Bond Funds

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Bond Funds

Postby dms1873 » Mon Jul 01, 2013 11:17 pm

I am a recent convert to index funds. I am learning a great deal from reading these forums and the many links and resources but I still have several questions about diversification, primarily bond funds.

I currently have 30% of my taxable brokerage account in three Vanguard bond funds: long-term corporate, intermediate corporate, intermediate government. Now I learn that I should not hold bonds in a taxable account. I do have traditional and Roth IRAs with Vanguard. Should I sell the funds in the taxable account and reopen and diversify in one or more the tax-sheltered accounts?

Last question for now, I struggle with investing significant amounts in bond funds when all have negative YTD returns and the interest rate outlook is not good. Is it still important to keep the diversification? If so, what suggestions do you have for bond funds? I am looking at two Vanguard mutual funds: Total Bond Market Index and Total International Bond Index.

Thanks for any help and advice.
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Re: Bond Funds

Postby Jim180 » Mon Jul 01, 2013 11:41 pm

I would get out of that Long-Term bond fund ASAP! If you have bond funds keep the duration short to intermediate. Have you had these bond funds for a while?
Are you reinvesting the dividends? Also your age would be helpful.
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Re: Bond Funds

Postby dms1873 » Mon Jul 01, 2013 11:45 pm

Jim180,

I have held all of the bond funds for about six months. I do reinvest dividends. I am 54 years old and stable income (full-time salary plus a pension distribution) and I plan to work and invest for 8-12 more years.
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Re: Bond Funds

Postby Jim180 » Mon Jul 01, 2013 11:56 pm

dms1873 wrote:Jim180,

I have held all of the bond funds for about six months. I do reinvest dividends. I am 54 years old and stable income (full-time salary plus a pension distribution) and I plan to work and invest for 8-12 more years.

Well, the decision comes down to your risk tolerance. If it bothers you a lot watching the NAV of those bond funds drop then I would take that 30% and bulld a ladder of CD's.
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Re: Bond Funds

Postby FinancialDave » Tue Jul 02, 2013 1:15 am

dms1873 wrote:Jim180,

I have held all of the bond funds for about six months. I do reinvest dividends. I am 54 years old and stable income (full-time salary plus a pension distribution) and I plan to work and invest for 8-12 more years.


No one here can really tell you what your bond allocation should be, you have to decide that for yourself. The good news is if you have a secure pension you may not need as many bonds as you think. Jack Bogle pointed this out on a recent CNBC interview and there was much discussion on both sides of this in a recent thread. I personally come out on the side of less bonds. However, I would not make this type of change (30% of your account) all at once, unless you are only moving their location. I would maybe take a shot at 2% per week, if you are going to unload some of the allocation for awhile and see how you like it.



fd
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Re: Bond Funds

Postby dms1873 » Tue Jul 02, 2013 2:11 am

Thanks FinancialDave,

I found and read the article and Bogle's comments about retirement/pension income streams. I also enjoyed reading your posts and the opinions of others in the previous forums.

Without a pension and based on the age-based formula, I should be at a 60/40 allocation. But since my pension is stable and provides close to half of the income I need to continue with my current modest lifestyle, I don't see the need to allocate 40% of my portfolio into funds that are losing money and value. I was thinking (in my unique situation) of an 80/20 allocation and maybe some of that 20% in money market or CD. Since I am still new to low-cost index funds I want to find an allocation with which I'm comfortable (as Bogle stated in the CNBC interview) and stick with that allocation.

Thanks again.
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Re: Bond Funds

Postby stlutz » Tue Jul 02, 2013 3:19 am

I don't see the need to allocate 40% of my portfolio into funds that are losing money and value.


The bond fund armageddon was so two weeks ago.

When you allocate your investments between multiple asset classes (US stocks, Intl stocks, and bonds are a common combination), something is always not going to do well. Second, because fund X was doing poorly in June doesn't mean that the same will be true in July. If you are going to reduce your bond allocation because of a bad June, does that mean you'll reduce your stock allocation next time they have a bad month? Isn't that buying high and selling low?

There is no "optimal" asset allocation that is just perfect for you. Come up with something sensible and stick with it. Common longstanding advice (dating back to Ben Graham in the 1930s) is to not drop below 25% in bonds or 25% in stocks. If you have trouble dealing with a modest bond decline, you then taking the risk of an 80% stock portfolio is something I would question.

FWIW.
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Re: Bond Funds

Postby Tom_T » Tue Jul 02, 2013 8:23 am

dms1873 wrote:... I don't see the need to allocate 40% of my portfolio into funds that are losing money and value. I was thinking (in my unique situation) of an 80/20 allocation and maybe some of that 20% in money market or CD.

You expect to reduce your chances of losing money by going to 80% equities instead of 60%?
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Re: Bond Funds

Postby dbr » Tue Jul 02, 2013 9:11 am

dms1873 wrote:Without a pension and based on the age-based formula, I should be at a 60/40 allocation. But since my pension is stable and provides close to half of the income I need to continue with my current modest lifestyle, I don't see the need to allocate 40% of my portfolio into funds that are losing money and value. I was thinking (in my unique situation) of an 80/20 allocation and maybe some of that 20% in money market or CD. Since I am still new to low-cost index funds I want to find an allocation with which I'm comfortable (as Bogle stated in the CNBC interview) and stick with that allocation.


