No. of Recommendations: 6
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What are the risks from investing in bond funds?
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The principal risks for bond funds are:
---Interest Rate Risk;
---Reinvestment Risk;
---Refinancing and Call Risk;
---Default Risk


How Does Interest Rate Risk Affect Bond Funds?

• A bond fund's NAV is based on the tradable value of its current bond holdings, and one of the most important determining factors of a bond's value is how its coupon relates to prevailing interest rates on bonds of similar type and maturity.
---With Treasuries coupon versus prevailing interest rates is the only factor in valuation.

• When relevant interest rates go up, the value of the bonds go down, and so does a fund's NAV.
----When relevant interest rates go down, the value of the bonds go up, and so does a fund's NAV.
---Contrary to what some people seem to believe, there is nothing equivalent to “opting out” of the changing valuations of bonds by holding to maturity.
---There is no “reset” of bond fund NAVs when the current holdings have all matured.

• The bottom line is, if relevant interest rates are lower on the average when you buy fund shares than when you sell them, you will have to sell your shares for less, on the average, than what you paid for them, no matter how long you hold the fund. (This assumes other factors that affect bond values even out.)

• Interest Rate Risk is measured by multiplying the percentage point change (basis points/100) to relevant interest rates by the fund's “average duration.”
---Average duration is a complex measure, because a fund holds many bonds, but it is basically a weighted sum of changes to the salable value of each individual bond if there was an instantaneous 1% point shift in coupon for an analogous bond.
---A fund's average duration is an estimate that keeps changing with the fund's holdings, and it may prove quite unreliable for funds that hold a high proportion of bonds subject to calls and, especially, refinancing.

• Funds with longer average maturities (i.e., long bond funds versus short bond funds) will have higher average durations, so their asset values will decrease or increase more for the same change in relevant interest rates.
---Since, it is coupons on bonds of similar type and maturity that matter, it is theoretically possible for the asset value of a short-term fund to change more than that of a long term fund, provided short term interest rates change substantially more than long term rates, though this would be a rare event.

• When the interest rate that affects a fund's asset value goes up or down, the yield (and dividends) for the fund also goes up or down.
---To some extent, a higher yield will compensate for loss to NAV when interest rates go up.
---However, contrary to popular belief and some misleading graphs and models, the higher yield will never completely cover losses from a lower share price during the relevant period (the fund's duration). (This assumes gradual change in interest rates.)
---Graphs and models of returns that extend beyond the duration time frame and show you can achieve a higher total return than the beginning yield are misleading.
---The simple fact is, if you had chosen to purchase a CD or an individual bond that had a yield about the same as the fund's and a maturity about the same as the fund's duration, you would be able to buy more shares in the fund on the maturity date than the number owned by someone who bought fund shares in the first place.
---Another common misconception is that reinvesting dividends significantly changes the equation. If you reinvest dividends through the whole period, again assuming gradual change, the shares bought with dividends above the median share price on the way down will more or less cancel out those bought below the median share price. (More shares will be bought below the median price, because the dividends will be higher, but not enough to make much of a difference.)

• Interest rate risk must be taken seriously, but should not be exaggerated, especially since so many investors have no choice but bond funds and money markets for non-stock assets in retirement accounts.
---Under most circumstances, if you hold onto a fund for at least as long as its duration, all that will happen in a rising interest rate environment is that your total return will be less than the beginning yield and you could have done better with a bond or a CD, if that option were available to you.
---If interest rates change suddenly by a large amount, and you need to sell fund shares, you could end up with a serious loss, especially in a long bond fund.

• Consider some examples (assuming gradual change in interest rates and using SEC Yield as a proxy for interest rates and to cover compounding).
---For an intermediate bond fund with a duration of 5 and an initial yield of 4%, if the yield goes up to 6% over 5 years, the NAV will go down by 10% (2% points times duration of 5), while the average yield will be 5%. Average the 10% loss over 5 years (2%) and subtract from the average yield of 5% and the total annual return will be 3%. This is less than the initial yield of 4% and less than a 5-year CD with a 4% APY, but isn't close to a loss.
---For a short term bond fund with a duration of 2 and an initial yield of 3%, an increase to a 4% yield over 2 years would mean a 2% loss, averaged at 1% loss per year, subtracted from an average yield of 3.5% leaves a 2.5% annualized return. Again, this is somewhat below the initial yield.
---If we looked at the same short term fund but used an increase in yield from 3% to 7% over 2 years, the annualized return would be 1%, but still in the black.
---For a long bond fund with duration 10 and initial yield of 5%, if the yield went up to 9% over 10 years, the 40% loss would average out to 4% per year, with an average yield of 7%, for a total return of 3%. Notice that even with this dramatic rise in interest rates for a long bond fund, the result is just 2% points less per year than the initial yield not a devastating loss. If you had bought a 5% 5-year CD and rolled it over to a 7% CD, you would have done better by 3% per year.
---Finally, consider the same long bond fund if interest rates went from 5% to 9% in just 5 years. There would still be a 40% loss and average yield of 7%, but the loss would be amortized over 5 years, not 10, so the net return over the 5 years would be a 5% loss.

