Objective information about retirement, financial planning and investments


Understanding Your Bond Fund’s Duration


Interest Rates

For most of the past 30 years bonds and bond mutual funds have had the proverbial wind in their sails. Interest rates have steadily headed downwards. Bond prices and interest rates have an inverse relationship.

Last week, however, the Fed increased interest rates by 25 basis points (0.25%). They also indicated that they would continue to raise rates this year as, in their view, our economy has reached a new phase. This is part of an overall tightening of the money supply to keep the economy from overheating, including an effort to keep inflation in check.

Many investors may be wondering what this means for their bond mutual funds ETFs. A key number that all holders of bond funds and ETFs must know and understand is the fund’s duration.

What is duration? 

Bond mutual funds and ETFs are a portfolio of individual bonds.

According to Morningstar, “Duration is a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond. A bond’s duration is expressed in years and is generally shorter than its maturity.

All things being equal, a bond with a longer time to maturity will have a higher duration meaning its price is more sensitive to changes in interest rates. Likewise, the higher the bond’s coupon rate (the stated interest rate paid by the bond) the lower the bond’s duration. Bonds with a shorter time to maturity and a higher coupon rate will have a lower duration and their price will be less sensitive to changes in interest rates.

The duration of a bond fund or ETF can be found on the fund’s fact sheet usually posted on the fund company’s site, or the portfolio tab on the fund’s listing on Morningstar.com.

What does bond fund duration tell us? 

The largest bond fund, Vanguard Total Bond Market Index (ticker VBMFX), has an effective duration of 6.05 years according to Morningstar. This tells us that if interest rates rise by 1% the value of the underlying bonds held by the fund would likely decline by around 6.05%.  Note this number is an approximation and bond prices are impacted by factors other than changes in interest rates. This fund roughly tracks the aggregate U.S. bond market.

By comparison Vanguard Long-Term Investment Grade (ticker VWESX) has longer duration of 13.31 years and would see a greater impact from rising interest rates.

The Vanguard Short-Term Bond Index ETF (ticker BSV) has a duration of 2.76 years.

The actively managed Double Line Total Return Bond Fund I (ticker DBLTX), managed by Jeffrey Gundlach who many call the “bond king,” has a duration of 3.98 years.

What should I do now?

As mentioned above, duration is a good indicator of the potential impact of a change in interest rates upon the value of your bond fund, but other factors also come into play. In 2008, many bond funds saw outsized losses and investors moved their money into Treasuries as a safe haven during the financial meltdown.

Many high-quality bond funds suffered major losses that year based only upon this flight to quality by investors.

Longer term the total return of a bond fund or ETF is driven by income payments as well as the direction of interest rates. Lower coupon bonds will be replaced by bonds with higher coupon rates over time.

Bonds are traded on the secondary market and prices are a function of supply and demand much like with stocks.

Bond mutual funds and ETFs offer the advantage of a managed portfolio.  On the flip side unlike an individual bond, bond mutual funds and ETFs never mature.

Is it time to get out of bond funds?  The point of this article is not to advocate that you do anything differently, but rather that you understand the potential duration risk in any bond mutual funds or ETFs that you currently hold or may be considering for purchase.

Bond funds and ETFs still have a place in diversified portfolios, but for many investors the characteristics of the fixed income portion of their portfolios may need an adjustment. This might mean shortening up on bond fund duration and looking at other, non-core types of bond funds.

The landscape of the financial markets is continually evolving and interest rates are a part of this evolution. As investors we need to understand the potential implications on our portfolios and adjust as needed.

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? Check out my Financial Review/Second Opinion for Individuals service.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services.  

Photo credit:  Flickr

5 Mutual Fund Investing Lessons from the Bill Gross Saga


The soap opera at PIMco that began with the departure of Co-CEO Mohamed El-Erian in January came to a head with the recent departure of PIMco flounder Bill Gross.   More than just being the founder of PIMco Gross managed the firm’s flagship mutual fund PIMco Total Return (PTTRX).  His high profile exit once again brings one of the pitfalls of investing in actively managed mutual funds to the forefront.  Here are 5 mutual fund investing lessons from the Bill Gross saga.

Know who is in charge of your fund 

Bill Gross was the very public face of PIMco and was known as the “Bond King.”  To his credit he built PIMco Total Return into the world’s largest bond fund and the fund did very well for investors over the years.  The question investors, financial advisors, and institutions are now asking themselves is what is the future of the fund without Gross?

While PIMco promoted two very able managers to take over at Total Return, the redemptions that have plagued the fund over the past several years as a result of its downturn in performance have continued and seem to be accelerating in the short-term.  Much of this I’m sure stems from the uncertainty over the direction of the fund under these new managers.

Succession planning is vital

While most fund manager changes don’t take place in this fashion if you invest in a mutual fund run by a superstar manager what happens if he or she leaves?  For example does Fidelity have a plan to replace Will Danoff when he decides to leave Fidelity Contra (FCNTX)?

