Isn't it a good thing if bond prices fall?

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
User avatar
Taylor Larimore
Advisory Board
Posts: 25981
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Stable Value Funds ?

Post by Taylor Larimore » Sat Jul 20, 2013 3:45 pm

Thanks for the reply Taylor ! Much appreciated.

Admitedly I'm a newbie investor trying to get my head around things. I totally understand the concept of diversification in the AA strategy. I guess I'm not understanding the 'safety' or 'ballast' aspect as you cite. By safety, are you referring to the fact that my FI portion of my AA (let's assume 50% FI), will not LOSE money as that 40-50% is diverted away from (not allocated to) falling equity markets ? If so, it seems to me I'd rather have it in my stable value fund earning less than inflation rather than earing nothing or perhaps losing ?

Mitch:

By "safety" I am referring to the fact that you are unlikely to lose much money in good quality short- or intermediate-term bond funds. Total Bond Market's worst annual decline was -3%. You should expect to see the stock part of your portfolio decline -50% or more.

I see nothing wrong with using a stable value fund in a good company for portfolio "safety." In return for the increased safety of the stable value fund, you lose the opportunity for a larger gain and you may lose liquidity. Not a big decision either way.

The important decision is your portfolio's stock/fixed-income ratio. More than anything else, this asset-allocation decision determines the expected risk and expected return of your portfolio.

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

User avatar
ogd
Posts: 4807
Joined: Thu Jun 14, 2012 11:43 pm

Re: Isn't it a good thing if bond prices fall?

Post by ogd » Sat Jul 20, 2013 3:52 pm

Kevin M wrote:I think you made a rational choice, and that it is most likely to work out well for you. You have access to a type of fixed-income investment that many of us don't. Vanguard doesn't offer us a stable value fund. Your SV fund provides a yield that is in the ballpark of TBM, perhaps higher, but with less risk. For those who say "bonds are for safety", it is an excellent choice. If it were me, I probably would have put 100% of my fixed income in the plan into the SV fund.

The message from Vanguard, which is consistent with most of what is being said here, is that although rising interest rates would result in temporary losses (and we've recently seen an example of that), eventually it will result in higher long-term returns. By using the SV fund, you can avoid the losses, and then gradually move back into TBM as the rates increase more and more above the SV fund (if that happens). I simply ignore those who deride this as market timing, since I'm confident that the trade off between expected return and risk makes this a rational decision.

Yup. There is a simple rule here: if you're breaking your IPS to move between two assets that exist in the market, you are market-timing and you're probably missing something that the market isn't. If one of them lives outside the market, then it might make sense to move, if the reason for the price advantage is clear. The SV fund is outside the market: it's specialized for retirement plans and it takes advantage of the fact that retirement money is slow-moving and in extreme cases withdrawals can be forcefully limited. Another example is CDs and savings accounts, where the bank might place a premium on attracting new customers (and it works! my main bank got me this way).

If I had one I'd probably use a rule like Kevin is proposing about the TBM yield having to be a certain percentage higher than SV before you move back.

MitchC
Posts: 66
Joined: Wed Jul 03, 2013 6:02 pm

Re: Isn't it a good thing if bond prices fall?

Post by MitchC » Sat Jul 20, 2013 4:11 pm

Thanks Taylor (and others).

Yes, having the SV fund available to consider as a bond substitute is a luxury most don't have outside a 401k. I will use it to my advantage for the time being. Can always reallocate the SV $ into the TBM or Pimco Total Return at some point. The FI portion is the least of my worries though, with the possible (likely ?) loss of 50% of my equities in the future. But as I read in someone's book, "a turtle does not get anywhere until it sticks out it's neck" :shock:

joer1212
Posts: 395
Joined: Sun Feb 17, 2013 1:55 pm

Re: Isn't it a good thing if bond prices fall?

Post by joer1212 » Sun Jul 21, 2013 12:41 am

Kevin M wrote: If it were me, I probably would have put 100% of my fixed income in the plan into the SV fund.


I didn't because you never know what may happen.

The rest of your comments were very enlightening, Kevin. I actually made the move to sv because of advice you gave earlier in this post. I took it to heart because it made sense. Thanks.

longview
Posts: 354
Joined: Wed Mar 19, 2008 5:26 am

Re: Isn't it a good thing if bond prices fall?

