(PUB) Investing 2015

amount, as the bond contract states. But as I noted, with the next-day issu- ance of a 3% bond that is virtually iden- tical, the price of the 2% bond will have fallen, and an investor would be able to buy it for less than $100. The coupon or interest rate is part of the contract and does not change. The fact that, as investors, we know what our income will be on the day we buy it is the reason bonds are also called fixed-income securities. However, because the yield describes your total return, investors often prefer to discuss a bond’s yield rather than its price when buying, selling and analyzing bonds. Realize, of course, that if you sell your bond before it matures, your return may be different depending on whether prices have risen or fallen between the time you bought the bond and the time you sold it. So the total return for a new buyer of the day-old, 2% coupon bond, who paid less than $100 for it, is both the $2 annual interest collected over the bond’s life plus the difference between the amount paid for the bond and the full $100 principal received at matu- rity. In this case, your yield will be greater than the 2% coupon rate on the bond. A bond’s yield when you purchase it tells you the total return you will receive if you hold the bond to matu- rity. But what about the yield on a bond fund as opposed to an individual bond? Even though a bond fund doesn’t have a maturity date, the fund’s yield when you purchase the fund is still a good estimate of what its returns will be over time. You can see in the table above that Total Bond Market ’s SEC yield has done a decent job of predicting the fund’s returns over the ensuing five years. Maturity vs. Duration Not all bonds see their prices rise or fall equally in response to changes in interest rates. The key factor influenc- ing a bond’s sensitivity to interest rates is its maturity. Maturity is simply the time between now and the date when it will be repaid. For example, a bond issued in June 2015 with a maturity >

1%, you’d expect the price to fall 5.5%. (The duration calculation is a little more complex than I have described, but the nuances are irrelevant to most investors like you and me.) Unlike maturity, which ticks down each day toward the contractual matu- rity date, duration is not fixed and may change as interest rates rise and fall. As an example, let’s look at one of Vanguard’s bond funds and compare maturities and durations over time. At the end of 2013, the average weighted maturity of the Treasury bonds held by Long-Term Treasury was 24.3 years. The duration of the portfolio was 14.9 years, meaning that, if inter- est rates rose 1%, we could expect to see the fund lose about 14.9% in price. Conversely, if interest rates fell 1%, we could expect about a 14.9% gain. One year later, at the end of 2014, the average maturity of Long-Term Treasury’s portfolio was half a year longer or so, at 24.9 years. However, the fund’s duration had jumped all the way to 16.4 years. While the aver- age maturity of the bonds in the fund increased by 0.6 years, the risk went up meaningfully more, by 1.5 years. Why? Because yields fell in 2014. The 10-year Treasury bond’s yield (a com- mon benchmark when talking about the bond market) fell from 3.04% to 2.17% over the course of the year. With inter- est rates having fallen, long-term bonds become more interest-rate sensitive, hence riskier. Knowing the fund’s maturity is 24 or so years tells you plenty about how sensitive Long-Term Treasury is to changes in interest rates. But duration gives you the Hi-Def picture. Coffee Break Those are the basics. You might want to let that sit for a while and then re-read the parts that don’t make perfect sense. If you still have questions after- ward, feel free to write in at service@ adviseronline.com so our entire team can take your thoughts into account in our upcoming pieces. It’s a lot to cover, I know. Next month, we’ll dive a bit deeper into the risks of bonds and the trade-offs to consider. n

Bond Funds’ Yields Predict Returns

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Total Bond Market Index SEC Yield Return Over Next 5 Years

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4.00%

2.00%

0.00%

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4/97

4/99

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4/15

date in June 2025 has a maturity of 10 years and is known as a 10-year bond. The basic guideline is, the longer a bond’s maturity, the greater the impact a change in interest rates will have on its price. Think back to my original example. That 1% change in interest rates made the older 2% bond less valu- able than the day-newer 3% bond. But if we had been talking about 20-year bonds rather than 10-year bonds, that 1% difference would be seen as hav- ing even greater value because you are loaning your money out for twice as long, and the old bond’s price would drop even further. Maturity gets you most of the way to understanding the price-yield rela- tionship—and most people can just stop there—but it doesn’t tell the whole story. You have to consider the starting income level. Think about it this way: A 1% change in interest rates has a much bigger impact on bonds paying 2% than, say, bonds paying 10%. The calculation that is designed to take all the variables of maturity and current interest rates into account is called duration . A bond’s duration gives you a fairly accurate measure of just how much you can expect a bond’s price to move in response to a 1% change in interest rates. To complicate matters, when you see a bond or bond fund’s duration, it is typically quoted in years, yet it really should be quoted in percent. So, if the duration is 5.5 years and interest rates were to drop by 1%, the bond or fund’s price would be expected to rise by 5.5%. Conversely, if interest rates rose

6 • Fund Family Shareholder Association

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