Perhaps I dont quite understand bonds

[BHawks87]

It seems like there are a lot of folks on here who are dropping their bond allocation, changing to TIPS, or changing bond funds because of the change in interest rates. Wouldn't that be market timing or am I missing something here?

[chaz]

Possibly timing.

Look at the forum wiki.

[retiredjg]

It seems like there are a lot of folks on here who are dropping their bond allocation, changing to TIPS, or changing bond funds because of the change in interest rates. Wouldn't that be market timing or am I missing something here?

People are frustrated that fixed income investments are paying so little. It could be seen as market timing. Or it could be seen as just getting the best thing you can get within the group of things that could be used for the fixed or bond portion of your allocation.

I suspect that some folks are doing the research and optimizing a bit. I suspect others are just flailing around, buying and selling.

As for actually dropping your bond allocation and adding more stocks, some people call this "tactical" asset allocation. Even Jack Bogle has said that a little bit of tactical shifting around is probably ok. It is market timing, no doubt about it. But in small doses and with a well thought out plan, I doubt it is a big problem.

[FNK]

Bonds are much less unpredictable than stocks. In particular, with today's interest rates there's little expected upside to holding bonds. The only unpredictable thing is how long before interest rates go up. So call it market timing if you must, but with much better visibility than stock market timing.

[WendyW]

`
I'm not an expert on bonds, but here is what I think is maybe going on:

When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.

When interest rates are 6%, you don't really know whether rates will go up to 8%, or drop to 4%.

But today, the benchmark interest rate in the United States is 0.25 percent.

So maybe interest rates will go up to 2%, and bond prices will fall.

But could interest rates go down to negative 2%? I'm not sure, but I think this is unlikely or maybe impossible.

So in today's bond environment, there seems to be downside -- but not a lot of upside.
,

[BHawks87]

`
I'm not an expert on bonds, but here is what I think is maybe going on:

When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.

When interest rates are 6%, you don't really know whether rates will go up to 8%, or drop to 4%.

But today, the benchmark interest rate in the United States is 0.25 percent.

So maybe interest rates will go up to 2%, and bond prices will fall.

But could interest rates go down to negative 2%? I'm not sure, but I think this is unlikely or maybe impossible.

So in today's bond environment, there seems to be downside -- but not a lot of upside.
,

This makes sense. Since interest rates are already bottomed out there is only one way for them to go which means bonds will drop.

[retiredjg]

This makes sense. Since interest rates are already bottomed out there is only one way for them to go which means bonds will drop.

Yes, the value of the bonds you have will drop some if interest rates go up (not a lot in relation to how much stocks can drop). But what the bonds pay you will go up (precisely because the interest rates have gone up). So all is not lost.

Some people don't know this and it seems that others forget it. Some people just assume the sky is going to fall because interest rates can't really go down, but they sure could go up.

Interestingly, some of these same people think nothing of putting a huge part of their portfolio in stocks - which could drop WAY more in 3 months than a bond could ever imagine dropping. Fear is a strange thing and frequently, it is not logical.

Don't fear bonds. But if you like CDs and can find some paying something worthwhile, holding CDs instead of bonds is pretty harmless and might even work out better.

You might check out the Wiki (link in upper right corner) for more bond information.

[WendyW]

Yes, the value of the bonds you have will drop some if interest rates go up (not a lot in relation to how much stocks can drop).

Err... Doesn't the value of a 30-year treasury bond drop by 14% when interest rates increase by just 1% ?

But what the bonds pay you will go up (precisely because the interest rates have gone up).

Wait, what? If I buy a $1000 bond that pays a 1% coupon, doesn't it pay $10 a year in interest regardless of what interest rates do?

[nisiprius]

They are flailing. The return for low-risk investments is much lower than it used to be. (There's at least a suspicion that the return for stocks may be lower, too, but that's a separate topic). For whatever reason, they cannot accept the low rate of return so they are casting around anxiously looking a bit desperately for something better. In the process, they may be looking at unfamiliar investments and kidding themselves both about the risk of the investments and what their own risk tolerance is.

