Are Bogleheads generally against long term bonds?

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bellemastiff
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Are Bogleheads generally against long term bonds?

Post by bellemastiff »

I am very thankful to all the advice and encouragement I'm reading at the board. I'm new to the community but it's helping me make decisions responsibly so thanks to all of you :-)

My question is regarding fixed income. I am younger and will likely be in the top marginal bracket for the forseeable future. I have a 60/40 portfolio and most of the assets are in taxable accounts -- I'm planning to exclusively use VG muni funds for the 40% fixed income portion.

Here are the two funds I am looking at:

https://personal.vanguard.com/us/funds/ ... IntExt=INT avg duration mid 5's, avg maturity mid 5's, yield 2.5%
https://personal.vanguard.com/us/funds/ ... IntExt=INT avg duration mid 7's, avg maturity 9, yield 3.5%

I am considering putting 20% in the intermediate muni fund, and 20% in the long term muni fund. (As others have pointed out, the VG LT muni fund is more like "intermediate plus" with an avg maturity of 9 years.)

I am wondering if people think this is too risky. I understand both inflation and interest rates are historically very low right now (though, the correction in bond prices make them marginally more attractive now -- I am 'neutral' as to whether inflation and interest rates might go up or down in the medium term future).

The attraction for me of this fixed income mix is the weighted yield of 3% -- assuming inflation rate of 2.0 to 2.75%, it still ekes out 25 to 100 basis points of 'real' income. I also like the fact the the weighted duration would be only 6.5ish and the weighted maturity would be 7.5ish -- and also that VG does their own credit quality research, making the whole mix safer still. I understand the duration and maturity aren't at the 'very low risk' end of the spectrum, but all things considered they seem to be conservative numbers for a fixed income portfolio that has two funds in it, one of which is 'intermediate' and the other 'long term'.

Any ways I am wondering if folks here would consider this mix of fixed income 'reaching for yield' ?

I know it won't cushion the overall portfolio in a major market drawdown like short term muni's or treasury's would. But either of those (treasuries in a taxable account) would be more or less locking in a negative real yield. That's hard to impossible for me to stomach. Anyways just curious of your all thoughts.
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Re: Are Bogleheads generally against long term bonds?

Post by dbr »

If one is to find a criterion for "reaching for yield" or "optimizing the yield curve" one could consider a suggestion by Larry Swedroe that the risk in extra duration is worth taking if one can gain at least 20bp in yield for each year of extra duration, for nominal bonds. I believe he suggests 15bp/year to justify extended duration in muni's.

Note your question is not really about long bonds as your choices are clearly somewhere in the intermediate range. There is an argument that intermediate durations are often the sweet spot for those seeking to balance duration risk and yield.

Long bonds (meaning durations of more than 10 years, maybe really 15-20 years, will not look like a good risk/return trade off for most investors. One rationale that might apply is that long bonds may be a better diversifier for portfolios that are mostly equities. In any case at 20% or so of a portfolio bond risk of any duration is pretty much irrelevant.
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Re: Are Bogleheads generally against long term bonds?

Post by Dandy »

I think you need to ask yourself what is the purpose of the fixed income portion of your portfolio. If it is to add some stability to it so that you can take more risk on the equity side then you should be less concerned about yield and more concerned about stability and diversification. The longer term muni bond fund may provide a bit more yield but give that up if/when rates rise (at least for awhile). Your equity investments have much more volatility and can easily gain or lose 1% in a day.

For me I would keep fixed income conservative and more diverse. All in for muni bonds/funds is relatively safe but it is still only one segment of the fixed income market. As I recall during the 2008 crisis hedge funds were selling muni holdings and caused that market to plunge - ok not much was safe but those holding Treasuries did ok. I would think carefully about a fixed income strategy that was all about avoiding tax. When/if the market plunges the tax savings can often look puny compared to the losses. As an example on the equity side I worked where many execs had most of their investments in company stock - in a very good company. When things started to slip they were still making great money but were afraid to sell any co stock because of the cap gains. Many followed the stock down to very low levels and lost a ton of money before they sold some. Now many are sitting with large cap losses they might never be able to use. I think they would gladly have taken the cap gain tax early on than the result.

My point isn't that the "long" term muni is bad - more that all muni might be riskier than you think.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

Dandy,

I hear you. I guess I could envision a 20% capital loss on these but not a 50% loss (assuming a maturity of 9 or so) if interest rates and inflation get ugly.

