Coming Bond Market Crash

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Coming Bond Market Crash

Postby Nicho_1978 » Sun Jan 06, 2013 1:14 pm

I’ve been hearing lots of talk lately about the coming bond market crash due to rising interest rates, especially in the last couple of days. Well I went back and look at the data from the 1980s when interest rates were on an upward trajectory and found that the rising interest rates did not significantly affect funds that invest heavily in bonds. This is especially true for broad bond market funds such as VBMFX and to a lesser extent for long term bond funds such as VUSTX.

As an example, the five biggest increases in interest rates occurred in 2009 (58% average increase), 1999 (35% average increase), 1994 (37% average increase), 1987 (21% average increase),
and 1978(18% average increase). However, during this period, VBMFX returned positive performance every year except in 1994 (-2.66% in) and 1999 (-0.76%). VUSTX returned negative performance every during this period but the worst year occurred in 2009 (-12%) and 1999 (-9%).

Granted pass performance does not indicate future performance, am I missing something here or are there really more dangers ahead in the bond market than what history suggest? Thanks?
Last edited by Nicho_1978 on Sun Jan 06, 2013 2:20 pm, edited 1 time in total.
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Re: Coming Bond Market Crash

Postby chaz » Sun Jan 06, 2013 1:36 pm

No one can accurately predict the future.
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Re: Coming Bond Market Crash

Postby am » Sun Jan 06, 2013 1:49 pm

How about the CD "crash" which is here already? You are guaranteed to lose money/purchasing power by putting your money into CDs. A crash to me implies an event that truly impacts. Does not seem like bonds can really crash, especially since their interest payments will increase during this "crash".
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Re: Coming Bond Market Crash

Postby zebrafish » Sun Jan 06, 2013 1:54 pm

No one can predict the future, but if we go from an interest rate of 1% to 5%, that is a 500% increase-- so maybe the previous data does not apply well. Maybe there are other factors at work (fear, emotion, etc.) which are different now, which gets back to no one being able to predict the future.
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Sun Jan 06, 2013 1:55 pm

Nicho_1978 wrote:I’ve been hearing lots of talk lately about the coming bond market crash due to rising interest rates, especially in the last couple of days. Well I went back and look at the data from the 1980s when interest rates were on an upward trajectory and found that the rising interest rates did not significantly affect funds that invest heavily in bonds. This is especially true for broad bond market funds such as VBMFX and to a lesser extent for long term bond funds such as VUSTX.


Keep in mind that you were starting from a higher rate back then - which makes a big difference. Back in the 1970's, bonds were called "certificates of confiscation."
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Sun Jan 06, 2013 2:07 pm

am wrote:How about the CD "crash" which is here already? You are guaranteed to lose money/purchasing power by putting your money into CDs. A crash to me implies an event that truly impacts. Does not seem like bonds can really crash, especially since their interest payments will increase during this "crash".


Bonds are no better than CD's - both have a negative real rate unless credit risk on the bonds is high.

If you don't think bonds can crash - think again. They will recover over time, but with rates as low as this, a return to "normalcy" may be very painful in the short-intermediate term.
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Re: Coming Bond Market Crash

Postby Nicho_1978 » Sun Jan 06, 2013 2:13 pm

am wrote:How about the CD "crash" which is here already? You are guaranteed to lose money/purchasing power by putting your money into CDs. A crash to me implies an event that truly impacts. Does not seem like bonds can really crash, especially since their interest payments will increase during this "crash".


I was wondering about this as well. Is this true?. If so, this would blunt the impact of any capital gains lost. Perhaps this is why the historic data (which does include interest payments) shows such an insignificant effect.
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Re: Coming Bond Market Crash

Postby dbr » Sun Jan 06, 2013 2:25 pm

Nicho_1978 wrote:
am wrote:How about the CD "crash" which is here already? You are guaranteed to lose money/purchasing power by putting your money into CDs. A crash to me implies an event that truly impacts. Does not seem like bonds can really crash, especially since their interest payments will increase during this "crash".


