Cash + LT Bonds = TBM?

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Cash + LT Bonds = TBM?

Postby connya » Wed May 22, 2013 7:45 pm

If I hold 1/3 Vanguard LT bond fund and 2/3 money market fund, my average duration will be about the same as TBM. Will it perform similarly to TBM?

According to M*, the LT fund holds almost no mortgage backed securities, but I am less worried about this because I know some here (notably Larry Swedroe) do not like GNMA in the first place. Any reason I should be leery of dropping GNMA?

The LT fund also has greater credit risk than TBM - will the "zero" risk MM fund balance this out? I understand MM funds are not insured - does this mean they are riskier than I assume? Wikipedia tells me there have only ever been a few money market "failures", failing meaning share prices dropping from $1.00 to $0.95 or so. That doesn't sound risky to me but what do I know?

I understand this is called a bond barbell and there are many threads about it, but I can't find anything about a cash - bond barbell so I hope this new thread is warranted.

The reason I ask is that I've just realized that the only reasonably priced fund in my wife's 401k is a money market fund, so if I could incorporate it into my portfolio without changing the characteristics noticeably that would be neato.

Thanks for any responses!
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Re: Cash + LT Bonds = TBM?

Postby nisiprius » Wed May 22, 2013 8:19 pm

Re safety of money market funds, it's a mystery... they are clearly not as safe as an FDIC-insured bank account, but they are probably very safe. But the reason it is a mystery is that clearly, after some forty years of safety and stability, things have changed. Do read Valuethinker's post on Systemic Dangers--issues re personal investing. The famous money market fund failure was Reserve Primary, particularly shocking as it was one of the oldest or perhaps the oldest money market fund. Although fund shareholders got very close to all of their money back--I think it was well over 95%, maybe 98%--it took something like two years. They had no access at all to their money for months, then got it back in chunks, something like half back within a year.

Money market funds are like banks were before the Fed and the FDIC: their safety is based on the integrity of the fund managers and their prudence in what they invest in. After the bank failures of the Great Depression, the FDIC was instituted and banks were subjected to a lot of pesky regulations in the public interest. Money market funds were conceived as an end-run, a way to provide a bank-like product without those pesky bank regulations, and before Reserve Primary, had been managed conservatively enough that they had been safe. Would you or I have spotted the problems in Reserve Primary before it failed? I don't know about you, but I can answer for me: no, I would not have.

Re "cash + LT bonds," one thing I would be concerned about is your ability to state the course in that combination. I think the bond bubble talk is wildly overhyped, and while I sure hope interest rates eventually rise, people show far greater certainty about how things will play out than they should. Nevertheless, if there is a sharp, large rise in interest rates, the Vanguard long-term bond fund has a 15-year duration, while Total bond has a 5-year duration. It will drop three times as much as Total Bond does. And it will take longer to recover. If one imagines a 2-3% rise in interest rates, Long-Term Bond Index could conceivably fall 30-45%, Now since it will only be 1/3 of your holdings, indeed, your total fixed income will only fall 10%-15%, but you probably won't see it that way--you'll see the two slices separately and you'll see the long-term fund get beaten up pretty badly. Will you be able to hang on if that happens?
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Re: Cash + LT Bonds = TBM?

Postby connya » Wed May 22, 2013 9:15 pm

Thank you for the excellent response, nisiprius. I read Valuethinker's thread and my takeaway is that MMF risk is probably very low, but very real - not just some farfetched hypothetical doomsday situation. The money market fund I am considering (IPFIX DWLXX) invests primarily in MBS. I will take that risk now only because the amounts I am investing are relatively (and absolutely) small.

I am confident I can stay the course with TBM. I am confident I can stay the course with the cash/LT allocation IF the entire pie still looks like TBM. My worry is that cash/LT will somehow perform substantially differently from TBM. If that happened I would go back to TBM.
Last edited by connya on Wed May 22, 2013 9:29 pm, edited 1 time in total.
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Re: Cash + LT Bonds = TBM?

Postby rmelvey » Wed May 22, 2013 9:16 pm

Google "bullet" vs "barbell."

Assuming a parallel shift in interest rates, you are correct that the same weighted duration means they will act similarly. However the yield curve has many moments of non-parallel shifts. Check out this thread for more details:
viewtopic.php?f=10&t=105661&p=1534223

The barbell will outperform in periods of unexpected yield curve inversion :happy

My FI allocation is a blend of bills and 30 year Treasuries (that will be rolled over to fresh 30 year ones when they reach 25 years)
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Re: Cash + LT Bonds = TBM?

Postby ogd » Wed May 22, 2013 9:50 pm

connya wrote:The reason I ask is that I've just realized that the only reasonably priced fund in my wife's 401k is a money market fund, so if I could incorporate it into my portfolio without changing the characteristics noticeably that would be neato.


Hmmm, what's it yielding? If it's next to nothing, like most MMF's these days, then I would say that as much as I hate fund fees, a MMF is a waste of tax-advantaged space. You could hold that cash outside the 401k, making some 1% before tax, and use the 401k for stocks. Even with 1% fees, the tax discount on stock returns is probably worth it.

Your barbell plan sounds fine otherwise, the risk and duration balances out nicely.
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Re: Cash + LT Bonds = TBM?

Postby connya » Wed May 22, 2013 9:57 pm

rmelvey wrote:Google "bullet" vs "barbell."

