# Bonds and Interest Rates

There is a lot of stuff on the internet that deals with understanding bonds…many of them are either too technical OR too simple. How do I know this? I know because reading just one leads to a lot of unanswered questions and doubts. So, I decided to see if I can simplify them to a level where one can understand with just a single read. This level of over simplification will put me on top of the murder list for most financial experts, but please bear with me and let me know if I am egregiously wrong in any of the simplifications and I will correct them.

That said, it is time to learn some bond terminologies.

### Bond Terminologies

Let us discuss a few of the terms you will find in almost all articles on bonds in the internet.

Types of bonds (lowest risk and hence lowest reward first)

• Treasury bills or T-bills
• Government bonds
• Corporate bonds
• High Yield bonds
• Emerging market bonds

Bond Parameters

• Purchase price
• Price paid to buy the bond ðŸ™‚
• Coupon or Interest
• The periodic (yearly, half yearly, etc) interest payments paid to the bond holder
• Yield
• A fancy term used to describe the return provided by a fixed income investment like a bond
• Yield = Coupon(Interest) / Purchase price of the bond
• Maturity
• After what time period will the bond principal be returned back to the investor (me).
• When I buy a bond, I am loaning the bond purchase price amount to somebody (us govt, municipality, company)
• For the duration of the maturity period (say 10 year bond), I get periodic coupon/interest payments.
• At the maturity date, I get money I loaned out back.

Example:

• Lets say that purchase price of bond X is \$1000.
• TheÂ  guaranteed Coupon or Interest is say \$60 per year
• The yield will then be \$60/\$1000 = 6%
• Bond X has a yield of 6% earning \$60 interest/coupon per year.

Bond Rating

We talked about Bond X in the previous example. We said that the guaranteed coupon/interest is \$20 per year. The only exception to the guarantee is if the bond issuer defaults on the payment. For example, some bond issuers in Detroit have defaulted on the bond interest payments and declared bankruptcy. To gauge the credit worthiness of a bond, there are some rating agencies (big ones are Standard and Poor’s, Moody’s, Fitch ratings)Â  that classify different bonds into the following rating bands:

• AAA: Prime
• AÂ Â Â  : Upper medium Grade
• BAÂ  : Non-investment grade speculative
• BÂ Â Â  : Highly speculative
• CAA: Substantial risks/Extremely speculative
• CAÂ  : Default imminent with little prospect of recovery
• CÂ Â Â  : In Default
• DÂ Â Â  : In Default

Obviously, AAA is the best and D is the worst in the scale above.

### Interest rates increases and effects on Bonds

Many many articles on the net talk about this statement “Interest rates and bond prices have an inverse relationship. When interest rates fall, bond prices usually rise and when interest rates rise, bond prices usually fall.”. What the hell does this mean? Let us take some examples and see what it means to a non-financial person.

Let us take the story of two bonds: Bond X and Bond Y.

Bond X

• AAA rated, 6% yield, purchase price=\$1000, 10 yr maturity
• yield = coupon/purchase price => coupon/interest = yield * purchase price = 6% * 1000 => \$60

Bond Y

• AAA rated, 7% yield (interest rates increased by 1%), purchase price is still \$1000, 10 yr maturity
• coupon = 7% * 1000 => \$70.

So, we have two bonds, with the same rating and purchase price, offering different yields. Bond Y will pay \$70 dollars every year for 10 yrs but Bond X will pay \$10 less for the same 10 years. So, why would anybody buy Bond X? This is the reason why Bond X’s value will fall when interest rates rise as there is a newer bond that offers more interest/coupon money for the same purchase price.

Let us take this one step further.

• The total return for Bond Y is: 10 years * \$70 per year => \$700
• The total return for Bond X is 10 years * \$60 per year => \$600
• For Bond X to compete with Bond Y, Bond X should also somehow lead to an equal return for the purchaser i.e. the \$100 difference has to be made up somehow.
• But, the coupon/interest for Bond X is fixed at \$60 per year…so, the only other way to make up the \$100 difference is to reduce the purchase price from \$1000 to \$900.
• So, Bond X is now sold like below:
• AAA rated, purchase price=\$900, 10 yr maturity
• yield = coupon/purchase price = 60/900 = 6.66% yield (up from 6%)
• A rising yield is hence bad news for any bond as itÂ  usually means that the bond price has been lowered forcefully.
• I.e. if I had bought Bond X for \$1000 and I am forced to sell it for some reason when the interest rate has risen by 1%, I am going to lose \$100 for each bond that I bought at \$1000.