But I think the short term worry has to be balanced with my long term concern: in a taxable account , the compounding effect of +1% triple net (Real) yield vs -1% triple net (Real) yield.
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Re: Are Bogleheads generally against long term bonds?

Post by The Wizard »

Yes,BHs are generally against LT bond funds right now.
Once rates go up a bit, that preference may change...
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

I would think carefully about a fixed income strategy that was all about avoiding tax.
At a 25% marginal rate I would agree but an all-in rate of ~50% becomes one of, if not THE, dominant factor in the compounded returns. If we're talking 4% gross taxable yield, inflation (the hidden tax) plus the explicit tax wipes out 100% of the income. And god forbid if there are any fees!
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

If you want a deflation hedge, long term treasuries are the best hedge out there. So if you own them for that purpose and don't overdo it, then you are just fine.

Long term bonds can be very volatile investments. It is the belief among many here that interest rates have been held artificially low and are due to go up. This would have a pretty adverse effect on your long term bonds. But of course no one here really knows the future.

For myself, I stick with Intermediate Term Investment Grade Bonds for the bulk of my fixed income investments. You get most of the yield with a lot less volatility.

Many folks talk about the Permanent Portfolio which is 25% Long Term Treasuries, 25% Cash, 25% US Stocks, and 25% Gold. I don't invest this way myself but this portfolio has done well over time. It hedges against deflation, inflation, and the stocks give you the benefit of economic growth. So this is a good example of a portfolio that hedges and works pretty well.

So if you own these as a hedge and realize that they are volatile, you will be just fine. If you are simply reaching for yield, be prepared for tears when interest rates go up.
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Re: Are Bogleheads generally against long term bonds?

Post by nisiprius »

Personally, I just don't like riskier bonds. (Just as I don't like supposedly-less-volatile stocks). They're neither fish, flesh, fowl, nor good red herring, and they just muddy the waters. Larry Swedroe's Rule for Prudent Investing #18 (from The Quest for Alpha) is:
Take your risk on the equity side. The role of bonds is to provide the anchor to the portfolio, reducing overall portfolio risk to the appropriate level.
The baseline for thinking about portfolios should be something like Total Stock Market for stocks, Total Bond Market for bonds. If you want to do something different from that, the question that needs to be answered is, "Why, exactly, do I think it would be much better to add an allocation to riskier bonds (long-term, "high yield," emerging markets, whatever) rather than simply increasing my stock allocation?

Advocates, of course, have answers to such questions, but when you look at it that way the answers usually turn out to be subtle and dubious things. I prefer to keep it simple, because I can't convince myself that complicating things is going to make much difference.
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bellemastiff
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

The baseline for thinking about portfolios should be something like Total Stock Market for stocks, Total Bond Market for bonds. If you want to do something different from that, the question that needs to be answered is, "Why, exactly, do I think it would be much better to add an allocation to riskier bonds (long-term, "high yield," emerging markets, whatever) rather than simply increasing my stock allocation?
Good question. Here's why. Your model portfolio's fixed income portion, in a tax-deferred account, has a positive real yield net of inflation.

On the taxable side, to achieve a similar positive real yield from the fixed income portion, one has to look at either
a) intermediate/LT muni's
or
b) high yield corporates or some other similarly risky taxable bond segment.

Another note. I'd consider myself as a fledgling Boglehead and am a big believer that the simple portfolios (like the one you mention) are nearly always appropriate for individual investors.

That said, it doesn't pass my "common sense" test, that an investment would yield you negative income. An investment should pay you a stream of income (even if it's very low), and if that stream of income (plus the capital appreciation) doesn't exceed the inflation rate, then it's a cra*ppy investment. Since both inflation or deflation are possible, I am 'neutral' (I won't take a bet) on inflation vs. deflation.

Now if it's cash you need in the next 3 years, sure, put it in T-bills or money market or whatever, and know that the govt is thefting 1.5% or whatever from you per year, but at least you're not risking a 20% loss. I get it.

But for a long term investment it just doesn't pass my BS test to lock in a negative real yield.
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Re: Are Bogleheads generally against long term bonds?

Post by LadyGeek »

I've posted this in other threads, but it bears repeating (municipal bonds are categorized as high-yield bonds):
The wiki has some background info: High yield bonds

High-yield bonds may have the volatility of stocks, but they are not stocks. See the wiki article under "Role in a portfolio." You can also search this forum.

