What is the likely effect of a Fed rate cut on corporate bond funds like VTC? I would think if the Fed rate goes down it would make the corporate bonds more valuable as their dividends become relatively higher.
I would think if the Fed rate goes down it would make the corporate bonds more valuable as their dividends become relatively higher.
Substitute "coupons" for "dividends" and you are correct. All else being equal, when interest rates fall, fixed-rate bond values rise, so bond funds will now have larger asset values and should rise in value.
There are other factors for corporate bonds such as credit risk, but in general yes, as interest rates decrease bond prices increase.
Say you have a $100 bond (with no default risk) that pays a 5% coupon in 1 year. Meaning, in one year you'll get paid a $5 coupon plus the $100 face value of the bond.
If yields are 5%, the bond will be worth it's face value ($100) since you get $105 from the bond, which is a 5% gain and matches the underlying interest rate.
Now, yields rise to 7.5%. Your bond cannot be worth $100 since you could buy a bond that pays 7.5% for $100 (using the same math as above). So your bond is now worth about:
$100 * (1+5%) / (1+7.5%) = $97.67 because
$105/97.67 = 1+7.5%.
Since you got $105 but you could have gotten $107 based on the yield.
Later, yields fall to 4%. Now your bond is worth more because bonds with only a 4% coupon will be worth $100. THe value of your bond is about:
$100 * (1+5%) / (1+4%) = $100.96
Thus, as the Fed Rate drops, bond values rise and thus the value of a bond fund will rise.