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 Post subject: Making Sense of Bonds and Bond Funds
PostPosted: Wed Apr 25, 2012 11:49 pm 

Joined: Fri Mar 30, 2012 10:15 pm
Posts: 22
As part of my ongoing "financial reorganization and optimization", I'm currently doing some research about bonds. I think I'm grasping most aspects, but it'd be nice if some others can confirm my understanding thus far and provide a little input.

So here's my understanding so far in terms of (individual) bonds. Bonds are conservative investments in which you are essentially lending money to an entity in return for bi-annual payments (coupons) and the return of your full principal after the maturity date. If the company defaults, they are still legally obligated to pay back your full principal, but not necessarily interest payments (?). Early redemption, on the other hand, can result in losses or gains (depending on the current interest rate).

Here's my understanding of bond funds thus far. Bond funds are managed by a bond fund manager and consist of a large collection of individual bonds. Due to the diversity of funds, they are sometimes considered safer than individual funds. However, a bond fund can gain or lose value (NAV) because the fund manager often sells the bonds in the fund prior to maturity. In other words, there is no guarantee on the value of the principal with bond funds. Thus, [if you wait until maturity] of an individual bond then the worst you can do is break even; but with bond funds the worst you can do is lose all your money. As interest rates rise, bond prices fall, and vise versa. But the advantage of a bond funds seem to be less risk of loses from default and the benefit of diversification, reducing the interest rate risk.

Taking a look at https://personal.vanguard.com/us/funds/snapshot?FundId=0132&FundIntExt=INT#hist=tab%3A1, it appears that the annual returns are between 3-4% depending on duration. But then the year-to-date percentage is listed at 0.72%. I’m not sure how to interpret this; is it low because it’s only just past the first quarter of the year and will expect to rise closer to the 3-4% range, or is it simply due to poor performance this particular year?

Also, when I look at the distributions for 2011 (for example) I see 16 distributions listed, at roughly 1.8% yield each (average). Does this mean that someone owning the fund in 2011 would have received an interest payment of 1.8%, 16 times during that year?

If this is the case, why not allocate emergency fund money in a fund like this? Even right now (as of 03/30/2012), with a low 1.54% yield, it’s a lot better than the money markets or short term CD’s that I’ve seen, yet liquid enough for an emergency fund. This particular fund has no purchase fee and no redemption fee.


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 Post subject: Re: Making Sense of Bonds and Bond Funds
PostPosted: Thu Apr 26, 2012 9:35 am 
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Joined: Wed Sep 23, 2009 9:01 am
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blueskyy wrote:
So here's my understanding so far in terms of (individual) bonds. Bonds are conservative investments in which you are essentially lending money to an entity in return for bi-annual payments (coupons) and the return of your full principal after the maturity date. If the company defaults, they are still legally obligated to pay back your full principal, but not necessarily interest payments (?). Early redemption, on the other hand, can result in losses or gains (depending on the current interest rate).

Sort of..

Bonds are often considered conservative investments but I would not use that term, partly because "conservative" has a pretty obscure meaning. People often use that term to mean low risk. Bonds can be anywhere from 0 risk to far more risky than stocks, depending on your definition of risk. In general, high quality bonds maturing in the near future will have more predictable returns than many other investments. US Treasury bonds have, by definition, 0 risk. Yet, a 30 year bond will fluctuate dramatically in price as interest rates change. An overnight bond to a company teetering on bankruptcy on the other hand may have a very solid price.

The legal claim that a particular bond has is specified in a document called a "debenture." Generally there are two different claims that a bond may have. A revenue bond will have a claim against revenue. A company might issue a revenue bond to fund a specific project. For example, a company building a mall might finance it with revenue bonds that are repaid with the revenue from the mall. If the mall does not earn revenue, the company does not pay the bondholders even if the company otherwise makes a profit. The other type of bond is a general obligation bond. A GO bond is a debt owed by the company issuing it and usually must be repaid before stockholders are paid. But among bondholders there are different tiers. Some bonds are subordinated to others meaning they are only paid after the others are paid in full. It is now fairly common to see companies issue bonds to fund credit card debt and that sort of thing.

