Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.
Support MFO
Donate through PayPal
Bond Funds: How To Use Diversification To Minimize Risks
I am confused by this statement in the linked report: "There is a common misperception that holding a bond to maturity makes your portfolio immune to interest rate risk. The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon."
Seems to me that holding a bond to maturity does make your portfolio immune to interest rate risk. You will get the bond coupon and your principal back regardless of interest rate changes assuming the issuer does not default.
This article was a joy to read because it provided support to my reasoning as to the benefits for my investment sleve management system. Currently, within my income sleeve I hold six funds. They are GIFAX, LALDX, LBNDX, NEFZX, THIFX, TSIAX. With these holdings the sleeve is comprised of a bank loan fund, a couple short term bond funds, a couple multi sector income funds and a high yield fund. By combining these holdings within a sleeve they now fit toghter and come together as a team. And, if one of the team members falters then there are the others that can provide support and offer production to continue advance the sleeve.
As for what this is worth ... and, its posssible bnefits ... you decide for yourself.
I am confused by this statement in the linked report: "There is a common misperception that holding a bond to maturity makes your portfolio immune to interest rate risk. The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon."
Seems to me that holding a bond to maturity does make your portfolio immune to interest rate risk. You will get the bond coupon and your principal back regardless of interest rate changes assuming the issuer does not default.
I believe the author eluded to tax harvesting the potential losses from selling a bond prior to maturity and pooling these losses against any gains. Then using remaining proceeds from the sale of the bond would be used to buy a higher yielding bond.
Obviously this has to happen in taxable accounts.
Including an example and showing the math would have made this much clearer to the reader.
I am confused by this statement in the linked report: "There is a common misperception that holding a bond to maturity makes your portfolio immune to interest rate risk. The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon."
Seems to me that holding a bond to maturity does make your portfolio immune to interest rate risk. You will get the bond coupon and your principal back regardless of interest rate changes assuming the issuer does not default.
The author is referring to the total return of the bond. And implicit in the discussion is that the investor is going to be a long term owner of bonds. What the author said does not hold true if someone buys bonds today, interest rates rise tomorrow, and they sell their bonds at a loss of principal and the proceeds go into some other investment.
"The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon"
Scenario A: The bond is held to maturity, so there is no loss of principal. However, there is a "loss"......the person is getting less semi-annual interest than he would get from selling his bonds at a loss and buying the current bonds. He gets more semi-annual interest from the higher coupon current bonds. The trade-off: he took a loss of principal on the bonds he owned.
Scenario B: He sells his bonds at a capital loss, and immediately purchases the current higher coupon bonds. His loss of capital will eventually be made up for by the extra interest he is earning, since he now owns bonds with higher coupons.
Again, this only works for the long term owner of bonds, not the person who sells at a loss and puts the proceeds elsewhere.
The concept that the author presents works the same for individual bonds and bond funds......again, for the long term owner of bonds.....not for the person timing the bond market........not for the person who is changing his asset allocation % of bonds vs. stocks after rates change.
It may be even easier to explain (or, my mind may just work in strange ways).
Say you purchase a bond with the intent of holding it to maturity. (This is the only assumption I will make about you - it doesn't matter whether you are a long term holder. The hold to maturity assumption is necessary, else one cannot say that the original bond is "immune" to interest rate risk.)
Interest rates rise. Your intent has not changed; you intend to hold a bond that matures on a specific date. You can sell your bond at a loss, and purchase another one to replace the bond you owned. No change of grade or maturity date.
You'll get a higher yield on the replacement bond, that will exactly make up for the loss. How could it be otherwise? You could have purchased your own bond back at market price you just sold it for.
Tax treatment is another matter. When you sell the bond at a loss, you'll have a capital loss. But the higher interest that you earn on the replacement bond will be taxed as ordinary income. If you purchased your own bond back (at a discount), the "appreciation" back to par from the discounted price would be considered ordinary income by the IRS. Whether you buy back your own bond or a different replacement bond, from a tax perspective swapping bonds looks like a losing tactic.
