Is bond diversification as important as stock diversificatio

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Re: Is bond diversification as important as stock diversific

Postby hoops777 » Tue Jan 22, 2013 9:11 pm

Taylor is there any scenario where one could lose money reinvesting their dividends back into the total bond over the next 10 years?The bond ladder experts do not paint a pretty picture for bond funds right now.
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Worried about bonds and terrified about stocks.

Postby Taylor Larimore » Tue Jan 22, 2013 10:08 pm

hoops777 wrote:Taylor is there any scenario where one could lose money reinvesting their dividends back into the total bond over the next 10 years? The bond ladder experts do not paint a pretty picture for bond funds right now.

Hoops:
The answer to your question must be "yes." There are scenarios when one could lose money in Total Bond Market Index Fund over the next 10 years because almost anything can happen in the stock and bond markets. Skeptics have been fearful for years. No one can forecast (with accuracy) stock or bond returns.

Joe Davis is Vanguard's Chief Economist. He wrote:

"The yield on the 10-year Treasury bond nearly doubled, rising from approximately 8.0% in December 1975 to as high as 15.3% in September 1981--Yet a hypothetical $10,000 investment in the Barclays' Capital U.S.Aggregate Bond Index (the benchmark for the Vanguard Total Bond Market Index) made on December 31st, 1975 would have increased to over $13,500 by September 1981."


Anyone worried about losing money in Vanguard's Total Bond Market Index Fund (whose worst annual return was -2.66%) should be absolutely terrified about losing money in stocks.

Best wishes.
Taylor
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Re: Is bond diversification as important as stock diversific

Postby Rick Ferri » Tue Jan 22, 2013 10:44 pm

I'm late to this thread, but really have nothing new to add about high yield over what I've been saying for the past 14 years posting in this message board and M* Dieheads.

1) Clearly, a true passive investor would not have an opinion about the efficiency of a one particular segment of the market, in this case high yield. Why some people have singled out HY as the exception is beyond my imagination.

2) EVERY study on HY quoted in this conversation was done during a falling interest rate environmental. There are NO studies of how high yield has performed over an extended period of flat rates or rising rates. That makes ALL the research suspect to a predetermined bias.

3) The idea that high yield is a combination of equity risk and interest rate risk is absurd. HY has outperformed both stocks and Treasury bonds over the past 10 years. Thus, it cannot be a combination of stocks and Treasuries as some people suggest. There MUST be unique risk in the asset class.

4) My research shows that about 20% of a B-BB high yield portfolio is equity-like risk, 40% is interest rate risk, and the remaining 40% is split between credit risk and unique default risk. Credit risk is the risk of a downgrade and default risk is the risk of default. It is the unique default risk that provides a portfolio diversification benefit.

5) High yield bonds and TIPS are predominant parts of the US bond market and should be part of a total bond portfolio. They are not part of the Barclays Capital Aggregate Bond index so are not in the Vanguard Total Bond Index fund. A small position to both HY and TIPS complete a portfolio and adds diversification.

Rick Ferri - CFA Charterholder (wanted to clear that up also)
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Re: Is bond diversification as important as stock diversific

Postby magician » Tue Jan 22, 2013 10:55 pm

Rick Ferri wrote:Rick Ferri - CFA Charterholder (wanted to clear that up also)

;)
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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Wed Jan 23, 2013 12:22 am

few thoughts
Clearly, a true passive investor would not have an opinion about the efficiency of a one particular segment of the market, in this case high yield. Why some people have singled out HY as the exception is beyond my imagination.


Well there is a whole body of literature on many anomalies to the EMH. Penny stocks, IPOs, stocks in bankruptcy, momentum, and any asset with lottery like characteristics. So no one is singling out HY.


The idea that high yield is a combination of equity risk and interest rate risk is absurd.

My research shows that about 20% of a B-BB high yield portfolio is equity-like risk,


Seems to me to be a conflict between these two statement. Either there is equity like risk or not. There are many papers on the subject, including the one I just cited by Vanguard that state there is equity like risk in HY. Are they all absurd, including Vanguard

High yield bonds and TIPS are predominant parts of the US bond market and should be part of a total bond portfolio
. This is an opinion, not a fact.

I guess David Swensen is also absurd with his advice to ignore HY.

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Re: Is bond diversification as important as stock diversific

Postby magician » Wed Jan 23, 2013 12:34 am

larryswedroe wrote:
The idea that high yield is a combination of equity risk and interest rate risk is absurd.

My research shows that about 20% of a B-BB high yield portfolio is equity-like risk,

Seems to me to be a conflict between these two statement. Either there is equity like risk or not.

