Question on Bonds & Interest Rates

Let's say Coke sold off some bonds at 7% coupon over 5yrs. I buy 1K shares at $10 each. Now interest
rates are going up. I've read that this will negatively impact my bond holdings.

Will it effect the $10 valuation? Won't Coke, regardless of where interest rates are in 5yrs have to
pay me back with 7% compounded interest? Don't most bonds end up getting redeemed at "par"?

Also, my understanding is that municipal bonds would be 100% immune to interest rate fluctuations since
they're government issue. Right?

Lastly, if interest rates keep hiking up, and the face value of my fictitious coke bond drops, wouldn't
the lowered price just make it more attractive to own? Because now in 5yrs, I'll get paid for each
bond at $10 + the 7% annuallized interest.

I've been reading faq after faq on this matter & I know I'm missing something painfully obvious.

Re: Question on Bonds & Interest Rates

You know, I honestly don't know the answer to this. But I've been looking into safe bond
funds to diversify my holdings and came up with a few that I wanted to post. FIgure this
will be as good a threat as any:


VWAHX - 6% avg over 5yr
VMLTX - 6.68% avg over 5yr
DODIX - 7% avg over 5yr
HABDX - 8% avg over 5yr

The two Vanguard funds are tax-exempt. FWIW, muni's are also effected by interest rate hikes.

Mike Hunt <> wrote:
> Let's say Coke sold off some bonds at 7% coupon over 5yrs. I buy 1K shares at $10 each. Now interest
> rates are going up. I've read that this will negatively impact my bond holdings.
>
> Will it effect the $10 valuation? Won't Coke, regardless of where interest rates are in 5yrs have to
> pay me back with 7% compounded interest? Don't most bonds end up getting redeemed at "par"?
>
> Also, my understanding is that municipal bonds would be 100% immune to interest rate fluctuations since
> they're government issue. Right?
>
> Lastly, if interest rates keep hiking up, and the face value of my fictitious coke bond drops, wouldn't
> the lowered price just make it more attractive to own? Because now in 5yrs, I'll get paid for each
> bond at $10 + the 7% annuallized interest.
>
> I've been reading faq after faq on this matter & I know I'm missing something painfully obvious.

Re: Question on Bonds & Interest Rates

Mike Hunt wrote:
> Let's say Coke sold off some bonds at 7% coupon over 5yrs. I buy 1K shares at $10 each. Now interest
> rates are going up. I've read that this will negatively impact my bond holdings.
>
> Will it effect the $10 valuation? Won't Coke, regardless of where interest rates are in 5yrs have to
> pay me back with 7% compounded interest? Don't most bonds end up getting redeemed at "par"?
>

Ignoring discounting of future returns for the moment, your total return
will be 5 years interest of 7% of $10 or $0.70
each year plus your initial $10 investment given back at the end making
a total of $13.5 per bond received by the end of
5 years. This will happen if you hold to maturity and coke neither
defaults on interest payments nor goes bust, regardless
of what interest rates do. However, you won't get compound interest,
just $0.70 cash per bond per year. What you do with the
cash is up to you.

The complication only arises if a) the interest rate changes and b) you
want to sell the bonds before maturity.
To see this, suppose interest rates go up and coke is now selling bonds
for $10 that give 8% instead of 7%.
Buyers of these bonds will get 5 x $0.80 + $10 = $14 back at maturity,
so they won't want to pay you $10 for your
less valuable bonds. For them to make the same $4 profit as they would
on new 8% bonds they would only pay you $9.50
for your old 7% bonds. Then they would still get the 5 x $0.70 interest
payments plus the $10 par value back at maturity
on your old bonds and make $13.5-$9.50 = $4.00.

So the current value of your bonds would drop from $10 to $9.50 and you
would make a loss if you sold. This is why bonds
are not risk-free. They have interest-rate risk. You can avoid any loss
by not selling and holding to maturity but then
you lose the opportunity to invest at higher interest rates.

