Rates on Bonds

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Rates on Bonds

Postby forestlake » Sun Feb 10, 2013 2:56 pm

I'm a little confused about what was said recently in a webcast from Vanguard's CIO. The discussion was about bond rates going up ("bond cliff").

At the end of the discussion, he said:

"If you're a buy and hold investor with a bond fund, and rates go up, you'll take a principal hit in the short term. You'll lose money in the short term. BUT, you'll be reinvesting at higher rates."

This may be due to my general ignorance on how bonds work, but I just don't understand the following:

1. If you're not selling, how do you "lose money in the short term"? I understand (I think) where he says "you'll take a principal hit in the short term" which I believe means the face value of your fund will decrease?
2. The last sentence - when he mentions "reinvesting", is he referring to where you would have the fund set to reinvest dividends? If not, I'm not sure what this means.
3. Why is "reinvesting at higher rates" a good thing as he implies?

Thanks for your patience in helping me understand this.
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Re: Rates on Bonds

Postby dbr » Sun Feb 10, 2013 3:30 pm

forestlake wrote:I'm a little confused about what was said recently in a webcast from Vanguard's CIO. The discussion was about bond rates going up ("bond cliff").

At the end of the discussion, he said:

"If you're a buy and hold investor with a bond fund, and rates go up, you'll take a principal hit in the short term. You'll lose money in the short term. BUT, you'll be reinvesting at higher rates."

This may be due to my general ignorance on how bonds work, but I just don't understand the following:

1. If you're not selling, how do you "lose money in the short term"? I understand (I think) where he says "you'll take a principal hit in the short term" which I believe means the face value of your fund will decrease?

By definition if your wealth invested in this fund has decreased, then you have lost wealth. You have not lost money, because wealth invested in stocks and bonds is not money. Such wealth can be converted to money by selling the investment. I am sure you are thinking, correctly that only then can you know that you have lost money. What happens next could be one thing if you stay in the fund and another thing if you take the wealth out and invest it in something else. Whether or not you will have less wealth after some time goes by depends on what you do with the money. If this discussion sounds pedantic, that is because it is. Discussions about whether or not one has lost money when an investment falls in value are semantic debates that are unnecessary in the presence of simple facts.



2. The last sentence - when he mentions "reinvesting", is he referring to where you would have the fund set to reinvest dividends? If not, I'm not sure what this means.

Sure, he is thinking of reinvested dividends. You would not earn the current yield on money that is not re-invested in the fund. What he is really referring to here is the fact that when an interest rate increases, the NAV of the fund drops. One can then calculate what happens next. If one continues to take the dividends, the NAV will remain unchanged and the number of shares held will remain unchanged, so the value held in the fund will be unchanged and depressed from what it was. If one reinvests the dividends, one will own more and more shares and the wealth held will increase. Because the now reinvested dividends are earning more interest than the fund earned before, eventually the value held in the fund will equal what the fund would have been worth, with dividends reinvested, at the previous lower rate. The length of time required to reach this point of indifference to interest rate increases is defined to be the duration. After rpassing this point in time the previously depressed investment will be worth more and more than it would have been if interest rates had not increased. Over time, investors are better off if interest rates are higher rather than lower. If interest rates increase other than in a single step at a point in time then the effect has to be convoluted over some period of time. (see http://en.wikipedia.org/wiki/Convolution ), at least I think that is what the calculation amounts to.


3. Why is "reinvesting at higher rates" a good thing as he implies?

See above.

Thanks for your patience in helping me understand this.
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Re: Rates on Bonds

Postby stlutz » Sun Feb 10, 2013 3:32 pm

Hi forestlake--

#1) The value of your holding will decline in the short term. Suppose I bought a bond yesterday for $100 that yielded 2%. Today, rates have suddenly shot up to 3%. At the same time, I need to sell my bond to pay for an unexpected expense. I can no longer sell it for $100 as who would buy my bond at 2% when they can buy a new one for 3%? As such, I have to take less than $100 for my bond to make up for that interest difference and I end up with a short-term loss.

