A few days ago I chatted with some financial planners. They were recommending some bond funds as alternatives to holding cash or money-market funds.
I admit that I haven't looked at bond funds too closely. I knew that there was an inverse relationship between the price of bonds and the interest rate: as rates go up, the bond price falls, and vice versa. What I hadn't considered was how the length of the term of the bond affected how much the price would swing under an interest rate change.
When they quoted the 52-week high/low swing of the bond fund they were recommending, I was surprised how narrow it was: something like only a 2% price swing over the entire year. This was for a bond funds consisting of funds with a maturity with one to five years. Another bond fund with a longer average term fluctuated a little bit more: something like 8%.
Why do shorter-term bond funds fluctuate more than longer-term bond funds?
The longer-term bond funds have a higher yield; this reflects the fact that the money is being tied up for a longer period of time. But with this higher bond fund yield comes more fluctuation in the price of the fund. Why?
The financial planner I talked to gave me a very simple example. Let's say I bought a single $10,000 bond that yields 2% annually. So, I'd expect $200/year interest from my bond.
Tomorrow, rates jump to 3%. The investor who buys tomorrow can expect $300/year in interest from the same $10,000 commitment.
Now, let's suppose I suddenly need the money and want to sell the bond tomorrow. My bond only pays 2%. The going market rate is 3%. So I'll have to discount the price of my bond to compete with the current bonds being sold.
How much I discount it depends on the term of the bond. If it's a two year bond I'm selling, then I'll need to compensate the new owner for two years' worth of the shortfall in interest earnings. The interest shortfall is $100/year. So (roughly speaking) I'll need to sell the bond to him for $9,800, or 2% less than what I bought it for, since he'll earn $600 in interest with a current market-rate bond, and only $400 with mine.
If, instead, it's a ten year bond, then I'll need to discount the bond price more. Now we're talking about $1,000 in lost interest, so I'll need to sell it for $9,000, or 10% less. This is a much larger fluctuation for the same interest rate change.
Anyway, this example made immediate sense to me; hope it helps you!
