Bond ETFs a certain loss?

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TwoSolitudes
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Bond ETFs a certain loss?

Post by TwoSolitudes »

Hey folks new poster here and one that is just now converting everything over to an index based portfolio. I'll post a before and after once I have competed it.

But my question is on Bonds. Currently I have none, I am 100% equities. So looking at the model portfolio's I should be thinking of something like 10%-40% of my holdings converted to bond ETFs. But the more I read about bonds today the sillier it seems to buy any. I want to make sure I understand it correctly so please let me know if my logic is off:

1. The primary role of Bonds is to provide stability in a portfolio and reduce risk and losses during corrections. (in corrections Bonds will lose far less than equities would and might even gain a bit). This makes sense to me.

2. But over a period of 10 years a 100% equity portfolio will significantly outperform a bond/equity mix- so long as you don't sell your holdings and keep your contributions the same. This also makes sense. If you can ride through and don't need the income, holding equities is better than holding bonds.

3. Today's rates almost guarantee that bond ETFs will break even at best and will likely take losses over the next 5 years at least. (assuming you don't load up on junk). If rates stay the same or go lower you don't even match inflation. If they go up the bond values will fall and you are looking at capital losses.

So assuming you don't need any income from your investments for at least 8-10 years and will continue to contribute regularly to them over that time, and assuming you have no bonds now- does it make any sense to buy an almost certain loss? I am thinking of just doing an ETF split of roughly one third US/Canada/International and keeping that in balance.(I am Canadian) and leaving bond ETFs aside until either rates start to go up or I am much closer to needing to get income from the portfolio.

Is this crazy talk, or does it make sense?
Alex Frakt
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Re: Bond ETFs a certain loss?

Post by Alex Frakt »

#2 is overly optimistic. There is no guarantee that equities will outperform bonds over any given 10 year period. You are also missing that holding bonds and rebalancing during equity downturns allows you to buy more equities at bargain prices. Finally, you need to be very wary of basing your decision on recent performance. If stocks have performed well for several years, it's easy to believe it's going to continue forever. But historically, a run like we are currently experiencing is more likely to reverse in the next couple of years rather than continue.
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TwoSolitudes
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Re: Bond ETFs a certain loss?

Post by TwoSolitudes »

Alex Frakt wrote:#2 is overly optimistic. There is no guarantee that equities will outperform bonds over any given 10 year period. You are also missing that holding bonds and rebalancing during equity downturns allows you to buy more equities at bargain prices. Finally, you need to be very wary of basing your decision on recent performance. If stocks have performed well for several years, it's easy to believe it's going to continue forever. But historically, a run like we are currently experiencing is more likely to reverse in the next couple of years rather than continue.
I understand this and I figure we are due for a correction in the next few years. But as long as I am not going to sell the equities and keep making my normal monthly contributions, would't the equities still outperform overall after a short period? Having something to use for buying after a orrection has some value- but again since Bonds are a losing proposition even just keeping some case much make more sense, no?
kenner
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Re: Bond ETFs a certain loss?

Post by kenner »

TwoSolitudes,

What you are saying is not "crazy talk". However, in the very recent past, bonds outperformed stocks over a 30-year period.

The key to successful long-term investing is mastering behavior and balance. Diversify wisely and stay the course.

Best wishes,
Ken
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in_reality
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Re: Bond ETFs a certain loss?

Post by in_reality »

TwoSolitudes wrote: So assuming you don't need any income from your investments for at least 8-10 years and will continue to contribute regularly to them over that time, and assuming you have no bonds now- does it make any sense to buy an almost certain loss? I am thinking of just doing an ETF split of roughly one third US/Canada/International and keeping that in balance.(I am Canadian) and leaving bond ETFs aside until either rates start to go up or I am much closer to needing to get income from the portfolio.
You conclusion makes pretty good sense.

I have a few quibbles.

#1 Even when you need income, you don't need bonds. You never really need bonds for income. You can just as easily sell some appreciated stock if you need the money.

#2 While your conclusion is certainly valid logically, I don't think you can make the assumptions you do to reach it. If the market tanks and you lose your job, you would be perhaps forced to sell equities at their lows. If you had bonds, they wouldn't have dropped so far and so selling them may not cause the same losses.

I don't have an optimal plan to recommend sorry. What I do recommend is planning not only for the best case, but other cases as well.

So, if really holding 100% stocks and having to sell some at a 50% loss unexpectedly is better than have 20%+ in safe bonds you could sell well then I don't know what to say -- maybe you have a point. If the market tanks, won't bonds likely strengthen just when you want to sell?
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Re: Bond ETFs a certain loss?

