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Let's say you buy a bond fund in a high-rate environment. The bond fund will consist of many bonds paying high coupons. If rates stay still, you expect to make decent money from the coupons.

Now, let's say as soon as you buy the bond fund, rates fall. Of course you make even more money now, from both the coupons as well as the falling rates increasing the value of your bonds.

But ...

If the portfolio manager of the bond fund does not sell your bonds, then they will eventually pull-to-par, and you will earn the original yield of the bond, i.e. you lose out on your "bonus" from the falling rates.

If the portfolio manager of the bond fund does sell your bonds, he will re-invest in other bonds trading in the market; these bonds pay lower coupons because rates have fallen, thus while you cash in on your "bonus" today from falling rates, your future yield is lower, because the bonds in your bond fund now pay fewer coupons.

Is my logic correct? And thusly, bond funds tend to mean-revert, i.e. if rates fall/rise, that might give you a bonus or a loss now, but you can expect to revert to the original yield over time (*assuming rates don't change any further!).

ammo 45
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That's not exactly how bond funds work. The "yield" reported by the fund is the average yield (not necessarily the coupon rate) of its constituent bonds. If rates fall, the bonds in the funds will be worth more, thus the value of the fund goes up. If the manager decides to replace them with lower coupon bonds, then either the fund will make capital gains by selling more valuable funds, or it will buy more of the lower coupon bonds. Over time, if market yields do not change, the fund will tend toward the new yield as it replaces bonds (either voluntarily or after they mature).

In other words, bond funds do not guarantee a specific yield like individual bonds do (barring default) - the yield fluctuates with the market.

D Stanley
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Bond fund prices do not mean-revert, but bond yields tend to do.

Assuming a bond fund is actively managed and there is no mandate to keep the duration of the fund’s portfolio at a certain level, you are right to expect that the fund’s managers spot the opportunity and lower the portfolio’s duration substantially when they think the rates are close to the bottom. However, most bond fund managers don’t do that to a very significant extent because then they run the risk of underperforming their benchmarks for too long and too much.

On the other hand, actively managed bond funds usually do better than their equity counterparts with some 70% of the former outperforming their benchmarks vs 30% of the latter on an annual basis on the average over the long term.

Alper
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What you explain has nothing to do with mean reversion or the way most bond funds work. Mean reversion means that an asset's price will tend to converge to the average price over time.

Technically, with bonds you never revert to any yield, unless the interest rate environment you compare is identical.

With regards to funds, most have a mandate for a specific maturity and never mature, see https://money.stackexchange.com/a/156572/109107 for details. Insofar, you don't have an actual yield that you can expect because the fund sells bonds before they mature and reinvests in new bonds.

AKdemy
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