Learning About Bonds: Interest Rate Risk, Time Horizons, and Duration

For a long time, the my knowledge of bonds could be summed up in one sentence: Bonds are an IOU where you lend money to someone and they pay you interest plus your principal back eventually. There are many risks with bonds, and just two of them are credit risk and interest rate risk. Credit risk is the possibility that you won’t be paid back. Interest rate risk is the fact that once you’ve bought a bond, the value of that bond varies with prevailing interest rates.

Why Bond Values Change With Interest Rates
Let’s say you bought a bond from the US Treasury for $1,000 at pays 4% annual interest once a year ($40). What if the next day, market conditions change and now the US Treasury offers $1,000 bonds paying 5% interest ($50). Nobody would buy your bond for $1,000 anymore, they’d only pay $800 for it, since $40 is 5% of $800. This is why you may have read that bond prices tend to move in the opposite direction of interest rates.

So what’s the next level of understanding? I think this recent Vanguard Blog article on bonds expands on things nicely. The primary point is that the impact of rising or falling rates on bond returns varies depending on time horizons and the duration of your bonds.

Maturity vs. Duration
When you look at the stats for a bond mutual fund, you’ll see both average maturity and average duration. While a bond’s maturity is how long before your principal is repaid, the fact that most bonds pay out regular interest payments (coupons) changes the actual sensitivity to interest rates. This is where average duration comes in – it takes into account the relative discounted cash flows to accurately measure price sensitivity with respect to interest rate. Short version: Look at duration, not just maturity.

Time Horizons
The table taken from the article shows how the impact of interest rates changes with time horizon. In this scenario, you have a bond fund with a duration of 5.8 years and an initial yield to maturity of 4%. Then we see what happens if rates either stay the same, rise to 6%, or drop to 2%. (Rates are assumed to change evenly over two years). As with most bond funds, the interest income is continuously reinvested into new bonds.

If your time horizon is a lot shorter than your duration, then we see that the major risk is rising interest rates. Rising rates can crush your returns, while falling rates can boost them. However, if your time horizon is a lot longer than your duration, then the larger risk is lower interest rates, because as you re-invest your interest payments into new bonds (with lower interest rates), those lower rates will hurt your return in the long run.

Another interest thing to notice is that if you held for the exact length of the duration, 5.8 years in this case, then your annualized return would be very close to your initial yield of 4%, regardless of whether rates rose or fell.

In general, if you’re saving for a short-term goal, it may be wise to pick a duration that is also short enough so that interest rate swings won’t wipe you out. If your time horizon is for a retirement that is decades away, then picking a duration for a bond fund is more about other factors than just predicting upcoming interest rates. Remember, future higher interest rates can actually help your long-term returns. For example, consider the balance between the increased volatility of long-term bonds with their higher long-term historical returns.

Comments

  1. I have a question for you in hopes that you know the answer. I look at the graph on Yahoo finance for the Vanguard Intermediate term bond fund (VBIIX), and since inception, it seems the average price is around $10 a share. Now, certainly the fund fluctuates in price on a daily basis for the reasons mentioned in your article. But long-term, it seems to stay the same price.

    Is there a reason for this? I am aware that all your gains come from dividends not reflected in the graph. But I’m more interested in the fundamental reason why the price seems to always stay around $10.

    Would it be a good idea to try to buy the fund as close to or less than $10 as possible? Is that the way to “price” bond funds and determine what a good entry point is?

  2. Rick, I think the reason the price tends to stay at $10 is because the gains are paid out as dividends… does that make sense?

    I have VFSTX and it pays a dividend at the end of each month.

  3. @Rick – As Mark said and you said, the Yahoo chart is only showing the NAV (net asset value), and that fund pays out the dividends (interest payments) on a monthly basis so the interest doesn’t “build-up” in the NAV. For a better chart showing the total performance (change in NAV + dividends), see this Morningstar quote page for VBIIX.

    I wouldn’t bother trying to get near $10. You can see from the Yahoo historical prices page (link) the NAV slowly creeps up each month, until the dividend is paid out and the price then drops again.

    And as talked about above, a low price may simply mean rates have risen recently, and so future interest payment may be higher. Conversely, a high price mean rates have dropped recently, and future interest payments will be lower. So getting in below $10 doesn’t mean you got a “deal”. Predicting future interest rates are very tricky.

  4. I am aware that the graph doesn’t include dividends. I mentioned this in my post. I guess I was wondering what fundamental reason causes the fund to stay near $10.

    The point is to try to find a good entry point. Bond funds seem pretty expensive right night. I think many people expect the FED to start increasing interest rates soon, and when this happens the bonds will drop in price. I don’t want to buy a bunch of bonds, only to have them lose 10% in value in the next year.

