A Dangerous Misunderstanding about Bond Rates?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.

A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sat Jul 13, 2013 1:48 pm

I keep seeing people posting in various threads that rising rates are good for bond funds because it means they'll be earning more interest.

But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.

They won't. When rates rise the amount the fund would get from selling its existing bonds drops (so your NAV drops), but the bonds in the fund keep paying the same amount they were paying before. The yield of the fund rises because it is calculated using both the monthly payment and the price of the fund. But to get the higher yield you have to buy shares at that new, lower price.

Bond fund managers can only buy new bonds paying more if bonds they currently hold are redeemed or if they get new money. Only a small percent of the fund's bonds mature each year. And in bond categories where bonds can be redeemed early (callable bonds) once rates rise to where they were 3 or 4 years ago these bonds will not be called, but will remain in the fund for many more years. Callable bonds have been getting called for the past 30 years, which has had an impact on the funds' performance that won't be there anymore.

As far as new money coming into the fund goes, investors are yanking their money out of bond funds at a high rate which means bond fund managers aren't going to have a whole lot of new money to invest in new, higher paying bonds, save for the reinvested dividends of investors who stick with the fund and do NOT spend their monthly dividends on living expenses. But many retirees with bond-heavy portfolios use those monthly dividends to pay bills. So there's no new money coming in to buy higher-paying bonds from them.

Finally, bond funds with longer durations hold older bonds with much higher coupons that will be maturing over the next few years. Funds currently hold 10 and 20 year bonds with 5-7% coupons that will be redeemed over the next few years. When they are redeemed, the new bonds they are replaced with are not likely to be paying as much which will lower the bond funds monthly payment even though rates may have risen.

So there is a many-year gap between the time that rates rise and immediately reduce the value of the bonds in a bond fund and the time when the fund fills up with new bonds paying those higher rates. For now, you should expect to see monthly dividends very much like what you have been seeing for the past year no matter what happens to your funds NAV. If your bond fund holds many old long bonds with high coupons that are getting ready to mature, the monthly dividend payment you get may even drop while rates rise.

Vanguard repeatedly tells investors that they can expect a total return from the Total Bond Fund of slightly less than 2% for the next 10 to 15 years no matter what rates do.

This is the absolute truth. I suspect that many people who are now saying, "It's great news that interest rates are rising, because when rates go up, you earn more from your bond fund" are going to be getting a very unpleasant surprise. I also suspect that when they finally figure out what really happens to bond funds when rates rise many, more of them will flee these funds (along the lines of investors who sold out in 2008) and that this will cause more strain and worse deterioration of fund NAVs.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Call_Me_Op » Sat Jul 13, 2013 2:10 pm

Scooter,

I think when people state that rising rates are good for bond funds, they are referring to the fact that over time the total return will be higher. However, you are correct that it may be misinterpreted. I see a lot of posts here from folks who don't understand how bonds and bonds funds work at even an elementary level. They should hit the books before implementing their investing plan.
Best regards, -Op

"In the middle of difficulty lies opportunity." Einstein
Call_Me_Op
 
Posts: 4567
Joined: Mon Sep 07, 2009 3:57 pm
Location: Milky Way

Re: A Dangerous Misunderstanding about Bond Rates?

Postby YDNAL » Sat Jul 13, 2013 3:08 pm

Scooter57 wrote:I keep seeing people posting in various threads that rising rates are good for bond funds because it means they'll be earning more interest.

But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.

Perhaps some people may be confused.

The Boglehead Wiki is clear in this regard.
Link: http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics
Boglehead Wiki wrote:Duration has another useful summary property, which is that if the yield curve shifts in parallel, then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss. 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.
Landy
Be yourself, everyone else is already taken -- Oscar Wilde
YDNAL
 
Posts: 13349
Joined: Tue Apr 10, 2007 5:04 pm
Location: Biscayne Bay

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Munir » Sat Jul 13, 2013 3:31 pm

YDNAL wrote:
The Boglehead Wiki is clear in this regard.
Link: http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics
Boglehead Wiki wrote:Duration has another useful summary property, which is that if the yield curve shifts in parallel, then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss. 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.


Isn't it also correct that the conclusion of the Wiki statement above applies to a one-time rise in rates only? If there are successive rate increases over a period of time, then the calculations have to be adjusted individually to each rise in rates, which really makes it difficult to predict what happens to the total value of a bond fund over time since there rarely is a single rise in rates. Therefore, one can expect a greater decrease in bond NAV over a period of time of successive raises in rates than what seems to be the prediction at the initial rate rise.
Last edited by Munir on Sat Jul 13, 2013 3:59 pm, edited 1 time in total.
User avatar
Munir
 
Posts: 1737
Joined: Mon Feb 26, 2007 5:39 pm
Location: Oregon

Re: A Dangerous Misunderstanding about Bond Rates?

Postby EmergDoc » Sat Jul 13, 2013 3:45 pm

I haven't yet bought most of the bonds I'll own on the eve of my retirement. Rising rates are good for my bond investments.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy
4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
User avatar
EmergDoc
 
Posts: 9912
Joined: Fri Mar 02, 2007 10:11 pm
Location: Greatest Snow On Earth

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 3:51 pm

Scooter57 wrote:But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.

They won't. When rates rise the amount the fund would get from selling its existing bonds drops (so your NAV drops), but the bonds in the fund keep paying the same amount they were paying before. The yield of the fund rises because it is calculated using both the monthly payment and the price of the fund. But to get the higher yield you have to buy shares at that new, lower price.

The right way to explain this is that the fund dividend, in dollars, is slowly heading up. It's definitely the case that current shareholders in the fund cannot expect the same returns on their original investment as someone previously in cash that is buying into the fund anew. The loss is real. The new shareholder is getting the new and improved market yields on their purchase (making the fund a more attractive buy, btw), whereas the old shareholder has to wait for the loss to be overcome. However, money rebalanced into the fund or money previously kept away because of low yields will produce more, and that's the immediate good news.

Scooter57 wrote:Bond fund managers can only buy new bonds paying more if bonds they currently hold are redeemed or if they get new money. Only a small percent of the fund's bonds mature each year.

Clearly, you understand how maturing bond capital is able to earn more dollars per share immediately by being rolled into higher yields. But this also applies equally to bonds not held to full maturity. For example, if an intermediate bond fund rolls over 3-year bonds into 7-year bonds as part of normal operation, and rates increase by 1 percent even without curve steepening, the 3-year bond takes a much lesser hit than the 7-year simply because of its smaller duration. Then the fund is able to buy more of the 7-year bonds than it used to, or equivalently the same amount but with higher yield. This is the same effect as rollover at maturity.

If the curve steepens due to perception of interest rate risk, like it has recently, then the discrepancy in NAV loss is even higher and the dividend increase more immediate.

It will take a while for the entire portfolio to start earning the new higher yields on the old shares' cost basis -- about the same as duration. Like I said, the loss is real and new money is in a much better position than the old. However, the yield increases are guaranteed to happen slowly but surely. The main argument I've been making here on the forum is that this is much more benign than the similar hits to stocks, where if you're lucky your dividends will stay the same, but if the market has it right the dividends will eventually go down.

Scooter57 wrote:And in bond categories where bonds can be redeemed early (callable bonds) once rates rise to where they were 3 or 4 years ago these bonds will not be called, but will remain in the fund for many more years. Callable bonds have been getting called for the past 30 years, which has had an impact on the funds' performance that won't be there anymore.

No question that callable bonds respond differently to interest rates, and you have to know what you are buying.

Scooter57 wrote:As far as new money coming into the fund goes, investors are yanking their money out of bond funds at a high rate which means bond fund managers aren't going to have a whole lot of new money to invest in new, higher paying bonds, save for the reinvested dividends of investors who stick with the fund and do NOT spend their monthly dividends on living expenses. But many retirees with bond-heavy portfolios use those monthly dividends to pay bills. So there's no new money coming in to buy higher-paying bonds from them.

