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 am a bond fund veteran but a neophyte bond investor. Duration is useful and is a measure of principal risk, but when interest rates change they don’t change by the same amount over the entire range of maturities. I believe the interest rate on shorter durations changes much more than longer durations – yes? It would be helpful to know how the yield curve changes in a rising and falling interest rate environment. It could be that sometimes shorter durations have a higher actual principal risk than longer durations.
All this makes sense, but does not explain why bonds and bond funds are “tanking” when interest rates are not going up …in fact, savings rates, as meager as they are, actually falling!….so why are even the short term funds dropping so much – very frustrating!!
True investment in bonds are difficult to understand. They may soften the blow under volatile market conditions but they still tend to go down under steady market conditions such as Dow near 11000-11400 during last month or so. Why not consider fixed term deposites instead even at low rates such as 1.3-1.5% returns.
I know I am probably wrong in my assessment. Total bond market index fund-Admiral shares had lost about 2% during last 2-3 months. Any suggestions. Is it still good to hold….
can you please do the same thing on GNMA’S?Good job you did on bonds….Thanks. TOC
When the stock market began to rise, after the big decline, I transferred money from index stock fund to index bond fund for a year. Now that bond prices are high, it is time to sell bonds and buy back stocks. Like the fellow stated above, buy low , sell high.
I have managed to maintain an element of portfolio value with this strategy.
Regardless of the bond prices, I love the steady monthly dividends – makes the house payment.
Did you ever present the answer to the comment that suggested the effect of not re-investing the interest, but using it for retirement income? Especially, in Bond
Funds? And what would be the risk in this approach?
I think Wall Street has people confused. Bonds have one purpose only and that is income generation. One should only own bonds long term for income generation in a portfolio so you can retire. You should never own bonds for capital appreciation. One should never sell bonds at a loss because of interest rate changes. Rate changes are a fact of life and I do not waste valuable time predicting or worrying about future rates. If rates go up I KNOW that my principle will initially decline, however long term, my interest payments will purchase more bonds at higher yields. Wall Street has people fixated on short term capital gains and not llong term investment horizons and tends to ignore the importance of CASH FLOW. They will convince you to sell your long bond at a loss, so you can purchase short bonds at lower yields. More transaction costs equals more profits for Wall Street. Since when is 1 or 2 % yield better than 6%? Also remember that when rates rise, stocks fall as well ,yet most stocks except for dividend payers provide no cash flow. I only invest in investment grade closed end bond funds. They trade like stocks and are quite volatile at times, yet I find that the volatility usually gives me reinvestment opportunities on big down days. Most pay their yield in monthly installments which results in a reliable income stream. I am eager for rates to go up so I can buy more bonds at higher yields. Bring it on.
please show charts for someone who takes dividends and capitol gains out. showing share price results only
Most analysist of bonds refer to government bonds, not corporate bonds. It is difficult to find info on just corporate bonds for the novice or slightly knowledgeable investor. It would be nice if those who write about bonds would identify which they are writing about. This last down-turn showed that “investors” will by government bonds for “security” no matter what the yield is. Yet corporate bonds had relatively hight yields. As government bonds increase in yield, will corporate bonds decrease in desireablitly in the eye of the investor?
August 9, 2010 at 9:53 pm. You said it in a nut shell, I was just thinking, why am I still in the stock market everyday on the computer and not having good days watching my investments go up down like a yo-yo trying to make money in my retirement. The dividends do help. But at 68 I should just be thinking were am I going next for fun……….I was just thinking of getting into tax free bonds for the income, having the interest direct deposited and start spending after 48 years of work and saving. Reading your coment reminded me, and I feel the same let the kids go out and earn it like we did, and if any is left, well so be it, use it wisely. I’m thinking individual muni’s pay a higher divident then a mutural fund and guessing the purchase price is much higher.
The best reason to buy bonds (or bond funds, etc.) is portfolio diversification. Including bonds in a portfolio usually decreases its volatility. This lower volatility helps to dissuade investors from abandoning the market when prices are low.
Many investors buy bonds for an income stream, but there are other ways to get that stream, such as stock dividends, or selling some some stocks (or stock funds, etc.).
Having some cash in your portfolio is always a good idea, even when the cash earns little or no interest.
Too many investors worry about timing investments, when they should be concentrating on portfolio diversification.
Excellent article.
If end of the year I have reinvested dividend and by the end of the year the bond prices drop leading to loss in the value of the investment. Are dividends taxable in this situation?
I feel just a little slow at understanding and need a bottom line dollar figure for the end result based on the graph above. If I invested 1000 dollars in bonds at 4% and the interest rose to 6% Where would I be at the end of 1, 2, 3, etc.. years? Like wise, if the interest rate was reversed, where would I be after a given number of years. I think that should be addressed, then it would be more easily understood by more people. Thank you.
Bonds are confusing. It would be good to “show the math” of how to calculate those numbers. With interest rates at 0% it seems they could only go up, taking prices down.
When bond yields drop, prices rise and my bonds become more valuable. When yields rise, the prices of bonds drop. True, mine become less valuable, but so do others, so the bond manager can now buy more bonds for less money, which will some day rise in price when the yields drop. I can’t possibly know enough to time when I should sell and buy, so I let the bond managers do that. Seems to work and I don’t have to understand all this tricky stuff. Isn’t it kind of like dollar cost averaging stocks?