Then there are issues of security. A bond might be backed by the general corporate assets, by specific properties like real estate, or even by a specific contract. A construction company for example might issue a bond secured by a bridge it is building on which it holds title until completion.

All these things are spelled out in the debenture. If a company defaults on a bond then the bondholders only have a claim on the security pledged in the debenture. For a general obligation bond the bondholders have preference to common stock holders but line up after certain other secured creditors. In recent years it is not at all unusual for bondholders to lose significantly in bankruptcy proceedings.

blueskyy wrote:
Here's my understanding of bond funds thus far. Bond funds are managed by a bond fund manager and consist of a large collection of individual bonds. Due to the diversity of funds, they are sometimes considered safer than individual funds. However, a bond fund can gain or lose value (NAV) because the fund manager often sells the bonds in the fund prior to maturity. In other words, there is no guarantee on the value of the principal with bond funds. Thus, [if you wait until maturity] of an individual bond then the worst you can do is break even; but with bond funds the worst you can do is lose all your money. As interest rates rise, bond prices fall, and vise versa. But the advantage of a bond funds seem to be less risk of loses from default and the benefit of diversification, reducing the interest rate risk.


The two main benefits of bond funds are diversification and convenience. Buying an individual bond is possible but commissions/spreads can be rather high and they are not exactly transparent.

The issue with NAV changing is correct but it can also be calculated. It is not a random, unpredictable change. When interest rates rise, the present value of the future interest payments goes down. That's why the bond price goes down. If you own an individual bond your principal value will indeed not go down. But you are kidding yourself to think you have not lost money. The fact that the future interest payments you are entitled to are paid at a lower rate than you could get elsewhere is a loss to you! If you want to close your eyes and pretend you've lost nothing then that's a personal decision.

A bond fund, on the other hand, will give you a number called "duration" or more properly "Macauley duration" that can be used to determine how much the value of a bond fund will go down when interest rates rise. Technically speaking it is the number of years it will take to break even on the current portfolio (or bond) compared to holding a new one at the new rate. But a simpler way to use it is that if a fund has a duration of 3.6 years then, if rates on similar bonds go up by 1% the price of your bond fund will go down by 3.6%. There are of course daily variations in price for other reasons as well including accumulation and distribution of interest payments and market attitudes about the risk in the portfolio.

blueskyy wrote:
Taking a look at https://personal.vanguard.com/us/funds/snapshot?FundId=0132&FundIntExt=INT#hist=tab%3A1, it appears that the annual returns are between 3-4% depending on duration. But then the year-to-date percentage is listed at 0.72%. I’m not sure how to interpret this; is it low because it’s only just past the first quarter of the year and will expect to rise closer to the 3-4% range, or is it simply due to poor performance this particular year?


Probably but I'd need to study it further.

blueskyy wrote:
Also, when I look at the distributions for 2011 (for example) I see 16 distributions listed, at roughly 1.8% yield each (average). Doese this mean that someone owning the fund in 2011 would have received an interest payment of 1.8%, 16 times during that year?


There were probably monthly interest distributions as well as semi annual distributions of short and long term capital gains (2 distributions per half) from trading the fund does. But again, I'd have to look kclosely.

blueskyy wrote:
If this is the case, why not allocate emergency fund money in a fund like this? Even right now (as of 03/30/2012), with a low 1.54% yield, it’s a lot better than the money markets or short term CD’s that I’ve seen, yet liquid enough for an emergency fund. This particular fund has no purchase fee and no redemption fee.


In my opinion a SHORT TERM bond fund is appropriate for an emergency fund. But you will want to make sure you can write checks against it so that you can access the money in a hurry.


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 Post subject: Re: Making Sense of Bonds and Bond Funds
PostPosted: Thu Apr 26, 2012 10:21 am 

Joined: Fri Mar 16, 2012 7:33 am
Posts: 107
Thanks for the above...saved me some time writing.

See my thread on "tiered cash" where I talk about moving my emergency money into a short term bond fund. I think it could work well for me, but it is reaching for yield and people have lost a lot of money doing just that.

At times bond funds do trade at random outside of interest rate and credit factors. But that is usually short lived and often corrects itself. A good example was last year when Meredith Whitney made her very incorrect call about municipal bonds...she has been wrong so far.

