Hoping for clarification on bond fund questions

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Hilltop
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Hoping for clarification on bond fund questions

Post by Hilltop » Tue Oct 16, 2018 5:00 pm

I am very appreciative of all of the helpful information provided by all of you on this site. I have a few questions regarding bond funds that I am hoping someone can clarify for me. Apologies in advance as I suspect that these reflect very fundamental bond misunderstandings or territory previously covered.

1. Apart from indicating maturity and sensitivity to potential change in interest rates, does a bond fund’s duration also reflect the credit quality or other risks associated with the underlying bond holdings?

2. If I hold $100k in Total Bond (VBTLX) with an SEC yield of 3.3 and duration of 6.2 and $100k in Short term Corporate (VSCSX) with an SEC yield of 3.5 and duration of 2.7, is this equivalent to having a $200k fund with an SEC yield of 3.4 and duration of 4.45?

3. Given VSCSX’s higher SEC yield and lower duration, what motivates the intermediate term investor going with Total Bond over Short Term Corporate. Does the greater stability of VBTLX’s government holdings justify its lower yield and greater interest rate sensitivity? Is the assumption that VBTLX’s longer term yields will ultimately swing in a more favorable direction and result in a better risk/reward than VSCSX over a six-year horizon?

Thanks very much.

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EddieGee
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Re: Hoping for clarification on bond fund questions

Post by EddieGee » Tue Oct 16, 2018 5:17 pm

To answer your questions:

1. No. Duration only reflects the relationship of interest rate sensitivity and time. "Credit risk," the risk that a company may not have the resources to redeem the bond in full or at all at maturity, does not enter into duration.

2. Roughly yes. The math is a little more complicated than a simple average but your answer should be pretty close to the real one.

3. Ultimately, the yield represents the aggregate of what the investment world thinks it should be. This is a complex topic, but the main components of a bond's yield are its maturity date, and the corresponding point on the treasury yield curve, and the premium investors expect above treasury yield based on the bond issuer's financial strength. Right now the yield curve is relatively "flat," i.e. the increase in interest rate that you receive for accepting a longer timeframe is quite modest by historical standards. This situation, plus the fact that many, if not most, people think that interest rates will continue to rise, leads a lot of investors including me to focus on short term bonds and avoid anything intermediate- or especially long-term. The counterargument is that you can't outguess the market itself, and anything that the marketplace as a whole knows is already factored into bond prices - so don't try to guess which maturity is best, just buy the total bond market which gives you "the whole ball of wax." It's up to you which of these philosophies (or something else) makes the most sense to you.

blevine
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Re: Hoping for clarification on bond fund questions

Post by blevine » Tue Oct 16, 2018 5:32 pm

Duration is actually a more general concept than reported by funds. It is the sensitivity to changes in some rate curve. The above answer is correct, as to how to interpret what is on Morningstar and fund websites. But bond fund managers look at multiple variants/definitions of duration, and at least one (spread duration) is a measure of financial strength of the bond issuer. Funds do not generally report this but instead report avg credit rating. Avg credit rating is based on some credit rating agency opinion, spreads are a market opinion, and spread duration is is how sensitive the bonds would be to changes in that market opinion.

Note the short term corp represents credit/default risk, and tsy long term bonds represent rate risk. Long term corp bond entails both risks. The difference in yield between a us tsy and corp bond of same maturity is the “spread”. Bigger the spread, more risk is perceived by wall street, for which you are compensated with a higher yield.

alex_686
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Re: Hoping for clarification on bond fund questions

Post by alex_686 » Tue Oct 16, 2018 7:22 pm

There are flavors of duration that measure interest rate risk. The duration posted by funds is the average cash flow in years. Technically the one posted by fund does not measure interest rate risk, but the values between the 2 are pretty close.

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galeno
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Re: Hoping for clarification on bond fund questions

Post by galeno » Tue Oct 16, 2018 8:01 pm

1. No

2. Yes

3. Lower credit (default) risk and better ballast (goes up when your stocks go down).
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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happysteward
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Re: Hoping for clarification on bond fund questions

Post by happysteward » Wed Oct 17, 2018 6:34 am

Remember total return in a bond fund is a combination of yield and NAV ups and downs. I think the theory is if you hold your bond fund for the duration you will achieve the SEC yield

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Hilltop
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Re: Hoping for clarification on bond fund questions

Post by Hilltop » Wed Oct 17, 2018 8:09 am

Great comments, everyone. Thank you for taking the time to respond.

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