Unexpected Bond Fund Risks?

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Unexpected Bond Fund Risks?

Postby Call_Me_Op » Thu Jun 27, 2013 7:58 am

About 1 month ago, I purchased a chunk of Vanguard short-term tax-exempt fund (Admiral Shares). At the time, it was yielding about 0.25%. Today, it is yielding about 0.45%, or about 0.2% higher. The duration of this fund is 1.2 years.

So I would expect my initial investment to be down by about 1.2*0.2% = 0.24%. Yet, it is down over 0.6%. Can anyone explain this discrepancy? Are there other factors at play that I would not have expected? I would assume that short-term munis are very liquid, so would not have expected significant market impact costs.
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Thu Jun 27, 2013 8:37 am

FYI, I spoke to Vangaurd about this this morning at some length. They could not answer my question, except to say that it was an abnormal market. This may be the first concrete example I have seen of "sell-off risk", a risk I have discussed here several times. This is a risk specific to mutual funds. I was told I need to write the fund manager via snail mail to get a detailed answer on this. I am disappointed I have to do this to get the answer to my question.

So to all who think that bond mutual funds are as safe as holding a basket of individual bonds, please take note.
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Re: Unexpected Bond Fund Risks?

Postby z3r0c00l » Thu Jun 27, 2013 8:50 am

Dividend?
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Re: Unexpected Bond Fund Risks?

Postby G-Money » Thu Jun 27, 2013 8:58 am

Call_Me_Op wrote:So I would expect my initial investment to be down by about 1.2*0.2% = 0.24%.

I would only expect this with a fund invested in bonds with absolutely no credit risk (i.e., Treasuries). VWSTX has about 15% in AAA, 63% in AA, 20% in A, and 2% in BBB. Equity risk and credit risk are highly correlated. So it might be reasonable to expect the credit spreads to have widened a bit, which would have further depressed prices.

Also, I'm not surprised that the Vanguard CSR could not answer your question. Explaining the vagaries of the market isn't what they're trained to do, other than to say basic stuff like "equities are riskier than bonds," etc. Honestly, I'd be surprised if you got a particularly substantive response from the fund manager. If you do get a response, I'd appreciate if you'd share with the rest of us.
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Thu Jun 27, 2013 8:59 am

No, cannot be explained by a dividend because dividend yield is too low. In one month, the dividend yield would be only 0.02% of the original investment.
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Re: Unexpected Bond Fund Risks?

Postby tadamsmar » Thu Jun 27, 2013 9:09 am

There are a list of risks for the fund here, seems like some of those could explain a price fluctuation no linked to interest rates:

https://personal.vanguard.com/us/funds/ ... =INT#tab=2
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Thu Jun 27, 2013 9:16 am

G-Money wrote:
Call_Me_Op wrote:So I would expect my initial investment to be down by about 1.2*0.2% = 0.24%.

I would only expect this with a fund invested in bonds with absolutely no credit risk (i.e., Treasuries). VWSTX has about 15% in AAA, 63% in AA, 20% in A, and 2% in BBB. Equity risk and credit risk are highly correlated. So it might be reasonable to expect the credit spreads to have widened a bit, which would have further depressed prices.


I guess I would not have expected a significant change in credit spread relatively high-quality munis, but suppose that this could be a factor.
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Thu Jun 27, 2013 9:18 am

tadamsmar wrote:There are a list of risks for the fund here, seems like some of those could explain a price fluctuation no linked to interest rates:

https://personal.vanguard.com/us/funds/ ... =INT#tab=2


Certainly. Liquidity risk is very much related to "sell-off risk."

This experience furthers my resolve to stick only with the very highest credit quality and liquidity for my fixed-income holdings.
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Re: Unexpected Bond Fund Risks?

Postby Chindsey » Thu Jun 27, 2013 5:24 pm

So, what's your plan, Call_Me_Op?

I'm curious because 40% of my taxable investments are in the Short-Term Tax-Exempt Bond Fund (Admiral shares).
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Re: Unexpected Bond Fund Risks?

Postby tadamsmar » Thu Jun 27, 2013 8:33 pm

I noticed back during the 2008 crash (after the fact) that treasury bond had a big drop and had a big rebound after a few months. I did not think it made sense for treasury bonds to drop at that point. All I could figure is that investors were selling off total bond funds to get out of mortgage bonds and corporate bonds and got out of treasury bonds as a side effect.
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Re: Unexpected Bond Fund Risks?

Postby richard » Thu Jun 27, 2013 8:44 pm

Call_Me_Op wrote:I would assume that short-term munis are very liquid, so would not have expected significant market impact costs.

Why would you assume that? My general impression of the muni market is a lot of relatively small issues with relatively little trading (compare US treasuries), although I haven't done any research on the short muni fund.
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Re: Unexpected Bond Fund Risks?

Postby nedsaid » Thu Jun 27, 2013 9:08 pm

Duration is a calculated estimate of how a fund might perform when interest rates rise. it is not a guarantee of how the fund will react. Investment history does not repeat itself, it just rhymes. Each market situation is a bit unique and each time asset classes act differently. Normally asset classes act pretty much the way we expect, but there are times they don't. This is one of those times.

