No. of Recommendations: 0
I understand how interest rate risk works for individual bonds. I am sure there are calculators on the web for this -- but the arithmatic is straight forward anyway -

My questions relates to interest rate risk with mutual funds.

It seems to me some portion of the risk may be altered or changed because a collection of bonds is involved. If I purchase a mutual fund with an average duration of 4.1 years and a 25% portfolio turnover typically -- is my interest rate risk going to deviate significantly from a bond with say 4 year until maturity?

Another side of the same question -- if I buy an individual bond and hold it until maturity I will get the coupon plus the principle. If I buy a mutual fund it seems to me I essentially loose the redemption money (if goes into a pot and is reinvested). If there is not some decrease in the interest rate risk then I would expect people to leave bond funds dramtically in periods of rising interest rates.

Gordon
Atlanta
Print the post Back To Top
No. of Recommendations: 0
(Gordon:)Another side of the same question -- if I buy an individual bond and hold it until maturity I will get the coupon plus the principle. If I buy a mutual fund it seems to me I essentially loose the redemption money (if goes into a pot and is reinvested).
______________________________________
You don't lose the redemption money - what you lose is the certainty of the locked-in yield to maturity that you get when you buy an indiviual bond yourself. You're at the mercy of the fund managers, who are in turn may be forced to make transactions by circumstances beyond their control. [See below]
______________________________________
If there is not some decrease in the interest rate risk then I would expect people to leave bond funds dramtically in periods of rising interest rates.
______________________________________
That can happen, and when you have a "run on the bank" [or fund], the fund managers have to sell some holdings to raise cash to redeem the shares of the exiting shareholders. And this may be in spite of whatever their market strategy would otherwise be.

Bill
Print the post Back To Top
No. of Recommendations: 1
"My questions relates to interest rate risk with mutual funds.

It seems to me some portion of the risk may be altered or changed because a collection of bonds is involved. If I purchase a mutual fund with an average duration of 4.1 years and a 25% portfolio turnover typically -- is my interest rate risk going to deviate significantly from a bond with say 4 year until maturity?

Another side of the same question -- if I buy an individual bond and hold it until maturity I will get the coupon plus the principle. If I buy a mutual fund it seems to me I essentially loose the redemption money (if goes into a pot and is reinvested). If there is not some decrease in the interest rate risk then I would expect people to leave bond funds dramtically in periods of rising interest rates."

Gordon,

Extensive redemptions during a panic may affect bond funds that do a lot of game playing (derivatives, etc.), but if you're dealing with a standard bond fund, say something like TIAA-Cref's Bond Plus or a Vanguard Index or standard bond fund, the real issue is what the NAV is when you sell shares compared to when you buy shares. The NAV is determined by the value of the bonds held by the fund on a given day, which depends on what is going on in the bond market (i.e., in relation to the actual bonds, or their equivalents, held by the fund, not some headline grabbing interest rate, notably the Fed's).

For a fund, average duration is a complex measure, I have no interest in trying to understand, that more or less approximates the average years to maturity of the fund's holdings (if you just owned an individual bond, year to maturity is what would be your key to evaluating interest rate risk). In some way redemption issues get calculated into the average duration measure. (I remember reading something on Vanguard about how they do duration calculations and deciding I'd just take their word for it.)

Basically, the easiest way to look at interest rate risk for a fund is to look at the current yield and the current average duration on the fund. The NAV of the fund should drop (or increase) by multiplying change in yield basis points (100 basis points = 1% point change) by the average duration. So, if you are dealing with a fund with a 4.1% average duration and a 4% current yield, and the fund's yield rose to 6%, the NAV should drop 8.2%. Even if you had a long bond fund, with a duration of 11, and you saw a change in yields of 300 basis points, you'd still only be looking at a 30% loss in NAV.

This is why I have no patience either with those who preach panic from rising interest rates or those who dismiss the risks, if you hold and reinvest dividends. The reality is, if you do hold onto a fund, the end result over time, in a rising interest rate environment, is the loss in NAV will hurt your total return to the point you'd have been better off with something like CDs or EE bonds or buying individual bonds, but you won't end up losing your principle.
Print the post Back To Top
No. of Recommendations: 0
Author: Lokicious | Date: 9/22/04 11:50 AM | Number: 10815
The NAV of the fund should drop (or increase) by multiplying change in yield basis points (100 basis points = 1% point change) by the average duration. So, if you are dealing with a fund with a 4.1% average duration and a 4% current yield, and the fund's yield rose to 6%, the NAV should drop 8.2%.

