Struggling with BND

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Struggling with BND

Postby InvestorNewb » Wed Dec 19, 2012 4:53 pm

Hello,

I think I've finally decided on my long-term strategy, although I'm struggling with bonds. My strategy is simple: hold equities (namely VTI and VXUS) in my taxable accounts, and hold bonds in my tax-advantaged accounts. I will keep my international allocation to 20-30%.

My struggle is with holding BND, when there are other bond funds available with higher returns. For instance, according to Vanguard's web site, the Extended Duration Treasury ETF (EDV) has averaged 12.8% per year since inception (2007) and the Long-Term Corporate Bond ETF (VCLT) has averaged 13.19% per year since inception (2009).

In one year, VCLT has returned 3 times what BND did. My online brokerage account shows VCLT having a cumulative return of 42.32% since inception and EDV having a cumulative return of 78.34% since inception. These appear to be pretty high given the short time horizons for these funds and the low level of risk. Based on the returns, they have that equity investment "feeling".

What do you think about having a 3-fund portfolio that substitutes BND with VCLT or EDV instead?
Current Holdings: VTI, VXUS, VNQ, VCE (largest to smallest)
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Re: Struggling with BND

Postby DSInvestor » Wed Dec 19, 2012 4:57 pm

Do not chase performance. Long term bond funds have had larger gains than intermediate term bond funds as interest rates have fallen. If rates rise, long term bond funds will decline more than intermediate term bond funds. See Vanguard page Get to k now your bond fund: Duration:
https://personal.vanguard.com/us/insigh ... s-duration

InvestorNewb wrote:These appear to be pretty high given the short time horizons for these funds and the low level of risk. Based on the returns, they have that equity investment "feeling".

Remember why you want bonds in the first place - for diversification, stability and rebalancing. If you wanted equity investment feeling, why not just hold bonds and skip bonds all together. Remember why you want bonds and stick with to your investment plan.

I have seen from your other posts that you're a Canadian investor. As a Canadian investor, your bond allocation has significant currency risk. USD/CAD exchange rates have moved quite a bit. See Yahoo 5 yr chart of USD/CAD exchange rate:
Image

I suggest using a low cost Canadian Bond index fund instead to eliminate the currency risk in this part of your portfolio that is supposed to be stable.

iShares Canada has XBB ETF DEX Universe Bond Index MER=0.33%
TD Canadian Bond Index-e MER=0.50%

iShares Canada: http://ca.ishares.com/home.htm

IMO, a 3 fund portfolio of VTI, VXUS and XBB would be better than VTI, VXUS and BND for a Canadian investor.
Last edited by DSInvestor on Wed Dec 19, 2012 5:18 pm, edited 3 times in total.
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Re: Struggling with BND

Postby nisiprius » Wed Dec 19, 2012 5:13 pm

I wouldn't do it.

To begin with, I certainly wouldn't look at one-year returns, both because it's too short to tell you anything, and also because the last year or two have been very unusual.

With ordinary investment-grade bonds there's a pretty direct risk/reward relationship. The longer bonds have a higher return because they're farther out on the yield curve, but they have interest rate sensitivity in direct proportion to their average duration. There are different reasons for wanting to hold bonds in a portfolio, but for me it's the simple-minded one of diluting risk, taming the volatility of the whole portfolio. By the time you get out to long-term bonds you're starting to get a lot of volatility. And you also have inflation risk getting worse and worse the farther out you go.

I feel that long-term bonds are a sort of specialty item, like "high-yield" bonds. Some people want them because the low (NOT negative!) correlation with stocks may have a beneficial effect on the portfolio as a whole that may partially counterbalance the extra risk in the bonds by themselves. That's a little too subtle for me.

Compare these growth charts and remember it's a semi-log scale, so bigger wiggles mean bigger percentage changes. I picked "long-term Treasury" just because it goes back farther than "long-term bond index."

The amount of up-and-down fluctuation in the orange line (long-term Treasuries) is more than I would be comfortable with in what is supposed to be the low-risk part of my portfolio.

Image

And let's look at the area around 1994. You'll notice that there are quite a few drops that large in the chart.

Image

From 1/31/1994 to 10/31/1994, Total Bond dropped less than 5%, while Long-Term Treasury dropped more than 10%. And as I say that's not the only place.
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Re: Struggling with BND

Postby Clearly_Irrational » Wed Dec 19, 2012 5:37 pm

InvestorNewb wrote:What do you think about having a 3-fund portfolio that substitutes BND with VCLT or EDV instead?


