Still don’t understand Bond Index Funds..

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Phinance
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Still don’t understand Bond Index Funds..

Post by Phinance » Fri Nov 01, 2019 9:50 am

I think I have an intuitive understanding of stock index funds, it makes sense to me how the individual companies within the stock index portfolio affect the overall price of the stock index fund (i.e. VTSAX or VTIAX).

However, when it comes to bond funds I don’t really have a clue. For example, I own a federally exempt intermediate bond fund (VWIUX, in my taxable account). How will the price of the fund and the yield change over time? When interest rates go up vs. down? My basic understanding is that if interest rates continue to go down the price of the bond fund would go up but the monthly yield would go down also. Is this correct? :?
"Our life is frittered away by detail. Simplify, simplify." -Thoreau

Elysium
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Re: Still don’t understand Bond Index Funds..

Post by Elysium » Fri Nov 01, 2019 9:56 am

Phinance wrote:
Fri Nov 01, 2019 9:50 am
I think I have an intuitive understanding of stock index funds, it makes sense to me how the individual companies within the stock index portfolio affect the overall price of the stock index fund (i.e. VTSAX or VTIAX).

However, when it comes to bond funds I don’t really have a clue. For example, I own a federally exempt intermediate bond fund (VWIUX, in my taxable account). How will the price of the fund and the yield change over time? When interest rates go up vs. down? My basic understanding is that if interest rates continue to go down the price of the bond fund would go up but the monthly yield would go down also. Is this correct? :?
When rates go down bond prices go up, this will reflect in the daily price movements, and the inverse is true also. You got this part right.

The yield will change when re-investment occurs when the note becomes due. For instance if the fund is holding a 5 year bond that matures in 12/2019 at 2% yield, and the new rate on the 5 year bond is only 1.75% then the fund will have replace the maturing note with lower yielding new note with maturity on 12/2024 (hypothetical scenarios), causing average yields to go down over time. This is in general how lower rates impact average yield on bond funds, it's also connected to re-investment risk.

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Tyler Aspect
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Re: Still don’t understand Bond Index Funds..

Post by Tyler Aspect » Fri Nov 01, 2019 2:20 pm

Individual bonds have individual issuer risks. Diversified bond index funds are designed to avoid single issuer defaults.

Bonds are easy to understand. Each bond pays a fixed yield, and the principle amount is paid back at the bond's maturity date. Bonds held at a brokerage account has a mark to market net asset value.

If the market yield for that bond's type increased, then the existing bond's net asset value will drop. This is because a new buyer could purchase the same type of bond with higher dividends. However, the net asset value recovers as the remaining dividend payments get delivered, until your principle amount is paid back (100% recovery of net asset value). At this point you can see the yield increase is to your benefit, because repurchased bond is at a higher yield.

A bond fund contains a collection of bonds, each maturing at a staggered maturity date. The same behavior I mentioned in the previous paragraph works for a bond fund as well. After a yield increase if you hold an intermediate term bond fund for 7 years or longer, then the initial net asset loss is erased by the income stream to a relative gain.

A long term investor of the total bond market index would like to see yield increases instead of yield decreases!
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MotoTrojan
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Re: Still don’t understand Bond Index Funds..

Post by MotoTrojan » Fri Nov 01, 2019 2:29 pm

Easier to think in single bonds. Here is an example that helped me a bunch.

I offer to send you $1/year for 5 years, if you give me $10. This bond yields 10% and it is obviously worth $10 at this point (you could sell to someone else for that much).

Next day someone else comes out and says they will pay $2/year for 5 years, if you give them the same $10; a 20% yield. Nobody would ever give you $10 now since your bond only pays out $1/year and they can get $2/year, but someone would be more than happy to give you $5 for your bond since that would make the $1/year payout an equivalent 20%. So the amount of money paid out by the bond doesn't actually change, but it's ratio compared to how much that bond could be sold for does.

So when your NAV goes up and yield down, your payouts actually stay fixed, but as you reinvest those payouts into new bonds (via the same fund perhaps) you will be paying a higher NAV, and getting a lower yield on future payouts.

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Re: Still don’t understand Bond Index Funds..

Post by Grt2bOutdoors » Fri Nov 01, 2019 2:33 pm

Tyler Aspect wrote:
Fri Nov 01, 2019 2:20 pm
Individual bonds have individual issuer risks. Diversified bond index funds are designed to avoid single issuer defaults.
Diversified bond index funds are designed to spread the risk of any one single issuer default from having a significant impact on the performance of the fund. An index fund is not designed to "avoid" rather it is designed to mitigate or keep small the risk incurred from one single issuer defaulting on its obligations.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

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UpsetRaptor
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Re: Still don’t understand Bond Index Funds..

Post by UpsetRaptor » Fri Nov 01, 2019 3:56 pm

I have a similar question about how bond index work that may be applicable to this thread vs starting a whole new.

Suppose I buy a bond index fund, let's say VBTLX. Suppose at time of purchase the weighted average coupon rate of the bond index fund is X, general interest rates are Y, and the market's expectation of rate movement in the future is Z. Over the next several years, interest rates go up and down, bond prices go down and up, and the bond market does bond market things with VBTLX yield. But after several years I sell and at that time X, Y, and Z are, hypothetically, exactly what they were when I bought. Will my annual total return for those years be exactly equal to the bond index fund coupon rate?

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Re: Still don’t understand Bond Index Funds..