The effects of money coming and going can be confusing -- at first glance it seems that it has the effects you describe, forcing bond sales and preventing bond buys. The key point, though, is that all the cash flow happens at marked-to-market prices, where all bonds old and new yield pretty much the same. For example, from current Treasury pricing:
Code: Select all
Maturity   Coupon   Bid   Asked   Chg   Asked yield
2/15/2023   2.000   95.2109   95.2734   -0.2266   2.559
2/15/2023   7.125   139.8438   139.8906   -0.3047   2.434

These are 10 year (-ish) bonds with immensely different coupons, yet they yield pretty much the same on the current price(the last column). What differs is the shape of the distribution, the high-coupon bond is much more front-loaded thus lower duration. Still, even for these wildly different bonds I can trade in and out anytime I want and make pretty much the same money.

It might be simplest to do all this reasoning not on mutual funds with their constant revolving door, but on ETF shares which are baskets of bonds unaffected by the selling and buying of other baskets. In other words, take the buying and selling out of the picture. Then realize that even for the mutual fund, the pricing of cash flows at NAV has the exact same effect.

Scooter57 wrote:So there is a many-year gap between the time that rates rise and immediately reduce the value of the bonds in a bond fund and the time when the fund fills up with new bonds paying those higher rates. For now, you should expect to see monthly dividends very much like what you have been seeing for the past year no matter what happens to your funds NAV. If your bond fund holds many old long bonds with high coupons that are getting ready to mature, the monthly dividend payment you get may even drop while rates rise.

Yes -- like I said, the loss is real and it will take a while to be overcome. But again, the good news is that dividends are going up even on existing money, and also -- there are higher yielding bonds available to be bought! What retirees have been waiting all along. Consider this argument I made in another thread:
myself wrote:If the 5-year treasury went up to 10% tomorrow without inflation, it would be a substantial hit to my portfolio (~50% of bonds, ~20% of total). It would also enable me to retire the day after tomorrow if I so wanted. This is not true for a 20% drop caused by the stock market.

Maybe there are others who are only a few percent rise in interest rates away from a comfortable retirement.

Scooter57 wrote:Vanguard repeatedly tells investors that they can expect a total return from the Total Bond Fund of slightly less than 2% for the next 10 to 15 years no matter what rates do.

Is this current? That 2% seems too low and the 10-15 too high, and it sounds more like an older market call to me. Can you provide a link?

Scooter57 wrote:This is the absolute truth. I suspect that many people who are now saying, "It's great news that interest rates are rising, because when rates go up, you earn more from your bond fund" are going to be getting a very unpleasant surprise. I also suspect that when they finally figure out what really happens to bond funds when rates rise many, more of them will flee these funds (along the lines of investors who sold out in 2008) and that this will cause more strain and worse deterioration of fund NAVs.

Expectations have to be realistic, and it's a good idea to be prepared to see NAV drops, even while staying humble about one's capability to predict them. But fundamentally, I can't believe they will drop too far if there is no inflation in the picture because before long they will become too darn attractive compared to everything else. And inflation is a whole different discussion.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby dm200 » Sat Jul 13, 2013 4:21 pm

Scooter57 wrote:I keep seeing people posting in various threads that rising rates are good for bond funds because it means they'll be earning more interest.

But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.

They won't. When rates rise the amount the fund would get from selling its existing bonds drops (so your NAV drops), but the bonds in the fund keep paying the same amount they were paying before. The yield of the fund rises because it is calculated using both the monthly payment and the price of the fund. But to get the higher yield you have to buy shares at that new, lower price.

Bond fund managers can only buy new bonds paying more if bonds they currently hold are redeemed or if they get new money. Only a small percent of the fund's bonds mature each year. And in bond categories where bonds can be redeemed early (callable bonds) once rates rise to where they were 3 or 4 years ago these bonds will not be called, but will remain in the fund for many more years. Callable bonds have been getting called for the past 30 years, which has had an impact on the funds' performance that won't be there anymore.

As far as new money coming into the fund goes, investors are yanking their money out of bond funds at a high rate which means bond fund managers aren't going to have a whole lot of new money to invest in new, higher paying bonds, save for the reinvested dividends of investors who stick with the fund and do NOT spend their monthly dividends on living expenses. But many retirees with bond-heavy portfolios use those monthly dividends to pay bills. So there's no new money coming in to buy higher-paying bonds from them.

Finally, bond funds with longer durations hold older bonds with much higher coupons that will be maturing over the next few years. Funds currently hold 10 and 20 year bonds with 5-7% coupons that will be redeemed over the next few years. When they are redeemed, the new bonds they are replaced with are not likely to be paying as much which will lower the bond funds monthly payment even though rates may have risen.
So there is a many-year gap between the time that rates rise and immediately reduce the value of the bonds in a bond fund and the time when the fund fills up with new bonds paying those higher rates. For now, you should expect to see monthly dividends very much like what you have been seeing for the past year no matter what happens to your funds NAV. If your bond fund holds many old long bonds with high coupons that are getting ready to mature, the monthly dividend payment you get may even drop while rates rise.

Vanguard repeatedly tells investors that they can expect a total return from the Total Bond Fund of slightly less than 2% for the next 10 to 15 years no matter what rates do.

This is the absolute truth. I suspect that many people who are now saying, "It's great news that interest rates are rising, because when rates go up, you earn more from your bond fund" are going to be getting a very unpleasant surprise. I also suspect that when they finally figure out what really happens to bond funds when rates rise many, more of them will flee these funds (along the lines of investors who sold out in 2008) and that this will cause more strain and worse deterioration of fund NAVs.


Let me just point out one part (that highlighted in red) of your post that is either incorrect, or I am misinterpreting it, or might be somewhat misleading. It appears that most (perhaps all, except possibly very short term) of the Vanguard Bond funds have such a high annual turnover rate that they must not hold most bonds "to maturity". They must be doing a lot of selling and buying. Of course, even when selling and buying, the changes in rates mean that the bonds in the portfolio when rates increased for that term are "worth" less.

It is also, in my opinion, very important to note that the NAV in a Bond fund will go down when the fund does a capital gains distribution. This is true, whether the distribution is reinvested or not. Such a drop in NAV is (nearly anyway) completely irrelevant to risk or returns on the fund. So, for example, the GNMA fund (VFIJX) had such capital gains distributions on December 28, 2012. That day, the NAV dropped from 11.00 per share the 27th to 10.91 on the 28th. I do not know how to separate how much of this (might be more or less than 0.09) is due to the distribution, but it is certain that just tracking the NAV can give incorrect and misleading conclusions about the fund. [If anyone can point out if or how the distribution can be precisely quantified, I would appreciate it]
User avatar
dm200
 
Posts: 6579
Joined: Mon Feb 26, 2007 3:21 pm
Location: Washington DC area

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ofcmetz » Sat Jul 13, 2013 4:49 pm

Scooter57 wrote:I keep seeing people posting in various threads that rising rates are good for bond funds because it means they'll be earning more interest.

But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.


At it most simple level, the increase in interest rates is a good thing. Did we really want the TBM fund to continue at 1.5% SEC yield? You make a lot of good points in your OP. It is true that it takes time for the funds to pay more interest and that the initial increase in yield only benefits new shares purchased through either cash or with the dividends that the fund pays. Over time, it benefits all the shares and as other posters have pointed out this is where the duration comes into play.

I like the title of the thread as it got me to click, but I have to disagree that the misunderstanding you are talking about is actually dangerous. For many buy, hold, and rebalance boglehead style investors, the rising rates are a good thing for their fixed income investments. Even if they know this without fully understanding it, then it still may cause them to be more likely to stick with their plan and not abandon their funds just because the NAV is falling. Therefore instead of dangerous maybe it is just a helpful misunderstanding?

Thanks for taking the time to post the long explanation Scooter. :D
Showing up at the donut shop at 5 am to get them hot out of the oil is an example of successful market timing.
User avatar
ofcmetz
 
Posts: 1731
Joined: Tue Feb 08, 2011 9:09 pm
Location: Louisiana

Re: A Dangerous Misunderstanding about Bond Rates?

Postby adam1712 » Sat Jul 13, 2013 5:03 pm

I think it's pretty simple, if you plan to hold a bond fund longer than the duration, you want rates to rise.
adam1712
 
Posts: 187
Joined: Fri Jun 01, 2007 6:21 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Ged » Sat Jul 13, 2013 5:10 pm

Scooter57 wrote:So there is a many-year gap between the time that rates rise and immediately reduce the value of the bonds in a bond fund and the time when the fund fills up with new bonds paying those higher rates. For now, you should expect to see monthly dividends very much like what you have been seeing for the past year no matter what happens to your funds NAV. If your bond fund holds many old long bonds with high coupons that are getting ready to mature, the monthly dividend payment you get may even drop while rates rise.


