Are Long-Term Bonds better than Short-Term?

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thethinker
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Are Long-Term Bonds better than Short-Term?

Post by thethinker »

I have read quite a few posts on here and know that many of you do not believe in individual bonds. I would ask you please overlook this point if possible. I was talking with my father in law who is a Orthodontist and he was sharing with me some lessons he learned over the years. Many of the lessons were very helpful items and I truly believe we can all learn something from our elders.

As it came to investing, he told me that he has learned from others: A) "You" are your own best ability to earn income, B) Never lose your investment principal, C) Keep your money working for you and reinvest profits to compound interest and D) Never try to time any market. (I hope I paraphrased him correctly)

With that, he is a believer in buying municipal bonds (or at least quality AAA) in the long term variety. I did not understand something to the effect of "buying a bond at the peak of a Yield Curve", but that particular bond was likely around a 15-17 year bond (or maybe that was the average)?

Doing a quick search for Indiana Muni Bonds it looks like bonds in this date rage (say 17 years) would pay at about a 5% rate per year, while something short term (say 5 years) is paying closer to 3%. His comments were that his money would earn him 5% today rather than 3% and though he takes risk of inflation after a 5 year period, he has earned more income in those first 5 years to make up for that potential risk. He also originally only bought one bond, which turned into 2 and 3, etc. So while he does not have these systematically laddered, he continued to reinvest the coupons into new bonds each year (or a few times per year), because he is not trying to time the market. He also owns many bonds, I would guess quite a few hundred thousand dollars worth, which offers him somewhat of a risk protection I'm guessing, over a person who has just a couple bonds.



So with all that history, is he correct to buy that the peak of the yield curve even if the bond is 15+ years and hold until maturity? The reading I have done on this forum has usually suggested only buying short term bonds (less than 5 years), from the few people that comment on individual bonds. So where does my father in law have it wrong? He is a smart man and I am not trying to prove him wrong or rub this in his face, but he sounded very logical to me that one day I would want to have enough money to buy a few bonds each year (thus averaging the long term interest rates over time) and buy at the peak of the yield curve (which usually means 15+ years) so my money can earn the most interest today while protecting the principal --- but where has he gone wrong?

on a side note, he talked about callable bonds, I am not sure how big or small of a factor that is in future replies. He is not a fan of callable bonds, but did admit to having them too. Thanks to anyone who read this far, and I hope to learn from your replies.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by patrick »

This sort of strategy is not really protecting completely. It's always possible for prices to fall. Perhaps the idea was that you'd be protected because you plan to hold to maturity, but a lot could happen in 15 years to change your mind. The longer term you buy the more likely some reason to sell will come up -- and the larger the potential loss from an interest rate increase. Furthermore, even if you use high rated bonds there is no absolute guarantee against default, and if you have only one (or a few) bonds you have undiversified default risk which is worse. Finally, inflation is not just a risk after 5 years, it is a risk from the very start.

This is not to say that long-term bonds are necessarily a bad idea. They do indeed tend to give higher interest rates than short bonds. But they don't give guaranteed protection, unless you are somehow certain of never needing to sell any of them before maturity, and you are certain there will be no defaults, and you are also certain that inflation will not be a problem.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by kontango »

The problem with the analysis (if I understand it correctly) is that your FIL is comparing the 5% with the 3% return. The more relevant comparison, in my opinion, is the opportunity cost of being locked in at 5% (for 17 years) if interest rates go much higher.

Also your FIL's advice of "Never lose your investment principal" will likely be violated if you are holding 17 year bonds and interest rates rise. Sure, you'll get back every penny (ignoring default risk) at maturity, but it could be a bumpy ride along the way!

Best of luck!
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Aptenodytes »

You don't buy at the peak of the yield curve. Yield curves are asymptotic, meaning they don't really peak except at the maximum available duration (except in rare circumstances where things get inverted).

You choose a location on the yield curve that has the combination of yield and duration that makes sense for you, in comparison to all other available combinations. I think many people would consider 15 years extreme right now, in that the extra yield you get in exchange for going out so far in duration is not worthwhile. But others look at the same data and jump on the 30-year yields. You have to decide for yourself; there's no formula that works for all.

When I look at the data, I see a sweet spot at about the 7-year mark. Through that mark you are getting about 30 BPS for each additional year of duration (in Treasuries). After that the increment drops off, 18 for extending from 7 years to 10; 7 for extending from 10-20; 3 for extending from 20-30.

Other things come into play besides getting the best bang for the buck; if you are matching future bond maturities to future liabilties, then you might get value from a very long term bond even if the yields are low.

Each segment of the bond market has its own yield curve and they bend differently. If you are in the muni market, you have to look at the muni curve.

He is right to avoid callable bonds; doing so prevents the issuer from taking back a high-yield bond if yields drop.

My own take on your father in law's approach is that it is highly sound for someone who has zero tolerance or zero need for risk. In practice, nobody has zero tolerance for risk -- it is impossible to live life without taking risk. Maybe he has zero need for risk -- that seems entirely plausible thinking back on my orthodontist bills. But they way you've summarized it is dubious -- never losing your principal as a categorical maxim. That's not a logical approach unless you have a pathology that makes you totally freak out and engage in self-destructive behavior if principal drops just the slightest bit. There are such people, and they should do something like what your father in law does. But I think they are rare.

So his approach is probably perfect for him, with the key condition being zero need for risk. But it is probably poorly suited to almost everyone else. In other words, no need to talk him out of it, but don't adopt it yourself without very careful introspection first.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

patrick wrote:unless you are somehow certain of never needing to sell any of them before maturity, and you are certain there will be no defaults, and you are also certain that inflation will not be a problem.
If someone can be certain to not sell until maturity, then this plan is ok?

and no one can be certain that inflation will not be a problem, but isn't that true for every and all investment or lack of investment?
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Re: Are Long-Term Bonds be better than Short-Term?

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kontango wrote:The problem with the analysis (if I understand it correctly) is that your FIL is comparing the 5% with the 3% return. The more relevant comparison, in my opinion, is the opportunity cost of being locked in at 5% (for 17 years) if interest rates go much higher.

Also your FIL's advice of "Never lose your investment principal" will likely be violated if you are holding 17 year bonds and interest rates rise. Sure, you'll get back every penny (ignoring default risk) at maturity, but it could be a bumpy ride along the way!
This is something I would like to learn more about. Can you explain this in a bit more of a basic mathematic way please?
To explain his view: if he is buying 17-year bonds, a few times per year, then he will continually be averaging the rates of return. This goes to his point that he is not trying to time the market and not trying to guess if and when interest rates will rise or fall but that he will buy bonds each year no matter which direction the rates may be moving.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

Aptenodytes wrote:You don't buy at the peak of the yield curve. Yield curves are asymptotic, meaning they don't really peak except at the maximum available duration (except in rare circumstances where things get inverted).

You choose a location on the yield curve that has the combination of yield and duration that makes sense for you, in comparison to all other available combinations. I think many people would consider 15 years extreme right now, in that the extra yield you get in exchange for going out so far in duration is not worthwhile. But others look at the same data and jump on the 30-year yields. You have to decide for yourself; there's no formula that works for all.