Do you mean that when stocks decline you will decide to bail out from "funds that are losing money and value"? What will you buy then? There are some serious problems with Mr. Bogle's advice when the overall concepts of risk and return have been lost --- or aren't even in the conversation to start with.

Also, your situation is not unique. Lots of people have pensions and SS supplying a significant fraction of their income without concluding that they want to put their assets almost entirely at risk of the volatility that stocks will have. There may be no harm there if the investor can tolerate stock market declines without bailing out. Panic selling at a stock market low is possibly the one single really disastrous thing an investor can do, so what would you do?

I think a more rational approach to asset allocation in retirement is to look at the factors that dictate successful funding of income in retirement. A basic approach is to assess what amount of withdrawal can be sustained. The answer to that is something like the 4% rule, or maybe less, if you believe the current pessimistic outlook presented in some quarters. The effect of asset allocation on that is minor unless one has too little in stocks, say less than 40%, but it doesn't seem to help much to have more. There is also the point of view that almost all of what one needs for income should be accounted for by secure income streams, meaning inflation adjusted annuities or at least TIPS bonds. Cash and nominal bonds can be ravaged by inflation and don't have enough return (nor TIPS right now) to sustain retirement withdrawals. Age in bonds, with or without capitalizing pensions, does not really address the mechanics of income generation in retirement.
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Re: Bond Funds

Postby sls239 » Tue Jul 02, 2013 9:54 am

You are going to have to decide your asset allocation.

However, whether it changes or you just want something more tax efficient, your first step should be to stop re-investing the dividends on the taxable bond funds.

Also, I'd like to humbly suggest you take a look at I-bonds, as you don't pay state income tax on them and they are tax deferred and they aren't securities so their value doesn't go up or down with the market mood, and they are inflation indexed unlike the bond categories you listed.
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Re: Bond Funds

Postby hollowcave2 » Tue Jul 02, 2013 10:35 am

The best way to hold bonds is in a tax deferred account, but obviously, if you need the money today, or are living off of the distributions, then a taxable account is OK. It just depends on your needs and how much we can lower your tax liability. If you don't need the money now and are not spending the distributions, then yes, it makes sense to switch to the tax sheltered account. But if you'll need those funds within the next couple of years, then stay the course.

If you do switch, you'll have an opportunity to make changes. The only recommendation I have is to stick with the intermediate term funds if you're nervous about rates. But if your time horizon is longer than the fund's duration, I think you'll be OK with any domestic bond choice at Vanguard.
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Re: Bond Funds

Postby Call_Me_Op » Tue Jul 02, 2013 10:39 am

dms1873 wrote: Now I learn that I should not hold bonds in a taxable account... Should I sell the funds in the taxable account and reopen and diversify in one or more the tax-sheltered accounts?

Last question for now, I struggle with investing significant amounts in bond funds when all have negative YTD returns and the interest rate outlook is not good.


1.) Not true that bonds shouldn't be held in taxable. This is an over-simplification. If you have a choice of where to hold taxable bonds, it is probably better to hold in a tax-free or tax-deferred account, but there are other considerations.

2.) Negative YTD returns mean the yields are higher than at the beginning of the year - making bonds a better buy (higher expected return) now. Nobody knows the interest-rate outlook - they can only speculate. Understand the risks associated with bonds and choose an allocation percentage, vehicle, and duration with which you are comfortable.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
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Re: Bond Funds

Postby FinancialDave » Tue Jul 02, 2013 10:45 am

stlutz wrote:
The bond fund armageddon was so two weeks ago.



You are joking right!

:oops:
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Re: Bond Funds

Postby FinancialDave » Tue Jul 02, 2013 10:48 am

sls239 wrote:You are going to have to decide your asset allocation.

However, whether it changes or you just want something more tax efficient, your first step should be to stop re-investing the dividends on the taxable bond funds.

Also, I'd like to humbly suggest you take a look at I-bonds, as you don't pay state income tax on them and they are tax deferred and they aren't securities so their value doesn't go up or down with the market mood, and they are inflation indexed unlike the bond categories you listed.


+1

So much better idea than CD ladders.

fd
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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 11:25 am

80% stocks is  too high for an investor a decade away from retirement, pension notwithstanding. Consider reducing duration or using cash if you must; better yet, consult your IPS to see if it says anything about exiting bonds based on changes in interest rates. Reacting this way to market moves is bad for you long term.

So the outlook on interest rates might look unappealing to you, but here's the good thing about interest rates rising: you start making more money. In time, you make up for the capital loss, and then some. Interest rate risk is in a way benign, in that it eventually starts working for you. This Vanguard paper talks about the process, in the last chapter on interest rate scenarios: https://personal.vanguard.com/pdf/icrdir.pdf .

Now compare that to the equity risk that you are considering taking. When that shows up, the downside is far more brutal and there is no guarantee whatsoever of recovery. Moreover, it may coincide with your employer (and possibly even your pension) getting in trouble. Here's what the world looks like with the two stock allocations during a 50% slide in stocks:

At 80% stocks: you've lost 40% of your money already, with no end in sight. Two thirds of the rest is still at risk.
At 60% stocks: you've lost 30% of your money already, with no end in sight. 40% of the rest is still at risk.

