dimbmw wrote:ogd wrote:dimbmw wrote:I think you understand it right. The fund will **sell your bonds that lost their NAV at a loss for you**. And then you will have to wait years hoping to recover losses by earning interest the fund pays.

...snip...

I actually don't understand what particularly did you consider a primitive understanding in my reply?

If the fund buys a bond at, say, $100, and the next day it's NAV drops to,say, $90 because of interest rates increase, then yes, you lost money, your $10, and then you start to recover your losses by getting a higher interest rate (with the same bond or with the one that the fund will decide to buy instead of this one).

The part I highlighted, which is that the

*sale* causes a loss. Consider your example, $100 depreciated to $90. I'll add yield numbers to the example: the bond started at, say, 2% for 5 years and if it depreciated to $90 the interest rates must have jumped to 4.23%. By holding the original bond to maturity I get $10 of capital appreciation, plus another $10 in coupons, total $110. Now if I sell it and replace it with a fresh bond trading at $100 and making 4.23% interest, I get no capital appreciation, but I get $90 x 5 x 4.23% = $19.03 interest; total $119.03, i.e. pretty much the same; slighly less because the fresh bond pays me more money sooner, e.g. $3.8 in the first year vs $2, which is considered more valuable because I can reinvest.

So I can sell depreciated bonds back and forth and I end up in the same place.

*It's not the sale that causes the loss, it's what you held at the time of the increase*. If you're considering holding 5 year bonds anyway, it doesn't matter whether you hold them on your own or in an intermediate fund, they will be hit just the same and the fund's activities will not make the matters worse.

In practice, what the fund actually does is replace the 5 year bond with maybe a 10 year to keep duration constant, which at steep yield curves like today means getting maybe 5% instead of 4.25%. So the roll transaction is making me more money, not causing a loss. However, steep yield curves are not expected to persist, which brings us to your next point.

dimbmw wrote:on the same page 139 of the Bogle's book, just the next phrase after the one quoted above: "The only way for a manager to add an increment to that return is to make interest rate bets-for example, by selling bonds when he expects rates to go up (and prices down), and then buying bonds when the reverse is expected to happen".

This is true because of the curve-flattening expectation that I mentioned; this is why the SEC yield is a good predictor of returns despite the fact that rolling bonds on the current yield curve would seem to generate higher returns. But note that the bond manager in a boring conservative fund like Vanguard's is not making bets when replacing bonds, just simply keeping duration constant, because bond duration decreases every day by, well, about one day so it has to be actively kept in check.

I said "primitive understanding" when I should have perhaps used the nicer word "incomplete", so apologies there. I think the part you're missing is that prices of depreciated bonds appreciate constantly towards par at about the rate of current market yields (

*edit: minus the coupon rate of the original bond*) for the remaining period, they don't simply stay at $90 until just before maturity and then jump to $100. So it follows that selling at any point between now and maturity is

**not** a bone-headed decision that you could avoid if you were your own bond manager. You are simply trading one YtM for another, comparable or higher.