Bond Fund Basics

Not financial advice, etc etc. There’s a reason that bonds are getting some attention, interest rates are higher. However, people don’t understand what they are actually doing when they ‘buy bonds.’ Let’s correct that.

There are intentional shortcuts here, you are reading the writing of a bond trader, yo. There are subtleties that would result in a 10,000 word article, no one would read it.

When you buy an individual bond

  • You pay 100 (or the market price). You are buying an amount equal to an original principal, to be paid at maturity.

  • You receive stated, periodic interest payments, called coupons (let’s call it 5%). You owe income taxes on those interest payments when you receive the payments, unless the coupons are tax-exempt (municipal bonds, for example).

  • Prior to maturity, the market price of that bond MOVES, it does not stay at 100. If you sell a bond prior to the maturity date, you receive a market price which will very likely not equal 100, that is determined by financial markets. If Jae’s Rib Shack goes bankrupt, then a bond holder receives a pro rata share of the company assets, after it’s current bills and senior obligations are paid.

    AHEM, the NPV has moved because the denominator has moved, or investors don’t believe that Jae’s Rib Shack can pay the “C (which we presume to be the 5%).”

  • On the stated maturity date, you receive 100, the original principal (assuming no default).

  • The problem here is that the market data about individual bonds is not readily available, and you cannot execute an investment anywhere near where the professional market executes a bond transaction.

When you buy units in a bond fund

  • You pay XXX, the price of a bond fund unit (or ETF).

  • You receive interest which represents your prorata share of the all the different individual bonds inside the bond fund.

  • When individual components inside the bond fund no longer fit the criteria of the bond fund, they are sold or bought, at the discretion of the bond fund manager. There can be capital gains or losses.

  • The price of the bond fund unit moves because the market price of the components inside the bond fund move.

  • There is NO stated maturity date, you are simply the owner of a slice of all the individual components. At no point, do you receive XXX on a stated date (as in the example of an individual bond).

Results can be wildly different

  • You can have unrealized and realized gains and losses because the price of the bond fund unit, or the individual bond, can fluctuate.

  • You can have interest payments, you will have to pay taxes on them when received, if the fund is sitting in a taxable account.

  • Means that you have rolling, ongoing market risk. But now the differences begin. If you own an individual bond, then you have interim risk, but that risk ends when the bond matures, and you are repaid your original principal, guaranteed by the company / borrower (Jae’s Rib Shack in this example).

  • In a bond fund, this is never the situation, unless the market price is precisely the same as when you first bought, and there is never a stated date where this is guaranteed in a bond fund.

  • These differences have been ignored, until the past 18 months, when the market price of bonds have moved by more that stocks, in certain time periods. There were many periods in 2022 when stocks performed poorly, and bonds performed worse.

Why Am I Writing This Today?

  • 2 Year US Treasury Notes pay 4.80% a year. That is true, but even ETFs will have a rolling set of US Treasury Notes that fit this maturity.

  • 10 Year US Treasury Notes pay 3.35% a year. That is also true, but the price fluctuation of this security is MUCH higher (approximately 5 times higher) if there is an interest rate movement.

  • Means that you have a balance between receiving interest payments (4.8% vs 3.35%) and market price movements. It is up to the investor to decide which risk to accept. The implication is that there are different reasons that an investor would choose one maturity over another. If someone believes that they are not going to hold until maturity, then the 2 Year security will have smaller interim price changes for a 1% change in interest rates.

Bond Ladder: What Is It?

  • Bond ladders are simply a series of investments in individual bonds (the first example). The design is so you have a predictable return for that money, over the specified time periods. If this is your financial requirement or objective, this is entirely reasonable. It still has the execution problem mentioned at the beginning of this article.

  • A bond ladder is just a name. It is a series of principal deposits of 100, to receive some pattern of interest payments, and then a return of your principal deposits, 100, at different points in time.

  • Yes, there are many ways that you can do this. For example, you can buy a set of bank CDs. You can buy a series of fixed rate annuities (with minimum maturity of 2 years, it is called a Multi-Year Guaranteed Annuity). Don’t let jargon distract you: the cash flows follow the identical pattern. If it walks like a duck, and quacks like a duck, it’s a duck.

Which One Is For Me?

  • The interesting thing is that interest rates are no longer zero now, so these investments are generating cash / earnings which can fit an overall financial plan. If this fits your objective or within your financial plan, then this is about comparing the returns under different techniques.

  • Bond fund is very liquid, it takes nothing to change your mind.

  • Individual bonds are not liquid and price discovery is very difficult, if not impossible. If you are buying an individual bond, then you will not receive reliable estimates of the market price on an interim basis. You will not execute at a price which resembles the professional market, you will not even be close to the actual, professional market price. All attempts to correct this have, for the most part, failed.

  • Multi-Year Guaranteed Annuities are not well-understood, but this type of annuity works like a bank CD (without an FDIC guarantee, I am talking about the pattern of cash flows). The added feature here is that there are no taxes to be paid on an MYGA until you have withdrawn from the annuity. Again, since rates are no longer zero, that means that the compounding occurs on a pre-tax basis, and this compounding now matters.

  • Bank CDs also compound, BUT you are responsible to pay taxes on a CD on an interim basis, when your account is credited with the interest payment.

Your job? As always, it is to correctly identify your objective. Then, understand how these different instruments can fit the objective. Finally, you can then decide on the AMOUNT of investment/purchases that would fit within your entire setup.

This will help you take back control of your money, so that you can align your money with your priorities. Ain’t my money, it’s yours.