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Please help clarify how bond funds work regarding the interest they pay.

If I pay $1000 for an individual bond paying 10%, I expect to get $100 per year for the life of the bond. The payout is not affected by changes in current interest rates in the general market.

If I pay $1000 for shares (100 at $10.00 / share) in a bond fund that currently is paying 10% interest, I would expect to also earn $100 per year on the investment. However if the NAV goes down (say to $9.00 / share) due to increases in interest rates in the overall market, but if the fund has neither bought nor sold any bonds, how much interest dollars could I expect to receive? I.e, how are current interest payouts computed for a bond FUND? Would a person who spends $1000 today to buy into the fund at 9.00/share (111.1 shares)get more interest money payed out then I would?


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If a bond fund is paying $1 per share annually, as long as the fund continues to hold those bonds, it should continue to pay the $1 per share no matter what interest rates do. All shareholders receive the same per share distributions no matter what they paid for the shares.
However, as time passes, some of the bonds mature, or may be called away. Shareholders redeem their shares and the manager may have to sell shares to pay them. New shareholders may buy shares, and the manager must invest the money by buying new bonds.
There is a tendency in bond funds, like equity funds, for happy shareholders to buy more shares and disgruntled shareholders to wish to redeem and seek a more lucrative investment. Therefore there is a tendency to buy high and sell low, and the manager must buy and sell at the wrong time. This tendency, plus the fact that the manager must be paid, are two of the reasons why you may do better buying bonds than bond funds. When the manager must sell when the NAV is down, thus realizing losses, you as a remaining shareholder realize losses also. If the manager could be buying when the NAV is down, he could buy higher yielding bonds, but that is exactly when he must be selling. Only when interest rates are falling again, and the NAV rising, do people start seeing his fund as a good investment. Then he must buy at the higher price. Further, if he has been fortunate enough to be able to buy when rates are up, the high-yielding securities may be called away when the companies that issued the bonds see they could refinance at a lower price and the high-yielding issue gets called.
Laddering maturities helps this somewhat, because if the maturing securities give enough cash flow to pay redeeming investors, the manager may not have to sell into a bad market.
The yield of the bond fund is in fact affected by all of these things. If you look at the yields of bond funds over years, you see decrease in dividend when interest rates are falling, but much less if any increase in the dividend when the rates are rising.
Bonds mature, and their payments are stable unless something awful happens so the issuer can't pay. Bond funds have no maturity date. If you own a long term bond fund for 30 years, you still have a long term bond fund. Your bond may be called away, but if you bought it at a discount in the first place that should not be a disaster.
Best wishes, Chris
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