DQOTD: What's Baked Into Bond Fund NAVs Already?

[Midpack]

We all know bond fund NAVs have declined with the Fed interest rate hikes. We also know there are likely more rate hikes to come, so has some of that already been baked into current bond fund NAVs? Do bond fund NAVs correlate with interest rates in real time, or do they bake in what's expected? Just curious as I DCA my Roth conversions...

 

[OldShooter]

Well, your question is really "What's baked into individual bond prices?" The NAV is just arithmetic.

 

[COcheesehead]

It’s not that simple. Duration of the bond or fund comes into play as well. The short end reacts more to the Fed. The intermediate and long end react more to the future of the economy.
Thus short term rates are going up. Intermediate and long are going down.

 

[audreyh1]

I suspect a lot of damage has already been done.

The intermediate and longer rates seem resilient, but the shorter-term funds are taking it on the chin due to yield curve inversion.

We just don’t know how much more damage may come. Will continued Fed Fund rate increases push the entire inverted curve higher? Who knows?

An economic slowdown or recession will help protect the intermediate and longer term bond prices.

I don’t worry about it, I just rebalance my AA occasionally.

 

[OldShooter]

It’s not that simple. Duration of the bond or fund comes into play as well. The short end reacts more to the Fed. The intermediate and long end react more to the future of the economy.
Thus short term rates are going up. Intermediate and long are going down.

Sure. All true. But those parameters derive from the fund's holdings, not from some kind other pricing mechanism. Net Asset Value is simply the total value of the fund's assets, so whatever is "baked in" is necessarily baked in at the level of the individual bond issues held.

 

[audreyh1]

DQOTD = Dumb Question of the Day

I’ve seen you use that acronym over many years, but finally looked it up!

 

[daylatedollarshort]

The bond market seems to be pricing in a recession followed by a return to recent normal of low interest rates. Interest rates have been dropping for decades, but those rates are very low in the context of a longer time frame. Recent inflation reports were 9.1%. 5 years Treasuries are 2.79%. That is a pretty big gap. Historically, the Fed has had to raise interest rates higher than inflation in order to get inflation under control. So is the market accurately predicting a recession and a return to recent low normal rates or is it suffering from recency bias, and interest rates are going to be higher in the short term as well as long term, like they were for decades prior to the 80s?

Of course I don't know the future, but I suspect the odds are good that the Fed will go with what has worked historically and raise rates more than is baked into current bond yields. The longer inflation stays high, the more is seems like the start of a new trend towards higher interest rates going forward and not some post-Covid transitory blip. We're only buying individual bonds right now with maturity dates and no long term bonds except for TIPS so it is all good no matter what happens.

 

[Montecfo]

We are in recession, but a mild one so far. The FED seems to be moving back to dove mode.

Will they stay dovish? Until after the mid-terms, I expect so just from their rhetoric.

I would say a quick turnaround in inflation based on the current hike path is what is reflected. Is that what will happen?

I am dubious. I now feel like it could be a long slog to beat inflation with a reluctant Fed making only modest changes.

But after mid-terms, things could change if inflation has not declined meaningfully.

So my view is we have more rate risk from here. I am still keeping maturities short.

 

[COcheesehead]

We are in recession, but a mild one so far. The FED seems to be moving back to dove mode.

Will they stay dovish? Until after the mid-terms, I expect so just from their rhetoric.

I would say a quick turnaround in inflation based on the current hike path is what is reflected. Is that what will happen?

I am dubious. I now feel like it could be a long slog to beat inflation with a reluctant Fed making only modest changes.

But after mid-terms, things could change if inflation has not declined meaningfully.

So my view is we have more rate risk from here. I am still keeping maturities short.

I don’t think the FED is in dove mode. Based on what they’ve said, it all sounds pretty hawkish.

 

[COcheesehead]

Sure. All true. But those parameters derive from the fund's holdings, not from some kind other pricing mechanism. Net Asset Value is simply the total value of the fund's assets, so whatever is "baked in" is necessarily baked in at the level of the individual bond issues held.

I thought that is sorta what I said. That the price is determined by where the bond or fund sits on the curve. One affected by the FED more than the other. The NAV isn’t a simple rolling up of the contents of the fund though. The NAV also reflects the fund’s expenses and to a degree it’s redemptions, which is a drag on returns, something you don’t have if you own the bond outright.

 

[Montecfo]

I don’t think the FED is in dove mode. Based on what they’ve said, it all sounds pretty hawkish.

I hope you are right. I wonder why this FED is making no move and has apparent plan to stop rate hikes under 4%...out through 2023.

Rhetoric is interesting but actions speak louder. JPowell said future hikes will likely be more modest than the 75 basis points of last two hikes. Why would he say that I wonder?

 

[Freedom56]

Short duration bond funds are in for more pain as money market fund yields already exceed those of short duration bond funds. As the Fed continues to raise rates, the 30 day treasury will move up in line with the Fed funds rate. Money market fund yields will track up to 30 day treasury yields. As that happens, money market fund yields will exceed those of most bond funds with 100% liquidity and zero risk to capital.

 

[eytonxav]

Didn't seem like a dumb question at all to me. I wonder the same, bonds have really taken it on the chin, so will declines remain proportional with what happened in the 1H as rates rose or is something baked in and the declines be more muted? In other words, does the duration metric continue to hold fast with further rate increases.