I was wondering about this as well. Is this true?. If so, this would blunt the impact of any capital gains lost. Perhaps this is why the historic data (which does include interest payments) shows such an insignificant effect.


Read here: http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics

Scroll down and read the discussion on duration.
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Re: Coming Bond Market Crash

Postby Harold » Sun Jan 06, 2013 2:55 pm

If you would like a less mysterious way to look at it, consider that pure investors are giving an entity current money in exchange for expected future cash flows: in the case of stocks, future earnings (ultimately returned to investors in the form of dividends); in the case of bonds, a defined stream of payments; in the case of real estate, rents; etc.

The money investors need to hand over is the current “price” based on supply of and demand for those cash flows. If one wishes to determine a corresponding interest rate for that price, he simply calculates what the expected cash flows would need to be discounted at to attain the current value.

The truly spectacular crashes occur when people realize (or fear) that the anticipated cash flows will not truly materialize (e.g. maybe there are not massive profits coming to Pets.com for shipping kitty litter to your door). Less dramatic declines can occur when there’s either less demand or greater supply for those cash flows still expected (with those lower prices leading to higher discount rates).

With bonds of reasonable quality, we have reasonable assurance that the defined payments will be made – the only question being whether we are paying too much for them.

So rather than some nebulous concern about the state of bond interest rates, one should more reasonably be wondering whether anything is going to sharply decrease the demand for safe bond cash flows, or is going to sharply increase the supply of those safe cash flows. Nobody can predict that, but the current global situation still shows strong demand for that level of safety, and little indication of greater supply being made available.

And even if there were to be a significant change – if you’re an individual bond holder, you get the cash flows you paid for; if you hold shares in a bond fund, you’ll get cash flows the bond fund paid for, and you’ll be continually buying “cheaper” cash flows as the bond fund makes its trades. You can certainly still lose money – but nowhere near as dramatically as if the cash flows were to disappear altogether.
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Re: Coming Bond Market Crash

Postby sscritic » Sun Jan 06, 2013 3:05 pm

I don't get this bond stuff too much, but try this.

A: interest rates go from 1% to 3% (I think this is a 200% increase the way you were figuring).

B: interest rates go from 10% to 12% (a 20% increase).

If the fund under A has the same duration as the fund under B, the two crashes will be identical in terms of decline in NAV. However, in situation A your interest rate triples rather than going up only 20%. I know, the dollar increase is the same, but don't you feel better knowing you will be earning three times as much on your CD?
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Re: Coming Bond Market Crash

Postby tfb » Sun Jan 06, 2013 3:49 pm

Nicho_1978 wrote:Granted pass performance does not indicate future performance, am I missing something here or are there really more dangers ahead in the bond market than what history suggest?

Yes. When you have a 8% yield, it can cushion a 5% principal loss and still make the total [nominal] return positive. When you have a 1% yield, a 5% principal loss will turn the total [nominal] return negative.
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Re: Coming Bond Market Crash

Postby HenryPorter » Sun Jan 06, 2013 4:31 pm

No bond crash if rates are raised in a friendly way.
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Re: Coming Bond Market Crash

Postby spanky123 » Sun Jan 06, 2013 4:40 pm

Call_Me_Op wrote:
am wrote:How about the CD "crash" which is here already? You are guaranteed to lose money/purchasing power by putting your money into CDs. A crash to me implies an event that truly impacts. Does not seem like bonds can really crash, especially since their interest payments will increase during this "crash".


Bonds are no better than CD's - both have a negative real rate unless credit risk on the bonds is high.

If you don't think bonds can crash - think again. They will recover over time, but with rates as low as this, a return to "normalcy" may be very painful in the short-intermediate term.


