What will happen to my bond interest payments?

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
retiringtype
Posts: 27
Joined: Fri May 20, 2016 11:00 am

What will happen to my bond interest payments?

Post by retiringtype » Mon Jul 11, 2016 12:36 pm

HI all. Trying to plan my upcoming retirement and need to determine the monthly income my bond funds can/will generate. So I have a quick question: In the event of a rate rise, and the resulting drop in NAV of a bond fund, what will happen to the monthly interest payments? Will they go up, down or stay about the same? Is there a definitive answer? I figure that the drop in NAV will be made up for by the rise in the rate. But, then again, I'm far from an expert. (That's why I'm here.)

Thanks in advance.

jjface
Posts: 2482
Joined: Thu Mar 19, 2015 6:18 pm

Re: What will happen to my bond interest payments?

Post by jjface » Mon Jul 11, 2016 12:43 pm

When the fund buys new bonds then the overall yield should increase as these new bonds will have higher yields. So it depends on when the fund buys new bonds which depends on the duration of the fund. I suppose also the amount of new deposits.

The drop in Nav is because new bonds will have higher yields so the old ones you hold paying less yield are worth less. So you do not get compensated for the lower NAV but you can take advantage of higher yields once the old bonds are redeemed at the end of their term.

User avatar
Phineas J. Whoopee
Posts: 6928
Joined: Sun Dec 18, 2011 6:18 pm

Re: What will happen to my bond interest payments?

Post by Phineas J. Whoopee » Mon Jul 11, 2016 2:16 pm

Hi retiringtype. Let's see if I can address your question. It will take a few paragraphs, I'm afraid.

First, we need to get terminology straight. It's extremely important, because we often go around and around, and have incorrect assertions made here at bogleheads.org simply because people use one term when they mean another.

You're asking about a fund, but a fund is nothing more than a collection of individual bonds. It's simpler to talk about those, so we'll start there and then expand to funds. We'll also stick to plain-vanilla type bonds, without call provisions or interest rate adjustments or anything like that. OK?

I'm making up numbers so they're easy to calculate. No number in this post is meant to imply it's realistic to expect that rate today.

You're asking about your "bond interest payments." In a single, ordinary nominal-type bond, that's called the coupon. It's the interest rate on the bond's face value, which was set at issue. The coupon remains the same for the life of the bond. A ten-year, $1000 face value bond which was issued with a 5% coupon will pay $50 per year for ten years. At the end of the term it will also pay back the original $1000. That's the case no matter who ends up owning the bond. When the day to pay comes, the issuer is required to pay whoever the owner is. That's it.

And maybe, in the above paragraph, I've already answered the question about bond interest payments.

A vocabulary term which is in many ways more interesting, but gets confusing to those not in the know, is yield, and in particular, Yield to Maturity, YTM. Still in the context of a single bond, YTM is the total return you will get if you buy the bond at today's price and hold it to maturity. Besides the cash coupon payments, it includes two more things:

1) The fact that as any bond approaches maturity, regardless of previous fluctuations its market value approaches its face value. Think about it. For a $1000 face value bond that matures tomorrow, how much more would anybody pay to buy, or less accept if selling, than $1000? Not much, I should think.

2) Reinvestments of the coupons, often referred to as interest-on-interest.

Sometimes posters asked about yields, assuming it means coupon, and others responded as if the person meant YTM even though it was obvious they didn't, and didn't yet know the difference. I hope we've stamped out that practice.

Yield makes reference to the current market value of a bond, whether or not the person who owns it wants to pretend its value doesn't fluctuate. Therefore, and this is crucially important, if the price of the bond goes down its YTM immediately goes up, and vice versa. It has nothing to do with future bond sales, maturities, purchases, and reinvestments, because yield, YTM, is right now, based in part on right now's price.

It's a widely misunderstood point, and the misconception often is asserted to new investors even though future sales and purchases have nothing to do with today's YTM. Maybe eventually they will have something to do with coupon, more on that in a moment, but not with today's yield.

Now, what about a bond fund, which as I wrote is nothing more nor less than a collection of individual bonds? The coupons pay out however much interest they pay, which a mutual fund distributes as dividends to the holders (having to do with legal structure of funds, nothing to be concerned about in this explanation). It's a number of cents, perhaps even more than 100 of them, per share. The YTM changes constantly because the net asset value of the fund does, but the number of dollars per year might be more or less stable, or quite variable. Here's the final term we're going to introduce: average duration.