It sounds to me as though Rick is saying that the conventional wisdom is that the risk in HY is solely a combination of equity risk and interest-rate risk, and he's disputing that: he maintains that there are other risks unique to HY that are neither equity risk nor interest-rate risk. That's not to say that HY doesn't have some measure of equity-like risk and some measure of interest-rate risk (it would be stupid to doubt the latter), but those two aren't sufficient; there's something else in there.

In short, there's no conflict in Rick's two statements.
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Re: Is bond diversification as important as stock diversific

Postby Akiva » Wed Jan 23, 2013 1:55 am

Rick Ferri wrote:1) Clearly, a true passive investor would not have an opinion about the efficiency of a one particular segment of the market, in this case high yield. Why some people have singled out HY as the exception is beyond my imagination.


5) High yield bonds and TIPS are predominant parts of the US bond market and should be part of a total bond portfolio. They are not part of the Barclays Capital Aggregate Bond index so are not in the Vanguard Total Bond Index fund. A small position to both HY and TIPS complete a portfolio and adds diversification.


I see no point in getting into an argument with you about this, I'm just trying to clear something up. It seemed, from the thread linked above, that you previously invested in emerging market bonds but stopped doing so when valuations got too high. I then assumed from context that your position on high yield was the same; it seems I was incorrect about this. But what you said above here doesn't seem to square with what you said there about EM bonds.

Surely ceasing to allocate to EM bonds because they are no longer a good deal is not passive and constitutes "an opinion about the efficiency of one particular segment of the market". Furthermore why would reasoning like #5 not compel an allocation to EM bonds for a passive investor who chose to diversify internationally?
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Re: Is bond diversification as important as stock diversific

Postby hoops777 » Wed Jan 23, 2013 2:32 am

When I started this thread I never anticipated such a discussion.So....Should I add the vang inter muni fund to go with total bond and my Ibonds :?: :confused
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Getting to Dublin

Postby Taylor Larimore » Wed Jan 23, 2013 8:58 am

Bogleheads:

There is more than one road to Dublin.

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Re: Is bond diversification as important as stock diversific

Postby Rick Ferri » Wed Jan 23, 2013 9:45 am

Akiva wrote: It seemed, from the thread linked above, that you previously invested in emerging market bonds but stopped doing so when valuations got too high.


I stopped investing in emerging market bonds because the cost to invest was becoming increasingly too high relative to the yield. It's not the asset class that I have an issue with. It's the cost to invest in that asset class. An asset class may make sense if the fee is 1.0% and the SEC yield is 10%, but it doesn't make sense when the yield falls to 5%. The same logic goes for international real estate and developed market bonds, which is way I don't invest in those asset classes. The cost to invest in high yield relative to return is rising, but it's not at point where I would consider pulling the plug.

Taylor Larimore wrote:Bogleheads: There is more than one road to Dublin.


And this is the bottom line. Boglehead philosophy is the consistant - we are talking about differences in strategy. See this Morningstar video to learn the difference, The Three Keys to Investment Success. This is also the subject of an upcoming mini-book and e-book.

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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Wed Jan 23, 2013 10:32 am

Magician
The academic research, which is what I have cited, doesn't say that there is no unique risk in HY, it's just that there is not much, and your paying more than you should for the term risk (Treasuries or CDs can cost you nothing) and call risk has gone unrewarded, let alone the issue of why investors would take that risk (unless perhaps they had a fixed rate mortgage of equal amount that they could prepay) and you have the location issue.
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Re: Is bond diversification as important as stock diversific

Postby Akiva » Wed Jan 23, 2013 11:24 am

hoops777 wrote:When I started this thread I never anticipated such a discussion.So....Should I add the vang inter muni fund to go with total bond and my Ibonds :?: :confused


This depends on your tax situation. There are converters you can find online that will tell you what the tax equivalent yields are on the muni fund vs the total bond fund or intermediate treasuries. If you are out of tax sheltered space, you should invest in munis if the tax equivalent yield is higher.
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Re: Is bond diversification as important as stock diversific

Postby Rick Ferri » Wed Jan 23, 2013 11:30 am

larryswedroe wrote: call risk has gone unrewarded,


I agree with that. It's worse with municipal bonds.

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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Wed Jan 23, 2013 11:46 am

Rick
Not sure it's worse, but that is another reason to avoid muni funds and build individual ladders to avoid the call risk. We won't buy a bond unless it has at least 80% call protection (relative to the maturity) and we try to avoid it if possible). Certainly has helped investors by following that policy.

I simply don't understand why investors are willing to give up control over maturity risk, something they do with corporate debt even investment grade but more so with HY because you can get called even if rates don't fall or just time passing and it moves down the curve but because credit rating improves or stock market improves and they can issue equity instead. The exception is bonds trading at big discount, which is why the fallen angels have done so much better, MBS and can be the case also with munis.