Post by richard »

TwoSolitudes wrote:
Alex Frakt wrote:#2 is overly optimistic. There is no guarantee that equities will outperform bonds over any given 10 year period. You are also missing that holding bonds and rebalancing during equity downturns allows you to buy more equities at bargain prices. Finally, you need to be very wary of basing your decision on recent performance. If stocks have performed well for several years, it's easy to believe it's going to continue forever. But historically, a run like we are currently experiencing is more likely to reverse in the next couple of years rather than continue.
I understand this and I figure we are due for a correction in the next few years. But as long as I am not going to sell the equities and keep making my normal monthly contributions, would't the equities still outperform overall after a short period? Having something to use for buying after a orrection has some value- but again since Bonds are a losing proposition even just keeping some case much make more sense, no?
There is no guarantee equities will outperform bonds over any given period. This is true even if you have great strength of character and stay the course through thick and thin. Stocks could fail to outperform for decades.

Why do you believe bonds are a losing proposition? If interest rates increase, the value of bonds holdings will initially decrease, but after a while, the higher rates and the ability to buy bonds at lower prices will more than make up for this, resulting in higher returns than if rates stayed the same or declined.
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TwoSolitudes
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Re: Bond ETFs a certain loss?

Post by TwoSolitudes »

Thanks. That is actually pretty reassuring. I would have a hard time buying them thinking I was just throwing money away- but there is some value there I guess even in this environment. Maybe a 15% allocation for now.....
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Re: Bond ETFs a certain loss?

Post by dbr »

You might want to approach this from the point of view of the risk and return of your portfolio as a whole. After all the basic idea is to adjust the proportion of stocks and bonds to pick the location you want along that continuum.
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Re: Bond ETFs a certain loss?

Post by Alex Frakt »

BTW, your safe money doesn't have to be all bonds. A quick look suggests that you can find savings account yields from Canadian banks that match or beat short to intermediate term government bond yields. Perhaps split your non-equity holdings into a mix of savings and Intermediate Term Corporate bonds for now? This is roughly what Jack Bogle is currently recommending.

You should also think about paying down student loan (or any other) debt you might have. This will free up money in the future when bond yields may be more reasonable.

Finally, before you go 100% anything, take a few minutes to look at the chart of asset class returns over the last 20 years at http://www.bogleheads.org/wiki/Callan_p ... nt_returns (you have to click on it a couple of times to get it full sized). Take a note of the actual returns as well as the relative changes.
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Re: Bond ETFs a certain loss?

Post by hollowcave2 »

Since #1 and #2 have been commented upon, I'll comment on #3.

Assertion #3 sounds like it is based on fear, speculative assumptions, and what you've heard in the media. You've offered no reasonable data to back up your assertion #3.

Sure, I can think of many scenarios where #3 can happen but I can think of an equal amount of scenarios where #3 does not happen. There's too many variables involved. It depends on what interest rates do as well as your choice of fund.

You can manage your risk in a bond fund by selecting a fund that meets your time horizon and needs. If you have a five year horizon, pick a short term duration fund. Even if rates rise, and you stick to your plan, there's a very good chance you will come out ahead. It depends on how quickly rates move, if they move, and it also depends on your ability to stay with the fund even if it temporarily shows a capital loss. Increased rates can help you in that you will receive more income over time. I believe Vanguard has an article about rising rates and bond funds. If you select a short term or intermediate term fund and hold it for a period longer than the duration, there's a very good chance you will have a higher total return than if rates fell. Higher income eventually leads to higher total returns in a "reasonable" market environment, despite the lower bond prices.

You can also read all of the bond fund threads that have been posted here on this subject, and also look at the Boglehead Wiki.

I don't mean to be critical, but it's important to not assume rash assumptions when investing. Take a look at the Wiki and evaluate your own risk tolerance and needs.

Steve
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TwoSolitudes
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Re: Bond ETFs a certain loss?

Post by TwoSolitudes »

Again, thanks everyone. Good links and great ideas to consider. The savings option at a Bank is worth a very close look. And that return chart is fascinating.

I started out thinking that I would shoot for a 20% Bonds (or safe) allocation, then gradually increase that over the next 10 years. After reading so many ideas on Bonds being a waste I was wavering... If I had any debt I would obviously pay that down first. But I am happy to say I am debt free on everything including my house.

20% with some medium term holdings would appear to be the right call for me. And I guess selling off some of my current very high performing equities to do it- is pretty much what the re-balancing is supposed to be about.
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Re: Bond ETFs a certain loss?

Post by z3r0c00l »

We had a great break from these bond posts for a while, I guess because bonds once again beat expectations. Now that interest rates are increasing a bit, the posts are back.
70% Global Stocks / 30% Bonds
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Re: Bond ETFs a certain loss?

Post by rca1824 »

TwoSolitudes wrote:2. But over a period of 10 years a 100% equity portfolio will significantly outperform a bond/equity mix- so long as you don't sell your holdings and keep your contributions the same. This also makes sense. If you can ride through and don't need the income, holding equities is better than holding bonds.
This is precisely my belief as well, and I have the numbers to back it up. But I would be hesitant to claim 100% equity outperforms any bond/equity mix over 10 years.