• Here is a real world example of what happens to a fund when interest rates rise, in this case to Vanguard's Short Term Bond Index Fund for 2005 (unfortunately, the link is obsolete):
---If we invested $1000 on December 31 2004 at $10.14/share, we would have owned 98.62 shares.
---Jan 31 Distribution of .02723/share, or $2.685, reinvested at $10.11, add .26 shares for 98.88. Feb 28 distribution of .02489/share, or $2.46, reinvested at $10.04, add .25 shares for 99.13. March 31 distribution of .02817/share, or $2.79, reinvested at $9.99, add .28 shares for 99.41. April 29 distribution of .02771/share, or $2.76, reinvested at $10.04, add .27 shares for 99.68. May 31 distribution of .02888/share, or $2.88, reinvested at $10.09, add .29 shares for 99.97. June 30 distribution of .02837/share, or $2.836, reinvested at $10.07, add .28 shares for 100.25. July 29 distribution of .02990/ share, or $2.997, reinvested at $10.07, add .30 shares for 100.55. August 31 distribution of .03021/share, or $3.038, reinvested at $10.05, add .30 shares, for 100.85. September 30 distribution of .02966/share, or $2.99, reinvested at $9.96, add .30 shares for 101.15. October 31 distribution of .03132/share, or $3.168, reinvested at $9.91, add .32 shares for 101.47. November 30 distribution of .03105/share, or $3.15, reinvested at $9.91, add .32 shares for 101.79. December 30 distribution of .03257/share, or $3.315, reinvest at $9.92, add .33 shares for 102.12.
---At the end of the year the total value for our shares is $1013, a 1.3% gain for the year.
---Over the year, the “income return” was 3.48%, with a capital loss of 2.17%, as the NAV went from $10.14 to $9.92, a loss per share of 2.17%.
---The fund's SEC yield went from 3.24% to 4.55%, a change of 131 basis points, which with duration around 2.4 would have predicted a loss of 3.14%. On the other hand, the loss using “distribution yield” as change in interest rates would have been predicted to be 1.7%. (There are other factors beside interest rate changes that affect NAV, but the discrepancy is probably best attributed to the inherently approximate nature of trying to calculate interest rate risk on funds.)


How Does “Reinvestment Risk” Affect Bond Funds?

• As bonds held by funds mature, as dividends are paid into the fund, and as investors buy new shares, all (or most) of that money must be invested by purchasing bonds.

• If interest rates are low, the fund has to buy bonds with low yields.

• More aggressive bond picking and trading funds do try to maneuver around, or even take advantage of, low interest rates, with mixed success (and high costs).
---Conservative funds just buy according their rules, and it is much more difficult for them to work from educated guesses about when to lock in yields and when to stick to shorter maturities than it is for individuals.

• The problem for funds of having to buy bonds with low yields is sometimes exacerbated because, when interest rates go down and Net Asset Values go up, many people start chasing after the hot returns. (Or, it may simply be that there is a flight to bonds during a stock market crash.)
---The result is that a fund may have large amounts of new money to invest when interest rates are low.
---Then, when interest rates go up and many people sell their fund shares because of falling NAVs, the fund is left with less money to buy bonds with higher yields.
---A fund with a disproportionate amount of low yield bonds is also more susceptible to “interest rate risk.”
---Some funds do try to restrict momentum trading to prevent this problem, but it isn't just caused by momentum traders.


How Do “Call Risk” and “Refinancing Risk” Affect Bond Funds?

• Many bond funds hold mortgage bonds, subject to refinancing, and/or corporate (and other) bonds that have call provisions.

• To some extent, the prospects for calls and refinancing are priced into the bonds.
---However, the valuation is more or less based on the likelihood of calls and refinancing given the current interest rate environment.
---If interest rates fall significantly, calls and refinancing become more prevalent, and when a bond that was priced at a premium to face value gets called, the fund only receives face value.
---A mortgage bond with a coupon higher than the new, lower, rates on mortgages, would also have been valued at a premium, and as portions of the principal are returned during refinancing, the return is at face value not at the premium.
---Even if a bond selling at a premium is not called, the greater chance of being called will have a negative impact on its price (counterbalancing the potential increase in value from the higher coupon relative to falling interest rates).