In both of these situations, the best thing to do, not knowing the future, is to clench your teeth, take some of the safe money and rebalance into more stocks. The absolute worst is to cut your losses and sell out of the stock market until things look safe again (NB: some refugees from 2008 are still waiting for that green light). The difference in outcome between these two decisions can be immense. The question is, which one if the two allocations will make it possible for you to choose the right one? Maybe both, but as a data point - you are here, having lost a few percent of your portfolio to interest rate risk and already looking to justify selling half of your bond position.

As an investor close to retirement, there is another thing you don't have even if your income is safe: a lifetime of earnings ahead of you to rebound from the losses of an 80% stocks portfolio that decides to stay down for a decade or more, or from a panic sell under duress. I would say that 60% is the absolute maximum for your age and anything above is a big mistake. For the other 40%, you might consider FDIC-insured cash or shorter bonds if the interest rates are really keeping you up at night. At the same time, remember that the interest rate increase has already happened to the market's best guess and bonds are already cheaper / better yielding than when you bought. And that while long bonds are certainly volatile, that extra risk does not go unrewarded.

Above all, staying the course is usually a better answer than trying to outmaneuver the market. Writing a Policy Statement if you don't have one, or reading it if you do, will help keep you honest about it.
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Re: Bond Funds

Postby Jim180 » Tue Jul 02, 2013 11:45 am

FinancialDave wrote:
+1

So much better idea than CD ladders.

fd
I-Bonds are OK but I think the OP needs to be aware of the fact that there is a $10K per year limit on the purchase of I-Bonds. Therefore a ladder of CD's can still be used while waiting to purchase I-Bonds each year if it is a large sum of money.
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Re: Bond Funds

Postby FinancialDave » Tue Jul 02, 2013 11:52 am

And just how long would you expect a 40% slide in stocks would last and how damaging would that be to someone with a 25 to 30+ year retirement growth window.

And just how long might a 40% drop in bonds last and how damaging might that be in the same above time frame.

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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 12:01 pm

FinancialDave wrote:And just how long would you expect a 40% slide in stocks would last and how damaging would that be to someone with a 25 to 30+ year retirement growth window.

It might last forever, as far as we know. At that moment in time the market believes that stocks will actually do that bad. The OP only has 8-12 more years of earnings, as he mentioned.

FinancialDave wrote:And just how long might a 40% drop in bonds last and how damaging might that be in the same above time frame.

For intermediate bonds, 5-6 years, after which the losses have been recovered and the fund is yielding 9-10% going forward. A pretty swell time to be a retiree. Gradual losses might make this horizon longer, but at the same time each successive drop accelerates the recovery due to yields. If the rate increases are not steep enough, the point of full recovery eventually stops moving altogeher.

The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).
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Re: Bond Funds

Postby Call_Me_Op » Tue Jul 02, 2013 12:09 pm

ogd wrote:The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).


I am not as comfortable as you are with bond funds. There are risks in bond funds that not many fully appreciate. Among them are manager risk, sell-off risk, and NAV erosion. All of these have the potential to produce losses that are not necessarily recoverable.
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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 12:17 pm

Call_Me_Op wrote:
ogd wrote:The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).


I am not as comfortable as you are with bond funds. There are risks in bond funds that not many fully appreciate. Among them are manager risk, sell-off risk, and NAV erosion. All of these have the potential to produce losses that are not necessarily recoverable.

To be sure, a rogue manager could in theory decide to rob you of your recovery potential. I don't think many of them are prone to doing this, least of all Vanguard funds with their boring conservative approach. Sell-off risk, a liquidity-induced drop in bond prices, is a temporary condition and only short-term traders need to be concerned with it. I don't know what you mean by NAV erosion.
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Re: Bond Funds

Postby Tom_T » Tue Jul 02, 2013 12:55 pm

Do bond funds not earn higher interest when rates go up?

If the rate on a fund with an average duration of five years went up 1% a year for the next ten years, after five years you would be making money each year, not losing money.
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Re: Bond Funds

Postby dm200 » Tue Jul 02, 2013 1:11 pm

Call_Me_Op wrote:
ogd wrote:The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).


I am not as comfortable as you are with bond funds. There are risks in bond funds that not many fully appreciate. Among them are manager risk, sell-off risk, and NAV erosion. All of these have the potential to produce losses that are not necessarily recoverable.


As far as I know, anyone purchasing a Vanguard Bond fund must agree that they have read the prospectus and know about the fund. The risks of the fund are clearly listed. The information is there, but it is up to the purchaser to evaluate whether is it "fully appreciated".

As far as a "permanent loss" as it relates to the NAV of a bond fund, while a given NAV may never recover to a given value, you need to factor in the income generated by the fund holdings.
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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 1:38 pm

For those of you uncomfortable with NAV decreases, remember that it's the one thing that protects you from losing money to outgoing shareholders. If the NAV was unchanged, they could sell out of the fund with no loss and leave the remaining shareholders holding the bag. At the lower NAV, the losses are spread fairly.
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Re: Bond Funds

Postby JambokLive » Tue Jul 02, 2013 1:41 pm

I always hear others remarking and recommending iBonds, however given the limited amount of iBonds you can purchase each year...for even a modest portfolio the max iBonds don't really materially impact the portfolio, in my case with a 4M portfolio max iBonds are just a rounding error, I also find all the recommendations for CDs is not practical for a large portfolio. Spreading even a modest portfolio across a "cd ladder and staying under the insured max is difficult and does not scale well.