Post by longview » Sun Jul 21, 2013 7:41 pm

1) Interest rates rise in the next two years...most likely scenario; but as you point out, not a certainty. If correct, then at the end of two years, I'll cash out of CDs and buy bond funds at deflated market prices. You will experience a decline in the market value of your holdings and this decline could be significant. My basis will be lower than your basis and I will own more shares than you. From this point forward, assuming we both reinvest dividends, I'll continue to outperform you every year because I will always hold more shares.


My question on this has always been: what if rates keep going up after 2 years?

Imagine rates go up for the next 20 years. Do you never get in? When do you get in? How do you know?
(To color my comments: my situation is ER trying to make a large portfolio that is 99% taxable last 45 years)

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Sun Jul 21, 2013 8:08 pm

longview wrote:My question on this has always been: what if rates keep going up after 2 years?

Imagine rates go up for the next 20 years. Do you never get in? When do you get in? How do you know?

Good questions. For me, part of the answer is that you don't have to do all or the other. You don't have to be just in our out.

I have 2/3 in non-brokered (NB) CDs, and 1/3 in (mostly) intermediate-term investment-grade and muni bond funds, which have higher yields (and more risk) than the CDs. I have shifted gradually from bond funds to CDs as interest rates have declined and bond prices have risen over the last three years (taking some of my "prepaid interest" off the table). I stopped shifting as of May (my last CD purchase), after which rates started increasing. As of May I no longer own any short-term bond funds, since CDs offer better risk/return, IMO.

I would shift more into CDs if rates declined much further below the lows of May. I will start gradually shifting back into bonds if rates increase enough above NB CD yields at the time, unless CD yields also rise accordingly, in which case I'll just rollover to new CDs, or even break existing CDs to buy higher-yielding CDs if rates increase enough to warrant it.

The higher bond yields, the more potential upside from decreasing rates (and increasing prices). I want to get paid enough to make taking the interest-rate risk worth it. My long-term investment-grade bond fund yield is about 4.7%. If it hits 5% I'll add some more to it. I'll probably start "rebalancing" back into bond funds if they lose 10%-20% from their recent highs (lower end for intermediate-term, higher end for long-term).

Also, it doesn't make that much difference if your equity allocation is relatively high, since your stocks are likely to dominate the performance of your portfolio. My equity allocation is relatively low, so I pay more attention to fixed income than others might.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

Tom_T
Posts: 1461
Joined: Wed Aug 29, 2007 2:33 pm

Re: Isn't it a good thing if bond prices fall?

Post by Tom_T » Mon Jul 22, 2013 7:51 am

Keep in mind that the higher the rates go, the less time it will take for your bond fund to make up for the loss in NAV via higher interest. If the NAV of a fund with a moderate duration drops 5% due to a one-point rate hike, but the fund is then yielding 6% instead of 5%, you are actually ahead of the game (lose 5% in price, but earn 6% in interest.)

(This is nominal, of course. Inflation is another story.)

Red Rover
Posts: 67
Joined: Fri Jul 05, 2013 10:05 am

Re: Isn't it a good thing if bond prices fall?

Post by Red Rover » Mon Jul 22, 2013 8:41 am

Is there a way to calculate how long a 1% increase in interest will take to offset a 5% loss in principal, i.e. the value of the bonds themselves, especially when fund managers don't hold them to maturity? How will the recent large withdrawls from bond funds impact the future gains in the fund?

It is easy to understand how the impact of interest works on individual bonds held to maturity, but not on funds that are selling bonds prior to maturity and realizing the loss of the value of the bonds sold.

blueridge
Posts: 66
Joined: Tue Jun 25, 2013 3:46 pm

Re: Isn't it a good thing if bond prices fall?

Post by blueridge » Mon Jul 22, 2013 10:51 am

Red Rover wrote:Is there a way to calculate how long a 1% increase in interest will take to offset a 5% loss in principal, i.e. the value of the bonds themselves, especially when fund managers don't hold them to maturity? How will the recent large withdrawls from bond funds impact the future gains in the fund?

It is easy to understand how the impact of interest works on individual bonds held to maturity, but not on funds that are selling bonds prior to maturity and realizing the loss of the value of the bonds sold.

For an index fund, it will still take, roughly, the average duration of the fund.

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Mon Jul 22, 2013 1:39 pm

Duration is not how long to recoup the loss--it's how long until your return is the same as if there had been no interest rate change. And always remember this only applies for a one-time increase in rate. If rates increase again, you must restart the duration clock.

Due to the unknowns in how the fund is managed (what bonds are bought/sold and when), and, as noted above, since all but the shortest-term funds don't hold bonds to maturity, I view this as a rough rule of thumb for bond funds. I am not an expert on this, but I haven't seen any bond experts on this forum say it's really wrong.