If you buy a bond, at best, you will get interest and par value back. At worst, it would be zero or a few dollars in several years. As a bondholder you stand in line ahead of shareholders, but when bankruptcy ends there may not be anything left for you.

Another thing to consider is inflation...which in my opinion is the biggest risk to a bond investor. Right now you can lend $1,000 to the US Government and earn 3.2% interest for the next 30 years and get back your same $1,000 principal in 2042. No thanks....in 2042 that $1,000 is going to buy far less than it does today.


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 Post subject: Re: Making Sense of Bonds and Bond Funds
PostPosted: Thu Apr 26, 2012 12:02 pm 
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bill o wrote:
At times bond funds do trade at random outside of interest rate and credit factors. But that is usually short lived and often corrects itself. A good example was last year when Meredith Whitney made her very incorrect call about municipal bonds...she has been wrong so far.


Yes. In general as a bond or bond fund becomes more risky it begins to behave more like an equity security. Junk bond funds, for example, behave a lot like stock funds. In my opinion Meredith, who knows here stuff, missed that key point. Municipal bonds have always been very safe because they are largely backed by municipal tax revenues and are usually insured. I think what happened is that those revenues and the insurance were called into question and that caused them to trade more like equities for a while. Yields went up. Then, when everyone settled down and municipal budgets started to recover the bond prices went up as yields went back to normal. Since few actual defaults occurred, investors discounted the risk part.

bill o wrote:
If you buy a bond, at best, you will get interest and par value back. At worst, it would be zero or a few dollars in several years. As a bondholder you stand in line ahead of shareholders, but when bankruptcy ends there may not be anything left for you.


As a GENERAL OBLIGATION bondholder you are at the front of the pack. So many bonds these days are backed by specific assets like loan portfolios or individual capital projects that you have to be careful about your position in the hierarchy if bankruptcy is even a remote possibility.

bill o wrote:
Another thing to consider is inflation...which in my opinion is the biggest risk to a bond investor. Right now you can lend $1,000 to the US Government and earn 3.2% interest for the next 30 years and get back your same $1,000 principal in 2042. No thanks....in 2042 that $1,000 is going to buy far less than it does today.
[/quote]

Yes, inflation is certainly a risk. I don't expect it but I concede that no one can predict it that far out. If you truly believe the market is always right then you can take solace in the current market pricing of inflation at about 2.5% over the next 30 years. That makes a 3.2% government bond seem fairly good. People for decades happily bough Treasuries yielding that.


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 Post subject: Re: Making Sense of Bonds and Bond Funds
PostPosted: Thu Apr 26, 2012 12:38 pm 

Joined: Fri Mar 16, 2012 7:33 am
Posts: 107
The below is from Berkshire Hathaway's most recent annual letter to shareholders:

Quote:
Investments that are denominated in a given currency include money-market funds, bonds, mortgages,
bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.”
In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many
countries, even as the holders continued to receive timely payments of interest and principal. This ugly
result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic
forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such
policies spin out of control.
Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86%
in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy
what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually
from bond investments over that period to simply maintain its purchasing power. Its managers would
have been kidding themselves if they thought of any portion of that interest as “income.”
For tax-paying investors like you and me, the picture has been far worse. During the same 47-year
period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But
if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would
have yielded nothing in the way of real income. This investor’s visible income tax would have stripped
him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining
4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax
that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our
currency, but the hand that activates our government’s printing press has been all too human.
High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based
investments – and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come
close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a
warning label.
Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds
significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample
liquidity occupies center stage and will never be slighted, however inadequate rates may be.
Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be
counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity
is $20 billion; $10 billion is our absolute minimum.
Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related
securities only if they offer the possibility of unusual gain – either because a particular credit is
mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the
possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve
exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from
such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems
apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”


His thoughts do an excellent job stating the real risk of bonds.....Of course, BRK still owns them.


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 Post subject: Re: Making Sense of Bonds and Bond Funds
PostPosted: Fri Apr 27, 2012 5:22 pm 

Joined: Fri Mar 30, 2012 10:15 pm
Posts: 22
Thanks for clearing some of that up. It's a lot to consider.


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