I realize that boogle heads come in all shapes and sizes, however it would be nice to hear from those who have even a modest portfolio, if you are relying on iBonds and cds

Thanks
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Re: Bond Funds

Postby z3r0c00l » Tue Jul 02, 2013 3:47 pm

JambokLive wrote:I always hear others remarking and recommending iBonds, however given the limited amount of iBonds you can purchase each year...for even a modest portfolio the max iBonds don't really materially impact the portfolio

I realize that boogle heads come in all shapes and sizes, however it would be nice to hear from those who have even a modest portfolio, if you are relying on iBonds and cds


Why limit your CD investments to what can be insured? Do we demand to have our mutual funds FDIC insured also?
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Re: Bond Funds

Postby G-Money » Tue Jul 02, 2013 3:53 pm

z3r0c00l wrote:Why limit your CD investments to what can be insured?

Uncompensated risk. Any amount over FDIC/NCUA limits is unsecured debt. It's like buying an illiquid, undiversified corporate bond. I'd want a substantial premium for that.
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Re: Bond Funds

Postby FinancialDave » Tue Jul 02, 2013 5:05 pm

Tom_T wrote:Do bond funds not earn higher interest when rates go up?

If the rate on a fund with an average duration of five years went up 1% a year for the next ten years, after five years you would be making money each year, not losing money.


I don't see your hypothesis as a given for a couple of reasons.

1. Just because a bond fund has an "average duration" of 5 years does not mean all the bonds in the fund have a duration of 5 years - a portion of the fund could have much longer duration. Take for instance the Intermediate Bond Category index -- the category average is that these bonds have about 20% in the 20-30 year bond category. Now a lot of managers have trimmed this down such as in the Vanguard VBIIX, but that just means that the others have more.

2. So where the bond fund goes in the future of rising rates is very dependent on two things, neither of which can be predicted by anyone. The seriousness of the cash flow and how it changes over time, and secondly which bonds the fund manager decides to sell.


Now let's look at your scenario in another light, with the same rising rates for 10 years and just make one small assumption, that every one of those years the net cash is always in an "outflow" mode (because peoples principal keeps eroding at around 5% per year.) To keep the duration somewhat the same, the manager has to sell bonds. The interest rates on the bonds he has does not change, so how would you be making money after five years, when the interest rates on the bonds have not changed. Only if the manager decided to increase the duration and keep more of the higher paying long bonds could there be much of a significant difference in the yield, at least IMO. Any bonds that do mature are not able to be replaced by higher yielding bonds because there is no cash to do so.

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Re: Bond Funds

Postby Call_Me_Op » Tue Jul 02, 2013 5:16 pm

ogd wrote:
Call_Me_Op wrote:
ogd wrote:The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).


I am not as comfortable as you are with bond funds. There are risks in bond funds that not many fully appreciate. Among them are manager risk, sell-off risk, and NAV erosion. All of these have the potential to produce losses that are not necessarily recoverable.

To be sure, a rogue manager could in theory decide to rob you of your recovery potential. I don't think many of them are prone to doing this, least of all Vanguard funds with their boring conservative approach. Sell-off risk, a liquidity-induced drop in bond prices, is a temporary condition and only short-term traders need to be concerned with it. I don't know what you mean by NAV erosion.


Per Larry Swedroe (and other bond experts, including Annette Thau), sell-off risk entails unrecoverable losses. I must admit I am still trying to understand the details myself. It may be that the commissions on the illiquid bonds increase.

NAV erosion occurs when fund managers buy a lot of premium bonds to juice-up the interest rate of the fund. When these bonds mature, they mature below par causing erosion of the NAV.
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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 5:21 pm

FinancialDave wrote:1. Just because a bond fund has an "average duration" of 5 years does not mean all the bonds in the fund have a duration of 5 years - a portion of the fund could have much longer duration. Take for instance the Intermediate Bond Category index -- the category average is that these bonds have about 20% in the 20-30 year bond category. Now a lot of managers have trimmed this down such as in the Vanguard VBIIX, but that just means that the others have more.

Yes, and they have 10% in the 1-3 year category (too much for me -- those yield less than my savings accounts). How does that matter? The average duration takes all of the bonds into account and the aggregate response to interest rates.

FinancialDave wrote:Now let's look at your scenario in another light, with the same rising rates for 10 years and just make one small assumption, that every one of those years the net cash is always in an "outflow" mode (because peoples principal keeps eroding at around 5% per year.) To keep the duration somewhat the same, the manager has to sell bonds. The interest rates on the bonds he has does not change, so how would you be making money after five years, when the interest rates on the bonds have not changed.

Oh brother. First off, the outflows don't matter because the manager can sell bonds of whatever maturity they like in the portfolio, at any time. So they can simply trim 5% by value from each maturity point, and the value of the bonds sold is still adequately represented by the NAV (the cash given to the outgoing investors).

Second, absolutely he gets more money -- in actual dollars not just percentages. By simply holding a bond to maturity, you get to buy higher yielding bonds with the payment. Which is not what they do, but the principle is the same: sell bonds on the short side which have approached maturity and their value is almost restored, buy high yielding bonds on the long side, at a discount or fresh off the presses. Essentially, with the passage of time bonds move towards the par value, restoring value to the fund -- value which can be used to get more yield.

