A Dangerous Misunderstanding about Bond Rates?

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Ranger
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Ranger »

patrick wrote: This is wrong because it ignores the recovery of the principal value of bonds as they get closer to maturity.
Ahh. My calculation was based on single bond. Yes, it does recover because of the laddering of bonds. But in the rising interest rate environment it will still end up loser because of rising inflation. I guess holding Inflation bonds and regular TBM will mitigate the risk.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Ranger: At the current time it is the real rates that are rising. Inflation is relatively unchanged at a very low level. For example, the real return on the 10 year TIPS has increased by more than 1% in the last year.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Electron »

Scooter57 wrote:I keep seeing people posting in various threads that rising rates are good for bond funds because it means they'll be earning more interest.
Those concerned about NAV loss can simply invest in bond ladders rather than bond funds. Higher rates will be welcome when a bond matures and is replaced with a bond at a higher interest rate.

The post about bond returns from 1940 through 1980 makes an excellent point, but note also the extreme rise in rates over that particular period.

http://research.stlouisfed.org/fred2/se ... 10?cid=115

Lastly, we should not forget why we own bonds. They are a source of income and a hedge against deflation and any shock to the economy or stock market. Diversification means that all asset classes in a portfolio may not perform well all the time.
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Ranger
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Ranger »

billyt wrote:Ranger: At the current time it is the real rates that are rising. Inflation is relatively unchanged at a very low level. For example, the real return on the 10 year TIPS has increased by more than 1% in the last year.
Yes, these days are anomaly. But otherwise correlation is pretty strong between rising interest rate and rising CPI. Here is the FRED graph

Image
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Ranger: the correlation exists but it's driven by inflation. A rise necessarily causes rising interest rates because nobody is willing to hold 2% bonds with 10% inflation anymore.

You can't just say "interest rates can only go up from here" and conclude that inflation is soon to follow. You have to make some arguments specifically about inflation.
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Phineas J. Whoopee
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Phineas J. Whoopee »

Hi Scooter,

I'm happy to see you've abandoned some of your previous incorrect notions.

What part of the word "fixed" in the term "fixed income" do you think only you understand?

PJW
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by pastafarian »

Scooter57 wrote:Well, I remember going to the grocery store each week in 1981...

So while it might not have been Weimar Germany, it was pretty darn scary and it had major implications for me for the next 25 years as far as what I could afford to live in. It isn't anything I ever want to live through again, that's for sure.
I remember 1981 vividly too. The Solidarity movement in Poland, Soviet troop movements along the Polish frontier, DDR's mobilization drills along the German border picked up by our intel sources. I remember my squadron in Germany prepping for the Soviet invasion of Poland that HQ USAFE said was inevitable. I remember thinking as the brand new guy, I might die before I ever completed my mission ready qualification. Prepping for World War III occupied most of my time...flying fast and low over Germany...and chasing women...and drinking German beer. Three years later I bought my first house with a 13% interest rate. Interest rates didn't scare me then, I can't imagine the discomfort you felt checking prices in the grocery store.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Phineas J. Whoopee »

pastafarian wrote:
Scooter57 wrote:Well, I remember going to the grocery store each week in 1981...

So while it might not have been Weimar Germany, it was pretty darn scary and it had major implications for me for the next 25 years as far as what I could afford to live in. It isn't anything I ever want to live through again, that's for sure.
I remember 1981 vividly too. The Solidarity movement in Poland, Soviet troop movements along the Polish frontier, DDR's mobilization drills along the German border picked up by our intel sources. I remember my squadron in Germany prepping for the Soviet invasion of Poland that HQ USAFE said was inevitable. I remember thinking as the brand new guy, I might die before I ever completed my mission ready qualification. Prepping for World War III occupied most of my time...flying fast and low over Germany...and chasing women...and drinking German beer. Three years later I bought my first house with a 13% interest rate. Interest rates didn't scare me then, I can't imagine the discomfort you felt checking prices in the grocery store.
:beer
Well said.

