The Longer They Are, the Harder They Fall

By Scott Lummer
Chief Investment Officer, mPower

Today's question is about that incredibly exciting topic, bond funds.

"Dear Scott,

I am assuming that while share prices were going down because of the interest rate rise, there would be some positive impact from funds replacing maturing "low rate" bonds with new "higher rate" bonds, and that the duration of funds' new bond investments would be a factor."

Well, in answer to your question, I would like to say z …z …z …z … oh, I'm sorry, I dozed off there for a minute. It tends to happen when I start talking about bonds. You see, for the typical long-term investor, bonds are kind of boring, and for the typical long-term analyst like me, bonds are very boring. It's kind of like analyzing a British-produced movie about the early 1900s -- I challenge you do it without falling asleep, especially if it involves a relationship between Anthony Hopkins and Helena Bonham Cart …z …z … see, it can't be done.

However, although talking about bonds is not terribly exciting, your question is very important. So I will answer it, but please forgive me for resorting to some cheap ploys to hold everyone's attention.

Bond Prices Affected by Extraterrestrials!

First the basics. As you said, when interest rates rise, bonds fall, as do bond funds. However, not all bond funds are created equal. The longer they are (in terms of maturity, or duration), the harder they fall. The longer a bond fund's duration, the farther it may plummet.

Duration is the average maturity of the fund. A fund that invested in bonds that paid only money (and not coupons) in 5 years would have a duration of 5 years. A fund with 50% invested in bonds that pay money in 5 years, with the other 50% in bonds that pay money in 6 years, would have a duration of 5 1/2 years. (Because most bonds pay coupons in addition to cash at maturity, a bond's duration is usually less than the time it takes to mature).

If interest rates rose to 12% very rapidly, what would happen over the next 4 years?

If your bond fund's duration were longer than 4 years, its value would immediately fall. Shorter-time-horizon bonds would mature and be replaced by newer, higher yielding bonds, yet this gain would not be enough to make up for the value lost in the 4-year duration bonds.

Buying Short Term Bonds is a Guaranteed Method of Losing Weight!

If, however, you owned a bond fund with a duration of less than 4 years, the situation would be slightly different. Yes, the bond fund would still fall in value, but not by as much as a long-duration fund. And there would be a larger proportion of shorter-time-horizon bonds that would be replaced with the higher yielding new bonds.

For this fund, the gain in the yields would offset the loss in bond values, and you would make money over the 4 years. Consequently, shorter duration bond funds are far less risky for you to invest in than long duration funds.

Another way of looking at risk is to ignore the fund values and simply focus on yield.

First of all, remember that the typical reason bond yields go up is because of a real or perceived rise in inflation. And if inflation goes up, you will need a bigger yield from the bond to keep up with inflation.

A shorter duration fund will see its yield rise relatively quickly, lagging inflation by only a year or two. If you are investing for a relatively long time period (more than 10 years), the lag will not be too severe and the bond fund will come close to matching inflation. However, the yield on a longer duration bond fund will be much more rigid as inflation rises, and it will do a very poor job of keeping pace with inflation, even over a 10-year period. Once again, you can see how the longer-term bond fund is riskier.

The Path to Utopia is Paved With Bond Funds

So, which type of fund should you buy? Like most aspects of investing, risk typically trades off against return. With bond funds, risk is directly related to duration. A fund with a 6-year duration has triple the risk of a fund with a 2-year duration. Yet the return differences are small.

Bonds with a 2-year duration are currently yielding 6.4%, while bonds with a 6-year duration are yielding 6.6%. If that small 0.2% difference in return does not seem worth the extra risk to you, I agree. And that difference in return is not unusual -- it is consistent with data over the last 30 years.

For that reason, I think it makes sense to invest in shorter duration bond funds (1 to 3 years) instead of intermediate or long duration bond funds. If you do not have any shorter duration bond funds in your 401(k) plan, you should consider putting the majority of your bond investments in a stable value fund (they typically have shorter duration). And if you have neither a short-term bond fund nor a stable value fund, you might want to put a large amount of your bond investments in a money market fund.

Now that I have finished answering your question, I'm going out to rent Howard's End.

To read Scott's past articles, please visit the 401Kafé Library.