One of the long-time co-managers of Oakmark Equity-Income (OAKBX) retired a couple of years ago.  This was planned and announced ahead of time.  Shortly after that the fund brought on four younger co-managers to help the remaining long-tenured manager manage the fund and more importantly to provide succession and continuity for the fund’s shareholders.

The investment process matters 

What makes an actively managed mutual fund unique is its investment process.  If the fund were to merely mimic its underlying index why not just invest in a low cost, passively managed index fund?  There have been a number of articles in the financial press in recent years discussing “closet index” funds.  These are actively managed funds that for all intents and purposes look much like their underlying benchmark.  This is fairly prevalent in the large cap arena with many funds mimicking the S&P 500.  Why invest in an actively managed fund that is really nothing more than an overpriced index fund?

An institutionalized investment process is key when a manager leaves a fund.  I can think of three small cap funds I’ve used over the years that transitioned to new managers seamlessly via the use of a solid investment process.  While it is expected that the new managers may make some changes over time, I’ve also seen well-known funds replace a superstar manager and essentially have the new manager start over.  The results are too often not what shareholders have come to expect.  To a point this is what has happened to Fidelity’s one-time flagship fund Magellan since the legendary Peter Lynch left a number of years ago.  Subsequent managers have never been able to come close to replicating the fund’s former lofty position.

Even the best managers have down periods 

Bill Gross has made a lot of money for shareholders in PIMco Total Return and other funds he managed over time.  However Total Return has lagged its peers over the past several years which has led to a lot of money flowing out of the fund and the firm in recent years.  It is not uncommon for a top manager to go through a few down years over the course of a solid long-term run.  The trick is to be able to determine if this is a temporary thing, or if this manager’s best days are in the past.  For example if the fund has grown to be too large the manager may have more money to manage than he or she can effectively invest.

Is an index fund a better alternative? 

To be clear I am not in the camp that indexing is the only way to go when investing.  There are a number of very good active managers out there, the trick is to be able to identify them and to understand what makes their strategy and investment process successful.

However before ever investing in an actively managed mutual fund, ask yourself what will I be gaining over investing in an index mutual fund or ETF?

It was sad for me to see Gross’ tenure at PIMco end as it did.  It is not always easy to go out on top.  Michael Jordan should have quit after sinking the winning shot to secure the Chicago Bulls’ last championship.  Perhaps the role model here is the late Al McGuire whose last game as the men’s basketball coach at Marquette ended with the Warriors winning the 1977 NCAA championship.

For more on Bill Gross and PIMco please check out my two recent articles for Investopedia:   What To Expect From Pimco After Bill Gross and Pimco Investor? Consider This Before Bailing.  

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

Prognosticators or Product Sellers?


PIMco’s Bill Gross is arguably the best bond manager around and a really smart guy.  He and several of his PIMco colleagues are also master salesmen, just witness the number of appearances on CNBC and how often they are quoted in the financial press.  In the interest of full disclosure I have a fair amount of client assets invested with PIMco.

CNBC.com - 1996

In his August investment outlook letter, Gross proclaimed “… the cult of equity is dying.”  As we’ve come to expect, Gross lays out a very logical case to support his argument and he also says that the bond returns that we’ve seen over the past 30 years are unlikely to be replicated into the future as well.

At the end of the day this is a stroke of genius on many levels.  First it’s controversial and gets people writing and talking about Gross and PIMco.   Second, even with a new push into equities, PIMco is a bond shop.  I can’t help but think that anytime Gross talks down equities there is some motive, conscious or otherwise, to push PIMco’s fixed income products.

Josh Brown in his excellent blog The Reformed Broker recently wrote a post calling out Morgan Creek CEO and CIO Mark Yusko for predicting flat returns for equities over the next 9-10 years and conveniently suggesting alternative investments as the only way for financial advisors to achieve the types of returns their clients expect over this time horizon.

Morgan Creek is in the alternative investments business, and while I’m sure Mr. Yusko is a very bright guy, let’s face it this is just another thinly veiled sales pitch, aimed at financial advisors, for what his firm is selling.

The list goes on and on.  Except during the duration of the Olympics, I generally have CNBC on in the background during the business day.  Many of the guests function in the same fashion.  “Equities are the place to be” might be the mantra of a growth stock mutual fund manager.  The manager of a commodities fund might be predicting inflation into the future and touting commodities as a way to hedge against it.

Look I’m not saying any of these folks are bad people and don’t know what they are doing.  Whether you are a money manager or a financial advisor, you have to engage in sales and marketing in order to attract clients.  Financial advice is a business like any other in that respect.

As a financial advisor whose clients count on me to recommend financial strategies and the products to implement those strategies, I’ve learned to be an intent, but detached listener of pitches.  I attend several conferences throughout the year and listen in on any number of webinars and conference calls on a regular basis.  Many of these are sponsored and presented by financial services providers.   Generally there is much good information presented, but one always has to listen with a critical ear.

As always, please feel free to contact me with any financial planning questions or concerns you may have.