When I look at the data, I see a sweet spot at about the 7-year mark. Through that mark you are getting about 30 BPS for each additional year of duration (in Treasuries). After that the increment drops off, 18 for extending from 7 years to 10; 7 for extending from 10-20; 3 for extending from 20-30.
This part is my fault, he was explaining it to me and I did not understand, so I misspoke when i said the peak of the yield curve. He was explaining that some formula is used to compare the duration with the yield and finding a "sweet spot". I am sure you know this but it was my understanding that if a 9 year bond had a 4% yield but a 10year bond had a 14% yield, that you select the 10 year bond (that one is obvious just because I dont understand the complexities of this formula). This is slightly off topic, but what is this formula/equation called? is there something you can direct me to, or share more information with me so I can learn how to find this sweet spot? I am guessing your comment about BPS has something to do with what I am trying to describe.


Aptenodytes wrote: Other things come into play besides getting the best bang for the buck; if you are matching future bond maturities to future liabilties, then you might get value from a very long term bond even if the yields are low.

Each segment of the bond market has its own yield curve and they bend differently. If you are in the muni market, you have to look at the muni curve.

He is right to avoid callable bonds; doing so prevents the issuer from taking back a high-yield bond if yields drop.
He does not look at the markets (maybe he is wrong in this point), as he continued to buy each year and, as mentioned before, does not try to time the market. His point is continually buy and in a way 'cost average'. Also while he does not like callable bonds, he does own some - again, back to his point that he would rather earn 5% today even if it gets called in 5 years (rather than 17) over earning 3% today and the bond maturing in 5 years --- it sounds like you would say this is wrong, so could you please tell me why?


Aptenodytes wrote:My own take on your father in law's approach is that it is highly sound for someone who has zero tolerance or zero need for risk. In practice, nobody has zero tolerance for risk -- it is impossible to live life without taking risk. Maybe he has zero need for risk -- that seems entirely plausible thinking back on my orthodontist bills. But they way you've summarized it is dubious -- never losing your principal as a categorical maxim. That's not a logical approach unless you have a pathology that makes you totally freak out and engage in self-destructive behavior if principal drops just the slightest bit. There are such people, and they should do something like what your father in law does. But I think they are rare.

So his approach is probably perfect for him, with the key condition being zero need for risk. But it is probably poorly suited to almost everyone else. In other words, no need to talk him out of it, but don't adopt it yourself without very careful introspection first.
Doesnt W.Buffett have two rules of investing? #1 Dont Lose Principal and #2 Refer to rule 1? (a poor paraphrasing job I'm sure). Or am I thinking of someone else?

While I agree that there is no chance to live in a bubble, and he is not the 'bubble type'. You are correct that he earns a good income, he also lives a life around saving not keeping up with the jones. He is not trying to get rich quick by picking the newest IPO, but wants to have his money work for him a bit rather than sit in a mattress. I cannot put my finger on it, but I think there is a problem with this strategy (maybe something to do with inflation, but as I said I dont know much about the mathematics of this), maybe more than 1 problem. So I hope to hear back from you and thank you for the information you have already shared.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

thethinker wrote:
kontango wrote:The problem with the analysis (if I understand it correctly) is that your FIL is comparing the 5% with the 3% return. The more relevant comparison, in my opinion, is the opportunity cost of being locked in at 5% (for 17 years) if interest rates go much higher.

Also your FIL's advice of "Never lose your investment principal" will likely be violated if you are holding 17 year bonds and interest rates rise. Sure, you'll get back every penny (ignoring default risk) at maturity, but it could be a bumpy ride along the way!
This is something I would like to learn more about. Can you explain this in a bit more of a basic mathematic way please?
To explain his view: if he is buying 17-year bonds, a few times per year, then he will continually be averaging the rates of return. This goes to his point that he is not trying to time the market and not trying to guess if and when interest rates will rise or fall but that he will buy bonds each year no matter which direction the rates may be moving.

That's true until he needs to start cashing them in. Then as his need for cash falls below the duration in years of his investment, volatility in his prices is a serious issue. If we have another 1994 in the middle of it (US 30 year Treasury dropped -20%) then he's going to take pain. He's also quite illiquid-- hard to sell those bonds without taking a bath.

There's a 'kink' in 'normal' yield curves around 7-10 years, and most of the yield pickup comes from stretching that far. There isn't usually, I don't think, a lot more yield pickup beyond 10 years.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by dbr »

thethinker wrote: Doesnt W.Buffett have two rules of investing? #1 Dont Lose Principal and #2 Refer to rule 1? (a poor paraphrasing job I'm sure). Or am I thinking of someone else?
You can't take a rule like that out of the blue and use it to make investing decisions. Right off the bat it would mean than people like you and me could never invest in stocks and bonds because those entities do vary in market price and could well decline in value below the purchase price at one time or another, even including reinvested dividends. For stocks that is almost a certainty.

When you start to invoke reasoning about holding to maturity it becomes true that under that condition a person will not lose money in nominal terms, at least including interest paid. So here the price for a guarantee of return of principal is loss of liquidity and loss of opportunity to invest in something better. Whether these things are costs of significance to the investor depends.

There is another factor and that is inflation risk. Long bonds will return the nominal principal but not the purchasing power of those dollars. In theory expectations for inflation are priced into the interest rate that is available. In practice there is serious inflation risk for unexpected inflation in long bonds. I don't think most people think 17 year bonds are a good risk except possibly TIPS.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Doc »

Valuethinker wrote: There's a 'kink' in 'normal' yield curves around 7-10 years, and most of the yield pickup comes from stretching that far. There isn't usually, I don't think, a lot more yield pickup beyond 10 years.
I believe Larry Swedroe makes a similar point in his bond book. One of the reasons not to use a Total Bond Market fund is its inclusion of ten year plus bonds. When the Treasury began issuing 30 year bonds in 2006 the long bond issue in TBM became more significant.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by stlutz »

Going back to the OP, if one buys bonds maturing in 15 years over a period of 15 years (e.g. every year you buy 1 new 15 year bond), you'll end up with a portfolio with an approximate average maturity of 7.5, and a duration likely in the 6.5 or so range--or just a little bit longer than the VG Intermediate Term Tax Exempt fund which has an average duration of 5.2.

In short, if you want to purse a strategy of buying new bonds with maturities a little over 10 years, a great way to do that is to simply invest in the VG fund--it is doing the same thing.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

Valuethinker wrote:
That's true until he needs to start cashing them in. Then as his need for cash falls below the duration in years of his investment, volatility in his prices is a serious issue. If we have another 1994 in the middle of it (US 30 year Treasury dropped -20%) then he's going to take pain. He's also quite illiquid-- hard to sell those bonds without taking a bath.

There's a 'kink' in 'normal' yield curves around 7-10 years, and most of the yield pickup comes from stretching that far. There isn't usually, I don't think, a lot more yield pickup beyond 10 years.
so if he never has a need to cash them, then this formula he set forth with the constant buying of longer term bonds is a good idea?
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Aptenodytes »

Why do you care so much about understanding the details of his IPS? My advice would be to turn your attention to your own, and take a look at some of the excellent resources here that will help you out. Along the way you'll come to understand what he's up to as well.

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Re: Are Long-Term Bonds be better than Short-Term?