Does that mean you have no or minimal position in bonds now?
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Sun Jan 06, 2013 4:56 pm

I hold a modest position in total bond and TIPS in my retirement account. I am willing to take a possible hit there, as I will not be touching it for many years. In taxable, my bonds are very short and very high quality.
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Re: Coming Bond Market Crash

Postby camper » Sun Jan 06, 2013 5:00 pm

We have heard of the pending doom and gloom of rising interest rates for a couple years now. Those that think they know when it will actually happen are fooling themselves. Tune out the noise. Stay the course.
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Re: Coming Bond Market Crash

Postby spanky123 » Sun Jan 06, 2013 7:20 pm

camper wrote:We have heard of the pending doom and gloom of rising interest rates for a couple years now. Those that think they know when it will actually happen are fooling themselves. Tune out the noise. Stay the course.

Staying the course seems so simple but yet so hard to follow.
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Re: Coming Bond Market Crash

Postby dbcoop » Sun Jan 06, 2013 7:25 pm

HenryPorter wrote:No bond crash if rates are raised in a friendly way.
I'm bewildered, how might that be?
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Re: Coming Bond Market Crash

Postby nisiprius » Sun Jan 06, 2013 7:41 pm

What do people think a bond market "crash" might consist of? The silly bond is only going to pay back $1,000 when it matures, no matter what. Just how much of a mania can possibly develop over the prospect of getting $1,000 on, let's say, January 15, 2022? How much are people going to bid that up? There are no stories to spin, no castles in the air. The sky is not the limit, you're under a $1,000 ceiling. The potential wealth is not limited only by your imagination, it's limited to $1,000. No matter what happens, no matter if the bond issuer discovers cold fusion or a tablet that turns water into gasoline or the philosopher's stone, at best that bond is only going to return $1,000 ten years from now, and maybe $20 a year every year from now until then.

Would you pay, say, $5,000, $6,000, $10,000 for that? No, of course not, and neither is anybody else. So the values can't be insanely elevated, and they can't crash the way tech stocks did in 2000.

Look at what happened to interest rates in 2004-2007.

Image

Do you remember a bond "crash" during that period of time? Me, neither.

In 1994, the press described events as a "bond massacre," and described 1993 as a "bond bubble." What, exactly, would you seen then as a buy-and-hold investor, reinvesting dividends, in Vanguard Total Bond Market Fund?

Image

You'd have seen your holding decline by less than 5% in value, and you'd have seen it fully recover in less than 18 months.

If you'd actually been able to predict the future, would it have been better pull out of Total Bond and miss out on that 18 month dip? Sure it would. Was it it great big wealth-vaporizing deal if you didn't? No.
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Re: Coming Bond Market Crash

Postby FinancialDave » Sun Jan 06, 2013 7:46 pm

HenryPorter wrote:No bond crash if rates are raised in a friendly way.


So the fact that the 10 year treasury yield is up close to 20% in just a few months, and the total return for the last 52 weeks is -2.93% doesn't bother anyone??

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Re: Coming Bond Market Crash

Postby livesoft » Sun Jan 06, 2013 7:50 pm

FinancialDave wrote:
HenryPorter wrote:No bond crash if rates are raised in a friendly way.


So the fact that the 10 year treasury yield is up close to 20% in just a few months, and the total return for the last 52 weeks is -2.93% doesn't bother anyone??

fd

Since January rolled around, YTD is no longer the same as 1-year return.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Coming Bond Market Crash

Postby Nicho_1978 » Sun Jan 06, 2013 8:23 pm

nisiprius wrote:What do people think a bond market "crash" might consist of? The silly bond is only going to pay back $1,000 when it matures, no matter what. Just how much of a mania can possibly develop over the prospect of getting $1,000 on, let's say, January 15, 2022? How much are people going to bid that up? There are no stories to spin, no castles in the air. The sky is not the limit, you're under a $1,000 ceiling. The potential wealth is not limited only by your imagination, it's limited to $1,000. No matter what happens, no matter if the bond issuer discovers cold fusion or a tablet that turns water into gasoline or the philosopher's stone, at best that bond is only going to return $1,000 ten years from now, and maybe $20 a year every year from now until then.


