Question about bond funds

From: Peter Palma <rpalma@msai.mea.com>
Subject: Question about bond funds
Date: Wed, 28 Oct 1998 16:18:37 -0500

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I understand from reading bond fund prospectus, that the share value of
bond funds
goes down when interest rates go up.

I know that the main purpose of bond funds is the interest return, not
fund 
appreciation, but the interest rates are so low now that it seems like
the 
interest rates (long term) are much more likely to go up than down. 


How is this accounted for in the share price (or interest rate paid)?


As a completely hypothetical example, say two years ago the interest
rate was 8%
and I bought $10,000 worth of a bond fund that was paying 5% interest,
tax free.

The interest rates have gone down 2% to 6% since then which has
increased the per share
value of the fund. If I sell now, I've made a windfall profit on my
capital in addition to the interest that I've accumulated.

Compare that to now, when interest rates. are extremely low. If I buy
$10,000 worth of a bond fund now when interest rates are 6% and the bond
fund is paying 5% interest, I'm fine as long as I collect interest and
don't sell the shares.  If however, I decide in 2 years to sell the bond
fund, my guess is that the interest rate is more likely to be 8% than
4%.
So, I'll more likely lose capital on the per share price than gain.

Is this just a bad time to buy bond funds, or is this capital risk
reflected in the interest paid by the bonds?

In my example above, would the bond fund from two years ago when
interest rates were higher be paying a lower rate of interest than the
current 5%?

An example with historical numbers for share price and interest return
would probably help.

- -

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