Here are 2 articles by Larry Swedroe:

- Know the data before buying high-yield bonds (May 2, 2013)
- Why junk bonds aren't a good portfolio fit (July 13, 2012)
This is excellent advice:
nisiprius wrote:Larry Swedroe's Rule for Prudent Investing #18 (from The Quest for Alpha) is:
Take your risk on the equity side. The role of bonds is to provide the anchor to the portfolio, reducing overall portfolio risk to the appropriate level.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

municipal bonds are categorized as high-yield bonds
Sorry, they are?

The funds in question hold AAA to A rated bonds. I'd consider them higher quality than 'high quality corporates' ?
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Re: Are Bogleheads generally against long term bonds?

Post by whomever »

One thing that I haven't seen mentioned is prevailing interest rates. If it was 1981 and 30 year treasuries were paying 13%, I would like them more than I do today :-).
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

The problem is that no one knows the future. In 1982, a very smart investment would have been to back up the truck and load up on US Treasury 30 year bonds. One would have had 30 years of 14% return with less volatility than stocks. Equivalent return for less risk.

Of course in 1982, I had no money. I was a poor college student. Started my IRA with Bank Certificates of Deposits and later on went to individual stocks then mutual funds and then index fiunds.

And no one knew that the bond market would have a 30 year bull run and that stocks would run strong for the next 18. In retrospect, long term treasury bonds were a brilliant investment.

What if we have an extended bear market in bonds? Increasing interest rates and decreasing bond values. Long term treasuries would be a poor investment in that enviroment.

If I were a betting man, the odds for a bond rally continuing after a 30 year bull run don't seem good. Invest in bonds but realize that returns will be subdued going forward. This is particularly true of long term bonds. They just don't seem like a good bet now.
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Re: Are Bogleheads generally against long term bonds?

Post by LadyGeek »

bellemastiff wrote:
municipal bonds are categorized as high-yield bonds
Sorry, they are?

The funds in question hold AAA to A rated bonds. I'd consider them higher quality than 'high quality corporates' ?
Good point. It does depend on the credit rating (I just added this link to the wiki article.)
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

What if we have an extended bear market in bonds? Increasing interest rates and decreasing bond values. Long term treasuries would be a poor investment in that enviroment.
Agreed.

But don't Bogleheads resist 'bets'?

You might also bet that the economy will be flat (and Fed giving near zero interest rates) for a decade. In this case the short term bonds would lose maybe 10% of their real value over a 10 year period and long term bonds would outperform.

I guess to split the difference you end up with intermediates. Though as I point out, VG's long term muni fund basically seems like "intermediate plus" to me.
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

I am of the opinion that valuations matter. How much value is there in an asset class that just finished a 30 year bull market?

So when I use the word "bet", I am taking valuations into account. Betting on cheap has better odds than betting on expensive.

Keep in mind, I still advocate bond investing. Bonds are still the best game out there to reduce risk in a portfolio. I would say that their diversification benefits are less than before but still important.

I also am not a believer in the "all or nothing" philosophy. If we had a very sluggish economy and deflation going forward, bonds would continue to do great. So I am not one of these guys that are "all in" or "all out". We have to be prepared for the possiblity we might be wrong. Markets do not have to obey our market expectations.

Historically though, the odds for inflation are far greater than deflation. I have constructed my portfolio to guard against inflation.
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Re: Are Bogleheads generally against long term bonds?

Post by bertilak »

nedsaid wrote:I have constructed my portfolio to guard against inflation.
What exact strategies are you using to do that? It is something I worry think about as my pension is not inflation indexed and is a very big part of my retirement income.

My main "strategy" is that I get all the income I currently need from SS+pension and I count on my IRA to supply anything above that, including inflation protection. I put "strategy" in quotes because that seems rather passive. It would be nice if I could do something more proactive about it, but I don't really think I need to. (Yes, I know inflation-indexed SPIAs are a possibility if it come to that.)

To the OP:

Another thought about long term bonds: A bond ladder you hold to maturity works good with long term bonds, perhaps TIPS to account for inflation. Low, but guaranteed return. When you retire that guarantee will seem more important that it might right now.
Last edited by bertilak on Sat Oct 12, 2013 11:04 am, edited 2 times in total.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

I am of the opinion that valuations matter. How much value is there in an asset class that just finished a 30 year bull market?

