(PUB) Investing 2015

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Fund Family Shareholder Association

www.adviseronline.com

LAST MONTH

we discussed the basics

of bonds—what a bond is, how bond

prices and yields relate to one another,

and the difference between maturity

and duration as well as

yield and interest rates.

If you need a refresher,

go ahead and pull out last

month’s issue. (If you’ve

misplaced it, you can

download a copy at www.

AdviserOnline.com.)

Having dealt with

the mechanics, let’s dive

in a bit deeper and talk

about some of the risks associated with

investing in bonds and bond funds. That

knowledge base will allow us to take a

rational and well-educated look at the

chicken-little headlines and articles,

such as

Barron’s

recent cover story

“Trouble Ahead for Bond Funds.”

That story (and others like it) play

on investors’ fears rather than provide a

sober analysis of bonds, bond funds and

how to use them in the current econom-

ic and market environment. There are a

lot of holes in the article, but here’s the

big piece those stories completely miss:

Investors should actually welcome ris-

ing interest rates. Let me explain.

Short or Long Maturity?

Let’s pick up where we left off last

month talking about maturities. A key

decision bond investors must make is

how long they are willing to lend their

money before they’re paid back. Bond

funds don’t have maturity dates, but

this question translates to your choice

of funds focused on bonds with short,

intermediate or long-term maturities.

As we discussed last month,

inter-

est-rate risk

is the impact of rising and

falling interest rates on bond prices, and

the longer a bond’s maturity, the greater

that impact will be. In other words, a

Treasury bond that matures in five years

will have a more stable price than a

Treasury that matures in 20 years. (The

same logic applies to short versus long

maturity bond funds, as we’ll see in a

moment.) But price is only one piece

of the bond equation—what about the

income your bonds generate?

A risk that often goes

unnoticed but has a big

impact on bond investors

reinvestment risk

, or

the risk that, when your

bond matures and your

principal is returned to

you, the options avail-

able for reinvesting the

money pay a lower yield.

For bond investors, this

occurs when interest rates are on the

decline. Suppose you buy a bond that

matures in two years and yields 4%.

After two years, the borrower returns

the money you lent, and you want to

invest in another two-year bond. But

now interest rates have declined and

two-year bonds yield 2%. That’s rein-

vestment risk. You would have been

better off at your initial purchase by

buying a bond with a longer maturity.

Of course, hindsight is always 20-20,

and the fact that you can make an error

when you buy a bond is why we talk

about risk in the first place.

Bond investors seem to love it when

interest rates are falling, because the

prices on their bonds rise, as they’ve

done for more than 30 years. But they

should be disappointed when it comes

time to reinvest that money. Therein

lies the silver lining to a rising interest-

rate environment: You get the opportu-

nity to invest in better (higher) yielding

options as your bonds mature.

Reinvestment risk means that your

future level of income is less certain.

So when you choose a short maturity

bond (or bond fund) over one with a

longer maturity, you are exchanging a

more stable price for a less stable level

of income over time. Conversely, with

the long maturity bond, your price is

more variable, but your income is more

consistent.

You can get a good sense of the

trade-off between price risk and income

risk in the charts below showing the

month-end price (with capital gain dis-

tributions added back in) and the distrib-

uted monthly income of

Short-Term

Treasury

and

Long-Term Treasury

over the past 15 years. Short-Term

Treasury’s price was much more consis-

tent, trading between $10.02 and $11.00

over the past 15 years, while Long-Term

Treasury’s price ranged from $10.20 to

$14.19. Both funds saw their income

decline over this 15-year stretch from a

similar level of about $0.05 per share,

but Long-Term Treasury’s distributions

only fell to $0.03 a share, while Short-

Term Treasury’s fell nearly to zero, and

experienced more ups and downs along

the way.

So, when choosing between a short

and a long-maturity bond (or bond

BONDS 101 – PART I I

Balancing Trade-Offs

Stable Prices…

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Short-Term Treasury

Long-Term Treasury

$10.0

$10.5

$11.0

$11.5

$12.0

$12.5

$13.0

$13.5

$14.0

$14.5

Fund Price

…Or Stable Income

Short-Term Treasury

Long-Term Treasury

$0.00

$0.01

$0.02

$0.03

$0.04

$0.05

$0.06

$0.07