You can do a very rough calculation to see how long to recoup the loss. Let's consider a fund with duration of 5 years and starting interest rate of 2%, for a quick 1 percentage point increase of yield to 3%. Value will decline by about 5%, and you now earn about 3% per year. In two years you will have earned 6%, thus a bit more than the 5% loss, so the time to recoup loss is a little less than two years.

Starting at 5%, for a 1 pp increase to 6% you will recoup the loss in a little less than a year. So the higher the interest rate, the faster you recover from the loss. But note you are not ahead after a year--you've still only made 1% for the year, instead of 5%.

The duration rule of thumb applies, at least roughly, regardless of the starting interest rate. In the first example above, you will have earned about 2% per year after five years, and in the second example, you will have earned about 5% per year after five years. Once the five year mark is past, you start pulling ahead of what you would have earned if interest rates had not risen. This is why everyone keeps saying that rising rates are good for bond owners in the long run.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Mon Jul 22, 2013 1:55 pm

Red Rover wrote:It is easy to understand how the impact of interest works on individual bonds held to maturity, but not on funds that are selling bonds prior to maturity and realizing the loss of the value of the bonds sold.

I don't think this matters much. The efficiency of the bond market basically makes it so that your return will be about the same whether you continue to hold a bond, or sell the bond and buy another bond of the same remaining maturity but with a different coupon rate.

Maybe it will even be a bit better for a bond fund, because they are targeting a constant average maturity, bonds are constantly decreasing in remaining maturity, so it seems they need to be selling bonds that are falling below their target maturity range and replenishing bonds at the longer end of the range. With a positively sloped yield curve, the longer maturity bonds will have higher yields, which could help you recover even faster.

I'm not really sure about this, but in another thread it was being argued that because of this "riding the yield curve" effect, the return of an intermediate-term bond fund is likely to be higher than predicted by the SEC yield or average YTM. IMO, the affect was being overestimated and relies too much on assuming that the current shape of the yield curve will persist, but nevertheless, there was some reasonable rationale behind it. It seems to me that that same rationale would benefit bond funds in terms of time to recover NAV losses from increasing rates.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

gerrym51
Posts: 1679
Joined: Sat Apr 27, 2013 1:44 pm

Re: Isn't it a good thing if bond prices fall?

Post by gerrym51 » Mon Jul 22, 2013 2:02 pm

I have some brokerd cds at fidelity.even though they are fdic guaranteed they are actually bonds. every time interest rates rise the amount that i could sell them for that day goes down in the column marked value of holding . Fidelity is giving me the estimate i could sell that day. in effect i still have the full value of the actual cd's i bought. holding a bond to term gets it;s full value.

epilnk
Posts: 2603
Joined: Wed Apr 18, 2007 7:05 pm

Re: Isn't it a good thing if bond prices fall?

Post by epilnk » Mon Jul 22, 2013 2:30 pm

longview wrote:
1) Interest rates rise in the next two years...most likely scenario; but as you point out, not a certainty. If correct, then at the end of two years, I'll cash out of CDs and buy bond funds at deflated market prices. You will experience a decline in the market value of your holdings and this decline could be significant. My basis will be lower than your basis and I will own more shares than you. From this point forward, assuming we both reinvest dividends, I'll continue to outperform you every year because I will always hold more shares.


My question on this has always been: what if rates keep going up after 2 years?

Imagine rates go up for the next 20 years. Do you never get in? When do you get in? How do you know?


I figure my bonds will more or less take care of themselves. If I were going to store some cash in CDs as "dry powder" for market timing purposes, I'd probably use it during a stock downturn. More potential upside there.

User avatar
ogd
Posts: 4807
Joined: Thu Jun 14, 2012 11:43 pm

Re: Isn't it a good thing if bond prices fall?

Post by ogd » Mon Jul 22, 2013 3:52 pm

Kevin M wrote:I'm not really sure about this, but in another thread it was being argued that because of this "riding the yield curve" effect, the return of an intermediate-term bond fund is likely to be higher than predicted by the SEC yield or average YTM. IMO, the affect was being overestimated and relies too much on assuming that the current shape of the yield curve will persist, but nevertheless, there was some reasonable rationale behind it. It seems to me that that same rationale would benefit bond funds in terms of time to recover NAV losses from increasing rates.