Your plots captures the sentiment of the original post better than I could. The plots of the eighties are even more pronounced than the ones you showed. They show an extended upward trajectory in rates since the late seventies and just like you said, the bond market did not loose any significant value then either.
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Sun Jan 06, 2013 8:53 pm

Be careful about using the 1970's (or 1990's, or 2000's) to predict what might happen going forward. The rates did not start anywhere near as low as they are today. When you start out with a higher rate, you can more easily offset a given rate increase. At 1% interest, there is very little to compensate for a drop in value.
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Re: Coming Bond Market Crash

Postby rustymutt » Sun Jan 06, 2013 9:02 pm

HenryPorter wrote:No bond crash if rates are raised in a friendly way.


And how does a friendly crash occur?
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Re: Coming Bond Market Crash

Postby rustymutt » Sun Jan 06, 2013 9:04 pm

I wouldn't normally be to concerned about a bond crash. What does worry me now, is the that the Feds have already indicated that policy going forward will be higher rates. That's got me worried.
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Re: Coming Bond Market Crash

Postby patrick » Sun Jan 06, 2013 10:10 pm

If your duration is long enough, you can lose quite a bit due to even a modest interest rate increase. To take an extreme example, consider what happened recently with Vanguard's Extended-Duration Treasury ETF (EDV), which has an average duration of about 25 years. From December 26, 2008 to April 5, 2010 this fund lost approximately 42% of its value (see http://finance.yahoo.com/q/hp?s=EDV&a=11&b=26&c=2008&d=03&e=5&f=2010&g=d&z=66&y=0).

This sort of loss should not really be expected from bond investments of more normal duration. However, if interest rates increase to historical average levels over a short period of time (please note I'm not saying that such a thing is likely) you could still see a double-digit loss even on intermediate-term bonds. Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now. Thus, for many of us, interest rates remaining low would be the real disaster.

For long term bond investments the real danger is from inflation. Inflation can cause large losses over a period of decades even if the nominal value of your investment increases significantly. For example, from the end of 1940 to the end of 1981 an investment in treasury bonds would increased by a factor of 2.97 (see http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html). However, consumer prices increased by a factor of 6.67 over the same time period (see ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt). The end result is that, in real terms, a long term bond investor over this 41 year period would have lost about 55%!
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Re: Coming Bond Market Crash

Postby Nicho_1978 » Sun Jan 06, 2013 11:17 pm

patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?
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Re: Coming Bond Market Crash

Postby dbr » Sun Jan 06, 2013 11:22 pm

Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?


No. You will have a guarantee that you will have the same amount of money you would have had at the rate just before the change 5 years after the last change in interest rates. If interest rates follow a continuous upward trend your return will also be continuously depressed. If interest rates enter a downward trend, your return will be enhanced.
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Re: Coming Bond Market Crash

Postby HomerJ » Sun Jan 06, 2013 11:42 pm

camper wrote:We have heard of the pending doom and gloom of rising interest rates for a couple years now. Those that think they know when it will actually happen are fooling themselves. Tune out the noise. Stay the course.


The Total Bond Market Index Fund is up like 20% in the last three years...

So even if there is a crash ("crash" in bonds means a 5% or 10% drop), staying the course over the last couple of years while everyone warned of the imminient bond crash will work out fine for me, even if it does finally happen this year.
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Re: Coming Bond Market Crash

Postby hazlitt777 » Sun Jan 06, 2013 11:50 pm

I think there is broad agreement that the longer the duration of a bond the more sensitive it is to an increase in interest rates.

We have seen how bonds have benefited from rates being low and going lower. I think the intermediate term bond index for example had done over 7% this past year and what is the average rate on those bonds? Maybe 2%.

If rates go up they will definitely take a hit.

I think the biggest misconception about bonds or even money markets is that they are the definition of safety. Big mistake.

The closest we can get to safety is broad diversification. For me that is stocks, bonds and gold. I know any of these assets can take a big hit any time. But together, as a whole, they give my overall portfolio stability, protection, and real potential for real growth.

I personally, thought bonds would have taken a bit hit already. I was wrong. But to think they are bedrock is a big mistake. The closest to bedrock safety we can find in this life, financially speaking, is real and broad diversification.
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Re: Coming Bond Market Crash

Postby bikenfool » Sun Jan 06, 2013 11:51 pm

dbr wrote:
Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?


