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spasmous
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 Posted: Sun Apr 01, 2007 6:45 am Post subject: Bond fund in 401k |
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I am holding a percentage of my 401k in a bond fund (Fidelity Total
Bond) based on the conventional wisdom of holding 110-age (or
whatever) percent as bonds. I'm still intrigued how complicated bonds
are, and have noticed several posts where bond funds are criticized.
The criticism seems mostly due to loss of principal + fees which are
not a factor in individual bonds.
As far as I see on yahoo finance, the value of a share in a bond fund
remains fairly constant (for investment grade at least).
Now here's where things get foggy for me (if they're not already!).
The shareholder receives a dividend payment that fluctuates with the
interest rate.
The bond fund continually adds new bonds at current yields and loses
old bonds as they mature. Therefore the yield should follow the
interest rate, with a certain time lag that relates to the average
maturity of the bonds held.
When you factor in dividend reinvestment then you are continually
buying in at the current yield and the fund is lagging the interest
rate, and so over 20 years the value of your holdings will be quite
insensitive to interest rates.
I'm just trying to understand so please whack me with the clue bat if
you have one ;) |
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Andrew Koenig
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| Posted: Sun Apr 01, 2007 7:10 pm Post subject: Re: Bond fund in 401k |
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"spasmous" <spasmous@gmail.com> wrote in message
news:1175391923.060443.56890@l77g2000hsb.googlegroups.com...
| Quote: |
I am holding a percentage of my 401k in a bond fund (Fidelity Total
Bond) based on the conventional wisdom of holding 110-age (or
whatever) percent as bonds. I'm still intrigued how complicated bonds
are, and have noticed several posts where bond funds are criticized.
The criticism seems mostly due to loss of principal + fees which are
not a factor in individual bonds.
|
Sure they are. If you own an individual bond, you probably had to pay fees
when you bought it. Moreover, if you want to sell it before it matures, you
may not be able to do so for its face value, depending on what happened to
interest rates between the time of purchase and the time of sale.
| Quote: |
As far as I see on yahoo finance, the value of a share in a bond fund
remains fairly constant (for investment grade at least).
|
Nope -- it changes with the prevailing interest rates. Rate goes up, share
value goes down, and vice versa. How much it goes up or down depends on the
duration of the bonds in the fund. The longer the duration, the more
sensitive the share price is to interest rate changes.
| Quote: |
Now here's where things get foggy for me (if they're not already!).
The shareholder receives a dividend payment that fluctuates with the
interest rate.
|
Not quite -- it fluctuates with the interest rates of the bonds that are
currently in the fund.
| Quote: |
The bond fund continually adds new bonds at current yields and loses
old bonds as they mature. Therefore the yield should follow the
interest rate, with a certain time lag that relates to the average
maturity of the bonds held.
|
Correct. Because the bonds pay over their entire life, the fluctuations
kind of average out, and typically the share price of a bond fund will
fluctuate only about half as much as the bonds' maturity would suggest,
because on average the bonds are halfway through their life.
That's why bond funds talk about duration separately from maturity. When a
fund says its bonds have a 4-year duration, that more or less means that on
average, the bonds in the fund will mature in 4 years. It also means that
the share price is expected to fall 4% for each 1% increase in the
prevailing interest rates, and rise 4% for each 1% drop in the interest
rates.
So if the Fed raises rates by 0.25%, you can expect the share value of a
bond fund with 4-year duration to drop by 1%.
| Quote: |
When you factor in dividend reinvestment then you are continually
buying in at the current yield and the fund is lagging the interest
rate, and so over 20 years the value of your holdings will be quite
insensitive to interest rates.
|
The 20-year average of the value of your bond-fund holdings will be
sensitive to the 20-year average interest rates. |
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Mark Freeland
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| Posted: Sun Apr 01, 2007 7:57 pm Post subject: Re: Bond fund in 401k |
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"Andrew Koenig" <ark@acm.org> wrote in message
news:A3PPh.5396$VU4.3818@bgtnsc05-news.ops.worldnet.att.net...
| Quote: |
Correct. Because the bonds pay over their entire life, the fluctuations
kind of average out, and typically the share price of a bond fund will
fluctuate only about half as much as the bonds' maturity would suggest,
because on average the bonds are halfway through their life.
That's why bond funds talk about duration separately from maturity. When
a fund says its bonds have a 4-year duration, that more or less means that
on average, the bonds in the fund will mature in 4 years. It also means
that the share price is expected to fall 4% for each 1% increase in the
prevailing interest rates, and rise 4% for each 1% drop in the interest
rates.
|
Not exactly. The original (Macaulay) definition of duration is the average
not of maturities, but of cash flows. For zero coupon bonds (which have no
cash flow, except for the payment of face value at maturity) this is the
same as average maturity, but for other bonds, duration is shorter.
