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Understanding bonds: Borrowing from the future

At the end of each

quarter

, I look over the charts that describe the highest and lowest yielding assets of the prior quarter or year or whatever. Many investors do this, and it serves mainly to remind us of all the fantastic money we could have made if we had bought something other than what we owned.

No matter how good an investor you are, there is always some asset that provided greater returns than the ones you own. Such is life, and an important part of being a good investor involves shrugging off such reports and sticking to what we have planned.

A client brought to my attention one of these summary charts recently and pointed out some bond mutual funds that reported returns of more than 10 percent in 2006. While he was too polite to say so directly, the implication was that similar bond funds I had bought for his account were paying monthly interest dividends that equated to only about 5.25 percent.

Being a true believer in accountability, I have to take this question seriously and look at what was going on with these funds.

First, we must realize that the figures reported in the paper are the total returns of the bonds in that fund. Total returns are the sum of interest payments received, plus the change in market value of the bonds actually owned.

The bond fund in question owned bonds that paid an average interest rate of 5.25 percent. So, how is it that the fund reported a total return of 10 percent? Simple, the bonds went up in value from, say, 100 cents on the dollar, to 104.75 cents.

The 4.75 percent of price gain, when added to the 5.25 percent of interest received, produced the 10 percent total return reported in the newspaper.

This is simple enough, but there is a reason bonds are called fixed income investments. Bonds carry a fixed interest rate, or coupon. If a 10-year bond pays a 5.25 percent coupon, that means you will receive 5.25 percent per year until the bond matures. Period. Nothing more and, barring a default, nothing less.

If you put that bond - or a fund full of them - in your account and check back 10 years later, there is no possible way you will make more than 5.25 percent average annualized return on the investment.

So, how is it that the newspaper says that a fund full of those bonds paid 10 percent last year? Note that I mentioned above that the average annualized return is fixed in stone.

The word “average” is the key operative here. For every year that those bonds pay more than 5.25 percent due to a rise in value, they will pay less than 5.25 percent in the future.

Take our simple example above. The bonds rose in value to 104.75, from 100. However, they still pay 5.25 percent, or $5.25 per $100 face amount of bonds.

Since that face amount of bonds is worth $104.75 today, we aren’t really earning 5.25 percent. We need to divide the interest payment, or $5.25, by the value of the bond, or $104.75, to arrive at our true yield for the year 2007.

It turns out that the bond is now only paying us 5.01 percent. In exchange for a short-term bump in our year 2006 paper results, we will now earn less going forward.

In this light, we should now take a closer look at that portfolio of bonds that returned 10 percent last year. Do we buy it expecting to make 10 percent again?

Surely not, the bonds in the portfolio only pay 5.01 percent in interest, whereas last year they paid 5.25 percent. The mere fact that last year was a good year automatically means that we should expect less this year.

This outlook doesn’t involve any economic forecasting. It is simply the algebra behind bond payments and prices. In order for that fund to have another 10 percent year, the underlying 10-year bonds will have to rise in value another 4.99 percent.

Importantly, if that happens it only means that the bonds will yield even less in 2008 - 4.40 percent to be exact. The only way to continue to earn a higher return than the interest rate printed on the bond is for interest rates to continue to fall, forever.

There is no free lunch in the bond market. If your bonds bear a given rate of interest on the day you buy them, it is wholly nonsensical to expect to earn anything more than that number during the lifetime of those bonds.

Anything more you earn on paper today is merely borrowed from the future, and you will eventually pay it back through lower future returns.