So when I use the word "bet", I am taking valuations into account. Betting on cheap has better odds than betting on expensive.
Totally agree. And here we must acknowledge QE.

PE10 is 24 (about 50% overvalued) so stocks are an unattractive valuation. Bonds (short, interm., LT) all seem overvalued as well. My personal conclusion is all asset classes seem about equally overvalued (roughly) which was the whole point of QE.

If they're all roughly equally overvalued then it actually takes me back to square one which is the basic allocation regardless of valuation.
Historically though, the odds for inflation are far greater than deflation. I have constructed my portfolio to guard against inflation.
Here I agree with you. We have about 50M net savers in America. And 200M net debtors (plus 51 large net debtors in the form of 50 states plus a federal government). The 200M + 51 are in debt on 'fixed' terms and inflation would hugely help them decrease their debt load on a real basis. We live in a democracy so something tells me the 50M 'net savers' are going to be 'outvoted' as to whether inflation is a 'good thing' ...
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

You got it. If you are a government that owes lots of money, the best way out is to inflate it away. Holders of War Bonds purchased during WWII found this out the hard way. The purchasing power of the dollar was cut in half during the war years. Quite interesting to hear my father relate the price of automobiles over the years. A real eye opener.

So yes, we could get deflation. But the odds of inflation seem to be greater. Your point about the savers being outvoted by the debtors is spot on. So be not only a saver but an investor.

As far as stock market valuations it isn't surprising that stocks trade higher in an era of low interest rates. Really a stock is only a cash flow from a business. The cash flow would be valued higher when the competition pays so little interest.
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

Bertilak, I use US Stocks, Foreign Stocks, REITs, TIPS, and Foreign Bonds to guard against inflation and hedge a falling dollar. Nothing magical about it.

Hope it works. Check back with me in 10 years and I will tell you if it worked or not. So far so good.

You have highlighted a difficult problem for retirees to solve. The problem of inflation. There is no magical way to beat it, you just have to assume a certain degree of risk. Even at that, there are no guarantees. I don't have a certain answer but do the best I can.
A fool and his money are good for business.
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Re: Are Bogleheads generally against long term bonds?

Post by bertilak »

nedsaid wrote:Bertilak, I use US Stocks, Foreign Stocks, REITs, TIPS, and Foreign Bonds to guard against inflation and hedge a falling dollar. Nothing magical about it.

Hope it works. Check back with me in 10 years and I will tell you if it worked or not. So far so good.

You have highlighted a difficult problem for retirees to solve. The problem of inflation. There is no magical way to beat it, you just have to assume a certain degree of risk. Even at that, there are no guarantees. I don't have a certain answer but do the best I can.
OK, much as I thought. I still look for that magic bullet now and then!
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Re: Are Bogleheads generally against long term bonds?

Post by staythecourse »

Do you have a mortgage? If so, it is likely higher then the yields you mentioned. With the last tax law changes the high income worker has a phase out of deductions. I would calculate yours and see if you mortgage is no longer deductible. For me it looks like I will be able to deduct most of my property taxes only so my full mortgage is not deductible. So that means my 3.875% on my mortgage is the best yield at no risk I will find going forward for awhile. So, I am likely going to sell my bonds in tax deferred and hide more equity there and use the leftover money to pay down my mortgage.

Good luck.
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Re: Are Bogleheads generally against long term bonds?

Post by grok87 »

bellemastiff wrote:I am very thankful to all the advice and encouragement I'm reading at the board. I'm new to the community but it's helping me make decisions responsibly so thanks to all of you :-)

My question is regarding fixed income. I am younger and will likely be in the top marginal bracket for the forseeable future. I have a 60/40 portfolio and most of the assets are in taxable accounts -- I'm planning to exclusively use VG muni funds for the 40% fixed income portion.

Here are the two funds I am looking at:

https://personal.vanguard.com/us/funds/ ... IntExt=INT avg duration mid 5's, avg maturity mid 5's, yield 2.5%
https://personal.vanguard.com/us/funds/ ... IntExt=INT avg duration mid 7's, avg maturity 9, yield 3.5%

I am considering putting 20% in the intermediate muni fund, and 20% in the long term muni fund. (As others have pointed out, the VG LT muni fund is more like "intermediate plus" with an avg maturity of 9 years.)