When France occupies the Financial District and Silicon Valley to seize all the output as war reparations I'll get worried.

PJW
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by fishnskiguy »

Scooter57 wrote:

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

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

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


The person who bought a CD ladder during the same period, in contrast, will end up with more money each year even if the CD ladder started out paying less than the bond fund. If it paid the same as the bond fund when the intial investments were made, the CD ladder will way outperform the bond fund. It will always give a positive return. And if the CDs can be broken, long low paying CDs can be broken with the loss of only perhaps 6 months of interest (.5% to 1%) and reinvested at 3% or 4% when rates reach that level, further boosting gains.
If someone can show me why the math in MY example is flawed, I'd greatly appreciate it. Every single example I've seen including those from Vanguard, shows what happens after 1 year of falling rates or harks back to a period when rates started to rise from a MUCH higher initial interest rate which has a big .
The part I have highlighted in red is one hundred percent wrong.

A bond fund with a duration of something around 2.5 years and a five year rolling CD ladder will be worth within pennies of each other over a twenty year period no matter how interest rates change or when they change or how much they change. Well, OK, a large upward rate spike in year eighteen or nineteen will have the bond fund worth a smidgen less than the CD ladder, but otherwise they will be worth the same.

In my humble opinion, Scooter 57 is doing a significant disservice to bond fund holders by suggesting that CDs are some how a much better long term investment than a good old intermediate term bond fund. They are not. And I say this as a guy who has held short and intermediate term bond funds and CD ladders in various form for most of the last fifty years.

Sure, a CD ladder provides the psychological crutch of never going down in value following a rise in interest rates, but then a CD ladder won't pop up in value like a bond fund does when rates drop.

A bond fund will perform exactly like a rolling ladder of similarly durationed bonds held to maturity. It has to, lest the laws of mathematics be violated.

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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Ranger »

ogd wrote: You have to make some arguments specifically about inflation.

Here is one scenario. If and when traders perceive expansionary monetary policy will come to an end, they push the interest rates up. This increase in interest rate kicks up mortgage rate and hence less affordability of housing and increase in rental prices. Both rental prices and mortgage rate(financing cost) is part of OER (Owners Equivalent Rent). OER is big part of CPI(U). We already seen mortgage rate spiking 100 bp in last month.

There are some other factors like wage increase in last couple of reports (even tho' from very low base) and higher oil prices in last couple of months will trickle thro' in next couple of months. Also corporations in good financial health have pricing power these days.

One can neglect above factors as normal, but OER will have huge effect in my personal opinion in the next year report.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Ranger: sure, but both mortgage rates and oil have been at this level or higher and inflation was still a no-show. Anyway, this is going off-topic - perhaps worth opening a different thread.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Scooter57 »

I'm seeing snarly personal attacks here, and assertions stated as if they were self-evident, but no fact-based arguments supporting the claims being made that my arguments are wrong.

When people resort to personal attacks it's usually a sign that they don't have compelling arguments to offer, so they try to distract people with ad hominem attacks.

In ten years we'll all have a much better understanding of how bond funds work. Meanwhile, I urge anyone who is confused by the many different opinions found here--and elsewhere--to take your time before making any major bond fund investment. Don't rely on the assertions of any anonymous poster unless they are backed up with compelling arguments backed up with documented facts.