Assuming a parallel shift in interest rates, you are correct that the same weighted duration means they will act similarly. However the yield curve has many moments of non-parallel shifts. Check out this thread for more details:
viewtopic.php?f=10&t=105661&p=1534223

The barbell will outperform in periods of unexpected yield curve inversion :happy

My FI allocation is a blend of bills and 30 year Treasuries (that will be rolled over to fresh 30 year ones when they reach 25 years)


This stuff is a bit beyond me so let me see if I am getting it. A quote from the thread you linked:

Clive wrote:Over the long term, the average yield curve tends towards averaging out flat overall. Robert Shiller's data for example indicates the average of the 1 year yield since 1871 to be close to the average yield of the 10 year yield.

[Distracting in-line display of animated graphic removed by admin LadyGeek. You can view it here: http://www.jfholdings.pwp.blueyonder.co ... dcurve.gif]


My shaky understanding is that my strategy IS a barbell, and that barbells outperform when long term rates go down relative to short term, and underperform when long term rates go up relative to short term, but these things average out over a long period of time so one does not have statistically higher expected returns than the other. Is that right?

ogd wrote:Hmmm, what's it yielding? If it's next to nothing, like most MMF's these days, then I would say that as much as I hate fund fees, a MMF is a waste of tax-advantaged space. You could hold that cash outside the 401k, making some 1% before tax, and use the 401k for stocks. Even with 1% fees, the tax discount on stock returns is probably worth it.

Your barbell plan sounds fine otherwise, the risk and duration balances out nicely.


It does yield next to nothing, but I have no taxable investments. If I can hold part of my bond allocation in an inexpensive MMF in the 401k, I can hold the stocks in a different 401k or an IRA with much lower expenses.
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Re: Cash + LT Bonds = TBM?

Postby rmelvey » Wed May 22, 2013 10:53 pm

connya,

I believe that everything you said is correct. Some other things to google are "pure expectations theory" and "liquidity premium" with regards to bonds. Those two should help you round out your thoughts. I think the correct statement is that the barbell outperforms when short rates go up more than expected.... Remember that the long end of the curve is roughly a geometric average of expected forward short term rates.

At the end of the day, the barbell vs. bullet decision is very minor. Most bogleheads decide to go with the bullet or TBM, but the barbell works very similarly. Personally, I find the barbell to be more flexible and it gives you more control. For example, right now I have my LT bonds in my Roth and my cash in I-Bonds (planning to redeem them if rates rise). I think the benefits of this type of barbell are quite self explanatory :)

FWIW I believe Larry Swedroe doesn't like the barbell, and Grok does. I believe Taylor has a relevant saying about when experts disagree... :happy
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Re: Cash + LT Bonds = TBM?

Postby connya » Wed May 22, 2013 11:42 pm

I thought I had a general idea about how bonds worked but much of this is new and interesting. Thank you all for such great information! I am going to study this further (learning about geometric averages will have to wait until tomorrow) but I have decided to go ahead with the cash + LT bond allocation.

:beer
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Re: Cash + LT Bonds = TBM?

Postby Iorek » Wed May 22, 2013 11:55 pm

rmelvey wrote:My FI allocation is a blend of bills and 30 year Treasuries (that will be rolled over to fresh 30 year ones when they reach 25 years)


Have you considered some EE bonds as substitutes for the 30 year treasuries (are the limits too low to be practical)?
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Re: Cash + LT Bonds = TBM?

Postby rmelvey » Thu May 23, 2013 12:13 am

Iorek wrote:
rmelvey wrote:My FI allocation is a blend of bills and 30 year Treasuries (that will be rolled over to fresh 30 year ones when they reach 25 years)


Have you considered some EE bonds as substitutes for the 30 year treasuries (are the limits too low to be practical)?


I have! What I have settled on instead is to treat them as a cash equivalent for now. If rates jumped I would redeem but if rates stay low for long enough I will just ride them out till maturity. So, for me EE bond is cash but with a call option on a depression :P I really don't like that EE-bonds are very illiquid if you are treating them like the 20 year zero coupon bond... no opportunity to rebalance out of them and into equities.

They are an interesting instrument.
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Re: Cash + LT Bonds = TBM?

Postby grok87 » Thu May 23, 2013 11:44 pm

rmelvey wrote:connya,

I believe that everything you said is correct. Some other things to google are "pure expectations theory" and "liquidity premium" with regards to bonds. Those two should help you round out your thoughts. I think the correct statement is that the barbell outperforms when short rates go up more than expected.... Remember that the long end of the curve is roughly a geometric average of expected forward short term rates.

At the end of the day, the barbell vs. bullet decision is very minor. Most bogleheads decide to go with the bullet or TBM, but the barbell works very similarly. Personally, I find the barbell to be more flexible and it gives you more control. For example, right now I have my LT bonds in my Roth and my cash in I-Bonds (planning to redeem them if rates rise). I think the benefits of this type of barbell are quite self explanatory :)

FWIW I believe Larry Swedroe doesn't like the barbell, and Grok does. I believe Taylor has a relevant saying about when experts disagree... :happy

Larry and I may or may not be in agreement. I think we both agree that long term corporate bonds are generally poor Investments. See this link for example
viewtopic.php?f=10&t=116549&newpost=1701385
I think the barbell can be very useful, but I would recommend doing it with treasuries or high quality munis.
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