It's very understandable, I think probably everyone's doing a little bit of that. I have been flailing, too. I have a medium-sized chunk of money which, for my own good reasons, I want to keep in the Vanguard account, and I've shifted most of it from money market to short-term bond index. I think I have a rationale but it might be a rationalization.

The pain over low interest rates has created opportunities for other financial products. These pitches might have fallen on deaf ears when traditional core bond funds were chugging along slow and steady, but now people are responding to them.

[Since interest rates are already bottomed out there is only one way for them to go which means bonds will drop.

They have not bottomed out, and I do not understand why people keep saying this. If you are a bank borrowing overnight from the Fed, then, OK yes, they have bottomed out. Here's the latest Treasury yield curve:

Code: Select all

7 Yr    10 Yr   20 Yr   30 Yr
1.05    1.63    2.37    2.80

There is no reason in the world why they cannot go any darned direction they please.

[WendyW]

They have not bottomed out, and I [b]do not understand why people keep saying this
There is no reason in the world why they cannot go any darned direction they please.

I know that interest rates could go to 20%, because they've been there before.
Are you saying that interest rates could just as easily go to NEGATIVE 20%?
Serious question by the way. Can interest rates go negative?

[Call_Me_Op]

They have not bottomed out, and I [b]do not understand why people keep saying this
There is no reason in the world why they cannot go any darned direction they please.

I know that interest rates could go to 20%, because they've been there before.
Are you saying that interest rates could just as easily go to NEGATIVE 20%?
Serious question by the way. Can interest rates go negative?

Yes, (nominal) interest rates can go negative - and have - for brief periods. But I do not think they can go very much negative for very long - because there is always the mattress alternative that is competing for "safe" money. That said, they can go to zero and stay there for a long time.

[retiredjg]

Yes, the value of the bonds you have will drop some if interest rates go up (not a lot in relation to how much stocks can drop).

Err... Doesn't the value of a 30-year treasury bond drop by 14% when interest rates increase by just 1% ?

But what the bonds pay you will go up (precisely because the interest rates have gone up).

Wait, what? If I buy a $1000 bond that pays a 1% coupon, doesn't it pay $10 a year in interest regardless of what interest rates do?

Sorry, I should have been clearer. I'm talking about bond funds, not individual bonds. Bond funds contain newly issued bonds that reflect the new interest rates.

I'm not sure the exact answer to the questions you are asking about a specific issue of a specific bond. But my understanding is that if you hold an individual bond to maturity, you don't lose any value. But you would lose value if you sell it before maturity because people aren't that interested in your bond when the new ones are more attractive (paying more). Therefore, the only way to sell yours is to lower the price.

About the drop of 14%, my understanding is that the value will drop in accordance to the duration of the bond. A bond fund with a duration of 14 years could be expected to drop about 14% in value if interest rates go up 1%. That's a lot. That's why people here don't usually recommend long term bond funds. I'm not sure exactly how accurately that translates to a 30 year Treasury, but I'm thinking that people who buy Treasury bonds expect to hold them to maturity (therefore, no loss in value).

[Call_Me_Op]

I'm not sure exactly how accurately that translates to a 30 year Treasury, but I'm thinking that people who buy Treasury bonds expect to hold them to maturity (therefore, no loss in value).

Clarification: If a 30 year treasury is held to maturity, there is no loss of nominal value. The real value - what it can buy - may be destroyed - which is the principal risk.

[nisiprius]

They have not bottomed out, and I do not understand why people keep saying this.
There is no reason in the world why they cannot go any darned direction they please.

I know that interest rates could go to 20%, because they've been there before. Are you saying that interest rates could just as easily go to NEGATIVE 20%? Can interest rates go negative?