My understanding from reading is this:

When the rates rise the drop in value of the bonds in the fund the yield on all bonds as a percentage of the value of the bonds automatically increases because of the drop in value.

Example: Suppose I own a bond fund holding a collection of bonds with a 5 year average maturity.

Interest rates increase 1%, and the NAV of the fund (and the average value of the bonds in the fund) decreases 5%. The SEC yield of the bonds is constant, and therefore the % yield of the fund has immediately increased 5%. In five years that increased % yield will replace the lost NAV.

The monthly dividends will not change, but they are a higher percentage of the NAV.

Bonds that are purchased to replace bonds in the fund will not yield more as a percentage of the face value.

The benefit of the increased rate is that re-invested dividends and principle will result in a gradually increasing income stream. The key here is that if you are not reinvesting dividends the income stream will not increase.

This is why increasing rates don't necessarily benefit people who are living off of bond investments, and IMHO one of the reasons that a diverse portfolio of bonds and stocks is important even in retirement.

Other opinions are welcome; I am just starting to seriously think about bond investing.
Lack of planning on your part does not constitute an emergency on my part.
User avatar
Ged
 
Posts: 1710
Joined: Mon May 13, 2013 2:48 pm
Location: Roke

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 5:16 pm

Ged wrote:The benefit of the increased rate is that re-invested dividends and principle will result in a gradually increasing income stream. The key here is that if you are not reinvesting dividends the income stream will not increase.

Actually, this is not true. Reinvesting principal will get you higher yields. This can be either at maturity or halfway through, see my example above with the rolling of a 3-year into a 7-year bond.

So even if you don't reinvest any dividends, the dividends will go up.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sat Jul 13, 2013 5:50 pm

ogd wrote:
Scooter57 wrote:Vanguard repeatedly tells investors that they can expect a total return from the Total Bond Fund of slightly less than 2% for the next 10 to 15 years no matter what rates do.

Is this current? That 2% seems too low and the 10-15 too high, and it sounds more like an older market call to me. Can you provide a link?



Here's one:
https://personal.vanguard.com/us/insights/article/anxiety-bonds-032013
"For some time now, we've been encouraging clients to reevaluate their expectations for fixed income returns. For well over a decade, investors have benefited from a historic bond bull market, but given current interest rates, it's difficult to imagine similar returns in the future. In fact, the Vanguard Capital Markets Model® suggests that the "central tendency" for annualized returns of the broad taxable U.S. bond market will be only 1%–2% over the next decade."

This was also explicitly stated by, I believe, Ken Volpert, during an live online discussion session held back in March with Volpert and someone from the Investor Relations group. He specifically said to expect to earn the current yield of the TBM fund over the next 10-15 years.

To get to another point you made:
ogd wrote:Clearly, you understand how maturing bond capital is able to earn more dollars per share immediately by being rolled into higher yields. But this also applies equally to bonds not held to full maturity. For example, if an intermediate bond fund rolls over 3-year bonds into 7-year bonds as part of normal operation, and rates increase by 1 percent even without curve steepening, the 3-year bond takes a much lesser hit than the 7-year simply because of its smaller duration. Then the fund is able to buy more of the 7-year bonds than it used to, or equivalently the same amount but with higher yield. This is the same effect as rollover at maturity.


If your bond fund manager replaces 3 year maturity bonds with 7 year maturity bonds paying more and the bond rates go up another percent or two, the NAV of your fund will drop further and the time it will take to recover your capital investment will be longer.

There is no magic way to improve bond returns with active trading because all bonds of the same rating get priced to the same current rate and maturity standard. You are talking about playing with the yield curve, which is a speculative play. But doing that is exactly how big fat famous bond and hedge funds often lose their shirts, because it is a form of market timing. If you go long to raise yield, you get slaughtered when rates continue to rise. All the people who have been doing that were doing it under the assumption that rates would stay flat, which they stopped doing in May. A lot of people have lost a lot of money on that bet, and one hopes that Vanguard is not investing our money in ways that assume they know where rates are going.

They probably aren't. It's my understanding that when Vanguard sells within its funds it is doing so to keep the maturity of the fund within its defined parameters. So if it is an intermediate term fund, when bonds have only 2 years left on them, they get sold since they are now short term bonds and replaced with bonds that have more time on them. They aren't replacing a 3 year bond with a 7 year bond. They are replacing the 3 year bond they bought 2 years ago with a 5 year bond they buy now. To replace it with a 7 year bond would be to shift the fund's maturity and duration towards the long side of the spectrum, which would be dangerous unless one was certain that rates would not continue to rise, which of course, no one can be certain of.
Last edited by Scooter57 on Sat Jul 13, 2013 5:55 pm, edited 1 time in total.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sat Jul 13, 2013 5:52 pm

Please go look at some growth charts for bond funds. For the most part, bond funds gain value slowly over the years, with really minor fluctuations caused by NAV changes. Examine them during periods of rising rates: 2003-2006, 1994, 1950-1981. In the big picture, the total return of bond funds is positive, year after year after year. It is difficult to find instances where the 5-year return is negative. Bond funds are the slow, sleepy, safe part of your portfolio. They will, over the longish run (5 plus years), return your principal with some interest. Higher interest rates mean more return. Whatever short term drop they may experience is nothing compared to the volatility of stocks.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 6:00 pm

Ged wrote:I can see how that would work in the context of individual bonds. But does it apply to bond funds as well?

Yup. All that an [intermediate] fund does differently is that it rolls over before maturity so as not to force the investor to hold low-yielding short bonds if they don't want to.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sat Jul 13, 2013 6:02 pm

Scooter: Forecasts made in March are now seriously out of date as rates have risen significantly since then. The SEC yield on TBM is 1.99%, Intermediate Corporates approaching 3%, inflation protected yields approaching positive territory. Interest rates have already risen significantly.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Ged » Sat Jul 13, 2013 6:09 pm

ogd wrote:
Ged wrote:The benefit of the increased rate is that re-invested dividends and principle will result in a gradually increasing income stream. The key here is that if you are not reinvesting dividends the income stream will not increase.

Actually, this is not true. Reinvesting principal will get you higher yields. This can be either at maturity or halfway through, see my example above with the rolling of a 3-year into a 7-year bond.

So even if you don't reinvest any dividends, the dividends will go up.


It seems to me your example is a case of taking on a longer duration as yields increase, which entails increasing risk. Something I would hope a fund manager would not do. If I wanted that I'd reallocate into a longer duration fund.
Lack of planning on your part does not constitute an emergency on my part.
User avatar
Ged
 
Posts: 1710
Joined: Mon May 13, 2013 2:48 pm
Location: Roke

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sat Jul 13, 2013 6:11 pm

No, the fund is constantly rolling over from shorter to longer term bonds to maintain a constant duration for the fund.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 6:20 pm

Right, billyt. This is what the fund does constantly (note how I was saying "as part of normal operation") and not in response to changes in interest rates. Edit: the direct analogue is maintaining a bond ladder and rolling over a tenth or so (the maturing bonds) every year, without changing your risk profile.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Electron » Sat Jul 13, 2013 6:27 pm

Scooter57 wrote:Vanguard repeatedly tells investors that they can expect a total return from the Total Bond Fund of slightly less than 2% for the next 10 to 15 years no matter what rates do.

That simple model is discussed by John Bogle in Common Sense on Mutual Funds on page 48. In looking at the table, the actual return was lower than the predicted return by 2%-3% in the 1950s and 1960s. That suggests that the ten year return going forward could even be negative.

I'd suggest that bond investors look at charts of past performance in the bond market. Data is available on Morningstar for the Vanguard Bond Index fund going back to 1986. In particular, look at years such as 1994 when the Federal Reserve instituted a series of short term rate increases.

Here are two factors that would impact total return in a rising rate environment.

1. A bond ladder in a period of low interest rates would have a higher duration than a ladder of the exact same maturities in a period of higher interest rates. That is because coupon income affects duration. The higher duration translates to a larger percentage change in NAV if rates change by the same amount.