This may be true, but the fund's yield will also increase accordingly. Then, after this drop in NAV, as older low yield bonds mature and are replaced with new higher yield bonds, the fund's yield will continue to increase until after interest rates stop rising. If you are reinvesting the dividend, it will keep your total investment value nearly constant.

You can also play the changing interest rates by moving to shorter duration bond funds when interest rates are rising and longer duration funds when rates are falling. And, since the effect on the NAV and yields always lags behind the changes in interest rates, you don't even have to be able to time the market to do this.

Russ
Print the post Back To Top
No. of Recommendations: 0
"This may be true, but the fund's yield will also increase accordingly. Then, after this drop in NAV, as older low yield bonds mature and are replaced with new higher yield bonds, the fund's yield will continue to increase until after interest rates stop rising. If you are reinvesting the dividend, it will keep your total investment value nearly constant."

Russ,

I'm not sure what your mean by "nearly" constant, but it is basic arithmetic that, as long as interest rates have risen above your initial NAV purchase price, the drop in NAV will be more than any gain from higher interest rates, even with reinvested dividends, at least until after you have held until the "average duration" period has passed. In other words, your total return will be less than the inital yield on the fund when you bought your shares. How much less, or whether you might end up with a loss, depends on how much rates go up and what the duration on the fund is.
Print the post Back To Top
No. of Recommendations: 0
...the drop in NAV will be more than any gain from higher interest rates, even with reinvested dividends, at least until after you have held until the "average duration" period has passed.

Is this any different than holding a single bond?
Print the post Back To Top
No. of Recommendations: 2
"Is this any different than holding a single bond? "

Totally. A bond matures. The mutual fund, with few exceptions, does not. There are a few closed end funds which as a part of their prospectus have the objective of paying as much interest as consistent with good investment practice until a certain date; then selling any remaining assets that have not matured, distributing all proceeds to their shareholders, and ceasing to exist.
Those are called term trusts.
But in general, mutual funds do not mature.

Best wishes, Chris
Print the post Back To Top
No. of Recommendations: 0
"...the drop in NAV will be more than any gain from higher interest rates, even with reinvested dividends, at least until after you have held until the "average duration" period has passed.

Is this any different than holding a single bond?"

To reiterate what Chris said, this is indeed different. If you own a bond, ignoring default and call issues, if you hold until maturity, you will get back the face value of the bond plus all the interest you've been getting paid for the life of the bond. With a fund, in a rising interest rate environment, when the maturity period (duration) has been reached, you will be left with something less than the NAV you started with plus accrued interest.

Print the post Back To Top
No. of Recommendations: 0
With a fund, in a rising interest rate environment, when the maturity period (duration) has been reached, you will be left with something less than the NAV you started with plus accrued interest.

OK, say that our economy takes off as a result of these stimulating tax cuts that have been passed.
<pauses for Loki's hysterical laughter to stop>

The herd that has moved into bond funds then see equities pop and moves their money en masse out of the bond funds.

Would this not create a dramatic fall of the bond funds' NAV as the bonds are sold at a steep discount to cover this outflow? Plus an additive effect of causing a discounted value to the bonds that are retained by the funds?
Then wouldn't even the ER's will increase to cover the transaction costs of the sell off?

Then fast forward to when the reality sinks in the equity pop was irrational exuberance Part II and unsustainable. The herd starts to move back into the bond funds, but the underlying bonds are now being bought at extremely low yields.
Would this not create another drop in the NAV as the value of the bonds that were retained are diluted?

OK, this is a badly written horror story, but an attenuated, more realistic version of this is what keeps me in CD's and MMA's as my fixed income component.

Am I delusional, or at the least, ignorant of bond market reality, about what could happen?


Keith
~ always paranoid of when the boulder will be getting away next
Print the post Back To Top
No. of Recommendations: 0
Keith,

I asked a question similar to this recently and the reply was along the lines that I didn't really understand just how big the bond market was. I thought about making some smartass remark, then, instead I just thought about it. I suddenly realized that with the biggest buyers of US Treasuries being actual governments, the one who replied to me was right. There are truly MASSIVE amounts of moneys involved in bonds. Plus, it's not likely that the Chinese and Japanese (and others) governments would go chasing after money the way investors do. They have a different agenda that keeps them in US Treasuries.

