Author Topic: Understanding bond funds  (Read 9473 times)

starguru

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Understanding bond funds
« on: December 31, 2013, 08:23:33 AM »
I am trying to understand how pricing for bond funds works.  I think I understand how bond pricing can fluctuate with changing interest rates, but I think bond funds are very different animals.

I am looking at the historical data for one bond fund I have in my 401k, PIMCO Total Return Fund Institutional Class, and going back ten years the price of the fund has fluctuated between $10 and $11.75 per share. 

https://www.google.com/finance?client=ob&q=MUTF:PTTRX

Are bond fund shares priced based on the current price of the underlying bonds in which the fund invests, or is it on the interest return of those bonds?  When a bond fund buys bonds, does it hold them or sell them to maturity? Do all bond funds pay dividends, as payments are made on the underlying bond?  And if so, is the main profit generator for these funds these payments?

Is it just a dumb idea to invest in bond funds now, given that interest rates are so low, or does that not matter for a bond fund (as opposed to a bond). 

KingCoin

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Re: Understanding bond funds
« Reply #1 on: December 31, 2013, 08:59:33 AM »
That's a whole lot of questions. Did you try googling "understanding bond funds" to see what you can answer by yourself? Something like this might be a good place to start:
http://www.investopedia.com/articles/mutualfund/05/062805.asp

In short, the price of the fund will reflect the price of the underlying bonds. The fund will periodically (usually quarterly or monthly) distribute interest payments made by the underlying bonds. The fund may buy or sell bonds in order to match its mandate. For instance, a long dated investment grade fund may sell bonds that are downgraded to junk or become too short maturity and replace them with longer dated investment grade bonds. The funds performance will be a result of bond price movements as well as interest payments. Which one is the main "profit generator" depends on the volatility and movement of interest rates and credit spreads.  No one knows for sure whether bonds will rise or fall in price from here. They're probably an appropriate part of a diversified portfolio. Bond funds will obey the same general pricing laws as individual bonds, but on a more diversified basis.

Morningstar.com is a good resource to do research on funds.
« Last Edit: December 31, 2013, 09:06:43 AM by KingCoin »

starguru

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Re: Understanding bond funds
« Reply #2 on: December 31, 2013, 09:57:35 AM »
I did do a bunch of reading before asking.  Lot's of articles explain bonds, and some explain the basics of bond funds, but none that I saw talked about how bond fund pricing moves.

So from what you wrote, it doesn't make too much sense to invest in bonds or bond funds now since as interest rates rise bond prices fall?  How does one reconcile that with investment strategies that traditionally would say X% should be in bonds and Y% should be in stocks, in a low interest rate environment?

joleran

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Re: Understanding bond funds
« Reply #3 on: December 31, 2013, 10:10:33 AM »
Market timing is generally frowned upon, which is kind of what you're talking about (refusing to buy bonds "high").  That said, I think you're right and that traditional bonds have run into a fundamental wall that will bring about a lengthy bear market in bonds at worst, or middling 1-2% real returns at best.  I would recommend replacing them with p2p lending for fixed income with good return and ultra low correlation with the stock market.

Richard3

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Re: Understanding bond funds
« Reply #4 on: January 01, 2014, 04:26:11 PM »
I'm not convinced p2p lending has ultra low correlation with the stock market.

The level of the stock market is quite strongly correlated with the overall health of the economy (however you choose to measure it).

People's ability to repay loans is quite strongly correlated with the overall health of the economy.

This suggests that p2p lending default rates and the stock market will have positive correlation. Whether it's noticeably less than the bond market's correlation with the stock market or not would take more detailed investigation.

Another thing to consider is that the downside of bonds (especially diversified funds) is much more limited than p2p lending which even when diversified (in terms of having lots of small loans) seems to be mostly consumer lending to average or worse credit risks. Bond holders rarely get completely screwed even when the issuer goes belly up.

KingCoin

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Re: Understanding bond funds
« Reply #5 on: January 01, 2014, 06:21:32 PM »
I'm not convinced p2p lending has ultra low correlation with the stock market.

The level of the stock market is quite strongly correlated with the overall health of the economy (however you choose to measure it).