No. You will have a guarantee that you will have the same amount of money you would have had at the rate just before the change 5 years after the last change in interest rates. If interest rates follow a continuous upward trend your return will also be continuously depressed. If interest rates enter a downward trend, your return will be enhanced.


Isn't your statement counter to this sentence from the wiki (http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics#Duration)
"Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen."
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Re: Coming Bond Market Crash

Postby Munir » Mon Jan 07, 2013 12:26 am

bradrh wrote:
dbr wrote:
Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?


No. You will have a guarantee that you will have the same amount of money you would have had at the rate just before the change 5 years after the last change in interest rates. If interest rates follow a continuous upward trend your return will also be continuously depressed. If interest rates enter a downward trend, your return will be enhanced.


Isn't your statement counter to this sentence from the wiki (http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics#Duration)
"Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen."


The statement you quote from the wiki is correct if there is a one time rise in interest rates right now, and then they hold steady for five years. If there is a continuing rise in rates over the five years, then you have to recalibrate the value of your holdings each time rates rise, and start a new five year cycle (assuming we are talking about a bond fund with a five year duration). That's how I understand it and what I think dbr is saying.
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Re: Coming Bond Market Crash

Postby hazlitt777 » Mon Jan 07, 2013 12:41 am

Munir wrote:
bradrh wrote:
dbr wrote:
Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?


No. You will have a guarantee that you will have the same amount of money you would have had at the rate just before the change 5 years after the last change in interest rates. If interest rates follow a continuous upward trend your return will also be continuously depressed. If interest rates enter a downward trend, your return will be enhanced.


Isn't your statement counter to this sentence from the wiki (http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics#Duration)
"Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen."


The statement you quote from the wiki is correct if there is a one time rise in interest rates right now, and then they hold steady for five years. If there is a continuing rise in rates over the five years, then you have to recalibrate the value of your holdings each time rates rise, and start a new five year cycle (assuming we are talking about a bond fund with a five year duration). That's how I understand it and what I think dbr is saying.


And none of this ensures one will have more purchasing power than when you originally invested. And so, bonds are never free of risk, no different than any other financial asset.
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Re: Coming Bond Market Crash

Postby FinancialDave » Mon Jan 07, 2013 2:07 am

livesoft wrote:
FinancialDave wrote:
HenryPorter wrote:No bond crash if rates are raised in a friendly way.


So the fact that the 10 year treasury yield is up close to 20% in just a few months, and the total return for the last 52 weeks is -2.93% doesn't bother anyone??

fd

Since January rolled around, YTD is no longer the same as 1-year return.


None of my numbers had anything to do with YTD. The negative 2.93% was quoted in the WSJ as the total return of the 10 yr over the last 52 weeks.
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Re: Coming Bond Market Crash

Postby Nicho_1978 » Mon Jan 07, 2013 6:43 am

Portfolio B consisting of 100% Total bond market fund with an average duration of about 5 years would have returned an average of 7.5% over the last 30 years.

Portfolio B consisting of 85% of a 2-year term bond fund and 15% equities would have returned a slightly higher 8% over the same time frame.

Portfolio B is a lot safer because its more diversified and have half the interest rate rise risk of portfolio A because of its shorter duration. The only drawback is that monthly income from portfolio A is 3 times more than portfolio B.
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Re: Coming Bond Market Crash

Postby nisiprius » Mon Jan 07, 2013 7:24 am

Call_Me_Op wrote:Be careful about using the 1970's (or 1990's, or 2000's) to predict what might happen going forward. The rates did not start anywhere near as low as they are today. When you start out with a higher rate, you can more easily offset a given rate increase. At 1% interest, there is very little to compensate for a drop in value.
I've shown the same thing with what appear to be older bond mutual funds for what might be called the "secular" rise from 1950-1980. I don't like to keep reproducing the charts for two reasons. The first is that I don't really know what was in the funds. The second is that while I am interested in showing them as evidence for the effect of rising rates, as soon as I show them I always get caught up immediately in a different issue, which is that whenever you point out that the rate rise from 1950 to 1980 was a strong headwind, not a crash, someone immediately point out what is also true--which is that the rate rise was actually due to inflation, and that while the effect of the interest rate rise on nominal dollars was not apocalyptic, the effect of the inflation was devastating--which is correct, but a separate issue.

