Q. How long will it take for my core bond fund to start producing? As a retiree, it is hard to swallow the losses encountered this past year. I am contemplating going into a bond ladder after the Fed raises rates again, assuming the returns held to maturity may average 3.5%. When will bonds go up?
— Investor
A. It’s been a rough, rough, rough year.
The good news for investors is that for the first time in many years, the interest rates on bonds have become attractive.
Let’s go over some bond basics first.
Every bond has a face value which is usually the price of the bond when it was first issued, an interest rate or coupon rate, and a maturity date, which is the number of years it will be in existence, said Deva Panambur, a fee-only planner with Sarsi, LLC in West New York.
Investors who own a bond earn income calculated as the interest rate on the face value, which is paid out every year or sometimes more frequently, he said. At maturity, the face value, also known as principal, is returned to the investor.
“The rate of return you earn for owning a bond till maturity is called the yield-to-maturity. If you buy a bond for a price equal to its face value, its yield-to-maturity is equal to the coupon rate,” Panambur said. “However, the price of the bond is not constant because it is inversely related to interest rates.”
If interest rates move up prices fall and vice versa, he said, and the longer the maturity of the bond, the more sensitive it is to interest rates.
If you buy a single bond at any price and hold it to maturity, then you know that the rate of return that you earn will be equal to the starting yield-to-maturity, no matter what happens to the price of the bond before maturity, he said. This assumes that the issuer of the bond remains solvent to make coupon payments and return the face value.
However, if you sell the bond before maturity, you will earn a lower return than the starting yield-to-maturity if interest rates have risen since you bought it or a higher return if interest rates have fallen after you bought the bond, he said. Therefore, if you own an individual bond that has fallen in price, you will only want to sell it if you can replace it with a bond with a better risk/return profile, he said.
Panambur said a bond fund has many bonds with different maturities and interest rates to diversify interest rate sensitivity and other risks such as credit risk. When interest rates rise, bond funds lose value because the individual bonds lose value. However, he said, maturing bonds are reinvested at a higher interest rate and that benefits investors who will start getting a higher income and the bond fund will have a higher expected future return.
“A bond ladder, which is a portfolio of bonds of different maturities, acts similarly,” he said. “Therefore, if you own a bond fund or have a bond ladder you will want to hold on to them.”
If you are planning to invest in bonds now, rates are attractive as compared to the recent past.
“If you are worried about a further increase in interest rates, you will want to leg into the investment or reduce the overall interest rate sensitivity of your bond portfolio by adding low maturity bonds or bond funds,” Panambur said. “Interest rates change constantly, and while they are rising now, they could start falling if the economy stalls and inflation falls. When that happens, bonds and bond funds will appreciate.”
This article was published on Sept 1, 2022