The rancor bond discussions produce of late suggest that some people are very uncomfortable with the possibility that their beliefs might be wrong and responding very emotionally to anyone who raises issues that make them uncomfortable. Objective observers can draw their own conclusions. I've made my arguments and supported them, and I'm moving on. Time will tell who was "doing a significant disservice" by urging people consider CDs in place of bond funds.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Scooter57: what happened to the data? This:
ogd wrote:
Scooter57 wrote:Invest 10,000 at 1%. Rates go up 1% to 2%. Principal drops to $9,500. At the end of year 1 you have $9690. ($9500*1.02)
Rates rise to 3%. Your $9590 loses 5% and becomes $9206. At the end of year 2 you have $9878 ($9206 * 1.03).
Rates go up another 1% to 4%. Your $9878 loses another 5% and you have $9,384. At the end of the year 3 you have $9,759 ($9,384*1.04)
Rates go up another 1% to 5%. Your $9,759 drops by 5% and you have $9271. At the end of year 4 you have $9735. (9271*1.05)
Rates go up another 1% to 6%. Your $9735 loses 5% and you have $9248. At the end of year 5 you have $9,803.
...
If someone can show me why the math in MY example is flawed, I'd greatly appreciate it.
Scooter57: Your example completely ignores the recovery in bond values as they approach maturity inside the fund. This is going to take some work, but considering that you are saying that about half of the bogleheads philosophy is wrong and Vanguard is being deceitful and other things like that, you owe it to us. Here's how to begin:
Read http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics in detail
Use http://www.treasury.gov/resource-center ... &year=2013 to see yield curves, under e.g. rate changes of the past.
Consider a simple model of an intermediate fund that takes 7 year bonds down to 3 years, then sells them. The fund start from a steady state of owning 5 bonds at 7, 6, 5, 4, 3 years from maturily respectively.
Use http://www.investopedia.com/calculator/bondprice.aspx to compute the prices at which these bonds are exchanged.
Then come back here and report the numbers. I am very confident that the return won't be negative.
You need to own up to it, I think.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by fishnskiguy »

Scooter57 wrote:I'm seeing snarly personal attacks here, and assertions stated as if they were self-evident, but no fact-based arguments supporting the claims being made that my arguments are wrong.

When people resort to personal attacks it's usually a sign that they don't have compelling arguments to offer, so they try to distract people with ad hominem attacks.

In ten years we'll all have a much better understanding of how bond funds work. Meanwhile, I urge anyone who is confused by the many different opinions found here--and elsewhere--to take your time before making any major bond fund investment. Don't rely on the assertions of any anonymous poster unless they are backed up with compelling arguments backed up with documented facts.

The rancor bond discussions produce of late suggest that some people are very uncomfortable with the possibility that their beliefs might be wrong and responding very emotionally to anyone who raises issues that make them uncomfortable. Objective observers can draw their own conclusions. I've made my arguments and supported them, and I'm moving on. Time will tell who was "doing a significant disservice" by urging people consider CDs in place of bond funds.
As a moderator on this forum, I keep a pretty sharp eye out for personal attacks. I've seen none on this thread. It's not a personal attack to point out errors. That's all most of us are trying to do.

Chris
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by pastafarian »

Scooter57 wrote:I'm seeing snarly personal attacks here..
Hey it's just my avatar. :wink:
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

It is really a disservice to suggest that there is some mystery about 'how bond funds work'. There is an immense literature about bond strategies going back many years. Any sensible strategy for open-ended investing in individual bonds essentially amounts to creating your own bond fund. Why re-invent the wheel? For many of us, investing in a bond index fund, or a low cost, conservatively run managed fund, is optimum. Yes, markets are always full of surprises, but the behavior of bond funds is reasonably well constrained by the laws of mathematics. Collecting a bunch of bonds into a fund does not somehow magically change a staid and predictable security into a scary and erratic investment vehicle. Yes, there are well known risks for bonds and bond funds (eg inflation). You know what you are getting when you buy a bond fund (the current SEC yield). There are no monsters hiding under the bed.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Munir »

fishnskiguy wrote:
Scooter57 wrote:I'm seeing snarly personal attacks here, and assertions stated as if they were self-evident, but no fact-based arguments supporting the claims being made that my arguments are wrong.

When people resort to personal attacks it's usually a sign that they don't have compelling arguments to offer, so they try to distract people with ad hominem attacks.