#2) Yes, he means reinvesting dividends in the fund.

#3) Reinvesting at higher rates means that you're taking the interest payments and buying new bonds at the new higher yield. So, take my example above. Instead of selling the bond, I would take my $2 in interest and buy at new higher-yielding bond at 3%.

In all of this, the key number to look at is "duration". It tells you two things:

--Approximately how much your fund will rise or fall in value given a 1% change in rates
--Approximately how many years it takes for things to "even out" given a change in rates.

So, suppose your bond fund duration is 5 and you have the scenario I've outlined above where rates go from 2% to 3%. In the short-term, the value of your holding will decline by 5%. With the reinvestment of dividends and the rollver of of old 2% bonds into new 3% bonds as the old bonds mature, it will take about 5 years to value of your holding to recover to the point where it is as if rates had never gone up.

http://www.bogleheads.org/wiki/Bonds:_A ... s#Duration
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Re: Rates on Bonds

Postby midareff » Sun Feb 10, 2013 3:42 pm

stlutz wrote:Hi forestlake--

#1) The value of your holding will decline in the short term. Suppose I bought a bond yesterday for $100 that yielded 2%. Today, rates have suddenly shot up to 3%. At the same time, I need to sell my bond to pay for an unexpected expense. I can no longer sell it for $100 as who would buy my bond at 2% when they can buy a new one for 3%? As such, I have to take less than $100 for my bond to make up for that interest difference and I end up with a short-term loss.

#2) Yes, he means reinvesting dividends in the fund.

#3) Reinvesting at higher rates means that you're taking the interest payments and buying new bonds at the new higher yield. So, take my example above. Instead of selling the bond, I would take my $2 in interest and buy at new higher-yielding bond at 3%.

In all of this, the key number to look at is "duration". It tells you two things:

--Approximately how much your fund will rise or fall in value given a 1% change in rates
--Approximately how many years it takes for things to "even out" given a change in rates.

So, suppose your bond fund duration is 5 and you have the scenario I've outlined above where rates go from 2% to 3%. In the short-term, the value of your holding will decline by 5%. With the reinvestment of dividends and the rollver of of old 2% bonds into new 3% bonds as the old bonds mature, it will take about 5 years to value of your holding to recover to the point where it is as if rates had never gone up.

http://www.bogleheads.org/wiki/Bonds:_A ... s#Duration


If your bond fund (5 year duration) has experienced an interest rate increase from 2% to 3% it has lost about 5% of its $$ value (selling price). At a 3% interest rate it takes 5%/3% or 1.67 years for the value (selling price) to have been restored through the reinvestment of dividends. The remaining 3.33 years at a return of 3% provide a roughly 10-% return for the overall 5 year period. You can compare this to 5 years of a 2% return and things are now equal... for the situation. However, from June 27, 2003 through June 29, 2006, the Fed raised rates .25%, 17 consecutive times. From 4.0% to 8.25% (we are speaking Prime Rate)... that will make the math A BIT different. Then cometh the Black Swan and the Prime rate was dropped from that rate to 3.25% on December 16, 2008. This resulted in the opposite force to bonds... a steady upwards value (resale) push as rates deceased. http://www.fedprimerate.com/wall_street ... istory.htm

When rates are decreasing it is a good time to be long, and the opposite of course. I don't have a crystal ball, neither does anyone on this board as to how low is the lowest, and how long it will last, or when rates will go up, or how far or when. Pick an allocation you are comfortable with and go with it.
Last edited by midareff on Sun Feb 10, 2013 4:01 pm, edited 1 time in total.
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Re: Rates on Bonds

Postby dbr » Sun Feb 10, 2013 3:45 pm

midareff wrote:
If your bond fund (5 year duration) has experienced an interest rate increase from 2% to 3% it has lost about 5% of its $$ value (selling price). At a 3% interest rate it takes 5%/3% or 1.67 years for the value (selling price) to have been restored through the reinvestment of dividends.