It's easy to badmouth bond funds when you don't understand how they work. I'm not even saying you need to understand all the intricacies, but how about a little trust that they work as advertised?
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Re: Bond Funds

Postby linuxizer » Tue Jul 02, 2013 5:24 pm

FinancialDave wrote:
1. Just because a bond fund has an "average duration" of 5 years does not mean all the bonds in the fund have a duration of 5 years - a portion of the fund could have much longer duration. Take for instance the Intermediate Bond Category index -- the category average is that these bonds have about 20% in the 20-30 year bond category. Now a lot of managers have trimmed this down such as in the Vanguard VBIIX, but that just means that the others have more.

2. So where the bond fund goes in the future of rising rates is very dependent on two things, neither of which can be predicted by anyone. The seriousness of the cash flow and how it changes over time, and secondly which bonds the fund manager decides to sell.

Now let's look at your scenario in another light, with the same rising rates for 10 years and just make one small assumption, that every one of those years the net cash is always in an "outflow" mode (because peoples principal keeps eroding at around 5% per year.) To keep the duration somewhat the same, the manager has to sell bonds. The interest rates on the bonds he has does not change, so how would you be making money after five years, when the interest rates on the bonds have not changed. Only if the manager decided to increase the duration and keep more of the higher paying long bonds could there be much of a significant difference in the yield, at least IMO. Any bonds that do mature are not able to be replaced by higher yielding bonds because there is no cash to do so.


Duration is duration. Funds have a target. If they sell, they sell equally. If they sell long, they sell short. If they do that without selling medium, then they've decreased the convexity and thus increased the interest rate sensitivity, but I don't think that's what you were claiming, and it's a second order effect.

Your last sentence misses the whole reason why NAV adjusts instantly. The manager can replace any bond he/she wants at market rate. That's what marking to market does.
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Re: Bond Funds

Postby Kevin M » Tue Jul 02, 2013 5:42 pm

JambokLive wrote:I always hear others remarking and recommending iBonds, however given the limited amount of iBonds you can purchase each year...for even a modest portfolio the max iBonds don't really materially impact the portfolio, in my case with a 4M portfolio max iBonds are just a rounding error, I also find all the recommendations for CDs is not practical for a large portfolio. Spreading even a modest portfolio across a "cd ladder and staying under the insured max is difficult and does not scale well.

I realize that boogle heads come in all shapes and sizes, however it would be nice to hear from those who have even a modest portfolio, if you are relying on iBonds and cds

Thanks

Yes, I am. You're right, I Bonds are pretty much a rounding error, but I still take advantage of them, and you can buy $20K per year if you have a living trust (which I have done the last few years).

With CDs, you can easily get much more than $250K coverage per bank/CU in taxable accounts by using POD, trust, or multiple ownership categories, which I do. The limit does apply to IRAs, but putting $1M in four banks/CUs, or $2M in eight is worth it to me for the higher yield and lower risk compared to comparable bonds or bond funds. The lack of scalability is why Treasuries sometimes yield much less than comparable CDs.

My allocation is 70% fixed income, and of that, about 2/3 is in CDs and most of the rest is primarily in intermediate-term investment-grade and muni-bond funds.

Kevin
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Re: Bond Funds

Postby Chris M » Tue Jul 02, 2013 5:49 pm

Call_Me_Op wrote:
dms1873 wrote: Now I learn that I should not hold bonds in a taxable account... Should I sell the funds in the taxable account and reopen and diversify in one or more the tax-sheltered accounts?

Last question for now, I struggle with investing significant amounts in bond funds when all have negative YTD returns and the interest rate outlook is not good.


1.) Not true that bonds shouldn't be held in taxable. This is an over-simplification. If you have a choice of where to hold taxable bonds, it is probably better to hold in a tax-free or tax-deferred account, but there are other considerations.


I would keep your bonds in tax-deferred accounts, but save your tax free accounts for high-returning assets--i.e., stocks (and preferably small value would go in the Roth first).
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Re: Bond Funds

Postby ogd » Tue Jul 02, 2013 5:53 pm

Call_Me_Op wrote:Per Larry Swedroe (and other bond experts, including Annette Thau), sell-off risk entails unrecoverable losses. I must admit I am still trying to understand the details myself. It may be that the commissions on the illiquid bonds increase.

Ah -- I thought you meant it in the sense used by the talking heads trying to outmaneouver each other before a certain market turns illiquid.

Of all the supposed disadvantages of bond funds, this one sounds plausible to me, much more so in the muni bond market than anywhere else. It would work by way of fund NAV prices being too high given the price that bonds can actually be sold for incl. trading fees, which means that the sellers are being paid too much. It doesn't seem to apply to ETFs at all, with baskets being sold separately and the sellers bearing the cost in the form of liquidity discounts. Yet muni ETFs don't appear to be espoused as the solution to this problem, and I haven't seen studies of past muni sell-offs that show that this has been a significant drag. So if the problem exists, it must be small.

Call_Me_Op wrote:NAV erosion occurs when fund managers buy a lot of premium bonds to juice-up the interest rate of the fund. When these bonds mature, they mature below par causing erosion of the NAV.

Prima facie, it appears that this is not affecting my total returns with reinvestment at all. If I was a retiree, it might have lead me into spending fund dividends that can't be sustained (and fooled me into choosing a fund with unsustainable yields). I believe that this is the problem that SEC yield reports were designed to solve -- they do take into account the depreciation of premium bonds.
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Re: Bond Funds

Postby FinancialDave » Wed Jul 03, 2013 11:04 am

Call_Me_Op wrote:
ogd wrote:
Call_Me_Op wrote:
ogd wrote:The only scenario where the losses are permanent is if they are due to inflation outpacing interest rates (inflation is the enemy of present or future cash).