I am wondering if people think this is too risky.
You are asking about long term munis. Let's start off with long term bonds in general to provide some context:

1) Long term treasuries- as nedsaid points out there is a school of thought that these are good hedge diversifier for an equity portfolio. Certainly it worked that way in 2008/09

2) Long term tips- a good foundation to build a retirement portfolio upon. see this thread
http://www.bogleheads.org/forum/viewtopic.php?t=71927

3) Long term corporates- I would avoid these. See this thread
http://www.bogleheads.org/forum/viewtop ... 0&t=116549

Now let's get to your long term munis. The answer is, to my mind, that I'm not a huge fan. Maybe a long term state GO might be ok- Not much credit risk over treasuries. But most muni funds have more credit-risky bonds. Think detroit and puerto rico.
Vanguard funds dont have much puerto rico but they do have some.
https://personal.vanguard.com/us/FundsA ... bleIndex=2
So its not clear this credit risk is rewarded for long term muni bonds any more than for corporates as per point 3) above. THe other issue is call risk. Muni bonds originally issued with maturities of >10 years are generally callable. Call risk is usually a risk you want to avoid- it tends to work against you as a bond buyer.

So i don't know. i'm not saying totally avoid, but tread carefully perhaps.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

Good tip on the mortgage (but doesn't apply, in my case).
So its not clear this credit risk is rewarded for long term muni bonds any more than for corporates as per point 3) above. '
I would argue that on a historical basis (and, IMO, probably future basis) long term muni bonds have much less credit risk than comparable quality (A to AAA) corporate bonds. For every 'Detroit' there are dozens of similar situations in the corporate universe.
THe other issue is call risk. Muni bonds originally issued with maturities of >10 years are generally callable. Call risk is usually a risk you want to avoid- it tends to work against you as a bond buyer.
I hear you. The VG LT muni fund has an avg maturity of 9 years, though. So it's more "intermediate plus".

I guess I feel like in my personal situation, if I average together Interm. and Long term muni funds from VG, I end up with a weighted duration of around 6.5 and weighted maturity of around 7.5 (if both funds are weighted equally). It intuitively feels to me like a sweet spot of decent yield and only moderate inflation and interest rate risk. I feel the credit risk is minimal given that VG does their own credit research and sticks to the highly rated issues.
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Re: Are Bogleheads generally against long term bonds?

Post by sharke »

bellemastiff wrote:
The baseline for thinking about portfolios should be something like Total Stock Market for stocks, Total Bond Market for bonds. If you want to do something different from that, the question that needs to be answered is, "Why, exactly, do I think it would be much better to add an allocation to riskier bonds (long-term, "high yield," emerging markets, whatever) rather than simply increasing my stock allocation?
Good question. Here's why. Your model portfolio's fixed income portion, in a tax-deferred account, has a positive real yield net of inflation.

On the taxable side, to achieve a similar positive real yield from the fixed income portion, one has to look at either
a) intermediate/LT muni's
or
b) high yield corporates or some other similarly risky taxable bond segment.
I think this gets to a more specific question: Where to put fixed income if you are in a very high tax bracket and you've run out of space in tax deferred accounts?

In my case, I've stuck to my asset allocation, which leads me to hold over 60% of my fixed income in taxable, currently broken down like this:
61% VCLAX (California Long Term Tax Exempt: 3.53% SEC yield, avg maturity 9.6 years, avg duration 7.8 years)
13% Stable Value (401k)
13% Pimco Total Return (401k)
13% Vanguard Total Bond (401k)

Instead of VCLAX I could use a muni fund with a shorter duration, like VCADX (2.47% SEC yield, avg maturity 5.8 years, avg duration 5.8 years), or mix the two funds, similar to what bellemastiff is considering.
dbr wrote:If one is to find a criterion for "reaching for yield" or "optimizing the yield curve" one could consider a suggestion by Larry Swedroe that the risk in extra duration is worth taking if one can gain at least 20bp in yield for each year of extra duration, for nominal bonds. I believe he suggests 15bp/year to justify extended duration in muni's.
Thanks for this rule of thumb. If we apply it in my case, then VCLAX is the obvious choice. However if we consider having 60% of fixed income in VCLAX to be risky, and we then follow the advice from Nisi and others to take risks on the equity side instead, it means we should choose alternatives in taxable, conceding a negative real return for a large percentage of the portfolio, and perhaps offset this by changing our overall asset allocation? It's a bit of a quandary.
I survived the Great Bond Crash of 2013!
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

Thanks for this rule of thumb. If we apply it in my case, then VCLAX is the obvious choice.
Exactly. Actually, it appears to me based on the 15bps rule of thumb (or just looking at the yield curve) that the sweet spot and best deal in bonds right now is "intermediate plus" (or "Long Term Light") -- maturities of 8 to 15 years. Thankfully this is what the VG fixed income team is holding, in the Long Term Muni fund (rather than reaching further out with an avg 15 year maturity or something).

