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http://flagship5.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/VanViewsNCArticlePublic.jsp?chunk=/freshness/News_and_Views/news_ALL_risingrates_06092004_ALL.html

A new commentary from Vanguard on affects of interest rates on bond funds. Nothing new to those of us who've heard it before, but worth reading for those still struggling to understand.
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1. If you're investing for income, a decline in principal won't affect your income stream. As your fund's share price declines, its yield will rise, but the dollar amount of your monthly distribution is unlikely to change much.

Not sure what they mean by this. If you are taking a distribution, you are selling shares at the reduced NAV.

JG

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Doesn't this mean if you're taking dividends the dollar amount of your monthly distribution is unlikely to change much. Whereas, if you reinvest dividends, the dollar amount buys more shares as the NAV decreases.

db
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Not sure what they mean by this. If you are taking a distribution, you are selling shares at the reduced NAV.

You are not selling shares...you are taking distributions from the dividends.

ACME
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A question, as I am not familiar with bond/bond funds.

Suppose today I buy 10 year treasury bond worth 10K yielding 4.8%. Does this mean

1) As long as the bond price doesn't change, I will get $480/year.

2) Suppose the bond loses its value and it is now worth 9K, but the yield is 6%. Does this mean I will get interest payment of $600/year?

3) Also no matter what the yield is on maturity, will I get back my principle 10K?

What is the good source for a newbie to learn the basics of bond investing?

Thanks...
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Greetings amateur,

Here is my best guess at some answers:


Suppose today I buy 10 year treasury bond worth 10K yielding 4.8%. Does this mean

1) As long as the bond price doesn't change, I will get $480/year.


No, you'll get $480/year as long as the bond isn't called away. This may be a rare thing but I think there is a possibility for the Treasury to buy back bonds that are outstanding.

2) Suppose the bond loses its value and it is now worth 9K, but the yield is 6%. Does this mean I will get interest payment of $600/year?

I don't see how that can happen on one level. I could see the bond becoming worth 9K and then the yield will be 5.3% as you'll still get $480/year so that as the price goes down the yield goes up. This is an inverse relationship as the coupons from the bond don't change if we are talking about a vanilla Treasury.

Now if this is a TIPS then the principal will fluctuate and the coupon payment as a dollar amount but not the percentage and this is what can make an inflation-indexed treasury bond(which is what a TIPS is) attractive in some situations. In the case of an inflation-indexed bond, the principal is adjusted every 6 months based on CPI figures so that if that goes up then the face value of the bond goes up though the coupon rate stays the same the dollar amount may also go up. For more, take a look at http://www.publicdebt.treas.gov/sec/seciis.htm for one starting point.

3) Also no matter what the yield is on maturity, will I get back my principle 10K?

Yes, assuming the treasury still exists at maturity. If the government goes ka-bluie then this may not necessarily happen.

What is the good source for a newbie to learn the basics of bond investing?

A couple of starting points:
http://www.investinginbonds.com/
http://invest-faq.com/articles/index-bonds.html

http://www.fool.com/school/basics/basics05.htm

Another idea for bond fund basics would be something like "Mutual Funds for Dummies" by Eric Tyson which has some good stuff.

HTH,
JB
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"A question, as I am not familiar with bond/bond funds."

What is the good source for a newbie to learn the basics of bond investing?"

Welcome aboard,

A lot of us were where you are not so long ago (I started looking into bonds about 3 years ago). Probably my best source was Vanguard's web site: they have a lot of explanatory links (though you have to dig), and there's much to be learned about how bonds of different sorts work (not just funds) by downloading their PDFs for prospecti and annual reports from different bond funds. There are also several reference books on bonds, which others here have tried.

Suppose today I buy 10 year treasury bond worth 10K yielding 4.8%. Does this mean

1) As long as the bond price doesn't change, I will get $480/year.

2) Suppose the bond loses its value and it is now worth 9K, but the yield is 6%. Does this mean I will get interest payment of $600/year?

3) Also no matter what the yield is on maturity, will I get back my principle 10K?