Of course real life is more complicated in that an interest payment of
$0.70 received in three years time, say, is worth
less than one received now. If you had it now you could invest it at 7%
and it would be worth 1.07^3 x $0.70 = $0.86 in
three years time. So the $0.70 in three years time is only worth
$0.70/1.07^3 = $0.57 now. You have to compare the present
values of all the returns on the old and new bonds to see how much the
price of the old bonds falls due to the interest rate rise.


> Also, my understanding is that municipal bonds would be 100% immune to interest rate fluctuations since
> they're government issue. Right?
>
Wrong. No difference. You only avoid interest rate risk by holding to
maturity. Otherwise if the interest rate goes up, bond resale values
fall, whoever issues them.

> Lastly, if interest rates keep hiking up, and the face value of my fictitious coke bond drops, wouldn't
> the lowered price just make it more attractive to own? Because now in 5yrs, I'll get paid for each
> bond at $10 + the 7% annuallized interest.
>
No, you will always be paid the coupon rate on them when you bought them
on the par value. That's why the bond price falls (or rises) with
interest rate changes.

> I've been reading faq after faq on this matter & I know I'm missing something painfully obvious.

Re: Question on Bonds & Interest Rates

David Wilkinson wrote:
> Mike Hunt wrote:
>
>> Let's say Coke sold off some bonds at 7% coupon over 5yrs. I buy 1K
>> shares at $10 each. Now interest
>> rates are going up. I've read that this will negatively impact my
>> bond holdings.
>>
>> Will it effect the $10 valuation? Won't Coke, regardless of where
>> interest rates are in 5yrs have to pay me back with 7% compounded
>> interest? Don't most bonds end up getting redeemed at "par"?
>>
>
> Ignoring discounting of future returns for the moment, your total return
> will be 5 years interest of 7% of $10 or $0.70
> each year plus your initial $10 investment given back at the end making
> a total of $13.5 per bond received by the end of
> 5 years. This will happen if you hold to maturity and coke neither
> defaults on interest payments nor goes bust, regardless
> of what interest rates do. However, you won't get compound interest,
> just $0.70 cash per bond per year. What you do with the
> cash is up to you.
>
> The complication only arises if a) the interest rate changes and b) you
> want to sell the bonds before maturity.
> To see this, suppose interest rates go up and coke is now selling bonds
> for $10 that give 8% instead of 7%.
> Buyers of these bonds will get 5 x $0.80 + $10 = $14 back at maturity,
> so they won't want to pay you $10 for your
> less valuable bonds. For them to make the same $4 profit as they would
> on new 8% bonds they would only pay you $9.50
> for your old 7% bonds. Then they would still get the 5 x $0.70 interest
> payments plus the $10 par value back at maturity
> on your old bonds and make $13.5-$9.50 = $4.00.
>
> So the current value of your bonds would drop from $10 to $9.50 and you
> would make a loss if you sold. This is why bonds
> are not risk-free. They have interest-rate risk. You can avoid any loss
> by not selling and holding to maturity but then
> you lose the opportunity to invest at higher interest rates.
>
> Of course real life is more complicated in that an interest payment of
> $0.70 received in three years time, say, is worth
> less than one received now. If you had it now you could invest it at 7%
> and it would be worth 1.07^3 x $0.70 = $0.86 in
> three years time. So the $0.70 in three years time is only worth
> $0.70/1.07^3 = $0.57 now. You have to compare the present
> values of all the returns on the old and new bonds to see how much the
> price of the old bonds falls due to the interest rate rise.
>
>
>> Also, my understanding is that municipal bonds would be 100% immune to
>> interest rate fluctuations since
>> they're government issue. Right?
>>
> Wrong. No difference. You only avoid interest rate risk by holding to
> maturity. Otherwise if the interest rate goes up, bond resale values
> fall, whoever issues them.
>
>> Lastly, if interest rates keep hiking up, and the face value of my
>> fictitious coke bond drops, wouldn't
>> the lowered price just make it more attractive to own? Because now in
>> 5yrs, I'll get paid for each
>> bond at $10 + the 7% annuallized interest.
>>
> No, you will always be paid the coupon rate on them when you bought them
> on the par value. That's why the bond price falls (or rises) with
> interest rate changes.
>
>> I've been reading faq after faq on this matter & I know I'm missing
>> something painfully obvious.
>
>
Or look at it another way, with discounting. How much are the future
returns on your 5-year, $10 bond at 7% worth in today's money?