(Note that even if you're talking about muni bonds, the "phantom interest" due to the "appreciation" of the bond due to market discount is considered taxable income.)
Edit: if you purchase your own bond back, you have a wash sale, the maturity price will be the same as the purchase price (assuming your original purchase was at par), and you'll just have received the same interest payments you would have gotten had you not sold and repurchased your bond. In short, swapping a bond for itself winds up having no net tax effect. But swapping a bond for an equivalent one does, for the worse.
Comments
"There is a common misperception that holding a bond to maturity makes your portfolio immune to interest rate risk. The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon."
Seems to me that holding a bond to maturity does make your portfolio immune to interest rate risk. You will get the bond coupon and your principal back regardless of interest rate changes assuming the issuer does not default.
This article was a joy to read because it provided support to my reasoning as to the benefits for my investment sleve management system. Currently, within my income sleeve I hold six funds. They are GIFAX, LALDX, LBNDX, NEFZX, THIFX, TSIAX. With these holdings the sleeve is comprised of a bank loan fund, a couple short term bond funds, a couple multi sector income funds and a high yield fund. By combining these holdings within a sleeve they now fit toghter and come together as a team. And, if one of the team members falters then there are the others that can provide support and offer production to continue advance the sleeve.
As for what this is worth ... and, its posssible bnefits ... you decide for yourself.
Obviously this has to happen in taxable accounts.
Including an example and showing the math would have made this much clearer to the reader.
And implicit in the discussion is that the investor is going to be a long term owner of bonds. What the author said does not hold true if someone buys bonds today, interest rates rise tomorrow, and they sell their bonds at a loss of principal and the proceeds go into some other investment.
"The reality is, when rates rise, the total expected return from a bond is identical, regardless of whether the bond is held to maturity or sold at a loss and replaced with a bond that pays a higher coupon"
Scenario A: The bond is held to maturity, so there is no loss of principal. However, there is a "loss"......the person is getting less semi-annual interest than he would get from selling his bonds at a loss and buying the current bonds. He gets more semi-annual interest from the higher coupon current bonds. The trade-off: he took a loss of principal on the bonds he owned.
Scenario B: He sells his bonds at a capital loss, and immediately purchases the current higher coupon bonds. His loss of capital will eventually be made up for by the extra interest he is earning, since he now owns bonds with higher coupons.
Again, this only works for the long term owner of bonds, not the person who sells at a loss and puts the proceeds elsewhere.
The concept that the author presents works the same for individual bonds and bond funds......again, for the long term owner of bonds.....not for the person timing the bond market........not for the person who is changing his asset allocation % of bonds vs. stocks after rates change.
Say you purchase a bond with the intent of holding it to maturity. (This is the only assumption I will make about you - it doesn't matter whether you are a long term holder. The hold to maturity assumption is necessary, else one cannot say that the original bond is "immune" to interest rate risk.)
Interest rates rise. Your intent has not changed; you intend to hold a bond that matures on a specific date. You can sell your bond at a loss, and purchase another one to replace the bond you owned. No change of grade or maturity date.
You'll get a higher yield on the replacement bond, that will exactly make up for the loss. How could it be otherwise? You could have purchased your own bond back at market price you just sold it for.
Tax treatment is another matter. When you sell the bond at a loss, you'll have a capital loss. But the higher interest that you earn on the replacement bond will be taxed as ordinary income. If you purchased your own bond back (at a discount), the "appreciation" back to par from the discounted price would be considered ordinary income by the IRS. Whether you buy back your own bond or a different replacement bond, from a tax perspective swapping bonds looks like a losing tactic.
(Note that even if you're talking about muni bonds, the "phantom interest" due to the "appreciation" of the bond due to market discount is considered taxable income.)
Edit: if you purchase your own bond back, you have a wash sale, the maturity price will be the same as the purchase price (assuming your original purchase was at par), and you'll just have received the same interest payments you would have gotten had you not sold and repurchased your bond. In short, swapping a bond for itself winds up having no net tax effect. But swapping a bond for an equivalent one does, for the worse.