From: pearson_steven@tandem.com (Steven R. Pearson)
Subject: Re: re: "Coupon Rates" vs "Market Rates"
Organization: Tandem Computers Inc.,  Cupertino, CA
Date: Tue, 10 Nov 1992 19:49:32 GMT

In article <g8n1n!_@rpi.edu>, floydb@rpi.edu writes:
> 
> [...]
>
> From my previous posting, I guessed that as new bonds come out with
> higher coupon rates existing bonds with lower coupon rates will have
> to be discounted (e.g. from 100% to maybe 95% of face value) in order to
> competitively increase their effective yield (e.g. from 5% to 
> 5%/.95=6.1%). 

Or, the new bonds will be issued at a premium price (i.e. they will cost
more than face value).  It is a technicality, but your assumption that
coupon rates will rise in the future does not explicitly require that
general market interest rates will rise.  Coupon rates tend to follow
current market interest rates, but are not required to.  Any difference
between them is made up for by premium or discount bond pricing.
This can apply to newly issued bonds as well as existing bonds.

> Would the net asset value of a bond mutual fund decrease if the fund
> retained its existing portfolio and didn't hedge or buy new bonds?
> In practice, does hedging and turnover of portfolio sufficiently limit
> reduction of NAV?

Generally, the NAV will fall in the face of rising market interest rates.
Funds can play various games in an attempt to overcome this if they
forecast it properly (sell bonds to raise cash in anticipation, hedge using
options, cutting the dividend).  Note that a fund will definitely buy new bonds,
as they are more or less constantly turning over their portfolios.  Most funds
keep their average maturity in a certain range as specified by their investment
objectives.  To do this, aging bonds must be sold and different bonds of
the appropriate maturity purchased.

There are a couple exceptions.  Some funds target maturity dates instead of
average maturity.  The Benham Target Maturities funds are a "famous" example.
In this case, there may be no need to turn over the portfolio because of
shortening maturities.  When the securities in the fund mature, the fund will
either dissolve or reorganize itself.  The other exceptions are the very short term
funds. A short term bond fund or money market fund may decide to hold a bond
to maturity.  It may be able to do this without disrupting the fund's average
maturity.  However, such funds may need to buy or sell securities in any case
to handle inflows/outflows of money.

Note also that simply "buying new bonds" will not prevent a drop in NAV.
To the extent that a fund holds bonds at the time the market interest
rate changes, it will experience a NAV loss that can not be made up by
turning over the portfolio.  For example, if the NAV falls from $10 to $9
on a rise in interest rates, the fund still only has $9 per share to invest if
it were to convert to all "new" bonds.  Either way, the new yield is in line
with the market yield, and the existing shareholders have taken their lumps.

A fund could in theory sell all its bonds just prior to a rise in rates, and then
buy back after the rise (old bonds or new, it wouldn't matter which).  However,
in practice nobody has such a good crystal ball.  Also, interest rates do not rise
or fall instantaneously but are constantly in flux.  Further, most funds investment
objectives specify a maximum amount of cash holdings.  And, a big bond fund
selling all its wares might influence the market in and of itself.  Thus, such a
thing is in many ways prevented in reality.

> What is the experience of those who have invested in bond funds during
> the past two or more years? What has the net asset value done and how
> have the monthly dividends been effected? This past 12 months has seen
> ever decreasing coupon rates as the Fed-Funds Rate has declined from
> around 6% to 3%. 

Yes, recent history has been good for bond holders.  Total returns for bonds
have been propped up by capital gains.  (Note it is not relevant to compare fund
NAV's over long periods of time because they are affected not only by the
value of underlying holdings, but by the "re-valuations" that occur each time
the fund makes a distribution).

> If one is to buy and hold an investment in a bond mutual fund, is the
> NAV all that important? It would be nice to buy at a historic low NAV
> in order to increase the chance of realizing a capital gain, in addition
> to income.

A bond fund may always be near its historic low NAV.  Total return is more
interesting, for the reason I mentioned above.  As for bonds in general, now things
are much closer to a historic low YIELD (aka historically high price) as opposed to
a historically low price.

-steve p.  (opinions mine, no warranty, standard disclaimers)
Newsgroups: misc.invest