No, I'm just making an observation that's so stupidly obvious that you're looking for more than is there. The Fed sets interest rates for overnight borrowing by banks, and it's essentially zero. The marketplace sets the rates for longer-term bonds, although the Fed is trying to drive them down. I am just saying something that's plumb obvious and simply factual:

Code: Select all

7 Yr    10 Yr   20 Yr   30 Yr
1.05    1.63    2.37    2.80

1.05% is not zero. 1.63% is not zero. 2.37% is not zero. 2.80% is not zero. It is not true that "interest rates" can only go up. Those four interest rates can go down. The smug and oversimplified along the lines of "interest rates can only go up, and when they do, your bonds are gonna go down" does more harm than good.

[WendyW]

The real value - what it can buy - may be destroyed - which is the principal risk.

Correct. If we're merely trying to reach some magical DOLLAR amount at retirement, then interest rate movements after we've purchased a bond are irrelevant.

What we're trying to do, though, is to build Purchasing Power for retirement. If we own a bunch of 20 or 30 year bonds and interest rates rise even a little bit, we are going to get creamed.

[livesoft]

Can interest rates go negative?

They already have or are pretty close:

http://www.bloomberg.com/news/2012-12-0 ... rancs.html
http://blogs.wsj.com/economics/2012/08/ ... us-option/
http://www.theweek.co.uk/eurozone/50473 ... est-threat
http://seekingalpha.com/article/756361- ... t-bonds-go
http://www.bloomberg.com/news/2012-10-0 ... t-bny.html
From 2004: http://www.newyorkfed.org/research/curr ... i10-5.html

[tfb]

For whatever reason, they cannot accept the low rate of return so they are casting around anxiously looking a bit desperately for something better. In the process, they may be looking at unfamiliar investments and kidding themselves both about the risk of the investments and what their own risk tolerance is.

Or they may re-discover products they haven't associated with "investing" or "investment," such as I Bonds and FDIC insured savings accounts and CDs. Bonds and bond funds are not the only options for fixed income. I Bonds and FDIC are a free lunch to small individual investors, not available to large institutional investors and foreign governments with millions and billions to invest requiring high liquidity. If you don't need the liquidity (at least not on 100% of your fixed income money), don't compete for liquidity with the institutional investors and foreign governments.

[retiredjg]

I'm not sure exactly how accurately that translates to a 30 year Treasury, but I'm thinking that people who buy Treasury bonds expect to hold them to maturity (therefore, no loss in value).

Clarification: If a 30 year treasury is held to maturity, there is no loss of nominal value. The real value - what it can buy - may be destroyed - which is the principal risk.

Thanks. That does seem more better.

So why do people use 30 year treasury bonds? I'm pretty unfamiliar with these puppies and I'm not seeing much of an attraction.

[WendyW]

So why do people use 30 year treasury bonds? I'm pretty unfamiliar with these puppies and I'm not seeing much of an attraction.

If interest rates were 6% or so, I could totally understand why someone would want to hold bonds: bonds' value would be expected to move oppositely to the value of equities, providing stability to an investment portfolio.

What I don't understand is why we'd want to hold 10 or 20 or 30-year bonds today, when interest rates are 0.25%.
Lots of potential downside, very little upside.
There must be something that I am missing.

[retiredjg]

I don't know why you would want to hold that type of bond either. But that doesn't mean you shouldn't hold bonds (or some other type of fixed income investment). There are other choices.

I guess that's what the original poster's question is all about.

[WendyW]

The problem with "other" type of bonds though (short bonds, or TIP bonds) is that they don't have that high negative correlation to equities, so their value as a portfolio hedge is limited.

These kinds of bonds provide a little bit of relief in very turbulent times like 2008, but mostly are just a drag on returns.

[happymob]

So why do people use 30 year treasury bonds? I'm pretty unfamiliar with these puppies and I'm not seeing much of an attraction.

If interest rates were 6% or so, I could totally understand why someone would want to hold bonds: bonds' value would be expected to move oppositely to the value of equities, providing stability to an investment portfolio.

What I don't understand is why we'd want to hold 10 or 20 or 30-year bonds today, when interest rates are 0.25%.
Lots of potential downside, very little upside.
There must be something that I am missing.

