Author Topic: Do bond fund distributions increase with inflation?  (Read 1619 times)

TonyPlush

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Do bond fund distributions increase with inflation?
« on: July 26, 2018, 07:05:51 AM »
Basic question that I'm having conceptualizing...

Do bond fund yields adjust for inflation over time?

Say I have $10,000 to put in a Vanguard Total Bond Market Index Fund (VBTLX) and it pays out ~3% annually or $300 a year. If I never touch the $10,000 principal, in 30 years will my investment still pay $300, or will that $300 have increased at a rate equal to inflation?

Thanks!

Radagast

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Re: Do bond fund distributions increase with inflation?
« Reply #1 on: July 26, 2018, 09:25:09 AM »
Not typically. There certain bonds linked to inflation, like Treasury Inflation Protested Securities (TIPS) and Series I savings bonds (only through Treasury Direct or paper from a tax return), but they often have low yields. TIPS funds are pretty common.

For everything else, the only way for them to match inflation is if investors demand high yields, which will take years to catch up for a fund like VBTLX. This results in a double whammy to bonds in a rising inflation situation: bonds lose value to inflation, and then they also lose value as yields rise meaning investors are not willing to pay as much for earlier issues. People who fear inflation like short term bonds because they will regain their value quickly.

That is why we usually favor stock funds around here: bonds will scarcely return anything after you subtract inflation.


PizzaSteve

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Re: Do bond fund distributions increase with inflation?
« Reply #2 on: July 27, 2018, 10:03:22 AM »
I had a few comments to add along with the prior reply.  A bond itself does not change its payout, as stated, unless it is a specific type that does so, like an iBond.  Also, a bond fund holds mostly fixed securities.

However, a bond fund will post what is called an average duration, usually something like 7 years for a medium term fund.  So generally, half the bonds will mature before that time and new bonds will be purchased, which will yield higher amounts due to the inflation. 

So, over time, a bond fund's payments do increase with inflation, just not quite as fast as the inflation rate.  If inflation stabilizes, the value of the fund shares will recover as well.  Over time, expect bonds to yield slightly above inflation and there are many sites which show the value of holding bonds long term.  Like stock funds, you should think of bond funds as long term investments you hold for 10 plus years.

Also, the expected rate of inflation is already priced into the bonds yields, so it is only 'higher than expected' inflation that decreases bond values, not raw nominal inflation.

Trying to time in and out of bonds by guessing future inflation rates better than the market is just as futile as trying to predict the economy to time stock purchases on dips (a generally accepted view for individual investors, though hedge funds and other quantitative analysts sometime try). 

I would recommend an asset allocation plan based on a solid understanding of portfolio theory and your investment time horizon.  If your hoizon is 30 plus years, 0 to 20% bonds is a reasonable allocation that generally does not hurt returns over a 30 year horizon and somewhat smooths the annual swings.
« Last Edit: July 27, 2018, 10:07:50 AM by PizzaSteve »

AnswerIs42

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Re: Do bond fund distributions increase with inflation?
« Reply #3 on: July 27, 2018, 01:54:29 PM »
However, a bond fund will post what is called an average duration, usually something like 7 years for a medium term fund.  So generally, half the bonds will mature before that time and new bonds will be purchased, which will yield higher amounts due to the inflation. 
I don't get what you're saying here...

So a bond fund buys $1000 worth of bonds that pay 4% per year. After a number of years that bond matures and the fund gets its $1000 back. The fund then invests this in another bond that pays 4% a year, and the yield is the same $40.

It might be higher or lower than 4% depending on what the going rate is, but I don't see how it increases with inflation?

MustacheAndaHalf

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Re: Do bond fund distributions increase with inflation?
« Reply #4 on: July 29, 2018, 02:15:54 AM »
I think people are mixing up "inflation" with "interest rates", which are not the same thing.

Inflation means the average car today compared to the average car 20 years from now will have different prices.  When you retire, you need to pay higher prices than now.

For individuals, interest rates are what a bank pays you (among other situations).  And interest rates tend to influence bond yields.  When interest rates go up, bond yields tend to go up.