I am not as comfortable as you are with bond funds. There are risks in bond funds that not many fully appreciate. Among them are manager risk, sell-off risk, and NAV erosion. All of these have the potential to produce losses that are not necessarily recoverable.

To be sure, a rogue manager could in theory decide to rob you of your recovery potential. I don't think many of them are prone to doing this, least of all Vanguard funds with their boring conservative approach. Sell-off risk, a liquidity-induced drop in bond prices, is a temporary condition and only short-term traders need to be concerned with it. I don't know what you mean by NAV erosion.


Per Larry Swedroe (and other bond experts, including Annette Thau), sell-off risk entails unrecoverable losses. I must admit I am still trying to understand the details myself. It may be that the commissions on the illiquid bonds increase.

NAV erosion occurs when fund managers buy a lot of premium bonds to juice-up the interest rate of the fund. When these bonds mature, they mature below par causing erosion of the NAV.


I think you have hit on part of it, and it doesn't seem that hard to understand, and that is the illiquid nature that bonds could fall into if everyone wants to sell. If the Fed is selling, and all the bond managers are selling - who are going to be the buyers of these bonds? Other bond managers can't be buyers at any price if they don't have any cash to do so. This would drive the NAV down well below what those who can only do the "simple bond math" would be able to predict.

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Re: Bond Funds

Postby linuxizer » Wed Jul 03, 2013 11:13 am

FinancialDave wrote:I think you have hit on part of it, and it doesn't seem that hard to understand, and that is the illiquid nature that bonds could fall into if everyone wants to sell. If the Fed is selling, and all the bond managers are selling - who are going to be the buyers of these bonds? Other bond managers can't be buyers at any price if they don't have any cash to do so. This would drive the NAV down well below what those who can only do the "simple bond math" would be able to predict.


How is that a problem for those who don't sell the fund.

Look, to claim that this stuff hurts longterm fund holders, you have to claim that somehow people selling the fund are being let off easy. To do that, you have to claim that the NAV is mis-calculated. And if you could show that the NAV was mis-calculated, then the SEC or fund could fix the formula and it would no longer be mis-calculated.
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Re: Bond Funds

Postby FinancialDave » Wed Jul 03, 2013 11:45 am

linuxizer wrote:
FinancialDave wrote:I think you have hit on part of it, and it doesn't seem that hard to understand, and that is the illiquid nature that bonds could fall into if everyone wants to sell. If the Fed is selling, and all the bond managers are selling - who are going to be the buyers of these bonds? Other bond managers can't be buyers at any price if they don't have any cash to do so. This would drive the NAV down well below what those who can only do the "simple bond math" would be able to predict.


How is that a problem for those who don't sell the fund.



It is no more of a problem than the guy holding a stock paying a 2% dividend as everyone rushes for the door. The dividend could be maintained all the way down - until it isn't. Eventually the door could hit you in the backside.

Holding a bond fund is not like holding a bond, you can't get your money back at some specified point of time. It would not even take everyone to bail on the fund, just enough to drive the NAV to zero, which of course depends on how illiquid or "mis-priced" the bonds become. If the manager is forced to sell his bonds at 50 cents on the dollar (not saying this is going to happen - just pointing out how your bond fund can go to zero) you might begin to see how "the door could hit you in the backside."
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Re: Bond Funds

Postby ogd » Wed Jul 03, 2013 12:01 pm

linuxizer wrote:
FinancialDave wrote:I think you have hit on part of it, and it doesn't seem that hard to understand, and that is the illiquid nature that bonds could fall into if everyone wants to sell. If the Fed is selling, and all the bond managers are selling - who are going to be the buyers of these bonds? Other bond managers can't be buyers at any price if they don't have any cash to do so. This would drive the NAV down well below what those who can only do the "simple bond math" would be able to predict.


How is that a problem for those who don't sell the fund.

Look, to claim that this stuff hurts longterm fund holders, you have to claim that somehow people selling the fund are being let off easy. To do that, you have to claim that the NAV is mis-calculated. And if you could show that the NAV was mis-calculated, then the SEC or fund could fix the formula and it would no longer be mis-calculated.

Specifically, the NAV would have to be too high for what the fund was actually able to sell the bonds for incl fees, forcing it to hand too much cash to the outgoing investors.

If the NAV is "too low" (??) or an accurate representation of the bond market, dire as it might be, I am not affected by outgoing sellers at all. Even if the NAV reflects 50% losses -- the sellers are taking that huge hit and I'm still not affected (same as holding the individual bonds). Is this getting through?
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Re: Bond Funds

Postby linuxizer » Wed Jul 03, 2013 12:02 pm

FinancialDave wrote:Holding a bond fund is not like holding a bond, you can't get your money back at some specified point of time. It would not even take everyone to bail on the fund, just enough to drive the NAV to zero, which of course depends on how illiquid or "mis-priced" the bonds become. If the manager is forced to sell his bonds at 50 cents on the dollar (not saying this is going to happen - just pointing out how your bond fund can go to zero) you might begin to see how "the door could hit you in the backside."


Except that's not at all how bond funds work....
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Re: Bond Funds

Postby Kevin M » Wed Jul 03, 2013 2:33 pm

I would be buying more of any bond fund I own hand over fist well before NAV hit 0, as I'm sure many others would. This talk is just silly.