There's one other wrinkle - you use present value of the cash flow. Here's
a good page on duration, that starts off with an example demonstrating this
definition. The above paragraph makes much more sense if you look at the
numbers in the example.
http://www.finpipe.com/duration.htm
But the duration that represents the rate of change of share price as
interest rate changes is something slightly different; it's called modified
duration. *Very* roughly speaking, it's the Macaulay duration divided by
1+rate.
Key points - average duration is shorter than average maturity, sometimes
significantly so. See, e.g. Vanguard's long term taxable bond funds. Also,
as Andrew said, the duration figure you usually see tells you how much the
bond/fund price will change (in percentage terms) with a 1% change in
interest rates.
https://flagship.vanguard.com/VGApp/hnw/FundsByType?loc=&View=BA
Current duration on their long term bond index fund is 11.1 years; average
maturity is 20.3 years.
Mark Freeland
BnetOnewsX@sbcglobal.net |
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Andrew Koenig
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| Posted: Sun Apr 01, 2007 8:19 pm Post subject: Re: Bond fund in 401k |
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"Mark Freeland" <BnetOnewsX@sbcglobal.net> wrote in message
news:6LPPh.1773$5e2.1255@newssvr11.news.prodigy.net...
| Quote: |
That's why bond funds talk about duration separately from maturity. When
a fund says its bonds have a 4-year duration, that more or less means
that on average, the bonds in the fund will mature in 4 years. It also
means that the share price is expected to fall 4% for each 1% increase in
the prevailing interest rates, and rise 4% for each 1% drop in the
interest rates.
Not exactly. The original (Macaulay) definition of duration is the
average not of maturities, but of cash flows. For zero coupon bonds
(which have no cash flow, except for the payment of face value at
maturity) this is the same as average maturity, but for other bonds,
duration is shorter.
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You're right -- I was oversimplifying ;-) |
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Herb
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| Posted: Mon Apr 02, 2007 12:02 am Post subject: Re: Bond fund in 401k |
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"Andrew Koenig" <ark@acm.org> wrote in message
news:A3PPh.5396$VU4.3818@bgtnsc05-news.ops.worldnet.att.net...
[snip]
| Quote: |
So if the Fed raises rates by 0.25%, you can expect the share value of a
bond fund with 4-year duration to drop by 1%.
|
The Fed sets rates on very short-term loans to banks. The interest rates on
bonds are set in a relatively free market. Although the two are not
entirely unrelated, they can be very different. In today's world so awash
in dollars, long term bond rates have been rather resistant to Fed attempts
to raise short-term rates.
-herb |
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darkness39
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| Posted: Tue Apr 03, 2007 1:41 pm Post subject: Re: Bond fund in 401k |
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On Apr 1, 3:57 pm, "Mark Freeland" <BnetOne...@sbcglobal.net> wrote:
Without using stripped coupon bonds, its very difficult to get a 'long
bond' fund with duration out more than about 10 years.
| Quote: |
From memory, the 'convexity' of a bond is its sensitivity to changes
in interest rates? And a higher coupon bond, all things being equal, |
will be less sensitive to interest rate changes (because it has a
lower duration-- more of the cash comes back in the early years). |
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Flasherly
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| Posted: Tue Apr 03, 2007 10:49 pm Post subject: Re: Bond fund in 401k |
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On Mar 31, 9:45 pm, "spasmous" <spasm...@gmail.com> wrote:
| Quote: |
I am holding a percentage of my 401k in a bond fund (Fidelity Total
Bond) based on the conventional wisdom of holding 110-age (or
whatever) percent as bonds. I'm still intrigued how complicated bonds
are, and have noticed several posts where bond funds are criticized.
The criticism seems mostly due to loss of principal + fees which are
not a factor in individual bonds.
As far as I see on yahoo finance, the value of a share in a bond fund
remains fairly constant (for investment grade at least).
Now here's where things get foggy for me (if they're not already!).
The shareholder receives a dividend payment that fluctuates with the
interest rate.
The bond fund continually adds new bonds at current yields and loses
old bonds as they mature. Therefore the yield should follow the
interest rate, with a certain time lag that relates to the average
maturity of the bonds held.
When you factor in dividend reinvestment then you are continually
buying in at the current yield and the fund is lagging the interest
rate, and so over 20 years the value of your holdings will be quite
insensitive to interest rates.
I'm just trying to understand so please whack me with the clue bat if
you have one ;)
|
Article on a similar total bond aggregate, nice comparison and strong
points to consider for other bond issues.
http://www.marketwatch.com/news/story/2007-bond-outlook/story.aspx?guid=%7B0573307C-18B9-4257-9563-57B50A3D05AE%7D |
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Mark Freeland
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| Posted: Wed Apr 04, 2007 3:22 am Post subject: Re: Bond fund in 401k |
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"darkness39" <darkness39@yahoo.com> wrote in message
news:1175589702.568891.165220@q75g2000hsh.googlegroups.com...
| Quote: |
On Apr 1, 3:57 pm, "Mark Freeland" <BnetOne...@sbcglobal.net> wrote:
https://flagship.vanguard.com/VGApp/hnw/FundsByType?loc=&View=BA
Current duration on their long term bond index fund is 11.1 years;
average
maturity is 20.3 years.