I have been checking up on my investments and pretty much the bond funds have dropped more than the stocks and stock funds. Bonds have not been a buffer at all this time, in fact owning them seems to have increased the losses a bit.

It amazes me that experienced investors react with dismay that investments aren't performing exactly the way they thought they would. Investing is not an exact science. Human behavior is involved and thus odd things happen from time to time.

Just because we can calculate with precision the effects of human behavior in the past does not mean we can with the same precision project those effects with the same precision. Investing is not a math problem. Math helps a whole lot but is not the whole thing.
Last edited by nedsaid on Fri Jun 28, 2013 12:23 am, edited 1 time in total.
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Re: Unexpected Bond Fund Risks?

Postby stlutz » Thu Jun 27, 2013 10:20 pm

We were discussing in another thread a couple of days back that the SEC Yield measure seems to run a little bit behind where the market is (in that case we were looking at Int. Term. Treasury)--almost as of some type of averaging across time is going on. My hypothesis is that if you wait a couple of weeks and there are no more big rate changes during that time, that the SEC yield will continue to climb. We will have to wait and see if that is actually the case or not.
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Re: Unexpected Bond Fund Risks?

Postby Dale_G » Thu Jun 27, 2013 11:05 pm

The devil is in the details.

First of all, we are talking about a decline in price of 7 cents - from $15.90 on 05/28/2013 to $15.83 on 06/27/2013.

1. I am not sure how Vanguard rounds, but there is a possible rounding variance of up to .999 cents per share - cumulative for the buy NAV and current NAV - call it a penny.

2. The dividend actually does count. In Vanguard bond funds you accrue the interest on a daily basis, but the interest is not reflected in the NAV. On June 28th you will receive a dividend of about 1.3 cents a share. The payment of the dividend will not cause a decrease in the NAV. The value of your shares on June 27th is about 1.3 cents higher than the NAV.

3. Most importantly, the SEC yield is not a snapshot of the yield based on today's NAV. Rather the SEC yield as indicated in note A following the SEC yield on the Vanguard site is:
BASED ON HOLDINGS' YIELD TO MATURITY FOR LAST 30 DAYS; DISTRIBUTION MAY DIFFER


So, if rates are rising over 30 days, the SEC yield will understate the yield at the end of the period.

If there is no change in the NAV of this fund over the next 30 days (meaning that there is no change in interest rates), you will the the SEC yield will none-the-less increase.

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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Fri Jun 28, 2013 5:22 am

Chindsey wrote:So, what's your plan, Call_Me_Op?

I'm curious because 40% of my taxable investments are in the Short-Term Tax-Exempt Bond Fund (Admiral shares).


I have already implemented it - for better or worse. I sold my position and put the proceeds in 6 month brokerage CD's yielding 0.5%. In my mind, this was simply tax-loss harvesting. But in addition to that, I wanted to move these funds into an investment vehicle that I fully understand. The difference of 18 or so basis points of after-tax interest does not seem to justify the incremental risk.

I have some of my money invested in aggressive stock categories. However, for the fixed-income side, I want to keep it very safe because I do not believe I could re-earn it if lost. It seems that there are risks/issues associated with the muni funds that I do not yet fully understand. I have been discussing "sell-off risk" with Larry Swedroe off-line and I still do not have a complete grasp on how it works.

What was disconcerting about this experience is I hold many brokerage CD's, some with 1 year maturity. The secondary market value of these hardly budged while I saw my muni fund with 1.2 year duration lose several hundred dollars (50K investment). Not sure why I want to lose several hundred bucks if I can get about the same yield with minimal loss of principal value. At least I know that the CD's will be worth face value in a year or less.
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Re: Unexpected Bond Fund Risks?

Postby #Cruncher » Fri Jun 28, 2013 6:25 am

Call_Me_Op wrote:About 1 month ago,... it was yielding about 0.25%.
Where do you get the "0.25%", Call_Me_Op? Clicking Search for more historical price information on the Vanguard Short-Term Tax-Exempt Fund Admiral Shares (VWSUX) Price & Portfolio tab I see the SEC yield for this fund ranging only between 0.43% and 0.46% from 5/13/2013 to 6/27/2013.

Dale_G wrote:... the SEC yield is not a snapshot of the yield based on today's NAV. Rather the SEC yield .. is "BASED ON HOLDINGS' YIELD TO MATURITY FOR LAST 30 DAYS"
Good point, Dale_G. This makes it too coarse a measure to use as a stand in for determining the change in yield to maturity (YTM) over such a short time period. Better to turn the calculation around. Using the dates Dale_G mentions, the NAV per share fell "from $15.90 on 05/28/2013 to $15.83 on 06/27/2013". Add back $0.01 for the dividend and we have a decrease of $0.06 or about 0.4%. Dividing this by the 1.2 duration means the YTM rose about 0.3%

So why then did the YTM of this fund rise by 0.3% in the past month? 1-year Treasuries rose only 0.02% points (from 0.13% to 0.15%) and 2-year Treasuries only 0.07% points (from 0.29% to 0.36%) from 5/28/2013 to 6/27/2013. (See Daily Treasury Yield Curve Rates 2013.) So it looks like the cause is mainly an increase in the spread between short term municipals and short term Treasuries.
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Re: Unexpected Bond Fund Risks?

