Do you still profit when bonds fall?

Chenner

As a new poster I cannot include a link, so I will refer to the article in question without the http and www bits:
trustnet.com/News/525084/why-rising-interest-rates-dont-mean-bonds-will-lose-you-money/1/1/

Is there a wise person who can explain if (and how) this logic works for a buy-and-hold portfolio bond allocation for a passive investor?

The explanation and accompanying graph seem to suggest that even if bond prices fall, the corresponding increase in yield will result in an overall gain.

I understand the principle that bond yield is inverse to price. But I do not see how a buy and hold bond allocation benefits from a gain in the yield if prices fall.

The investor buys a bond for £100 with a 5% yield, the potential annual gain is £5. But if bond prices fall 10% the bond is worth £90. The yield on the bond to a new buyer
is now 5.66% (£5 on £90). But the buy and hold investor who paid £100 still gets £5, so overall their position is a £5 loss (£90 value + £5 income less £100 paid).

So how does this gain shown in the graph work for the passive investor?

Linton

Bonds have a maturity date at which it is guaranteed that they will be redeemed at face value. So near to maturity the price muust return to the face value. The price of a bond can never drop so far that a buyer would make an overall loss if they kept the bond until maturity - no sane investor would ever buy that bond. So your example is wrong, the bond price could not have dropped to £90 if it was only one year from maturity.

In this respect bond funds are inferior to actual bonds - you as an investor dont directly get the protection of the maturity date. However the effect will prevent bond prices dropping excessively, and I believe that if interest rates rise slowly owning bonds or bond funds will not be the disaster some people have suggested. The fall in value of the bond will be mitigated by the interest earned and in the case of funds by the higher interest earned on new bond purchases.

coyrls

What worries me is that if a drop in a bond fund's (active or passive) price results in people selling at a rate that is equal or greater than the rate a which the underlying bonds in the fund are maturing, then no new bonds will be purchased at higher interest rates and the price will continue to drop resulting in more sales and a downward spiral.

Linton

coyrls wrote: »

What worries me is that if a drop in a bond fund's (active or passive) price results in people selling at a rate that is equal or greater than the rate a which the underlying bonds in the fund are maturing, then no new bonds will be purchased at higher interest rates and the price will continue to drop resulting in more sales and a downward spiral.

The price cant continue to drop as the value of the bonds held by the fund will be supported by the redemption at maturity. The value of a bond fund is simply the market value of the bonds it holds and is not affected by large sales in that particular fund.

Of course in the very unlikely event if everyone in the world does start selling their bonds and the price really does drop below the "correct price" then you should be buying as fast as you can.

The key point is that, unlike shares, safe bonds such as gilts do have an intrinsic absolute calculatable value and so cannot fluctuate wildly in response to market forces.

puk999

Linton wrote: »

The price of a bond can never drop so far that a buyer would make an overall loss if they kept the bond until maturity - no sane investor would ever buy that bond.

Wouldn't the buyer make a gain if they bought for £90 and received £100 at maturity?

So your example is wrong, the bond price could not have dropped to £90 if it was only one year from maturity.

Where did the "one year" bit come from?

Your_Hero

Chenner wrote: »

As a new poster I cannot include a link, so I will refer to the article in question without the http and www bits:
trustnet.com/News/525084/why-rising-interest-rates-dont-mean-bonds-will-lose-you-money/1/1/

Is there a wise person who can explain if (and how) this logic works for a buy-and-hold portfolio bond allocation for a passive investor?

The explanation and accompanying graph seem to suggest that even if bond prices fall, the corresponding increase in yield will result in an overall gain.

I understand the principle that bond yield is inverse to price. But I do not see how a buy and hold bond allocation benefits from a gain in the yield if prices fall.

The investor buys a bond for £100 with a 5% yield, the potential annual gain is £5. But if bond prices fall 10% the bond is worth £90. The yield on the bond to a new buyer
is now 5.66% (£5 on £90). But the buy and hold investor who paid £100 still gets £5, so overall their position is a £5 loss (£90 value + £5 income less £100 paid).

So how does this gain shown in the graph work for the passive investor?

The article on Trustnet shows how holding onto it could produce a better result (than selling), since the coupon payment (£5 in your example) will still be paid and the cumulative effect of this could be positive, assuming it is higher than the fall in price. Moreover, the expectations of interest rate change could already be priced into the bonds too so the actual fall in value may not be as much as you think. You don't benefit as such from a higher yield because the coupon payments are still the same for the buy and hold.

kidmugsy

I've never bought a bond fund - they seem to me to surrender the key advantage of bonds, as described by Linton. Buying and holding individual gilts, and even a convertible, in PEPs and then ISAs worked out pretty well for us.

Every now and then I consider buying a bond fund, and then funk it.

Linton

puk999 wrote: »

Wouldn't the buyer make a gain if they bought for £90 and received £100 at maturity?



Where did the "one year" bit come from?

Sorry, wrong way round - bonds cannot rise so far above face value that a buyer would make a loss if held to maturity nor fall so far that the seller would be would be throwing away a guaranteed profit. So there is a correct price for a bond based on the assumption that the future gains from interest and redemption are discounted by the then current interest rates.

The one year came from the OP only taking 1 years interest into account.

colsten

Don't bond holders still carry the risk that the[retail] bond issuer will default, leading to a 100% loss in the worst case?

Linton

colsten wrote: »

Don't bond holders still carry the risk that the[retail] bond issuer will default, leading to a 100% loss in the worst case?

Yes - that is why the interest rates for corporate bonds are higher than for government backed bonds (eg gilts). Broadly speaking the higher the risk the more the bond behaves like an equivalent share. When the economy is failing shares fall, and because companies are more likely to go bust a higher risk corporate bond will fall in value. This is the opposite of gilts where decreases in share prices make the guaranteed gilt more desirable and so those bond prices increase.

One slight mitigation - bond holders are higher in the pecking order than share holders when the assets of a bankrupt company are realised. And of course if a bond falls in price the effective rate of interest increases so even a dodgy company bond does have some value. So unlike shares the price of a corporate bond cannot stay extremely low for a long period of time.

Chenner

Thank you, especially Linton and Your Hero. All clear now and an education in one of the key benefits of bonds.