Except 30-year treasuries aren't yielding 0.25%. They are yielding 2.8%.

If you start early enough in your life, it seems perfectly reasonable to build a 30-year bond ladder with treasuries that you purchase at auction and hold to maturity. There is, of course, inflation risk, which can be mitigated somewhat by simultaneously building a 30-year TIPS ladder (though this wasn't an option for many years where only 20-year TIPS were auctioned off).

It is a little bit of a pain, but building your own bond ladder at Fidelity (and now Vanguard) isn't actually that hard, and you avoid fees entirely.

And yes, I shudder when I see current 30-year bond treasury and 30-year TIPS yields. I don't know if those bets will pay off or not, but it's what we have.

[LH]

It seems like there are a lot of folks on here who are dropping their bond allocation, changing to TIPS, or changing bond funds because of the change in interest rates. Wouldn't that be market timing or am I missing something here?

timing.

Now some things, like switching to a government guaranteed CD or something from a T Bill, is just smart play, unless the FDIC guarantee fails while the T bill guarantee does not.

But otherwise, just timing.

[Call_Me_Op]

So why do people use 30 year treasury bonds? I'm pretty unfamiliar with these puppies and I'm not seeing much of an attraction.

Two reasons mainly:

1.) As part of a diversified portfolio, where a relatively small allocation to long-term treasuries serves as a hedge against deflation/financial crises (flight to safety).
2.) When there are well defined nominal liabilities, so that liability matching can be employed.

Of course, if interest rates spike and you believe that inflation will be brought under control, picking-up some 30 year treasuries can lock-in a high guaranteed rate for a very long time. Some people were well served by doing this in the 1980's.

[NYBoglehead]

I think there is a significant difference between market timing and recognizing that bonds are paying absolute garbage right now and that taking on more risk by moving heavier into equities might be reasonable. You can always rebalance later. Bonds should play an important part of everyone's portfolio but they're not always as "safe" as many would have you believe. There is already the risk that inflation will outpace the interest earned AND when interest rates rise the NAVs of bond funds will take a temporary dive.

[dbr]

What I don't understand is why we'd want to hold 10 or 20 or 30-year bonds today, when interest rates are 0.25%.
Lots of potential downside, very little upside.
There must be something that I am missing.

Except that very few individual investors hold much in 10 or 20 or 30 years bonds now or at any other time. It has always been generic advice to stay short to intermediate in bonds, say out to 5 or 6 years max, and some people have always said "stay short (as in SHORT) in bonds." There is a rationale for going out into the intermediate yield on the curve when the yield curve is steep. That is just moderately so today with short bonds being very low in yield. Here is the curve for Treasuries. You are mostly arguing against a straw man.

http://stockcharts.com/freecharts/yieldcurve.html

[Angst]

If you start early enough in your life, it seems perfectly reasonable to build a 30-year bond ladder with treasuries that you purchase at auction and hold to maturity. There is, of course, inflation risk, which can be mitigated somewhat by simultaneously building a 30-year TIPS ladder (though this wasn't an option for many years where only 20-year TIPS were auctioned off).

Anyone who's committed to holding LT treasuries to maturity might consider first filling that ladder with "20 year" series EE savings bonds paying 3.5%.

[RupertSM]

You need to consider how bonds, whether they are US treasuries, IG corporates, mortgage bonds, non US$ denominated, etc fit into your AA. For example, I prefer to own US Treasuries, and long dated ones at that, as part of my AA. Why? Longer duration US Treasuries allow me to take more risk in my equity allocation - perhaps owning more emerging market equity or having a higher % of equities overall in my portfolio. I am NOT buying bonds for their fixed income, but for their ability to dampen the volatility of my portfolio.

[nisiprius]

I think there is a significant difference between market timing and recognizing that bonds are paying absolute garbage right now and that taking on more risk by moving heavier into equities might be reasonable.

Except that advocates of stocks have always said that. When have bonds not paid "absolute garbage," compared to stocks?