2. Reinvested income at lower rates would add less to total return than reinvestment at higher rates.

The chart below shows Total Return for the Vanguard Bond Index fund. Change the chart period from 10 Years to Maximum. Click on "Growth" at the upper left corner of the chart to show "Price" or "Rolling Returns". NAV has ranged from below $9.00 to about $11.25 since 1986. Capital gain distributions should have been fairly minor or non-existent in most periods.

http://quote.morningstar.com/fund/chart ... ture=en-us

The bond index is structured like a bond ladder with bonds maturing at a fairly steady rate. The monthly dividend would slowly rise if portfolio holdings are replaced with bonds paying a higher interest rate.
Electron
User avatar
Electron
 
Posts: 997
Joined: Sat Mar 10, 2007 9:46 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sat Jul 13, 2013 6:29 pm

ogd,

On what do you base this assumption? I can find absolutely nothing online from Vanguard explaining exactly how they manage the maturity and duration of their funds, save for the maturity parameters set for the bonds that the fund holds. I have noted that Morningstar explains that many fund (including Vanguard's) have shortened the duration of the fund as much as possible in the expectation of rates beginning to rise. But I think you may be misunderstanding the impact of buying those new bonds on the fund.

Remember, many of those old bonds that are now being sold because they are too short were paying coupons HIGHER than current bonds are paying now, even after the recent rise in rates. A 7 year bond bought 7 years ago was paying 5% or more. You won't be finding any of those to replace it with.


billyt,

So you are saying that the people at Vanguard who manage these funds and are warning us that they are only going to return 1-2% over the next decade don't understand bonds? I'd suspect that they do.

The reason real return is going to be low has nothing to do with the SEC rate. It has to do with the fact that people holding the bond fund in March of 2013 had locked in the fund's current return for the duration, and if rates continued to rise, for a nother duration-long period after that--stretching perhaps into the next decade. That is what Vanguard is trying to tell people, but they aren't doing it very well because they don't want people to dump the funds.

But every time you buy into the bond fund you are locking in today's yield for at least the duration and then for longer every time that the rates go up again.
---
Your misunderstanding of what the SEC yield represents is exactly the kind of dangerous misunderstanding I posted this message to flag. You really do NOT understand how bond funds work, and because you don't, you are likely to make decisions dangerous to your retirement.
---

To address the issue of past results: There are huge differences between the situation now and the situation in the years you cited, starting from the fact that the rates at the time were, in terms of compounding power, far higher than they are now. I have seen a top executive at Vanguard quoted as saying that the situation with bonds now is unlike anything he has seen in the past. (You can probalby find it on your own with some googling.)

When rates went from 7% to 8% back in the 1990s the impact was lessened because the dividends compound so much faster at 7% than they do at 1.7%. At 7% your money doubles every 10 years. At 1.7% it doubles every 42 years.

Not understanding this difference when you are locking in these 1.something rates with current bond fund purchases could be very devastating to your future financial security. Because the only way ten years of earning 1.7% on your money isn't devastating is if real inflation stays below 1.7% for the entire ten years. To believe it will, is to make a big, fat, dangerous bet about what inflation will be in the future.

This is a bet none of us can make accurately because inflation can be spurred by unpredictable events like sudden spikes in the price of materials like metals and energy, or crop failures. But if you bet on low inflation and are wrong and inflation rises only to 4 or 5%, your bond fund will always be giving you a real return that is below inflation and will take many more years to catch up. If inflation goes higher--which I've lived through myself and still remember vividly, getting your bond fund money back with a 20% increase over a decade will be a huge loss because inflation may have doubled the price of everything.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sat Jul 13, 2013 6:42 pm

Scooter: The effective Federal funds rate was about 1% in the early 50's and rose to nearly 20% by 1981. In nominal terms, bond funds did just fine. You are absolutely right that inflation is a serious concern for any fixed income investment. That is what inflation protected bonds are all about. You are also right that when you buy into a bond fund, you are effectively locking in the current rate for the duration. The SEC yield is the best estimate of future fund returns. You can now lock in a 2% return, rather than close to 1% return available in March. The returns of the shares you bought earlier will also gradually increase. When you buy bonds consistently during your investing lifetime, you will earn the average interest rate over that period. If the average rates are higher, you will make more money.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 6:49 pm

Scooter57 wrote:ogd,

On what do you base this assumption? I can find absolutely nothing online from Vanguard explaining exactly how they manage the maturity and duration of their funds, save for the maturity parameters set for the bonds that the fund holds. I have noted that Morningstar explains that many fund (including Vanguard's) have shortened the duration of the fund as much as possible in the expectation of rates beginning to rise. But I think you may be misunderstanding the impact of buying those new bonds on the fund.

I am basing this on the shape of the maturity curve of my intermediate bond funds. E.g. VFIUX:

Code: Select all
% Bonds    Benchmark    Category Avg
1 to 3 Years   0.00   —   4.35   
3 to 5 Years   51.89   —   9.85   
5 to 7 Years   21.42   —   8.47   
7 to 10 Years   26.68   —   25.54   
10 to 15 Years   0.00   —   10.27   
15 to 20 Years   0.00   —   1.03   
20 to 30 Years   0.00   —   37.49   
Over 30 Years   0.00   —   1.96   

Clearly, they get replaced before they hit three years and this is pretty common among bond funds. I invest in plain old boring funds with fixed maturity targets. My other big holding, VCADX, looks similar but more spread out in the longer maturities. If e.g. Wellesley managers make a market call on duration that's their business not mine.

But even if we knew nothing about the portfolios -- bonds don't last forever, so they either get replaced or allowed to mature. The logic still applies either way.

Scooter57 wrote:Remember, many of those old bonds that are now being sold because they are too short were paying coupons HIGHER than current bonds are paying now, even after the recent rise in rates. A 7 year bond bought 7 years ago was paying 5% or more. You won't be finding any of those to replace it with.

Look again at my Treasury quote from above:
Code: Select all
Maturity   Coupon   Bid   Asked   Chg   Asked yield
2/15/2023   2.000   95.2109   95.2734   -0.2266   2.559
2/15/2023   7.125   139.8438   139.8906   -0.3047   2.434

At the price they are traded, the difference between the yield of a 2% and 7% Treasury maturing on the same date is less than 0.2%! It doesn't really matter which one you hold. Even that tiny difference is directly due to the 7% bond's slightly lower duration.

Scooter57 wrote:If inflation goes higher--which I've lived through myself and still remember vividly, getting your bond fund money back with a 20% increase over a decade will be a huge loss because inflation may have doubled the price of everything.

Sure thing. Inflation is an enemy. But I think it's best kept separate from the rates discussion. One reason is, we have TIPS as a solution. The second is causation -- while it's entirely reasonable to expect interest rates to return to more normal values in a functioning economy, the same cannot be said about inflation and you need to make an entirely different set of arguments.

(edit: fixed quote. twice)
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby garlandwhizzer » Sat Jul 13, 2013 6:53 pm

adam1712 wrote
I think it's pretty simple, if you plan to hold a bond fund longer than the duration, you want rates to rise.


Investors who bought intermediate term Treasuries starting in 1940 and bought them every year for the next 40 years wound up losing real purchasing power over the full 40 full period. Talk about a bear market? Negative real returns after 4 decades! This was the worst in history and it was in a consistently rising interest rate environment (10 yr. 2% yield in 1940 went to about 16% in 1982, a 800% gain). Rising inflation, gradual at first then spiking at the end, basically devastated bond holders much worse than stock holders for 4 decades, a fact that few of us seem to be aware of now after three decades of the greatest bull market in US bond history.

All the happy talk about rising rates from bond lovers on this forum assumes that inflation, which has been declining for 30+ years, will remain near target and under control and that if it increases at all, that rise will be only slow and gradual to some fixed and agreeable level where it will settle down and remain stable. In that situation bond returns do in fact catch up with loss of principal value from rising rates, but I think it is important to remember that such a result, while it may be most probable, is not guaranteed in the intermediate or long term. Once inflation gets started it can become difficult to keep that genie in the bottle as regulators discovered in the late 70s and early 80s. The only way to stop it is to drive interest rates so high that all economic growth stops and a deep recession starts as it did in the early 80s. Needless to say, that is not a politically popular position to take. Paul Volcker stepped up the plate at the critical hour in the early 80s, otherwise we might have gone into the kind hyperinflation that hit Germany in the 20s and multiple emerging markets since.