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dbr wrote:
thethinker wrote: Doesnt W.Buffett have two rules of investing? #1 Dont Lose Principal and #2 Refer to rule 1? (a poor paraphrasing job I'm sure). Or am I thinking of someone else?
You can't take a rule like that out of the blue and use it to make investing decisions.
I am sorry for that dbr, I did not mean to throw in some random comment. I was simply including that argument that a loss of principal is a lot harder to recover from with future investments. I think its something like this (correct my math please): a 30% loss in principal requires a 42% gain to recover from that loss back to even. That was all I meant. We do not live in a bubble so clearly risk is inevitable, I guess I only was suggesting that muni bonds may offer a significantly decreased risk at losing principal than many other investments.




dbr wrote:When you start to invoke reasoning about holding to maturity it becomes true that under that condition a person will not lose money in nominal terms, at least including interest paid. So here the price for a guarantee of return of principal is loss of liquidity and loss of opportunity to invest in something better. Whether these things are costs of significance to the investor depends.

There is another factor and that is inflation risk. Long bonds will return the nominal principal but not the purchasing power of those dollars. In theory expectations for inflation are priced into the interest rate that is available. In practice there is serious inflation risk for unexpected inflation in long bonds. I don't think most people think 17 year bonds are a good risk except possibly TIPS.

this is a bit more of what i was curious about. if he can accept the loss of liquidity, then this still sounds like a solid investment strategy.

however your talk about inflation risk is something I am curious about. if he is purchasing 1 bond every 3 months (for example), and does this every year without caring about the yield being offered, and he holds all the bonds to maturity (10-20 year bonds, for example), would this 'reinvestment of coupons into new bonds' give him the ability to 'average' his yield in such a way as to lower his risk of inflation? I am sure I would be missing something here, so please educate me more about this please. Also, on a side note, is inflation a risk that everyone takes (index funds as well as bonds), or is this specific to long term bonds? thanks!
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

stlutz wrote:Going back to the OP, if one buys bonds maturing in 15 years over a period of 15 years (e.g. every year you buy 1 new 15 year bond), you'll end up with a portfolio with an approximate average maturity of 7.5, and a duration likely in the 6.5 or so range--or just a little bit longer than the VG Intermediate Term Tax Exempt fund which has an average duration of 5.2.

In short, if you want to purse a strategy of buying new bonds with maturities a little over 10 years, a great way to do that is to simply invest in the VG fund--it is doing the same thing.
While that is similar, wouldn't the example you gave of buying individual bonds return a higher gain? Also, with all this talk about liquidity from people in earlier posts, the coupons gained each year from the bonds does offer the opportunity at being liquid for a specific purchase, given a few months, rather than selling a fund or selling bonds or reinvesting in new bonds - does that too give an advantage to the individual bond example? Thank you for your comment, I hope these questions are not too basic. My understanding of this is very elementary and I really appreciate all the comments posted here!
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Re: Are Long-Term Bonds be better than Short-Term?

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Aptenodytes wrote:Why do you care so much about understanding the details of his IPS? My advice would be to turn your attention to your own, and take a look at some of the excellent resources here that will help you out. Along the way you'll come to understand what he's up to as well.

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I am interested because he sounds very logical. He is a good man overall (which doesnt mean he has a great investment strategy), but he lives well, he was offering advice, and I am questioning if this advice is a good idea for me to follow. It made me curious to learn more about what he is doing and possible errors as to why I should avoid what he is doing....or why I should learn more and follow in similar footsteps.

thank you for the links, I will get to reading those today!
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Re: Are Long-Term Bonds be better than Short-Term?

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thethinker wrote: I am interested because he sounds very logical. He is a good man overall (which doesnt mean he has a great investment strategy), but he lives well, he was offering advice, and I am questioning if this advice is a good idea for me to follow. It made me curious to learn more about what he is doing and possible errors as to why I should avoid what he is doing....or why I should learn more and follow in similar footsteps.

thank you for the links, I will get to reading those today!
He has therefore done you a great favor by prompting you to ask a bunch of serious questions about long-term investing. And it sounds like he did it without being heavy-handed or preachy. That's a gift to be thankful for.

So now is the time to steer your gaze away from his situation and towards your own. You'll find many helpful people on this forum eager to respond as you work your way through everything.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by ogd »

thethinker wrote:so if he never has a need to cash them, then this formula he set forth with the constant buying of longer term bonds is a good idea?
1) Never say never.
2) There is a price to pay for longer term bonds even if you never sell: if interest rates rise, you have to spend a longer time earning lower yields before you get to take advantage of the higher yields. This opportunity cost can be huge in extreme situations. The higher yield certainly doesn't come for free.
3) Tying it all together: the market prices reflect both of these concerns; in fact the primary effect in the pricing of the yield curve is thought to be the market's expectations of when and by how much the rates are likely to move. This means neither long nor short is a particularly good deal all things considered.
4) There are very few reasons for an individual investor to be buying individual municipal bonds. This is a complex, hard to understand market with a lot of sophisticated players waiting to take advantage of the small fry, beginning with one's broker, and one where diversification is important. A fund is much better. If you don't trust me -- perhaps trust our fellow poster and author Rick Ferri, who used to manage hundreds of millions in individual bonds and now uses funds only: http://www.bogleheads.org/forum/viewtop ... 5#p1897797 .

Your father in law sounds like a smart man and I really like his rules A (particularly), C and D. Rule B is best avoided, not because anyone wants to lose principal, but because of the extreme limitations that result: no stocks and suboptimal bond investments.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by adam1712 »

I don't think your father-in-law is wrong. Most Bogleheads feel that the most important factors for investing are to save an adequate amount, don't overreact to market moves by staying the course, and keep investing costs low.

Many on this site including myself would argue that a more classic approach of stocks combined with shorter term bonds offer a slightly better risk/reward profile and flexibility to a typical individual investor. But I have no doubt that your FIL's investments have worked well for him. Because the market is mostly efficient, there's a broad range of investments that will perform well if you save, stay the course, and keep costs low.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by dbr »

thethinker wrote:
dbr wrote:
thethinker wrote: Doesnt W.Buffett have two rules of investing? #1 Dont Lose Principal and #2 Refer to rule 1? (a poor paraphrasing job I'm sure). Or am I thinking of someone else?
You can't take a rule like that out of the blue and use it to make investing decisions.
I am sorry for that dbr, I did not mean to throw in some random comment. I was simply including that argument that a loss of principal is a lot harder to recover from with future investments. I think its something like this (correct my math please): a 30% loss in principal requires a 42% gain to recover from that loss back to even. That was all I meant. We do not live in a bubble so clearly risk is inevitable, I guess I only was suggesting that muni bonds may offer a significantly decreased risk at losing principal than many other investments.

It's not to be sorry. I think you are misunderstanding that arithmetic. While the numbers you quote are, of course, valid because they are just arithmetic facts, it is not a conclusion that it is harder to recover from losses than it is to incur them. The fact that the US stock market is vastly higher today than at almost all times in its history proves that recoveries are easier and larger than crashes. Otherwise markets would decline on average rather than gain on average. Bonds are not stocks and on average neither lose nor gain, as far as market prices go. I will add the disclaimer to prevent people from jumping in that the future is never certain.