It's not at all clear that the relationship between stocks and bonds has changed. Certainly, if you believe that the future returns of stocks are the same as ever and that the future returns of bonds have dropped, one might put more into stocks. But there are two parts to that equation, and you can't get the answer by looking at only one of them.

And if "interest rates can only go up," then when that happens it will affect stocks too--in the same direction, at the same time, and for the same reason. An expectation of rising interest rates does not automatically mean you should shift to stocks.

[TSR]

I'm sorry to ask a dumb follow-up, but I am a little confused as to what all this means for the average investor. Obviously the key of "pick an allocation and don't go swaying with every wind that comes along" is still the BH mantra, right? But take the following hypothetical: an investor who is still well in the "accumulation phase" and who would normally want an 80/20 allocation between, say, TSM and TBM, has exactly $100,000 sitting in a money-market fund in a retirement account ready to invest. Are we saying that such a person should (1) modify the plan to go 100% equities for the next ten years (approx), (2) SLIGHTLY modify the plan to go 85/15 TSM/TBM, or (3) stick with the plan?

[Abe]

Serious question by the way. Can interest rates go negative?

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

[nisiprius]

Serious question by the way. Can interest rates go negative?

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

For safekeeping? Like the bank rental I pay for a safe deposit box? That's just a flip remark about a possibility that occurs off the top of my head. No, I can't imagine a retail investor doing that, but I can imagine an institutional investor with a need to put a billion dollars somewhere doing it.

Also, Treasury bill rates tabulated in a reference book, the SBBI Classic Yearbook, are shown as very slightly negative in 1940, but it doesn't mean much--I forget the boring technical explanation. Ah, Google found it. They were exempt from personal property tax in some states, so T-bills at a very slight negative rate were a better deal than paying taxes on something else with a small positive rate...

[Phineas J. Whoopee]

Serious question by the way. Can interest rates go negative?

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

Because it was the best available option.

You or I might be able to liquidate all financial assets into $100 bills and store them somewhere. Large companies like Federal Screw can't.

Moreover, in 2011 1-month T-bills sold at a premium to par in the secondary market several times. Treasury rules don't presently permit submitting negative bids for nominals (although they do for inflation protected securities), but rules can be changed.

Like the US Denmark borrows in a currency it issues: the Danish Kroner. Last summer its official interest rate dropped below zero, and there were takers. In fact, the secondary market had anticipated the officials by going negative first.
http://uk.reuters.com/article/2012/07/05/denmark-rates-idUKL6E8I5A8520120705

Bank of New York Mellon started negative interest on deposit accounts last year as well:
http://americanpowerblog.blogspot.com/2011/08/bank-of-new-york-mellon-charging.html

The Repo (Repurchase Agreement, similar to a secured loan) market went negative in 2003:
http://www.newyorkfed.org/research/current_issues/ci10-5/ci10-5.html

Interest rates most certainly can go lower than they are today. I'd also like to echo nisiprius' point that unlike the Federal Funds rate (which you can only access if you are a bank, and only if you're just borrowing overnight to shore up your reserves), Treasury rates most certainly have room to go down before they reach 0%.

PJW
[Edited to add two more references.]

[retiredjg]

Are we saying that such a person should (1) modify the plan to go 100% equities for the next ten years (approx), (2) SLIGHTLY modify the plan to go 85/15 TSM/TBM, or (3) stick with the plan?

In my opinion, the Boglehead approach would be to stick with the plan.

[Abe]

Serious question by the way. Can interest rates go negative?

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

Because it was the best available option.

If someone wants to borrow my money, I have the option of not loaning it to them. That is a better option than paying them to borrow my money.

[Phineas J. Whoopee]

Serious question by the way. Can interest rates go negative?

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

Because it was the best available option.

If someone wants to borrow my money, I have the option of not loaning it to them. That is a better option than paying them to borrow my money.

That's why we said upthread:

...I can't imagine a retail investor doing that, but I can imagine an institutional investor with a need to put a billion dollars somewhere doing it. ...