• The result is that funds with high call and refinancing risk are likely to lose asset value from calls and refinancing during periods of falling interest rates.
---This loss in asset value will often go unnoticed, because others bonds held by the fund increase in value with lower interest rates, so the fund's NAV may still show a gain or, at least, stay even.
---Nonetheless, the fund has lost value compared to the gain from falling interest rates it would otherwise have had to offset the lower yield and dividend distribution.
---When, and if, interest rates return to the starting point, the fund's NAV will be lower than at the start, because of the lost value from calls and refinancing.

• Refinancing risk seems to have more of an impact on funds than calls, so it is advisable to look at a fund's holdings to see what proportion are mortgage bonds.
---Some funds tell you they have high refinancing risk, if you check under risks.
---The Lehman Aggregate (Total) Bond Index had over 37% of its assets in mortgage bonds (mostly government-backed) as of 10/31/2006.
---Analysis of Vanguard's Total Bond Market Index Fund suggests it lost an average of about 100 basis points per year due to refinancing and calls (and some to default risk) over both the 10-year period from 1996-2005 and the 5-year period from 2001-2005.
---Vanguard's GNMA fund had a slightly negative capital return from 1996-2005, even though the income return for 1996 was 7.25% and for 2005 was 4.67%. Refinancing turned what should have been a solid gain in NAV from falling interest rates into a loss.

• Many funds do not hold mortgage bonds and are not subject to refinancing risk, including Treasury funds and most Corporate funds.
---Vanguard's Short Term, Intermediate Term, and Long Term Index Funds (and the Lehman indices they track) do not hold mortgage bonds.

• It is, of course, always advisable also to check about call risk for funds, as well as refinancing risk.


How Does “Default Risk” Affect Bond Funds?

• The values of bonds with credit ratings (excluding Treasuries) are always fluctuating, as traders reassess default risk.
---The asset values of funds that hold these bonds, therefore, also fluctuates with changing perceptions of default risk, although this is usually hard to notice, given the greater impact of day to day changes in interest rates.
---Downgrades, upgrades, and watches by credit agencies affect trader assessments, but default risk gets reassessed daily anyway.

• When bonds default, all or part of their value is lost, as is that part of a fund's asset value.
---Most funds have highly diversified bond portfolios, so even the default of a major company with much outstanding debt will have a relatively small impact. (The loss in value is usually gradual, because the company's rating has been falling for some time.)
---Aggressive funds that take large positions in high-risk companies are in danger of big losses from defaults, if their bets turn out to be wrong.

• Sometimes there is a broad revaluation in the bond market of the “risk premium” on corporate bonds in general, or lower investment grade or junk bonds in particular.
---This change in risk premiums usually corresponds to deteriorating and improving economic conditions, with risk premiums increasing, as defaults seem more likely with economic weakness.
---Junk bond funds often sustain significant losses to share price during hard economic times, despite falling interest rates that would otherwise increase the value of their bonds, to some extent because of actual defaults, but more because of fear of defaults.
---An Investment Grade Corporate fund, during falling interest rates and a poor economy, may end up with a lower total return than a Treasury fund of the same maturity level, despite having a higher income return, because of an increased risk premium (and increased calls).
---In reverse, with an improving economy, a junk fund may do very well, even with higher interest rates, and an Investment Grade Corporate fund may be less hurt by rising interest rates than a Treasury fund, because of a decreased risk premium.

• However, this logic that the increased real risk of default for heavily indebted and struggling companies during recessions and economic slowdowns should lead to higher risk premiums, is sometimes undermined because investors buy low rated bonds, despite the risks, seeking high yields, as the yields on safer bonds go down.
---Typically, during economic hard times, the Federal Reserve lowers its discount rate and yields on Treasuries and high investment grade corporate bonds also drop.
---These lower rates make riskier bonds tempting, and there may be enough buyers to drive up prices on junk bonds, with junk bond funds seeing rising share prices. (We are seeing a modest example of this during an economic slowdown in the latter half of 2006.)
---On the other hand, during 1991 and again during 2000-2003, when the economy was in or heading into serious trouble, junk bond values plunged, so this flight to yield may be more of a blip, before the real hard times are clearly visible.
http://quote.fool.com/chart.aspx?s=VWEHX&q=l&l=off&t=my

• For more on default risk and risk premium and their effect on junk bond funds, see: http://boards.fool.com/Message.asp?mid=24896100
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