A question about Bond Fund

[rsingh6675]

Last year I bot VWLTX (Long term Tax-Free) & VFIIX (Vanguard GNMA fund) . I have hard time understanding bond funds. Will I loose money in these funds if the interest goes up?
Thanks

 

[Onward]

I'm also trying to learn more about bonds and bond funds. Here's something from Vanguard that I found helpful:

Bonds and rates: The reality behind the headlines
http://bit.ly/dbs2lW

 

[LOL!]

Only if you sell before "duration" years since the last rate hike. You will break even in "duration" years if there are no more rate hikes. Unfortunately, once hikes start, they keep coming and you get further and further behind --- until rates start dropping again.

You may have noticed that rates just went up after the market closed today. All bond funds will take a hit tomorrow.

 

[brewer12345]

The short answer is that fixed coupon bonds do drop in value as rates rise. The amount to which they drop in value versus a given rate increase varies directly with the average duration (think maturity) of the bonds in question.

 

[rsingh6675]

So my question is if I don't sell this fund for nest 5-10 years, will I keep getting same monthly dividend or the dividend will go down? VWLTX pays tax free dividend @ 4.4% annual rate.

 

[FIREd]

Let's look at a simplistic example:

Let's say you have $100K invested in a bond fund with a 5 year average duration and paying 4% per year in dividend. Assuming that the interest rate does not change, you have:

Year 1: $100K Principal + $4K dividend = $104K
Year 2: $104K Principal + $4K dividend = $108K
Year 3: $108K Principal + $4K dividend = $112K
Year 4: $112K Principal + $4K dividend = $116K
Year 5: $116K Principal + $4K dividend = $120K

Let's imagine now that the interest rate goes up 1% at the beginning of year 1. Then the value of your principal ($100K) will go down 5% to $95K (because the bond fund's average duration is 5 year so the value of your principal will go down by 5% for every 1% increase in interest rate). But since the interest rate has gone up 1%, now the fund pays 5% per year in dividend. So:

Year 1: $95K Principal + $5K dividend = $100K
Year 2: $100K Principal + $5K dividend = $105K
Year 3: $105K Principal + $5K dividend = $110K
Year 4: $110K Principal + $5K dividend = $115K
Year 5: $115K Principal + $5K dividend = $120K

Therefore, after 5 years (the bond fund's average duration), you end up with the same amount of money whether the interest rate has gone up or not. If you sell the bond fund before the end of the 5-year period, however, you will have been hurt by the higher interest rate.

 

[brewer12345]

Uhhh, one problem. If we are talking about a fixed coupon bond portfolio, the interest will not magically shift upwards right after the market rate shift. More likely the interest income will be 4k, 4.2k, 4.4k, 4.6k, etc. Not the end of the world, but worth noting.

 

[FIREd]

Uhhh, one problem. If we are talking about a fixed coupon bond portfolio, the interest will not magically shift upwards right after the market rate shift. More likely the interest income will be 4k, 4.2k, 4.4k, 4.6k, etc. Not the end of the world, but worth noting.

Well, I did say my example was simplistic... I was just trying to illustrate the concept with a simple, easy to understand example. But feel free to elaborate.

 

[brewer12345]

Well, I did say my example was simplistic... I was just trying to illustrate the concept with a simple, easy to understand example. But feel free to elaborate.

Fair enough. You are right to leave it simple. Do not want to confuse OP.

 

[LOL!]

So my question is if I don't sell this fund for nest 5-10 years, will I keep getting same monthly dividend or the dividend will go down? VWLTX pays tax free dividend @ 4.4% annual rate.

The monthly dividend will change. You can go to the Vanguard site and see all the per-share monthly dividends for the past several years. The dividend is not constant. It goes down. It goes up.

If you are not re-investing dividends, then the scenario I first described (must wait "duration" years to break even) does not apply.

 

[Gone4Good]

Also, all interest rates are not the same.

The common fear is that the Fed will eventually have to increase rates from ~0% and that will be bad for fixed income investors. However, not all rates are at zero. The "yield curve" is very steep right now (meaning that longer maturities have a much higher yield than shorter maturities). When the Fed starts raising rates, it's normal for that yield curve to flatten (yields on short maturities go up more than yields on longer dated maturities). That's another way of saying that longer dated maturities are already pricing in some of that expected Fed tightening. Depending on how much interest rates rise, and how much the yield curve flattens, the hit to your bonds may not be all that large. And may not even be enough to fully offset the coupon you earn.

But its no easier to figure out the direction and magnitude of interest rate changes than it is to figure out similar moves in the stock market. So my advice would be to diversify your fixed income portfolio just like your stock portfolio and forget about it.

 

[Onward]

Here's a good intro to bonds and interest rates in the Feb 21 WSJ.

Bond Bubble? What You Can Do About It. - WSJ.com