Given the non-zero risk of inflation in the future, I don't believe that bonds are risk-free and bond returns in real dollars are likely to remain very low during the next decade or two. You certainly need to have bonds in a portfolio to cushion the volatility of stocks, but I don't count on them much for gains.

Garland Whizzer
garlandwhizzer
 
Posts: 556
Joined: Fri Aug 06, 2010 4:42 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby adam1712 » Sat Jul 13, 2013 7:21 pm

garlandwhizzer wrote:adam1712 wrote
I think it's pretty simple, if you plan to hold a bond fund longer than the duration, you want rates to rise.


Investors who bought intermediate term Treasuries starting in 1940 and bought them every year for the next 40 years wound up losing real purchasing power over the full 40 full period. Talk about a bear market? Negative real returns after 4 decades! This was the worst in history and it was in a consistently rising interest rate environment (10 yr. 2% yield in 1940 went to about 16% in 1982, a 800% gain). Rising inflation, gradual at first then spiking at the end, basically devastated bond holders much worse than stock holders for 4 decades, a fact that few of us seem to be aware of now after three decades of the greatest bull market in US bond history.

All the happy talk about rising rates from bond lovers on this forum assumes that inflation, which has been declining for 30+ years, will remain near target and under control and that if it increases at all, that rise will be only slow and gradual to some fixed and agreeable level where it will settle down and remain stable. In that situation bond returns do in fact catch up with loss of principal value from rising rates, but I think it is important to remember that such a result, while it may be most probable, is not guaranteed in the intermediate or long term. Once inflation gets started it can become difficult to keep that genie in the bottle as regulators discovered in the late 70s and early 80s. The only way to stop it is to drive interest rates so high that all economic growth stops and a deep recession starts as it did in the early 80s. Needless to say, that is not a politically popular position to take. Paul Volcker stepped up the plate at the critical hour in the early 80s, otherwise we might have gone into the kind hyperinflation that hit Germany in the 20s and multiple emerging markets since.

Given the non-zero risk of inflation in the future, I don't believe that bonds are risk-free and bond returns in real dollars are likely to remain very low during the next decade or two. You certainly need to have bonds in a portfolio to cushion the volatility of stocks, but I don't count on them much for gains.

Garland Whizzer


Fair enough, long term bond fund holders want real interest rates to rise.
adam1712
 
Posts: 187
Joined: Fri Jun 01, 2007 6:21 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby RenoJay » Sat Jul 13, 2013 7:51 pm

Nice original post. It seems very simple to me: rates rise, bond prices drop. Anyone who is expecting some immediate, magic elixir is, in my opinion, deceiving themselves unless they believe rates will generally remain where they are or decline.
RenoJay
 
Posts: 724
Joined: Tue Nov 17, 2009 12:20 pm
Location: Nevada

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sat Jul 13, 2013 7:52 pm

What this period has in common with that period starting in the 1940s that garlandwhizzer alluded to is that the 1940s were the only other time in history when the government pushed short term rates below real inflation using artificial means in order to deal with a war-caused deficit. Then we inflated that deficit away.

There was a far larger population in its young and middle years back then compared to now when the total population skews older, but I remember that all the retired old people in the family who had saved were very poor by the mid 60s, unlike the generation of their children more of whom retired comfortably. My dad, in his 60s then, used to get upset at the "horrifying" prices in the supermarket.

How many here who are enthusiastic about rising rates are old enough to remember the inflation of the 60s and hyperinflation of the 70s?
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby nisiprius » Sat Jul 13, 2013 8:00 pm

Scooter57 wrote:How many here who are enthusiastic about rising rates are old enough to remember the inflation of the 60s and hyperinflation of the 70s?
I am old enough to remember those decades, but what I remember is the inflation of the early 1950s--a guy on the news with a pointer and an easel with a picture of a shrinking dollar on it. I don't remember the 60s as being too bad. I do remember the inflation of the late 1970s and early 1980s, and Nixon's attempt to freeze prices.

I do not remember any period of hyperinflation. I think I'd remember it if there had been one. (Hyperinflation means an inflation rate of 50% per MONTH).
Last edited by nisiprius on Sat Jul 13, 2013 8:27 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
 
Posts: 24860
Joined: Thu Jul 26, 2007 10:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Ged » Sat Jul 13, 2013 8:10 pm

Scooter57 wrote:What this period has in common with that period starting in the 1940s that garlandwhizzer alluded to is that the 1940s were the only other time in history when the government pushed short term rates below real inflation using artificial means in order to deal with a war-caused deficit. Then we inflated that deficit away.

There was a far larger population in its young and middle years back then compared to now when the total population skews older, but I remember that all the retired old people in the family who had saved were very poor by the mid 60s, unlike the generation of their children more of whom retired comfortably. My dad, in his 60s then, used to get upset at the "horrifying" prices in the supermarket.

How many here who are enthusiastic about rising rates are old enough to remember the inflation of the 60s and hyperinflation of the 70s?


I lived through that time. It was very hard on people who had pensions that were not indexed. The Federal Government was severely impacted because a they lost a lot of scientific talent from defense agencies (including my father) to early retirement because civil service salaries were not indexed to inflation while pensions were. The result was that you could take retirement and be making getting more money from your pension in 3-4 years than if you had kept working.

I wouldn't call it hyperinflation though. Hyperinflation is generally defined as inflation rates greater than 50% per month. That's roughly fifty times the max during the 1970's.
Lack of planning on your part does not constitute an emergency on my part.
User avatar
Ged
 
Posts: 1710
Joined: Mon May 13, 2013 2:48 pm
Location: Roke

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sat Jul 13, 2013 8:28 pm

Well, I remember going to the grocery store each week in 1981 and seeing the prices of every can or jar on the shelf had risen another 20 or 30 cents. Week after week after week. And I also remember my boss giving us a hefty raise we didn't expect because of the inflation. But even with the raises that doubled my salary within 3 years I couldn't afford a decent house because the prices of the houses were rising even faster than my salary. When I finally bought a house it was on a mortgage near 17%. And though I refinanced a few years later at 10%, I never caught up to people who had bought their houses before the 70s inflation started because I didn't have the house equity they did or the ridiculously low 6% mortgages they had, either.

So while it might not have been Weimar Germany, it was pretty darn scary and it had major implications for me for the next 25 years as far as what I could afford to live in. It isn't anything I ever want to live through again, that's for sure. But it is also a big part of why, besides the academic reasons that make bonds look bad, I can't see locking in a 2 or 3% interest rate for a decade. I'm perfectly willing to "miss out" on 1 or 2% of interest on my money if it means that I can also miss out on decades of experiencing much larger permanent drops in my money's earning power. As it is, the money I have in my Prime Money Market Fund has outperformed most of the Vanguard Bond Funds this past six months (which is when I had fixed income ready to invest after cashing out the crappy funds I inherited) and it outperformed them simply by not tanking to where a year's worth of interest went pffffft.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby nisiprius » Sat Jul 13, 2013 8:36 pm

With regard to the original content. Bonds pay interest. That's all they do. You're not participating in a company's growth or its business, you're just lending them money at an agreed-on rate.

In the fundamental scheme of things, of course a rise in the real interest rate (above inflation) is good for people who are buying bonds. Which is better, to buy $100,000 worth of bonds and get $5,000 a year or buy $100,000 worth of bonds and get $1,000 a year? The question answers itself. Rates, relative to inflation, have been held down. They likely will rise to their natural rate, which seems to be somewhere in the general ballpark of 3% above inflation.

In the fundamental scheme of things, if you're holding lousy old low-paying bonds, of course their market value is going to drop. Who is going to pay you $100,000 for your bonds that pay $1,000 if they can buy new ones that pay $5,000 a year? This is a problem if you can't wait for your bonds to mature. It's also a problem in that you may have stocked up on lousy old bonds that don't pay as much as you need. It's bad now, it will be better later. If you need money now and you can't wait for later, it's bad.