Kevin: as one of the participants in that thread, I am slowly coming to terms with the fact that based on historical evidence, the market is *that good* at predicting future interest rates, so that the yield curve cannot be taken advantage of for too long. The effect that makes the SEC yield a good predictor is actually curve flattening as the market's predictions come to pass, rather than something intrinsic in the yield calculation. My conclusion is that trying to move ahead of a market that predicts the path of future yields with 91% accuracy (Bogle's number) is even more pointless than I thought.

billyt
Posts: 677
Joined: Wed Aug 06, 2008 9:57 am

Re: Isn't it a good thing if bond prices fall?

Post by billyt » Mon Jul 22, 2013 5:07 pm

I think the key is that this is not a market prediction, but just bond math. You are buying into a bond ladder with known future cash flows (interest and return of principle). Yes, changes in interest rates can change this a bit, but not very much. It is no surprise that the 10-year subsequent return is within a few percent of the SEC yield or YTM.

billyt
Posts: 677
Joined: Wed Aug 06, 2008 9:57 am

Re: Isn't it a good thing if bond prices fall?

Post by billyt » Mon Jul 22, 2013 5:13 pm

And another thing. This is not a prediction of future interest rates, just a calculation of the expected return of the bond fund. Future interest rates are unknown, the future returns of a bond fund are relatively well known.

billyt
Posts: 677
Joined: Wed Aug 06, 2008 9:57 am

Re: Isn't it a good thing if bond prices fall?

Post by billyt » Mon Jul 22, 2013 5:20 pm

What that graph really shows is that today's 10 year annualized returns is a good approximation of what the average SEC yield was 10 years ago. This is not a prediction at all.

User avatar
ogd
Posts: 4807
Joined: Thu Jun 14, 2012 11:43 pm

Re: Isn't it a good thing if bond prices fall?

Post by ogd » Mon Jul 22, 2013 6:15 pm

billyt wrote:I think the key is that this is not a market prediction, but just bond math. You are buying into a bond ladder with known future cash flows (interest and return of principle). Yes, changes in interest rates can change this a bit, but not very much. It is no surprise that the 10-year subsequent return is within a few percent of the SEC yield or YTM.

Negative. The SEC yield is a YTM for the portfolio, but the bond fund will be more aggressive than that. If the yield curve didn't change, it would make more money. See that thread -- and maybe post there, this is getting off-topic. Perhaps I'll convince you when I write that bond fund simulator that I was mentioning in a PM :)

billyt wrote:What that graph really shows is that today's 10 year annualized returns is a good approximation of what the average SEC yield was 10 years ago. This is not a prediction at all.

I would call it historical evidence for the predictive power of the yield curve.

User avatar
hollowcave2
Posts: 1790
Joined: Thu Mar 01, 2007 3:22 pm
Location: Sacramento, CA

Re: Isn't it a good thing if bond prices fall?

Post by hollowcave2 » Mon Jul 22, 2013 6:21 pm

Personally, I'd love to see some higher rates. Overall, this will give me a higher expected total return, since I also have a long time horizon.

billyt
Posts: 677
Joined: Wed Aug 06, 2008 9:57 am

Re: Isn't it a good thing if bond prices fall?

Post by billyt » Tue Jul 23, 2013 4:57 am

ogd: Are we talking about the same chart, posted in this thread by Kevin? That chart compares the 10 year return of the aggregate bond index to the SEC yield 10 years ago. All that is tells you is that the SEC yield is a good estimate of future returns. That is a no brainer, as the future cash flows of a bond ladder are well defined. Yes, you can try to improve some on that, but the differences are quite small. That is regardless of changes in interest rates. This says nothing at all about future rates, which could do anything.

User avatar
ogd
Posts: 4807
Joined: Thu Jun 14, 2012 11:43 pm

Re: Isn't it a good thing if bond prices fall?

Post by ogd » Tue Jul 23, 2013 11:22 am

billyt: yes, we are talking about that chart. It is counter-intuitive.

The problem with SEC yield is that it represents the returns if the fund's portfolio is allowed to taper to duration zero in 5 years' time (for an intermediate fund). For example, the SEC yield of Inter-term Treasury Adm matches the 5-year Treasury yield (held to maturity) pretty closely. The fund will, of course, not hold to maturity, and four years from now it will still have a duration of five rather than one. At the current yield curve, this would be greatly rewarded, with up to double the yield over the 5 year period. The thread that I mentioned, with the calculations, is viewtopic.php?f=10&t=118751#p1733929

Historically though, the SEC yield does seem to match the future returns, so it makes you wonder why -- there must be bond market effects that flatten the yield curve to deny the extra return that exists at first glance. There are multiple theories about the shape of the curve, you can read about them here: http://en.wikipedia.org/wiki/Yield_curve#Theory . I used to think that the curve was simply about interest rate risk, but it seems that it's more complicated, and at least a major component is actually the expected path of those yields, which is often (but not always) followed.