In ten years we'll all have a much better understanding of how bond funds work. Meanwhile, I urge anyone who is confused by the many different opinions found here--and elsewhere--to take your time before making any major bond fund investment. Don't rely on the assertions of any anonymous poster unless they are backed up with compelling arguments backed up with documented facts.

The rancor bond discussions produce of late suggest that some people are very uncomfortable with the possibility that their beliefs might be wrong and responding very emotionally to anyone who raises issues that make them uncomfortable. Objective observers can draw their own conclusions. I've made my arguments and supported them, and I'm moving on. Time will tell who was "doing a significant disservice" by urging people consider CDs in place of bond funds.
As a moderator on this forum, I keep a pretty sharp eye out for personal attacks. I've seen none on this thread. It's not a personal attack to point out errors. That's all most of us are trying to do.

Chris
Scooter's comments on personal attacks (that seem to be continuing) are correct and valid.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Munir: If you are referring to my post, I apologize. Just trying to point in the direction the fact-based evidence. I am aware that my tone may come off as aggressive. Just my personality. Again, apologies for any perceived offense.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Munir »

billyt wrote:Munir: If you are referring to my post, I apologize. Just trying to point in the direction the fact-based evidence. I am aware that my tone may come off as aggressive. Just my personality. Again, apologies for any perceived offense.
Thanks for commenting, billyt. I wasn't thinking specifically of your post, but the general tone used againt scooter. I don't necessarily agree with everything he says, and he has used strong langauge in the past himself, but seems to have moderated his tone recently. Some posters try and hide their hositility behind "jokes" which really are not funny if one is the target. My point is that maybe the moderator who is commenting on this isuue is missing such comments. Of course, I might be the one to be called thin-skinned and seeing offenses when none are intended but aren't insults usually seen by the eyes of the beholdeth?

Maybe it's time for all to lighten up and move on- including myself.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by pastafarian »

Munir wrote:Thanks for commenting, billyt. I wasn't thinking specifically of your post, but the general tone used againt scooter. I don't necessarily agree with everything he says, and he has used strong langauge in the past himself, but seems to have moderated his tone recently. Some posters try and hide their hositility behind "jokes" which really are not funny if one is the target. My point is that maybe the moderator who is commenting on this isuue is missing such comments. Of course, I might be the one to be called thin-skinned and seeing offenses when none are intended but aren't insults usually seen by the eyes of the beholdeth?

Maybe it's time for all to lighten up and move on- including myself.
Oh my...we are a pretty sensitive crowd. Please do not infer that in the pejorative, that is not implied. My joke was a play on scooter57's use of the word "snarly" instead of "snarky." My avatar shows Hobbes making a face, not really snarling. Hostility toward scooter57? I suspect or at least hope he was employing what I'd best describe as hyperbole with respect to him being scared in 1981. For me 1981 was one of the most exciting years in my life. I tell my co-pilots that my tour in Germany was more fun than a bachelor ought to have. Investing and retirement planning never entered my mind. So I stand by my statement that I have no sense for his discomfort. I do however take exception to his persistent message that bond fund owners are making a terrible mistake and he's here to show us the error of our ways. [hyperbole]And if we don't reform to his line of thought, embrace his sermon, he'll continue to remind the timid/unsure/hesitant amongst us why owning bond funds is stupid.[/hyperbole]

Cheers :beer
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by hollowcave2 »

But reading these threads it seems to me that a lot of people are confused and think that a immediate rise in the yield of a fund means that they will be earning more each month.
I think most people on this board are savvy enough to know that it takes time. Most investors also know about the concept of duration and how important it is to invest in a fund for a period longer than its duration. I hope that most people on this board don't expect an instant result.