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Re: Is bond diversification as important as stock diversific

Postby assumer » Wed Jan 23, 2013 12:02 pm

Rick Ferri wrote:
larryswedroe wrote: call risk has gone unrewarded,


I agree with that. It's worse with municipal bonds.

Rick Ferri


What is "call risk"?
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No Help From High Yield Bonds

Postby EDN » Wed Jan 23, 2013 12:06 pm

A previous post I made in this thread showed about a 1% portfolio (opportunity) "cost" to using HY Bonds as opposed to just taking more equity risk (higher stock allocation and tilting more to small and value companies) within the framework of one specific asset allocation. I thought it would be beneficial to walk through a more generic framework to illustrate these same points.

Conceivably, a balanced portfolio investor (60% stocks and 40% bonds) will wonder whether or not taking additional risk in bonds is "worthwhile".

A) From 1996-2012 (inception of S&P 600 Value data used later), a 60% Russell 3000 Index, 40% Barclays Aggregate Bond Index portfolio ("P1") has earned +7.3% with an annual SD of 11.2. If we instead add 10% in HY bonds for a portfolio that is 60% Russell 3000 Index, 30% Barclays Aggregate Bond Index, and 10% Barclays Corporate High Yield Index ("P2"), over the same period we find return goes up to +7.4% and SD jumps to 12.6. The first mix lost -11.9% in 00-02 and -20.3% in 08, the later lost -14.8% and -23.4%. Most would look at this and say the additional risk has not been worthwhile.

B) But lets say you want to take on additional risk in pursuit of higher returns. What about adding an allocation to the stocks that typically issue high-yield debt -- small value companies? Over the same period, a 40% Russell 3000, 20% S&P 600 Value, 40% Barclays Aggregate Bond Index ("P3") earned +7.8% with an annual SD of 10.5. The diversification benefit of adding small value actually offset its higher stand-alone risk, producing a better portfolio result than either P1 or P2. And with losses of -2% and -18.7% in the two bear markets highlighted above, it was clearly a more palatable portfolio in the rough times.

C) However, some will take this thought further and say, OK, I like "P3", but what about adding HY bonds to that mix? A 40% Russell 3000, 20% S&P 600 Value, 30% Barclays Aggregate Bond Index, 10% Barclays Corporate High-Yield Index allocation ("P4") earned +7.9% with an SD of 11.8. That is more than 100bps of higher risk for 0.1% higher returns compared to P3. Not very compelling.

D) But, again, lets go with it and assume P3 isn't sufficiently juiced for you. You are still better off taking more risk in equities and keeping bonds for the portfolio ballast. A 40% Russell 3000, 30% S&P 600 Value, 30% Barclays Aggregate Bond Index ("P5") earned +8.2% with an SD of 12.1. The average loss for P4 across the two bear markets was -13.5% and -13.1% for P5.

F) Finally, if you want to take the "bonds = portfolio ballast" concept to the extreme, you'd substitute Barclays Treasury for Barclays Aggregate Bond in P5. "P6" is 40% Russell 3000 Index, 30% S&P 600 Value, 30% Barclays Treasury Index, and earned +8.2% over this period with an SD of 11.4. Bear market losses only averaged -11.6% with this mix.

So we've come full circle and we find a few basic tenants are universal:
1. Equities are for longer-term appreciation and diversification across small and value also valuable.
2. Bonds are ideally used to dampen portfolio risk and the highest quality bonds should be used in the smallest increments necessary.
3. Adding alternative assets like High Yield Bonds, Convertible Bonds, Preferred Stocks, and many others does not provide any additional benefit, often leading to higher risk and lower returning portfolios.
4. Working with markets and taking advantage of all they offer (highest returns in stocks and highest safety in bonds) can add 1% or more to a traditional Total Market portfolio (see P6 vs P1). Using them in other ways can add an additional (opportunity) "cost" of 1% ("P7", a 40% Russell 3000, 35% S&P 600 Value, 25% Barclays Treasury Index mix, earned +8.4% with an SD of 12.4, which is the same volatility and 1% higher returns than P2).

Investing passively is important. Staying the course is crucial. But better allocations can also add to an investor's bottom line--to that point, if you know what they are, why not use them?

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Re: Is bond diversification as important as stock diversific

Postby magician » Wed Jan 23, 2013 12:06 pm

larryswedroe wrote:The academic research, which is what I have cited, doesn't say that there is no unique risk in HY, it's just that there is not much, and your paying more than you should for the term risk (Treasuries or CDs can cost you nothing) and call risk has gone unrewarded, let alone the issue of why investors would take that risk (unless perhaps they had a fixed rate mortgage of equal amount that they could prepay) and you have the location issue.

I understand that (and wasn't arguing against any of it); I simply argued against the view that Rick's two statements were inconsistent.

