Understanding bond funds (friend, years, older, cost)

[mathjak107]

nothing can be more confusing sometimes then understanding bond funds....

when you buy a bond you generally pay 1,000 bucks and get promised a certain interest rate if its a newly issued bond... an older bond trades based on market action so you may pay more then 1,000 dollars for it, or under 1000 depending on what it takes to make that bond equal exactley what a new bond today will pay.. so you end up with a fixed bond value and fixed interest value.

a bond fund is nothing more then a huge collection of bonds maturing at different times...since they are always buying new bonds and selling older ones the principal value fluctuates and the interest rate fluctuates...

where the biggest group of bonds lies is called the funds duration value..

now heres the part most dont realize

ILL TRY TO MAKE IT SIMPLE:

if you buy an intermediate term treasury bond fund it holds an assortment of bonds... some may be new , some maybe nearing maturity at 10 years....

the bulk of the bonds fall out somewhere in between usually. thats a duration of 5 years..

lets say you buy in at 10 bucks a share and 5% yield........

the bulk of the bonds fall in the middle at 5 years...

if rates rise to 6% your share price falls to 9.50....

if you stay in the fund and rates dont change for 5 years you will get an extra 1% a year interest for 5 years making you whole again at a total return of 10 bucks.....

as you can see if you stay in a bond fund long enough there is a pretty good chance you will end up with a total return that approximates the same deal you would have gotten had you bought an individual bond.


now pay close attention here, that only holds true for treasuries...everything else carrys credit and market risk not just interest rate risk like treasuries... your bond fund can take a hit merley based on market perception of some of the bonds outlook in the fund. corporate bonds trade like stocks on fear and greed and not just where interest rates are.

if a bond fund has a few defaults or credit down grades your share price will take a hit.. there is no additional interest to offest that, you can and will loose money. or the reverse, if bonds in the fund are upgraded you will make extra return..

a bond fund consists of 2 parts to its total return, what happened to the share price and what happened to the interest rate portion...the 2 together are the real story.... getting 10% interest on a share price thats down 40% since you bought it is smoke and mirrors.... eventually you will need to rebalance your portfolio or sell some shares for more money and you will pay the piper.. or your heirs will get a much smaller inheiratence but there so no way you can pretend nothing is happening to the share price because you like the interest rate... remember that rate can drop on a dime too as it fluctuates with the markets .. if you had a million bucks and the shares drop 40% so did your net worth . its no different than if you owned high divided paying stocks and the down turn came.... your net worth for all calculations of withdrawl dropped..... dont forget a bonds fund interest changes every day so you cant count on it .... if you bought fidelity hi yield fund in march you bought in at 15% interest, today only 5 months later that income stream is 7% and a fraction... yes your shares went up and in this case you are ahead but the point is you cant just look at the income stream as if it was a fixed bond.... you may be up or you may be down, there is no such thing as if your in the fund long enough you will be whole again like you would be in treasuries or maybe even muni's... today though muni's may not hold true either

figuring out all this stuff isnt that hard but you have to step back from focusing on the interest and look at the entire total return...


the longer the bonds duration the more its effected by interest rates, a 10 year treasury will drop less than a 30 year if rates rise,,,,, in fact a 30 year zero coupon treasury can rise or fall as much as 30% with just a 1 point change,,, talk about volatile....that has stocks beat most of the time in volatility if you dont hold it full term or stay in the bond fund long enough.

right now high quality corporate bonds are a great value compared to teasuries, the spread in rates between the 2 are unusally wide but there is risk, gm, citi bank, ford, aig were all AAA rated corporate bonds at one time to the people and funds who bought them.

[mathjak107]

one very important point...when you say go to vanguards site and look at the yield on a bond fund and it says 8% ...if you didnt buy that fund today at that share price that yield is NOT YOUR YIELD..

that yield is determined by 2 parts, the actual amount of the dividend paid and the price per share you buy in at...

those 2 determine your yield,... so the person who buys today pays 10 bucks and gets 8% yield .... you however own it a while, your average cost per share was 20 bucks as the fund dropped alot.... you take the yield and divide by your average cost per share , you my friend are getting 4% not 8%