Slowly rising rates are good for bond funds over the long run.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

There is an interesting question there. Assuming one is holding the fund for their investment lifetime (in other words well past the duration), which is better for the total return over the long run: a dramatic rise in rates that stabilizes at a higher level, or several years of gradually rising rates. I am not sure, but I think a big, one time, rise in rates is better for your total return, but of course might be very disruptive to the markets.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by rustymutt »

Bonds are simple to understand. If rates go up, the price of the bond will drop, and visa versa.
Even educators need education. And some can be hard headed to the point of needing time out.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Yes, of course, but the higher rates make up for the loss and you will earn more over time than if rates had not risen.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by rkhusky »

billyt wrote:There is an interesting question there. Assuming one is holding the fund for their investment lifetime (in other words well past the duration), which is better for the total return over the long run: a dramatic rise in rates that stabilizes at a higher level, or several years of gradually rising rates. I am not sure, but I think a big, one time, rise in rates is better for your total return, but of course might be very disruptive to the markets.
It depends on how much the interest rate changes and how fast. I have a few plots here that illustrate the issue:

http://www.bogleheads.org/forum/viewtop ... 8#p1729815
http://www.bogleheads.org/forum/viewtop ... 8#p1731284
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Thanks for that rkhusky. So it is true that, despite the initial pain, a sharp one-time increase in rates provides better returns going forward than a gradual one.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

billyt wrote:There is an interesting question there. Assuming one is holding the fund for their investment lifetime (in other words well past the duration), which is better for the total return over the long run: a dramatic rise in rates that stabilizes at a higher level, or several years of gradually rising rates. I am not sure, but I think a big, one time, rise in rates is better for your total return, but of course might be very disruptive to the markets.
billyt: the big rise is better without a doubt. You can even prove it: a dollar invested in the fund in that scenario earns at least as much interest at any point in time than in the slow rise scenario. It earns more as soon as you begin to reinvest capital. From then on it's just a matter of waiting long enough to make up the difference in NAV loss between the two scenarios, which means duration or less.

We've seen variants of the slow rise scenario in the past: between 6/16/2003 and 6/18/2007 5 year treasury rates rose from a low of 2.08% to a high of 5.18%, against a backdrop of Fed funds rate going from 1% to 5.25%. What happened to Treasury funds? the IT fund VFIUX returned 6.8% between those exact dates, which is not a stellar return for four years, but it's not a disaster either. I wish we had had another year or two of stable rates to see it actually pull ahead of where it would have been without the rate increase (+8% -ish), but of course the crisis followed and Treasuries were golden for the next couple of years.

Edit: also, the 6.8% number is with perfect timing. If you jumped out 1 month before the low, you have to beat 9.4% returns. If you jumped back in 1 month after the high, you have to beat 8.1%. 3 months after the high, 12.6% but we're entering financial crisis territory which is admittedly unfair.

The point is, it's not that bad, the funds recover and after every increase they are better investments than they were before.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by rkhusky »

billyt wrote:Thanks for that rkhusky. So it is true that, despite the initial pain, a sharp one-time increase in rates provides better returns going forward than a gradual one.
The second link actually shows a situation where the opposite occurs, the gradual increase is better than the sharp increase. I haven't figured out yet what the boundary is, but since this is based on such a simple relationship, I wouldn't put too much stock in precise answers, just the overall idea that eventually you will recoup the value lost in the NAV drop.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

rkhusky wrote:
billyt wrote:Thanks for that rkhusky. So it is true that, despite the initial pain, a sharp one-time increase in rates provides better returns going forward than a gradual one.
The second link actually shows a situation where the opposite occurs, the gradual increase is better than the sharp increase. I haven't figured out yet what the boundary is, but since this is based on such a simple relationship, I wouldn't put too much stock in precise answers, just the overall idea that eventually you will recoup the value lost in the NAV drop.
rkhusky: actually, that second graph bothers me. Are you sure about this? As I mentioned above, there shouldn't be any point in time when the initial investment in the "jump" scenario earns less than the "linear increase" scenario, so "jump" should eventually exceed it like it does in the other graphs. E.g. imagine doing the same to a single bond with a 15 years duration, in the long term the lines overlap. What was your methodology? Would it handle the single bond scenario correctly?
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Thanks, I didn't fully take that in the first time I looked. Seems a little strange as ogd says. Also why is one case still growing faster than the other (the curves are not parallel, but getting farther and farther apart). Could you double-check. I would also like to learn the details of how you modeled that, as I was trying to do the same thing.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by yukon50 »