I appreciate all of the research you've done in this area.
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Re: Is bond diversification as important as stock diversific

Postby magician » Wed Jan 23, 2013 12:11 pm

assumer wrote:
Rick Ferri wrote:
larryswedroe wrote: call risk has gone unrewarded,

I agree with that. It's worse with municipal bonds.

Rick Ferri

What is "call risk"?

If you own a callable bond - a bond in which the issuer has the option to pay it off early (usually at a premium) - then there is a risk that the issuer will exercise that option and pay the bond off early, whether you like it or not. And you won't like it: call options are exercised when interest rates are low (usually so that the issuer can issue new bonds with a lower coupon), so you get all of your money back and have to reinvest it at current (low) rates rather than continue to receive old (high) rates.
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Re: Is bond diversification as important as stock diversific

Postby Doc » Wed Jan 23, 2013 12:33 pm

magician wrote: If you own a callable bond ...


The same problem exists with mortgage backed securities as home owners refinance at lower rates. Great for the home owner not so much for the retiree trying to live off the income from his GNMA fund.

This is why Larry lumps callable corporates, munis and MBS together at times.
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Re: Is bond diversification as important as stock diversific

Postby magician » Wed Jan 23, 2013 12:49 pm

Doc wrote:
magician wrote: If you own a callable bond ...

The same problem exists with mortgage backed securities as home owners refinance at lower rates.

Yes, a prepayment option is the same as a call option.

If a bond issue has a sinking fund provision, that is similar to a call option as well.
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Re: Is bond diversification as important as stock diversific

Postby Rick Ferri » Wed Jan 23, 2013 1:03 pm

A call gives the bond issuer (lender) an option to pay the bond off early while the bond buyer (investor) does not have the option to demand immediate payment. The value of this option is embedded in the market price of the bond.

A call option has the most value to the lenders in a falling interest rates environment because they can refinance at a lower cost. This has been the case since 1979. In a sense, when we take out a mortgage, we are issuing a bond with a call option to a mortgage company. We retain the right to pay off the loan at anytime. This has benefited many of us who have refinanced several times.

That being said, perhaps in the next 25 years the lenders will benefit more than borrowers because it's likely that there will not be as many calls starting from a very low interest rate environment.

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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Wed Jan 23, 2013 1:30 pm

Rick
While they may be true that reduced risk is surely built into prices currently. Likely contributing to the lower spread on junk bonds
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Re: Is bond diversification as important as stock diversific

Postby Rick Ferri » Wed Jan 23, 2013 1:39 pm

larryswedroe wrote:Rick
While they may be true that reduced risk is surely built into prices currently. Likely contributing to the lower spread on junk bonds
Best wishes
Larry


Could be. I don't have data on callable junk versus non-callable junk to assess the option cost. Do you?

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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Wed Jan 23, 2013 4:44 pm

Rick
No I don't either, which is why I asked (:-)) If I had it would share it
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Re: Is bond diversification as important as stock diversific

Postby Bradley » Fri Jan 25, 2013 3:21 pm

larryswedroe wrote:Bradley

Try this piece I wrote which also cites the literature, two papers including Fridson's
http://seekingalpha.com/article/58172-d ... gh-returns

Hope that helps
Larry



Larry,

A belated thank you for taking the time to post your reference material, U-verse had an outage which left us without tv, phone or internet for a few days. I have all your books and used to read all your posts for years and have learned much from your works. We are fortunate to have your input. Let's put aside the academic back-tested portfolios for this discussion and talk actual real world data. I have followed the published advice of another respected poster/money manager who included VWEAX in his WSJ published “model” portfolio. A few months ago, having read your opinions on HY, efficiency and risk, I asked my independent advisor what my SD was. From 3/2006 - 10/2012 it was 14.80 annualized. It fit right between DFA Normal Balanced Strategy of 12.99 and DFA Aggressive Balanced strategy 17.34 for the same time period, right where one would expect to find it given my FI/equity allocation. Yet with only two DFA funds, both of which are the two smallest holdings in that model portfolio, it out-performed all other DFA “benchmark/model” portfolios in total return and growth of wealth. And I mean all portfolios, DFA Fixed Balance to DFA Equity Balanced.
So, ..............we have a portfolio made up of primarily low cost, diversified Vanguard funds including VWEAX, which outperformed the costlier and “more efficient” totally DFA funded portfolios from 3/06 to 10/12. Their were shorter periods of time when some of the DFA portfolios did outperform. Some of the differential may be explained by differences in rebalancing which has only been done twice vs yearly for DFA? Who cares, based on my experience I find VWEAX did not cause enough inefficiency to be of concern.

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Re: Is bond diversification as important as stock diversific

Postby Angst » Fri Jan 25, 2013 3:50 pm

magician wrote:
assumer wrote:
Rick Ferri wrote:
larryswedroe wrote: call risk has gone unrewarded,

I agree with that. It's worse with municipal bonds.