### Interest rates decreases and effects on Bonds

The oppositeÂ  happens when interest rate decreases….the older bonds provide higher interest rates than the newer bonds and hence they become more valuable i.e. their yield increases.

Let us take this one step further.

• The total return for Bond A (older) is: 10 years * \$70 per year => \$700
• The total return for Bond B (newer, 1% lower interest rate now) is 10 years * \$60 per year => \$600
• Bond A offers a better deal than Bond B by about \$100. So, when all we can get today (with a 1% reduced interest rate) is Bond B, Bond A will command a premium i.e. the purchase price for Bond A becomes \$1100 instead of \$1000.
• So, Bond A is now sold like below:
• AAA rated, purchase price=\$1100, 10 yr maturity
• yield = coupon/purchase price = 70/1100 = 6.36% yield (down from 7%)
• A falling yield is hence good news for any bond as itÂ  usually means that the bond price has been increased by falling interest rates.
• I.e. if I had bought Bond A for \$1000 and I am forced to sell it for some reason when the interest rate has dropped by 1%, I am going to gain \$100 for each bond that I bought at \$1000.

### Important Note

Whether interest rates are falling OR raising, when it comes to individual bonds, the bond purchase price (i.e. the principal) is guaranteed to be returned to the bond purchaser if the bond is not sold until the maturity date.

### Next

If we have understood the above basics, the next challenge is to understand what happens to Bond Funds w.r.t. interest rate changes. Note that the impact on Bond funds are different than just Bonds.

# Bucket Approach to Retirement

There is a common question among those planning/approaching retirement and definitely among those already in retirement.

That question is:

• How to withdraw money from the retirement funds?
• How to invest the remaining money while in retirement?
• How much to withdraw each year?
• How to not not be too conservative and run out of money?

A recent article I read from Christine Benz (Morning Star, published around 2012) was very informative to me. I am enclosing a link to that article here.

# Power of compounding…..

While reading a forum post on Mr. Money Mustache, I found an interesting article mention that I thought would be useful to add here: Every 25-Year-Old In America Should See This Chart

Irrespective of the age mention in the title, everybody can benefit from the article…so, don’t get put off by the title.

# What is Tax Efficient Investing?

Before we talk about tax efficient investing, lets talk about the two different types of accounts: Tax-advantaged and Taxable accounts.

Examples of this type of accounts are 401K and IRA accounts. I do not have to pay taxes when I file taxes every year for any gains produced by investments in these accounts. The gains can be via capital gains, dividend distributions, interest, etc. The gains can grow in a tax-free environmentÂ  until money is withdrawn from these accounts. At that time, taxes will need to be paid based on the tax bracket one is at that time.

### Taxable Accounts

Any account that is not tax-advantaged is a Taxable account. For example, my bank account with cash that produces interest is a taxable account because I will have to pay taxes on the interest money reported by the bank. Likewise, my Vanguard investment accounts, using post-tax money from my bank account, are taxable as well i.e. any dividends and/or capital gain distributions are taxable as well.

### Tax-Efficient Investing

Gains produced in taxable accounts will be taxed according to the tax bracket one is in. Lets take an example. Consider the fund VDIGX…a dividend growth fund from Vanguard. The expected distributions for this fund for theÂ  year 2014 are as follows:

Dividend Growth FundÂ Â Â  VDIGX

• Dividends: \$0.17
• Short Term: \$0.07
• Long Term: \$0.25

Each of the different category of gains are taxed at different levels depending on the investor’s tax bracket

• Short term gains taxed at investor’s tax bracket (say 33%)
• Long term gains taxed at 20% (fixed)
• Dividends (qualified 100%) taxed at 15% (for folks in 33% tax bracket)

Tax-efficient investing is choosing investments in such a way that the taxes paid on the gains is minimized as much as possible. In the above example, it would be most tax-efficient if all of the gain comes in the form of dividends which are the least taxed category at 15%.

Consider another example of VCAIX….a California MUNI fund from Vanguard as well. This fund invests in MUNI bonds within California. The special treatment given to such bonds is that the gains form such bonds are both Federal and State Tax free and in most cases AMT free as well. For now, lets ignore AMT free…I will talk about this in another post. Now consider the gains produced by VCAIX for the calendar year 2014.

CA Intermediate-Term Tax-Exempt VCAIX

• Dividends: \$0.02
• Short term: \$0
• Long Term: \$0

For a resident of California, all the gains produced by VCAIX are completely *tax-free* i.e. both federal and state tax free. If not a resident of California, then it is only Federal tax free and state taxes have to be paid. So, in comparison to VDIGX,Â  for a resident of California, VCAIX isdefinitely more tax efficient than VDIGX.