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

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

How many here who are enthusiastic about rising rates are old enough to remember the inflation of the 60s and hyperinflation of the 70s?
Very interesting thoughts. What did the government do back then to push short term rates artificially low?
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by rkhusky »

billyt wrote:Thanks, I didn't fully take that in the first time I looked. Seems a little strange as ogd says. Also why is one case still growing faster than the other (the curves are not parallel, but getting farther and farther apart). Could you double-check. I would also like to learn the details of how you modeled that, as I was trying to do the same thing.
I used the same method in all the charts, just switched the parameters. I just used the idea that a fund will drop by an amount equal to the duration times the interest rate increase and computed things month by month, including reinvestment of dividends. You are right that after the interest rate increases stop the lines should be parallel. I'll have to check into it.
Last edited by rkhusky on Mon Jul 15, 2013 1:45 pm, edited 1 time in total.
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ogd
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

rkhusky wrote:I used the same method in all the charts, just switched the parameters. I just used the idea that a fund will drop by an amount equal to the duration times the interest rate increase and computed things month by month, including reinvestment of dividends. You are right that after the interest rate increases stop the lines should be parallel. I'll have to check into it.
They should cross at some point afterwards, not just stay parallel. Did you take into account the duration decrease when the rates jump (i.e. convexity)?

(In the single long bond case the lines would eventually overlap, at maturity when the rate stops increasing, and stay so, because the bond never has a chance to profit from higher yields. Anything more dynamic means they cross and "jump" becomes more profitable).
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by david9117 »

Interesting posts and excellent discussions.

I am still left wondering if there is any thing actionable from an portfolio perspective for me.

The various bond scenarios (sudden interest jump, gradual interest increase, inflation etc.) discussed here also need to take into account what the impact on stocks of these various scenarios. Interested in my *** total portfolio change *** w.r.t each of the bond scenarios and not just bonds.

So right now left with investing in total bond index (VBMFX) till I get a better understanding of this interaction.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

ogd, you seem to have a good handle on this. What is the simplest way to model this in an Excel spreadsheet, using simplifying assumptions and rules of thumb? I tried to do this 2 ways:

1) NAV hit is equal to the duration times the rate change, bonds accumulate dividends at the new interest rate (on the new NAV) immediately thereafter. Tried the same thing for both singe rate change and multiple rate changes.

2) Built an imaginary 10-year rolling bond ladder. As bonds are rolled, they get the new interest rate. No NAV adjustment necessary assuming hold to maturity.

I understand that the real world calculations are much more complex, but are these toy models sufficient to get an understanding of how funds work and approximate various hypothetical scenarios?

Suggestions for improvement appreciated.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by rkhusky »

ogd wrote:
rkhusky wrote:I used the same method in all the charts, just switched the parameters. I just used the idea that a fund will drop by an amount equal to the duration times the interest rate increase and computed things month by month, including reinvestment of dividends. You are right that after the interest rate increases stop the lines should be parallel. I'll have to check into it.
They should cross at some point afterwards, not just stay parallel. Did you take into account the duration decrease when the rates jump (i.e. convexity)?

(In the single long bond case the lines would eventually overlap, at maturity when the rate stops increasing, and stay so, because the bond never has a chance to profit from higher yields. Anything more dynamic means they cross and "jump" becomes more profitable).
I assumed the duration remains constant, which is approximately true for a bond fund, unless the overall market changes, which I did not account for.