Rick Ferri

What is "call risk"?

If you own a callable bond - a bond in which the issuer has the option to pay it off early (usually at a premium) - then there is a risk that the issuer will exercise that option and pay the bond off early, whether you like it or not. And you won't like it: call options are exercised when interest rates are low (usually so that the issuer can issue new bonds with a lower coupon), so you get all of your money back and have to reinvest it at current (low) rates rather than continue to receive old (high) rates.

With mortgage rates at historic lows and not much room to drop further, at least in terms of discrete numbers, shouldn't these be promising days for MBS holders with respect to call risk?
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Ruining the DFA Balanced Strategies with HY Bonds

Postby EDN » Fri Jan 25, 2013 4:13 pm

Bradley wrote:

Larry,

A belated thank you for taking the time to post your reference material, U-verse had an outage which left us without tv, phone or internet for a few days. I have all your books and used to read all your posts for years and have learned much from your works. We are fortunate to have your input. Let's put aside the academic back-tested portfolios for this discussion and talk actual real world data. I have followed the published advice of another respected poster/money manager who included VWEAX in his WSJ published “model” portfolio. A few months ago, having read your opinions on HY, efficiency and risk, I asked my independent advisor what my SD was. From 3/2006 - 10/2012 it was 14.80 annualized. It fit right between DFA Normal Balanced Strategy of 12.99 and DFA Aggressive Balanced strategy 17.34 for the same time period, right where one would expect to find it given my FI/equity allocation. Yet with only two DFA funds, both of which are the two smallest holdings in that model portfolio, it out-performed all other DFA “benchmark/model” portfolios in total return and growth of wealth. And I mean all portfolios, DFA Fixed Balance to DFA Equity Balanced.
So, ..............we have a portfolio made up of primarily low cost, diversified Vanguard funds including VWEAX, which outperformed the costlier and “more efficient” totally DFA funded portfolios from 3/06 to 10/12. Their were shorter periods of time when some of the DFA portfolios did outperform. Some of the differential may be explained by differences in rebalancing which has only been done twice vs yearly for DFA? Who cares, based on my experience I find VWEAX did not cause enough inefficiency to be of concern.

Bradley


Bradley,

This period is too short and the comparison too noisy to say anything meaningful about using HY Bonds or anything else. Differences in returns were mostly attributable to different bond durations during this period -- one in which rates fell precipitously and the longer your bond holdings the better (DFA Balanced Strategies use ultra-short term bonds vs. intermediate bonds in your example). Looked at another way, over this same period, 1YR bonds tripled the return on Int'l developed stocks. Under this view of investing, we should also conclude that cash is a superior portfolio substitute to international stocks.

But lets take the DFA Balanced Strategies you mention as yet another example of the inefficiencies of adding HY Bonds to a balanced portfolio. We will go back to 1999 (first full year of live funds for DFA EM Value and Small) and look at the "Normal Balanced" Allocation (12% S&P 500, 12% US Large Value, 6% US Micro, 6% US Small Value, 6% REIT, 6% Int'l Large Value, 3% Int'l Small, 3% Int'l Small Value, 3% EM Value, 3% EM Small, 10% 1YR Fixed, 10% 2YR Global, 10% Short-term Government, 10% 5YR Global). Its return through 2012 was +7.4% per year with an SD of 12.8.

Now lets try to increase the returns of this portfolio by adding the Barclays HY Bond Index to the mix. We will keep the stock allocation the same, but reduce the short-term bond allocation to 30% (7.5% apiece) to make room for 10% Barclays HY Index. This lifts our return to +7.7% with an SD of 14.6 -- or 0.3% higher returns with about 2.0 more volatility. Not many would sign up for this tradeoff.

Instead, we know that investors are better off increasing expected return and risk by (a) holding relatively more stocks, (b) tilting more to small and value, or (c) both. If we do (c), moving the stock allocation up to 65% and tilting more to small and value*, we find the return for this period goes up to 8.5% with a matching SD of 14.6...about a 1% better risk-adjusted return.

So again it appears the actual cost of using HY bonds is about 1% lower portfolio returns (on a risk-adjusted basis). My previous post found this, my hypothetical scenario found this, and is again confirmed by this example.

Eric

*6.5% S&P 500, 6.5& US Large Value, 13% US Micro, 13% US Small Value, 6.5% REIT, 3.25% Int'l Value, 3.25% Int'l Small, 6.5% Int'l Small Value, 3.25% EM Value, 3.25% EM Small, 8.75% each in 1YR Fixed, 2YR Global, Short-Term Government, and 5YR Global.