I've also done computer simulations and they show the same thing. If you look at a) gradual rises, such as the historical average 0.5%/year rise from around 1950 to 1980, b) rotating bond collections or ladders (resembling mutual funds), c) intermediate terms, and d) total return, you don't get dramatic crashes. You get headwinds, you get underperformance relative to what was expected, you get competitive losses relative to other investment moves you might have taken. But you don't get dramatic, wealth-vaporizing crashes.

The "crash" talk always seems to embody a number of unstated assumptions: an instantaneous interest rate rise; ignoring accumulating interest and paying attention only to capital (de)preciation; individual bonds rather than funds; and durations about twice as long as that of typical "core" bond funds.

Now it is very hard to tell what the rhetoricians of doom mean, what people think they mean, and what rhetoricians of doom hope people will think they mean. In their August 2010 article, The Great American Bond Bubble, Siegel and Schwartz lead off by talking about the tech crash when "highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago." They then say "A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds." What would an ordinary retail investor be expected to think? What percentage drop are they talking about, ballpark?

Elsewhere they interestingly phrased statement that quantities the drop without naming it as a percentage: "bondholders will suffer a capital loss more than three times the current yield." That works out to less than 8%.

Would you regard an 8% drop your bond fund as "far more serious" than the dot-bomb crash?
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Re: Coming Bond Market Crash

Postby nisiprius » Mon Jan 07, 2013 7:29 am

hazlitt777 wrote:And none of this ensures one will have more purchasing power than when you originally invested. And so, bonds are never free of risk, no different than any other financial asset.
Oh, if only there were some kind of bond that were, oh, I don't know, indexed to inflation or something, that gave you a guaranteed real return... :wink:
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Mon Jan 07, 2013 7:29 am

Nisi,

A recent article pointed-out that if bonds were to rapidly return to their historical average inflation premium of 3%, intermediate bond funds could see a drop of 25%.

There is a bright side to rate increases. After a period of paper losses, as long as you hold onto your funds, you will end up better off in the long run.
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Mon Jan 07, 2013 7:31 am

nisiprius wrote:
hazlitt777 wrote:And none of this ensures one will have more purchasing power than when you originally invested. And so, bonds are never free of risk, no different than any other financial asset.
Oh, if only there were some kind of bond that were, oh, I don't know, indexed to inflation or something, that gave you a guaranteed real return... :wink:


..of less than zero. :wink:
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Re: Coming Bond Market Crash

Postby nisiprius » Mon Jan 07, 2013 7:39 am

Call_Me_Op wrote:Nisi,

A recent article pointed-out that if bonds were to rapidly return to their historical average inflation premium of 3%, intermediate bond funds could see a drop of 25%.

There is a bright side to rate increases. After a period of paper losses, as long as you hold onto your funds, you will end up better off in the long run.
That actually doesn't sound mathematically correct to me and doesn't match what I've seen in my computer simulations. I hasten to add that my simulations are amateurish and might be bogus, although Grabiner and some other people who've eyeballed them don't think they're crazy nuts.

If we say a) inflation is about zero, and b) the ten-year rate is about 1.75%, and c) the duration of Total Bond is about 5 years, then you are talking about a rapid rise from 1.75% to 3%. Call if 1-1/2%. That would imply a corresponding drop in Total Bond of about 5 * 1.5% = 7.5%. That's quite a bit different from 25%.

What's that recent article and what details do they give on their methodology?

"Rapidly" is very important here, though. Short-term rapid fluctuations do create short-term mirror-image rapid fluctuations in market value--one is a ragged sawtooth that's an upside-down version of the other ragged sawtooth. But those are just the sorts of things a long-term investor shouldn't be obsessing over.
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Re: Coming Bond Market Crash

Postby Call_Me_Op » Mon Jan 07, 2013 8:00 am

nisiprius wrote:If we say a) inflation is about zero.