The analysis you refer to is the fact that investment return and volatility of investment return are linked; the more possibility for return the more uncertainty in the actual development of that return year by year. Bonds return less than stocks but are more certain in return, so there is indeed less risk of value falling from year to year. Bonds of longer duration (sort of like maturity) tend to fluctuate more from year to year than those of shorter duration. The concern with those long bonds is that fluctuations can be large from year to year compared to short bonds, but still small compared to stocks. The question is whether loss of liquidity and opportunity cost is worth it as a strategy to offset volatility.

dbr wrote:When you start to invoke reasoning about holding to maturity it becomes true that under that condition a person will not lose money in nominal terms, at least including interest paid. So here the price for a guarantee of return of principal is loss of liquidity and loss of opportunity to invest in something better. Whether these things are costs of significance to the investor depends.

There is another factor and that is inflation risk. Long bonds will return the nominal principal but not the purchasing power of those dollars. In theory expectations for inflation are priced into the interest rate that is available. In practice there is serious inflation risk for unexpected inflation in long bonds. I don't think most people think 17 year bonds are a good risk except possibly TIPS.
however your talk about inflation risk is something I am curious about. if he is purchasing 1 bond every 3 months (for example), and does this every year without caring about the yield being offered, and he holds all the bonds to maturity (10-20 year bonds, for example), would this 'reinvestment of coupons into new bonds' give him the ability to 'average' his yield in such a way as to lower his risk of inflation? I am sure I would be missing something here, so please educate me more about this please. Also, on a side note, is inflation a risk that everyone takes (index funds as well as bonds), or is this specific to long term bonds? thanks!

Everything that is denominated in currency is at risk to inflation in that the ability of that currency to purchase things is eaten away by inflation. At least that is the normal case in healthy economies that have not entered a deflationary crisis. The particular problem with bonds is that the principal to be returned is fixed in currency units and the interest payment on a bond, the coupon, is fixed in currency units. There is no mechanism to compensate for inflation as it occurs beyond taking a bet that future inflation will be what we think it will be. Other investments have a chance of outrunning inflation, which stocks tend to do in the long run, or being relatively constant relative to inflation as do real assets such as property and commodities. TIPS are the single asset that actually can be bought with a contract to be compensated for actual inflation, although it can happen that the real interest rate available for that investment is negative. Real interest rates for nominal investments of the same risk will also be negative under those conditions. It is true that if one buys a ladder of bonds, investing every year, that current inflation will be incorporated in the available yield, but each one of those bonds will be exposed to a 17-20 year future of unexpected inflation. If inflation increases and one tries to get out of the bond, that will not work because interest rates will rise and bond prices will fall.

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Re: Are Long-Term Bonds be better than Short-Term?

Post by RNJ »

I rarely chime in on this kind of thread as I've got a lot of my own learning to do. That said, I think I may have a little value to add here. The strategy you describe (that of your FIL) may be perfect - for him. I infer from your description that he is a man with a relatively high income, who has lived well below his means for many years, has substantial savings to secure his retirement (and thus little need to take any risk), and that the likelihood of his having to sell his bonds at a loss in a crisis is close enough to zero that the he can afford the "risk" of longer-term bonds. That's your FIL's situation.

Is it yours?

And, by the way, even Mr. Buffet loses principle: http://www.reuters.com/article/2014/03/ ... QG20140301

Good luck.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

adam1712 wrote:Many on this site including myself would argue that a more classic approach of stocks combined with shorter term bonds offer a slightly better risk/reward profile and flexibility to a typical individual investor. But I have no doubt that your FIL's investments have worked well for him. Because the market is mostly efficient, there's a broad range of investments that will perform well if you save, stay the course, and keep costs low.
I would really like to learn your side of that argument - that a classic approach of stocks and short term bonds is better in the risk/reward range. is that something you may be able to explain to me or show me in terms of numbers please? thanks.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

thethinker wrote:
Valuethinker wrote:
That's true until he needs to start cashing them in. Then as his need for cash falls below the duration in years of his investment, volatility in his prices is a serious issue. If we have another 1994 in the middle of it (US 30 year Treasury dropped -20%) then he's going to take pain. He's also quite illiquid-- hard to sell those bonds without taking a bath.

There's a 'kink' in 'normal' yield curves around 7-10 years, and most of the yield pickup comes from stretching that far. There isn't usually, I don't think, a lot more yield pickup beyond 10 years.
so if he never has a need to cash them, then this formula he set forth with the constant buying of longer term bonds is a good idea?
In essence yes. By 'going long' he has more volatility in portfolio value, but the income is constant and he gets a (modest) pickup from the upward slope of the yield curve (if the 17 year rate is higher than the 10 year).

A secondary issue is he is running higher credit risk-- that increases with the term of the bond.

However few of us are in the position where we never care about the capital value of our portfolio, ie that we have infinite time horizons.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

thethinker wrote:
adam1712 wrote:Many on this site including myself would argue that a more classic approach of stocks combined with shorter term bonds offer a slightly better risk/reward profile and flexibility to a typical individual investor. But I have no doubt that your FIL's investments have worked well for him. Because the market is mostly efficient, there's a broad range of investments that will perform well if you save, stay the course, and keep costs low.
I would really like to learn your side of that argument - that a classic approach of stocks and short term bonds is better in the risk/reward range. is that something you may be able to explain to me or show me in terms of numbers please? thanks.
The intuition is easy.

ST bonds have similar yields and therefore returns, but far less volatility and probably less correlation with stocks (both stocks and bonds tend not to do well with rising interest rates, although that is certain for bonds, and not always the case for stocks). If you build a portfolio with a relatively safe asset, and a risky asset (stocks, eg Vanguard Total Stock Market fund which is as close to Beta= 1.0 as you can get in 1 stock market) then if one of them has less correlation with the other it improves the 'efficiency' of the portfolio: for the same risk, higher return or for lower risk the same return.

David Swensen of Yale Endowment fame makes a point that long term Treasury bonds protect you against *deflation* better than ST bonds (or stocks). Whereas ST bonds provide better protection against inflation (if inflation rises, interest rates will rise, and you roll over the bonds into higher yielding ones).
Last edited by Valuethinker on Sat Mar 08, 2014 3:55 pm, edited 1 time in total.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

thethinker wrote:
Aptenodytes wrote:Why do you care so much about understanding the details of his IPS? My advice would be to turn your attention to your own, and take a look at some of the excellent resources here that will help you out. Along the way you'll come to understand what he's up to as well.

Getting Started
Investing, includes discussion of bond basics.

I am interested because he sounds very logical. He is a good man overall (which doesnt mean he has a great investment strategy), but he lives well, he was offering advice, and I am questioning if this advice is a good idea for me to follow. It made me curious to learn more about what he is doing and possible errors as to why I should avoid what he is doing....or why I should learn more and follow in similar footsteps.

thank you for the links, I will get to reading those today!
One thing. A lot of money has been lost in this world by 'chasing yield'.

The world has changed. Go back to 1980 and I bet there was a hell of a premium being in 17 year bonds over 10 year, say. Given tax rates at that time, also being in munis over straight bonds.

Things have changed. The yield premium of a 17 year bond over a 10 year now is small. You are not being much rewarded for that risk *unless* we have disinflation (low or negative inflation for an extended period).

Then you'll wish you bought the 30 year Treasury Bond stripped (ie zero coupon) ;-). But beware, the 30 year zero has a higher volatility than the S&P500 (or it did at one time) ;-).
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Re: Are Long-Term Bonds be better than Short-Term?

Post by adam1712 »

thethinker wrote:
adam1712 wrote:Many on this site including myself would argue that a more classic approach of stocks combined with shorter term bonds offer a slightly better risk/reward profile and flexibility to a typical individual investor. But I have no doubt that your FIL's investments have worked well for him. Because the market is mostly efficient, there's a broad range of investments that will perform well if you save, stay the course, and keep costs low.
I would really like to learn your side of that argument - that a classic approach of stocks and short term bonds is better in the risk/reward range. is that something you may be able to explain to me or show me in terms of numbers please? thanks.
I'm by no means an expert but here are the two arguments that I hear that have been persuasive to me:

1) When possible, you should diversify. I think you should definitely hold some higher risk/higher expected returning assets like stocks to get a good return in good economic times. The best counter asset that will hold it's value in poor times are short-term bonds/cash/TIPS. You could set up a portfolio of mostly long-term bonds that have historically provided similar returns as the stock/short term bond portfolio, but I don't like the idea of only owning one asset class. It's hard to predict the future and I want to be well-diversified.

The question then becomes why not own short-term bonds, long-term bonds, and stocks to be even more diversified.
2) This is a closer call to me, but I know I've seen the argument (sorry I don't have sources close at hand) that companies that are in insurance/pensions are limited in their ability to invest in stocks and have a large need for long term bonds. This drives rates down and experts have said that individual investors aren't as well compensated with higher interest rates as they should be for long-term bonds.

Personally, I don't spend a lot of time digging any deeper into the subject. I only invest in three funds, Vanguard Total Bond, Vanguard Total Stock, and Vanguard Total International (ok, four since I also hold Vanguard AWexUS in my Roth instead of Total Int'l). It works for me since I feel broadly diversified and it's simple to understand and maintain.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by ogd »

Valuethinker wrote:The world has changed. Go back to 1980 and I bet there was a hell of a premium being in 17 year bonds over 10 year, say. Given tax rates at that time, also being in munis over straight bonds.
Actually, you'd be surprised. In January 1980 the 20 year was 10.65%, the 10 year was 10.80% (!!) and perhaps most surprisingly the 1 year was 12.06% (!!!). Perhaps people were getting an inkling of how good the 20 year was going to be going forward. The other side of the interest rate risk coin is that you lock in a rate for a long period of time.

Today, the same numbers are 3.45%, 2.80% and 0.13% respectively. In relative terms at least, the yield curve is unusually steep by historical standards. It's debatable how much to pay attention to relative vs absolute, given inflation as a constant bite from all of the maturities.

I agree with your other points, of course.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

ogd wrote:
thethinker wrote:so if he never has a need to cash them, then this formula he set forth with the constant buying of longer term bonds is a good idea?
1) Never say never.
2) There is a price to pay for longer term bonds even if you never sell: if interest rates rise, you have to spend a longer time earning lower yields before you get to take advantage of the higher yields. This opportunity cost can be huge in extreme situations. The higher yield certainly doesn't come for free.
3) Tying it all together: the market prices reflect both of these concerns; in fact the primary effect in the pricing of the yield curve is thought to be the market's expectations of when and by how much the rates are likely to move. This means neither long nor short is a particularly good deal all things considered.
4) There are very few reasons for an individual investor to be buying individual municipal bonds. This is a complex, hard to understand market with a lot of sophisticated players waiting to take advantage of the small fry, beginning with one's broker, and one where diversification is important. A fund is much better. If you don't trust me -- perhaps trust our fellow poster and author Rick Ferri, who used to manage hundreds of millions in individual bonds and now uses funds only: http://www.bogleheads.org/forum/viewtop ... 5#p1897797 .

Your father in law sounds like a smart man and I really like his rules A (particularly), C and D. Rule B is best avoided, not because anyone wants to lose principal, but because of the extreme limitations that result: no stocks and suboptimal bond investments.


from your points above.
1) true.
2) If I understand your point correctly, i would say that he is constantly buying new bonds. So as soon as he as enough money made from the coupons of his existing bonds, he is buying new ones and this gives him the ability to invest both when yields are high and low and he will therefore not be timing the market but simply getting a general average yield across many decades. Isnt that the right thing to do; not time a market?
3) Are you saying these muni bonds are almost the equivalent of an I-Bond.....that, in the end and over a long period of time, the muni bonds will overall have a yield that averages close to inflation?
4) Thank you for the link. And I do plan to read more information from Rick Ferri.

He is a logical and smart man, which is why I started this post. Because I know he is trying to direct me in a way that he finds to have worked for him. However of my limited time on here, his ideas contradict what many smart people here are saying. But to a person such as myself who is risk adverse (as I guess many people on here would say), I wouldn't mind a slightly lesser return which provides a lower risk. Is there any information you can share which shows how these bonds are not worth the lower risk in the long run to someone like me in his late 20s? thanks again!
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Re: Are Long-Term Bonds be better than Short-Term?

Post by hoops777 »

I am not buying the thinkers story,but this has been a good thread :wink:
K.I.S.S........so easy to say so difficult to do.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

hoops777 wrote:I am not buying the thinkers story,but this has been a good thread :wink:
thanks for the post, but there isnt a 'story to buy here. I am just curious as to the problem with what my FIL is doing for his investment strategy and to learn an error he may have overlooked. I hope youll add information if you have anything to offer. thanks. I am glad you like the thread, it has been educational for me too.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by wshang »

The common wisdom on the street is the long bond is due for a fall. Unless I am mistaken, the money flows have reflected that too. Usually though, the contrarian prevails, the Fed has its hand on the scales and who really knows how this scenario is going to play out with unwinding of their position. Although I am not acting contrarian on the long bond, it might be interesting to note this post and check up in 5, 7 and ten years and see how well the 'smart' money performed.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by hoops777 »

You are most welcome and I will just leave it at that?Good luck with your search for knowledge :wink:
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Re: Are Long-Term Bonds be better than Short-Term?

Post by grayfox »

thethinker wrote: So with all that history, is he correct to buy that the peak of the yield curve even if the bond is 15+ years and hold until maturity? The reading I have done on this forum has usually suggested only buying short term bonds (less than 5 years), from the few people that comment on individual bonds. So where does my father in law have it wrong? He is a smart man and I am not trying to prove him wrong or rub this in his face, but he sounded very logical to me that one day I would want to have enough money to buy a few bonds each year (thus averaging the long term interest rates over time) and buy at the peak of the yield curve (which usually means 15+ years) so my money can earn the most interest today while protecting the principal --- but where has he gone wrong?
I would not say that he has gone wrong.

The only comment I would make is that Municipal bonds have credit risk, which means risk of default. So you want to be diversified, which means bonds from different issuers.

How diversified do you want to be?
Well, how much of your portfolio would you be willing to loose in a default? 10%? 5%? 1%?
If 1%, then you would want to own 100 different issuers and have 1% in each. If you want 100 different bonds, that would be a large portfolio of muni. Probably multi-million. And I would want to stay on top of things if some municipality runs into problems. That would be a lot of work. No, thanks!

So it is 100x simpler to own a bond fund. Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX) holds 3832 different bonds, plus professionals to monitor the credit worthiness of issuers, which most individuals are not capable of doing themselves. (You could try relying on credit ratings, but can you trust the rating agencies? A when a bond finally gets downgraded, it is probably too late. Vanguard can do their own credit analysis and sell sooner.)

And don't get me started on how opaque the muni bond market is and how much you will get ripped off if you ever have to sell a muni bond.

For those reasons I stick with low-cost bond funds for muni bonds. Someone else may decide individual muni's are worth the extra effort. To each, his own.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

ogd wrote:
Valuethinker wrote:The world has changed. Go back to 1980 and I bet there was a hell of a premium being in 17 year bonds over 10 year, say. Given tax rates at that time, also being in munis over straight bonds.
Actually, you'd be surprised. In January 1980 the 20 year was 10.65%, the 10 year was 10.80% (!!) and perhaps most surprisingly the 1 year was 12.06% (!!!). Perhaps people were getting an inkling of how good the 20 year was going to be going forward. The other side of the interest rate risk coin is that you lock in a rate for a long period of time.

Today, the same numbers are 3.45%, 2.80% and 0.13% respectively. In relative terms at least, the yield curve is unusually steep by historical standards. It's debatable how much to pay attention to relative vs absolute, given inflation as a constant bite from all of the maturities.

I agree with your other points, of course.
Thank you for the correction! Was your data source the Fed (St Louis)?

The phenomenon of the inverse yield curve is familiar to us all: when the Fed slams on the brakes, the curve flattens and even goes negative, as the market figures eventually inflation will come down and the Fed will ease off.

The virtue of being in long bonds then was that interest rates from 1981 to 2012 fell further than any of us could have imagined, just as someone in 1945 probably could not imagine the loss of 95% of their purchasing power in a 3.5% gilt stock (ie UK government bond) over the next 35 years.

The virtures of a long bond during long disinflationary (falling inflation rates) or deflationary (negative inflation) is thus emphasized.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

adam1712 wrote:
thethinker wrote:
adam1712 wrote:Many on this site including myself would argue that a more classic approach of stocks combined with shorter term bonds offer a slightly better risk/reward profile and flexibility to a typical individual investor. But I have no doubt that your FIL's investments have worked well for him. Because the market is mostly efficient, there's a broad range of investments that will perform well if you save, stay the course, and keep costs low.
I would really like to learn your side of that argument - that a classic approach of stocks and short term bonds is better in the risk/reward range. is that something you may be able to explain to me or show me in terms of numbers please? thanks.
I'm by no means an expert but here are the two arguments that I hear that have been persuasive to me:

1) When possible, you should diversify. I think you should definitely hold some higher risk/higher expected returning assets like stocks to get a good return in good economic times. The best counter asset that will hold it's value in poor times are short-term bonds/cash/TIPS. You could set up a portfolio of mostly long-term bonds that have historically provided similar returns as the stock/short term bond portfolio, but I don't like the idea of only owning one asset class. It's hard to predict the future and I want to be well-diversified.

The question then becomes why not own short-term bonds, long-term bonds, and stocks to be even more diversified.
2) This is a closer call to me, but I know I've seen the argument (sorry I don't have sources close at hand) that companies that are in insurance/pensions are limited in their ability to invest in stocks and have a large need for long term bonds. This drives rates down and experts have said that individual investors aren't as well compensated with higher interest rates as they should be for long-term bonds.

Personally, I don't spend a lot of time digging any deeper into the subject. I only invest in three funds, Vanguard Total Bond, Vanguard Total Stock, and Vanguard Total International (ok, four since I also hold Vanguard AWexUS in my Roth instead of Total Int'l). It works for me since I feel broadly diversified and it's simple to understand and maintain.
The institutional explanation is a good one. Regulation *does* require insurance companies to match long term liabilities (annuities and life insurance) with long term safe assets (LT US Treasuries)-- as I understand US insurance regulation anyways. In the UK at least this is extended to pension funds: and so the pension fund industry petitioned (and got) the UK govt to issue 50 year gilts (UK treasury bonds).

In the UK the yield on the longest gilts (30 years) is habitually *below* that of the 10 year. Because the buyers just buy them, and sit on them. And there's always a demand for spare stock (ie bonds for sale).

All the empirical studies suggest a ST bond fund is the most diversifying, against an equity fund. Swensen's addition is that if we have a Japan (and now Europe) scenario of disinflation/ outright deflation, long Treasury Bonds protect you.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by richard »

adam1712 wrote:1) When possible, you should diversify. I think you should definitely hold some higher risk/higher expected returning assets like stocks to get a good return in good economic times. The best counter asset that will hold it's value in poor times are short-term bonds/cash/TIPS. You could set up a portfolio of mostly long-term bonds that have historically provided similar returns as the stock/short term bond portfolio, but I don't like the idea of only owning one asset class. It's hard to predict the future and I want to be well-diversified.

The question then becomes why not own short-term bonds, long-term bonds, and stocks to be even more diversified.
2) This is a closer call to me, but I know I've seen the argument (sorry I don't have sources close at hand) that companies that are in insurance/pensions are limited in their ability to invest in stocks and have a large need for long term bonds. This drives rates down and experts have said that individual investors aren't as well compensated with higher interest rates as they should be for long-term bonds.
1) There is a lot to be said for diversification. What's best to hold in bad times depends on the type of bad times, but bad times are often associated with low interest rates and long treasuries do well when rates drop.

2) Insurance and pension companies often have long-term fixed nominal liabilities and therefore hold long bonds to match assets and liabilities, decreasing rates relative to shorter bonds. This seems logical, but it is far from clear how much of an effect this has on rates.

Wikipedia has a good article on the general subject http://en.wikipedia.org/wiki/Yield_curve

If you are an income investor, long bonds provide a more stable income stream than short bonds. They also tend to provide higher yields than shorter bonds, although rising rates can negate that advantage. Something that is more certain and more stable would seem safer than something less certain and less stable.

On the other hand, if you are likely to sell bonds, then you might want to focus on principal value rather than income, in which case short bonds move less in response to interest rate changes.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by richard »

20-year treasury yields minus 10-year yields since 1955.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by YDNAL »

thethinker [OP] » Sat Mar 08, 2014 1:47 am wrote:So while he does not have these systematically laddered, he continued to reinvest the coupons into new bonds each year (or a few times per year), because he is not trying to time the market. <snip>

So with all that history, is he correct to buy that the peak of the yield curve even if the bond is 15+ years and hold until maturity? The reading I have done on this forum has usually suggested only buying short term bonds (less than 5 years), from the few people that comment on individual bonds. So where does my father in law have it wrong?
A few random thoughts.
  • 1. Sure, a LT bond *tends to* add compensation over shorter bonds, with additional risks. There are no free lunches.
    2. Today, with 3x the maturity, a 20-yr Treasury provides 58% more yield (3.27% vs. 2.07%) for 13 years longer maturity than the 7-yr provides. Also, it provides ~70 basis points (3.27% vs. 2.60%) over the 10-year. However, the yield curve shifts - not static.
    3. When holding to maturity, you are guaranteed par (absent default). But, par over a longer periods is significantly exposed to Inflation. And, without a pre-determined "ladder", your FIL may be lacking a plan to cover specific needs of varying timeframes.
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Re: Are Long-Term Bonds be better than Short-Term?

Post by ogd »

thethinker wrote:
ogd wrote:
thethinker wrote:so if he never has a need to cash them, then this formula he set forth with the constant buying of longer term bonds is a good idea?
1) Never say never.
2) There is a price to pay for longer term bonds even if you never sell: if interest rates rise, you have to spend a longer time earning lower yields before you get to take advantage of the higher yields. This opportunity cost can be huge in extreme situations. The higher yield certainly doesn't come for free.
3) Tying it all together: the market prices reflect both of these concerns; in fact the primary effect in the pricing of the yield curve is thought to be the market's expectations of when and by how much the rates are likely to move. This means neither long nor short is a particularly good deal all things considered.
4) There are very few reasons for an individual investor to be buying individual municipal bonds. This is a complex, hard to understand market with a lot of sophisticated players waiting to take advantage of the small fry, beginning with one's broker, and one where diversification is important. A fund is much better. If you don't trust me -- perhaps trust our fellow poster and author Rick Ferri, who used to manage hundreds of millions in individual bonds and now uses funds only: http://www.bogleheads.org/forum/viewtop ... 5#p1897797 .

Your father in law sounds like a smart man and I really like his rules A (particularly), C and D. Rule B is best avoided, not because anyone wants to lose principal, but because of the extreme limitations that result: no stocks and suboptimal bond investments.

from your points above.
1) true.
2) If I understand your point correctly, i would say that he is constantly buying new bonds. So as soon as he as enough money made from the coupons of his existing bonds, he is buying new ones and this gives him the ability to invest both when yields are high and low and he will therefore not be timing the market but simply getting a general average yield across many decades. Isnt that the right thing to do; not time a market?
My point was not about market timing, but that looking at the yield curve and deciding that this point is the best deal assumes you know better than the market, that you have a better estimate of the risks of long-term bonds than the market. This is a tall order. Once again, it's not like you are getting that extra 1% for free, it means you are locked in for a far longer period of time and may miss opportunities that make that 1% look like peanuts. For example, if rates in the 10 year maturity range climb to 7%, the opportunity cost of holding a 3% 20 year vs a 2% 10 year is: (20 - 10) x (7 - 3) = 40%, whereas the extra yield you got in the first 10 years was only 10%.

Also, your father in law in effect has short, medium and long bonds, as an artifact of his initial bonds getting shorter and shorter. So he is diversified and you should be too.
thethinker wrote:3) Are you saying these muni bonds are almost the equivalent of an I-Bond.....that, in the end and over a long period of time, the muni bonds will overall have a yield that averages close to inflation?
They will yield more than that, and they should -- because they are more risky as well. But to a first approximation the differences between yields for bonds of the same quality but longer and shorter are due to the market's expectation of higher interest rates, part of which is inflation expectations, plus a risk premium connected to the uncertainty of these expectations.

It's very complicated and I strongly recommend using a fund instead of doing it yourself. I do the same with mid six figures muni investments.
thethinker wrote:4) Thank you for the link. And I do plan to read more information from Rick Ferri.

He is a logical and smart man, which is why I started this post. Because I know he is trying to direct me in a way that he finds to have worked for him. However of my limited time on here, his ideas contradict what many smart people here are saying. But to a person such as myself who is risk adverse (as I guess many people on here would say), I wouldn't mind a slightly lesser return which provides a lower risk. Is there any information you can share which shows how these bonds are not worth the lower risk in the long run to someone like me in his late 20s? thanks again!
There are many sets of numbers about the performance of various allocation. Perhaps most famous is this type of graph which you can find in a variety of places (I just sourced one from another post on the forum).

Image
Not only do you notice that by taking on more risk, with stocks, you can get better returns, but 100% bonds is actually more risky than mixing in a small amount of stocks, while being lower returning as well.

That's why I said a hard rule against principal at risk isn't going to do you much good, not to mention that only Treasuries fully fulfill it (munis can default), and arguably only inflation-protected securities (TIPS) fulfill the spirit of the rule. At the cost of earning next to nothing.

Hope this helps!
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Re: Are Long-Term Bonds be better than Short-Term?

Post by ogd »

Valuethinker wrote:Thank you for the correction! Was your data source the Fed (St Louis)?

The phenomenon of the inverse yield curve is familiar to us all: when the Fed slams on the brakes, the curve flattens and even goes negative, as the market figures eventually inflation will come down and the Fed will ease off.
Yes, the text data at http://research.stlouisfed.org/fred2/data/GS10.txt, change that last number accordingly. It's always fun to look at and I have it in my mind to put it in a 3D plot someday.

That the curve was actually inverted was a surprise to me too, but I did know it's much flatter normally, in fact almost always, as the interest rate risk is balanced by the desire to lock in the current yields, such as they might be. Today's steep curve is rare and it reflects everyone's expectations of rates going up, already priced in.
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Post by Taylor Larimore »

thethinker:

Bonds are VERY complex instruments. In my opinion, they are much more difficult to understand than stocks. For this primary reason, I think most investors are better-off in a diversified, low-cost, bond index fund or bond managed fund where an experienced bond manager evaluates the bonds you will be holding.

Larry Swedroe and Joseph Hempen wrote a book titled, The Only Guide to a Winning Bond Strategy You'll Ever Need. You can read valuable excerpts here:

"The Only Guide to a Winning Bond Strategy"

Sample of municipal bond Indenture (61 pages).

Best wishes.
Taylor
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Valuethinker
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Valuethinker »

ogd wrote:
Valuethinker wrote:Thank you for the correction! Was your data source the Fed (St Louis)?

The phenomenon of the inverse yield curve is familiar to us all: when the Fed slams on the brakes, the curve flattens and even goes negative, as the market figures eventually inflation will come down and the Fed will ease off.
Yes, the text data at http://research.stlouisfed.org/fred2/data/GS10.txt, change that last number accordingly. It's always fun to look at and I have it in my mind to put it in a 3D plot someday.

That the curve was actually inverted was a surprise to me too, but I did know it's much flatter normally, in fact almost always, as the interest rate risk is balanced by the desire to lock in the current yields, such as they might be. Today's steep curve is rare and it reflects everyone's expectations of rates going up, already priced in.
I remember reading that Bill Gross made much of his outperformance by going a little short (long?) on the benchmark, thus picking up yield at a relatively low risk (must have been long). In effect I think a pricing anomaly that 5-7 year bonds were a little underpriced (that contradicts what I just wrote, which means I am garbling the story). He also practised 'riding the yield curve down' which makes sense, I think.
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Doc
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Re: Are Long-Term Bonds be better than Short-Term?

Post by Doc »

Valuethinker wrote: He also practised 'riding the yield curve down' which makes sense, I think.
I've always been of the opinion that Pimco's funds size and Gross' wide use of derivatives reduces the transaction cost so that riding the yield curve is more productive than many of his peers.

I think the skill here may be less in duration/credit picking and more in cost reduction. :idea:
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
linuxizer
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Re: Are Long-Term Bonds better than Short-Term?

Post by linuxizer »

Taylor Larimore wrote:Bonds are VERY complex instruments. In my opinion, they are much more difficult to understand than stocks.
Correct as usual, King Friday. I think of bonds like the Game of Life: really simple rules give rise to infinitely sophisticated emergent behavior.
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thethinker
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Re: "The only Guide to a Winning Bond Strategy" -- A Gem

Post by thethinker »

Taylor Larimore wrote:thethinker:

Bonds are VERY complex instruments. In my opinion, they are much more difficult to understand than stocks. For this primary reason, I think most investors are better-off in a diversified, low-cost, bond index fund or bond managed fund where an experienced bond manager evaluates the bonds you will be holding.

Larry Swedroe and Joseph Hempen wrote a book titled, The Only Guide to a Winning Bond Strategy You'll Ever Need. You can read valuable excerpts here:

"The Only Guide to a Winning Bond Strategy"

Sample of municipal bond Indenture (61 pages).

Best wishes.
Taylor
Thank you Taylor, I will read these links so I can learn more about this subject. thanks
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thethinker
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Re: Are Long-Term Bonds be better than Short-Term?

Post by thethinker »

Valuethinker wrote:
ogd wrote:
Valuethinker wrote:Thank you for the correction! Was your data source the Fed (St Louis)?

The phenomenon of the inverse yield curve is familiar to us all: when the Fed slams on the brakes, the curve flattens and even goes negative, as the market figures eventually inflation will come down and the Fed will ease off.
Yes, the text data at http://research.stlouisfed.org/fred2/data/GS10.txt, change that last number accordingly. It's always fun to look at and I have it in my mind to put it in a 3D plot someday.

That the curve was actually inverted was a surprise to me too, but I did know it's much flatter normally, in fact almost always, as the interest rate risk is balanced by the desire to lock in the current yields, such as they might be. Today's steep curve is rare and it reflects everyone's expectations of rates going up, already priced in.
I remember reading that Bill Gross made much of his outperformance by going a little short (long?) on the benchmark, thus picking up yield at a relatively low risk (must have been long). In effect I think a pricing anomaly that 5-7 year bonds were a little underpriced (that contradicts what I just wrote, which means I am garbling the story). He also practised 'riding the yield curve down' which makes sense, I think.

Valuethinker, is this the Bill Gross article you are talking about, or were you referencing something from years prior? thanks. http://money.cnn.com/2014/01/09/investi ... index.html
HurdyGurdy
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Re: Are Long-Term Bonds better than Short-Term?

Post by HurdyGurdy »

TheThinker, what your father in law has is what the wiki calls a bond ladder, http://www.bogleheads.org/wiki/Bond_Ladder

It is a very acceptable strategy, except that it is risky to just have one kind of bond (munis) from one state, as recent stories from California cities and Puerto Rico show.
Ken Carbaugh
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Re: Are Long-Term Bonds better than Short-Term?

Post by Ken Carbaugh »

Hey Thethinker, you said "Doing a quick search for Indiana Muni Bonds it looks like bonds in this date rage (say 17 years) would pay at about a 5% rate per year, while something short term (say 5 years) is paying closer to 3%."
Are you talking about Coupon or Yield to Maturity (YTM)? Your father in law may be looking at the coupon which is not the same as YTM. 17 year Muni bonds are yielding about to 3.6-4.30% right now. If he is missing any rungs in his ladder there may be years before he has any bonds maturing.
And for "buying a bond at the peak of a Yield Curve"... He could be talking a few things here. If you look at the muni yield curve there is a certain point where it begins to "flatten out". For example, a AAA 5 year muni is yielding about 1.11% and a 10 year is yielding about 2.54% so there is about a 1.4% difference in yield. A AAA 15 year muni is yielding about 3.14% and a 20 year is yielding about 3.53%, so the additional yield is not as dramatic so people say the curve "flattens out" and call it the "peak." And because this is investing, there are about 122,000 different ideas of where this "peak" is. And yes I am one of the 122,000. Or he could be talking about the taxable equivalent yield spread over A rated corporate bonds. Which pretty much works the same way.

Hope this helps - Ken
petem1866
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Re: Are Long-Term Bonds better than Short-Term?

Post by petem1866 »

I don't necessarily agree that callable bonds should be avoided assuming you understand the impact of the call and are considering both YTM and YTW. I actually like buying long term callable bonds trading at a bit of a premium in the current market environment. Assume a 15 year bond is callable in 7 years with a coupon of 5%, YTW of 4% and a YTM of 4.5%. A different 15 year bond is not callable (which typically makes it more expensive) and has a YTM of 4%. I'd definitely say that the better buy is the callable bond and here is why:

1) Interest rates go up as most people expect and in 7 years the yield of an 8 year bond is around or above 5%. Your bond won't be called initially and might eventually be called in the last few years. You've gotten somewhere between a 4-4.5% return for a 7-12 year bond which is impossible to do in today's environment. Further once the bond is called you can reinvest it in a new bond choosing the best duration for the given interest rate environment.

2) Interest rates stay the same or go down - Your bond will be called in 7 years and you will miss out on getting your 4% return for the last 8 years of the bond however you just bought a 7 year bond today with a yield of 4% which is probably 150-200 basis points better than you could have done with any other offering. In 7 years you would reevaluate whether you want to buy an 8 year bond at market rates or a new 15 year bond.

My general view of long term bonds is that there is nothing wrong with buying them. People have claimed that interest rates have nowhere to go but up for 4-5 years now. There is no guarantee that interest rates will be higher tomorrow than they are today or that they'll be higher in 5 years than they are tomorrow. You need to understand your own situation and understand what you are investing for. I personally only buy long term bonds (10 years or greater) with money that I know with a 99.9% certainty I won't need to touch until maturity. I understand the opportunity cost if rates go up and am fine with them. I like the certainty of getting an approximate 4% return on muni bonds (about 6.6% tax comparable) on my money. I have other investments that is focused for growth in an inflationary environment.
petem1866
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Re: Are Long-Term Bonds be better than Short-Term?

Post by petem1866 »

thethinker wrote:
however your talk about inflation risk is something I am curious about. if he is purchasing 1 bond every 3 months (for example), and does this every year without caring about the yield being offered, and he holds all the bonds to maturity (10-20 year bonds, for example), would this 'reinvestment of coupons into new bonds' give him the ability to 'average' his yield in such a way as to lower his risk of inflation? I am sure I would be missing something here, so please educate me more about this please. Also, on a side note, is inflation a risk that everyone takes (index funds as well as bonds), or is this specific to long term bonds? thanks!

I don't know that "reinvestment of the coupons" is really going to be all that effective to average yield. Especially doing it a few times a year. If you are getting a 4% coupon paid twice a year and try to buy new bonds with that payment you will be buying a very small number of bonds (unless you make a very large initial investment) which would also have a very small impact on the average yield of your portfolio.

Using numbers, if you buy 100 bonds around par for an initial investment of 100k, you will get about $2k every six months. Sure you can try to buy 2 new bonds every six months but that will be pretty difficult to do considering minimum sizes and all. Further in 5 years your 10% of new bonds will not change the average yield of your total portfolio all that much.
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