People's ability to repay loans is quite strongly correlated with the overall health of the economy.

This suggests that p2p lending default rates and the stock market will have positive correlation. Whether it's noticeably less than the bond market's correlation with the stock market or not would take more detailed investigation.

Another thing to consider is that the downside of bonds (especially diversified funds) is much more limited than p2p lending which even when diversified (in terms of having lots of small loans) seems to be mostly consumer lending to average or worse credit risks. Bond holders rarely get completely screwed even when the issuer goes belly up.

Yes. Because these loans aren't marked-to-market, they give the illusion of low correlation, when in fact they are very highly correlated with the stock market. They're very similar to the high yield bond market. Take a look at HYG during the crisis and tell me high risk loans aren't correlated with stocks.
« Last Edit: January 01, 2014, 08:52:18 PM by KingCoin »

joleran

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Re: Understanding bond funds
« Reply #6 on: January 02, 2014, 09:07:08 AM »
You make good arguments for correlation, but the p2p lending environment is not necessarily representative of the entire economy.   You control who you lend to, and you can manage risk in a number of ways.

Take a look at lending club returns for 2008: http://nickelsteamroller.com/lendingclub_return

In a year where VBTIX was essentially flat and VTSAX lost 38%, widely diversified p2p loans returned 6%.

KingCoin

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Re: Understanding bond funds
« Reply #7 on: January 02, 2014, 09:49:24 AM »
You make good arguments for correlation, but the p2p lending environment is not necessarily representative of the entire economy.   You control who you lend to, and you can manage risk in a number of ways.

Take a look at lending club returns for 2008: http://nickelsteamroller.com/lendingclub_return

In a year where VBTIX was essentially flat and VTSAX lost 38%, widely diversified p2p loans returned 6%.

LC didn't really start issuing loans until mid to late 2007, so almost all the outstanding loans in 2008 were very freshly issued. That would substantially reduce the rate of default. Additionally, loans issued in late 2008 and 2009 were done so at a very high interest rate. I suspect that new loans, issued at a lower interest rate and given a chance to age, will perform much more poorly in another downturn.

I don't disagree that LC loans can be an interesting portfolio diversifier, but you'd be kidding yourself to think they aren't highly correlated to the broad economy.

joleran

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Re: Understanding bond funds
« Reply #8 on: January 02, 2014, 10:03:19 AM »
Actually, the 6% stat I gave is for all loans issued in 2008, whether held to default or maturity.  Also, most loans issued in 2008 were issued at a lower interest rate than freshly minted loans are today (see: https://www.lendingclub.com/info/download-data.action and download the 2007-2011 file).

It seems very logical that unemployment and economic issues should definitely be correlated, but the numbers don't really seem to back this up.  A broadly diversified portfolio of LC notes has never lost money, 2007-2014.

sdp

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Re: Understanding bond funds
« Reply #9 on: January 02, 2014, 10:18:12 AM »
You can go ahead and assume the bond fund is priced out at the Net Asset Value of the fund holdings and will fluctuate as such.  There are going to be times when a small percentage of funds, be they closed ended or such, that will fluctuate over or under their NAV, but not by much and not for very long.

KingCoin

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Re: Understanding bond funds
« Reply #10 on: January 02, 2014, 10:21:28 AM »
Actually, the 6% stat I gave is for all loans issued in 2008, whether held to default or maturity.  Also, most loans issued in 2008 were issued at a lower interest rate than freshly minted loans are today (see: https://www.lendingclub.com/info/download-data.action and download the 2007-2011 file).

It seems very logical that unemployment and economic issues should definitely be correlated, but the numbers don't really seem to back this up.  A broadly diversified portfolio of LC notes has never lost money, 2007-2014.

OK, but loans issued in 2008 were issued more-or-less at the bottom of the market, and the economy improved from that point.  Loans issued in the heady days of 2006 might not have fared so well.

Overall, LC loans do have an impressive track record, their history is just too short to draw any sweeping conclusions, and is reason enough to be cautious.

joleran

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Re: Understanding bond funds
« Reply #11 on: January 02, 2014, 10:55:37 AM »
Fair enough, caution is definitely warranted, and making p2p loans more than 10% of your portfolio is a very high risk move. 