But in any case, what rational things are there to do about it?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
 
Posts: 24860
Joined: Thu Jul 26, 2007 10:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sat Jul 13, 2013 8:39 pm

It's very legitimate to be worried about inflation. But you have to admit that it doesn't have the same aura of inevitability that interest rates might have, and in fact inflation expectations have become a bit of a laughingstock in economic commentary in the last four years.

It is also legitimate to point to TIPS or I Bonds as a retiree's defense, and to say that in the long run higher TIPS yields are a good thing. And that inflation would affect all future cash instruments: individual bonds and CDs that you can't break out of in particular. And to note that the market does not seem to be worried about inflation in this latest series of rate moves. It's quite a different discussion.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby soar » Sat Jul 13, 2013 9:30 pm

Scooter57 wrote:So while it might not have been Weimar Germany, it was pretty darn scary and it had major implications for me for the next 25 years as far as what I could afford to live in. It isn't anything I ever want to live through again, that's for sure. But it is also a big part of why, besides the academic reasons that make bonds look bad, I can't see locking in a 2 or 3% interest rate for a decade. I'm perfectly willing to "miss out" on 1 or 2% of interest on my money if it means that I can also miss out on decades of experiencing much larger permanent drops in my money's earning power. As it is, the money I have in my Prime Money Market Fund has outperformed most of the Vanguard Bond Funds this past six months (which is when I had fixed income ready to invest after cashing out the crappy funds I inherited) and it outperformed them simply by not tanking to where a year's worth of interest went pffffft.
Last edited by soar on Sat Oct 05, 2013 1:54 pm, edited 1 time in total.
soar
 
Posts: 31
Joined: Tue Nov 27, 2012 4:08 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby user5027 » Sat Jul 13, 2013 10:16 pm

Scooter57 wrote:Well, I remember going to the grocery store each week in 1981 and seeing the prices of every can or jar on the shelf had risen another 20 or 30 cents.


Ahhh... 1981 those were the days. September 1981 the yield at Delaware Cash Reserve was 17%.
user5027
 
Posts: 258
Joined: Sat Jun 16, 2012 9:54 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby joe8d » Sat Jul 13, 2013 10:37 pm

:thumbsup Scooter.
All the Best,
Joe
User avatar
joe8d
 
Posts: 3294
Joined: Tue Feb 20, 2007 9:27 pm
Location: Buffalo,NY

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Munir » Sun Jul 14, 2013 12:01 am

joe8d wrote::thumbsup Scooter.


+1
User avatar
Munir
 
Posts: 1737
Joined: Mon Feb 26, 2007 5:39 pm
Location: Oregon

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sun Jul 14, 2013 12:24 am

Scooter57, I'd missed this message in the middle and there was a bit of a discontinuity in the discussion.
Scooter57 wrote:Here's one:
https://personal.vanguard.com/us/insights/article/anxiety-bonds-032013
I'd seen this one
"For some time now, we've been encouraging clients to reevaluate their expectations for fixed income returns. For well over a decade, investors have benefited from a historic bond bull market, but given current interest rates, it's difficult to imagine similar returns in the future. In fact, the Vanguard Capital Markets Model® suggests that the "central tendency" for annualized returns of the broad taxable U.S. bond market will be only 1%–2% over the next decade."

So yes it is an old quote -- this was roughly what Total Bond Market promised you back then. But we are almost a full percent higher now on the 5 year (and SEC yield of TBM is slowly adjusting to reflect that). And they never say that the returns are likely to be negative. And note that part of the reasoning is that there's no guarantee that Fed will rise rates anytime soon. Also, they explicitly warn against trying to market time by adjusting duration.

Scooter57 wrote:To get to another point you made:
ogd wrote:Clearly, you understand how maturing bond capital is able to earn more dollars per share immediately by being rolled into higher yields. But this also applies equally to bonds not held to full maturity. For example, if an intermediate bond fund rolls over 3-year bonds into 7-year bonds as part of normal operation, and rates increase by 1 percent even without curve steepening, the 3-year bond takes a much lesser hit than the 7-year simply because of its smaller duration. Then the fund is able to buy more of the 7-year bonds than it used to, or equivalently the same amount but with higher yield. This is the same effect as rollover at maturity.


If your bond fund manager replaces 3 year maturity bonds with 7 year maturity bonds paying more and the bond rates go up another percent or two, the NAV of your fund will drop further and the time it will take to recover your capital investment will be longer.

This is distinctly not true -- the transaction will not affect the NAV in any way, we are talking about a dollar to dollar swap, and my point is that the dollars from low maturity bonds are buying more high maturity bonds than they used to, increasing the dividends. I am not talking about "improving returns with trading" -- this is merely the bond fund equivalent of turning over a bond at maturity.
Edit: I initially read your point wrong, I see now that you are afraid of this transaction increasing duration and furthering losses. In an intermediate fund, it's more of a steady state, it happens all the time and it's designed to keep the duration steady.

I think that if you get over the fear of selling bonds before maturity and realize that it does not lose you money -- that it's the duration held during the rate increase that caused the damage, you will get over your fear of bond funds.

Scooter57 wrote:They probably aren't. It's my understanding that when Vanguard sells within its funds it is doing so to keep the maturity of the fund within its defined parameters. So if it is an intermediate term fund, when bonds have only 2 years left on them, they get sold since they are now short term bonds and replaced with bonds that have more time on them. They aren't replacing a 3 year bond with a 7 year bond. They are replacing the 3 year bond they bought 2 years ago with a 5 year bond they buy now. To replace it with a 7 year bond would be to shift the fund's maturity and duration towards the long side of the spectrum, which would be dangerous unless one was certain that rates would not continue to rise, which of course, no one can be certain of.

3-to-5 or 3-to-7 is rather irrelevant, the effect is the same. And I think that the latter is more representative of a 5 year duration fund, to maintain the steady state at 5 years (average of 3 and 7).
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Eureka » Sun Jul 14, 2013 1:06 am

After reading hundreds of posts in dozens of threads over the past couple months, I have concluded that some people probably know how bond funds will perform in a secular period of rising rates from historically low levels. I am, however, unable to determine who is right among the conflicting opinions. Frankly, I find that pretty disturbing on a website with so many thoughtful people.

I have drastically reduced the average duration of my bond holdings and the size of my bond portfolio over the past few weeks. I have a pretty good idea what money-market funds, savings accounts and CDs will do in a rising-rate environment, even if I don't know the exact timing or magnitude. I lived through the late '70s, too.
Eureka
 
Posts: 1082
Joined: Thu Apr 05, 2007 11:24 pm
Location: Illinois

Re: A Dangerous Misunderstanding about Bond Rates?

Postby EmergDoc » Sun Jul 14, 2013 2:16 am

Low rates are punishing savers and rewarding borrowers. I am becoming less and less of a borrower and more and more of a saver. Therefore higher rates are good, even if they come with some pain. And since only 10% of my portfolio is exposed to the pain, it isn't even that bad. Finally, my decision to hold the G fund instead of the F fund is paying some dividends! It'll take quite a few more rises in interest rates to make up for that decision 7 years ago.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy
4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
User avatar
EmergDoc
 
Posts: 9912
Joined: Fri Mar 02, 2007 10:11 pm
Location: Greatest Snow On Earth

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sun Jul 14, 2013 7:29 am

OK, let me try this one more time. This is basic arithmetic. Let's try some hypotheticals. You invest $10,000 in a bond fund at 2%, with a 5 year duration. Back of the envelope:

Scenario 1: rates don't change, no NAV change, over 10 years you expect $2,000 in interest, a little more (+$190) with compounding. Ending value $12,190.

Senario 2: Rates go to zero the day after you invest. Your bond fund is instantly worth $1000 (10%) more, but you don't collect any more interest. Ending value $11,000.

Scenario 3: Rates jump 5% the day after you invest and you instantly lose $2,500 (25%), but you are collecting 7% interest on $7,500: $525 or $5,250 over 10 years, with compounding, about $7250. Ending value about $14,750.

Several key points: No scenario gives a negative return over 10 years. The ending values are not dramatically different despite changes in interest rates. This is why the SEC yield is the best estimate of future bond fund returns. Increasing rates give you more $. Rising rates are good for bond fund owners. Short term pain, long term gain. A constantly rising rate (eg 1% per year for 5 years), will fall in between Scenario 2 & 3. Bond funds are sleepy, no drama. You are neither going to make a killing nor lose your shirt. Totally appropriate as a portfolio stabilizer. Set an allocation and maintain it, forget about market timing and collect the average return.

