are you best at? bond mutual fund or a “paper” bond.
And in this market are you better off with short term bond funds or intermediate bond funds?
thank you
Coupons are rarely explained. I would like to know how coupon percentages factor into the purchase of individual bonds.
Could you re-create the above table using lower interest rates (provided below) with the same 5.8 year duration bond fund?
Change in Yield
Row 1: Constant rate at 3%
Row 2: Falling Rates: 3% to 1%
Row 3: Rising Rates: 1% to 3%
If applicable, please discuss if it would be useful for investors to understand bond convexity (graph of bond price (Y) changes to bond yield changes (X-axis)) in their bond investing.
Thank you.
I appreciate that Vanguard is concerned enough about its customers to devote time to education about bonds. But based on some of the comments already posted, it is clear that many folks still do not ‘get it.’ Not sure about the genetic aspect, but it might help if made two points directly:
1. as we all know but keep forgetting, one should buy low and sell high or never, and bond fund prices tend to be high recently;
2. historically high bond fund prices WILL almost certainly decline eventually, and even though underlying interest payments reduce loss in the long run, one should avoid funds with historically high prices.
I’ve invested some money in municipal bonds. How can you tell what is a general bond issue and what is a private activity bond? I understand that privite activity bond interest can cause the AMT to be triggered.
I tried reading about that on the IRS site and they reference so many different forms that I finally gave up. Any help would be appreciated.
Based on this article, some may wish a rising and high interest rates in the coming 10, 20 or 30 years to benefit long term bond investors. But be careful about what you wish. The interest rates of nominal bonds consist of two components - inflation rate and real rate. If the rising and high interest rate is due to higher inflation rate, you might have more bond return (cash flow) but not better purchase power. So maybe just wish tamed/controlled inflation and reasonable/sustainable real rate.
Can you talk about what “spreads” are?
Thank you!
EVERYTHING the media report about bonds is from the point of view of bond traders, who want lower yields in order to grab short-term gains. Consequently, long-term bond-fund investors, adopting the media-promoted perspective, fail to see that rising yields better serve their wealth-building interests.
Following the diversification mantra reiterated by Vanguard, elaborate on how bond holdings act to smooth out stock market gyrations. This is one of their advantages pretty much regardless of interest rates, from what I am given to understand
Very good perspective. Two questions/ requests: 1) Can you reproduce the table shown when dividends are not reinvested? and 2) Given the historically low interests rates, do you really expect to see the same numerical relationship between bond pricing (based on duration) and interest rates. For instance if I hold long term bonds with a duration of 10 years and if interests rates rise by 4 pts say over 3 years, will I really see a 40% drop in the price on the bond ??
Thanks much!
One issue that needs to be clarified is for individuals that are using bonds for income streams, i.e. laddering bonds and holding them to maturity. In this case there is no loss of the face value assuming the bond is not in default and the only risk becomes a reduction in income if a new bond has a lower interest rate the the one that matures. Of course there is always the effect of inflation reducing the buying power of the income stream but this can be avoided via TIPs.
I believe there is basic flaw in looking at annualized returns for several years. One should reconsider the asset allocation each year, and act accordingly. Under those circumstances, shouldn’t it be the one year anticipated return that guides investment decisions?
So you now have PLENTY of ideas for future articles!
Your chart re impact of rising/lowering interest rates deals with bond funds only. Will you compare the impact of interest-rate changes on bond funds vs. individual bonds, please?
Use bonds as a source of income pure and simple. Buy a broad range index bond fund and forget about it’s NAV. Buy several: a short, an intermediate, and a long term total bond index fund. Buy each for it’s current rate of return and this becomes your decision point. When your return increases beyond this point, reinvest the difference and you will be buying new shares at depressed prices to your original entry price. If rates decline, marvel at your increased net worth. Win win.
Why not invest in Bonds now… Basically the economy will be slow to recover as people continue to save more and therefore interest rates will be slower to rise. Along those lines, the majority of the economic growth/recovery that has been reported thus far has come about by corporations cutting costs and not “real” growth. Deflation for next 2-3 years is likely making bonds more attractive.
Good informative article. Thank you. I figure if I keep reading about bonds even when I don’t understand everything I read, my bond gene will mutate, and I will have an epiphany. You lost me at the chart.
Well one thing about reading all these comments is that I’ve got a lot of company with my deficient financial genes! I always have some of my portfolio stashed in a mutual bond fund because it seems to balance out some of the losses when my other funds go down.
I bought a Corporate Bond in May matures 5/2016YTM is 9.82%..Bond value today is 109.635 or a gain over face value od $ 10,116….tempted to sell because of the large short term gain. Good idea or bad idea? Have other bonds also with gains over cost because of lower yields, but what rate does one then need to get to match the hi-yields? or is my question one of short terrm gain over long term, or just greed?
Everybody hopes that interest rates will be high when they retire because they want a high income stream. But many people don’t realize that interest rates are largely an assumption of what inflation will do over the term of the bond. Right now interst rates are low because inflation expectations are low. When rates go up it is a reflection of an expectation of higher inflation. So while you will enjoy a higher return when rates go up inflation will be taking just as big a bite out of your purchasing power.
Very informative article. I would like to see the table reproduced without the dividend reinvestment. This would view it from the perspective of someone who utilizes a bond fund primarily for income.
The bond fund return matrix pretty much explains the bond story. Great piece of information. Thanks for the article.
Does the length of time over which bond yields rise or fall affect the Net Asset Value of shares in bond fund? For example, if bond yields go up 2% very gradually over a 3 or 4 year period, will this affect the NAV differently than if the bond yields go up very quickly (say over a 6 month period)?
Consider preparing an asset allocation of funds that anticipate an inflation rate of 4%, 6%, 8%, and 10% in the next 3 years. This would be for retirees that use their funds for income. A success rate % would make it an attractive model. Thanks
So how would bond funds respond if inflation was going up as well as interest rates?
Senior Secured floating rate bonds ?
I was reading today about the one type of bond that value rises when interest rates rise.
Is this correct ? Any advice. thanks
For me it’s easiest to think in terms of a simple math equation.
$1000 x 4% = $40
The $40 (coupon) is always constant. So the only parts of the equation that can vary are the price and the interest rate. It’s easy then to see why there is an inverse relationship between bond prices and interest rates. In this example, where the $40 is always constant, an increase in interest rate to %5 will require a decrease in bond price to $800 in order to maintain the $40. The opposite is also true of course.
I am retired, I am concerned about the expected interest rate rise in the near term future (June, 2010 - Dec, 2011) at least I feel that interest rates have to rise sooner than we all expect. With an interest rate rise the value of our bond holdings are expected to decrease. I would like to move to bonds that have a shorter term (2 to 5 years), would this reduce the effect on the value of my bond portfolio with an interestrate rise and what effect would you expect on the rate of return on shorter term bonds.
I think people just confuse the yield with the dividend. The price of a bond changes, the dividend does not change. So if you are buying the same dividend for less cost that is higher yield. If you buy the same dividend for higher cost that’s a lower yield.
Since High Yield Bonds normally react differently in the price of the bond fund, than do say corporate high quality, and normally HY will rise in price when Equities rise in price, will there be a different reaction to an interest rate increase between HY and HQC bonds when interest rates rise. Will the price drop of fund shares of both types experience the reaction to their price shares for the bond funds. Thought I would ask the question, since allocation in your portfolio can be a little tricky when in certain instances the bond act’s like an equity, and in other times or rising interest rates in probably will react like a reqular corporate bond and depend on the duration of the bonds that are held. Any feed back will be appreciated