Bond Fund Interest

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Topic Author
Chip Shot
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Bond Fund Interest

Post by Chip Shot »

At the risk of sounding foolish..
I so struggle with understanding bond funds. So quarterly interest was just paid on my bond funds, yet the NAV of the funds dropped the same value. The net increase is always zero. Yes, I have more shares but at a lower NAV. It seems to me that the only way to make money is by potential NAV increases. Interest payments seem to be a wash. I always hear that increased yields will make up for the drop in value of bond funds due to rising interest rates, but if the yield is always zeroed out by a drop in the NAV, how do the yields make up for anything? I have to be missing something.
z3r0c00l
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Re: Bond Fund Interest

Post by z3r0c00l »

No, you really are making money. The NAV before the dividend included the expected dividend. The catch is you have to hold the bond fund for a while to get paid, you can't just buy it the day before, take the dividend, then sell. Imagine a balloon that swells a bit then releases a bit at the end of the month. Over long spans of time most of your return (ignoring individual bonds and long term bond funds) is most likely going to be on dividends. The SEC yield is a good estimate of what you should expect to make over the duration of the fund.
Last edited by z3r0c00l on Mon Oct 03, 2022 6:40 am, edited 2 times in total.
70% Global Stocks / 30% Bonds
MrJedi
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Re: Bond Fund Interest

Post by MrJedi »

The NAV has likely been impacted by rising interest rates.
dbr
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Re: Bond Fund Interest

Post by dbr »

A rational measure of investment performance is return. For a bond fund return includes interest paid but there is also volatility in the NAV in response to interest rate changes.* A good article is here: https://corporatefinanceinstitute.com/r ... tment-roi/ The dimensions of return are value per value per time and conventional units are dollars per dollar per year.

In Porfolio Visualizer you could enter VBMFX, for example, and see that from 1987 to now there is a CAGR** of 5%. You can select a table of annual returns that varies from a high of +18% to a low of -15%. The 4% standard deviation of annual returns gives a measure of the volatility. A really interesting thing in the graph you can see is how much the fund gained in 2018-2021 before losing so much in 2022. It is true the 2022 downturn is extreme and rare due to the extreme and rare rise in interest rates.

*In general when interest rate changes drive a bond fund up or down there is a following period when the value recovers, down or up, if interest rates stop changing. In reality interest rates are always changing and that adds to and subtracts from value. The math is discussed here: https://en.wikipedia.org/wiki/Bond_duration

**CAGR compound annual growth rate defined here: https://www.investopedia.com/terms/c/cagr.asp

Return is a concept that is most helpful in generally characterizing investment performance. It is both a sufficient and a necessary parameter to use to see the whole picture. One thing encompassed in this is making the step from understanding things like savings accounts to understanding the more complicated behavior of marketable assets such as stocks and bonds where the principal can vary in value as well as the interest or the dividend.
alex_686
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Re: Bond Fund Interest

Post by alex_686 »

I used to work in mutual fund accounting.

The sole purpose of dividends is to generate “reportable transactions” so you can fill out your income tax forms.

There is no other reason. It has zero economic impact. It is just a set of journal entries. It has zero performance impact, other than to make performance calculations harder.

If we had our preference, we fund accountants would rather have the fund’s NAV continuously increase via reinvested bond coupons. So much simpler.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
dbr
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Re: Bond Fund Interest

Post by dbr »

alex_686 wrote: Mon Oct 03, 2022 8:54 am I used to work in mutual fund accounting.

The sole purpose of dividends is to generate “reportable transactions” so you can fill out your income tax forms.

There is no other reason. It has zero economic impact. It is just a set of journal entries. It has zero performance impact, other than to make performance calculations harder.

If we had our preference, we fund accountants would rather have the fund’s NAV continuously increase via reinvested bond coupons. So much simpler.
It is tricky when a "share" is not a "share." And separating out a dividend, as you say for no impact on performance, confuses many people.
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retired@50
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Re: Bond Fund Interest

Post by retired@50 »

Chip Shot wrote: Mon Oct 03, 2022 6:33 am At the risk of sounding foolish..
I so struggle with understanding bond funds...
...
It seems to me that the only way to make money is by potential NAV increases... <- This isn't true.
See Section 3 - Sources of Return in the Boglehead wiki page on bonds.

Regards,
If liberty means anything at all it means the right to tell people what they do not want to hear. -George Orwell
dbr
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Re: Bond Fund Interest

Post by dbr »

retired@50 wrote: Mon Oct 03, 2022 9:51 am
Chip Shot wrote: Mon Oct 03, 2022 6:33 am At the risk of sounding foolish..
I so struggle with understanding bond funds...
...
It seems to me that the only way to make money is by potential NAV increases... <- This isn't true.
See Section 3 - Sources of Return in the Boglehead wiki page on bonds.

Regards,
Yes, to relate that back to the concept of return, return includes the interest and the assumed process is compound growth of return in period after period. If the interest paid is spent, then that is a withdrawal.