So, tax-efficient investing is not about NOT_PAYING_TAXES. It is about MINIMIZING-TAXES-PAID and hence maximizing the gain that the mutual fund delivers.

NOTE:

• VCAIX offers an appx gain of say 3%.But, being tax free means I get to keep the 3% completely.
• For a taxable (or a less tax-efficient) fund to allow me to keep 3% post taxes, the fund has to produce a gain much higher than 3% to compensate for the taxes that need to be paid.
• There is a calculator called Taxable Equivalent Yield Calculator (link below) where if I put in 3% and 33% as my tax bracket, I get the result of 4.48%. So, before paying taxes, the fund has to provide a gain of 4.48% so that post tax, I get to keep 3%.
• For a portion of my portfolio, I may decide to take less risk and go for VCAIX at 3% vs taking more risk and investing in another fund that produces 4.48% gain. Now you see the power of tax efficiency ðŸ™‚
• Of course, I do not want all my investments to be in VCAIX right…it is not diversified enough. So, asset allocation should still be higher priority than tax-efficient placement. Another post for this later….but for now, read the first link in the reference links below.

# Dividend Investing: Mutual funds v/s Individual stocks

Being a lazy investor who likes periodic investments, mutual funds is the most obvious alternative for me. But, there are many people who favor investing in individual stocks that lead to dividend income. If the dividend income is the same in both cases, then which one to pick? I.e. what are the tradeoffs in each method? Here are some thoughts with an example.

Let us consider VDIGX as the example mutual fund and a dividend producing individual stocks basket. The stocks we will assume to be part of both VDIGX and the stocks basket are:

• Wal-Mart Stores, Inc.
• Johnson & Johnson
• Microsoft Corporation
• Merck & Company, Inc.
• TJX Companies, Inc.
• Chevron Corporation

For an investor to maintain an individual stocks basket of the above stocks, he/she has to do a financial analysis of the companies involved OR at the least, spent time studying the reports available in the internet, company’s SEC filings, etc. One also has to evaluate the price of the stock based on its earnings potential. In short, there is a reasonable amount of financial knowledge and capability needed to invest in individual stocks.And, tax time can be a pain ðŸ™‚

But, the advantages are that once you own the stocks, you (the investor) gets to decide when to sell the stocks, when to realize capital gains (short or long term), buy and hold forever OR sell at the opportune time, buy and sell instantaneously during the day, etc etc. There may OR may not be commissions involved for buying/selling depending on the stock broker platform used (etrade, vanguard, and a whole host of providers with different fees per trade).

VDIGX, on the other hand, is totally controlled by the fund manager who currently happens to be Don Kilbride, a recognized name in the industry. He decides when to sell or buy company stocks, in what quantity, which companies to buy, etc. So, there is a loss of personal control over the investment. In addition, you (the investor) has to pay Don a fee for managing the investments. Since I do not have the time nor the knowledge to do a financial analysis, I have to pay Don the fees to do the work on my behalf. Since Don has a proven track record of producing reasonable gain, I am betting that past performance is a reasonable (but not guaranteed) predictor of future performance. Due to the loss of control, you (the investor) cannot control the time of selling/buying stocks, realization of capital gains (short or long term), which companies to buy, etc. For example, Don OR some other fund investor could sell VDIGX shares and force a capital gain of the short term. In addition, if you do not invest in the fund anymore after a certain amount of money, you still have to pay Don some money.

The advantage of course, is that you (the investor) does not have to evaluate the financial stability of the company, the value of the stock, etc etc. Don has years of experience in picking such stocks and also has a well known company like Wellington/Vanguard overseeing the process of picking such stocks. And tax time is as easy as taking the 1099 form that Vanguard will send for VDIGX and filling up the form in a tax form ðŸ™‚

For the lazy investor (like me), VDIGX is perfect. For the more knowledgeable investor, picking individual stocks may be the way. Hope this article gives a flavor of the issues to be aware of in choosing mutual funds vs individual stocks.

PS: For a more detailed article on tax treatment, please read another post by HumbleFI titled Tax consequences of investing in Mutual Funds

# Tax consequences of investing in Mutual Funds

One of the disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this actually mean? I will answer this in three sub sections

• Tax Terminologies w.r.t. Mutual Funds
• Special Dates w.r.t. Mutual Fund Distributions
• Tax consequences of Mutual Funds

## Tax Terminologies w.r.t Mutual Funds

Mutual Fund Distribution:

1. Mutual funds give back money to investors in two ways: through dividends and/or capital gains
2. These money give backs are called Distributions.

