Be Careful of the Bond Trap

When Coupon Is Greater Than Yield…

…that means prices are above par. Look at this chart on Treasury Bonds from this morning (10/7/2019)…

What can you extrapolate from this?  

Notice the price is $104.91 but the par value of this bond is $100.  Thus this bond is trading at a 4.91% premium. Believe it or not, this is INCREDIBLY important as you look at your own investments.

Vanguard Long Term Treasury Fund (VUSTX)

Now look at this from Yahoo Finance about the Vanguard Long Term Treasury Fund.

Notice the Year To Date Return is a whopping 19.43%!  That is insane because this is a bond fund and bond funds aren’t supposed to give you those huge returns, right?  Notice too the yield right now is a measly 2.44%.

Duration Risk

Finally, look at this…

Average maturity on that Vanguard Bond Fund is 24.2 years.  Duration is 17.41. Pretty easy to understand maturity, which is when you get your money back.  Duration, though, is a mathematical concept that says how much the fund will DROP in price if interest rates INCREASE by 1%.  

So, quiz for you. Interest rates increase by 2%.  How much will this fund drop?

If you said around 35%, you win the Interwebs for the day. 

Allright, but enough of that, what do these three charts have to do with anything?

HUGE PREMIUMS IN BONDS

The first chart showed you the PREMIUM that long term bonds are selling for now over par value. If you want to buy a 30 year U.S. Government Treasury bond you’d pay $104.91 for a bond that will mature at $100.  

Thus you are guaranteeing you’re going to have a capital loss on that bond.  You pay $104.91 in order to get $100 back which equates to losing .15% a year in price per share. Why would anyone do that? 

Well because that investor is getting a coupon of 2.25%.   So, while he is losing .15% a year on price per share, he is getting 2.25%, guaranteed mind you, in interest each year.  

Take the 2.25% he’s receiving subtract the .15% he’s losing and VOILA! his yield is around 2%.  There is NO WAY this investor will make MORE or make LESS than 2% if he holds this bond for 30 years.  It’s a mathematical impossibility, unless the bonds go bankrupt, of course. 

Par Value, Coupon and Maturity

The bond is issued at $100 with a coupon of 2.25%.  It will mature at…$100, 30 years from now. And, all the while, it will pay whoever owns it 2.25% each and every year. Government bonds are literally the simplest thing there is in the investment realm. 

“But Josh, I’m making over 19% in my Vanguard Government Bond Fund this year, so you’re wrong!!!”

I hear this a million times to Sunday, actually, and it stresses me out. The laws of bonds do not go away simply because you have a bond mutual fund.  Vanguard happens to own thousands of bonds in its portfolio. But EACH of those bonds are still dealing with the same rules: Bond A is issued at $100 with a Coupon of X%. Bond matures at $100 after paying that coupon each and every year.  Nothing else matters. 

Just because Vanguard owns thousands of bonds in the portfolio doesn’t allow them to escape the mathematics of how a bond works. When I see a bond fund up 19% in a few months time, like we’re seeing now, the only thing I see is a serious drop in interest rates that have happened, which TEMPORARILY inflates the price… but rest assured, my friends, that inflated price WILL go back down.  It’s inevitable. 

Inevitability of Bonds

 You will lose a good portion of that 19% over the course of your holding this fund. There simply is no getting around this.  The reason your fund is up so much is because they have some bonds in their portfolio that have MUCH higher coupons than the current 2.25%. So there are investors who will bid up the current price in order to capture that higher coupon. 

A bond issued in 2015 with a 4% coupon that’s trading at a hefty premium today will still mature at par value and as such that premium will just disappear over time. 

You could sell the fund now and take your 19% gains.  But what are you going to do with it? If you stay in bonds, you’ll be buying a 30 year Treasury that yields right around 2% right now. You’re still in the same predicament/ getting around 2% yields. 

 

UK BONDS

Look at this:

These are UK bonds.  I highlighted the 30 year.  Notice it has a coupon of 1.75% but if you were to buy it today you’d only get a yield of .95%.  Why is that?

Because the price you are paying is 20% above PAR!!!  And that in a nutshell is what you’re seeing in the bond mutual funds, such as the Vanguard Fund referenced above.  There are some bonds that have HUGE premiums because their coupon is so much higher than market averages. 

Matters not though. As this 30 year bond gets closer to maturity that price will drop, back to its issue/par value of $100 and the yield will go up back to its issue/coupon of 1.75%.   

Watch the Bond Trap

Please don’t get suckered into the Bond trap based on short term performance.  It’s all fleeting. Bonds provide you just two things, a bit of stability in your portfolio and a yield that can provide you a bit of return net of taxes and inflation. 

If you think it’ll do more than that, you’re greatly mistaken. 

© Copyright 2018 Heritage Wealth Planning