That is why the growth formula is finalvalue = initialvalue*(1+r1)*(1+r2)* . . . *(1+rn) where ri is the return in period i. The CAGR is then the value of r that if substituted for all the ri gives the same final value, that being one definition of what an average is with respect to a function of all the data points.
Topic Author
Chip Shot
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Re: Bond Fund Interest

Post by Chip Shot »

I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If I earn 2% interest on a $100 investment in a bank account, I now have $102
If I earn 2% interest on a $100 investment in a bond fund, the NAV drops 2% and I have $100.... This is the part that I am struggling with
dbr
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Re: Bond Fund Interest

Post by dbr »

Chip Shot wrote: Mon Oct 03, 2022 10:41 am I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If I earn 2% interest on a $100 investment in a bank account, I now have $102
If I earn 2% interest on a $100 investment in a bond fund, the NAV drops 2% and I have $100.... This is the part that I am struggling with
Actually you can earn 2% interest and the NAV drops 10%, or 5%, or doesn't drop, or goes up 3%, or goes up 10%. Put your fund in Portfolio Visualizer and look at the annual returns over a period of time. It would be helpful to make more comments to know what this fund is.

Another poster referred you to this https://www.bogleheads.org/wiki/Bond_ba ... _of_return which you need to read along with the rest of the Wiki on bonds, and also this part: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration
Scorpion Stare
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Re: Bond Fund Interest

Post by Scorpion Stare »

Chip Shot wrote: Mon Oct 03, 2022 10:41 am I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If you could set aside rate fluctuations (for example, if yields were perfectly unchanging for some period of time), you would see the NAV gradually increase as you get close to the dividend payment date, then drop when the dividend gets paid out, and then start slowly increasing again until the next payout. Your total value is increasing, but doing it steadily every day instead of suddenly once per month or once per quarter.

(Of course, in the real world where interest rates are volatile, it's hard to see this effect because of the additional day-to-day changes in NAV due to market fluctuations.)
dbr
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Re: Bond Fund Interest

Post by dbr »

Scorpion Stare wrote: Mon Oct 03, 2022 10:48 am
Chip Shot wrote: Mon Oct 03, 2022 10:41 am I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If you could set aside rate fluctuations (for example, if interest rates were perfectly unchanging for some period of time), you would see the NAV gradually increase as you get close to the dividend payment date, then drop when the dividend gets paid out, and then start slowly increasing again until the next payout. Your total value is increasing, but doing it steadily every day instead of suddenly once per month or once per quarter.

(Of course, in the real world where interest rates are volatile, it's hard to see this effect because of the additional day-to-day changes in NAV due to market fluctuations.)
Right. And then if one tracks the total value of the position including new shares bought by dividend reinvestment, one would have a steady rise on an exponential curve with the interest rate being the rate constant (it has dimension of inverse time). That is why neither the value of a share nor the number of shares alone describes the investment but rather one has to tally up the value. If one does not reinvest the dividends then the value over time is pushed down. That is also fine, but one has to do the right math to follow the result.
toddthebod
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Re: Bond Fund Interest

Post by toddthebod »

Chip Shot wrote: Mon Oct 03, 2022 10:41 am I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If I earn 2% interest on a $100 investment in a bank account, I now have $102
If I earn 2% interest on a $100 investment in a bond fund, the NAV drops 2% and I have $100.... This is the part that I am struggling with
You can't look at the day before the dividend and the day after. You have to track the NAV over a longer period, and that gets complicated by the fact that as interest rates have increased, the NAV has dropped because the bonds your fund holds are now worth less. In the long run, the NAV of your bond fund should be relatively constant, as all bonds' values return to face value as the bond approaches maturity.

To use your example, assuming yields remain relatively constant, what you should see is your NAV increasing by 2% over the course of the year, then 2% getting paid out as interest and the NAV dropping back to where it started.
alex_686
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Re: Bond Fund Interest

Post by alex_686 »

Chip Shot wrote: Mon Oct 03, 2022 10:41 am I understand the NAV moving around based upon current interest rate environment, but I assumed that the coupon payment would always be a net plus.
If I earn 2% interest on a $100 investment in a bank account, I now have $102
If I earn 2% interest on a $100 investment in a bond fund, the NAV drops 2% and I have $100.... This is the part that I am struggling with
And it is.

Mutual funds run on accrual accounting. Each day a bond earns a bit of the coupon. That income is treated as a asset. This increases the NAV. This is what you are referencing.

At least once a year - but quarterly, monthly, or daily are options - this income is recognized for tax purposes. A ledge movement transfers income as a dividend to the asset position. This non-economic event is the one confusing you.

Remember, if you are trying to use mutual fund dividends for anything other than tax recognition you are doing something wrong. A natural impulse, but wrong.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
dbr
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Re: Bond Fund Interest

Post by dbr »

alex_686 wrote: Mon Oct 03, 2022 11:15 am
Remember, if you are trying to use mutual fund dividends for anything other than tax recognition you are doing something wrong. A natural impulse, but wrong.
Which comes to the point of what it might mean to say a fund "generates" income in any but a tax sense.
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