Long term vs Short term Capital gains distribution

1. When a share in the mutual fund is held for less than one year and sold, the gains it generates are called Short term capital gains
2. When a share in the mutual fund is held for more than a year and sold, the gains it generates are called Long term capital gains
3. Short term cap gains are taxed as ordinary income….say 33% for many people in the Silicon Valley
4. Long term cap gains are taxed at a rate less than ordinary income….say 15%.
5. So, getting long term cap gains from mutual funds is very tax efficient.

Dividend Distributions

1. When a share OR a bond is held in a mutual fund, it can generate dividends and/or interest.
2. These dividends are taxed at a rate less than ordinary income…..say 15%
3. So, getting dividend distributions from mutual funds is very tax efficient.

Tax Exempt Mutual Funds

1. These funds are generally exempt from federal taxes, and in some cases, exempt from state taxed also depending on residence requirements.
2. Example: Municipal bond fund VCAIX (California MUNIs)Â  is both federal and state tax free because I am a resident of California.
3. I.e. distributions from tax-exempt funds like VCAIX do not pay tax!!
4. NOTE: There is a limit on how much tax-free income a person can get in one taxable year. AMT (Alternative Minimum Tax) enforces a minimum amount of tax per year i.e. makes sure that there are not too many tax deductions claimed in one taxable year.

AMT Free Mutual Funds

1. From Vanguard. AMT is defined as: A separate tax system designed to ensure that wealthy individuals and organizations pay at least a minimum amount of federal income taxes. Certain securities used to fund private, for-profit activities are subject to the AMT.
2. Each mutual fund can generate gains that are AMT free OR not. If a fund has no AMT exposure, it can’t trigger the AMT, no matter how much you own.
3. Consider the following two Vanguard mutual funds
4. If you are a California resident, the first fund is both federal and state tax free. Whether you get \$1000 tax free gain OR \$1000000 tax free gain, these gains will not trigger the AMT. The second is obviously not…there is a percentage of the gain that will count against the AMT limit. For example, if the AMT trigger limit is 169, getting a \$1000 gain will mean \$169 of it will apply towards the AMT limit and trigger it.

Form 1099-DIV

1. This form indicates mutual fund earnings shareholders must report on their income tax returns.

## Special Dates w.r.t. Mutual Fund Distributions

There are four important dates associated with a mutual fund distribution. This is because a mutual fund goes through a two step process in making distributions.

1. Declaration Date
1. On this date, the board of directors (for individual stocks) OR the mutual fund company/manager announce to the whole world that the individual stock OR the mutual fund will pay a dividend.
2. This date has no bearing on your taxes.
2. Ex-dividend Date
1. First, the fund “declares” the amount of distribution it intends to make and sets aside the necessary amount of cash to match the intended distribution.
2. Setting aside cash has the effect of lowering the NAV (net asset value) of the fund by the amount of cash that has been “taken out” of the fund for distribution purposes. Note that no cash payment is made to the fund owners at this step….cash is only set aside.
3. This date that has the most bearing on your taxes.
1. If you buy a dividend paying stock (or mutual fund share) one day before the ex-dividend date, you will still get the dividend. If you buy on the ex-dividend date, you won’t get the dividend.See Record date section next for more details.
2. If you want to sell a stockÂ (or mutual fund share) and still receive a dividend that has been declared, you need to sell on (or after) the ex-dividend day.
4. The ex-date is the second business day before the record date.
3. Record Date
1. This is the date on which the company looks at its records to see who the shareholders of the company are.
2. An investor must be listed as a record holder (of the stock or fund shares) to ensure the right of a dividend payout.
3. The ex-dividend date is usually 2 days before the Record date. And it takes 3 days to record an investor as a record holder. So, to be on the “books” on record date, the stock and/or fund purchase has to happen a day before the ex-dividend date. Purchasing on the ex-dividend date will not lead to the purchaser being on the record books and hence will not be a dividend target.
4. Payment Date
1. On this date, the fund actually pays the mutual fund share owners real money from the cash pool that is set aside on the ex-dividend date.
2. This date has no bearing on your taxes

## Tax Consequences of Mutual Funds

One of the main disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this mean? Lets see…