I also misspoke above. The curves should not be parallel, even though the interest rates are the same, because the curves are starting at different values.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

david9117: I don't think there's anything actionable if you don't fancy yourself a market timer.

You should be mentally prepared for NAV drops, knowing that they'll be recovered in time.

You should keep inflation in mind and how it can affect fixed income, now and always.

If you think yourself able to time future rate increases better than what the market has priced in, then being out of bonds during the increases would help, if the increases were hard and your timing tight. As bogleheads, we tend to not believe that we can do that.

As for funds vs individual bonds, this was always a red herring. The rates affect all bonds alike.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

rkhusky wrote:I assumed the duration remains constant, which is approximately true for a bond fund, unless the overall market changes, which I did not account for.
It's complicated. The duration of a portfolio naturally shortens after a rate increase. The manager can either keep it constant (lengthening maturities) or allow it to stay shorter. The first scenario is probably what you had in mind, but the yields would then be different (edit: higher). The second scenario is simpler to plot but some people might object to its realism. It's complicated :annoyed
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by dm200 »

ogd wrote:
rkhusky wrote:I assumed the duration remains constant, which is approximately true for a bond fund, unless the overall market changes, which I did not account for.
It's complicated. The duration of a portfolio naturally shortens after a rate increase. The manager can either keep it constant (lengthening maturities) or allow it to stay shorter. The first scenario is probably what you had in mind, but the yields would then be different (edit: higher). The second scenario is simpler to plot but some people might object to its realism. It's complicated :annoyed
I don't think you can assume that the duration of a given portfolio will shorten after a rate increase. Isn't that dependent on the nature of the holdings? For example, it may be true of mortgage-type bonds, but not true of Treasury bonds. Please correct me if I am wrong.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Kevin M »

ogd wrote:david9117: I don't think there's anything actionable if you don't fancy yourself a market timer.
Of course there is something actionable, and it's been discussed extensively in other threads (as I think you know): use non-brokered CDs with reasonable early withdrawal terms to reduce your interest-rate risk. You can deride it as market timing if you want, but the closer rates are to 0%, the more sense NB CDs make. And it doesn't have to be all or nothing; as I've mentioned many times, I have gradually moved about 2/3 of my fixed income into CDs as rates have declined, and still have about 1/3 in bond funds (but no treasuries for me, thank you very much; NB CDs provide a higher return with less risk up to 5 year maturities).

Having said this, I disagree with Scooter that a rolling ladder of brokered CDs having less interest-rate risk than a bond fund or a rolling ladder of bonds. A brokered CD responds to changes in interest rates just like a bond, and a perpetual rolling ladder is similar to a fund. The only benefit I know of for federally-insured brokered CDs relative to to treasuries is that you might get higher yields with essentially the same credit risk (none).

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Re: A Dangerous Misunderstanding about Bond Rates?

Post by gerrym51 »

Kevin M wrote:
ogd wrote:david9117: I don't think there's anything actionable if you don't fancy yourself a market timer.
Of course there is something actionable, and it's been discussed extensively in other threads (as I think you know): use non-brokered CDs with reasonable early withdrawal terms to reduce your interest-rate risk. You can deride it as market timing if you want, but the closer rates are to 0%, the more sense NB CDs make. And it doesn't have to be all or nothing; as I've mentioned many times, I have gradually moved about 2/3 of my fixed income into CDs as rates have declined, and still have about 1/3 in bond funds (but no treasuries for me, thank you very much; NB CDs provide a higher return with less risk up to 5 year maturities).

Having said this, I disagree with Scooter that a rolling ladder of brokered CDs having less interest-rate risk than a bond fund or a rolling ladder of bonds. A brokered CD responds to changes in interest rates just like a bond, and a perpetual rolling ladder is similar to a fund. The only benefit I know of for federally-insured brokered CDs relative to to treasuries is that you might get higher yields with essentially the same credit risk (none).