The bond fund NAV simply represents the value of the underlying bonds--by definition. The bonds a bond fund would be selling are the same bonds any other institution would be selling (or buying). If liquidity needs, or any other factor, forces a bond fund to sell bonds, there will be a price at which someone will buy them; that's what markets are for.

In times of crisis, assets move from weak hands to strong hands. We saw that in 2008 with corporate bonds; I was buying most of the way down--I bought LQD as low as $92/share (I think it got as low as $82, so I can't brag that I got the rock bottom price). I started selling lots when it hit $110, and continued until it hit $120; I've held what I had left as it has fallen back to about $114 today. Although this is an ETF, Vanguard's investment-grade mutual funds fared no worse in 2008--they didn't even drop as much (and I was buying them too).

I sold shares in other bond funds too as prices rose and rates fell over the past three years (and bought non-brokered CDs). I haven't sold a single bond fund share since prices started declining recently.

Now that I am 2/3 in non-brokered CDs (with about 5% in cash), I would be salivating if bond fund NAVs declined steeply, or as Warren Buffet said when asked how he felt about the stock market in 1974, "like an over-sexed guy in a harem": Warren Buffett--In 1974 - Forbes

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Re: Bond Funds

Postby FinancialDave » Fri Jul 05, 2013 2:53 pm

Except that's not at all how bond funds work....


I suggest if you want to know more about bond funds the Bogleheads Wiki is a good place to start:

http://www.bogleheads.org/wiki/Bond_funds

Pay particular attention to the section on Duration and what is says and what it does not say.

What it says:

Interest rates change continuously, not just at a single point in time. Therefore, as the time when you will need the money approaches, you must reduce your duration accordingly, to protect you against any further increases in prevailing rates.


What this means is you cannot just hold a bond fund with a duration of 5 years and expect you are going to get your money back at anytime past 5 years - as many have alluded to in numerous threads.

In fact there is no guarantee you will get your money back - the best chance you have would be to immediately sell your bond fund and buy an actual bond of the same duration at the higher interest rate and wait for the "duration number of years" for the bond to mature.

In the first place the concept of duration implies that you are reinvesting the income at the lower NAV. If you are not re-investing the income (spending it or otherwise) your duration is not 5 years, it is something longer. The concept can be used for stocks or bonds -- you should follow the duration link by Bernstein in this Wiki as how this applies to dividend paying stocks is quite interesting.

As interest rates continue to "tick up" your 5 year window continues to "roll out." That is why the Wiki suggests your best plan for actually using the money is to continually adjust your duration to your "need time," and why the suggestion is to use very short duration bond funds in your retirement account for your "spending bucket."

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Re: Bond Funds

Postby linuxizer » Fri Jul 05, 2013 3:03 pm

FinancialDave wrote:I suggest if you want to know more about bond funds the Bogleheads Wiki is a good place to start.


So it turns out I wrote large pieces of the wiki's articles on bond funds, including the ones you quote above. If you can search the forum you can see the extended discussions where a few thoughtful forum members and I discussed and worked out the general principle you quote.

None of that has anything to do with my comment, which was in response to your claim that panic selling could "drive the NAV to zero" even for those who do not sell. There's another thread going right now about "sell-off risk," and any such mechanism depends on the spread (which even in panics is a fairly small fraction of the overall bond value, and there appear to be mechanisms in place to pass even this cost on to the sellers to protect those who continue to hold the fund.
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Re: Bond Funds

Postby ogd » Fri Jul 05, 2013 3:28 pm

FinancialDave wrote:As interest rates continue to "tick up" your 5 year window continues to "roll out." That is why the Wiki suggests your best plan for actually using the money is to continually adjust your duration to your "need time," and why the suggestion is to use very short duration bond funds in your retirement account for your "spending bucket."

It is amazing how much this point, as stated, scares people. And fairly enough, as stated -- but there is an unstated part, a bit more complicated mathematically, that nevertheless kills this argument.

It's true that an interest rate increase will set back the recovery of your money. However, because of the higher interest rates you are getting, it also speeds it up. When the next increase hits, the acceleration from the previous increases is still in effect, and the new hike only adds to it. If the rates don't increase fast enough, their accumulated effects will return money faster than the NAV drops.

How fast is fast enough? In matematical terms, we're talking about a function (yields) that grows faster than it accumulates. Growth hurts in the immediate term through a proportional NAV drop, accumulation rewards in the long term. Bringing some calculus 101 into this, a function that grows that fast is necessarily exponential; in fact, Euler's constant e is certain to make an appearance, because integral(e^t dt) = e^t, so the function e to the power of t is the threshold above which a function can grow faster than its own accumulation. The t, lacking a time unit in the pure form, always need to be adjusted by a constant, but the basic principle remains.

Whatever you think about rates, they won't be exponential. A 1% rate doubling every year is 1024% by the 10th year, and that just won't happen. If you're dealing with merely linear rates, you will make your money fairly fast without fail. And in practice, we see this: between 2003-2007 VFITX returned 11% total while interest rates increased from 1% to 5.5%, bit of a worst-case scenario. It wasn't stellar by any means, but you got your money back.

The suggestion to use short-term bonds / accounts for immediate needs is, of course, sound.
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Re: Bond Funds

Postby linuxizer » Fri Jul 05, 2013 3:39 pm

ogd wrote:It's true that an interest rate increase will set back the recovery of your money. However, because of the higher interest rates you are getting, it also speeds it up. When the next increase hits, the acceleration from the previous increases is still in effect, and the new hike only adds to it. If the rates don't increase fast enough, their accumulated effects will return money faster than the NAV drops.