But it's not about zero. As I recall, the article assumed that inflation is running around 3%, and intermediate bonds would return 6%, up from 1% - so with a 5 year duration that is a drop of about 25%. I agree that this is a bit of a stretch - and probably represents worst case for intermediates.
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Re: Coming Bond Market Crash

Postby Rodc » Mon Jan 07, 2013 9:56 am

If you want to understand what a bond "crash" looks like you have to start back around 1950 or so. Bonds, at least high quality bonds, do not crash in the sense that stocks do (or at least haven't in the US, losing a war or having been overthrown in some other fashion and all bets are of). Rather they cause small losses year after year after year for large cumulative losses as they did for decades starting around 1950. Just as starting around the 1980s they were winners for 30 years.

See the next to last graph in this little write up I did a few years ago:

http://home.comcast.net/~rodec/finance/ ... nBonds.pdf

Note that a average annual loss of a few percent averaged over 30 years running is very ugly indeed.

Note also, stocks were not really a help, no great zig while the other zagged.

Note also, that had TIPS been available they might have been a big help.
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Re: Coming Bond Market Crash

Postby nisiprius » Mon Jan 07, 2013 10:07 am

Rodc wrote:If you want to understand what a bond "crash" looks like you have to start back around 1950 or so. Bonds, at least high quality bonds, do not crash in the sense that stocks do (or at least haven't in the US, losing a war or having been overthrown in some other fashion and all bets are of). Rather they cause small losses year after year after year for large cumulative losses as they did for decades starting around 1950....Note also, that had TIPS been available they might have been a big help.
Yes, but again, it really muddies the waters when one mixes up inflation risk and interest risk. You are talking about a combination of interest rate effects and inflation rate effects. It was the inflation rate effects that were devastating, not the interest rate effects, which simply don't match rhetoric like "far more serious consequences for investors [than the tech stock crash]."

If inflation is the fear, let's talk about inflation... and, of course, acknowledge the existence of TIPS. Let's not talk about hypothetical devastating crashes induced by interest rate rises.

I agree that inflation is a serious concern, and am surprised by an increasing number of posters asking about long-term nominal bond funds as core portfolio holdings.
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Re: Coming Bond Market Crash

Postby Ranger » Mon Jan 07, 2013 10:16 am

rustymutt wrote: What does worry me now, is the that the Feds have already indicated that policy going forward will be higher rates. That's got me worried.


With One hawkish committee member (Richmond Fed President Lacker) rolls off and dovish member ( Chicago Fed President Evans) joins the voting ranks in 2013, my crystal ball says that the FOMC will continue asset purchases into 2014 especially with below par GDP growth
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Re: Coming Bond Market Crash

Postby midareff » Mon Jan 07, 2013 10:22 am

Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?



There are no guarantees in investing, including that one........
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Re: Coming Bond Market Crash

Postby Doc » Mon Jan 07, 2013 10:50 am

nisi wrote:Do you remember a bond "crash" during that period of time? Me, neither.

I guess it all depends on the postion of the observer.

Image

Price chart.

Vanguard Intermediate down 15% (blue), Vanguard TIPS down 15% (green), Vanguard Intermediate Treasuries (orange) not so much.

So if you only look at Total Bond Market and only look at growth where the dividends offset the price drop you can't see the trees for the forest. And if you never try to rebalance into equites when the equity market tanks you don't give a RA anyway so why bother to look at anything?
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Re: Coming Bond Market Crash