I can appreciate that one should 'take risk on the equity side'. But the experts who advised that, did they do so, in the context that your fixed income should be guaranteed (more or less) to have a negative real yield?
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Re: Are Bogleheads generally against long term bonds?

Post by grok87 »

bellemastiff wrote:Good tip on the mortgage (but doesn't apply, in my case).
So its not clear this credit risk is rewarded for long term muni bonds any more than for corporates as per point 3) above. '
I would argue that on a historical basis (and, IMO, probably future basis) long term muni bonds have much less credit risk than comparable quality (A to AAA) corporate bonds. For every 'Detroit' there are dozens of similar situations in the corporate universe.
THe other issue is call risk. Muni bonds originally issued with maturities of >10 years are generally callable. Call risk is usually a risk you want to avoid- it tends to work against you as a bond buyer.
I hear you. The VG LT muni fund has an avg maturity of 9 years, though. So it's more "intermediate plus".

I guess I feel like in my personal situation, if I average together Interm. and Long term muni funds from VG, I end up with a weighted duration of around 6.5 and weighted maturity of around 7.5 (if both funds are weighted equally). It intuitively feels to me like a sweet spot of decent yield and only moderate inflation and interest rate risk. I feel the credit risk is minimal given that VG does their own credit research and sticks to the highly rated issues.
I agree with you that perhaps the credit risk is not such a bid risk.
The call risk worries me more. I hate callable bonds. It's such a free lunch for the bond issuer. Heads they win, tails they lose. I wouldn't take the average maturity of 9 years to mean that this is not an issue. I think a good chunk of the bonds in the fund are callable. I'll try to pull the stats on that at some point.
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Re: Are Bogleheads generally against long term bonds?

Post by fundtalk »

I think the plan for 50/50 in int TE and LT TE is very good. To be honest I think you could have 100% in either fund and be fine. I have used the two funds for tax loss harvesting for years. If you plot out the performance over many years, you can see the performance is very similar. As you already know the Vanguard LT fund really isn't long term and it is very good quality. No private activity bonds in either fund as opposed to the high yield muni fund.

I would agree with your assessment of QE influenced valuations, everything is overvalued. There was a very good review of this in the recent GMO letter by Ben Inker. Once it unwinds everything will get discounted (just like this summer). But, who knows when and there is no where safe to hide in the meantime.
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Re: Are Bogleheads generally against long term bonds?

Post by Call_Me_Op »

Characterizing muni bonds only in terms of duration is naive. The market is telling you something when a 7 year muni has a tax-equivalent yield of 5.5%, while a treasury of equivalent maturity is yielding 2%.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

The 'market' doesn't price treasuries to yield 2%. A man named Ben does. Who is naive ;-)
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Re: Are Bogleheads generally against long term bonds?

Post by Call_Me_Op »

bellemastiff wrote:The 'market' doesn't price treasuries to yield 2%. A man named Ben does. Who is naive ;-)
Not quite true but irrelevant. The return on a security can be modeled as a stacking of risk premiums. So, the 7 year treasury yield can be modeled as the risk free yield plus a premium for term risk. The yield of a 7 year muni can be modeled as the 7 year treasury yield plus a negative premium for the tax advantage plus a premium for other risks. The premium for these "other risks" (primarily credit/default risk) is extremely high right now.

Said differently, there is no free lunch.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

The yield of a 7 year muni can be modeled as the 7 year treasury yield plus a negative premium for the tax advantage plus a premium for other risks. The premium for these "other risks" (primarily credit/default risk) is extremely high right now.
Agreed. RELATIVE to other areas of the market -- treasurys, and stocks -- currently you get paid (in taxable accounts) a nice premium to take on the credit risk and other risks of muni bonds.

