I think I now have a very basic understanding of bond funds

[FoolishFilFive]

The experienced bond people should of course ignore this post; I'm graduating from bond fund primary school, they have already graduated from bond fund university.

I was pondering investing a modest lump sum in a bond etf. I looked at a very short maturity us treasury bills etf that was paying four percent. Then I looked at the vanguard total aggregate bond fund which paid two percent. How foolish of all the investors in that, thought I, why are they happy with a paltry two percent when a safe four percent is on offer?

But this didn't feel right. The vanguard fund is one of the biggest - surely all these investors can't be dim. They must be expecting some sort of capital gain.

It finally dawned on me ( as a way of understanding) to imagine that the vanguard fund had one Tesco bond in it that matured in a year, and the bond paid two percent. So the yield is two percent. But how much is the Tesco bond worth? It can't be worth more than the usual treasury bill. So it's probably worth about 95p. So in a years time, it'll have paid out two percent as yield and three percent as the capital gain, so total five percent. This must be the ytm, the yield to maturity.

So the two percent yield on the vanguard fund is of course misleading for those who think about bond funds in terms of bank accounts which pay interest - the ytm is actually the interesting measure.

Now I'm conscious that this is all a bit Noddy for the vast majority of people on here, but I thought I'd mention it in case anyone else had confused themselves in a similar way.

I know duration is a huge factor too, but that wasn't what became clear recently.

[Dicky99]

You'll also discover that some people on here with unsheltered cash to invest will seek out short duration low coupon bonds where the return is made primarily on the capital gain because coupons will be taxed as income whereas the the capital gain on government bonds is cgt free. So the lower the former and higher the latter the better.

[GoSeigen]

The experienced bond people should of course ignore this post; I'm graduating from bond fund primary school, they have already graduated from bond fund university.

I'm one of those people who try to do the opposite of what I'm told, LOL.

[...]
It finally dawned on me ( as a way of understanding) to imagine that the vanguard fund had one Tesco bond in it that matured in a year, and the bond paid two percent. So the yield is two percent. But how much is the Tesco bond worth? It can't be worth more than the usual treasury bill. So it's probably worth about 95p. So in a years time, it'll have paid out two percent as yield and three percent as the capital gain, so total five percent. This must be the ytm, the yield to maturity.

So the two percent yield on the vanguard fund is of course misleading for those who think about bond funds in terms of bank accounts which pay interest - the ytm is actually the interesting measure.
[...]

This is correct. Total return is the correct measure to base your decisions on: both the income and the change in capital value between purchase and disposal.

And guess what? Just as this is true of individual bonds and funds of bonds, it is also true for shares (individual and collective)!

EDIT: should add that it's important when reading the word yield to understand exactly what yield is being referred to -- it can have different meanings in different contexts and mixing them up could be an expensive mistake!


GS