As someone who’s highly curious about the stock market and investing in general, I admit to being quite confused about the use of bond funds. I understand quite clearly the purpose of purchasing a bond. If it is a safe bond (e.g. a U.S. Treasury note). To illustrate my confusion, let’s consider a bond ETF example.
Let’s look at the ETF with the symbol IEF. This ETF is a 7-10 year Treasury bond fund issued by iShares. In recent months, the price has increased rather significantly (due to the turmoil in the equities market). Let’s ignore the last few months, and look in particular at the history from Jan 16, 2004 to Nov. 16, 2007. I choose these dates because the value in 2004 is almost the exact same as the value in 2007. Using historical data available on a Treasury web page, we can find the average interest rate on a 10-year note issued around the date of Jan 16, 2004. The previous link shows an interest rate of 4.0%. Supposing that the interest is compounded annually, I would think that $1 worth of bonds purchased in 2004 would be worth $1.17 after 4 years (i.e. in 2008).
By looking at the chart of IEF over my indicated time scale, you can see that clearly, this appreciation did not occur. In fact, there were points in time at which selling the ETF would result in a loss! I’m clearly not getting something here. My expectation was (and still is, hence the confusion) that bonds should appreciate continuously. That’s the whole point of holding a bond. So why should the price fluctuate so much for bond funds. And given that, why would anyone buy a bond fund instead of actual bonds direct from the Treasury?
The short answer is that bond prices reflect the current interest rate, more or less.
Say you buy a five year old bond issued by Bullwinkle, Inc., that pays five percent. The current rate on new Bullwinkle bonds is four percent. You would pay more for that old bond than the face value, with the result that, even though the bond pays five percent, you (if you keep the bond to term) effectively get a four-percent return (the five percent interest you’re paid less the premium you paid to get the bond).
In addition to interest rate risk (the risk that rates will move higher than the rate on the boand) there is also insolvency/credit risk–the risk that the issuer will go bankrupt and not pay all of the principal and interest due on the bond. Credit risk for US treasury bonds is very low, but the risk for corporate bonds can be high, and is factored into bond prices.
Bonds and bond funds are different investments. You might buy a bond and hold it to maturity–you would ignore all interim interest rate and credit changes and get what the face of the bond says you will get (barring credit default). If you invest in a bond fund, however, expect the fund to trade bonds and have a return different from buying and holding bonds to maturity.
In addition to interest rate fluctuations and credit risk (as explained by Humble Servant), there’s the simple fact that bonds are traded, which results in different prices based on different expectations among the market participants.
Yes, one reason that the bond funds have a different rate of return compared to buying and holding bonds is that the fund trades funds. But even if the fund kept all bonds to maturity, the rate of return would be different because they hold many different bonds, and those bonds in turn are different from most of those held by a private investor.
There is also the element of speculation that will cause bonds to move. Even in a perfectly static market with fixed returns people will still move the price around to try and make a buck Pop Psychology - The Atlantic
In simplistic terms, it’s how much money you expect to make off of the bond.
One other factor effecting bond market prices - the condition of the issuing company. As you might guess, Circuit City bonds, if there are any, are well-nigh worthless, since there is at present reasonable doubt that the company may ever pay back the face amount.
A bond fund buys and sells bonds just like a stock fund buys and sells stocks (and a hedge fund . . . wait, never mind about this one). So the returns from a bond fund are totally different than the return from any particular bond.
What BJMoose said.
In more detail, though, it usually refers to the Yield to Maturity, which is based on the current market price, the coupon rate, the time to maturity and the assumption that interest payments are reinvested at the bond’s coupon rate.
Note also that bond yield and prices by definition fluctuate inversely. This is because the payout on the bond is fixed (assuming the bondholder isn’t insolvent when the obligation comes due). Therefore, the more you paid for the bond, the less profit (i.e., yield) you make at maturity – someone who paid $50 for a $100 payout has a better yield than someone who paid $60 for the same bond, even though both investors get paid the same amount at the same time.
Thanks. I knew that there was some sort of inverse relationship going on with yield, but couldn’t reconcile why higher bond prices were “bad” news compared to higher stock prices.