... You or I might be able to liquidate all financial assets into $100 bills and store them somewhere. Large companies like Federal Screw can't. ...

What do you do right now, when deposit accounts are paying less than expected inflation? Isn't the value of your account steadily going down, in real albeit not nominal dollars?

What would you do if deposit accounts were paying zero interest and charging monthly fees? Then the nominal dollars would be going down too. What would you do if they were explicitly charging you interest for the privilege of keeping your money there (like BONY Mellon did for some of its customers, as noted and referenced in my earlier post)?

That's why I wrote the bit about $100 bills.

PJW
[Edited once to soften the tone.]

[TSR]

Are we saying that such a person should (1) modify the plan to go 100% equities for the next ten years (approx), (2) SLIGHTLY modify the plan to go 85/15 TSM/TBM, or (3) stick with the plan?

In my opinion, the Boglehead approach would be to stick with the plan.

That was certainly my understanding (and my plan), but the more I hear people saying that they are making "strategic reallocations," "slight shifts," etc., the more I wonder. I actually know someone who needs to get into an appropriate allocation right now, and I worry that too many people are saying "stay away from bonds altogether right now" that folks with less knowledge won't know what's what.

[retiredjg]

...and I worry that too many people are saying "stay away from bonds altogether right now" that folks with less knowledge won't know what's what.

I think that is a legitimate concern.

[Abe]

What do you do right now, when deposit accounts are paying less than expected inflation? Isn't the value of your account steadily going down, in real albeit not nominal dollars?

What would you do if deposit accounts were paying zero interest and charging monthly fees? Then the nominal dollars would be going down too. What would you do if they were explicitly charging you interest for the privilege of keeping your money there (like BONY Mellon did for some of its customers, as noted and referenced in my earlier post)?

There are plenty of investments where an investor would lose money in real dollars; however, it should be obvious that I was talking in terms of nominal dollars.

If deposit accounts were paying zero interest and charging a monthly fee, I wouldn't deposit my money there. If they charged me interest for the privilege of keeping my money there, I would do the same, not deposit my money there.

[Clearly_Irrational]

So why do people use 30 year treasury bonds? I'm pretty unfamiliar with these puppies and I'm not seeing much of an attraction.

They have a higher return and they're more volatile (yes, that can be a good thing depending on your strategy).

[Clearly_Irrational]

I can't see how interest rates can go negative, at least not for very long. Why would anyone pay someone to borrow their money?

They're negative real right now all the way out through the 20yr mark. Actual cash is still worse since it generates zero nominal returns, and bank deposits are only insured up to 250k.

[Phineas J. Whoopee]

What do you do right now, when deposit accounts are paying less than expected inflation? Isn't the value of your account steadily going down, in real albeit not nominal dollars?

What would you do if deposit accounts were paying zero interest and charging monthly fees? Then the nominal dollars would be going down too. What would you do if they were explicitly charging you interest for the privilege of keeping your money there (like BONY Mellon did for some of its customers, as noted and referenced in my earlier post)?

There are plenty of investments where an investor would lose money in real dollars; however, it should be obvious that I was talking in terms of nominal dollars.

If deposit accounts were paying zero interest and charging a monthly fee, I wouldn't deposit my money there. If they charged me interest for the privilege of keeping my money there, I would do the same, not deposit my money there.

Precisely. $100 bills stored somewhere, as I said.

PJW

[Munir]

I do not understand these catastrophic fears about bonds. If one holds short or intermediate bond FUNDS and is able to hold them for the duration of the fund, then there is no problem with rising rates. Right? With the above caveat, why would anyone flee bond funds to the more risky and volatile equities?

[Phineas J. Whoopee]

I do not understand these catastrophic fears about bonds. If one holds short or intermediate bond FUNDS and is able to hold them for the duration of the fund, then there is no problem with rising rates. Right? With the above caveat, why would anyone flee bond funds to the more risky and volatile equities?

I couldn't agree more.

PJW