I think they are a valuable tool to exploit in today's no-real-winners bond market, and as they hopefully gain in consistent history I think they deserve a place in most people's portfolios.

Richard3

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Re: Understanding bond funds
« Reply #12 on: January 02, 2014, 12:03:30 PM »
You can go ahead and assume the bond fund is priced out at the Net Asset Value of the fund holdings and will fluctuate as such.  There are going to be times when a small percentage of funds, be they closed ended or such, that will fluctuate over or under their NAV, but not by much and not for very long.

An open ended fund must always be priced at its NAV (or at least yesterday's NAV) unless something weird is going on. Closed ended funds can drift (although the more straight-forward their holdings and the larger the fund less they will drift).

starguru

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Re: Understanding bond funds
« Reply #13 on: January 06, 2014, 07:28:07 AM »
As the OP sorry I disappeared. 

As a note, I already am about 2% of my portfolio in P2P and like it much.

But the original question is about understanding bond funds.  Specifically, it seems as if bond funds will follow bond pricing, so in a low interest environment bond funds will inevitably lose value assuming rates have to rise.  With that simple assumption, how does one balance the "don't try to time the market" rule with what is essentially knowledge of the future, that bond funds will remain flat?

KingCoin

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Re: Understanding bond funds
« Reply #14 on: January 06, 2014, 09:14:23 AM »
As the OP sorry I disappeared. 

As a note, I already am about 2% of my portfolio in P2P and like it much.

But the original question is about understanding bond funds.  Specifically, it seems as if bond funds will follow bond pricing, so in a low interest environment bond funds will inevitably lose value assuming rates have to rise.  With that simple assumption, how does one balance the "don't try to time the market" rule with what is essentially knowledge of the future, that bond funds will remain flat?

Rates don't have to rise. Take a look at Japan where rates have fallen for 30 years. Furthermore, bonds act as insurance against another recession or long term economic malaise. If stocks fall over the next decade, you'll be glad to have some bonds that rise and that you can rotate into stocks lower.

You're right that in the long term, bonds will probably be a loser vs other asset classes (though not necessarily as Japan has shown). They should reduce portfolio volatility substantially, however, which makes them a valuable part of your portfolio. How big a part is a function of your risk tolerance and investment horizon.

starguru

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Re: Understanding bond funds
« Reply #15 on: January 06, 2014, 11:10:39 AM »
As the OP sorry I disappeared. 

As a note, I already am about 2% of my portfolio in P2P and like it much.

But the original question is about understanding bond funds.  Specifically, it seems as if bond funds will follow bond pricing, so in a low interest environment bond funds will inevitably lose value assuming rates have to rise.  With that simple assumption, how does one balance the "don't try to time the market" rule with what is essentially knowledge of the future, that bond funds will remain flat?

Rates don't have to rise. Take a look at Japan where rates have fallen for 30 years. Furthermore, bonds act as insurance against another recession or long term economic malaise. If stocks fall over the next decade, you'll be glad to have some bonds that rise and that you can rotate into stocks lower.

You're right that in the long term, bonds will probably be a loser vs other asset classes (though not necessarily as Japan has shown). They should reduce portfolio volatility substantially, however, which makes them a valuable part of your portfolio. How big a part is a function of your risk tolerance and investment horizon.

As I understand though, are rates are basically already at 0%.  So bond rates cannot fall; at best they can stay the same, and at worst and most likely, interest rates will rise.  So bond prices have no place to go but stay flat or drop.  If I am worried about volatility, should I not just keep some of my investments in cash?

starguru

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Re: Understanding bond funds
« Reply #16 on: January 06, 2014, 11:30:47 AM »
Good article right here:

Why only millionaires should invest in bonds directly

From the article:

Quote
The reason people get freaked out about losing money with bond ETFs is that they are focusing only on the capital part of the equation. But the return of a bond is made up of two components: The capital gain or loss, and the coupon payments. Even if the price of a bond ETF drops when rates rise, you’ll continue to collect coupon payments, which will counter the drop in price. And these coupon payments will rise as the ETF rolls into new, higher-yielding bonds...

