So why are bonds down, and how is it that ultra-short term bond funds are down? Aren’t ultra-short term bonds supposed to be like cash?
I’m going to tell a hypothetical story, unfortunately there are some numbers involved but it’s not too bad (my original post was pretty much 4 lines of numbers and a sentence explaining it so…this is better).
In November of 2021 I went to Uncle Sam and made a deal to loan him $1,000 for 1 year. Now I’m a nice guy, everyone says so, but if you want to use my money for a year you have to pay me. Now back then the interest rate that my dear uncle was paying was 0.18%/year so he agreed to pay me $0.90 on May 13th and again on November 15th 2022 and return my $1,000 on November 15th, 2022.
Fast forward to today and my dear uncle paid me the $0.90 but the transmission on my truck is acting up and I need my $1,000 to fix it so I asked my uncle for the $1,000 and he said as far as he’s concerned I can walk until November. But my uncle borrows and pays back money all the time and while I was talking to him Jane came in and offered to loan him $1,000 for the next 6 months.
Being a savvy guy, I told Jane that she could just buy the debt from me since Uncle Sam owed me $1,000 to be paid back with $0.90 interest on November 15th. Unfortunately for me, Uncle Sam was offering to give Jane 1.44%/year interest for the next 6 months which means she would get $7.20 plus the $1,000 in November.
Since I really need the money now, I did some quick math. Since I’m going to get $1000.90 and she would get $1007.20 on November 15th we decided it would be fair to pay me less than $1,000 for the loan.
$1000.90 / $1007.40 = 99.374%
So I offered to sell her my debt for $993.74. She then gets her 1.44%/year ($993.74 * 1.44%/2 + $993.74 = $1000.90) and I get my truck transmission fixed! Unfortunately my $1,000 became $993.74 so I lost money even though it was an extremely short term bond.
The fortunate thing with short term bond funds is that the fund is there is a steady stream of bonds paying off the principal that is owed them and every time that happens they get to reinvest it at the current interest rate. What that means is that while the funds may be down, they will be paying a higher interest rate going forward which should make up for the losses as long as we DON’T PANIC!
Franklin Ochs, CFA®
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