Postby Buffetologist » Fri Jun 28, 2013 6:45 am

I sold my position and put the proceeds in 6 month brokerage CD's yielding 0.5%


There are bank money market funds paying double that. See depositaccounts.com

About the value of your fund dropping,

When you buy a risky bond, the bond holder has the option to default. Therefore:

The value of a risky bond = value of a safe bond - value of the option to default.

The value of the option to default is basically a put option on the assets of the borrower. In terms of credit quality, the value of the put option is worth a lot less for a stronger company than a weaker company because it is way out of the money.

Since the value of all options increase with stock market volatility, then the value of the risky bond decreases more than the value of a safe bond would.
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Fri Jun 28, 2013 7:14 am

#Cruncher,

Sorry, I actually purchased the fund 2 months ago and the SEC yield was 0.36 at that time. So there was a 0.10% change in the SEC yield and the fund lost just over 0.6% of its value. Sounds like there are a few possible explanations:

1.) SEC yield lag
2.) Large change in credit spread.
3.) Loss due to "sell-off" risk
4.)???
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Re: Unexpected Bond Fund Risks?

Postby Valuethinker » Fri Jun 28, 2013 9:29 am

Underlines the dangers of using Duration as your sole measure of risk.

Bonds also posess Convexity, the second derivative, the rate of change of Duration with respect to a change in yield.

And Modified Duration assumes *parallel* shifts in yield curves, when, in fact, yield curves change in slope all the time, even reverse direction.

Bonds got overbought, the market went into selloff mode. A 'crowded trade' in became a crowded trade out, result was big price reaction.
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Fri Jun 28, 2013 9:38 am

Hi Valuethinker,

Can you be more specific as to what you think (what risk factor or expense) caused the price change of this fund to differ from (change in rate)*(average duration)?
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Re: Unexpected Bond Fund Risks?

Postby rkhusky » Fri Jun 28, 2013 9:42 am

Call_Me_Op wrote:Hi Valuethinker,

Can you be more specific as to what you think (what risk factor or expense) caused the price change of this fund to differ from (change in rate)*(average duration)?


That formula is only valid when the market is rational. There is plenty of irrational investing taking place, especially when one only looks at one corner of the market or at one particular fund.
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Re: Unexpected Bond Fund Risks?

Postby Valuethinker » Fri Jun 28, 2013 9:54 am

Call_Me_Op wrote:Hi Valuethinker,

Can you be more specific as to what you think (what risk factor or expense) caused the price change of this fund to differ from (change in rate)*(average duration)?


Suppose the slope of the yield curve changed? Ie short rates moved up more than long rates? Modified Duration assumes a parallel shift in yield curve (which never happens). The short bonds in the portfolio would move down more than the long bonds.

Also with 2 bonds of the same maturity, they may have different convexities-- the one which is more convex will be more sensitive in price to a change in interest rates. There are also liquidity premia in there (more illiquid bonds will be more volatile).

Modified Duration is just a rough guide to sensitivity.

Note tax exempt bonds have ever weirder effects, because different investors have different sensitivities due to their tax position. And the Detroit bankruptcy may have put credit risk fear into the whole thing as well. Tax exempt bonds are quite illiquid, generally, so a relatively small number of sales will drive prices down (yields up).
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Re: Unexpected Bond Fund Risks?

Postby Call_Me_Op » Fri Jun 28, 2013 12:02 pm

I think ultimately, I was expecting a Vanguard short-term municipal fund to be more or less driven by interest rate risk. If so, with a ~ 1 year duration, it would have been a good parking place for money. Now I see that it may not be so good.
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Re: Unexpected Bond Fund Risks?

Postby Electron » Fri Jun 28, 2013 1:05 pm

Municipal bonds can have liquidity problems at times of stress in the market. Liquidity may be even less in the years following the 2008 financial crisis as there are fewer dealers and banks willing to take inventory.

Take a look at a long term chart showing NAV. Note periods where NAV had significant changes such as 2008.

http://quote.morningstar.com/fund/chart ... %2C0%22%7D

The chart can be changed from Price to Growth by clicking on the word Price.

If you bring up a similar chart for VWSTX (Investor Shares) you can see the price action going back to 1977. Note the 1994 period where the Fed had been aggressively increasing short term rates.

http://quote.morningstar.com/fund/chart ... %2C0%22%7D

As mentioned, duration is an estimate and it may not reflect price changes all the time and especially during periods of stress in the market. I also agree that the 30 day SEC yield lags in time.

Lastly, note that the distribution yield is 1.00% which could be another factor in the interest rate sensitivity.
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