Re: Question about bond funds

From: Rich Carreiro <rlcarr@animato.pn.com>
Subject: Re: Question about bond funds
Date: Mon, 2 Nov 1998 08:38:39 -0500

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>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)?

It isn't (at least not directly).  The share price of the fund (assuming an
open-end mutual fund, which are the overwhelming majority of mutual funds) is
simply its NAV, which is the assets of the fund minus its liabilities 
(i.e. its net worth) divided by the number of shares outstanding.  So the
only reason the fund's price changes is that the prices of the securities
it holds changes (and from the income those securities throw off).

>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.

Yup.

>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.

Yes.  You'd take a significant capital loss in that event.

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

Well, it depends what you mean.  The consensus opinion of the bond market
about interest rates, inflation, etc. in effect sets the yield to maturity
on bonds.  Right now, all those forces have come together to drive yields
very low (i.e. bond prices are high).  People are so positive on bonds
(or, more likely, so negative on other things) that they are willing to
tie up their money for significant lengths of time at low yields.  So
obviously lots of people think bonds are a good alternative to other
things right now.

>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%?

Probably not.  Bond funds have a maturity objective, and they will
trade bonds and reinvest matured bonds to stay with that objective.
So if long-term corporate bonds have a current yield of 5.5%, then
most long-term corporate bond funds will also have a yield of around
5.5%.

I also recommend going to the misc.invest FAQ (www.invest-faq.com)
and reading the article about the time value of money, which explains
why bonds behave the way they do.

Rich Carreiro
rlcarr@animato.pn.com
P5-100/RedHat Linux 4.1

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