Basically, long term treasuries issued at 4 % are
19 percent more valuable than long term treasuries issued at 3%.
This is why your LT Bond fund has done so well...your bond fund price probably appreciated 19 percent as well as you are receiving a 4% interest payment periodically. You are benefiting from the frighten public who are willing to pay 19% more for your collection of higher priced bonds verses what they are willing to pay for the lower priced LT bonds now being issued by the Fed. Moving from 3% to 2% would be a huge
22 percent increase in the value of the 3% LT treasuries and would make a 4% bond
44 percent more valuable.
Calculator Source:
bond-value-calculatorIn a diversified portfolio, your LT treasuries help cushion equities because they often move in the opposite direction to each other. Take a look at VTSMX (Total Stock Market) and EDV (Extended Duration Bonds)...they are almost a mirror image of one another.
If you owned both and rebalanced periodically you would be achieving what some allocation (conservative, moderate, balanced) fund managers try to achieve. How much you own of each kinda determines your risk/reward. In this environment I am not sure these rules still apply. In the future, as rates reverse higher, laddering individual bonds will make more sense and bond funds will suffer price depreciation.
Here's an interview you might like on the topic:
wealthtrackextra.com/full-episode-archive/2012/8/3/robert-kessler.html
Comments
With respect to bonds, I've always thought of the similarity to a long-term mortgage on a house. Lets say that a mortgage holder desires to sell the mortgage to a different party. If you were the mortgage buyer, would you rather buy someone's promise (mortgage) to pay 3% for 30 years or 6% for 30 years? Well if it's an income stream that you're looking for, of course you'd want the 6%. But the sellers aren't stupid- and neither are other potential buyers who are competing with you: you are going to have to pay a premium for that 6%, right? So if the current mortgage market rate has gone down, older mortgages are worth more to a buyer.
What if the current mortgage market rate goes up? Well, why would a mortgage purchaser want an older 3% mortgage when you can buy a new one that pays more? So the "resale value" of the older mortgages goes down.
If you've watch the Kessler video, you'll note that he does not see the current rate structure as going up- just the opposite. Is he correct? Not sure, but I think so.
Another consideration is the fact that if a purchaser buys a single mortgage, or a single bond, with the intention of holding it to maturity, there are fewer unknowns: at least you will get back the full amount of your investment at a particular point in time, plus interest along the way. (For simplicity, ignoring the possibilities that the bond may be called early, the mortgage may be paid off early, the bond issuer may go broke, or the mortgage may go into default,)
This situation is fairly easy to see if we talk about the current value, or speculate about the possible future value, of a single mortgage, or bond. It gets really messy with respect to bond funds though, because the valuation of any particular bond fund will of course depend upon the total value of their bond holdings, which may be (and probably are) comprised of many different bonds from many different issuers paying many different rates and due at many different times. This is exactly why some funds try to compartmentalize their bond holdings with respect to who issued them, and the terms: very short, short, medium, or long. Other funds may have an eclectic mix which makes sense to them. This means that you have to be very careful in your selection of a particular bond fund... and this is exactly why there are so many worries about the large numbers of people who are currently moving into bond funds- do they really understand what they are buying?
Both fixed mortgages and US government bonds are, essentially, loans at a specific rate with a promise to repay at a specific time, and secured by either property or "the full faith and credit" of the US government, and generally they will react the same way to changes in markets over time. This underscores the importance of the Fed promise to maintain the current low rates out until, what is it now, 2015? If you buy a new issue now (2 year or less), you have the full faith and credit of Mr. Bernanke that you won't take a major hit before then. Maybe. If inflation stays down. Which it may. Or may not. A lot of "ifs and mays" there...
As far as longer-term (more than 2 year) issues go, "fools rush in" seems appropriate.
The above remarks are from the perspective of an individual investor, and not from that of a professional bond trader. Hope this helps a little.
P.S. I just tried to watch your video link, but it crashed my computer... I have to get this problem fixed!
Derf