Terrible idea. I actually like long duration bond funds but you can't just throw them in willy nilly. Even for me EDV is too extreme, TLT is as far out as I'm willing to go currently. Though I do admit that if real yields for TLT were to go negative I would in theory have to move to longer duration according to my IPS. At that point I'd want to do some serious analysis as to why that was happening before making a decision.
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Re: Struggling with BND

Postby mdpsychcrnp » Thu Dec 20, 2012 1:19 am

Investor,
Everyone has their own philosophy, but you will get more bang for your buck if you do 40% VCIT, 40% BND, and 20% VWEHX. The combination gives you approximately the same return as the long term bond index without the volatility. You certainly take on a bit of credit risk in doing so but nothing absurd. As you will recall even Rick Ferri argues for a 20% bond allocation to VWEHX. Sure there will be Bogleheads who will crucify me over suggesting credit risk, but the risk/reward characteristics of that allocation are more favorable than long term bonds.
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Re: Struggling with BND

Postby mdpsychcrnp » Thu Dec 20, 2012 1:22 am

Given that VWEHX is closed at the moment except for those of us who already hold it, I would suggest JNK. It has a higher ER than admiral shares and has more credit risk but is performing quite favorably. Its credit risk is lower than the other high yield funds that I am aware of.
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Re: Struggling with BND

Postby Valuethinker » Thu Dec 20, 2012 8:51 am

If OP is Canadian then the advice to hold Canadian bonds is very good:

- run the CAD/ USD chart even further back. CAD was c. $1.02 USD in about 1974, fell to 60 cents in the early 90s, is now par more or less. That's huge volatility for a bond fund - with a global equity fund you can wear that

- US bonds don't offer any real advantages over Canadian dollar bonds. The yields are not higher, particularly, I don't believe. Canadian Real Return Bonds are just as unattractive as TIPS, but do offer protection against *Canadian* inflation

Until you get to the point where you are say 70%+ bonds, it's better to get the foreign currency diversification via the equity portfolio, rather than the bond portfolio. Your retirement expenses will be in CAD, why not hold your bonds in CAD?

Generally AFAIK there is no way in an RRSP to reclaim US withholding tax on ETFs? Making a strong preference for TSX listed ETFs?

An alternative to holding bond funds, if you have enough money in RRSP, is holding actual bonds. Canadian Treasury bonds or the highest rated provinces only (Alberta-- not sure which others). That means your duration is constantly shortening. I wish I had bought more RRBs directly on that basis (and had not sold some because 'the money had been made' at, oh, 1.5% real yield :( :( ).
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Re: Struggling with BND

Postby InvestorNewb » Thu Dec 20, 2012 3:53 pm

Thanks for the replies.

Valuethinker wrote:If OP is Canadian then the advice to hold Canadian bonds is very good:

- run the CAD/ USD chart even further back. CAD was c. $1.02 USD in about 1974, fell to 60 cents in the early 90s, is now par more or less. That's huge volatility for a bond fund - with a global equity fund you can wear that

- US bonds don't offer any real advantages over Canadian dollar bonds. The yields are not higher, particularly, I don't believe. Canadian Real Return Bonds are just as unattractive as TIPS, but do offer protection against *Canadian* inflation

Until you get to the point where you are say 70%+ bonds, it's better to get the foreign currency diversification via the equity portfolio, rather than the bond portfolio. Your retirement expenses will be in CAD, why not hold your bonds in CAD?

Generally AFAIK there is no way in an RRSP to reclaim US withholding tax on ETFs? Making a strong preference for TSX listed ETFs?

An alternative to holding bond funds, if you have enough money in RRSP, is holding actual bonds. Canadian Treasury bonds or the highest rated provinces only (Alberta-- not sure which others). That means your duration is constantly shortening. I wish I had bought more RRBs directly on that basis (and had not sold some because 'the money had been made' at, oh, 1.5% real yield :( :( ).


The reason I want to hold US bonds is because most of the income that my business generates is with the US, even though I am Canadian.

My savings are therefore mostly in USD. Are you suggesting that it would be better to convert the bond portion of my portfolio to CAD?
Current Holdings: VTI, VXUS, VNQ, VCE (largest to smallest)
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Re: Struggling with BND

Postby Noobvestor » Fri Dec 21, 2012 2:52 am

InvestorNewb wrote:Thanks for the replies.

