Do you have the bond gene?

Posted by on October 16, 2009 @ 9:23 am in Investing

One of the smartest people I know—a brilliant copy editor—used to shake her head as she read articles about bonds and the bond market.

“I think you have to be born with the bond gene to understand bonds,” she would mutter.

What set Mary to muttering, as I recall, was the fact that bond prices tend to move in the opposite direction of interest rates.

“You would think,” she’d say, “that higher interest rates would be good for bond investors. Wouldn’t I earn more?”

Was she in need of a bond-gene transplant? Not really. The impact of rising or falling rates on bond returns varies depending on time horizons.

The short term

When interest rates go up, the market value, or price, of an existing bond immediately falls. This adjustment occurs because an investor wouldn’t pay full price for an existing bond with a face value of $1,000 and a yield of 4% if she could get a similar $1,000 bond yielding 5%. It’s the opposite story when interest rates fall. If prevailing interest rates go from 5% to 4%, you’d expect to pay more for the existing 5% bond than for one yielding 4%.

So in the short run, rising interest rates are bad news and falling rates are good news for an investor who holds bonds or bond funds.

The long term

But over the longer term, rising interest rates can be good for bond investors. And falling rates, although they boost bond prices at first, eventually are not so good for bond investors.

The key is what happens over time as your bond investments throw off income and as bonds mature. The income from your bonds is either spent or reinvested. If you reinvest the income, and rates have gone up, that $100 earns more than if rates fell or held steady. And when a $1,000 bond you own (directly or in a bond fund) matures, you’d rather be able to reinvest that $1,000 in principal at, say, a 6% yield than at 4%. At 6%, money doubles in roughly 12 years. At 4%, it takes about 18 years to double.

For long-term bonds, it’s the interest income—and the reinvestment of that income—that accounts for the largest portion of total returns. Over time, the impact of price fluctuations is outweighed by the impact of reinvestments of income and principal.

The table below illustrates the disparate impact of rate changes over various periods, demonstrating how important an investor’s time horizon is when thinking about the risks of interest rates. For the long-term investor, the bigger risk is lower rates, not higher rates. The reverse is true for the short-term investor.

This element of time is too often missed, I think, in commentary on bonds and in the way some investors think about bonds. For example, bond mutual funds tend to attract increased cash from investors after interest rates have fallen and prices have appreciated—as reflected in cash flows during 2009. After periods of rising interest rates—when bond prices have fallen and bond fund returns are weak or negative—it’s not unusual to see money flowing out of bond funds.

It’s as if investors have a genetic inclination to use the rear-view mirror to guide them in moving forward.

Are there terms or concepts about bonds and bond investing that you find puzzling? Yield curves? Duration? Credit risk and credit spreads?

I’d be interested in hearing about them, then asking some of our bond experts to tackle the questions in a future post or posts.

Bond fund returns in three interest rate scenerios

Assumptions: Rates change evenly over two years; initial yield to maturity is 4%; initial duration is 5.8 years and changes as interest rates change; and—a key assumption—the bond fund’s interest income is reinvested. Data source: Vanguard.

Note: Investments in bond funds are subject to interest rate, credit, and inflation risk.

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