Kevin

Kevin,fidelity today brokered cd-5yr-2 percent new issue
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Electron
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Electron »

Here is a data point for those following John Bogle's simple bond forecasting model for the decade ahead.

The Vanguard site shows the SEC yield for the Total Bond Market Index fund at 3.50% on 7/14/03. Morningstar shows the Ten Year compounded return for the same fund at 4.39% on 7/12/13. Falling interest rates likely played a role in the return being higher than the forecast.

Common Sense on Mutual Funds shows the bond model forecast being off as much as +3.1% in the 1960s and -2.5% in the 1980s. It appears that the bond return forecast may be too high when rates rise and too low when rates decline.

I should note that the simple bond forecasting model uses the rate on Long Term Government bonds. It's not clear how the model performs with an intermediate term bond index fund.
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Kevin M
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Kevin M »

gerrym51 wrote: Kevin,fidelity today brokered cd-5yr-2 percent new issue
Great. Maybe we'll see some higher yields in NB CDs soon.

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Re: A Dangerous Misunderstanding about Bond Rates?

Post by billyt »

Like you said above Kevin, a brokered CD reacts just like a bond. I suspect non-brokered CD's will not. We may by transitioning out of this anomalous period where CD yields were higher than the comparable bond rates.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

dm200 wrote:I don't think you can assume that the duration of a given portfolio will shorten after a rate increase. Isn't that dependent on the nature of the holdings? For example, it may be true of mortgage-type bonds, but not true of Treasury bonds. Please correct me if I am wrong.
It's the other way around actually: duration of Treasury shortens, duration of mortgage-backed securities increases, because fewer of them are being called. I agree that it depends on the type of portfolio. The graph in question was VUSTX, long-term Treasuries.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Kevin M »

billyt wrote:Like you said above Kevin, a brokered CD reacts just like a bond. I suspect non-brokered CD's will not.
Non-brokered CDs cannot react like a bond or brokered CD, since there is no market for them. Assuming an early withdrawal is allowed, the value of the CD always is the original amount purchased plus reinvested and accrued interest minus the early withdrawal penalty.

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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Kevin M wrote:Of course there is something actionable, and it's been discussed extensively in other threads (as I think you know): use non-brokered CDs with reasonable early withdrawal terms to reduce your interest-rate risk. You can deride it as market timing if you want, but the closer rates are to 0%, the more sense NB CDs make. And it doesn't have to be all or nothing; as I've mentioned many times, I have gradually moved about 2/3 of my fixed income into CDs as rates have declined, and still have about 1/3 in bond funds (but no treasuries for me, thank you very much; NB CDs provide a higher return with less risk up to 5 year maturities).
Yes, in some situations non-brokered CDs might be better. The case is less clear-cut as 3 months ago (when, like we discussed, I was a fan of using them instead of shorter Treasuries), and they do have their drawbacks: liquidity, state taxes, can't be used in 401k and general hassle of dealing with random credit unions.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by Kevin M »

^Of course there are some other differences between CDs and bond funds, but I think we're mainly discussing interest-rate risk in this thread, and non-brokered CDs provide an alternative that significantly lowers interest rate risk (limited to the amount of the early withdrawal penalty). A couple of posters have asked about alternatives, seeming to not know there is at least one, so I was just correcting the mis-statement that there are none.

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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Electron wrote:The Vanguard site shows the SEC yield for the Total Bond Market Index fund at 3.50% on 7/14/03. Morningstar shows the Ten Year compounded return for the same fund at 4.39% on 7/12/13. Falling interest rates likely played a role in the return being higher than the forecast.
Electron: careful with that conclusion. The path is important. For example, the SEC yield on 07/14/2008 was 4.80% (so rising rates, generally speaking), total return between 2003-2008 was 4.9%. So the rising rates period actually helped quite a bit, more than the falling rates since 2008.
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Re: A Dangerous Misunderstanding about Bond Rates?

Post by ogd »

Kevin: fair enough.
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