According to your model (where the yield increase in muni's vs. Treasurys must be some sort of efficient frontier?) there is an implied increase in muni defaults of I *think literally +1,000% or more, vs. their historical average. Of course this may come to pass. But I doubt it.

Or another way I'd look at it is: muni's right now may be fairly priced (or a little expensive). Stocks are moderately expensive. Treasuries are ridiculously expensive. And of course QE has affected pricing on all of these. BUT, IMO, its effect on treasury prices/yields is the most extreme.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

The return on a security can be modeled as a stacking of risk premiums.
I do agree with this in the very long run. But in the short run, the 'market' misprices these risk premiums routinely. That's what I think may be occurring with treasuries vs. muni's right now.

One last point. In the Efficient Frontier there shouldn't be any arbitrage oppty's, and securities shouldn't be mispriced. Of course in the real world, it doesn't work out quite this way (manic Mr Market). Changing legal and tax structures can also create anomalies.

As the Fed buys their billions of Treasurys each month, it quite literally 'forces' other large debt buyers (like pension funds, endowments) further out along that efficient frontier risk curve. Quite literally they are reaching for yield as the Fed 'legislates' that short term treasurys Shall Have Negative Real Returns.

So the pricing effect of QE affects not only Treasurys but then those other securities as well (high quality corporates, junk, foreign soverign debt, etc).

But the tax-exempt status of muni's keeps their nominal yields low, and thus they are *mainly 'out of the picture' in terms of the universe of what a pension fund or endowment would buy up, as they decrease exposure to the treasury market due to the negative (or barely positive) real yield of the treasurys.

The endowments, pension funds, and 401k investors of the world are chasing the 'taxable' yield issues ... it's only the high-income individual investor who will get much value out of the tax-exempt issues. This, to me, is a sort of arbitrage oppty. If you're a high-income individual investor, you have a unique advantage and position to invest in a fixed income segment that isn't attractive to all these other 'yield-chasing' players , for 'legal' reasons. IMO this makes the muni market slightly less effected by the pricing distortion caused by QE.
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Re: Are Bogleheads generally against long term bonds?

Post by nisiprius »

bellemastiff wrote:The 'market' doesn't price treasuries to yield 2%. A man named Ben does. Who is naive ;-)
No, all Ben does is price rates on overnight loans to banks. Treasury security prices are set in auctions. You don't get much more "market" than that.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

Treasury security prices are set in auctions. You don't get much more "market" than that.
Sorry, you are suggesting the auction prices for Treasurys are not overwhelmingly manipulated by the Federal Reserve? As I understand it, it is the stated goal of QE to manipulate (and make artificially higher) the market price of Treasurys, forcing down their yields, thus forcing non-governmental investors to take on more risk in their investments (which, according to the experts at the Fed, will increase real economic activity)

I understand that government actions (and investment purchases) are part of the "market" but this "market" sure seems a lot more artificial and more directly government manipulated than other auction markets.
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Re: Are Bogleheads generally against long term bonds?

Post by Call_Me_Op »

bellemastiff wrote: According to your model (where the yield increase in muni's vs. Treasurys must be some sort of efficient frontier?) there is an implied increase in muni defaults of I *think literally +1,000% or more, vs. their historical average. Of course this may come to pass. But I doubt it.
The existence of a high credit risk premium does not imply that there is currently an increase in defaults. It means that "the market" (i.e., the participants in the market) fear a possible increase in down-grades and/or defaults, and are demanding a large premium for accepting the perceived risk. As with any fear, it may not come to pass - but that's how the market as a whole feels.
Last edited by Call_Me_Op on Sun Oct 13, 2013 9:49 am, edited 1 time in total.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

It means that "the market" (that is, participants in the market) fear a possible increase in down-grades and/or defaults, and are demanding a large premium for accepting the perceived risk.
Sorry. Read my quote above as "future defaults" (as in defaults occurring over the future life of the bonds), not "current defaults", as you say.
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Re: Are Bogleheads generally against long term bonds?

Post by Call_Me_Op »

bellemastiff wrote:
It means that "the market" (that is, participants in the market) fear a possible increase in down-grades and/or defaults, and are demanding a large premium for accepting the perceived risk.
Sorry. Read my quote above as "future defaults" (as in defaults occurring over the future life of the bonds), not "current defaults", as you say.
OK - but as I have said, the consensus of the market is that the high risk premium at the current time is justified.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

OK - but as I have said, the consensus of the market is that the high risk premium at the current time is justified.
Noted.