PS -- over the same period, a 27% Russell 3000, 9% S&P 600 Value, 6% Wilshire REIT Index, 5% MSCI Europe Index, 5% MSCI Pacific Index, 3.5% DFA Int'l Small Value Fund, 4.5% DFA Emerging Markets Fund, 30% Barclays Aggregate Bond Index, 10% Barclays HY Bond Index portfolio (net of ETF fees on indexes) earned +6.7% with an SD of 13.3, about 0.7% per year less than the DFA Normal Balanced Strategy with higher risk.
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Re: Is bond diversification as important as stock diversific

Postby magician » Fri Jan 25, 2013 5:43 pm

Angst wrote:
magician wrote:
assumer wrote:
Rick Ferri wrote:
larryswedroe wrote: call risk has gone unrewarded,

I agree with that. It's worse with municipal bonds.

Rick Ferri

What is "call risk"?

If you own a callable bond - a bond in which the issuer has the option to pay it off early (usually at a premium) - then there is a risk that the issuer will exercise that option and pay the bond off early, whether you like it or not. And you won't like it: call options are exercised when interest rates are low (usually so that the issuer can issue new bonds with a lower coupon), so you get all of your money back and have to reinvest it at current (low) rates rather than continue to receive old (high) rates.

With mortgage rates at historic lows and not much room to drop further, at least in terms of discrete numbers, shouldn't these be promising days for MBS holders with respect to call risk?

I would think so. (At least with respect to those homeowners who will be discouraged from refinancing. There will still be prepayments from homeowners who sell their homes and move; the low rates will have much less effect on them.)
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Re: Ruining the DFA Balanced Strategies with HY Bonds

Postby Bradley » Fri Jan 25, 2013 5:48 pm

EDN wrote:
Now lets try to increase the returns of this portfolio by adding the Barclays HY Bond Index to the mix.

Eric




Eric,

Thanks for taking the time add to conversation. The data I used was from actual investable funds. Could you run your example using the data of VWEAX which is investable, is 1/3 the cost of JNK, has higher quality bonds, lower SD and higher returns.

Thanks,
Bradley
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VWEAX is a Sorry Surrogate for HY Bonds

Postby EDN » Fri Jan 25, 2013 6:04 pm

Bradley,

I don't have the monthly returns for the Vanguard HY Fund, but it would only make matters worse. VWEAX has underperformed the Barclays Corporate High Yield Bond Index by 2.5% per year after expenses over the last decade with similar risk. If HY simulations didn't work with this much-better-performing index included, it sure isn't going to look good with the watered-down returning fund.

Get this--over the last 15 years, VWEAX has underperformed the Barclays Credit Index of investment grade corporate bonds!

I'm trying to be as true to the HY Bond asset class when I present these comparisons. It's not a good one, even before we account for how poorly it is represented by VWEAX.

Eric
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Re: VWEAX is a Sorry Surrogate for HY Bonds

Postby Rick Ferri » Fri Jan 25, 2013 6:19 pm

EDN wrote:Bradley,

I don't have the monthly returns for the Vanguard HY Fund, but it would only make matters worse. VWEAX has underperformed the Barclays Corporate High Yield Bond Index by 2.5% per year after expenses over the last decade with similar risk.


The Barclays Corporate High Yield Bond Index is a poor proxy for the Vanguard HY Fund. It is not the same risk. The Vanguard fund invests only in B-BB rated bonds while the Barclays index covers all junk down to CCC-. Accordingly, Barclays Corporate High Yield Bond Index is expected to have a higher return because there is more risk.

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VWEAX is a Sorry Surrogate for HY Bonds

Postby EDN » Fri Jan 25, 2013 6:51 pm

Rick Ferri wrote:
EDN wrote:Bradley,

I don't have the monthly returns for the Vanguard HY Fund, but it would only make matters worse. VWEAX has underperformed the Barclays Corporate High Yield Bond Index by 2.5% per year after expenses over the last decade with similar risk.


The Barclays Corporate High Yield Bond Index is a poor proxy for the Vanguard HY Fund. It is not the same risk. The Vanguard fund invests only in B-BB rated bonds while the Barclays index covers all junk down to CCC-. Accordingly, Barclays Corporate High Yield Bond Index is expected to have a higher return because there is more risk.

Rick Ferri


I look at it another way: VWEAX does a bad job of capturing the HY Bond asset class return (-2.5% over the last 10 years). In reality, VWEAX isn't even a high-yield fund, it is a hybrid of high-yield bonds and investment grade corporate bonds if we use the Barclays indexes as the true asset class -- about 65/35. Yet over longer periods, it has had risk more in line with HY Bonds with returns below investment grade corporate bonds.

I'm a big fan of many Vanguard funds, but this ain't one of them.