...“Anybody investing less than $1-million in bonds should do it through ETFs,” Mr. Hymas said. “If you have more than $1-million, then you can talk about buying individual issues, but if you have less than $1-million you’re either going to have poor diversification or poor pricing, perhaps both.”

NOTE: substitute "bond fund" for "ETF" in the article; you can use bond index mutual funds as well.

Thank you for this link.  I was wondering how the coupon repayment factored into bond (fund) pricing.  But still, even with the set payments, it seems like all that can do is mitigate a guaranteed loss in the present circumstances.

KingCoin

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Re: Understanding bond funds
« Reply #17 on: January 06, 2014, 01:37:44 PM »
As I understand though, are rates are basically already at 0%.  So bond rates cannot fall; at best they can stay the same, and at worst and most likely, interest rates will rise.  So bond prices have no place to go but stay flat or drop.  If I am worried about volatility, should I not just keep some of my investments in cash?

This is sort of a complex discussion.

Short dated bond yields are close to 0%, yes. However, if rates rise on those bonds, you wont really lose any money because the duration is so low. You can think of these bonds as slightly enhanced cash (they might yield 0.30% or so vs your checking account's 0.05%). You're neither going to make or lose much money on them.

Longer dated bonds have higher yields. Right now the 10y US government bond yields 2.75% which should at least keep up with inflation. These have some downside if rates continue to rise. For every 1% move in the interest rate, these should fall about 8% in price. The 10y has historically yielded about 2% more than inflation, so if rates entirely normalize over the next year, you'll probably lose ~14%. If we hit another rough patch (http://www.bloomberg.com/news/2014-01-02/china-s-runaway-train-is-running-out-of-track.html), you'll probably make ~12%.

If you wade into corporate bonds, you can get even higher yields, usually on the order of 4-6% since you're being compensated for corporate credit risk. These bonds will have less upside if the economy struggles since they're not a "flight to safety" asset, and widening credit spreads could mute returns.

High yield bonds will often yield 6%+ due to their increased default risk. These have considerable downside in an economic collapse. See the ETF HYG or JNK to see how they behave.

If you want to roll up your sleeves, you may be able to find low risk bonds that yield 7-9%. I've given a couple examples so far in the "Trade Idea Thread". This process is probably too advanced for most investors.

starguru

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Re: Understanding bond funds
« Reply #18 on: January 07, 2014, 08:23:31 AM »
As I understand though, are rates are basically already at 0%.  So bond rates cannot fall; at best they can stay the same, and at worst and most likely, interest rates will rise.  So bond prices have no place to go but stay flat or drop.  If I am worried about volatility, should I not just keep some of my investments in cash?

This is sort of a complex discussion.

Short dated bond yields are close to 0%, yes. However, if rates rise on those bonds, you wont really lose any money because the duration is so low. You can think of these bonds as slightly enhanced cash (they might yield 0.30% or so vs your checking account's 0.05%). You're neither going to make or lose much money on them.

Longer dated bonds have higher yields. Right now the 10y US government bond yields 2.75% which should at least keep up with inflation. These have some downside if rates continue to rise. For every 1% move in the interest rate, these should fall about 8% in price. The 10y has historically yielded about 2% more than inflation, so if rates entirely normalize over the next year, you'll probably lose ~14%. If we hit another rough patch (http://www.bloomberg.com/news/2014-01-02/china-s-runaway-train-is-running-out-of-track.html), you'll probably make ~12%.

If you wade into corporate bonds, you can get even higher yields, usually on the order of 4-6% since you're being compensated for corporate credit risk. These bonds will have less upside if the economy struggles since they're not a "flight to safety" asset, and widening credit spreads could mute returns.

High yield bonds will often yield 6%+ due to their increased default risk. These have considerable downside in an economic collapse. See the ETF HYG or JNK to see how they behave.

If you want to roll up your sleeves, you may be able to find low risk bonds that yield 7-9%. I've given a couple examples so far in the "Trade Idea Thread". This process is probably too advanced for most investors.

So are you basically saying that while interest rates are low, the specific rate we care about that drives bond (fund) pricing is not 0, its closer to 3%, and there is room for movement, and thus we can't claim knowledge of the future that would overrule the "don't try to time the market" guideline?   

