Bond funds: Say What?

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.