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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

How much the Federal Reserve bank is able to affect the longer term bond rates is a matter of debate.

The Fed has certainly tried to bring down long term rates with the "twist" and with Quantitative easing and I think they have had some success. The problem is that the Treasury Market and the Bond Market in general is huge, in the trillions of dollars. $85 billion a month in bond buying buy the Fed is a lot but compare that to the size of the bond market. My guess is that their ability to influence longer term bond rates is limited.

What has changed my thinking on this is reading an e-book by Warren Mosler and reading the Pragmatic Capitalism blog by Cullen Roche. I learned about Modern Monetary Theory and Monetary Realism. It is mainly a lesson in soft currencies and Keynesian economics. I am not a Keynesian, but it opened my eyes to a lot of things. The Federal Reserve Bank has a larger effect on interest rates than what I had previously believed. But the power is limited and not absolute.
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Re: Are Bogleheads generally against long term bonds?

Post by bellemastiff »

The Fed has certainly tried to bring down long term rates with the "twist" and with Quantitative easing and I think they have had some success. The problem is that the Treasury Market and the Bond Market in general is huge, in the trillions of dollars. $85 billion a month in bond buying buy the Fed is a lot but compare that to the size of the bond market. My guess is that their ability to influence longer term bond rates is limited.
Very interesting thought.

It's obviously impossibly to ascertain the exact pricing effects of QE on LT Treasurys. But let's assume for instance that at current yields, QE is a force driving the yield down by 100 basis points (meaning, if QE ended tomorrow, there would be some rocky gyrations for a month, but then yields on LT Treasurys would 'settle' 100bps higher than they currently are).

If that's the case, then there must be some other large forces keeping Treasury demand high (and yields fairly low), such as:
1. Increased investor demand for low risk assets (like Treasurys) after two decades of poor *actual/personal* equity returns
2. Increased investor demand for low risk assets (like Treasurys) as Baby Boomers retire and shift their asset allocations marginally from equities to bonds
3. A general market expectation that the next decade will see tepid economic growth and low inflation (or possibly outright deflation) despite all the large forces (voters with fixed rate debt) that in theory are encouraging inflation... this creating increased demand for low-risk, fixed-rate bonds

It sure seems the "Bonds Stink, Inflation Is Coming" trade is getting crowded. I won't lie, I'm halfway on the side of that trade, and probably always will be.

But the contrarian in me says that if 95% of people agree the a 30 year bond rally just CAN'T continue...
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Re: Are Bogleheads generally against long term bonds?

Post by nedsaid »

This is why I am not an "all or nothing" investor.

I am of the opinion that the returns on bonds going forward will be quite muted. You might get a tad over inflation and that is about it. The days of 3% real returns over inflation are done for now.

Nevertheless, I could be wrong. While I am not excited about Bonds, I hold them because I want income and want to dampen the volatility of my portfolio. The diversification benefits of bonds are lower than they used to be but are still important. If the economy continues to be sluggish and rates stay low, bonds will do okay. My expectation is that interest rates will go up over time but I could be wrong about that.

Keep in mind that the national savings equals the US National Debt. When the public sector is in deficit, the private sector is in surplus. When the public sector is in surplus, the private sector is in deficit. When new money is created through deficit spending, it has to go somewhere and that is into Treasury instruments. So the creation of money through deficit spending creates the demand for Treasuries!! This is why deficits have zero effect on interest rates, economists have never been able to make the connection and have never been able to prove the "crowding out" effect. You might say that deficits are self financing!! Food for thought.

Standard economic theory says that government deficits and borrowing create competition with the private sector and should drive up interest rates. In actual practice, this has not happened. During the Reagan years and during the Obama years, deficits increased and interest rates fell!! The Thatcher government in the UK had budget surpluses and were buying up UK gilts and interest rates went up!! My economics professor in college was correct that there is no relationship between deficits and interest rates.

So in real life, things don't work the way we suppose and this makes predictions so difficult. How money is created is more complex than what I mentioned above but it is a useful framework to understand credit markets. Private sector lending, primarily through banks also creates money. I am still trying to understand how it all works.

We are best served by being broadly diversified. Market predictions are often wrong and investment stategies based on those predictions are candidates for underperformance.
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