Without using stripped coupon bonds, its very difficult to get a 'long
bond' fund with duration out more than about 10 years.
|
Since I don't usually look at long term bonds (little additional yield, even
with normal yield curves; useful primarily for making interest rate bets) -
I'd never taken a close look at their durations. Instead of calculating the
duration myself, I took the easy way out, and picked a sample bond: CUSIP
931142CH4
If you feed that into Fidelity's bond engine, you get the figures:
http://fixedincome.fidelity.com/fi/FIBondDetails?cusip=931142CH4
Maturity April 5, 2027. Coupon 5.875%. Non-callable. Duration 11.69
years.
You are right - you cannot get much above 10 years. 'Course, as you note
below, if the coupon is lower then the duration will be longer (and the
sample bond above is selling at a slight premium, so a 20 year bond selling
at par would have a slightly longer duration).
| Quote: |
From memory, the 'convexity' of a bond is its sensitivity to changes
in interest rates?
|
Yes. d(Price)/d(discount rate) = modified duration.
d^2(Price)/d(discount rate)^2 = d(duration)/d(discount rate)
= rate of change of
duration as discount rate changes
= convexity
| Quote: |
And a higher coupon bond, all things being equal,
will be less sensitive to interest rate changes (because it has a
lower duration-- more of the cash comes back in the early years).
|
Nice thing about munis: Even though their coupons are lower (since they are
tax-free), and thus their durations are longer than comparable maturity
taxable bonds, they tend to have less interest rate risk. That's because
muni interest rates don't shift as much as, say, the treasury yield curve.
Mark Freeland
BnetOnewsX@sbcglobal.net |
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darkness39
Guest
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| Posted: Wed Apr 04, 2007 11:27 am Post subject: Re: Bond fund in 401k |
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On Apr 3, 11:22 pm, "Mark Freeland" <BnetOne...@sbcglobal.net> wrote:
| Quote: |
"darkness39" <darknes...@yahoo.com> wrote in message
news:1175589702.568891.165220@q75g2000hsh.googlegroups.com...
On Apr 1, 3:57 pm, "Mark Freeland" <BnetOne...@sbcglobal.net> wrote:
https://flagship.vanguard.com/VGApp/hnw/FundsByType?loc=&View=BA
Current duration on their long term bond index fund is 11.1 years;
average
maturity is 20.3 years.
Without using stripped coupon bonds, its very difficult to get a 'long
bond' fund with duration out more than about 10 years.
Since I don't usually look at long term bonds (little additional yield, even
with normal yield curves; useful primarily for making interest rate bets) -
I'd never taken a close look at their durations.
|
It's one of the 'puzzles' of investing. Long bonds don't pay you for
the risk. I think it is because it is a segmented market. The
typical buyers of long bonds are insurance companies with fixed future
liabilities.
Instead of calculating the
| Quote: |
duration myself, I took the easy way out, and picked a sample bond: CUSIP
931142CH4
If you feed that into Fidelity's bond engine, you get the figures:http://fixedincome.fidelity.com/fi/FIBondDetails?cusip=931142CH4
Maturity April 5, 2027. Coupon 5.875%. Non-callable. Duration 11.69
years.
You are right - you cannot get much above 10 years. 'Course, as you note
below, if the coupon is lower then the duration will be longer (and the
sample bond above is selling at a slight premium, so a 20 year bond selling
at par would have a slightly longer duration).
From memory, the 'convexity' of a bond is its sensitivity to changes
in interest rates?
Yes. d(Price)/d(discount rate) = modified duration.
d^2(Price)/d(discount rate)^2 = d(duration)/d(discount rate)
= rate of change of
duration as discount rate changes
= convexity
|
Thanks!
| Quote: |
And a higher coupon bond, all things being equal,
will be less sensitive to interest rate changes (because it has a
lower duration-- more of the cash comes back in the early years).
Nice thing about munis: Even though their coupons are lower (since they are
tax-free), and thus their durations are longer than comparable maturity
taxable bonds, they tend to have less interest rate risk. That's because
muni interest rates don't shift as much as, say, the treasury yield curve.
|
I suspect that is partly an artefact of the data.
By which I mean, they don't trade as much, so they don't show the same
sensitivity.
If you actually tried to trade them, they would behave more like
treasuries, by the time you had paid the bid-offer spread.
Market data is a real problem in the study of finance. Small caps
outperform, but if you pay the bid-offer spreads, by a lot less (and
they can't be dealt in size, normally, a significant problem for small
cap fund managers).
As another example, real estate is not correlated with stock markets.
But that is in part because real estate values are not assessed
continously, every trading day, whereas stock values are. So the
apparent independence of return is probably not entirely there. |
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