    That’s why I thought it might be a good idea to wait till it drops back to around $10 to purchase them, waiting until it reverts back to a “normal” price.

  5. Your reasoning for buying near $10 is not correct. Assuming prices proceed as historical prices have (going above $10 and then back to $10 after dividends are paid out), it will not matter when you buy. Here are two scenarios that may help:

    1) You buy at $10 at beginning of month. The price rises to $10.10 at the end of the month. After one month, you make 10 cents.

    2) You buy at $10.10 at end of month. The fund pays out 10 cents and the NAV is now at $10. The price rises back to you purchase price of $10.10 in one months time. After one month, you still make 10 cents.

    This is more an accounting issue as opposed to an investing/timing issue. If interest rates do go up, it will not really matter whether you bought at the beginning of the month or the end. You would still get your 10 cents and your NAV price will still plummet :)

  6. simplesimon says:

    @Rick:
    The chart within Jonathan’s post just showed why if you hold a bond fund to its average duration that the drop in price due to increasing interest rates is a wash compared to a drop in interest rate or even interest rates holding steady.

    “I was wondering what fundamental reason causes the fund to stay near $10.”

    A NAV tells you the net assets of the portfolio. It’s like creating your own bond ladder (and we can call this your own bond mutual fund). Why doesn’t the price grow over time like a stock? Because stocks are fundamentally different than bonds. Like stock, stock funds can grow in value because stocks grow in value. Individual bonds, like the ones in your bond ladder, do not grow in value when held to maturity. You pay $X, receive Y% interest, then get $X back upon maturity and this is reflected in a fairly stable NAV for bond funds.

    A bond fund’s chart on something like Yahoo! Finance could be misleading in showing how volatile the price can be. Try superimposing VBMFX with a stock fund like VTSMX over a 10-year period and VBMFX will be pretty much a straight line. Now isn’t that the kind of safety every investor seeks with the bond portion of their portfolio?

  7. The reason why VBIIX trades at a NAV close to 10 is because (for the most part) this is a buy and hold bond portfolio. Therefore, when you buy and hold a bond to maturity it does not matter what happens to the price of the bond before it matures. Basically, the bond will pay out at face amount at maturity regardless of what interest rate are.

    So, the reason that you pointed out: interest payments (dividends) are constantly paid out + buying and holding to maturity equal a “stable” NAV.

    For example, lets assume you buy a bond (at issuance) issued at par or $100. The bond matures in 10 years. For the first 5 years of the bond, interest rates go down; hence, the price of the bond goes up. Lets say to $110. Now, if you were in the business of “trading” bonds, you might realize that your bond appreciated in value and decide to sell netting a $10 gain, but if you continue to hold then that unrealized gain (the $10) remains unrealized until you sell the bond. Now, lets assume that for the next 4 years and 11 months interest rates keep going down. You would expect the price of your bond to keep going up right? wrong, everyone always tells you that bond prices vary with interest rate…. but everyone forgets that time to maturity is an important component as well. Regardless of how low interest rates are at the 9 year and 11 month mark (5 + 4.11) the price of your bond will be very close to par ($100) because there is only one more coupon payment to be made. Principal will also be paid off, but that does not change as interest rates change. Hence anyone willing to buy your bond at the 9 year 11 month mark will only be getting an above market payment on the coupon and the face value of the bond.

    Sorry for the long example, but hope that it was helpful to tie into the stable NAV discussion!

  8. If I never had a bond fund but now decided that I need to hold “120 -my age”% in bonds, what would you recommend the best way to carry this out.

    In my 401K, which is currently invested in 100% stocks; should I just Sell a few stocks and buy the bonds?
    Or I should direct a larger portion of my future contributions to bonds so as to benefit from the Dollar cost averaging?

    I just started a non deductible IRA, so the funds in that are not significant enough to buy the bonds. And for tax reasons; don’t want to hold bonds in my Taxable brokerage. So is 401K my only option for holding bonds?

  9. Doesn’t the option still exist to just hold the bond to maturity and collect what you agreed on from the start? That way fluctuations in the market don’t effect the final outcome at all.

  10. Right now people are hesitant to commit to intermediate term bond funds because they fear that interest rates will go up in the next few years. While the data from Vanguard show that you will be made whole after 6 years, they conveniently left out the scenario of investing in short-term CDs for two years before investing in intermediate term bond funds again when the interest rate is done rising from 4% to 6%. Of course one can argue you can’t time the interest rate movements. I would think between the two scenarios Vanguard showed, one is far more likely than the other.

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