Here is the data comparing 50%, 80%, and 100% equity worst, average, and 15th percentile (avg-1std) nominal returns for a 10-year holding period using real historical annual returns from 1927-present:

Code: Select all

      worst  avg  15th
 50%    2.4   7.4   4.2
 60%    1.8   8.1   4.43
 70%    1.1   8.7   4.58
 80%    0.3   9.2   4.64
 90%   -0.6   9.8   4.63
100%  -1.7  10.3   4.55
100% equity maxes expected returns, but at great risk. Scale back to 80%, and you are almost guaranteed not to lose money and you get the highest 15th percentile returns.
Last edited by rca1824 on Thu Jun 12, 2014 9:56 am, edited 3 times in total.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: Bond ETFs a certain loss?

Post by ctreada »

OP, I have had the same thought precisely and am grappling with the same quandary.

I know the "disciplined" approach is to have a lot of bonds, but quite frankly a low p/e stock with high div yield (or a basket of them) probably significantly outperforms bonds with extraordinarily low yield that would drop in value with any increase in rates.

I'm especially concerned with bonds after what's happened this year - https://personal.vanguard.com/us/funds/ ... class=bond

I just don't know how much better bonds can get. If you're following the money flows or perspective money flows, $KO is going to look a lot more attractive with a 3% div yield than a bond for a typical investor.

Some are arguing that high div yield stocks are the next bubble, and that they're the "new bonds" in the current artificially low-interest rate environment.

So, you aren't alone. I agree the disciplined Boglehead way to do this is to put a hefty % in bonds, but that just feels VERY, VERY risky. I'm significantly underweight bonds, even though I'm sure that would make me somewhat unpopular on this board.
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Re: Bond ETFs a certain loss?

Post by DonDraper »

I'm struggling with same dilemma. I'm considering using CD's, I Bonds, Online savings accounts for a portion of what would have been my bond allocation. It feels like market timing which I hate to do but it just seems foolish to sit with 30-40% bonds. The other issue is there is no CD option when it comes to 401k holdings. That also makes things difficult.

I don't really understand the pay down debt argument. Are people suggesting taking the 30% of your portfolio that would be in bonds and using that to pay down your mortgage? Then what, keep the remaining money all in equities or rebalance back to holding some bonds? That doesn't make sense.

It's a tough call.
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Re: Bond ETFs a certain loss?

Post by rca1824 »

DonDraper wrote:I'm struggling with same dilemma. I'm considering using CD's, I Bonds, Online savings accounts for a portion of what would have been my bond allocation. It feels like market timing which I hate to do but it just seems foolish to sit with 30-40% bonds. The other issue is there is no CD option when it comes to 401k holdings. That also makes things difficult.

I don't really understand the pay down debt argument. Are people suggesting taking the 30% of your portfolio that would be in bonds and using that to pay down your mortgage? Then what, keep the remaining money all in equities or rebalance back to holding some bonds? That doesn't make sense.

It's a tough call.
The problem with taking it out of your portfolio is that you can no longer rebalance with it. 10-year buy-and-hold returns are going to be riskier than 10-year rebalancing returns. Holding 30-40% bonds with the rest equity is not very risky. Just look at the return data I posted above.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: Bond ETFs a certain loss?

Post by ogd »

ctreada wrote:I agree the disciplined Boglehead way to do this is to put a hefty % in bonds, but that just feels VERY, VERY risky.
No. Bonds are never VERY, VERY risky based on interest rate risk alone. It's a funny thing with interest rate risk: when it shows up, it always pays you back. So you might see your value drop by 5%, but thereafter the higher yield makes it back fairly quickly. This recovery is guaranteed and built into the nature of bonds. (Nevermind that the 5% is an order of magnitude less than what stocks can do to you in a year).

There are no such guarantees with stocks, dividend paying or not. When BP got hit with the Gulf spill, it lost 50 billion in assets / future income without anything to show for it. Fortunately, it survived and thereafter it tracked the stock market so it did fairly well but if the economy had sputtered you'd still be in the dumps. At other times, a dividend stock can simply die due to the destruction of the underlying business, like Kodak or countless others.

The true enemies of bonds are inflation and credit risk, which do indeed cause irrecoverable losses. You get to pick how much you want of the latter, and of the former, well we know what the market's expectations are for the foreseeable future: they range between low and none.

Or look at history: between June 2003 and June 2006, the 10 year yield rose from 3.13 to 5.25% (a number which, if it occured right now, would be the point where every single retiree breathes a sigh of relief and dumps almost everything they own into the bonds and annuities they've been waiting for -- but I digress). I want you to take a look at this graph and tell me if that's what a VERY VERY risky investment looks like. Then extend it another three years to the right for perspective.

Now what bank CDs do for you is they let you avoid the initial drop (or cap it at 1% or so), then start making the higher yields immediately, meanwhile making the same SAFE yields (unlike stock dividends). This is indeed a free lunch and one should use it if it's available and they want to spend the effort. But otherwise, high quality bond funds are still a VERY safe place to hold the rainy day part of your portfolio.

All that said, kudos to you for looking at the YTD numbers the right way. It's unquestionable that bonds are less rewarding than at the start of the year. However, the reason for that is that the markets are worried about stuff (see the "equities at all time highs" threads) and less worried about yields going up anytime soon. The rewards of safe money are what they are and there is little alternative.
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