Duration isn't a complicated concept, though the math may be a little daunting. It's about today's value of what the bond will pay out in the future if held to maturity, and remember, a bond is a contract to pay certain amounts of money on certain days. It's measured in years, and a rough approximation, not an exactitude nor a definition, is the duration of a fund tells you how sensitive it is to changes in interest rates. Roughly, if a fund has a duration of 5 years, and prevailing interest rates rise by 1%, the net asset value will fall by 5%. That's OK. Remember, yields depend on today's prices. The price is down therefore the yield, YTM, has gone up. It happens to approximately work out that the duration is the break-even point, the time at which your wealth will be the same as if rates hadn't changed.

For purists, the idea in the previous paragraph is a linear approximation of a nonlinear function.

With me so far, retiringtype (and anybody eavesdropping)?

I said the payouts might be stable or vary a lot. It turns out bonds with longer durations keep paying out similar coupons for quite a while, and with shorter, the collection of bonds' payouts will vary. That is, longer-duration funds are more sensitive to interest-rate risk, which changes their values, so their yields immediately change, but the number of dollars they pay out, the coupons, remains stable for a long time. Shorter-duration funds don't change as much in value due to interest rate changes, but since they do roll their underlying holdings so frequently, the payout is much less stable.

I'll leave you with this quote by Jack Bogle, from his Twelve Pillars of Wisdom (this is the ninth pillar):
Jack Bogle wrote: ...
Pillar 9. You May Have a Stable Principal Value or a Stable Income Stream, But You May Not Have Both.

Contrast a money market fund, with its volatile income stream and fixed value, and a long-term government bond fund, with its relatively fixed income stream and extraordinarily volatile market value. Intelligent investing involves choices, compromises, and trade-offs, and your own financial position should determine the most suitable combination for your portfolio.
...
Did I help answer your question?

PJW

straws46
Posts: 83
Joined: Fri Jul 03, 2015 11:12 am

Re: What will happen to my bond interest payments?

Post by straws46 » Mon Jul 11, 2016 2:33 pm

All above true. For a simple answer, your payments will stay the same, but the marketplace will say you are getting a higher yield because they calculate the yield based on the new NAV. Same payments divided by lower NAV equals higher yield.

dbr
Posts: 25371
Joined: Sun Mar 04, 2007 9:50 am

Re: What will happen to my bond interest payments?

Post by dbr » Mon Jul 11, 2016 2:37 pm

In any case the amount of income you can obtain from a portfolio of investments does not have to be set by the dividends paid by your bond funds. Devising a plan based on that restriction puts you in a planning straightjacket and may also result in distorted or even unwise investment choices.

ryman554
Posts: 872
Joined: Sun Jan 12, 2014 9:44 pm

Re: What will happen to my bond interest payments?

Post by ryman554 » Mon Jul 11, 2016 2:41 pm

straws46 wrote:All above true. For a simple answer, your payments will stay the same, but the marketplace will say you are getting a higher yield because they calculate the yield based on the new NAV. Same payments divided by lower NAV equals higher yield.
Are you sure about that?

Take a limiting case -- bond fund with average maturity of 5 years. year 0, interest rates are 1% and have been for a very long time. You buy in. You get 1% a year. They suddenly jump to 2%, staying that way to 5 years. Your NAV drops. Oh well, that is a paper money loss. <why does it drop? Because you have to sell 1% bonds at a discount since there are 2% bonds at par value there for the taking.> At 5 years, most of the bonds have matured and new ones were purchased. You will be getting 2% a year at this point.

The monthly interest payments do not stay the same, they slowly (over the maturity period) shift to the prevailing rate.

straws46
Posts: 83
Joined: Fri Jul 03, 2015 11:12 am

Re: What will happen to my bond interest payments?

Post by straws46 » Mon Jul 11, 2016 2:53 pm

rymann554

You are right of course. My answer was based solely on what happens immediately when the market perceives a rate increase and the bond fund's NAV drops. That doesn't affect the holdings of the fund or the income it generates. Over time it will replace its lower yielding bonds with newer higher yielding bonds. That time frame is relative to the fund's duration.

dbr
Posts: 25371
Joined: Sun Mar 04, 2007 9:50 am

Re: What will happen to my bond interest payments?