 

[Chuckanut]

The people who predict a quick end to inflation and inflation fighting remind me of the videos I've seen of young French and British men going off to fight in the first battles of WWI. They are smiling and waving as they cheerfully anticipate quickly teaching 'the hun' a lesson he will never forget. Three maybe six months of whacking the enemy and they will return home as glorious heroes.

I have that same bad feeling today when I read about expectations that this inflation will decline in a year or so, then we will drift back to 3% mortgages in a few years after that.

I hope I am very wrong.

 

[daylatedollarshort]

I have that same bad feeling today when I read about expectations that this inflation will decline in a year or so, then we will drift back to 3% mortgages in a few years after that.

I hope I am very wrong.

Three percent and under mortgages we saw last year were at historical lows. I am not sure how likely those are to ever return, especially with inflation running so high right now, and due to factors without any short term solutions, like the war in Ukraine and Covid supply chain issues.

 

[foxfirev5]

What my simple mind still hasn't comprehended is why the bond fund goes down in value with higher rates yet the current distribution yield has barely moved. I know there's a lag but it makes me glad I'm 95% individual holdings with a couple of ladders. At least I know what I'm getting and when I'll get it. I'll let the equity portion of my investments provide the mystery.

 

[Freedom56]

What my simple mind still hasn't comprehended is why the bond fund goes down in value with higher rates yet the current distribution yield has barely moved. I know there's a lag but it makes me glad I'm 95% individual holdings with a couple of ladders. At least I know what I'm getting and when I'll get it. I'll let the equity portion of my investments provide the mystery.

Bond fund hold a lot of low coupon debt. While the value of that debt has dropped to compensate for the rise in yield, the fund is still receiving the same coupon payments.

 

[daylatedollarshort]

The U.K. had 9.4% inflation recently, compared to our 9.1%, and the Bank of England expects it to peak there at 13.3% in October. If we track a similar course, then the Fed will likely raise rates more than the market currently expects.

 

[all4j]

Maybe I'm missing something, but I can't imagine that everything has been baked in. The curve is inverted -- I realize there are different views on whether to look at 10yr & 2 yr, 10yr & 3 month, etc. But I think all are currently inverted. In addition to fed rate changes, there are other market factors to consider. China has cut back their purchases & of course so has the fed (so lower demand from 2 of bigger holders of treasuries). Meanwhile, I don't think supply is going down from treasury side, unsure of corporate or munis.

If it is all baked in, wouldn't that mean we're going to live with an inverted curve from now on? Negative real rates?

For me, bigger questions around how fast things will change & when curve "un-inverts" where/how will change come?

 

[OldShooter]

Maybe I'm missing something, but I can't imagine that everything has been baked in. ...

Probably that depends on what "baked in" means. Arguably the price of any security (bond, stock, etc.) is the current market consensus of its value.

One can debate the Efficient Market Hypthesis, which states that the current price reflects all available information, But I think the concept is fundamentally sound. So whatever the market thinks should be bake in, is.

 

[daylatedollarshort]

If it is all baked in, wouldn't that mean we're going to live with an inverted curve from now on? Negative real rates?

Good point. I have read that historically, inflation has never come down until the Fed raised interest rates higher than the inflation rate. Otherwise, if prices are going up next year by 9%, and real interest rates on Treasuries are -6%, that encourages people to buy now instead of saving money and keeps inflation spiraling.

 

[Montecfo]

It is not baked in in my view. Nor is the market efficient. Our wild market moves are evidence of that. And the runup to the rate hike cycle was heavily heavily telegraphed, yes bonds still sold off hard when rates actually began to rise.

I think today's jobs report shows that the Fed's dovish posture in comments after last rate hike probably will not last. Market now predicting an additional 75 basis points for Sept.

 

[aja8888]

I hope you are right. I wonder why this FED is making no move and has apparent plan to stop rate hikes under 4%...out through 2023.

Rhetoric is interesting but actions speak louder. JPowell said future hikes will likely be more modest than the 75 basis points of last two hikes. Why would he say that I wonder?

1. The FED has announced its planned interest rate hike and has done them according to schedule. That is the plan and no other has been announced.

2. The door has been opened to an August rate hike if deemed necessary.

3. QT has commenced and the FED has started rolling off MBS's (when they are paid off) and treasuries (when they mature). The FED has NOT started selling bonds or MBS's yet, but have the option. QT will kill inflation quickly as that pulls liquidity directly out of the economy.

4. The FED is looking for a "soft landing" type recession and we will have an landing, for sure, as inflation is deadly to the economy.

5. Powell's legacy is at risk as he doesn't want be remembered as the guy who let inflation kill the U.S. economy and potentially lose reserve status of the currency.

6. Dem's don't want to be in office if inflation kills the economy. Instructions have been forwarded to Powell already.

There is nothing DOVISH going on now.

 

[COcheesehead]

Yea, I don’t understand the interpretation of the Fed as dovish. Not based on everything I read.

 

[daylatedollarshort]

It is not baked in in my view. Nor is the market efficient. Our wild market moves are evidence of that. And the runup to the rate hike cycle was heavily heavily telegraphed, yes bonds still sold off hard when rates actually began to rise.

I used to believe the efficient market idea as well until this year when many of us on this forum sold off our bond funds when the Fed rate increases were announced and much of the market reacted only after the rate increases actually took effect. So it has made me question what other general maxims about the market we've been led to believe are 100% wrong?