Not convinced? Let's look at this another way: 10 year rolling ladder of 10 $1,000 bonds, equivalent to a constant duration bond fund.

Scenario 1: Collect $200 in coupons every year. Ending value $12,000.

Scenario 2: Collect $200 in coupons the first year, roll over the 1 year bond to a 10 year bond, and collect $180 the second year, $160 the third year...etc. Total coupons over 10 years $1,100; ending value $11,100.

Scenario 3: Collect $200 in coupons the first year, roll over the 1 year bond to a 10 year bond, and collect $250 the second year, $300 the third year...etc. Total coupons over 10 years $4250; ending value $14,250.

Back of the envelope, the same answer as above. There is no compounding in this case, just collect your coupons and spend or stuff them under the mattress. I am no bond expert (others here are) but this is basically how bond funds work. The rough arithmetic outlined is very simple and misses some nuances. You can make it more elegant and get a more precise answer, but it doesn't change the fundamentals.

Low interest rates are a concern. We hope rates go up. Inflation is a serious concern for fixed income that can be mitigated with inflation protected bonds. Rising rates are good for bond fund owners.

Scooter, happy to have a discussion, but with all due respect I think you are the one with the misunderstanding. This is not really a problem, except you are spreading your confusion to others. This has been discussed many times over the last few years, and I highly recommend the knowledge that is distilled in the Wiki.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sun Jul 14, 2013 8:56 am

Nisi,

This is actionable, because as we have discussed ad nauseum, there are alternative investments that can be made with fixed income that isn't subject to interest rate risk. CDs, and Money Market funds.

BillyT,

Your condescending tone is unwarranted. I don't make my investment decisions based on what I read on any web site's Wiki, so I have read quite a few books about bonds and what I learned from them has made me conclude that bond funds, in contrast to actual bonds, present real risks in the current scenario. I am far from being alone in this belief.

Your math example is very misleading because rates don't rise in a big chunk all at one time. They go up from a low like the one we have now a bit at a time over a prolonged period, so over your 10 year period you will have a loss of 1% here and of .5% there and then another loss of maybe .75% and then 2% so that your NAV drops slowly and the compounding that works so nicely when you get an instant rise to 7% also occurs far more slowly.

Here is a better example (using simple interest paid once a year to keep our heads from exploding):

Invest 10,000 at 1%. Rates go up 1% to 2%. Principal drops to $9,500. At the end of year 1 you have $9690. ($9500*1.02)
Rates rise to 3%. Your $9590 loses 5% and becomes $9206. At the end of year 2 you have $9878 ($9206 * 1.03).
Rates go up another 1% to 4%. Your $9878 loses another 5% and you have $9,384. At the end of the year 3 you have $9,759 ($9,384*1.04)
Rates go up another 1% to 5%. Your $9,759 drops by 5% and you have $9271. At the end of year 4 you have $9735. (9271*1.05)
Rates go up another 1% to 6%. Your $9735 loses 5% and you have $9248. At the end of year 5 you have $9,803.

Bottom line: at the end of the number of years represented by the duration your total return is indeed negative. And it will remain negative until rates stop rising. If you have a year or two in the middle where rates drop 1% you might break even, but you are not going to come out ahead in an environment where rates rise in more years than they drop.

The person who bought a CD ladder during the same period, in contrast, will end up with more money each year even if the CD ladder started out paying less than the bond fund. If it paid the same as the bond fund when the intial investments were made, the CD ladder will way outperform the bond fund. It will always give a positive return. And if the CDs can be broken, long low paying CDs can be broken with the loss of only perhaps 6 months of interest (.5% to 1%) and reinvested at 3% or 4% when rates reach that level, further boosting gains.

If someone can show me why the math in MY example is flawed, I'd greatly appreciate it. Every single example I've seen including those from Vanguard, shows what happens after 1 year of falling rates or harks back to a period when rates started to rise from a MUCH higher initial interest rate which has a big effect on how quickly you recover from that duration-described initial loss of NAV. When rates rose 1% from 7%, you lost 5% of your fund's value but still earned 7%, making up for the loss in NAV. When rates start at 1-4% that 5% drop does NOT get overcome. Big point that the people who sell you bond funds conveniently ignore in their soothing presentations.

Eureka,

Yes! Your point is what has started to make me very concerned because despite the certainty with which many people here insist that there scenarios are true, none of the data they use to support it holds up to close scrutiny, and there are so many different explanations and scenarios that one has to conclude that we are, as I have heard some Vanguard executives say, quite frankly, in uncharted territory.

Finally, to those of you who are urging people to sink their life savings into bond funds--remember that for many of us, the bond side of our portfolio isn't $20,000 or even $200,000. Retirees may be carrying anywhere from $500,000 to several million in fixed income, and a mistake in how that income is invested--one that cannot be reversed in a rising rate scenario--could be devastating.

The longer I read this board, the more disturbed I become at the way that some anonymous posters here tell people with millions of dollars they need to invest to put all their money into the market the next day into whatever investments the advice giver has decided makes sense for themselves. That advice giver may well be investing $200 a month and have assets of $25,000. And yet they have no compunctions about telling someone dealing with a multimillion dollar windfall what to do with it.

The principals we can all agree on are that we should keep our expenses low when we invest. All of us agree that we should come up with a split between fixed income and stocks that allows for buying when stocks are low and rebalancing when they are high. After that, intelligent people disagree. Most, but not all of us, agree that index funds are likely to give us a better outcome than stock picking. Some believe tilts make a difference. Some like balanced funds. But in every case, people's beliefs are highly conditioned by past investing history and their own, past investing experiences.

Nobody here has experience with what happens to bond funds bought at sub 2% initial yield in a period of rising rates, and it is just plain wrong to believe you know what will happen to them. There is a risk. There are alternative ways to invest fixed income that leave you with money with which to balance and survive stock losses.

I would much rather urge caution on people who are trying to figure out how to invest large sums (what billyt seems to think is scaring them) than urge people to take on risks that they clearly do not understand. And with every passing day that I spend reading this board it becomes clearer to me that there is a big risk here that people really do NOT understand.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sun Jul 14, 2013 9:22 am

Scooter:
Yes, in your hypothetical, it will take a little longer to get to positive returns. If you start at 1% and raise rates 1% a year, your return doesn't go positive until the end of year 8. But rates are higher than that now. Starting at 2% and raising 1% a year you turn positive by the end of year 6. Even if rates continue to increase, you will be at $12,296 by the end of year 10, better than if rates have stayed the same. If rates level off at 7%, the ending value at year 10 is $13,845. This is not any different from what I said previously, that the end result will fall between the bracketing scenarios. All my previous points still are valid:

No scenario gives a negative return over 10 years. The ending values are not dramatically different despite changes in interest rates. This is why the SEC yield is the best estimate of future bond fund returns. Increasing rates give you more $. Rising rates are good for bond fund owners. Short term pain, long term gain. A constantly rising rate (eg 1% per year for 5 years), will fall in between Scenario 2 & 3. Bond funds are sleepy, no drama. You are neither going to make a killing nor lose your shirt. Totally appropriate as a portfolio stabilizer. Set an allocation and maintain it, forget about market timing and collect the average return.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ofcmetz » Sun Jul 14, 2013 9:24 am

Scooter57 wrote:Nisi,

This is actionable, because as we have discussed ad nauseum, there are alternative investments that can be made with fixed income that isn't subject to interest rate risk. CDs, and Money Market funds.


Many here are able to use stable value funds in their 401K's or the TIAA Traditional Fund as well.
Showing up at the donut shop at 5 am to get them hot out of the oil is an example of successful market timing.
User avatar
ofcmetz
 
Posts: 1731
Joined: Tue Feb 08, 2011 9:09 pm
Location: Louisiana

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Scooter57 » Sun Jul 14, 2013 10:37 am

billyt wrote:Scooter:
Yes, in your hypothetical, it will take a little longer to get to positive returns. If you start at 1% and raise rates 1% a year, your return doesn't go positive until the end of year 8. But rates are higher than that now. Starting at 2% and raising 1% a year you turn positive by the end of year 6. Even if rates continue to increase, you will be at $12,296 by the end of year 10, better than if rates have stayed the same.