KingCoin

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Re: Understanding bond funds
« Reply #19 on: January 07, 2014, 08:30:18 AM »
So are you basically saying that while interest rates are low, the specific rate we care about that drives bond (fund) pricing is not 0, its closer to 3%, and there is room for movement, and thus we can't claim knowledge of the future that would overrule the "don't try to time the market" guideline?

Correct. The historical "norm" given current inflation levels is around 4-4.5%, so the wind is probably in your face so to speak, but there's no guarantee that we get there in the near term, or that rates don't move lower first.

starguru

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Re: Understanding bond funds
« Reply #20 on: January 07, 2014, 08:35:08 AM »
So are you basically saying that while interest rates are low, the specific rate we care about that drives bond (fund) pricing is not 0, its closer to 3%, and there is room for movement, and thus we can't claim knowledge of the future that would overrule the "don't try to time the market" guideline?

Correct. The historical "norm" given current inflation levels is around 4-4.5%, so the wind is probably in your face so to speak, but there's no guarantee that we get there in the near term, or that rates don't move lower first.

Ok cool.  Thanks for your patience.  Is there anything else I should be considering here?  I think I'm just going to stay the course (36years old, 80/20 split between stocks and bonds).


KingCoin

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Re: Understanding bond funds
« Reply #21 on: January 07, 2014, 08:41:52 AM »
Ok cool.  Thanks for your patience.  Is there anything else I should be considering here?  I think I'm just going to stay the course (36years old, 80/20 split between stocks and bonds).

This seems totally fine to me. Pushing stock allocation up to 90% and above is getting mighty aggressive. Keeping your bond allocation shorter dated (10y and shorter) will mitigate any fall-out from higher interest rates.

starguru

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Re: Understanding bond funds
« Reply #22 on: January 07, 2014, 08:52:35 AM »
Ok cool.  Thanks for your patience.  Is there anything else I should be considering here?  I think I'm just going to stay the course (36years old, 80/20 split between stocks and bonds).

This seems totally fine to me. Pushing stock allocation up to 90% and above is getting mighty aggressive. Keeping your bond allocation shorter dated (10y and shorter) will mitigate any fall-out from higher interest rates.

Keep in mind this is for my 401k, the only options are  PIMCO Total Return Fund Institutional Class (PTTRX) and Vanguard Total Bond Market Index Fund Institutional Plus (VBMPX).  The PIMCO has a higher fee (.46 vs .05) but has consistently performed 2% better as far back as 10 years.

Abe

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Re: Understanding bond funds
« Reply #23 on: January 07, 2014, 08:53:31 AM »
Sorry to pop in with another question, but with regards to losing value on bond funds, if I invested in a long-term fund now, and then keep my investment in for longer than the longest-term bond in that fund, would I be buffered from the loss in value if higher-yield bonds are issued after I buy into the fund? Or would the fund usually sell those bonds, take those losses to invest in new issues? Thanks!

KingCoin

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Re: Understanding bond funds
« Reply #24 on: January 07, 2014, 09:10:28 AM »
Sorry to pop in with another question, but with regards to losing value on bond funds, if I invested in a long-term fund now, and then keep my investment in for longer than the longest-term bond in that fund, would I be buffered from the loss in value if higher-yield bonds are issued after I buy into the fund? Or would the fund usually sell those bonds, take those losses to invest in new issues? Thanks!

Depends on the fund. An investment grade fund will sell bonds as they are downgraded in quality. However, they'll hold onto bonds if their price has fallen due to rising interest rates. Generally, speaking there is no "buffering" unless you invest more money as rates rise or credit spreads widen (in which case you're simply "averaging down").

An example:
A ~20yr bond fund holds bonds that yield 5% to maturity. Interest rates rise, and the yield on these bonds in the market place rises to 7%. This fund will suffer ~22% loss. New 20y bonds issues will be sold in the market at around 7%, but the bonds the fund holds now yield 7% too, so there's no profit in selling the bonds in the fund and buying the new issues. The good news is that your fund now has a yield to maturity of 7% instead of 5%, but you've suffered a 22% loss and that additional yield will essentially just pay back those losses over time.
« Last Edit: January 07, 2014, 06:10:07 PM by KingCoin »