Post by dbr » Mon Jul 11, 2016 2:58 pm

straws46 wrote:rymann554

You are right of course. My answer was based solely on what happens immediately when the market perceives a rate increase and the bond fund's NAV drops. That doesn't affect the holdings of the fund or the income it generates. Over time it will replace its lower yielding bonds with newer higher yielding bonds. That time frame is relative to the fund's duration.
And, of course, both the answers are right. The question is what is the OP's actual question. He is trying to plan a retirement on basis of taking as income the interest paid by a bond fund. In that case the plan is that he will get the prevailing interest rate delayed a bit, the delay being longer for longer duration funds. He is by definition not concerned with the NAV of his funds as the strategy is to never sell a bond but to only spend the interest.

The problem for the OP in this is that he does not know what future interest rates over the course of his retirement will be. That would not be a recipe for a very effective plan, one would think.

User avatar
Kevin M
Posts: 8972
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: What will happen to my bond interest payments?

Post by Kevin M » Mon Jul 11, 2016 3:08 pm

The bond fund dividends will stay about the same initially, since there would be no immediate changes in the interest payments of the underlying bonds. Then the dividends would gradually increase as bonds mature or are sold and new bonds are purchased at higher interest rates.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
saltycaper
Posts: 2553
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: What will happen to my bond interest payments?

Post by saltycaper » Wed Jul 13, 2016 1:55 am

straws46 wrote:
My answer was based solely on what happens immediately when the market perceives a rate increase and the bond fund's NAV drops. That doesn't affect the holdings of the fund or the income it generates.
Minor quibble (but I repeat myself): Couldn't the income be affected in the near term to the extent that capital gains distributions are affected?
Quod vitae sectabor iter?

User avatar
Kevin M
Posts: 8972
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: What will happen to my bond interest payments?

Post by Kevin M » Wed Jul 13, 2016 11:26 am

saltycaper wrote:
straws46 wrote: My answer was based solely on what happens immediately when the market perceives a rate increase and the bond fund's NAV drops. That doesn't affect the holdings of the fund or the income it generates.
Minor quibble (but I repeat myself): Couldn't the income be affected in the near term to the extent that capital gains distributions are affected?
OP asked about monthly income. Capital gain distributions are not part of monthly income, but are irregular and indeterminate distributions. Also, Vanguard includes capital gain distributions in the capital return portion of total return. Dividends comprise the income return portion. To see income return and capital return, see the "Price & Performance" -> "See cumulative, yearly, and quarterly historical returns" page, for example: Vanguard - Total Bond Market Index Fund Investor Shares - Historical Returns.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
saltycaper
Posts: 2553
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: What will happen to my bond interest payments?

Post by saltycaper » Wed Jul 13, 2016 11:42 am

Kevin M wrote:
saltycaper wrote:
straws46 wrote: My answer was based solely on what happens immediately when the market perceives a rate increase and the bond fund's NAV drops. That doesn't affect the holdings of the fund or the income it generates.
Minor quibble (but I repeat myself): Couldn't the income be affected in the near term to the extent that capital gains distributions are affected?
OP asked about monthly income. Capital gain distributions are not part of monthly income, but are irregular and indeterminate distributions. Also, Vanguard includes capital gain distributions in the capital return portion of total return. Dividends comprise the income return portion. To see income return and capital return, see the "Price & Performance" -> "See cumulative, yearly, and quarterly historical returns" page, for example: Vanguard - Total Bond Market Index Fund Investor Shares - Historical Returns.

Kevin
All things good to note, but the fact that Vanguard does not include capital gains in monthly income doesn't change the fact that it is included in cash received by the OP, and I think that's primarily what OP is concerned about. True though--not every month (or any month necessarily).
Quod vitae sectabor iter?

qwertyjazz
Posts: 1042
Joined: Tue Feb 23, 2016 4:24 am

Re: What will happen to my bond interest payments?

Post by qwertyjazz » Wed Jul 13, 2016 11:53 am

Do bond funds trade their bonds though or simply hold to maturity? This confuses me as if they speculate none of the previous analysis may necessarily be correct.

Thank you
QJ

User avatar
Kevin M
Posts: 8972
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: What will happen to my bond interest payments?