You will get $0.70 back each year plus the $10 par value back at the end
of the fifth year. With discounting, amount p received in n years is
worth p/1.07^n in todays money, at 7%.

Present value of future returns is, therefore:

Present Value = 0.7/1.07 + 0.7/1.07^2 + 0.7/1.07^3 + 0.7/1.07^4 +
0.7/1.07^5 +10/1.07^5

= 0.654 + 0.611 + 0.571 + 0.534 + 0.499 + 7.130

= $10

amazingly, which is why the bonds sell for that!

Now, suppose the interest rate goes up to 8%, the future returns are the
same in actual dollar values but discounted at 8% to present values.

New Present Value = 0.7/1.08 + 0.7/1.08^2 + ..., I am sure you get the idea,

= $9.60

so your present bond value drops from $10.00 to $9.60 as a resale value.

Apart from interest rate risk there is also default risk. US treasury
bonds are pretty well 100% safe because the government can always print
more money. Municipal bonds should be almost as safe. Company or
corporate bonds can default. Enron bonds are presumably worth little or
nothing now and bond holders will get neither interest nor return of
their par value. Rating agencies like Standard & Poor rate bonds from
AAA to junk status depending on how reliable they think the payments
will be. Coke would probably be up at the top there. Once-proud GM bonds
now have junk status. Junk and lowly rated bonds have to pay more
interest to compensate for the higher risk level or no one would buy them.

Re: Question on Bonds & Interest Rates

"David Wilkinson" <> wrote in message
news:dbq675$fkh$

> Or look at it another way, with discounting. How much are the future
> returns on your 5-year, $10 bond at 7% worth in today's money?
>
> You will get $0.70 back each year plus the $10 par value back at the end
> of the fifth year. With discounting, amount p received in n years is
> worth p/1.07^n in todays money, at 7%.
>
> Present value of future returns is, therefore:
>
> Present Value = 0.7/1.07 + 0.7/1.07^2 + 0.7/1.07^3 + 0.7/1.07^4 +
> 0.7/1.07^5 +10/1.07^5
>
> = 0.654 + 0.611 + 0.571 + 0.534 + 0.499 + 7.130
>
> = $10
>
> amazingly, which is why the bonds sell for that!


There's nothing amazing about it. It's simple arithmetic. It would only be
different if the interest rate weren't really 7%.

This is an excellent explication of present value. When you buy a bond you
are basically buying a flow of payments over a fixed period of time. As you
show, these can be discounted (the opposite of compounding interest) to the
present, using the prevailing interest rate.

I don't think people appreciate that this is simply a matter of calculation,
given the interest rate.

The only complicated part is what that interest rate is. It's pretty much
determined by the bond market which is relatively open and efficient.

-herb

Re: Question on Bonds & Interest Rates

The thing to remember. If interest rates go up the market value of a
bond goes down. If interest rates go down, the market value of a bond
goes up.

Also, if interest rates go down, frequently a company will call in
their higher priced bonds. Whether they can do this or not is dependent
on the written terms of the bond. Sometimes it is hard to find out if a
specific bond is callable. Some are, some aren't. If interest rates go
up, they won't call the bond. It wouldn't be to their advantage.

Buying individual bonds has the advantage that, if they are NOT
callable, you will get the interest rate until the end of the bond
term, barring a default.

Buying a bond mutual fund lessens the default risk as the fund holds
many many bonds. Some may default, but it won't matter much.

Buying bonds direct involves commissions on the buy and sale of the
bond.

Buying a bond mutual fund involves the costs the mutual fund company
charges to run the fund.