Let's start by assuming you buy a 10K 10-year treasury with 4.8% yield and hold onto it for 10 years until it reaches maturity. You will always get $480 per year, and at the end of 10 years you will get back your original $10K, Of course, if you put your $480 into something else each year, your compound yield will be a bit higher than 4.8%.

At no point will your bond start yielding 6%. That can happen with a bond fund, where the daily NAV fluctuates based on the tradeable value of the bonds it holds, and as it buys and sells bonds in changing interest rate environments, the yield on the fund goes up and down. But the bond you buy for yourself doesn't change yield (unless you buy TIPS, where they yield changes in relation to inflation, though the fixed portion of the yield never changes).

Now, if you sell the bond before 10 years, you will probably sell at a loss or a gain to accommodate changes in interest rates. You calculate how much the bond is worth by multiplying the change in basis points as a percent times the number of years remaining until maturity: so if, in your example, interest rates went up to 6% on 10-year treasuries in two years, you would have to sell your bond for a loss of 120 basis points (1.2% points change) times 8 years or 9.6%, i.e., it would be worth $9040 instead of $10000.


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Thanks jbking, Lokicious, now I have a better picture of bond yields...

My impression after going through your replies is - "If I buy a normal treasury bond (not TIPS) for 10K with yield 4.8%, I will continue to get $480/year as long as I hold it, irrespective of the bond price and yield. And if I hold it till maturity, it is almost like a 10 year CD with 4.8% interest rate." Am I right?


jbking, nice cautionary comments :) I will go through the sources you have mentioned, but it might take some time...

I invest/trade a lot in stocks and options, but bonds are new to me. Till now, I was always thinking of capital appreciation, but slowly I am looking at my portfolio as a source of regular steady income. One of these days, I will explain my situation to you and I will be looking forward to your comments.

Thanks again...
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My impression after going through your replies is - "If I buy a normal treasury bond (not TIPS) for 10K with yield 4.8%, I will continue to get $480/year as long as I hold it, irrespective of the bond price and yield. And if I hold it till maturity, it is almost like a 10 year CD with 4.8% interest rate." Am I right?

Right. It would be exactly like a CD that pays the interest into your money market or savings or checking account, instead of compounding it until maturity (my credit union offers such an option, which someday I may use).
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You are not selling shares...you are taking distributions from the dividends.

How do you tell Vanguard, for example, that you just want to take dividends from a bond fund? I thought you would have to sell shares of the bond fund at NAV to get a distribution.

Thanks,
JG
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How do you tell Vanguard, for example, that you just want to take dividends from a bond fund? I thought you would have to sell shares of the bond fund at NAV to get a distribution.

Most (all?) bond funds distribute their dividends on a regular schedule -- monthly, quarterly, etc. You have the option of taking the distribution in cash or reinvesting in additional shares.

In the article, they are talking about these distributions, not a sale of existing shares.

ACME
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How do you tell Vanguard, for example, that you just want to take dividends from a bond fund?

If your account is at Vanguard and the fund is in a taxable account, log on to the Vangaurd web site, click on "Account Options", then under "Dividends and Capital Gains" click on "view/change". The next screen shows the list of accounts you have and gives you the option of what you want to change for the dividends and capital gains distributions for each fund you check:

- Reinvest (the default if no election had been made)
- Transfer to a Bank Account
- Transfer to a Vanguard fund
- Mail a check.

Before I moved my funds to Vanguard, I had my funds automatically reinvest dividends and capital gains. When I moved my taxable investments, I decided to have Vanguard deposit the dividends and capital gains in my checking account so I can decide to then direct that money as well as additional money to invest into the fund most lacking according to my asset allocation plan. By having just one monthly purchase, it simplifies tracking of my basis and thus tax calculations, instead of having two monthly transactions (the monthly bond fund distribution and the monthly additional contribution).

I'll be keeping an eye on how well this method goes for a while. If I decide later that it would be better to reinvest, it is really easy to find on Vanguard's web site where to change that.

Note: the election doesn't change dividends that were previously invested (those reinvested dividends are treated by tax law as additional purchases), but it will affect future dividends until a subsequent election is made.
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MarkOYoung,

Thanks for that. My funds were reinvest which must be the default and I did not realize I could change it until you pointe it out.

JG
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