Perusing through the September 2009 issue, I stop at the "Ask SmartMoney" column to see what advice they have to offer readers. One reader asks what effect rising interest rates will have on a total bond market index fund? This is a great question which columnist Stephanie AuWerter answers well in 150 words or so, but with one major error.
She starts off okay, noting in the first two sentences that rising rates are generally bad for bond investors and that when rates rise, prices on existing bonds fall. This is indeed the fundamental relationship between rates and bond prices. She also addresses, quite succinctly and appropriately, that different bonds behave differently and that a total bond market index fund holds a variety of different bonds. As a consequence, the "diversity provides a cushion against losses when rates go up". A matter of degree for sure, but sound thinking.
Where I see a great disservice is in the second sentence below (third sentence in the column's answer; emphasis mine):
When rates increase, prices fall on existing bonds. That doesn't matter for folks who hold individual bonds until maturity, but for those who invest in bond mutual funds (which constantly buy and sell bonds in order to maintain the portfolio's overall duration and provide cash for withdrawals), it can lead to losses.
The error should be clear: if rising rates hurt bond funds, would they not also hurt individual bonds (all else equal)? Yet she explicitly states rising rates don't matter to the holders of individual bonds! Any reader who only somewhat understands bonds will be seriously and dangerously misled. I find this disservice worthy of posting about because even if the error gets corrected, no one reads the corrections in a magazine. Even if one did read the correction a month later, the lesson may have already been mis-learned, the reader may have already transacted or they may simply not remember what the correction is all about. In other words, the nature of media is such that a great miseducation is being performed with errors of this sort.
Now, to be fair, I know why she wrote that. The rest of the sentence tries to simply mention (no small task) that a portfolio which maintains a constant duration of bonds (or sells some bonds as they get closer to maturity and buys bonds expiring later, so as to maintain a relatively constant average maturity) is probably not going to ride out a rising rate storm very well. In contrast, when someone owns individual bonds, they can simply hold them to maturity.
The bond that matures in 5-years (we call this "a 5-year bond"), will mature in 4 years after a year goes by. As the maturity of those bonds shrinks with time passing, they become less sensitive to interest rate changes and revert closer to the par value ("par"="face" value). If you hold those bonds to maturity, you get back your full investment (barring defaults) and so the price between now and maturity "doesn't matter". Or does it?
Take the total bond market portfolio. It has a duration of 4 years. This means than if interest rates rise by 1% tomorrow, the price of all the bonds in that portfolio will fall by about 4%. Say someone purchased a 10-year bond at par paying 5%. This bond has a duration of about 8 years. If rates rise 1%, the bond will lose 8% overnight. The 8% loss will be recouped by the time the bond matures, but for the time being- as long as rates stay higher- the bond is going to be worth $92,000 compared to the $100,000 invested yesterday. Think that doesn't matter to someone looking at their portfolio?
I've seen it happen- someone reads similar things and the next thing you know they sell their bond funds and buy 20-year treasuries- exactly the wrong thing to do. It was a valiant effort to explain this in 150 words, but that one sentence fragment is dangerous!
I suspect like you do that her logic was based on a fixed coupon bond that doesn't default and where the investor doesn't not change expectations on returns. something like
ReplyDelete(1)Buy bond for 100, 5% interest
(2) collect interest
(3) collect principal at maturity
As long as the company pays the interest, it doesn't matter for the investor what the overall market does - s/he collects what s/he expected at time of investment.
The flaw in the logic of course is opportunity cost. Say inflation rises to 10% and you collect the 5%. Yup, exactly as you thought, so the cash flows don't change. The value is much lower of course given the raise in opportunity cost. But hey, it's a journalist....
Exactly.
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