1. From the previous section, we saw that Mutual funds can distribute two types of taxable gain to shareholders: ordinary dividends and capital gains distributions.
2. Let us say that I purchase shares of a mutual fund at \$10 per share and the share prices rises to \$100. Now, if I sell the 10 shares, there can be a taxable gain for the mutual fund because of the increased share price. This taxable gain will be distributed to all the mutual fund shareholders..in proportion to the number of shares that they own. Lets say that this year, I do not have money to pay taxes for the gain. So, I decide to not sell my shares this year.
3. But, if the mutual fund manager sells shares of one of the components of the mutual fund to re-balance it and there is a profit on the shares, then the mutual fund will distribute the gain to all the share holders.
4. This will lead to a gain for me for this year when I do not have the money to pay taxes for it. In the worst case, I may be forced to sell some shares to pay the tax to the government. This is what I meant by saying that the tax consequences are not in my (investor) control.

The other main disadvantage is the timing of the taxes paid. What does this mean?

Assumptions:

• New calendar start date: Jan 1
• Ex-date is Dec15th
• Record date is Dec 17th
• Payment date is Dec 20th.
• Tax year ends on Dec 31st

Scenario 1:

• Assume that Investor A bought 100 shares of a fund for \$10 a share on Jan 1st. The shares rose in value to \$20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on \$1,000â€”the capital gain of \$10 a share (\$20-\$10) times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
• Investor B buys 100 shares at the fundâ€™s new NAV of \$20 a share on May 1st, which includes the embedded gains (\$20-\$10). The shares rise to \$30 a share on Dec 1st, and Investor B sells his shares. Investor B would owe taxes on \$1,000â€”the capital gain of \$10 a share (\$30-\$20), times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
• In other words, Investor A owes taxes on the \$10 gain accrued while she owned the fund (Jan 1st to May 1st), and Investor B owes taxes on the \$10 gain accrued while he is invested (May 1st to Dec 1st). Each shareholder is paying for his or her own gains earned.

Scenario 2:

• Assume that Investor A bought 100 shares of a fund for \$10 a share like in Scenario 1 i.e. Jan 1st. The shares rose in value to \$20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on \$1,000â€”the capital gain of \$10 a share (\$20-\$10) times 100 shares. This is the same as in Scenario 1.
• Now assume Investor B bought his shares on Dec 14th i.e. one day before the ex-dividend date. So, on record date, Investor B will qualify as a record holder. So, Investor B buys his shares at \$20 on Dec 14th.
• On ex-date, cash is set aside proportional to the distribution needed. So, the NAV falls to \$10 per share, with \$1000 ((\$20-\$10) * 100) set aside as cash for distribution. On record date, it is decided that both Investor A and B are record holders and would get the dividend distribution.
• Investor A still owes taxes on \$1,000â€”the \$10 gain on her shares, bought at \$10 and sold at \$20, times 100 shares.
• Investor B bought the stock at \$20 and did not realize any gain…but must now pay taxes on \$1,000â€”the \$10 per-share distribution (\$20-\$10), times 100 shares. I.e. it seems like Investor B is paying taxes on zero gain…is this possible? No. Read next.
• The distribution reduces the fundâ€™s NAV to \$10. If Investor B pays the taxes from other assets and reinvests the full amount of the \$1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at \$20 a share, while the second 100 were purchased at \$10 a share. Investor Bâ€™s average cost basis for tax purposes is \$15 a share.
• Post the distribution (say May 1st of next year), lets say that the shares then rise by 50 percent, as in Scenario 1, to a new value of \$15 a share.
• When investor B sells his 200 shares at \$15 a share on May 1st of next year, for tax purposes he is treated as having purchased all those shares at his average cost basis of \$15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.

Is Investor B paying taxes on zero gain?

• Investor A paid her own taxes on the \$1,000 gain when she sold shares at \$20 with a cost basis of \$10; she delayed paying taxes until she sold.
• Investor B paid taxes on the \$1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price (\$15) as his cost basis. Thus, he pays taxes only on the \$1,000 that he earned while he owned the shares.
• For Investor B to pay taxes upfront, he has to have some additional money set aside OR have other assets. If he has no money set aside, then other assets may have to be sold to pay taxes. This forced sale may lead to a loss (selling low, bought high) OR may lead to more taxation due to capital gains. This is the other main disadvantage of mutual funds.

Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid.

• Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or
• Taxes may be paid later (if losses accrued before purchase offset realized gains)
• But total taxes paid will be the same.

Reference:

I read many web links to understand this, but I will list one main link that was helpful to me with actual examples.