Does dollar cost averaging into a bond fund mitigate rising interest rate risk?

Question

Everyone says not to buy bonds now because interest rates will rise. I'm wondering how dollar cost averaging (and reinvesting returns) helps reduce the risk.

I'm not sure how bond funds work in general. If I invest X each month, where does X go - an existing (low yield) bond, or a new bond (at the current interest rate)? Does that just depend on what the fund manager is doing at the time (buying/selling)?

If I put Y into a fund, and leave it there for 50 years, where does Y go when all of the bonds at the time I made the purchase mature? Does Y just get reinvested in new bonds at the interest rate at that time?

JB King · Accepted Answer

If I invest X each month, where does X go - an existing (low yield)
  bond, or a new bond (at the current interest rate)?

This has to be viewed in a larger context.  If the fund has outflows greater than or equal to inflows then chances are there isn't any buying being done with your money as that cash is going to those selling their shares in the fund.  If though inflows are greater than outflows, there may be some new purchases or not.  Don't forget that the new purchase could be an existing bond as the fund has to maintain the duration of being a short-term, intermediate-term or long-term bond fund though there are some exceptions like convertibles or high yield where duration isn't likely a factor.

Does that just depend on what the fund manager is doing at the time
  (buying/selling)?

No, it depends on the shares being created or redeemed as well as the manager's discretion.

If I put Y into a fund, and leave it there for 50 years, where does Y
  go when all of the bonds at the time I made the purchase mature?

You're missing that the fund may buy and sell bonds at various times as for example a long-term bond fund may not have issues nearing maturity because of what part of the yield curve it is to mimic.

Does Y just get reinvested in new bonds at the interest rate at that time?

Y gets mixed with the other money in the fund that may increase or decrease in value over time.  This is part of the risk in a bond fund where NAV can fluctuate versus a money market mutual fund where the NAV is somewhat fixed at $1/share.

JTP - Apologise to Monica · Answer

You are asking multiple questions here, pieces of which may have been addressed in other questions.

A bond (I'm using US Government bonds in this example, and making the 'zero risk of default' assumption) will be priced based on today's interest rate. This is true whether it's a 10% bond with 10 years left (say rates were 10% on the 30 yr bond 20 years ago) a 2% bond with 10 years, or a new 3% 10 year bond.

The rate I use above is the 'coupon' rate, i.e. the amount the bond will pay each year in interest. What's the same for each bond is called the "Yield to Maturity." The price adjusts, by the market, so the return over the next ten years is the same.

A bond fund simply contains a mix of bonds, but in aggregate, has a yield as well as a duration, the time-and-interest-weighted maturity.

When rates rise, the bond fund will drop in value based on this factor (duration).

Does this begin to answer your question?

user106563 · Answer

Great question.. something I am trying to figure out as well.
The way I see it: (Disclaimer: Not financial advice. Use your own judgement to make decisions)

You can DCA Bond ETF same as you DCA Stock ETF. You will Average out the YTM over time.
Important to recognize that Bond Price is dependent on Interest Rate and Credit Quality. So unlike a Stock where a company's fundamentals can turn around / improve driving prices higher; there is no such turn around for Bonds unless the Feds Change monetary policy to change interest rates. So your price "loss" on the Bond ETF is "forever" (remember Bond ETF never matures so there is no redemption of your Principal)...unless down the road Feds drop interest rates  and Bond prices move higher. Volatility is a dual edge sword.. so while stocks may fall rapidly they rise rapidly too...bonds have low volatility and drop are not frequent and neither is the upside.
The current market sentiment seems to favor Risk On...and with the money supply full on, expectation is inflation may rise quicker than anticipated and accordingly Feds may raise interest sooner too...the lower bond prices possibly reflect that expectation.
Will this expectation come true..no one knows...hence there is a risk and return toss up. If you sell the Bond etf to buy stock etf...how do you know stock etf are not overvalued and may face a sell off..
So net net...it all depends on your goals and your plan and comfort level with the risk return.

Does dollar cost averaging into a bond fund mitigate rising interest rate risk?

3 Answers

Add your own answers!

Ask a Question