Postby midareff » Mon Jan 07, 2013 10:55 am

There is an exercsie that is pretty easy to do to determine the effects...... granted this is rough but it should be in the ball park. Total Bond Market currently has an SEC of 1.49% and a duration of 5.2 years. We don't have to repeat the last rising interest rise scenario when the FED increased rates at 17 consecutive meetings a few years ago .. starting from a much more favorable 4%, but let's start with a 3/4 % per year rise for 4 years with 3% inflation (a lowball for the rate rise). The first year TBM has an SEC of 2.24 % to offset a 3.9 % price drop and has a loss of (pre-inflation) 1.66%. Second year the SEC has risen to 2.99 % to offset a 3.9 % price drop and the fund has lost another .91 %. Third year the SEC has risen to 3.74 % to offset another 3.9 % price drop .... fund losses another .16 %. Year four, SEC becomes 4.49 % to offset the 3.9 % price drop... fund is up .59 % for the year or a four year total of -2.14 %. Unfortunately that goes with a four year inflation of (conservatively) 12 % . You have lost about 14 % in purchasing power.

While this is all speculative it does put a flashlight on the relationship between SEC and duration.
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Re: Coming Bond Market Crash

Postby dbr » Mon Jan 07, 2013 11:21 am

bradrh wrote:
dbr wrote:
Nicho_1978 wrote:
patrick wrote: Keep in mind that if you hold the bond fund for a period of time longer than its duration, you will actually end up with more money in the end if interest rates increase now!


So if I have 100k invested in the total bond market fund now which have an average duration of approximately 5 years. Ill be gaurantee the 100 k plus any interest after 5 years regardless of whether interest rates rise or fall?


No. You will have a guarantee that you will have the same amount of money you would have had at the rate just before the change 5 years after the last change in interest rates. If interest rates follow a continuous upward trend your return will also be continuously depressed. If interest rates enter a downward trend, your return will be enhanced.


Isn't your statement counter to this sentence from the wiki (http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics#Duration)
"Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen."


No, it is exactly the same statement. If my wording isn't exactly clear then read the Wiki. What the Wiki doesn't discuss is what happens if interest rates continue to change instead of experience a one-time change. There are many people reaching the false conclusion that bond funds are immune to interest rate risk if held for the duration when the correct statement is held for the duration after the last interest rate change. Since interest rates never stop changing, conversation about holding bond funds as long as their duration is nonsense.
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Re: Coming Bond Market Crash

Postby Rodc » Mon Jan 07, 2013 11:36 am

Yes, but again, it really muddies the waters when one mixes up inflation risk and interest risk. You are talking about a combination of interest rate effects and inflation rate effects.


It is what it is. It was what happened. Was it a nice clean laboratory experiment? No. But unless you think the time period was so unique that it simply cannot repeat it is a very instructive example of what a bad bond situation can look like. I think it is very important because people, you included, tend to focus on very short time periods and say look, bonds are not very risky. Ok, not much bad happened from 1993 to 1996. So what? Three year periods are not the issue with bonds, decades are the issue with bonds. And that means you need a very long historical perspective if you want to understand the range of bond behavior. It is a point I feel is important to understand.

We are at record low interest rates. The money supply has been pumped up at historic rates. I have no idea what will happen. I am not adjusting my allocation. But, IMHO, it makes no sense to believe the conditions behind those early results cannot repeat. And thus the results shown are certainly applicable as far as the reasonable range of possibilities.
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Re: Coming Bond Market Crash

Postby reggiesimpson » Mon Jan 07, 2013 11:46 am

I buy bonds because they are not stocks (the fear and greed debate). I buy it with the intention of keeping it to maturity and collecting the interest along the way. I dont concern myself with the fluctuation in price (interest rates) because i know going in that its going to fluctuate. I came to terms with that years ago. I have always gotten my "$1000" back so thats resolved thank you. The primary question one may ask themselves is to individually ladder the bonds yourself or buy a fund and let them do it? IMHO.
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Re: Coming Bond Market Crash

Postby robj » Mon Jan 07, 2013 11:52 am

I wonder if this time when interest rates go up if it might stimulate the economy instead of depress it. Oldsters have so much of the nation's wealth tied up in CDs earning next to nothing that they are currently scared to spend money on anything but utilities and medicine. How about if they can earn 3-4% on 24-month CDs, don't people think that could result in some pent-up spending being released. Might be too simplistic, but I wonder if Japan's lost decade+ is surely the wrong model for the U.S. to be following.
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