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Response to Jack Sprat (Reply #8)

Fri Dec 16, 2011, 06:34 PM

9. One has to be careful using bond mutual funds in the way you are suggesting.

Here's why I say that;

(This by the way, is from an answer to a post asking about bond MF's I answered on the old DU. This is the post from that thread; http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=439&topic_id=2149841&mesg_id=2158409 )


So here's a hypothetical bond fund for clarification;

ABC Mutual Fund company forms the "Steady Freddy Bond Fund". The manager purchases 100 each of 100 different bonds, all with a 5% coupon and all of them purchased at par. He has 10,000 bonds in his portfolio. 10,000 X $1000 means the "Net Asset Value" (NAV) of the fund is $10,000,000 divided by the total number of shares issued. He sells shares to investors like you and me. Lets say there are 1000 investors and each of us buys an equal number of shares. We now own an equal share of those 100 issues and therefore we each own an equal share of those 10,000 bonds. Now lets also assume that these bonds have similar maturities - ten years but they mature in different months so that there is an almost constant stream of interest payments coming in almost every month of the year. If they all have that 5% coupon then it is easy to calculate that there is $500,000 in interest payments coming in every year. This interest money is transferred directly to the shareholders. In the case of Mutual Funds, you are given the option of receiving that money as cash or having it re-invested into the mutual fund and more shares are purchased. Therefore, your initial purchase of 1000 shares grows quickly with each successive interest distribution.

Here's where the problems begin with Bond funds. For the most part, bonds trade "Over The Counter" and are priced each time they trade. Since these trades happen all the time, the market price of a given issue can and will change regularly. Since the share price of a mutual fund is valued essentially like I describe above - the aggregate value of all the issues held by the fund divided by the number of shares issued equals the NAV. This is calculated each business day for every single mutual fund out there. That means the price of your bond fund can go down or it can go up, but since ALL bonds mature at Par and their price doesn't vary that wildly on a day-to-day basis, the share price of a bond fund doesn't fluctuate nearly a much as a pure stock fund or even a blended fund. Most bond funds price between $10 and $20.00/share, typically between $12.00 & $14.00. The thing is, they just don't go up in value as a general rule. They tend to hold a steady share price, varying by only a few cents on a daily basis unless something dramatic happens in the bond market and/or with a specific issue the manager has taken a large position with. The other thing that can change is the yield, as the manager may be selling and buying various bonds in and out of the fund all the time, doing his best to keep it in line with the objective stated in the prospectus. Since he is trading bonds into and out of the fund, he is getting bonds with different coupon rates and therefore different payments. This affects the amount of income being brought in by the fund and as a consequence, the amount paid to the shareholders.

In my hypothetical fund above, the fund is receiving interest payments of $500,000 per year divided by 12 months = roughly $41,667 per month. But what happens if he sells 25 of those 5% coupon issues and buys 25 issues that have a 4.5% coupon? Now the monthly income has fallen and as a consequence, all the shareholders will get less next month than they got this month. In that scenario, 25% of the portfolio now has a 4.5% coupon and 75% of the portfolio has a 5% coupon. It lowers the funds yield a bit. Also, what if those new bonds were bought at a discount to Par? Their price is now going to drop the share price of the fund. This is a bad thing for you if you want to sell your shares now, but a good thing for new buyers, as they are getting a better price than you did for almost the same yield.



I don't mean to tell you something you might be perfectly well aware of, so forgive me if I have. One just wants to make sure that if they plan on holding a bond fund for a relatively short time, they are able to collect enough in interest distributions to overcome any possible fall in share price at the time of a sale of shares. You are correct with regard to Vanguard though. Since they do have very low expenses and most of their funds have no purchase or selling fees, they are cheap to buy into and out of. The downside with Vanguard is that those low fees mean very little advice comes with buying their funds unless you pay for it!

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A HERETIC I AM Dec 2011 OP
Common Sense Party Dec 2011 #1
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Jack Sprat Dec 2011 #4
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