Photo credit:  Wikipedia

Enhanced by Zemanta

Bond Funds Safe Haven or Risky Asset? – An Update


The Frankfurt Bond Market

In September of 2009 I wrote Bond Funds Safe Haven or Risky Asset thinking that interest rates were headed up in the near future.  I wrote an update of this post in January of 2010 under the same premise.  This illustrates why I refrain from predicting anything.  As most of you are probably aware the Federal Reserve has continued its efforts to keep interest rates low.  At some point, however, rates are likely to rise (not a prediction).  Here are some of the factors to keep in mind if you own or are considering investing in a bond mutual fund or ETF.

Why are you investing in bonds?  Like any holding in your portfolio, you should have a reason to invest in bonds, whether via a fund or individual bonds.  Among the reasons to consider are diversification from stocks, yield, and the opportunity for growth via total return (price appreciation and income).

Using three Vanguard index funds as an example, the Vanguard Total Bond Market Index has a correlation of 0.05 to the Vanguard Total International Stock Index fund and -0.05 to the Vanguard Total Stock Market Index fund.  In both cases this means that the returns of the bond fund are virtually unrelated to those of the two stock funds over the past ten years.  A correlation of 1 between two funds would mean that they move in almost complete lockstep, a correlation of 0 means there is virtually no relationship.

Yields on investment grade bonds are down along with interest rates, many fixed income investors have moved into areas like high yield bonds (junk) or dividend paying stocks in search of current income.  Both moves will impact the risk profile of your portfolio.

Unlike individual bonds, bond funds do not mature.  If you buy a bond that matures in July of 2022, upon maturity you will receive the value of the bond (generally $1,000) and any interest payments that are made between now July and 2022.  Neither of these payments will be impacted by the direction of interest rates.  That said the price you would receive for the bond should you decide to sell it prior to maturity could fluctuate between now and 2022.  Other factors such as call provisions or a default by the bond issuer could also come into play.

On the other hand, bond fund portfolios are perpetual in nature.  Some of the bonds in the portfolio will mature, others will be sold by the manager for various reasons, and others will be added to the portfolio.  This fluidity makes bond funds continually sensitive to interest rate fluctuations.  The return on any bond fund will be a combination of interest payments received and the gains and losses of the underlying bonds in the portfolio.

Index funds track their index.  Rightly so, many advisors and financial journalists tout the benefits of investing in low cost index funds and ETFs.  For example, the Vanguard Total Bond Market Index fund ranked in the 31st percentile (top 31%) of its peer group of funds for the trailing 12 months; the 79th percentile for the trailing 3 years; the 44th percentile for the trailing 5 years; the 41st percentile for the trailing 10 years; and the 30th percentile for the trailing 15 years ended June 30.  As you can see this passively managed fund has beaten the majority of funds in the same Morningstar Intermediate Term Bond category over most trailing periods of time.

This cuts both ways.  In 2008 the fund ranked in the 10th percentile of its category due to its benchmark index having a significant allocation to Treasuries.  In 2009 the fund ranked in the 90th percentile and in 2010 in the 73rd percentile as corporates and other riskier bonds recovered from the flight to quality of 2008.

The point is that bond index funds may be constrained when interest rates rise; whereas an active manager might have more leeway within the fund’s investment policy to make trades to mitigate the impact of rising interest rates.

The future 

  • Total return of a bond fund is a combination of the price changes of the underlying holdings, gains or losses when those holding are sold, and the interest received from the individual holdings.
  • Bond prices are impacted by a number of factors:
    • The direction of interest rates.
    • Inflation, rising inflation is the enemy of most bond holders in that the interest rate payments they receive are fixed and lose purchasing power during periods of inflation.
    • The perceived ability of the issuer to make good on their promise to make periodic interest payments and to redeem the bond at maturity.
    • The time to maturity of the underlying bonds in the fund.  The longer the time to maturity, the more sensitive the bonds will be changes in the interest rate.
  • In the case of funds that hold foreign bonds, the relative value of the currency of the issuing country can impact the value of the fund if the fund does not hedge the various foreign currencies represented in the fund versus the dollar.
  • It is important to review any bond funds that you hold or are thinking of buying to try to get a feel as to the potential impact of rising interest rates on your fund.
  • A quick way to gauge the impact is to look at the fund’s duration.  This number can be found via Morningstar and certainly in other places.
    • For example, the Vanguard Total Bond Market Index fund has an effective duration of 5.11 years.  This means that the fund’s value would be expected to drop 5.11% should interest rates rise by 1%.
    • Of course the fund would still collect the interest paid on the bonds held in the fund.  Morningstar lists the fund’s current yield as 2.83%
    • The Vanguard Long-Term Bond Index fund’s duration is 14.19, indicating a significant drop in value should interest rates rise. 

Going forward it is imperative that you understand both the benefits provided by your bond fund investments and the risks inherent in the fund going forward.  The next ten years might look very different for fixed income investors than the last ten years.

Do you have questions about your bond funds or your overall portfolio?  Please feel free to contact me.