Bond fund/etf behavior

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Gleevec
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Bond fund/etf behavior

Post by Gleevec »

Apologies if too basic a question but I am confused about how bond funds/ETFs perform in an environment in which the underlying bonds are losing value in a rising interest rate environment, but the attractiveness of the bond fund/etf in terms of demand is rising (ie muni funds in higher tax environment)

In other words, for bond funds and ETFs, is more of the price derived from its underlying assets (bond yield) or the demand for the fund or ETF itself ?
alex_686
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Re: Bond fund/etf behavior

Post by alex_686 »

You are asking a tautological question.

The price of the fund is the value of the underlying assets. There is a edge case here when this is not true, but in those cases we don't know what the correct price is. So there is that.

For bonds, price and yield are the same. If you know the price of a bond you know its yield. If you know its yield you know its price.

If there is a increased demand for bonds for tax reasons then the bond's price will go up and its yield will go down. Thus the fund's price will go up and its yield will go down.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
dbr
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Re: Bond fund/etf behavior

Post by dbr »

So then the question would be does the price go up and the yield go down because there is demand for bonds or does the yield go up and the price go down because investors won't buy if the yield is not attractive or . . . .
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grabiner
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Re: Bond fund/etf behavior

Post by grabiner »

dbr wrote: Tue Sep 14, 2021 2:03 pm So then the question would be does the price go up and the yield go down because there is demand for bonds or does the yield go up and the price go down because investors won't buy if the yield is not attractive or . . . .
I would view price as the more independent variable. If the demand for a particular bond drops, its price will fall, and the mathematical equation means that the yield rises.

Now, one reason that the demand for the bond would drop is that the yields on competing bonds have risen. If the ten-year Treasury yield rises and its price falls, then the value of a ten-year corporate bond will decrease, as investors will only buy that bond if the spread over the Treasury yield is adequate compensation for the risk. The value of a mutual fund or ETF which holds multiple bonds will fall.

However, at the level of an individual bond, the demand is not necessarily tied to interest rates. If the default risk of a bond increases, the bond price will decrease even if yields elsewhere in the bond market do not change.
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nisiprius
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Re: Bond fund/etf behavior

Post by nisiprius »

(Many) bonds are contracts to pay specific numbers of dollars on specific dates. If you assume perfect credit (no default), and perfect competition, then this is the situation:

There are interlocking mathematical relationships that say that if certain packages of bonds are worth $X to buy today, then other somewhat different packages must also be worth $X.

For example, suppose that we have three bonds.
Bond X pays out $100 six months from now, and $1,100 (interest + principal) at maturity twelve months from now.
Bond Y is a zero coupon bond that matures and pays $100 six months from now.
Bond Z is a zero coupon bond that matures and pays $1,100 twelve months from now.

Now, the market can set prices to buy these bonds today. Call the prices pX, pY, pZ. There is a constraint. The market is not free to set any prices it likes. It must be true that pX is almost exactly equal to pY + pZ.

We don't know what pX is. We don't know what the split up is between pY and pZ. But we know that pX = pY + pZ.

If we try to work from market prices to "prevailing interest rates," what we can say is that if we look at the prices of all bonds on the market, we can describe those prices in a simple or economical way by stating "an interest rate for each term."

Rather than deal with three numbers, pX, pY, and pZ, we can just say "the interest rate is P% for six months and Q% for twelve months" and describe the market values with two numbers instead of three.

This would all be simple if all bonds were zero coupon bonds. It isn't that interest rates are set somewhere and cause bond prices to change. If we are talking about a zero coupon bond, about a payment to that comes due ten years from how, it is easy to see that "the bond fell in value" is the same thing as saying "the interest rate rose." If this bond is going to pay out nothing but a single payment of $1,100 ten years from now, and I can buy a freshly-issued bond that will pay $1,200--the "interest rate is 2% now"--obviously the first bond isn't worth $1,100 any more.

But it's hard to separate cause and effect. The fact that you can buy a bond that pays $1,200 causes us to say that the rate is 2%. Or, the fact that the rate is 2% causes people to issue bonds that will pay $1,200 if they want to compete successfully with other bonds that are in the market.

And a lot of the complexity comes because a typical bond doesn't represent a single future payment, but a package of payments occurring over time.
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TropikThunder
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Re: Bond fund/etf behavior

Post by TropikThunder »

Gleevec wrote: Tue Sep 14, 2021 1:33 pm In other words, for bond funds and ETFs, is more of the price derived from its underlying assets (bond yield) or the demand for the fund or ETF itself ?
The “price” of a mutual fund is determined differently than the “price” of an ETF if by price we mean what you would have to pay to buy it. Mutual fund NAV’s are calculated at the end of the trading day based on the performance of the underlying assets. IMO it’s easier to wrap your head around with a stock mutual fund (if the S&P500 goes up, then VFIAX will go up) but the process is the same for bond funds. If the underlying bonds decrease in value (linked to an increase in yield), then the NAV of the fund decreases as well.

As for ETF’s, the market price and the NAV are frequently disconnected - sometimes a little, sometimes a lot (this is what the premium/discount refers to). The NAV is still calculated based on underlying assets but the market price is determined independently - by what a buyer and seller are willing to trade at. If the premium/discount gets too big (ie if the market price deviates too much from the underlying NAV, then Authorized Participants step in to tighten the gap (I don’t have a pithy way of explaining how that works).

So the NAV of bond mutual funds is linked directly to the performance of the underlying assets because that is how the NAV is calculated by the fund provider. The NAV of a bond ETF is directly linked in the same way, but the market price can deviate based on actual trades. An ETF can (theoretically) have high demand driving up the market price even though the underlying assets are underperforming. That disconnect normally doesn’t last long though.
alex_686
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Re: Bond fund/etf behavior

Post by alex_686 »

TropikThunder wrote: Wed Sep 15, 2021 1:59 pm So the NAV of bond mutual funds is linked directly to the performance of the underlying assets because that is how the NAV is calculated by the fund provider. The NAV of a bond ETF is directly linked in the same way, but the market price can deviate based on actual trades. An ETF can (theoretically) have high demand driving up the market price even though the underlying assets are underperforming. That disconnect normally doesn’t last long though.
I am going to disagree with you on your first point. The NAV is actually a accountant's estimate of the fund's value. The NAV is as directly linked to the underlying assets as the ETF's market price. In short they are both high quality methods for pricing the fund. They both have different strengths and weaknesses.

We are now going deep into the weeds. It is highly dependent on the situation but I think that ETF's market prices are more accurate than NAV.

For context I have actually struck a fund's NAV and have worked a fair bit with pricing.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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