Eric
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Re: VWEAX is a Sorry Surrogate for HY Bonds

Postby Bradley » Fri Jan 25, 2013 6:55 pm

EDN wrote:Bradley,


Get this--over the last 15 years, VWEAX has underperformed the Barclays Credit Index of investment grade corporate bonds!


Eric


Eric,

VWEAX has not been in existence for 15 years.

JNK an investable fund that attempts to replicate your Index has an SD of 15.82 and a return of 8.37% over 5 years.

VWEAX has a lower SD of 12.07 and higher return of 9.32%

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VWEAX=Bad and JNK=Worse

Postby EDN » Fri Jan 25, 2013 7:37 pm

Bradley wrote:
EDN wrote:Bradley,


Get this--over the last 15 years, VWEAX has underperformed the Barclays Credit Index of investment grade corporate bonds!


Eric


Eric,

VWEAX has not been in existence for 15 years.

JNK an investable fund that attempts to replicate your Index has an SD of 15.82 and a return of 8.37% over 5 years.

VWEAX has a lower SD of 12.07 and higher return of 9.32%

Bradley


Bradley,

We can derive 15 year returns for Van HY Adm. from looking at the investor share and increasing the return by the lower fee of the admiral share (M* does this on their website, for example).

JNK is even worse at tracking the asset class (Barclays HY Index) than Vanguard HY due to the illiquidity of bond ETFs. So a bad fund (Vanguard HY) is better than an even worse ETF (JNK) doesn't make the Vanguard fund good. It's had similar risk as Barclays HY Index over time but trailed it badly (-2.5% over the last decade) and has been much riskier than investment grade bonds (Barclays Credit Index) yet has not outperformed it meaningfully (actually trailed it over last 15 years).

That's a lot not to like--and even without those flaws, the asset class itself isn't worth inclusion if an investment that captured it actually existed (which it doesn't).

Eric

PS--Vanguard shows you how badly the fund has done relative to Barclays HY Index right on the website, don't take my word for it ( and they've also written research on why HY doesn't work in a portfolio, so you don't have to take my word on that either)
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Re: Is bond diversification as important as stock diversific

Postby Bradley » Fri Jan 25, 2013 9:24 pm

VWEAX=Bad ???????????


Growth of $10,000 over 10 years in VWEAX is $21,855. (HY)

Growth of $10,000 over the same 10 years in VBTLX is $16,434. (Total Bond)

VWEAX outperformed the total bond fund by over 30% over the past 10 years.

In my opinion, the addition of VWEAX has been very rewarding to me.

VWEAX is simply an option and by no means needed.

Can someone, with hindsight find a better option, or an academic study to
discredit this option? No doubt.
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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Fri Jan 25, 2013 10:18 pm

Re call risk, with low rates it's now the PUT risk that one should worry about, longer than expected maturity.
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Re: Is bond diversification as important as stock diversific

Postby hoops777 » Fri Jan 25, 2013 10:54 pm

Past results are no guarantee of future returns,yet we base all of our future returns on academic theory based on past results,encompassing a totally different world and economy.
Last edited by hoops777 on Sat Jan 26, 2013 3:09 pm, edited 1 time in total.
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Re: Is bond diversification as important as stock diversific

Postby magician » Sat Jan 26, 2013 12:49 am

larryswedroe wrote:Re call risk, with low rates it's now the PUT risk that one should worry about, longer than expected maturity.

Put risk?

As the investor owns the put option, how can there be put risk?
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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Sat Jan 26, 2013 9:26 am

magician
no the borrower owns the put
MBS trade based on EXPECTED maturity, say 6 years. Rates go up and then the expected maturity increases as people won't move as frequently because they will have to pay a higher rate on their mortgage.
This is what makes MBS a lose/lose game. you lose if rates fall as investors prepay and you lose if they rise as investors pay slower. In return you get a generally small premium. This time we had an unusual situation since with housing prices collapsing investors could not refinance. So MBS did not take the expected hit they would have otherwise, leaving investors with reinvestment risk showing up. If rates do rise then you will see durations extending

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Re: Is bond diversification as important as stock diversific

Postby magician » Sat Jan 26, 2013 2:48 pm

larryswedroe wrote:magician
no the borrower owns the put
MBS trade based on EXPECTED maturity, say 6 years. Rates go up and then the expected maturity increases as people won't move as frequently because they will have to pay a higher rate on their mortgage.
This is what makes MBS a lose/lose game. you lose if rates fall as investors prepay and you lose if they rise as investors pay slower. In return you get a generally small premium. This time we had an unusual situation since with housing prices collapsing investors could not refinance. So MBS did not take the expected hit they would have otherwise, leaving investors with reinvestment risk showing up. If rates do rise then you will see durations extending

Larry

The borrower does not own a put option; the borrower owns a prepayment option, which he may not exercise. What you're describing is extension risk, which exists because a certain (non-zero) level of prepayments is expected, but may not materialize. It's not a put option, no matter how much the profession might try to bastardize the terminology.