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

The Longer They Are, the Harder They Fall

By Scott Lummer
Chief Investment Officer, mPower

Today's question is about that incredibly exciting topic, bond funds.

"Dear Scott,

I am assuming that while share prices were going down because of the interest rate rise, there would be some positive impact from funds replacing maturing "low rate" bonds with new "higher rate" bonds, and that the duration of funds' new bond investments would be a factor."

Well, in answer to your question, I would like to say z …z …z …z … oh, I'm sorry, I dozed off there for a minute. It tends to happen when I start talking about bonds. You see, for the typical long-term investor, bonds are kind of boring, and for the typical long-term analyst like me, bonds are very boring. It's kind of like analyzing a British-produced movie about the early 1900s -- I challenge you do it without falling asleep, especially if it involves a relationship between Anthony Hopkins and Helena Bonham Cart …z …z … see, it can't be done.

However, although talking about bonds is not terribly exciting, your question is very important. So I will answer it, but please forgive me for resorting to some cheap ploys to hold everyone's attention.

Bond Prices Affected by Extraterrestrials!

First the basics. As you said, when interest rates rise, bonds fall, as do bond funds. However, not all bond funds are created equal. The longer they are (in terms of maturity, or duration), the harder they fall. The longer a bond fund's duration, the farther it may plummet.

Duration is the average maturity of the fund. A fund that invested in bonds that paid only money (and not coupons) in 5 years would have a duration of 5 years. A fund with 50% invested in bonds that pay money in 5 years, with the other 50% in bonds that pay money in 6 years, would have a duration of 5 1/2 years. (Because most bonds pay coupons in addition to cash at maturity, a bond's duration is usually less than the time it takes to mature).

If interest rates rose to 12% very rapidly, what would happen over the next 4 years?

If your bond fund's duration were longer than 4 years, its value would immediately fall. Shorter-time-horizon bonds would mature and be replaced by newer, higher yielding bonds, yet this gain would not be enough to make up for the value lost in the 4-year duration bonds.

Buying Short Term Bonds is a Guaranteed Method of Losing Weight!

If, however, you owned a bond fund with a duration of less than 4 years, the situation would be slightly different. Yes, the bond fund would still fall in value, but not by as much as a long-duration fund. And there would be a larger proportion of shorter-time-horizon bonds that would be replaced with the higher yielding new bonds.

For this fund, the gain in the yields would offset the loss in bond values, and you would make money over the 4 years. Consequently, shorter duration bond funds are far less risky for you to invest in than long duration funds.

Another way of looking at risk is to ignore the fund values and simply focus on yield.

First of all, remember that the typical reason bond yields go up is because of a real or perceived rise in inflation. And if inflation goes up, you will need a bigger yield from the bond to keep up with inflation.

A shorter duration fund will see its yield rise relatively quickly, lagging inflation by only a year or two. If you are investing for a relatively long time period (more than 10 years), the lag will not be too severe and the bond fund will come close to matching inflation. However, the yield on a longer duration bond fund will be much more rigid as inflation rises, and it will do a very poor job of keeping pace with inflation, even over a 10-year period. Once again, you can see how the longer-term bond fund is riskier.

The Path to Utopia is Paved With Bond Funds

So, which type of fund should you buy? Like most aspects of investing, risk typically trades off against return. With bond funds, risk is directly related to duration. A fund with a 6-year duration has triple the risk of a fund with a 2-year duration. Yet the return differences are small.

Bonds with a 2-year duration are currently yielding 6.4%, while bonds with a 6-year duration are yielding 6.6%. If that small 0.2% difference in return does not seem worth the extra risk to you, I agree. And that difference in return is not unusual -- it is consistent with data over the last 30 years.

For that reason, I think it makes sense to invest in shorter duration bond funds (1 to 3 years) instead of intermediate or long duration bond funds. If you do not have any shorter duration bond funds in your 401(k) plan, you should consider putting the majority of your bond investments in a stable value fund (they typically have shorter duration). And if you have neither a short-term bond fund nor a stable value fund, you might want to put a large amount of your bond investments in a money market fund.

Now that I have finished answering your question, I'm going out to rent Howard's End.

To read Scott's past articles, please visit the 401Kafé Library.

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.