I realise that the issue here is mutual funds and corporate bonds. But, they are strongly tied. Investors go to corporates to get the extra yield, and assume the extra risk. But, for a AAA bond, there probably won't be all that much differential to an equivalent treasury.

Hedge
who barely knows how to spell most of the big words he just used ;)
Print the post Back To Top
No. of Recommendations: 0
Plus, it's not likely that the Chinese and Japanese (and others) governments would go chasing after money the way investors do.

Boy Hedge, ya hit another area of paranoia for me.
Granted, right now if they wanted to flex their influence, it'd be a case of cutting off their nose to spite their face. But as we progressively lose our economic dominance...

Keith
~ curling back up in the fetal position
Print the post Back To Top
No. of Recommendations: 2
"OK, say that our economy takes off as a result of these stimulating tax cuts that have been passed.
<pauses for Loki's hysterical laughter to stop>

The herd that has moved into bond funds then see equities pop and moves their money en masse out of the bond funds.

Would this not create a dramatic fall of the bond funds' NAV as the bonds are sold at a steep discount to cover this outflow? Plus an additive effect of causing a discounted value to the bonds that are retained by the funds?
Then wouldn't even the ER's will increase to cover the transaction costs of the sell off?

Then fast forward to when the reality sinks in the equity pop was irrational exuberance Part II and unsustainable. The herd starts to move back into the bond funds, but the underlying bonds are now being bought at extremely low yields.
Would this not create another drop in the NAV as the value of the bonds that were retained are diluted?

OK, this is a badly written horror story, but an attenuated, more realistic version of this is what keeps me in CD's and MMA's as my fixed income component.

Am I delusional, or at the least, ignorant of bond market reality, about what could happen?


Keith
~ always paranoid of when the boulder will be getting away next"

Sis,

The whole point of being a boulder roller, is you don't have to be paranoid. You are confident it will roll back down and you will have the joy of rolling it back up again. Unhappiness comes from the belief that next time it won't roll back down then discovering it does.

On tax cut renewal. These are the demand side tax cuts, aimed at working people who will spend the money now. They do have a stimulative effect, though true Keynesians would argue you get more bang for your deficit buck by hiring people to do needed projects (electrical grid, anyone?) with long term benefits to the nation, including job skills for those doing the work, rather than throwing money at people to consume. I doubt we'll see any new stimulus, since this is money people already have coming in (unlike the initial cut, when some people got checks, and others at least saw more in their pay stubs). Not passing continuation of these cuts could have led to quick recession. The political fight had to do with paying for these cuts by raising taxes n the wealthy, since in the long term, the deficits will be destructive and, as we know, the supply side myth that tax cuts for the rich stimulate the economy (through investment, i.e., hedge funds) more than enough to pay for themselves is empirical nonsense.

I don't think you're right about the second part of your scenario about bond fund NAVs dropping a second time when people rush back into bonds when they discover stocks are scary. At least according to the theory, the bonds held by the fund, including ones that may have been bought during the previous period of low yields, as well as ones bought when yields went up, will be worth more, so the NAV will go up.

The real scary issue, though, as you note in another post, is what happens if the international investors (including national banks, etc.) pull out. Then you get simulataneous bear markets in US stocks and bonds. This is, of course, why we are supposed to have a reasonable international asset allocation. The problem is, you might get flight to gold—which is why the gold bugs say by gold—or you might have worldwide depression, or maybe the US will do better than what seems to make sense (it tends to), so a heavy international asset allocation doesn't pay off. Hence, my preference for CDs.

Print the post Back To Top
No. of Recommendations: 0
Loki isn't the only one laughing.

brucedoe
Print the post Back To Top
No. of Recommendations: 0
Lokicious,

I suspect, along with some others, that we are closer to another recession than a continuation of an economic boom. There is often a recession in the year of off-term elections (second year of a presidency). If true, your preference for CDs has considerable merit.

I must say, however, that our TIPS and Vanguard TIPS Fund (VIPSX) are doing very well right now. The Fund is up well over 5% since we bought it. The January TIPS is not up as much, but is still well into the black.

brucedoe
Print the post Back To Top
No. of Recommendations: 0
Author: Lokicious | Date: 9/22/04 6:27 PM | Number: 10819
the drop in NAV will be more than any gain from higher interest rates, even with reinvested dividends, at least until after you have held until the "average duration" period has passed

Yes, this is what I meant.