Post by grabiner » Fri Nov 01, 2019 9:39 pm

UpsetRaptor wrote:
Fri Nov 01, 2019 3:56 pm
I have a similar question about how bond index work that may be applicable to this thread vs starting a whole new.

Suppose I buy a bond index fund, let's say VBTLX. Suppose at time of purchase the weighted average coupon rate of the bond index fund is X, general interest rates are Y, and the market's expectation of rate movement in the future is Z. Over the next several years, interest rates go up and down, bond prices go down and up, and the bond market does bond market things with VBTLX yield. But after several years I sell and at that time X, Y, and Z are, hypothetically, exactly what they were when I bought. Will my annual total return for those years be exactly equal to the bond index fund coupon rate?
The coupon rate is irrelevant in determining future returns; it is factored into the duration, as a higher-coupon bond has a shorter duration than a lower-coupon bond of the same maturity.

But the math still doesn't work out as you suggest. Suppose that you buy a bond fund with a 3% yield and a 5-year duration. Bond yields now rise to 4%. You lose 5% of your investment, but the bond fund returns 4% of the new value. Then, one year later, yields drop back to 3%. You gain 5% of your investment. Your one-year return was 4%, not 3%, even though the fund had a 3% yield at both the start and the end of the year.

If you hold a bond to maturity, then your return on that bond will be equal to the bond's current yield when you buy it, regardless of what happened to interest rates. But bond funds buy new bonds to replace maturing bonds, and you would do the same if you held your own rolling bond ladder; the returns on those new bonds does depend on what happened to interest rates.
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Re: Still don’t understand Bond Index Funds..

Post by Northern Flicker » Fri Nov 01, 2019 10:58 pm

Phinance wrote:
Fri Nov 01, 2019 9:50 am
I think I have an intuitive understanding of stock index funds, it makes sense to me how the individual companies within the stock index portfolio affect the overall price of the stock index fund (i.e. VTSAX or VTIAX).

However, when it comes to bond funds I don’t really have a clue. For example, I own a federally exempt intermediate bond fund (VWIUX, in my taxable account). How will the price of the fund and the yield change over time? When interest rates go up vs. down? My basic understanding is that if interest rates continue to go down the price of the bond fund would go up but the monthly yield would go down also. Is this correct? :?
First, this is not a bond index fund. It appears to be a well diversified muni bond fund well suited to someone who wants exposure to that asset class, but it is not a bond index fund.

Second, bonds with credit risk (or other risks besides just pure interest rate risk) are typically priced by a spread against a treasury bond of similar or the same duration.

Muni bonds have credit risk. An investor would only buy the bond if compensated with additional yield for taking the credit risk. Muni bonds often are callable. The call feature has value to the issuer, so an investor should be compensated with additional yield.

The additional yield to compensate for these risks would be referred to as a muni spread or muni risk premium. It is quite complex to model and calculate, so pricing a muni bond is complex. Individual investors will not typically be able to decide if a given individual muni bond is fairly priced. This is one good reason to hold a professionally managed fund like the Vanguard fund you hold.

When treasury interest rates change, muni bond spreads may not move in lock step, so the effect on the price of a muni bond is less predictable than it is for a treasury.

Because the credit risk unique to specific muni bonds is diversifiable, my opinion is that individual investors should not own individual muni bonds unless they are insured by a highly rated insurer. (This enables the diversification to occur at the insurer). That’s because the muni spread will not compensate you for the diversifiable part of credit risk.

I am not aware that insured muni bonds are still being issued. Thus, holding the Vanguard intermediate term muni fund is a good way for investors who benefit from holding munis to get this exposure with a diversified portfolio.
Index fund investor since 1987.

mortfree
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Re: Still don’t understand Bond Index Funds..

Post by mortfree » Fri Nov 01, 2019 11:41 pm

That’s why I invest in Wellesley (401K) and the Vanguard balanced index fund (Roth).

I don’t fully understand them so I chose those two funds above.

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Re: Still don’t understand Bond Index Funds..

Post by donaldfair71 » Sat Nov 02, 2019 5:38 am

Grt2bOutdoors wrote:
Fri Nov 01, 2019 2:33 pm
Tyler Aspect wrote:
Fri Nov 01, 2019 2:20 pm
Individual bonds have individual issuer risks. Diversified bond index funds are designed to avoid single issuer defaults.
Diversified bond index funds are designed to spread the risk of any one single issuer default from having a significant impact on the performance of the fund. An index fund is not designed to "avoid" rather it is designed to mitigate or keep small the risk incurred from one single issuer defaulting on its obligations.
Are you agreeing, disagreeing, or expanding on with this reply? Feels like you’re repeating what you quoted.

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Re: Still don’t understand Bond Index Funds..

Post by Grt2bOutdoors » Sat Nov 02, 2019 7:33 am

donaldfair71 wrote:
Sat Nov 02, 2019 5:38 am
Grt2bOutdoors wrote:
Fri Nov 01, 2019 2:33 pm
Tyler Aspect wrote:
Fri Nov 01, 2019 2:20 pm
Individual bonds have individual issuer risks. Diversified bond index funds are designed to avoid single issuer defaults.
Diversified bond index funds are designed to spread the risk of any one single issuer default from having a significant impact on the performance of the fund. An index fund is not designed to "avoid" rather it is designed to mitigate or keep small the risk incurred from one single issuer defaulting on its obligations.
Are you agreeing, disagreeing, or expanding on with this reply? Feels like you’re repeating what you quoted.
Expanding.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

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