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6 • Fund Family Shareholder Association
amount, as the bond contract states.
But as I noted, with the next-day issu-
ance of a 3% bond that is virtually iden-
tical, the price of the 2% bond will have
fallen, and an investor would be able to
buy it for less than $100.
The coupon or interest rate is part of
the contract and does not change. The
fact that, as investors, we know what
our income will be on the day we buy
it is the reason bonds are also called
fixed-income securities. However,
because the yield describes your total
return, investors often prefer to discuss
a bond’s yield rather than its price when
buying, selling and analyzing bonds.
Realize, of course, that if you sell your
bond before it matures, your return
may be different depending on whether
prices have risen or fallen between the
time you bought the bond and the time
you sold it.
So the total return for a new buyer
of the day-old, 2% coupon bond, who
paid less than $100 for it, is both the
$2 annual interest collected over the
bond’s life plus the difference between
the amount paid for the bond and the
full $100 principal received at matu-
rity. In this case, your yield will be
greater than the 2% coupon rate on the
bond.
A bond’s yield when you purchase
it tells you the total return you will
receive if you hold the bond to matu-
rity. But what about the yield on a bond
fund as opposed to an individual bond?
Even though a bond fund doesn’t have
a maturity date, the fund’s yield when
you purchase the fund is still a good
estimate of what its returns will be over
time. You can see in the table above
that Total Bond Market’s SEC yield
has done a decent job of predicting the
fund’s returns over the ensuing five
years.
Maturity vs. Duration
Not all bonds see their prices rise or
fall equally in response to changes in
interest rates. The key factor influenc-
ing a bond’s sensitivity to interest rates
is its maturity. Maturity is simply the
time between now and the date when
it will be repaid. For example, a bond
issued in June 2015 with a maturity
date in June 2025 has a maturity of 10
years and is known as a 10-year bond.
The basic guideline is, the longer a
bond’s maturity, the greater the impact
a change in interest rates will have on
its price. Think back to my original
example. That 1% change in interest
rates made the older 2% bond less valu-
able than the day-newer 3% bond. But
if we had been talking about 20-year
bonds rather than 10-year bonds, that
1% difference would be seen as hav-
ing even greater value because you are
loaning your money out for twice as
long, and the old bond’s price would
drop even further.
Maturity gets you most of the way
to understanding the price-yield rela-
tionship—and most people can just
stop there—but it doesn’t tell the whole
story. You have to consider the starting
income level. Think about it this way:
A 1% change in interest rates has a
much bigger impact on bonds paying
2% than, say, bonds paying 10%. The
calculation that is designed to take all
the variables of maturity and current
interest rates into account is called
duration. A bond’s duration gives you
a fairly accurate measure of just how
much you can expect a bond’s price to
move in response to a 1% change in
interest rates.
To complicate matters, when you
see a bond or bond fund’s duration, it
is typically quoted in years, yet it really
should be quoted in percent. So, if the
duration is 5.5 years and interest rates
were to drop by 1%, the bond or fund’s
price would be expected to rise by
5.5%. Conversely, if interest rates rose
1%, you’d expect the price to fall 5.5%.
(The duration calculation is a little
more complex than I have described,
but the nuances are irrelevant to most
investors like you and me.)
Unlike maturity, which ticks down
each day toward the contractual matu-
rity date, duration is not fixed and may
change as interest rates rise and fall.
As an example, let’s look at one of
Vanguard’s bond funds and compare
maturities and durations over time. At
the end of 2013, the average weighted
maturity of the Treasury bonds held
by Long-Term Treasury was 24.3
years. The duration of the portfolio
was 14.9 years, meaning that, if inter-
est rates rose 1%, we could expect to
see the fund lose about 14.9% in price.
Conversely, if interest rates fell 1%, we
could expect about a 14.9% gain.
One year later, at the end of 2014,
the average maturity of Long-Term
Treasury’s portfolio was half a year
longer or so, at 24.9 years. However,
the fund’s duration had jumped all
the way to 16.4 years. While the aver-
age maturity of the bonds in the fund
increased by 0.6 years, the risk went
up meaningfully more, by 1.5 years.
Why? Because yields fell in 2014. The
10-year Treasury bond’s yield (a com-
mon benchmark when talking about the
bond market) fell from 3.04% to 2.17%
over the course of the year. With inter-
est rates having fallen, long-term bonds
become more interest-rate sensitive,
hence riskier.
Knowing the fund’s maturity is 24
or so years tells you plenty about how
sensitive Long-Term Treasury is to
changes in interest rates. But duration
gives you the Hi-Def picture.
Coffee Break
Those are the basics. You might
want to let that sit for a while and then
re-read the parts that don’t make perfect
sense. If you still have questions after-
ward, feel free to write in at service@
adviseronline.com so our entire team
can take your thoughts into account in
our upcoming pieces. It’s a lot to cover,
I know. Next month, we’ll dive a bit
deeper into the risks of bonds and the
trade-offs to consider. n
Bond Funds’ Yields
Predict Returns
4/95 4/97 4/994/01 4/034/05 4/074/094/114/134/15
Total Bond Market Index SEC Yield
Return Over Next 5 Years
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
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