When the lender exercises a put option, the bond is paid off early. When the borrower decides not to exercise a prepayment (or call) option, the bond is not paid off early. To call the risk that a prepayment option isn't exercised put risk is, at best, confusing; calling it extension risk is not.
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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Sun Jan 27, 2013 1:40 pm

magician
yes, I was just using shorthand, calls (prepayment) and puts (xtension)Larry
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Re: Is bond diversification as important as stock diversific

Postby magician » Sun Jan 27, 2013 1:55 pm

larryswedroe wrote:magician
yes, I was just using shorthand, calls (prepayment) and puts (xtension)Larry

Thanks, Larry.
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Re: Is bond diversification as important as stock diversific

Postby Dandy » Sun Jan 27, 2013 2:51 pm

Total bond fund is very good but doesn't cover the fixed income territory. I believe fixed income diversification is a good idea. CDs, Ibonds, EE bonds, stable value funds, muni bonds, and inflation protection funds are not included in the Total Bond market fund. The other vehicles all have pro's and con's as far as risk/taxes/liquidity etc. I see no good reason to limit your self to only what the total bond market covers. Bogleheads often tilt on the equity side e.g. owning Total Stock Market and Small Cap Value. Why not tilt on the bond side with Total Bond fund and some short term corporate fund - duration diversification and tilt toward corporate??

I think in this unusual interest rate environment fixed income diversification makes even more sense. I don't favor high yield bonds due to their risk and equity like performance or mutual fund money market funds which offer almost no yield and online bank FDIC savings and money market deposit account are a better deal -- for now. I have no feel for the risks and rewards of foreign bonds/funds so I avoid them also.
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Re: Is bond diversification as important as stock diversific

Postby Beagler » Sun Jan 27, 2013 4:01 pm

assumer wrote:What is "call risk"?



http://bit.ly/X2h3ww
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Re: Is bond diversification as important as stock diversific

Postby Beagler » Sun Jan 27, 2013 4:13 pm

larryswedroe wrote:
I guess David Swensen is also absurd with his advice to ignore HY.


IIRC Mr. Swensen also advises against owing munis (with the exception of money market munis). Is he wrong?

Mr. Swensen appears to strongly favor US Treasuries. To some extent Mr. Bogle appears to part company with Mr. Swensen:

"CAVEAT: If there is a weakness to the case for the all-bond-market-index funds, it is that Barclay’s Aggregate Bond Index itself is so heavily weighted by U.S. Treasury and agency securities and federally backed mortgage bonds (GNMAs)." http://money-markets-blog.amazon.com/po ... Index-Fund

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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Sun Jan 27, 2013 5:13 pm

Beagler
I don't know why Swensen would say don't own munis. First, he is non taxable investor, at least as far as the Yale Endowment is concerned
as to munis, if you stick to the type of bonds I have recommended even in the great depression the default losses were close to zero, and given the higher AT yields I cannot see why one would argue against them.
As to high yield Swensen is an investor, and IMO there is no compelling case for investing and much to avoid as I have laid out, including call risk. And hybrid risk and lack of in general much reward to corporate risk, let alone junk. It's only the fallen angels for which there is support in the literature
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Re: Is bond diversification as important as stock diversific

Postby Beagler » Sun Jan 27, 2013 5:54 pm

larryswedroe wrote:I don't know why Swensen would say don't own munis.


From Unconventional Success, 2005, p. 117
Tax-exempt bond investors face the same set of misaligned interests that bedevil all non-Treasury bondholders. Aggressively priced debt issues that benefit the borrowers fail to compensate the lenders....Careful investors approach municipal bonds with great caution.
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Re: Is bond diversification as important as stock diversific

Postby Bustoff » Mon Jan 28, 2013 8:22 am

I wish this thread would have invested more time on the OP question.

Oh well, at least I learned what the letters VWEAX stand for.
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Re: Is bond diversification as important as stock diversific

Postby larryswedroe » Mon Jan 28, 2013 9:33 am

Beagler
but we avoid the very same issues that are similar to high yield debt, so that you don't have the problems
It's like the difference between buying AAA corporate and CCC.

And we basically also avoid call risk

You made the mistake of painting all munis with the same brush

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Re: Is bond diversification as important as stock diversific

Postby Bustoff » Mon Jan 28, 2013 11:52 am

larryswedroe wrote:The answer is you can really keep bonds simple, owning only Treasury, agencies, CDs and AAA/AA rated munis and you're fine, taking all the risk you need on the equity side
Best wishes
Larry


Larry - We are retired now. Does your advice above apply to retired folks ? (i.e. more concentrated in bonds. Perhaps a 40/60 or 30/70 stock bond allocation)
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