Unless you are buying many bonds (20 or so), and intend to hold them
for a long time, buying a no load bond mutual fund is probably a better
solution for most investors.

YOu can lessen the movement of your bond fund due to interest rate
fluctualtions by buying shorter term bond fund. But you get a lower
interest rate with shorter terms.

Re: Question on Bonds & Interest Rates

Mike Hunt wrote:
> Let's say Coke sold off some bonds at 7% coupon over 5yrs. I buy 1K shares at $10 each. Now interest
> rates are going up. I've read that this will negatively impact my bond holdings.
>
> Will it effect the $10 valuation? Won't Coke, regardless of where interest rates are in 5yrs have to
> pay me back with 7% compounded interest? Don't most bonds end up getting redeemed at "par"?
>
> Also, my understanding is that municipal bonds would be 100% immune to interest rate fluctuations since
> they're government issue. Right?

By now, you've already gotten some excellent replies that explain the
difference between holding a bond to maturity, versus attempting to sell
it before maturity at a time when the prevailing interest rates have
changed.

I just have one more thing to add: This NG is about *mutual funds*.
Typically a bond fund doesn't hold the bonds in its portfolio till their
maturity. A bond fund can buy and sell bonds at any time. Hence the
Net Asset Value (NAV) of the fund will fluctuate as the value of the
bonds that haven't yet matured fluctuate. And again, that value depends
on the prevailing interest rate at the time.

The practical effect of this is that owning individual bonds can be a
better choice, even for relative novices, than owning a bond fund.


--
Steven D. Litvintchouk
Email:

Remove the NOSPAM before replying to me.

Re: Question on Bonds & Interest Rates

"Steven L." <> wrote in message
news:m3zEe.2908$

> I just have one more thing to add: This NG is about *mutual funds*.
> Typically a bond fund doesn't hold the bonds in its portfolio till their
> maturity. A bond fund can buy and sell bonds at any time. Hence the
> Net Asset Value (NAV) of the fund will fluctuate as the value of the
> bonds that haven't yet matured fluctuate. And again, that value depends
> on the prevailing interest rate at the time.
>
> The practical effect of this is that owning individual bonds can be a
> better choice, even for relative novices, than owning a bond fund.
>
I don't understand this line of reasoning. The only difference between
holding a portfolio of bonds and a bond fund holding the same portfolio is
that the fund is required by law to mark things down to present value while
individuals are free to sell themselves the illusion that par value at some
maturity date in the future is the same as par value today. It is not.

If a fund doesn't hold a bond to maturity it is most likely because the
manager feels he/she can do better holding something else, instead.

-herb

Re: Question on Bonds & Interest Rates

I have a friend who bought about 20 AA or better bonds (some $400k
worth) about 7 years ago. He paid about 5% commission and intends to
hold to maturity (20 years). One company is in serious trouble and his
bond value in that company has gone down (though so far they are paying
the interest). Two others have redeemed their bonds so he has had to
pay more commisions and buy bonds at a lower rate. So buying bonds
direct is not trouble free, nor is it necessarily lower on
commissions.

If he had bought Vanguard Long Term Treasuries he wouldn't have these
problems.

Re: Question on Bonds & Interest Rates

Doug wrote:
>
> I have a friend who bought about 20 AA or better bonds (some $400k
> worth) about 7 years ago. [commissions, downgrades and calls described]
>
> If he had bought Vanguard Long Term Treasuries he wouldn't have these
> problems.

Doug, as much as I support the thesis that bond funds are less of a
hassle than investing in individual issues (just as equity funds are
less of a hassle than investing in individual stocks), IMHO you are
making an apples to oranges comparison here. Had your friend invested
in treasuries rather than corporates, he would not have experienced most
of the problems you describe.

Treasuries don't get downgraded, nor are they (usually) callable.
Further, they can be purchased at zero commission (through
TreasuryDirect, or at auction through Fidelity).
--
Mark Freeland

Re: Question on Bonds & Interest Rates

Yeah, well he went to a BROKER.