Valuethinker wrote:If OP is Canadian then the advice to hold Canadian bonds is very good:

- run the CAD/ USD chart even further back. CAD was c. $1.02 USD in about 1974, fell to 60 cents in the early 90s, is now par more or less. That's huge volatility for a bond fund - with a global equity fund you can wear that

- US bonds don't offer any real advantages over Canadian dollar bonds. The yields are not higher, particularly, I don't believe. Canadian Real Return Bonds are just as unattractive as TIPS, but do offer protection against *Canadian* inflation

Until you get to the point where you are say 70%+ bonds, it's better to get the foreign currency diversification via the equity portfolio, rather than the bond portfolio. Your retirement expenses will be in CAD, why not hold your bonds in CAD?

Generally AFAIK there is no way in an RRSP to reclaim US withholding tax on ETFs? Making a strong preference for TSX listed ETFs?

An alternative to holding bond funds, if you have enough money in RRSP, is holding actual bonds. Canadian Treasury bonds or the highest rated provinces only (Alberta-- not sure which others). That means your duration is constantly shortening. I wish I had bought more RRBs directly on that basis (and had not sold some because 'the money had been made' at, oh, 1.5% real yield :( :( ).


The reason I want to hold US bonds is because most of the income that my business generates is with the US, even though I am Canadian.

My savings are therefore mostly in USD. Are you suggesting that it would be better to convert the bond portion of my portfolio to CAD?


Where do you live now? Where do you play to live in the future? Where are your business expenses? Where are you legally a resident and/or citizen?
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
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Re: Struggling with BND

Postby Valuethinker » Fri Dec 21, 2012 9:14 am

InvestorNewb wrote:The reason I want to hold US bonds is because most of the income that my business generates is with the US, even though I am Canadian.

My savings are therefore mostly in USD. Are you suggesting that it would be better to convert the bond portion of my portfolio to CAD?


If your currency of liability (where you pay rent, mortgage, food, healthcare, education etc.) is different from currency of income then you have a fundamental mismatch-- you are at risk.

You can build up assets in your currency of liability to offset this (somewhat). If you plan to retire in Canada, then that is CAD.

The 'hedge' against USD rises CAD falls is actually to *borrow* in the USA-- but there's all kinds of issues in that (tax, volatility etc.). Companies that have large operations in the USA for example (that are not US cos.) usually borrow against those assets.

I would:

- hold your bonds in CAD (assuming you are not planning to retire somewhere else) - RRBs are the perfect asset, the yields are so low right now straight bonds up to 10 years maturity is more appropriate (gotta be in your RRSP or other tax saving fund-- otherwise you are getting a negative after tax real rate)-- a range up to 10 years I should say, not all in 10 year bonds (unless you can hold to maturity ie not a fund). You don't really want an average duration more than about 5 years

- diversify your equities 100% globally, which would be about 4.5% in Canada, about 50% in USA-- that's enough diversification. You want to get the Emerging Market/ Developed market split right. I am vague on fund weightings (the two main index providers, FTSE and MSCI have different definitions/ weightings of Emerging Markets) but my mental sense (to be checked!) is EM are c. 15-20% of developed markets. Either you find a fund that does that for you (holds both) OR you hold c. 10-20% in EM (I'd be more comfortable around 10% than around 20%, for shading-- '50 Shades of Eh?' ;-) ;-)).

You could argue you should not hold USD assets given one of your major assets (your income) is in USD. That is extreme in my view. Global diversification is best-- the US market has been a decent performer the last few years (stripping out currency effects). Note the US economy is definitely recovering, and higher interest rates (which will hit bonds) are in prospect, although probably not until 2014-- the market will move *before* that happens, though.

On a 60/40 equity/bond split you would then be c. 43% in CAD assets (40% bonds + 5% of 60% equities).

Remember Canada is the place where Nortel became more than 20% of the index- -it's not a diversified equity index (mostly banks and resource companies).

Once your target asset allocation gets to be more than about 60% bonds then there is an issue-- starting to have too many eggs in the CAD basket (I am assuming you will qualify for Canada Pension Plan? Any other Canadian pensions? Own your own home?). Once you get to 60-70% in bonds then you need to start to think about diversifying away from CAD (one good diversification is simply to hold lots of Real Return Bonds-- protection against Canadian CPI).

Note Canadian property is another CAD asset, along with CPP eligibility, and that would imply tilting even further away from CAD. Not an easy question but you could count your *equity* in your home as part of your asset allocation for purposes of currency diversification.

Tax matters a lot in this. You have to make sure you are in the right places to get the tax credits, maxxing RRSP and other means of deferring tax, etc.

The Financial Webring has good discussion and advice on these matters by Canadians.
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