In addition, I am pointing out that when dividends are considered, the total loss prior to reaching the average duration, is much less than the NAV loss.

Russ
Print the post Back To Top
No. of Recommendations: 0
Author: spinning | Date: 9/22/04 6:51 PM | Number: 10820
<<...the drop in NAV will be more than any gain from higher interest rates, even with reinvested dividends, at least until after you have held until the "average duration" period has passed.>>

Is this any different than holding a single bond?

Individual bonds mature, and you then have to decide what to do with the principle. Bond funds normally do not.

Actually, a bond fund behaves in much the same way as individual bonds in a diversified bond ladder, assuming you always roll over into a new bond as each bond matures. A diversified bond ladder has a value at any specific time that is determined by the average duration of the individual bonds, their coupons, and the movement of interest rates, just like the bond fund.

The difference when holding a bond ladder made from individual bonds that you own, is that you can stop rolling over the principle as bonds mature, and recover your entire original principle (minus any defaults). You obviously don't have this option with a bond fund.

Russ
Print the post Back To Top
No. of Recommendations: 0
Not passing continuation of these cuts could have led to quick recession.
Is this necessarily a bad thing?
I mean, yeah, it's a painful process, but it paves the way to more stability in the long haul.
I'm by no means a pure laissez-faire-ist, but I don't agree with any more intervention other than softening the rate of trends. Anything more only leads to a deferred, yet more dramatic, fall to the new stasis.
Our economy has more than matured enough to ever believe that we'll see growth rates that would prevent us from needing to pay the piper again. All we seem to keep doing is accruing more and more interest on that payment that is past due.


The real scary issue, though, as you note in another post, is what happens if the international investors (including national banks, etc.) pull out.
I grew up with the notion that China was a Sleeping Giant. But that was in military terms. What seems to be getting missed is that the Giant is sleeping and growing in our Treasury. Far more dangerous than having an armory and troop build up an ocean away.
We're truly going to be a in world of hurt when that Giant decides to wake up and go home!
Print the post Back To Top
No. of Recommendations: 3
Sis (Keith),

First on your non-mythical name, I admit I made a mistake and I take full responsibility for that mistake. I understand that admitting I make mistakes and taking responsibility makes me unqualified to be president, since that suggests I do not have direct access to God.

On economic theory. I'm not so much a Keynesian as an old-fashioned populist. I believe the economics game gets played with loaded dice and that relying on the "invisible hand" to correct the cheating is so much 18th C. religious nonsense and that the real correcting force must come from democratically elected governments imposing law and order, even if sometimes the law and order get too visibly-handed. Undoubtedly, even with well-regulated markets, there would be recessions and hard times, but other than wars and natural disasters, most of the extremes of boom and bust come from what ought to be criminal. The latest stock bubble and the losses sustained by hard working men and women who got talked into putting money into pump and dump scams (including the stock market as a whole as pumped by the securities industry when it was already too hot to handle) was a failure of regulation and requirements for accurate information (Congress prevented the SEC from imposing important disclosure and other rules during the '90s that would have helped). I think at least some of the housing push will be similar, notably for those using houses to pay for other loans.

At some point this country will have to lower its standard of living, as measured by consumption. But I'd start with the haves and have mores. (Don't you love the notion of Shrub as a small businessman—he's the part owner of a "small business" which he doesn't even remember. Basics of small business success—hard work, hard head for balance sheet, adaptability and problem solving skills.)
Print the post Back To Top
No. of Recommendations: 1
(Don't you love the notion of Shrub as a small businessman—he's the part owner of a "small business" which he doesn't even remember. Basics of small business success—hard work, hard head for balance sheet, adaptability and problem solving skills.)

I thought that was a telling moment RE: baby bush.

jmc
Print the post Back To Top
No. of Recommendations: 2
(Don't you love the notion of Shrub as a small businessman—he's the part owner of a "small business" which he doesn't even remember. Basics of small business success—hard work, hard head for balance sheet, adaptability and problem solving skills.)
___________________________________
I've seen "small businessmen" who did better at balancing a budget, too.
Print the post Back To Top
No. of Recommendations: 2
"I've seen "small businessmen" who did better at balancing a budget, too."

Not a whole lot of small business folks who stay in business without balancing a budget. Not a lot of ranchers, either, unless it's a hobby subsidized with insider trading profits on shares gotten as a director whose only qualification was his daddy.


Print the post Back To Top
Advertisement