Bonds

Today’s blog is going to be short and ‘sweet’. Over the next couple of weeks I will be turning my attention to some fun activities that include working on my taxes and college financial aid documents. Since the time I have to work on my blog will be limited I have decided to post some brief and to the point blogs on bonds. Today I’ll be talking about interest rate risk and average duration of bond funds.

The key to understanding the interest rate risk associated with bond funds is to be aware of bond funds average duration. If you like mathematics and have an interest in how bond duration is calculated you can check out the following URLs:

- http://en.wikipedia.org/wiki/Bond_duration
- http://www.investopedia.com/university/advancedbond/advancedbond5.asp

If you are interested in minutia, for giggles you can verify that the duration of zero coupon bonds is the same as the maturity of the bond. If the zero coupon bond has a 10 year maturity the duration will be 10 years. The good news is that some of the bond fund companies will give you the average duration for each of their bond funds. For example, the Vanguard and Fidelity bond funds will display the average duration when they are talking about their funds. I could not find any average duration of the Pimco funds on their website (I tried using my browser’s find command and could not find it).

Why are average durations for bond funds important for understanding interest rate risk? Here’s why: if the average duration for the bond fund is 7 years and interest rates go up 2% the value of your investment will decrease 14% (average duration X interest rate change = gain/loss). For example, suppose you have $10,000 invested in a bond fund the average duration of which is 7 years and interest rate goes up 2% you just lost $1400 of your investment. It works the opposite if the interest rate goes down by 2% -you just made $1400. This is the reason why some bond funds earned returns greater than 10% last year.

The first time you look at this, the inverse relationship between interest rates and bond prices seems somewhat illogical but, if you think about it, it does make sense. For example, if a bond is guaranteed by the issuer to pay 3% every year for ten years but the bond is sold in year 2 when the going interest rate is 4.5%, you would not receive the full price for the bond. The bond price would be discounted to make up for the 1.5% difference in the interest rate.

Examples of bond fund durations and interest rate risk:

Bond Fund Average Duration Interest Rate +2% Interest Rate -2%
Vanguard Total Bond

Market Index (VBMFX) 4.4 years -8.8% loss 8.8% gain
Vanguard Long-Term

Investment Grade (VWESX) 7 years -14% loss 14% gain
Fidelity Series Investment

Grade Bond Fund (FSIGX) 4 years -8% loss 8% gain


If you are risk averse or think interest rates are going up you would want to buy bond funds with low average durations (less than 1 year). You’d want to own high average duration bond funds (> 3 years) when you think interest rates are going down. Please do your homework. For any bond funds you own or want to buy you need to understand both the duration average for that fund as well as what you think the future interest rate environment will be.
Next week, I will write about different type of bonds. Future topics may include:

- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)

In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C.

Please add your insight. Let’s have an on-going discussion of financial and investing ideas.

Paul