Explaining personal finance can be pretty dull, but it’s a subject we all need to continually learn about. I’m trying to fix the problem by using a quirky (funny?) story to explain personal finance. In this story, two friends how bond mutual funds work.
The stories are written in chapter order, so that there is a logical flow for the reader. Enjoy!
Having an auto mechanic you trust is really important, Greg thought. More important than a good internist? Maybe so.
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Winger’s, Greg repair shop, was on a busy corner in the neighborhood. It was 7 in morning, and lots of dog walkers were out. As he parked in a spot, he noticed a dog walker heading for a low ledge that ran around Winger’s office. His dog hopped up a grabbed a dog treat. Greg walked over to the office door and noticed that the ledge had dog treats set out- great marketing idea.
He glanced through the marketing information for his 401(k) plan while he waiting for the shop to open. His friend Tony helped him understand how to allocate assets between stocks and bonds to achieve an asset mix. He had decided on a 50/50 mix of stock and bonds, and he’d selected Growth Fund of America as a stock fund. Now, he was looking a bond funds.
Greg heard a bark right outside of his window. There was a dog standoff in front of the ledge- looks like two dogs wanted the same treat….
He looked back at marketing stuff. OK, so a corporation issues a bond at a stated interest rate, and the firm pays that interest semi-annually to the investor. He pulled out his notes from the last conversation with Tony. Say IBM issues a $1,000 6%, 10-year corporate bond. The corporation pays $30 twice a year to the bondholder ($60 total), then repays the investor the $1,000 investment in 10 years. Makes sense.
He glanced up and noticed that the garage bay doors were opening for the day, so he headed into the office. Winger’s was a great shop, because they were able to “triage” any repairs on your car. They could fix the urgent ones- like a repair to get through inspection- but hold off on more expensive repairs, if you wanted. Honesty….
Tony called, and the two of them talked about bond funds. “Well, there’s another variable with a bond mutual fund”, Tony explained. “These fund aren’t just buying and holding all of the corporate bonds until maturity. They also buy and sell the bonds- for various reasons.”
“Oh- I didn’t realize that”, Greg said. “I’m getting an old change and a tune up at Wingers- you should see the size of the fish they have mounted on the wall- it’s the size of a twin bed….wow”.
Tony laughed. “Ha- yeah those guys are serious about fishing. Anyway, bonds are traded on exchanges just like stocks. And the price of a bond moves in the opposite direction of interest rates. Grab a pen- I’ll explain it.”
“Isn’t it like refinancing a house?” Greg thought. “If you have a 5% mortgage and rates go down, you can refinance at a lower rate- is it sorta like that?”
“Yeah- along the same lines. Think about that IBM $1,000 6%, 10-year corporate bond. If interest rates go up, investors will demand more than 6% for a 10-year bond of the same quality. So, the price of IBM’s 6% bond will decline. Maybe 10-year bonds of the same credit rating are paying 7%, and the IBM 6% bond price declines to $960. The investor still gets back $1,000 at maturity, so they make a $40 profit, along with the interest. The $40 discount entices them to buy the bond with the lower interest rate.”
As Greg jotted some notes, he noticed a new fish mounted above the door- these guys just don’t quit…..
Tony went on: “Now, think about when interest rate go down- the refinancing example. If IBM has a 6% 10-year bond outstanding and rates decline, they’d love to pay off the 6% bond and issue new debt at a lower rate. In some cases, they can do just that buy calling the bonds and paying investors off early. That’s a story for another day.”
Greg leaned back and stretched. “So, what you’re saying is that the bond fund manager may buy and sell the bonds to generate some gains- over and above the interest income- right?”
“That’s it- and that affects your return on the bond fund. We’ll dig into one of those bond funds, and you’ll see the impact of the bond trading. Hey- I gotta run, Greg. Call me later- and keep an eye on those fish.”
As always, this information is for educational purposes only. Consult a CPA or a financial advisor for more information.
Action step to consider:
Make sure that you understand the types of bonds in your bond mutual fund.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
(you tube channel) kenboydstl
Maciej Lewandowski, Vintage Cars, (CC By SA-2.0)