Index Bond fund – odd hypothetical example to test my perspective/understanding

[Earl E Retyre]

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 …

[soupcxan]

You have the right principles, IF you are holding actual bonds and you hold them to maturity and then reinvest. If you are using a bond fund, it is a little more complicated because the fund manager may sell some bonds after their value drops, realizing capital losses which will be passed along to you.

But you're generally correct that bond fund holders will see a falling NAV as rates rise, but eventually the yield will rise as the fund's holdings are reinvested in higher YTM bonds. Look at the chart on page 14 of this report from Vanguard.

https://personal.vanguard.com/pdf/icrdir.pdf

[brewer12345]

Quote:

Originally Posted by soupcxan You have the right principles, IF you are holding actual bonds and you hold them to maturity and then reinvest. If you are using a bond fund, it is a little more complicated because the fund manager may sell some bonds after their value drops, realizing capital losses which will be passed along to you.

Buzz! Wrong! Give yourself a whack with a wet noodle. You suffer the losses regardless of whether the bonds are held directlyor in a fund.

For OP, there are two things you care about as a bond investor (aside from credit risk): interest rate risk and inflation risk. Interest rate risk is the simplest. If market rates go up 1% in your example, the value of your bonds would fall by about 2% because your average duration is about 2 years. There are some other things that go on that can affect whether you lose more or less than 2% (you take it in the cornhole if you own agency MBS), but that is a reasonable rule of thumb.

More problematic is inflation risk. If we start getting into an inflationary environment you are a risk of real purchasing value declining as you describe. However, interest rates may move in line with inflation, may move not at all, may go up a lot more than inflation, or may even go down.

[Lsbcal]

Rather then trying to model a bond fund, why not take an existing indexed bond fund you are interested in and look at it's response to a sudden intermediate Treasury rate change?

Example:
From Nov 2010 to April 2011 the 5yr Treasury went from 1.2% to 2.2%.
During that period my data shows the following returns:
-1.4% for VBTLX (Vanguard Total Bond Mkt)
+1.0% for DODIX (Dodge and Cox Income)
-0.9% for PTTRX (Pimco Total Return)
-3.1% for IEI (Intermediate Treasury ETF)

From Jan 2009 to June 2009 the 5yr Treasury went from 1.6% to 2.5%
During that period my data shows the following returns:
2.2% for VBTLX (Vanguard Total Bond Mkt)
7.8% for DODIX (Dodge and Cox Income)
6.4% for PTTRX (Pimco Total Return)
-3.2% for IEI (Intermediate Treasury ETF)

[Earl E Retyre]

thanks, Lsbcal. VBTLX is the fund I am investing in. So, I like that example. Can you please explain how, when treasuries went from 1.2% to 2.2% VBTLX shows a negative return? I assume the fund is still returning positive and increasing dividends (between 1.2% and 2.2% annual ROI) but that the fund had capital depreciation due to inflation so the overall value of the bond fund dropped. Is that correct?

It is also interesting how, in your second example, the return increased.

[nun]

My bonds funds are part of my fixed income.......... So if the NAV goes down I don't really mind as the turn over in the fund will replace low interest bonds with higher interest rate ones and I'll make up the losses in a few years. In fact I'd probably be buying more bond funds when the NAV goes down. I tend to stick with high quality intermediate duration bond funds to reduce default risk and NAV interest rate volatility. If interest rates go up we'll probably be in a time of greater economic growth so I'll take the advantages that has for equities and ride out any bond value decrease and concentrate on the bond funds improving return.

[Lsbcal]

Quote:

Originally Posted by Earl E Retyre thanks, Lsbcal. VBTLX is the fund I am investing in. So, I like that example. Can you please explain how, when treasuries went from 1.2% to 2.2% VBTLX shows a negative return? I assume the fund is still returning positive and increasing dividends (between 1.2% and 2.2% annual ROI) but that the fund had capital depreciation due to inflation so the overall value of the bond fund dropped. Is that correct? It is also interesting how, in your second example, the return increased.

In the first example intermediate Treasury rates went up about 1% and this is consistent with IEI going down ~3% assuming IEI has a duration on the order of 3 years. VBTLX is not just composed of Treasuries so it did not sustain the full Treasury losses. Note interest rates don't have to go up just because of inflation, they could go up because of various factors including anticipated inflation. The active funds did better as they can have different maturities in Treasuries, load up on corporates, etc.

In the second example, we see the game is not just about intermediate Treasuries but the whole bond market: other Treasury maturities, corporates, foreign bond, etc.

FWIW, my intermediates are in PTTRX and DODIX. This is the only part of my portfolio in active funds.