Welcome to Firstlinks Edition 320

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I love those opening comments Graham.

My gut feel is, you’d be surprised how many people don’t understand the relationship between bond price and rate.

Perhaps Chris D, but my observation (based upon a couple of decades of presenting to audiences on the topic) is that there are more that understand that relationship than those who understand the way bond returns work over the life of the asset. As a result they get far too worried about short term volatility and forget about income, which increases as yields rise provided you either reinvest coupon interest or you own a portfolio of bonds that have maturities to reinvest.

Graham's article is a good lesson in short term volatility, which is a reality of investing in long term fixed income. But I know that Graham also realises that it's not the whole story either, hence his link to my article on the life of a bond.

And in response to James' comment about bond returns being 'assymetric', I don't know that Graham's article actually says that. In the short term, when capital value fluctuations dominate, they're symmetric. Yields up or down, the price change is going to be the duration of the bond times that change. (OK, for pedants like me, if it's a big yield change then it's not exactly symmetric because of convexity, but it's of the right order of magnitude.)

Where bond returns are asymetric is over the long run where they're biased on the upside, because you always have the positive impact of interest income dominating. Well, I suppose negative bond yields make the return assymetric on the downside, but the point is that the yield to maturity is always very close to the total return over the life of the bond. Those symmetric price fluctuations end up washing out by the maturity date of each asset.

Nice work on bonds, Graham – good for people to realise how asymmetric bond returns can be.

Personally, I think that the case for investing in fixed income (bonds) with a duration as long as that of equities presumes that you reinvest your income payments so that you get the benefits of compounding. That way, if yields increase after you make the investment, you'll be investing a lot of cash flows back into your portfolio at those higher yields, thus ratcheting the return up well beyond the initial purchase yield.

Unfortunately that ASX calculator - like so much of the bond information that a stock market provider like the ASX gives us - is only a snapshot of 'what if' scenarios at today's date. It doesn't show you how the investment might perform over it's entire life under different assumptions about reinvestment and the future path of the yield at which you make reinvestments. It therefore encourages overemphasis on the price change from a shift in yields as if that was an instantaneous outcome. Graham's example of a 1% change in yields is simply not going to happen in a day, especially on a long term bond. The longer the time period over which the change happens, the more important income accrual and reinvestment become in the final outcome and the less important is the change in price.