Bond fund durations are an approximation of how bond yield changes will impact the fund.  A bond fund duration of 7 years means that a 0.5% rise in bond yields hurts the bond fund (7 yrs * 0.5% / yr * -1 reverse impact) = -3.5%.  When new bonds offer better yields, old bonds need to drop in price to remain competitive.

PizzaSteve

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Re: Do bond fund distributions increase with inflation?
« Reply #5 on: July 29, 2018, 09:00:22 AM »
Yes.  If interest rates rise, the dividend rises, which over time mitigates the lost asset values posted in the first response.  Since the fund holds a mix of bonds, it is like a CD ladder in a way, if rates rise each new CD pays more.

Anyway, if you seriously want to understand bonds I recommend reading up on them at bogleheads or elsewhere.  It isnt practical to post education about bond funds as a response to an internet discussion forum.   However, it is often misunderstood how much inflation and interest rate changes impact bond fund values over time.  They really only drop a lot when unexpected inflation increases hit.

While interest rates and inflation are different things, as pointed out, they are highly correllated and tend to rise or fall in unison.
« Last Edit: July 29, 2018, 09:02:04 AM by PizzaSteve »

TonyPlush

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Re: Do bond fund distributions increase with inflation?
« Reply #6 on: July 30, 2018, 11:21:21 AM »
I had a few comments to add along with the prior reply.  A bond itself does not change its payout, as stated, unless it is a specific type that does so, like an iBond.  Also, a bond fund holds mostly fixed securities.

However, a bond fund will post what is called an average duration, usually something like 7 years for a medium term fund.  So generally, half the bonds will mature before that time and new bonds will be purchased, which will yield higher amounts due to the inflation. 

So, over time, a bond fund's payments do increase with inflation, just not quite as fast as the inflation rate.  If inflation stabilizes, the value of the fund shares will recover as well.  Over time, expect bonds to yield slightly above inflation and there are many sites which show the value of holding bonds long term.  Like stock funds, you should think of bond funds as long term investments you hold for 10 plus years.

Also, the expected rate of inflation is already priced into the bonds yields, so it is only 'higher than expected' inflation that decreases bond values, not raw nominal inflation.

Trying to time in and out of bonds by guessing future inflation rates better than the market is just as futile as trying to predict the economy to time stock purchases on dips (a generally accepted view for individual investors, though hedge funds and other quantitative analysts sometime try). 

I would recommend an asset allocation plan based on a solid understanding of portfolio theory and your investment time horizon.  If your hoizon is 30 plus years, 0 to 20% bonds is a reasonable allocation that generally does not hurt returns over a 30 year horizon and somewhat smooths the annual swings.
Great explanation, thanks!

One

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Re: Do bond fund distributions increase with inflation?
« Reply #7 on: July 31, 2018, 04:50:08 PM »
Wouldn't it be smarter to buy short term bonds at auction vs funds now?  As the fed raises rates the funds price will be reduced so you will loose money in the fund price also giving you less overall yield? If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal. 2.3% vs 2.8% or whatever?     

PizzaSteve

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Re: Do bond fund distributions increase with inflation?
« Reply #8 on: July 31, 2018, 06:06:53 PM »
Wouldn't it be smarter to buy short term bonds at auction vs funds now?  As the fed raises rates the funds price will be reduced so you will loose money in the fund price also giving you less overall yield? If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal. 2.3% vs 2.8% or whatever?   
You are basically describing what a shot term tbill fund does.  Bond funds exist that hold short, medium or long term bond durations.  There are also funds that invest in t bills, TIPS (inflation indexed), or tax free munis, corporates, or a mix like VG total bond.  They basically do what you are describing, which is why they are variable in their sensitivity to interest rate changes, and why their yields rise over time if interest rates rise (the OP question).

Whether this is good for your plan or not depends on you, your risk tolerance, desire to hold public debt (trust in govt vs corp vs bank income sources), etc.