Another interesting article that tries to quantify the "rolldown returns": http://www.galliard.com/LiteratureRetri ... ?ID=152560 . I haven't fully parsed it yet, but getting there; the gist of it is that you will get the higher returns if the yields are slower to move than the market expects.

Like I said, the more likely conclusion for me is that one should simply pick a duration (it doesn't even matter much if intermediate or short) and just stick with it, because the market is so far ahead of my ability to time this decision that any attempt is futile.

linuxizer
Posts: 1553
Joined: Wed Jan 02, 2008 7:55 am

Re: Isn't it a good thing if bond prices fall?

Post by linuxizer » Tue Jul 23, 2013 12:18 pm

ogd wrote:Like I said, the more likely conclusion for me is that one should simply pick a duration (it doesn't even matter much if intermediate or short) and just stick with it, because the market is so far ahead of my ability to time this decision that any attempt is futile.


Exactly.

One of the great paradoxes of this forum is that basically everyone here accepts the efficiency of the stock market, but the efficiency of the bond market is much more controversial. If anything, the bond market is more efficient (in the aggregate sense; individual issues can have substantial inefficiencies relating to trading costs, etc.)--there's only a few variables to consider (unlike the stock market), and thousands of analysis poring over them every instant trying to find an edge of a hundredth of a percentage point.

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Tue Jul 23, 2013 1:22 pm

Clarification about the chart (from Vanguard) that I posted. It is for the aggregate US bond market, so includes all maturities. For example, TBM includes 26% of 1-3 year maturities, while intermediate-term treasury includes none in that range. I believe the hypothesis about the possible benefit of riding the yield curve assumed no short maturity bonds.

Another minor point: it used YTM not SEC yield, although I assume that wouldn't make much difference since the latter should roughly lag the former by 30 days.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Tue Jul 23, 2013 1:25 pm

linuxizer wrote:One of the great paradoxes of this forum is that basically everyone here accepts the efficiency of the stock market, but the efficiency of the bond market is much more controversial.

Interesting conclusion. What observations do you base it on?

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

linuxizer
Posts: 1553
Joined: Wed Jan 02, 2008 7:55 am

Re: Isn't it a good thing if bond prices fall?

Post by linuxizer » Tue Jul 23, 2013 1:45 pm

Kevin M wrote:
linuxizer wrote:One of the great paradoxes of this forum is that basically everyone here accepts the efficiency of the stock market, but the efficiency of the bond market is much more controversial.

Interesting conclusion. What observations do you base it on?


Several years of "will I lose all my money in bond funds?", "should I shorten/length my durations now?", and similar threads, and the responses they get.

User avatar
Kevin M
Posts: 8840
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Isn't it a good thing if bond prices fall?

Post by Kevin M » Tue Jul 23, 2013 3:14 pm

^Hmm. How is this different than all the discussions about whether to tilt, slice and dice, considering valuations (e.g., note recent discussions about REITs being overvalued, and ongoing discussions about using PE10 to adjust allocations), etc.? If we all believe the stock market is efficient, shouldn't we all just hold total stock market funds and ignore valuations in our AA (I know many do exactly that, but we still discuss these things a lot)?

To me what's interesting are the often repeated statements to take risk on the equity side, bonds are for safety, etc., yet many of the people who say this use TBM for their bonds, and TBM is not safe. Of course it's much safer than stocks, but it's riskier than many other fixed income alternatives. So folks who use TBM are taking risk on the bond side too.

TBM is somewhere to the right of the zero risk point on the expected return vs. risk graph. Obviously what folks are really doing is selecting some point in the expected return vs. risk domain for their fixed income, consciously or unconsciously. They just happen to draw the line at TBM, as opposed to taking more risk in longer-term or high-yield bonds, or by holding more corporate bonds (as John Bogle has recently been recommending).

Investors who are serious about taking risk only on the equity side, and limit their fixed income to bonds, stick with short-term government bonds (and some do). Others who consider other fixed-income alternatives utilize non-brokered CDs with reasonable early withdrawal terms, which IMO are much safer than intermediate-term government bonds, and provide a higher yield to boot.

Kevin
||.......|| Suggested format for Asking Portfolio Questions (edit original post)

Post Reply