Yes, that example illustrates the difference between recovering its original NAV and recovering to the total value with dividends reinvested at 2% that it would have had if interest rates hadn't changed. This latter time is the five years duration.
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Re: Rates on Bonds

Postby magician » Sun Feb 10, 2013 4:35 pm

midareff wrote:
stlutz wrote:Hi forestlake--

#1) The value of your holding will decline in the short term. Suppose I bought a bond yesterday for $100 that yielded 2%. Today, rates have suddenly shot up to 3%. At the same time, I need to sell my bond to pay for an unexpected expense. I can no longer sell it for $100 as who would buy my bond at 2% when they can buy a new one for 3%? As such, I have to take less than $100 for my bond to make up for that interest difference and I end up with a short-term loss.

#2) Yes, he means reinvesting dividends in the fund.

#3) Reinvesting at higher rates means that you're taking the interest payments and buying new bonds at the new higher yield. So, take my example above. Instead of selling the bond, I would take my $2 in interest and buy at new higher-yielding bond at 3%.

In all of this, the key number to look at is "duration". It tells you two things:

--Approximately how much your fund will rise or fall in value given a 1% change in rates
--Approximately how many years it takes for things to "even out" given a change in rates.

So, suppose your bond fund duration is 5 and you have the scenario I've outlined above where rates go from 2% to 3%. In the short-term, the value of your holding will decline by 5%. With the reinvestment of dividends and the rollver of of old 2% bonds into new 3% bonds as the old bonds mature, it will take about 5 years to value of your holding to recover to the point where it is as if rates had never gone up.

http://www.bogleheads.org/wiki/Bonds:_A ... s#Duration

If your bond fund (5 year duration) has experienced an interest rate increase from 2% to 3% it has lost about 5% of its $$ value (selling price). At a 3% interest rate it takes 5%/3% or 1.67 years for the value (selling price) to have been restored through the reinvestment of dividends.

By "the value to have been restored" do you mean that it will return to the initial level, or to a level equivalent to the one it would have reached without the interest rate increase?

In either case, I believe that your calculation is incorrect. In many cases (e.g., bonds selling at a premium), it may never return to its initial level, and the time for it to return to the same level as if there had been no interest rate increase would be 5 years (the duration), not 1.67 years.
Simplify the complicated side; don't complify the simplicated side.
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Re: Rates on Bonds

Postby forestlake » Mon Feb 11, 2013 11:44 am

Thanks all - great info and clears a lot up for me.

It seems to me that a strategy of buy, hold and reinvest, no matter what's happening with rates, over the longer term (20+ years), is a pretty good (read: safe) way to go - thoughts?
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Re: Rates on Bonds

Postby midareff » Mon Feb 11, 2013 11:59 am

[quote="magician"][quote="midareff"][quote="stlutz"]Hi forestlake--

Magician.. the calculation is correct. It would take 1.67 year period for a 1% interest rate hike to a 2% yield 5 year duration fund to return to the value/price it was at originally through the reinvestment of the higher dividend. At 1.67 years your 3% dividend has replaced the 5% loss in value due to the rate increase. At 5 years the remaining 3.33 years at 3% have provided a 10% return over and above the restored value, just as 5 years at the original 2% return would have, making th money = in either case.

The real problem of course is that if inflation was 3% for that 5 years period you lost 5% real money on this investment.
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Re: Rates on Bonds

Postby midareff » Mon Feb 11, 2013 12:02 pm

forestlake wrote:Thanks all - great info and clears a lot up for me.

It seems to me that a strategy of buy, hold and reinvest, no matter what's happening with rates, over the longer term (20+ years), is a pretty good (read: safe) way to go - thoughts?



Yes, set a reasonable AA for your age and risk tolerance and go with it. It is good idea to hve a written AA plan so emotions and noise of the day don't get in your way.
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Re: Rates on Bonds

Postby MN Finance » Mon Feb 11, 2013 12:46 pm

One thing to note is that even if rates remain unchanged, the NAV of all bond funds is going to drop in value long term, since everything is trading above par. The total investment will, however, increase over time as a result of the monthly income payment reinvested.
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