Well put, and a nice example you gave. Another way of stating the kind of effect you're talking about is that duration is a function of the interest rate. So each successive change to interest rates causes the bond or collection of bonds (which we call a fund) to be less sensitive to the next change.
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Re: Bond Funds

Postby mrwalken » Fri Jul 05, 2013 3:56 pm

Wow, bond funds are getting torched again today. Youch!
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Re: Bond Funds

Postby ogd » Fri Jul 05, 2013 3:59 pm

Bonds, mrwalken. All Bonds.
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Re: Bond Funds

Postby linuxizer » Fri Jul 05, 2013 4:03 pm

ogd wrote:Bonds, mrwalken. All Bonds.


Where's the like button? :D
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Re: Bond Funds

Postby Kevin M » Fri Jul 05, 2013 5:14 pm

ogd wrote:And in practice, we see this: between 2003-2007 VFITX returned 11% total while interest rates increased from 1% to 5.5%, bit of a worst-case scenario.

What specific dates are you using and where are you getting your data?

On 1/2/2003 SEC yield for VFIUX (admiral shares version of VFITX) was 3.18% and 5-year treasury yields were 3.05%. Looks like the low SEC yield for that year was a little less than 2.4% in June of that year, and 5-year T yield got down to about 2.1%.

On 12/31/2007 SEC yield was 3.72%, so not much higher than the beginning of 2003. Looks like the SEC yield high was about 5.1% in July of that year, and ditto for 5-year Ts.

Between 6/15/2003 and 7/15/2007 M* shows $10K grew to $10,726, so about 7.3% cumulative.

The point remains valid that you "got your money back" and then some, But the interest rate increase looks like it was about 270 basis points using SEC yield and 300 basis points using 5-year treasury, not the 450 basis point increase you indicated. And the cumulative return looks like quite a bit less.

I know you are thorough, so I'm sure you have a good answer.

Just for fun, here's my back of the envelope calculations for interest rates rising 1 percentage point per year, steadily for 4 years in a fund with a duration of 5 years starting at 2%:

Code: Select all
year,  rate chg, cap loss, income, net return
year 1: 2%-3%,    -5%,      +2.5%,    -2.5%
year 2: 3%-4%,    -5%,      +3.5%,    -1.5%
year 3: 4%-5%,    -5%,      +4.5%,    -0.5%
year 4: 5%-6%,    -5%,      +5.5%,    +0.5%
cumulative                            -4.0%


I'm ignoring positive convexity, alluded to above by linuxer, but I don't think that would have a huge impact over this range, but lets say 100 basis points. This still looks quite a bit worse than the 2003-2007 period, even with the numbers I see. What are the flaws in these rough calcs that are large enough to account for the discrepancy?

Thanks,

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Re: Bond Funds

Postby Red Rover » Fri Jul 05, 2013 5:15 pm

I am getting ready to reallocate my portfolio from a balanced fund in my 457 account that holds about 22% in bonds. It's a fund of funds that does not give me the control I desire and, although it has done well, I want to reduce costs and control choices. I am looking at Vanguard Admiral Share funds including their Total Bond Fund (I know it's not really "total).

With bonds taking a beating of late, and with the potential for worse (1994 bond market?), is a 3.5% fixed rate in a tax deferred account something that should be considered as the fixed portion of my asset allocation?

I am considering it rather than allocating 20-30% of my portfolio to a Toatal Bond Fund right now. Is my thinking flawed?
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Re: Bond Funds

Postby ogd » Fri Jul 05, 2013 5:29 pm

Kevin M wrote:I know you are thorough, so I'm sure you have a good answer.

Hi Kevin,

I was not thorough on this one because it was meant to be a simple illustrative figure if you happened to own Treasuries in that period. I plopped Jan 1st in Morningstar for both years and I got "Vanguard Interm-Term Treasury Inv:11168.24". I did not want to cherry-pick intervals all that much, particularly since the years before and after the interval were dominated by stock worries (e.g. VFIUX was incredibly rewarding in 2007-2009). I don't doubt that if you pick the absolute worst 4-year interval things will look worse. I did not work the SEC yield into this, either.

Your back of the envelope calculation ignores, I think, the effect of bonds that have lost value returning to par; even if sold early they still appreciate constantly before then. This is not merely convexity riding like we were talking about in another thread. I didn't want to get into that, so I used a simple total figure from the real world.

Cheers!
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Re: Bond Funds

Postby Kevin M » Fri Jul 05, 2013 5:30 pm

Red Rover wrote:With bonds taking a beating of late, and with the potential for worse (1994 bond market?), is a 3.5% fixed rate in a tax deferred account something that should be considered as the fixed portion of my asset allocation?

Absofriginlutely! You must be talking about a stable value fund. That's an incredible rate for fixed income these days.

The main caution is that these funds are run by insurance companies, so the safety depends on the strength of the company behind it. There has been lots of discussion about this, but I don't recall hearing about anyone losing money in a SV fund.

Still, you have to wonder how they're offering such a high fixed rate in today's low-rate environment without taking excessive risk. The SV funds in the 401k plans of a couple of my family members are closer to 1%, which still ain't bad compared to close to 0% in a money market fund.

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