Earl E Retyre
Full time employment: Posting here.
- Joined
- Jan 1, 2010
- Messages
- 541
I read people’s perspective that investing in a bond fund right now may not be wise due to [expected] inflation risk. Perhaps I do not understand the way it works. So, let me explain my understanding/perception and let you poke holes at it. Please be kind.
For purposes of a hypothetical, yet very extreme example (to make my point and allow for easy math) let’s assume a bond index fund invests 1/3 in near-term bonds earning an average of 1%, 1/3 in mid-term bonds earning 2% and 1/3 in long-term bonds earning 3%. Therefore, the average of the portfolio is earning 2% today. Let’s say I invest $100,000 and therefore am earning $2,000/year today. So, far so good (I think).
Now, let’s assume that inflation sets in overnight and inflation goes up 1% (I said the example would be extreme to allow for illustration). So, tomorrow if someone bought the fund they would be earning near-term average 2%, mid-term 3% and long-term 4% for an overall bond fund average of 3%. In other words, anyone who invests $100,000 in the fund tomorrow would earn $3,000/year. That is why the value of my fund drops in value since it is only earning $2,000/year.
Let’s assume that, for purposes of my extreme example, near-term duration = 1 year; mid-term = 2 years and long-term = 3 years. Obviously that is not reality - but hopefully you are bearing with me. And let’s assume inflation does not change any more for 3 years or my example gets too complicated.
After 3 years, all my investments in the fund would have matured and would have been automatically re-invested by the fund manager in the higher rates. So, after 3 years, my fund is earning 3% or $3,000/year.
Therefore, one perspective would be that, even though the value of my fund initially dropped (due to inflation), as long as I do not sell the fund, my annual earnings gradually increased from a bottom of $2,000/year on up to $3,000/year by the end of the 3 years. And, in the long run the value of the $100,000 portfolio has not dropped either (compared to my initial $100,000 investment) since it is earning the $3,000/year.
Let’s assume most of my big costs are fixed (e.g., housing) and I can adjust for some rising costs (e.g., go out to restaurants less if meals cost slightly more to eat out) and am perfectly happy to live on $2,000/year. Then, inflation on my index bond fund is not necessarily a bad thing. It is actually increasing my ROI from $2,000/year to $3,000/year over time. Yeah, I would have been much better off, had I waited until tomorrow to earn the 3% right away, but the rise in inflation still helps my take home living expenses over time.
OK, throw darts at my logic …
For purposes of a hypothetical, yet very extreme example (to make my point and allow for easy math) let’s assume a bond index fund invests 1/3 in near-term bonds earning an average of 1%, 1/3 in mid-term bonds earning 2% and 1/3 in long-term bonds earning 3%. Therefore, the average of the portfolio is earning 2% today. Let’s say I invest $100,000 and therefore am earning $2,000/year today. So, far so good (I think).
Now, let’s assume that inflation sets in overnight and inflation goes up 1% (I said the example would be extreme to allow for illustration). So, tomorrow if someone bought the fund they would be earning near-term average 2%, mid-term 3% and long-term 4% for an overall bond fund average of 3%. In other words, anyone who invests $100,000 in the fund tomorrow would earn $3,000/year. That is why the value of my fund drops in value since it is only earning $2,000/year.
Let’s assume that, for purposes of my extreme example, near-term duration = 1 year; mid-term = 2 years and long-term = 3 years. Obviously that is not reality - but hopefully you are bearing with me. And let’s assume inflation does not change any more for 3 years or my example gets too complicated.
After 3 years, all my investments in the fund would have matured and would have been automatically re-invested by the fund manager in the higher rates. So, after 3 years, my fund is earning 3% or $3,000/year.
Therefore, one perspective would be that, even though the value of my fund initially dropped (due to inflation), as long as I do not sell the fund, my annual earnings gradually increased from a bottom of $2,000/year on up to $3,000/year by the end of the 3 years. And, in the long run the value of the $100,000 portfolio has not dropped either (compared to my initial $100,000 investment) since it is earning the $3,000/year.
Let’s assume most of my big costs are fixed (e.g., housing) and I can adjust for some rising costs (e.g., go out to restaurants less if meals cost slightly more to eat out) and am perfectly happy to live on $2,000/year. Then, inflation on my index bond fund is not necessarily a bad thing. It is actually increasing my ROI from $2,000/year to $3,000/year over time. Yeah, I would have been much better off, had I waited until tomorrow to earn the 3% right away, but the rise in inflation still helps my take home living expenses over time.
OK, throw darts at my logic …
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