Post by Kevin M » Wed Jul 13, 2016 12:09 pm

qwertyjazz wrote:Do bond funds trade their bonds though or simply hold to maturity? This confuses me as if they speculate none of the previous analysis may necessarily be correct.

Thank you
QJ
Depends on the bond fund, but most bond funds are not going to hold many bonds with less than one year to maturity, since that gets into the zone of money-market funds (TBM has only 1.6% with <1 year to maturity). Having said that, there is quite a bit of turnover in typical bond funds, but even with this, dividend distributions are fairly stable. You can see this by looking at the distribution history of bond funds.

For example, dividend distribution for VG total bond has been very close to $0.02 per share for the last 18 months, with price variation from 10.64 to 11.10 per share: Vanguard - Total Bond Market Index Fund Investor Shares - Distributions.

Regarding capital gain distributions, note that these have been minimal for TBM over the last 18 months, with three distributions totaling about $0.01 (for all three, not each).

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
ogd
Posts: 4828
Joined: Thu Jun 14, 2012 11:43 pm

Re: What will happen to my bond interest payments?

Post by ogd » Wed Jul 13, 2016 12:16 pm

straws46 wrote:All above true. For a simple answer, your payments will stay the same, but the marketplace will say you are getting a higher yield because they calculate the yield based on the new NAV. Same payments divided by lower NAV equals higher yield.
When it comes to yield to maturity, i.e. how much your bonds are returning vs distributing, the increase is much more than that. The yield goes up primarily because bond values immediately start recovering from the drop at a rate equal to (market rate - coupon rate) per year.

So it's possible (and even a likely scenario) that the NAV drops by 10%, but the yield doubles.
jjface wrote:When the fund buys new bonds then the overall yield should increase as these new bonds will have higher yields. So it depends on when the fund buys new bonds which depends on the duration of the fund. I suppose also the amount of new deposits.

The drop in Nav is because new bonds will have higher yields so the old ones you hold paying less yield are worth less. So you do not get compensated for the lower NAV but you can take advantage of higher yields once the old bonds are redeemed at the end of their term.
You do get compensated because the bonds immediately start returning more, as above. You may not immediately get higher distributions, as you and others mentioned.

But to highlight how arbitrary the distinction is: the fund could in fact exchange all bonds immediately and get all of its yield through distributions. In liquid bonds, the trading loss should be negligible (and there is no other hit to subsequent returns, despite the apparent capital loss). The reason it doesn't do that is it because it would be a disadvantage to their taxable shareholders, who would much rather get capital (re)appreciation than higher distributions. The shareholders who want to withdraw more can always sell -- again, at no detriment to subsequent returns vs the higher-distribution alternative.

In municipal bonds, the tax advantage is reversed, but they are not as liquid and the tax advantage of higher coupons vs capital gains is priced into the bonds to some degree. So the funds are not keen to exchange the entire portfolio either.
qwertyjazz wrote:Do bond funds trade their bonds though or simply hold to maturity? This confuses me as if they speculate none of the previous analysis may necessarily be correct.
Most funds trade their bonds before maturity. This is not necessarily speculation -- the funds we like do this more or less robotically, because bonds age and are no longer suitable for the fund's mandate long before maturity. For example, I don't want my 7-10 Treasury fund to hold Treasuries below 7 years that I can almost beat in a savings account.

It does not affect the previous analysis -- distribution will get closer and closer to market yields (perhaps only faster than if held to maturity), while yield will shoot up there immediately.

User avatar
saltycaper
Posts: 2553
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: What will happen to my bond interest payments?

Post by saltycaper » Wed Jul 13, 2016 12:22 pm

Kevin M wrote:
Regarding capital gain distributions, note that these have been minimal for TBM over the last 18 months, with three distributions totaling about $0.01 (for all three, not each).
Yes. Pretty small for TBM. On the other hand, as an extreme example, about 25% of Vanguard Extended Duration Treasury fund's distributions in 2015 were due to capital gains.
Quod vitae sectabor iter?

jjface
Posts: 2482
Joined: Thu Mar 19, 2015 6:18 pm

Re: What will happen to my bond interest payments?

Post by jjface » Wed Jul 13, 2016 12:46 pm

ogd wrote: You do get compensated because the bonds immediately start returning more, as above. You may not immediately get higher distributions, as you and others mentioned.
Oh yes I see. Thanks for the distinction.

Post Reply