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Declining Bond Price Impact at Maturity Versus Sold Today

A few weeks ago I responded to a comment for a reader on one of my bond posts regarding a fear of loss of bond principle when holding bond funds. As I responded to that comment I realized this might be a good topic to expound on as I know most people do not understand this particular topic. The loss of principle the reader was referring too was related to selling a bond before maturity. The topic for this post therefore is to speak to why Declining Bond Price impact on Bonds Held to Maturity Versus Bonds Sold is the same regardless of when you sell. It does not matter if it is to maturity or this moment.

How are Bonds Priced?

So lets start by talking for a moment about how are bonds are priced. So say I have a bond bought at face value (also known as par). This means I’ve bought the bond for what it will be worth at maturity. Now imagine that par bond, lets say it cost you 1000 dollars for a bond worth 1000 dollars at maturity. It has a coupon worth a 3% return. (An aside, you can learn more about coupons in this post.

Now imagine you have a second bond. All other conditions are equal: the economy is the same, the risk rating of the bond is the same, the issuer is the same, the calculability is the same, and even the duration of the bond is the same. Due to the efficient market theory, all other things being equal a 1000 dollar bond costing 900 dollars should have a lower coupon then the bond costing 1000 dollars. Why?

Why do Bond Prices Relate to Coupons?

In either case the 1000 dollars in face value returns 30 dollars a year in coupon. In either case when you are done with the bonds at maturity they are both worth 1000 dollars. So the 900 dollar bond would be worth both the coupon rate provided plus the discount on the bond. These two combined would be more to the investor then the 1000 dollar bond’s coupon alone. As such if it had the same coupon rate no one would buy the 1000 dollar bond. As such in order for the second bond to have the same coupon all other things equal it has to have the same price. Or to have the same price all other things equal it must have the same coupon.

Bond Prices in Relation to the Environment

Now that we understand the movement of the parameters in a steady state environment, lets go the other way. Imagine I have one bond worth 1000 dollars sold at par. It had a coupon of 3%. Now imagine inflation rose and inflation expectations increased. Suddenly you can buy a new bond at par under the same terms with a 4% coupon. The question becomes why would anyone ever buy your 3% coupon bond? Simply put they would only if you reduced the cost to make up for the lower coupon rate. To sell you would need to reduce the cost, or give a discount on the value of the bond. The discount provided would be equal to the present value of the difference in coupons between the two bonds. I.E. it would be tied to the value of making 4% instead of 3% each year of the bond. The bond’s price thus moves inverse to it’s yield. The price decreases when yields of the other bonds on the market, as visible by at par coupons, increases. The bond price increases when yields of the other bonds on the market, as visible by at par coupons, decrease.

Declining Bond Price impact on Bonds Held to Maturity Versus Bonds Sold

The implication of bond prices moving inverse to yields is that the price of the bond has essentially declined proportionately to the change in market yields. As such by definition your overall financial well being is the same whether you sell when the yield changes or hold until maturity. You are either paying for the reduction today based on the present value in the decline in price. Or you pay for the reduction later in the form of the future value of the decline in coupons. Da$ned if you do, Da$nd if you don’t.

A Caveat on Equality

The above theory assumes zero cost of trading a bond. In practice you have commissions added to bond price. You also have spreads. These costs of trading create a difference between what the bond is worth based on the above theory and what you can actually sell it for. These two items make actually selling early more costly then holding to maturity where you typically do not pay commissions or spreads. As such I rarely recommend selling an individual bond early.

The Caveat in Respect to Bond Funds

Here is where it gets interesting. The difference between you holding one bond and a bond fund holding millions significantly changes the impact of trading costs. Of course a bond fund will have to sell some bonds in order to make up for fund redemptions by fund holders. You get a choice on whether to sell. However, a bond fund can choose which bonds to sell to minimize the impact of trading costs. It also has market making power because of economies of sale. I.E. a bond fund does so much business in bonds that by it’s nature it can reduce spreads and commissions. Finally, because it constantly buys and sells it benefits from spreads often in the same ways it is harmed by spreads. They largely even out over time leaving commissions as the primary cost. Given how closely these bonds track their indexes and how low their expense ratios are, this theory largely holds.  Bond funds seem to be priced based on the price of their underlying holdings.  Trading costs appear to have minimal effect.

Conclusions

Based on the above there is no significant difference between bond funds and individual bonds from a rate change perspective. Both have the same disadvantages in relation to the duration of the underlying holdings.  This was my response to my reader during that bond fund discussion, however in a much more abbreviated way. Hopefully the details here give you more confidence in bond funds versus bonds in a rising rate environment. I believe the benefit of diversification of the bond funds to reduction in risk is worth it regardless of the rate environment. At very least you now understand the Declining Bond Price impact on Bonds Held to Maturity Versus Bonds Sold is the same.

8 Comments

  1. Mr. Need2save
    Mr. Need2save May 26, 2017

    I admit that I only have an elementary understanding of bonds. Your article confirmed some of my knowledge and I picked up a few new insights as well.

    I’m curious on your thoughts regarding bonds and the anticipated inflation that everyone keeps suggesting. Just stick with short term bonds? We don’t have a huge bond allocation, but we are starting to build it up a bit.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 26, 2017

      If I were building up a bond position today I’d go intermediate, something around the 3-5 year term. Because of inflation expectations combined with Qualitative easing the price of long term and short term bonds are depressed relative to their 3-5 year counterparts. You can see this by graphing out the available yield on various bonds and drawing a line between the 10 year and the 6 month based on 6 month intervals. You’ll see a premium in the 3-5 year above and beyond the slope of the curve. I personally would stick to something more liquid like a cd ladder in this time frame, so I can jump out of the holdings for minimal impact if inflation exceeds expectations. If inflation stays at 2% your fine, but I don’t have a crystal ball.

      • Mr. Need2save
        Mr. Need2save May 27, 2017

        Thanks for the insight, I’ll do some more research. And let me know if you find that crystal ball!

  2. Leo T. Ly
    Leo T. Ly May 26, 2017

    I am currently at an age where I can afford to take more risks and invest all my savings in either stocks or real estate. I understand the purpose of having a portion of bonds in my portfolio, but when the yield is so minuscule, I would rather put my money in blue chip stocks to earn more as I have a long investment horizon of at least 15 years.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 26, 2017

      To each their own. I hold only a small amount of bonds, as an emotional hedge against a market drop. Most of my bond allocation is actually my mortgage.

      But, sooner or later they will return to historic yields. My mortgage will also eventually be paid in full. At that point I will increase my bond holdings.

  3. Kevin @39months.com
    Kevin @39months.com May 26, 2017

    I think Bonds will become more “in vogue” in the years ahead as the interest rate rises. If bonds start returning their more historical levels (corporate bonds @7%, treasury at 6%) then folks wanting the follow the 4% rule will enjoy having a significant portion of their portfolio in “sure thing” bonds.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 26, 2017

      I totally agree. Eventually they will return to normal rates. At that point there will definitely be a lot more positives to investing in them.

  4. Mustard Seed Money
    Mustard Seed Money May 27, 2017

    Thanks for going in depth when it comes to bonds. I know that this is definitely one of my weak areas when it comes to finance.

    I also think that it’s interesting that Warren Buffett when he passes away, says that in his trust that 90% will go into a low cost Vanguard index fund and then 10% will go into short term government bonds.’

    So even the greatest investor thinks bonds should be part of the average persons portfolio.

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