Date: Sun, 2 Jan 2005 12:54:24 CST
From: "Elle Navorski" 
Newsgroups: misc.invest.financial-plan
Subject: Re: Long-Term Bond Mutual Fund(s) for Income
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"Elizabeth Richardson"  wrote
> "Elle Navorski"  wrote
> > 2.
> > By buying into this fund (VWESX) right now, I will have "locked in" a
rate
> > of return on my initial investment pretty much forever. That is, if I
put
> > $10,000 into VWESX on Monday, and if it's now yielding 5%, I'll make
$500
> > per year from this portion of my portfolio forever.
> >
>
> No. The dividend on a bond fund fluctuates in tandem with interest rates
for
> like securities. So, while logic says that interest will rise from here,
and
> if they do, your income will also rise, it is possible that interest
rates
> will fall, and your income will fall also.

I'm not sure we're quite on the same page here. I'd appreciate it if you
and others could keep reviewing new posts to this discussion and poke any
possible holes in my reasoning.

For the moment let's assume that:
a) Interest rates will only go up from whatever Monday's long-term,
investment grade rates are.

b) The current yield on a long term bond fund such as VWESX is 5%. Call
this C for current.

c) Interest rates rise 0.5% point a year for the next several years. Call
this R for rise.

d) the long term bond fund duration is 11 years.

The way I understand it, my income, in absolute dollars, after N years will
be

Yearly Income  = Original Principal*Bond Fund Yield*Reduction in NAV

Original Principal, $ = some constant = $10,000 here
Bond Fund Yield, % = C + NR
Reduction in NAV = 1 - Duration*R*N/100

With the assumptions above, C+NR increases more quickly than the reduction
in NAV. The result is that the yearly income, in absolute dollars, rises as
interest rates rise, even though the net asset value of the fund, and so
one's principal is declining.

For example, after 1, 2, and 3 years, the yearly incomes will be about:
$5200
$5300
$5400

The catch is that if I cash in my shares in the fund after three years, I
will get back only 83.5% of the principal, or about $8350 of the original
$10k.

To back up this contention of mine, I have four data points, representing
peaks and lows of net asset value (NAV), from about 1993 to the present for
the long term fund VWESX:

NAV        Fund Yield
9.76            5.89%
7.7              7.96%
9.76            5.79%
10.17          4.68%
7.89            8.45%

Moving from a NAV high to a NAV low always gives a higher income, in
absolute dollars.

I bear in mind that my original assumptions above may be wrong. I agree
that there are problems if, for example, long term interest rates go down.

Letting more years pass also changes the picture, but if you could check
the above for now and give me your thoughts, I'd appreciate it.

> I believe the only way you can
> "lock" in an interest rate on bonds is to buy the bonds directly, but
> someone else will surely address this.

Again, to try to get us on the same page (maybe we are; I'm just not sure
of it yet), I'm not talking about locking in interest rates. I'm talking
about whether one can lock in an absolute dollar figure of income via a
bond fund (what happens to principal be darned), particularly on the
assumption that interest rates are currently at record lows and can only go
up.

I appreciate your taking the time to mull this over.