Higher interest offsets lower bond fund value


"When interest rates rise," a Minnesota reader notes, "the net asset value [NAV] of my bond fund's shares will decline.

"But, won't the decline be offset by the higher interest that the fund pays?"

He has a point.

Bear it in mind if you own, or plan to buy, shares in bond funds -- especially funds that invest in long-term bonds -- and if you plan to reinvest dividends instead of taking them in cash.

Ever since the Consumer Price Index and interest rates began to tumble in 1981 -- when U.S. Treasury long bonds carried coupons of more than 14 percent -- every uptick in the CPI and rates caused investors to worry about declines in prices of bonds.

In recent weeks, as yields on the U.S. Treasury's new 30-year bonds fell below 6 percent and substantial further slippage seemed unlikely, investors were asking not only when interest rates would rise again but also how much different rates might go up.

The questions have spawned a range of forecasts that may have led you to think about selling long-term bond funds or just not buying them.

That's because interest rate risk -- the risk that bond and bond fund prices fall when interest rates rise -- is normally higher for long-term than for short-term securities.

But is selling or avoiding long-term fund shares appropriate?

That depends, in part, on whether you would reinvest dividends and on the point raised by the reader.

To understand this, some background may help.

If rates rise and you take dividends in cash, you can bet that your bond fund shares' value will fall while your income goes up. Under normal circumstances, the fall would be greatest for long-term bond fund shares; and their dividends should rise the least.

If your portfolio's value is important, your choice is clear: Go for short- and/or intermediate-term maturity funds.

On the other hand, if you invest in bond funds to diversify a growth-oriented portfolio and can afford to reinvest dividends, the decline in NAVs eventually would be offset by income compounding at higher rates.

The length of time until this offset occurs, said Ian A. MacKinnon, Vanguard senior vice president and head of its fixed-income group, is the weighted average duration of a bond fund. Thus, it applies across the board to short-intermediate-and long-term funds. To benefit from the offset, you need to choose funds whose durations equal your investment horizon.

"If you invest in a fund with a duration of, say, five years," Mr. MacKinnon says, "you'd have to want to be invested for five years."

What does duration mean?

Duration is an indicator of a bond's or a bond fund's sensitivity to interest rate risk.

It is more meaningful than maturity because it reflects the timing and magnitudes of all payments to a bondholder -- interest and principal -- not just the repayment of principal alone.

The longer the duration, the greater the interest rate risk (or the potential for appreciation when rates decline).

For zero coupon bonds, durations are the same as maturities. That's simply because they pay no interest.

But for ordinary coupon bonds, durations are shorter than maturities.

How much shorter depends in part on their coupon rates. Other things being equal, higher coupons mean shorter durations.

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