If you invested that $10K in an unbreakable 10 year 2% CD compounding monthly you would earn $12,211.99 over that same 10 year period. So the actual difference in yield over 10 years between your bond fund in a period of continually rising rates and a fixed rate investment at 2% is a whopping $85 or $8.50 a year (.085%) So though technically you have "more" than you would had rates not risen, the amount of that "more" is negligible.

This proves what I started out saying, that when you invest in a bond fund you are locking in the rate in effect at the time you bought into your bond fund no matter what rates do afterwards. Rising rates will not result in your getting any significantly higher return for a very long time.

The whole point of my original post is that while rates may rise, current bond fund holders will not benefit in any meaningful way from that rise, though many posts here suggest that naive investors believe they do.

So you have just proven my point. That debate is over.
Scooter57
 
Posts: 715
Joined: Thu Jan 24, 2013 10:20 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Ranger » Sun Jul 14, 2013 10:53 am

billyt wrote:OK, let me try this one more time. This is basic arithmetic. Let's try some hypotheticals. You invest $10,000 in a bond fund at 2%, with a 5 year duration. Back of the envelope:

Scenario 1: rates don't change, no NAV change, over 10 years you expect $2,000 in interest, a little more (+$190) with compounding. Ending value $12,190.

Senario 2: Rates go to zero the day after you invest. Your bond fund is instantly worth $1000 (10%) more, but you don't collect any more interest. Ending value $11,000.

Scenario 3: Rates jump 5% the day after you invest and you instantly lose $2,500 (25%), but you are collecting 7% interest on $7,500: $525 or $5,250 over 10 years, with compounding, about $7250. Ending value about $14,750.

Several key points: No scenario gives a negative return over 10 years. The ending values are not dramatically different despite changes in interest rates.


If the duration of the fund or bond is 5 years, it is appropriate to compare the value after 5 years. Investors can make their decision after 5 years and they will be happy to own 7% bond in your scenario. Also, theory in the forum is that, if the rate rises and if the dividends are reinvested investor will break-even at the end of duration period.

In your scenario 3, if the rate rises to 7%, bond fund will loose 25%, ($2,500), you still will be collecting coupon of $200 based on original coupon and it will be reinvested at the rate of 7%. My back of the envelope calculation gives me $1,055 total interest over 5 years. So at the end of 5 years investor lost $1450 ($1,055-$2,500) or about 14.5%. This is with out consideration of inflation. If the interest rate rises to 7%, one of the reason is inflation will be higher. Assuming same inflation rate as 5 year bond then in real terms investor lost 40%
User avatar
Ranger
 
Posts: 446
Joined: Tue Feb 20, 2007 11:27 pm
Location: Wolverine Nation

Re: A Dangerous Misunderstanding about Bond Rates?

Postby MnD » Sun Jul 14, 2013 11:01 am

nisiprius wrote:But in any case, what rational things are there to do about it?


I've been wearing my "I have access to the G Fund" t-shirt to the bars lately and am getting multiple marriage proposals from attractive strangers.
MnD
 
Posts: 2198
Joined: Mon Jan 14, 2008 1:41 pm

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sun Jul 14, 2013 12:05 pm

Scooter57 wrote:Invest 10,000 at 1%. Rates go up 1% to 2%. Principal drops to $9,500. At the end of year 1 you have $9690. ($9500*1.02)
Rates rise to 3%. Your $9590 loses 5% and becomes $9206. At the end of year 2 you have $9878 ($9206 * 1.03).
Rates go up another 1% to 4%. Your $9878 loses another 5% and you have $9,384. At the end of the year 3 you have $9,759 ($9,384*1.04)
Rates go up another 1% to 5%. Your $9,759 drops by 5% and you have $9271. At the end of year 4 you have $9735. (9271*1.05)
Rates go up another 1% to 6%. Your $9735 loses 5% and you have $9248. At the end of year 5 you have $9,803.
...
If someone can show me why the math in MY example is flawed, I'd greatly appreciate it.

Scooter57: Your example completely ignores the recovery in bond values as they approach maturity inside the fund. This is going to take some work, but considering that you are saying that about half of the bogleheads philosophy is wrong and Vanguard is being deceitful and other things like that, you owe it to us. Here's how to begin:
Read http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics in detail
Use http://www.treasury.gov/resource-center ... &year=2013 to see yield curves, under e.g. rate changes of the past.
Consider a simple model of an intermediate fund that takes 7 year bonds down to 3 years, then sells them. The fund start from a steady state of owning 5 bonds at 7, 6, 5, 4, 3 years from maturily respectively.
Use http://www.investopedia.com/calculator/bondprice.aspx to compute the prices at which these bonds are exchanged.
Then come back here and report the numbers. I am very confident that the return won't be negative.

Scooter57 wrote:The longer I read this board, the more disturbed I become at the way that some anonymous posters here tell people with millions of dollars they need to invest to put all their money into the market the next day into whatever investments the advice giver has decided makes sense for themselves. That advice giver may well be investing $200 a month and have assets of $25,000. And yet they have no compunctions about telling someone dealing with a multimillion dollar windfall what to do with it.

I didn't realize that this was a size contest, but here's the thing: I have very close to $1M in bonds alone, so a lot of skin in the game. However, if I had 10 times that portfolio and I was telling people to not trust any Vanguard advisors, any boglehead-type portfolio, that bond funds are a death trap that nobody understands, with very little other than flailing to back this up, then nobody should be listening to me regardless. Same if I was recommending that everyone go all-in into bond funds, leveraged 5x. The kind of advice really matters.

The first two words in this forum's mission is "Investing advice". If you are uncomfortable with that, I suggest you take it up with the admins.
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby billyt » Sun Jul 14, 2013 12:34 pm

Ranger: I think your back of the envelope calculation might be wrong because you come out with a loss at the end of 5 years. We know that the duration is the point of indifference, in other words, you end up with the same amount of gain that was originally predicted by the SEC yield. In other words, a positive return. The point here is that several posters are positing large and permanent bond fund losses going forward, simply because yields are rising, and that is simply not the case. Inflation is certainly a serious concern, which can be mitigated with inflation protected securities.
billyt
 
Posts: 631
Joined: Wed Aug 06, 2008 10:57 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby Ketawa » Sun Jul 14, 2013 12:45 pm

MnD wrote:
nisiprius wrote:But in any case, what rational things are there to do about it?


I've been wearing my "I have access to the G Fund" t-shirt to the bars lately and am getting multiple marriage proposals from attractive strangers.


:sharebeer
User avatar
Ketawa
 
Posts: 977
Joined: Mon Aug 22, 2011 2:11 am
Location: Norfolk

Re: A Dangerous Misunderstanding about Bond Rates?

Postby ogd » Sun Jul 14, 2013 12:53 pm

MnD wrote:
nisiprius wrote:But in any case, what rational things are there to do about it?


I've been wearing my "I have access to the G Fund" t-shirt to the bars lately and am getting multiple marriage proposals from attractive strangers.

Oooh the G fund. Are you single MnD? Actually, before you answer that -- does it allow joint assets?
User avatar
ogd
 
Posts: 2071
Joined: Fri Jun 15, 2012 12:43 am

Re: A Dangerous Misunderstanding about Bond Rates?

Postby patrick » Sun Jul 14, 2013 12:56 pm

Ranger wrote:In your scenario 3, if the rate rises to 7%, bond fund will loose 25%, ($2,500), you still will be collecting coupon of $200 based on original coupon and it will be reinvested at the rate of 7%. My back of the envelope calculation gives me $1,055 total interest over 5 years. So at the end of 5 years investor lost $1450 ($1,055-$2,500) or about 14.5%. This is with out consideration of inflation. If the interest rate rises to 7%, one of the reason is inflation will be higher. Assuming same inflation rate as 5 year bond then in real terms investor lost 40%


This is wrong because it ignores the recovery of the principal value of bonds as they get closer to maturity.
patrick
 
Posts: 771
Joined: Fri Sep 04, 2009 4:39 am

Next

Return to Investing - Theory, News & General

Who is online

Users browsing this forum: madbrain, Spewin, Y and 44 guests