One

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Re: Do bond fund distributions increase with inflation?
« Reply #9 on: July 31, 2018, 10:17:50 PM »
Wouldn't it be smarter to buy short term bonds at auction vs funds now?  As the fed raises rates the funds price will be reduced so you will loose money in the fund price also giving you less overall yield? If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal. 2.3% vs 2.8% or whatever?   
You are basically describing what a shot term tbill fund does.  Bond funds exist that hold short, medium or long term bond durations.  There are also funds that invest in t bills, TIPS (inflation indexed), or tax free munis, corporates, or a mix like VG total bond.  They basically do what you are describing, which is why they are variable in their sensitivity to interest rate changes, and why their yields rise over time if interest rates rise (the OP question).

Whether this is good for your plan or not depends on you, your risk tolerance, desire to hold public debt (trust in govt vs corp vs bank income sources), etc.
Yes, but the rates have been low for 10 years so aren't the funds full of low yielding bonds?

PizzaSteve

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Re: Do bond fund distributions increase with inflation?
« Reply #10 on: August 01, 2018, 09:41:57 AM »
Wouldn't it be smarter to buy short term bonds at auction vs funds now?  As the fed raises rates the funds price will be reduced so you will loose money in the fund price also giving you less overall yield? If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal. 2.3% vs 2.8% or whatever?   
You are basically describing what a shot term tbill fund does.  Bond funds exist that hold short, medium or long term bond durations.  There are also funds that invest in t bills, TIPS (inflation indexed), or tax free munis, corporates, or a mix like VG total bond.  They basically do what you are describing, which is why they are variable in their sensitivity to interest rate changes, and why their yields rise over time if interest rates rise (the OP question).

Whether this is good for your plan or not depends on you, your risk tolerance, desire to hold public debt (trust in govt vs corp vs bank income sources), etc.
Yes, but the rates have been low for 10 years so aren't the funds full of low yielding bonds?
Yes, and interest rates remain fairly low.  So the yield increases for bond funds will likely be slow (note if you buy a fixed bond, yield generally doesnt increase at all).

FYI, stock returns are also predicted to be lower as well (by Bogle, among others...which is normal towards the end of a bull market, which has been fueled by low interest rates and cheap capital).  Efficient markets mean there are no free lunches.  No equity returns without risk.  As equity risks drop via a stable economy, returns drop as well.  Difficult times bring risk up and the risk premiums rise.  These are basic economic concepts.  If you dont believe in the efficient market hypothesis, feel free to place your bets on the undervalued assets and make your premium bank.

Could future financial economics change, due to globalization, political or technology changes?  Sure.  People's best guesses of those risks are built into debt and equity and real estate valuations.  That is how markets work.

So bonds are relatively safe and not 100% correlated with stocks.  They are also easy to buy and manage, so they remain popular to mix with stocks for conservative investors.
« Last Edit: August 01, 2018, 09:46:28 AM by PizzaSteve »

MustacheAndaHalf

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Re: Do bond fund distributions increase with inflation?
« Reply #11 on: August 01, 2018, 10:35:53 AM »
If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal.
Those should be the same.  An increase in bond yields drops the value of existing bonds until the total return of both investments is the same.

PizzaSteve

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Re: Do bond fund distributions increase with inflation?
« Reply #12 on: August 01, 2018, 12:15:12 PM »
If you buy 1 year tbills you won't loose much because you hold the bond for the full year and buy a new one at the higher interest rate. All you'll loose is the difference between what you could have made and what you did make with no loss in principal.
Those should be the same.  An increase in bond yields drops the value of existing bonds until the total return of both investments is the same.
Yes. 

And the same is true for bond funds, assuming you dont sell.  Eventually the bond funds will cash in their old bonds for full principal, assuming no distributions occur, and buy new bonds with the proceeds, at the given rate.  At this time the net asset value should effectively be at par with expectations for the overall portfolio.  If interest cycles drop, values increase, but dividends do too, slower than the market, depending on average duration.  That is why you should check the average duration of your bond funds to make sure you are comfortable where they are (and of course fees and churn, you want both very low).  Bond funds naturally have a bit of churn, due to replacing the maturing bonds and the early refinancing of existing long term bonds when rates are low (called a call).  For example, a 30 year bond you happily expect to yield a rate forever usually has the ability to be called at par value after 10 years, which usually sucks because that means you wont get the (likely higher than market rate) payment for the full term.
« Last Edit: August 01, 2018, 12:23:41 PM by PizzaSteve »