1

Everyone says not to buy bonds now because interest rates will rise. I'm wondering how dollar cost averaging (and reinvesting returns) helps reduce the risk.

I'm not sure how bond funds work in general. If I invest X each month, where does X go - an existing (low yield) bond, or a new bond (at the current interest rate)? Does that just depend on what the fund manager is doing at the time (buying/selling)?

If I put Y into a fund, and leave it there for 50 years, where does Y go when all of the bonds at the time I made the purchase mature? Does Y just get reinvested in new bonds at the interest rate at that time?

  • 1
    If you want to mitigate interest rate risk, consider shorter term bond funds as these are less sensitive to interest rate moves. – JB King Sep 6 '13 at 16:04
  • @JBKing - his fund has 5.45 year duration. What do you consider "short"? – JoeTaxpayer Sep 6 '13 at 20:53
  • I'd look at Vanguard's 3 bond index funds for each time horizon: Short, Intermediate and Long. Short is 2.72 Yrs, Intermediate is 6.55 Yrs, and Long is 14.13 Yrs. Thus, I'd put 5.45 years as something close to the Intermediate territory. There are Ultrashort Bond Funds that have a duration down to about a year for something close to extreme. – JB King Sep 6 '13 at 21:30
  • I like the idea of ultrashort if OP wishes to keep such a high percent in bond funds. – JoeTaxpayer Sep 6 '13 at 21:55
3

If I invest X each month, where does X go - an existing (low yield) bond, or a new bond (at the current interest rate)?

This has to be viewed in a larger context. If the fund has outflows greater than or equal to inflows then chances are there isn't any buying being done with your money as that cash is going to those selling their shares in the fund. If though inflows are greater than outflows, there may be some new purchases or not. Don't forget that the new purchase could be an existing bond as the fund has to maintain the duration of being a short-term, intermediate-term or long-term bond fund though there are some exceptions like convertibles or high yield where duration isn't likely a factor.

Does that just depend on what the fund manager is doing at the time (buying/selling)?

No, it depends on the shares being created or redeemed as well as the manager's discretion.

If I put Y into a fund, and leave it there for 50 years, where does Y go when all of the bonds at the time I made the purchase mature?

You're missing that the fund may buy and sell bonds at various times as for example a long-term bond fund may not have issues nearing maturity because of what part of the yield curve it is to mimic.

Does Y just get reinvested in new bonds at the interest rate at that time?

Y gets mixed with the other money in the fund that may increase or decrease in value over time. This is part of the risk in a bond fund where NAV can fluctuate versus a money market mutual fund where the NAV is somewhat fixed at $1/share.

1

You are asking multiple questions here, pieces of which may have been addressed in other questions.

A bond (I'm using US Government bonds in this example, and making the 'zero risk of default' assumption) will be priced based on today's interest rate. This is true whether it's a 10% bond with 10 years left (say rates were 10% on the 30 yr bond 20 years ago) a 2% bond with 10 years, or a new 3% 10 year bond.

The rate I use above is the 'coupon' rate, i.e. the amount the bond will pay each year in interest. What's the same for each bond is called the "Yield to Maturity." The price adjusts, by the market, so the return over the next ten years is the same.

A bond fund simply contains a mix of bonds, but in aggregate, has a yield as well as a duration, the time-and-interest-weighted maturity.

When rates rise, the bond fund will drop in value based on this factor (duration).

Does this begin to answer your question?

  • Over time is the fund manager buying more bonds at (likely) higher interest rates as more of the fund's shares are purchased? I guess the question really is: does dollar cost averaging into a bond fund have less risk than purchasing a single bond at today's rate, and if so how much less? – Scott Anderson Sep 6 '13 at 15:56
  • Not really. Only for the fact that you're not buying 'at the top.' This is one of those rare times that, as you say, most agree we will see rates rise. This is not too different from buying in 2000 as the dot come bubble got ready to burst. In my opinion. – JoeTaxpayer Sep 6 '13 at 17:02
  • If you started dollar cost averaging into the stock market in 2000, that would have been better than going all in at the time right (meaning you would've lost less)? Does this same concept apply to bonds? – Scott Anderson Sep 6 '13 at 18:04
  • @Scott - In a sense, yes. What is the current yield of the fund you plan to buy? If you think the rate will be higher in 6 months, it may make sense to wait. Over the long term DCA is the natural way to invest, as you'll have income to invest each pay period. – JoeTaxpayer Sep 6 '13 at 18:09
  • Looks like 2.51%: quotes.morningstar.com/fund/…. I have about 12% of my portfollio in bonds and looking to increase it to 17% since I am turning 37 and want to use the 120-age formula. Trying to decide if I should try to time the market or just DCA to accomplish. – Scott Anderson Sep 6 '13 at 20:43

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .