Allan Roth on Bond Funds

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Allan Roth on Bond Funds

Postby Jacobkg » Mon Dec 14, 2009 6:03 pm

I know that the debate will rage on forever, but this article provides some nice simple calculations to go along with it...

http://moneywatch.bnet.com/investing/bl ... hoice/873/

For what its worth, I am squarely on Mr. Roth's side.
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Re: Allan Roth on Bond Funds

Postby fishnskiguy » Mon Dec 14, 2009 6:25 pm

Jacobkg wrote:I know that the debate will rage on forever, but this article provides some nice simple calculations to go along with it...

http://moneywatch.bnet.com/investing/bl ... hoice/873/

For what its worth, I am squarely on Mr. Roth's side.


I am too, in general. The exception being buying treasuries or TIPS at auction and holding to maturity. Your own personal bond fund with an expense ratio of zero.

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Re: Allan Roth on Bond Funds

Postby Allan Roth » Mon Dec 14, 2009 6:59 pm

fishnskiguy wrote:The exception being buying treasuries or TIPS at auction and holding to maturity. Your own personal bond fund with an expense ratio of zero.

Chris


You are right - diversification from default becomes unimportant when dealing with the US Gov't.
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Postby AzRunner » Mon Dec 14, 2009 7:15 pm

Allan,

Very nice example. This article should go into the Wiki as one attempt to stop the endless debate on this issue.

Norm
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Postby stevewolfe » Mon Dec 14, 2009 7:22 pm

I don't think it stops the debate and I don't think the debate should be stopped. One size fits all approach does not appear to exist in this case (for one example see posts above regarding Treasuries purchased at auction as described, among other places, in Larry Swedroe's book "The Only Guide to a Winning Bond Strategy You'll Ever Need").
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Postby dbr » Mon Dec 14, 2009 7:23 pm

I'm not sure the comfort of knowing that an individual bond will return 100% of the principal at maturity will be a factor that is outweighed by any amount of explanation or argument, even for investors that plan to retain most of the principal essentially forever.
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Postby natureexplorer » Mon Dec 14, 2009 7:37 pm

Great article, clear conclusions are always appreciated.

I wonder whether there are any low cost bond funds out there that offer date-specific maturation. I could imagine that people might be interested in shortening their maturity as they approach retirement or a major expense.

With the available bond funds, what is a good strategy to shorten your maturity over time in a taxable account - reinvest interest in a short-term fund? Or will it require redeeming shares? But what if you would have to realize a capital gain? Unless there is a solution to this taxable capital gain problem, I would see some demand for such a date-specific fund. I only shop at Vanguard for bond mutual funds, so I am not sure what's available. I am particularly interested in tax-exempt bonds.
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Postby bnw2001 » Mon Dec 14, 2009 8:02 pm

I agree the debate can and should continue. But I stick with bond funds for one simple reason--simplicity. They are available in my 401k and I can easily select them from a drop down list at vanguard.com.

I get a lot of utility from simplicity, and the opportunity cost is high for me. I'm not arguing that nobody else should make a different value judgment, but this is the one i make.
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Postby Jacobkg » Mon Dec 14, 2009 8:25 pm

natureexplorer,

you asked:
"But what if you would have to realize a capital gain? Unless there is a solution to this taxable capital gain problem, I would see some demand for such a date-specific fund."

Any capital gain that you realize in a bond fund would have been realized as interest payments instead if you held individual bonds (unless you bought discounted bonds, in which case it is a capital gain as well). Since the tax rate on interest is higher than the long term capital gains rate, you are not losing anything by selling longer duration bond funds in favor of shorter duration fund and paying the capital gains tax. If you held individual bonds you would have paid the same tax, just as income instead of capital gains. Nevertheless, try to hold as much of your bonds as possible in tax-deferred retirement accounts.

If you are saving for retirement, as most of us are, then instead of shortening your duration as you get closer, I would recommend investing in short and intermediate duration bond funds, with the plan of holding them forever (or until you need to sell shares as part of your retirement drawdown). This way you do not have to sell any shares during your entire accumulation phase, simplifying your life greatly.

Best,
Jacob
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Postby mikep » Mon Dec 14, 2009 8:35 pm

AzRunner wrote:Allan,

Very nice example. This article should go into the Wiki as one attempt to stop the endless debate on this issue.

Norm


Done - Please see Individual Bonds vs a Bond Fund on the Bogleheads Wiki.
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Postby bbrock » Mon Dec 14, 2009 8:40 pm

That was an informative article in which I agree with Allan. Thanks for posting the link.
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Postby natureexplorer » Mon Dec 14, 2009 8:55 pm

Jacob, thanks for your reply. What if we consider tax-exempt bonds, for which there is more reward for longer durations and for which the interest is not taxed (but interest in the form of capital gains would be)?

Nevertheless, try to hold as much of your bonds as possible in tax-deferred retirement accounts.


Yes, of course. I have most of my savings in a taxable account (93%). Despite maxing out my 401k contributions, I am currently contributing more to my taxable account. So my tax advantaged space is currently decreasing in significance. In my 401k I hold an expensive active bond fund (ER 0.99%) even though a 0.07% ER S&P500 index fund is available. In my Roth IRA, I hold REIT (VNQ) instead of bonds as I can buy tax-exempt bonds in the taxable account. Since my tax-advantaged space is only 7% and partially used up by bonds and with a 28% tax bracket, I feel like my only option at current yields is Vanguard tax-exempt bond funds.
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Postby bob90245 » Mon Dec 14, 2009 9:02 pm

The article doesn't make any sense to me. If an investor is worried about inflation (Roth's main point), wouldn't it make more sense to buy individual TIPS instead of nominal bonds?
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Postby Rodc » Mon Dec 14, 2009 9:04 pm

bob90245 wrote:The article doesn't make any sense to me. If an investor is worried about inflation (Roth's main point), wouldn't it be better to buy individual TIPS instead of nominal bonds?


Isn't inflation just one of the reasons why rates might go up? If you don't like that example, can't you just substitute one of the other reasons of your choosing? I don't think the reason has much to do with the overall point.
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Postby bob90245 » Mon Dec 14, 2009 9:11 pm

Rodc wrote:
bob90245 wrote:The article doesn't make any sense to me. If an investor is worried about inflation (Roth's main point), wouldn't it be better to buy individual TIPS instead of nominal bonds?

Isn't inflation just one of the reasons why rates might go up? If you don't like that example, can't you just substitute one of the other reasons of your choosing? I don't think the reason has much to do with the overall point.

There are very few reasons why the price of bonds should change. Inflation drives interest rates as Roth correctly points out.

On the other hand, if you hold corporate bonds, then changes in the credit rating of the issuing corporation would change the bond price. But as Larry commented, investors are not compensated to take that risk.
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Postby Jacobkg » Mon Dec 14, 2009 9:15 pm

I agree that tax-exempt bonds throw a wrench in the argument I made above. The question I guess then is what alternatives do you (and me too) have to investing in low-cost municipal bond funds. According to Larry Swedroe's book on bonds, he does not recommend investing less than $200,000 in individual bonds (I think that's 20 issues at $10,000 each, though I forget the exact numbers). Even then, I think the costs associated with buying (and selling) individual bonds would probably rival the relatively small capital gains you might incur by holding funds (that is pure speculation on my part, I have no data to support it). Bond funds are also more liquid, in case you need to sell some unexpectedly.

As far as the target-date style bond funds, I think I heard that iShares is going to be creating some ETFs. (see, for example, viewtopic.php?p=590180). I don't know how the taxes would work out in such a case.

At any rate, for me the liquidity and simplicity of Vanguard bond funds are preferable to holding individual bonds. I may, however, buy some iBonds or treasury notes at TreasuryDirect at some point.
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Postby Rodc » Mon Dec 14, 2009 10:01 pm

bob90245 wrote:
Rodc wrote:
bob90245 wrote:The article doesn't make any sense to me. If an investor is worried about inflation (Roth's main point), wouldn't it be better to buy individual TIPS instead of nominal bonds?

Isn't inflation just one of the reasons why rates might go up? If you don't like that example, can't you just substitute one of the other reasons of your choosing? I don't think the reason has much to do with the overall point.

There are very few reasons why the price of bonds should change. Inflation drives interest rates as Roth correctly points out.

On the other hand, if you hold corporate bonds, then changes in the credit rating of the issuing corporation would change the bond price. But as Larry commented, investors are not compensated to take that risk.


I would think that if the Fed tightens the money supply due perhaps to a fear of inflation (rather than inflation itself), or if China stops lending us gobs of money, we could see rates rise without inflation.
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Postby bob90245 » Mon Dec 14, 2009 10:36 pm

Rodc wrote:I would think that if the Fed tightens the money supply due perhaps to a fear of inflation (rather than inflation itself) ...

We're talking specifically about bonds, not bills or notes. Fed action will move shorter maturities, I agree. However, as far as I know, the Fed policy has little control over longer maturities, say, 5 years or more. Inflation is the overwhelming factor that drives bond rates.

Rodc wrote:... or if China stops lending us gobs of money

Right now, the Treasury has no problem finding buyers for its debt. If China wishes to sit out the next auction, other buyers will take their place.
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Postby linuxizer » Mon Dec 14, 2009 10:45 pm

bob90245 wrote:
Rodc wrote:I would think that if the Fed tightens the money supply due perhaps to a fear of inflation (rather than inflation itself) ...

We're talking specifically about bonds, not bills or notes. Fed action will move shorter maturities, I agree. However, as far as I know, the Fed policy has little control over longer maturities, say, 5 years or more. Inflation is the overwhelming factor that drives bond rates.


Aren't there fairly large swings in even long-term TIPS rates? Not all of that is liquidity premium....
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Postby fishnskiguy » Mon Dec 14, 2009 10:59 pm

bob90245 wrote:
Rodc wrote:I would think that if the Fed tightens the money supply due perhaps to a fear of inflation (rather than inflation itself) ...

We're talking specifically about bonds, not bills or notes. Fed action will move shorter maturities, I agree. However, as far as I know, the Fed policy has little control over longer maturities, say, 5 years or more. Inflation is the overwhelming factor that drives bond rates.

Rodc wrote:... or if China stops lending us gobs of money

Right now, the Treasury has no problem finding buyers for its debt. If China wishes to sit out the next auction, other buyers will take their place.



Inflation is the overwhelming factor that drives the non-real portion of bond rates.

The real return of treasuries is driven by (a) demand for capital and (b) the perceived risk of failure of the government to be able to pay.

Real return seems to swing between 1% and 4%, with 4% maybe an outlier due to TIPS newness (is that a word?) when they first came out. The inflation portion has been much bigger: maybe 2% to 12%.

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Postby spam » Tue Dec 15, 2009 6:50 am

Why is it that the Boglehead is supposed to hold equities through market crashes without any thought, and then sell individual bonds or CD's at the worst possible time before maturity? Does anyone else sense this inconsistancy?

What Allen is talking about is Opportunity Cost. I have a news flash. There is opportunity cost in every investment. There might be one exception if you happened to come accross it. That would be to buy this years best performer at the lowest possible price ... to the penny. If you managed to do this, then good for you. Next year, the weeping and gnashing of your teeth will resume as some other investment took the top spot.

I am underwhelmed. I was hoping to read a good article about immunization, or at least something about the intelligent use of either bonds or bond funds. I got neither. I want my money back.
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Postby linuxizer » Tue Dec 15, 2009 7:53 am

spam wrote:Why is it that the Boglehead is supposed to hold equities through market crashes without any thought, and then sell individual bonds or CD's at the worst possible time before maturity? Does anyone else sense this inconsistancy?


Because bonds are not stocks. Roth's point is that the opportunity cost is exactly equal to the price change. Opportunity cost is a real thing if you are invested in lower-yielding cash accounts when you could have stayed the course in bond funds.
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Postby JeremiahS » Tue Dec 15, 2009 10:41 am

spam wrote:I want my money back.


That's the problem with free advice.
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Postby Rodc » Tue Dec 15, 2009 12:18 pm

bob90245 wrote:
Rodc wrote:I would think that if the Fed tightens the money supply due perhaps to a fear of inflation (rather than inflation itself) ...

We're talking specifically about bonds, not bills or notes. Fed action will move shorter maturities, I agree. However, as far as I know, the Fed policy has little control over longer maturities, say, 5 years or more. Inflation is the overwhelming factor that drives bond rates.

Rodc wrote:... or if China stops lending us gobs of money

Right now, the Treasury has no problem finding buyers for its debt. If China wishes to sit out the next auction, other buyers will take their place.


On point one, you might be right. Changes at the short end tend, I think, to end up reflected at the longer end, but the yield curve can invert. I suspect we'd see a connection, but then again, maybe not.

As to the second, maybe. Well, yes other buyers will take their place, but at what price? Supply and demand and all that.
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Postby Jacobkg » Tue Dec 15, 2009 1:18 pm

"Why is it that the Boglehead is supposed to hold equities through market crashes without any thought, and then sell individual bonds or CD's at the worst possible time before maturity? Does anyone else sense this inconsistancy? "

I apologize for being slow, but I do not understand this statement. Can you please elaborate on which parts of the article are telling you to "sell individual bonds...at the worst possible time before maturity"? Also, where is the analogous situation with Stocks where you are being told to "hold equities...without any thought"? When you say that "What Allen is talking about is Opportunity Cost. I have a news flash. There is opportunity cost in every investment", are you inferring that Allan is implying otherwise? Please explain how?

Thanks.
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Postby bob90245 » Tue Dec 15, 2009 1:59 pm

Jacobkg wrote:When you say that "What Allen is talking about is Opportunity Cost. I have a news flash. There is opportunity cost in every investment", are you inferring that Allan is implying otherwise? Please explain how?

That was my impression, too. Why single out bonds as having opportunity cost while not mentioning that stocks also have opportunity cost, too. Sure, we all would like to avoid buying bonds (and stocks) right before their price drops. Unfortunately, your crystal ball is as cloudy as mine.
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Postby Allan Roth » Tue Dec 15, 2009 2:25 pm

bob90245 wrote:The article doesn't make any sense to me. If an investor is worried about inflation (Roth's main point), wouldn't it make more sense to buy individual TIPS instead of nominal bonds?


I'm a fan of TIPS. Here is something I wrote for Financial Planning Magazine on tips on TIPS.

http://www.financial-planning.com/fp_is ... 398-1.html
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Postby Allan Roth » Tue Dec 15, 2009 2:29 pm

bob90245 wrote:
Jacobkg wrote:When you say that "What Allen is talking about is Opportunity Cost. I have a news flash. There is opportunity cost in every investment", are you inferring that Allan is implying otherwise? Please explain how?

That was my impression, too. Why single out bonds as having opportunity cost while not mentioning that stocks also have opportunity cost, too. Sure, we all would like to avoid buying bonds (and stocks) right before their price drops. Unfortunately, your crystal ball is as cloudy as mine.


I agree that there is opportunity cost in every investment. I was only pointing out that holding a bond until maturity didn't eliminate the loss from the rise in interest rates.
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Allan Does Like Short-term C.D.s

Postby nvboglehead » Tue Dec 15, 2009 2:47 pm

I mostly agree with Allan that funds are better. But even he sees the wisdom of buying short-term c.d.s when they are offered at a nice premium to US Treasurys with comparable maturities. He makes this point in his book, How a Second Grader Beats Wall Street.

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Postby natureexplorer » Tue Dec 15, 2009 3:03 pm

Allan Roth wrote:I'm a fan of TIPS. Here is something I wrote for Financial Planning Magazine on tips on TIPS.

http://www.financial-planning.com/fp_is ... 398-1.html

Help them to remember that real return = rate x (1-marginal tax rate) - inflation.

Wouldn't the after-tax real return be negative in many cases (e.g. tax brackets 28% or higher or high inflation) in a taxable account?
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Postby Allan Roth » Tue Dec 15, 2009 3:57 pm

natureexplorer wrote:
Allan Roth wrote:I'm a fan of TIPS. Here is something I wrote for Financial Planning Magazine on tips on TIPS.

http://www.financial-planning.com/fp_is ... 398-1.html

Help them to remember that real return = rate x (1-marginal tax rate) - inflation.

Wouldn't the after-tax real return be negative in many cases (e.g. tax brackets 28% or higher or high inflation) in a taxable account?


Yes - the higher the inflation rate the lower the after-tax real return. Thus, while TIPS give us some insurance against inflation, they pay even more in real terms if it doesn't materialize.
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Postby natureexplorer » Tue Dec 15, 2009 4:00 pm

Allan Roth wrote:
natureexplorer wrote:
Allan Roth wrote:I'm a fan of TIPS. Here is something I wrote for Financial Planning Magazine on tips on TIPS.

http://www.financial-planning.com/fp_is ... 398-1.html

Help them to remember that real return = rate x (1-marginal tax rate) - inflation.

Wouldn't the after-tax real return be negative in many cases (e.g. tax brackets 28% or higher or high inflation) in a taxable account?


Yes - the higher the inflation rate the lower the after-tax real return. Thus, while TIPS give us some insurance against inflation, they pay even more in real terms if it doesn't materialize.

Would you hence still recommend to hold TIPS for someone with limited tax-advantaged space?
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TIPS in taxable?

Postby Taylor Larimore » Tue Dec 15, 2009 4:05 pm

H NE:

Unless I were in a very low tax-bracket, I would not own TIPS in a taxable account.
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Postby magellan » Tue Dec 15, 2009 4:09 pm

bob90245 wrote:
Jacobkg wrote:When you say that "What Allen is talking about is Opportunity Cost. I have a news flash. There is opportunity cost in every investment", are you inferring that Allan is implying otherwise? Please explain how?

That was my impression, too. Why single out bonds as having opportunity cost while not mentioning that stocks also have opportunity cost, too. Sure, we all would like to avoid buying bonds (and stocks) right before their price drops. Unfortunately, your crystal ball is as cloudy as mine.

Predictable cash flows. That's the reason it's possible/reasonable to single out bonds w.r.t. opportunity cost. Aside from credit risk, the cash flows from bonds are entirely predictable. With stocks, cash flows are totally unpredictable. That doesn't mean that real investment returns from bonds are more predictable than returns from stocks, but it is still a distinction with a very big difference and it enables a different kind of analysis on bonds that just isn't available for stocks.

Once you take credit risk out of the equation, you can compare two different bonds in a way that you can never do with stocks. This allows these opportunity cost considerations to be meaningful in a real-world sense, not just as an academic exercise.

Sure, Modern Portfolio Theory asserts that the risk premiums on various stocks are inextricably tied together also, but in practical terms, there are too many unknowable variables to meaningfully compare the future cash flow implications of selling one stock and replacing it with another. With bonds, these comparisons are meaningful.

I've been an adjunct finance instructor for almost 10 years and I've got to say that this concept of opportunity cost is probably the toughest one to get across to students. It's right up there with the related concept of sunk costs in terms of how hard it can be for students to grasp. I think it's something about how our brains are wired. But boy, I'm convinced we're definitely not naturally inclined to think about things this way. In some ways it's like looking at one of those puzzle-pictures with a pattern hidden inside it. Once you see the pattern, it's obvious and easily recognizable, but until you see it for the first time, it just doesn't seem to be there.

Jim

PS - This thread about the real-world limitations of the Gordon Growth Model really drives home how the unpredictability of cash flows from stocks makes them nearly impossible to value reliably and drives home this important difference between bonds and stocks.
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Re: TIPS in taxable?

Postby natureexplorer » Tue Dec 15, 2009 4:35 pm

Taylor Larimore wrote:H NE:

Unless I were in a very low tax-bracket, I would not own TIPS in a taxable account.


Thanks! What would you recommend instead?
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Re: TIPS in taxable?

Postby Taylor Larimore » Tue Dec 15, 2009 4:53 pm

Hi again:

I would fill-up my tax-deferred accounts with taxable bonds before even thinking of locating them in a taxable account.

After that, if bonds are still needed and I was in a higher tax bracket, I would use a good quality short-or intermediate-term tax-exempt bond fund. Maybe a state bond fund.

In a low-tax bracket, in a taxable account--probably Total Bond Market or I-bonds.
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Postby natureexplorer » Tue Dec 15, 2009 5:33 pm

Taylor, thanks!
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Postby spam » Tue Dec 15, 2009 5:50 pm

Allen Roth wrote:

I agree that there is opportunity cost in every investment. I was only pointing out that holding a bond until maturity didn't eliminate the loss from the rise in interest rates.


Hi Allen,

There is a big difference between "opportunity cost" which siphons a bit of gravy off a maturing CD, and the loss of principal that can happen when selling a bond fund that never matures.

If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100.

I guess that I should have bought that 1-year CD instead huh?

You are grieving the loss of a 2% interest rate increase (opportunity cost) by forgetting that it is multiplied with the duration (7 for example) to equal a loss of 14% in the NAV of the bond fund.
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Postby Jacobkg » Tue Dec 15, 2009 7:20 pm

"If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100. "

If you had bought a bond with the same duration as VBMFX for the same amount, and sold it a year later, you would have lost the same $1,100.
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Postby tfb » Tue Dec 15, 2009 11:11 pm

Jacobkg wrote:"If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100. "

If you had bought a bond with the same duration as VBMFX for the same amount, and sold it a year later, you would have lost the same $1,100.

No you would not. The bond's duration decreases over that one year period while the fund's duration does not. Suppose interest rates go up three years in a row, the loss from the bond will be much smaller than the loss from the fund.
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Postby fishnskiguy » Tue Dec 15, 2009 11:29 pm

spam wrote:Allen Roth wrote:

I agree that there is opportunity cost in every investment. I was only pointing out that holding a bond until maturity didn't eliminate the loss from the rise in interest rates.


Hi Allen,

There is a big difference between "opportunity cost" which siphons a bit of gravy off a maturing CD, and the loss of principal that can happen when selling a bond fund that never matures.

If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100.

I guess that I should have bought that 1-year CD instead huh?

You are grieving the loss of a 2% interest rate increase (opportunity cost) by forgetting that it is multiplied with the duration (7 for example) to equal a loss of 14% in the NAV of the bond fund.


Wrong.

An investment of $13439 into VBMFX in October 1993 grew to $14156 in October 1994.

Bond funds pay dividends. Capice?

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Postby linuxizer » Tue Dec 15, 2009 11:36 pm

spam wrote:If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100.

I guess that I should have bought that 1-year CD instead huh?


Spam-

This isn't even close to a consistent comparison. You're comparing a fund which assumes credit risk with a duration of just over 4 years to a CD (which has no credit risk) with a duration of just under 1 year. If you knew you needed the money in 1 year, buying VBMFX was simply not a good idea.

Were this coming from someone else I would say that you should just read more, but given that from our past conversations it appears that you have clearly read plenty of explanations, learned (Mr. Roth's, for one) and otherwise (mine) of how bonds (both funds and individual bonds) react to interest rate changes and still insist on coming up with ridiculous examples like this one, I am starting to think that you simply don't want to acknowledge any other opinion, no matter how well-supported.

I can refer you to our previous conversations on this issue and to the wiki, but I'm not sure it will help if you are not open to the possibility that funds will not cost you the farm.
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Postby linuxizer » Tue Dec 15, 2009 11:40 pm

tfb wrote:
Jacobkg wrote:"If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100. "

If you had bought a bond with the same duration as VBMFX for the same amount, and sold it a year later, you would have lost the same $1,100.

No you would not. The bond's duration decreases over that one year period while the fund's duration does not. Suppose interest rates go up three years in a row, the loss from the bond will be much smaller than the loss from the fund.


Bond duration does not decrease linearly for coupon-paying bonds. See my graph in the thread I linked to above. So you gain a lot less protection than you think you do by holding a coupon-paying bond and allowing time to lapse, at least in the first few years of the bond's existence.

Regardless, if you're withdrawing funds from an IT bond fund because you need the money, you were invested inappropriately (duration >> investment horizon) to begin with.
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Postby tfb » Wed Dec 16, 2009 12:11 am

linuxizer wrote:
tfb wrote:
Jacobkg wrote:"If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100. "

If you had bought a bond with the same duration as VBMFX for the same amount, and sold it a year later, you would have lost the same $1,100.

No you would not. The bond's duration decreases over that one year period while the fund's duration does not. Suppose interest rates go up three years in a row, the loss from the bond will be much smaller than the loss from the fund.


Bond duration does not decrease linearly for coupon-paying bonds. See my graph in the thread I linked to above. So you gain a lot less protection than you think you do by holding a coupon-paying bond and allowing time to lapse, at least in the first few years of the bond's existence.

Regardless, if you're withdrawing funds from an IT bond fund because you need the money, you were invested inappropriately (duration >> investment horizon) to begin with.

Non-linearly, true, but decreasing nonetheless. I was only commenting on the quoted assertion. I didn't say it was appropriately invested or not. Nor did the two posters engaged in that exchange. We can't assume people always invest appropriately. When they don't, one instrument gives them a smaller loss than another.

Please redo the duration graph with an intermediate term bond in today's low yield environment, like the ones typically found in the fund in question. It will be closer to linear than the long term bond you did before.
Last edited by tfb on Wed Dec 16, 2009 12:20 am, edited 3 times in total.
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Postby Jacobkg » Wed Dec 16, 2009 12:15 am

tfb wrote:No you would not. The bond's duration decreases over that one year period while the fund's duration does not.


You are correct sir, my mistake. It is important to recognize that for any individual bond, its duration will continue to shorten as the bond approaches maturity, whereas a bond fund tends to keep the same duration forever.

Nevertheless, I will reiterate my opinion that for the majority of investors, especially those accumulating for retirement, a constant-duration strategy is fitting, especially if it is intermediate-term. As a long-term investment vehicle, a low-cost bond fund will serve quite well, and no worse than a ladder of individual bonds.
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Postby linuxizer » Wed Dec 16, 2009 12:55 am

tfb wrote:Non-linearly, true, but decreasing nonetheless. Please redo the duration graph with an intermediate term bond in today's low yield environment, like the ones typically found in the fund in question. It will be closer to linear than the long term bond you did before.


You are certainly right that IT bonds will have a more linear duration decrease than LT bonds will, as you can see just by eyeballing the graph. Here's a close-up.

Image

More contemporary (lower) interest rates also make the curve flatter, since a greater proportion of the bond's payout is the maturity value:
Image
Image

I was only commenting on the quoted assertion. ... I didn't say it was appropriately invested or not. Nor did the two posters engaged in that exchange. We can't assume people always invest appropriately. When they don't, one instrument gives them a smaller loss than another.


This I disagree with vehemently. The advice to keep your duration shorter than or equal to your investment horizon is everywhere. Blaming failure to follow that advice on some inherent property of bond funds was not the point of the article under discussion here. The point is that bond funds are no riskier than the equivalent duration bond or portfolio of bonds. I have never seen anyone argue that holding a bond fund of 4 years' duration when your investment horizon dwindles to 0 years, as in your example, is the correct thing to do.
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Postby tfb » Wed Dec 16, 2009 1:59 am

linuxizer wrote:
tfb wrote:I was only commenting on the quoted assertion. ... I didn't say it was appropriately invested or not. Nor did the two posters engaged in that exchange. We can't assume people always invest appropriately. When they don't, one instrument gives them a smaller loss than another.


This I disagree with vehemently. The advice to keep your duration shorter than or equal to your investment horizon is everywhere. Blaming failure to follow that advice on some inherent property of bond funds was not the point of the article under discussion here. The point is that bond funds are no riskier than the equivalent duration bond or portfolio of bonds. I have never seen anyone argue that holding a bond fund of 4 years' duration when your investment horizon dwindles to 0 years, as in your example, is the correct thing to do.

Which sentence in the quote do you disagree with? Are you saying we should assume people always invest appropriately? Or are you saying if they didn't invest appropriately, the loss will be the same anyway? I did not blame anything.

The surprise to many investors is not that they should invest in something with a duration shorter than or equal to their investment horizon at the time the investment is made. People get that (I hope). But I haven't seen it emphasized enough that you have to keep it that way all the time as time goes by; that you should have two bond funds and you must shift from one fund to another periodically. It's a relatively new discovery on this forum. I haven't seen it outside of Bogleheads forums.
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Postby Jacobkg » Wed Dec 16, 2009 4:47 am

tfb,

That is a great point and I agree with you wholeheartedly. There are certainly important savings goals that people have which involve a more-or-less fixed end date. Saving for College comes to mind, as does saving for a house, if it is far enough in the future to warrant bond usage at all. I would hate to see someone who has been saving for their child's education for 10 or 15 years with a sizable portion in TBM suddenly see the amount drop by 4 or 5% right before the first payment is due, because they had their portfolio on autopilot and never shortened their duration. Perhaps one day we will see education-savings oriented target-date style funds which have a glide path from aggressive all the way to all-cash.

best,
Jacob
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Postby spam » Wed Dec 16, 2009 6:32 am

Jacobkg wrote:"If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100. "

If you had bought a bond with the same duration as VBMFX for the same amount, and sold it a year later, you would have lost the same $1,100.


Again, we are selling something before maturity. This is the part of the argument that is baffeling. yes, you would loose the same amount, but why would you do that at a loss?

As Bogleheads, we discuss the appropriate use of every investment and attempt to squeeze every single basis point out of it. EXCEPT FOR CD'S AND BONDS.

For some reason, we are locked into a cycle of bad reasoning where we abuse the use of one type of investment so we can crow about how much it is similar to the one we defend.

Why not discuss both the individual CD's strengths along side the strengths of the bond fund. We consistantly fail this simple task by preferring to abuse one investment to make the other look better. Vanguards fees may be low, but they are not ZERO, and it is easy to create a fixed income account with zero costs and fees.

Inside my fixed income portfolio, I hold a 10% slice that is "hold to maturity". My plan for each investment within this slice is ..... to hold to maturity. We never get to this discussion because we are always schilling for Vanguard Bond funds.
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Postby spam » Wed Dec 16, 2009 6:49 am

fishnskiguy wrote:
spam wrote:Allen Roth wrote:

I agree that there is opportunity cost in every investment. I was only pointing out that holding a bond until maturity didn't eliminate the loss from the rise in interest rates.


Hi Allen,

There is a big difference between "opportunity cost" which siphons a bit of gravy off a maturing CD, and the loss of principal that can happen when selling a bond fund that never matures.

If I had bought 1000 shares of VBMFX in October of 1993 for $10.32 each and sold them all a year later in October of 1994 for $9.22, I would have lost $1,100.

I guess that I should have bought that 1-year CD instead huh?

You are grieving the loss of a 2% interest rate increase (opportunity cost) by forgetting that it is multiplied with the duration (7 for example) to equal a loss of 14% in the NAV of the bond fund.


Wrong.

An investment of $13439 into VBMFX in October 1993 grew to $14156 in October 1994.

Bond funds pay dividends. Capice?

Chris


Again we mince words. Of course bond funds pay dividends. This is the only reason we buy them. However, there was a real loss of principal over this time period which amounted to $1.10 per share.

Meanwhile we labor over the "opportunity cost" of missing a slightly better yield over that 1 year period.

Image

Right now, bond funds are trading at or near their historic highs. There are hints of inflation, and interest rate increases could easily batter their NAV. This could be a very good time to either be short term, or in a ladder. Unfortunately, the analysis of the ladder seems to fall short of its intended purpose.

The time horizon is always unlimited when discussing bond funds, and we always fall into analysis that includes selling the individual bond before it matures.
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