Bonding In
When
you invest in a bond fund, you are investing in a basket of different bonds,
which are payment promises of governments, corporations or municipalities in
return of your money.
The par
value (or face value or nominal value) correspond to the price of a bond when
it was first issued, which are often $1000 or $100 for corporations and much
higher for governments. If you buy it when it is issued, you are buying it at
its par value, but its par value price will change thereafter in
function of how the investors value your bond (the price will vary but your investment
will stay the same, $1000). If you buy it later from an investors at a cheaper
price, you are buying it at discount, or at premium if at a higher price. The
par value determines how much you will get if you hold it until maturity, not
matter the fluctuations of the market.
At
its par value, your interest is determined by the coupon rate. For example,
with a 10-year bond with a par value of $1000 and a coupon of 6%, you will
receive $30 for 10 years twice a year as interest rates of individual bonds are
often payed semiannually. Nevertheless, some bonds have a floating-rate,
meaning that the interest rate will change along with the rate of some index. When
the bond matures, you will get your principal (the initial investment you made),
the face value of your bond, back.
The
coupon rate is only meaningful when the bond is at its par value (when it is
first issued). Afterwards, you must take in account the yield of the bond,
which is the rate of returns based on the current price of the bond in the
secondary market (between investors; see below).
What
drives bonds up and down, among others, is the interest rate determined by the
Federal Reserve. When the interest rate goes up, the value of your bond goes
down. Why? Because new issued bonds have a greater coupon rate, therefore
investors want them instead of your bond. Your bond will therefore be trading
at discount. When the interest rate goes down, your bond value would be trading
at premium (> par value) because new-issued bonds would have less value.
As
the image above from Bloomberg shows, a 10-year bond of the U.S.A government
has a coupon rate of 2% and a yield of 2, 21%.
CURRENT YIELD = (ANNUAL
INTEREST * 100) / PRICE
The
zero coupon rate bonds does not pay annual interests. Instead, those kind of
bonds are issued at discount to be redeemed at par. You make money from the
difference par price/maturity.
The yield shows the return you have on your
bond in the secondary market.
Mutual Change
Things
are a bit different with bond funds.
The
lender of the money receives often monthly payments (instead of semiannually
payments of individual bonds, as stated above) from the income earned by the
fund. The bonds of a bond fund have different maturity dates, in order to keep
the income coming at a regular pace. The fund manager, someone highly educated,
replaces then the old bonds with new ones (when the issuer pays off the bond,
for example). Therefore, there is no certainty that you will get your principal
back (as the manager does not wait to sell the bond at maturity). As a golden
rule in finance, asset allocation is what bond funds are about, therefore the
returns should be greater, especially with high-yield bond funds.
Contrary
to individual bonds, you can easily sell your assets, which unfortunately may
cause a snow-ball effect (see next title). Bond funds have a large number of
charges to cover marketing expenses, management fees, and they are not
obligated by law to disclose all of them. You have to be sure of all the costs
involved before stepping in a bond fund.
The Fear Factor
When
the Fed pushes the interest up, you may want to sell your bond quickly, which
is a bad idea because your manager, in order to keep the yield high, will sell
the highest-earnings bonds of the fund in order to avoid further losses (as a
bond fund is made of hundreds of different bonds) and compromise with redemption
(which is the yield the mutual fund promise its investors). Even if you keep
your bonds and wait to the storm to pass, you will feel it because the manager
may cut dividends. At the end, you will earn less and your bonds will value
less.
In a
bear market for stocks, investors willing to protect their assets invest in
sure securities like the U.S.A Treasury bonds, which have very little default
risk. As scarcity is élémentaire in
finance, as there is less bonds available, the prices will go up. If
prices go up, the yield of your bond will fall.
Game of Interests
The Fed showed no sign this month of a willingness of raising interest rates, mainly because of concerns over China's slowing economy and the fact that the US job market is not yet "fully recovered". The US bonds were higher seconds after the leaked announce. It is still a great time to invest in mutual fund bonds, even higher yielding mutual fund bonds, before the Fed pushes rates higher.