I just don't understand bonds...

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HotRod
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I just don't understand bonds...

Post by HotRod » Wed Jun 10, 2015 12:23 pm

Hi All,

I have posted before about allocating between stocks and cash instead of between stocks and bonds, and at the risk of being dense, I still dont get the stocks and bonds idea.

I know it's only one day, but as I write this the S&P 500 is up 1.27%. I have allocated some to BND (Vanguard total bond) which is down 0.13% and BSV (Vanguard short term Bond) which is down 0.03%

In fact BND has returned 0.78% YTD, but my Ally savings account is returning 1%. According to Yahoo Finance BND's 3 year avg return is 2%. I don't know what Ally paid over the last 3 years, but all in all I just don't see bonds as being a huge benefit over cash.

I've read an awful lot of literature on allocation and everything I've ever read recommends stocks and bonds. I know that I'm not smarter than all the experts :) so, what am I missing ?

I'm not writing to challenge anyone, I'm asking so that I can better understand.

Thanks, as always !!

MN Finance
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Re: I just don't understand bonds...

Post by MN Finance » Wed Jun 10, 2015 12:33 pm

Bonds have historically had a higher return than cash. The expectation is that they have a higher expected return. It's not much more complicated. Two additional points.

First, whatever your past observations are over 3 years is essentially meaningless in that it says nothing about long term expectations (and is just a random short period of time).

Second, given that short rates are at a historical low, other short options have, and may continue to have, sight out performance compared to short bonds themselves. Ie, cds and savings may be a better (temporary) alternative to treasury notes.

yosef
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Re: I just don't understand bonds...

Post by yosef » Wed Jun 10, 2015 12:34 pm

Well, bonds are at or at least not far off record low yields. So, yes they are not paying much and it probably won't get much better over the next few years if you believe the experts. So why invest in bonds over throwing money in your Ally account? Well, for one you can invest in bonds in a tax advantaged account. Secondly, historically speaking bonds have done better than savings accounts, dare I say by a substantial margin. That may or may not be the case at the moment, but certainly the expectation is that it will be true again at some point. I have no doubt others will give much better answers but those are the things that come to my mind first.

IPer
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Re: I just don't understand bonds...

Post by IPer » Wed Jun 10, 2015 12:37 pm

Expand your research to 5 years and multiples of 10 years. 3 years is too short to get any perspective.
Also you should know from the performance summaries of these ETFs that they have down years,
sometimes. So if there is a down year and then a recovery period then you can get an idea by looking
at that in relation to different 10 or 20 year snapshots. If you are in it for the short term and need to
reconcile daily this sort of investing is most likely not for you.
Read the Wiki Wiki !

sschullo
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Re: I just don't understand bonds...

Post by sschullo » Wed Jun 10, 2015 12:43 pm

Read Larry's (Swedroe) "Winning Bond Strategy" and Russell Wild's "Bond Investing for DUMMIES."
Public School K-12 Educators: "Ask NOT what your annuity sales person can do for you, ask what you can do to be a Do-It-Yourselfer (DIY)."

lack_ey
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Re: I just don't understand bonds...

Post by lack_ey » Wed Jun 10, 2015 12:47 pm

The nature of diversification is that you're not usually happy at everything all at the same time.

Bonds tend to not offer a huge benefit over cash, just usually modest or moderate improvements, nothing make-or-break. You can think of cash as just short-term bonds. To be honest, right now with online banks paying ~1%, this is a higher rate than you get from short-term Treasuries for less risk. I mean, the 3-month T-bill still only pays 0.02%, with the 2-year at 0.72%. If you own a total bond fund, some percentage of the fund is invested in these assets.

But note that over say the last five years or so, those who hid in cash or short-term bonds did somewhat more significantly worse than those who stuck to intermediate-term bonds. The latter had negative correlation with stocks and returned about 4.5% a year on their own (some part of that from rates falling; don't expect anything like that given the current yields today). So they improved a portfolio somewhat significantly over cash.
https://www.portfoliovisualizer.com/bac ... TBills2=40

Okay, cash an individual has access to would return more than T-bills, so if you want add some 0.40% a year to portfolio 2 in the link.'

If you're certain intermediate-term and long-term interest rates are going up and somewhat rapidly, cash is better than bonds so you avoid the capital losses. That's generally not what's happened since the financial crisis, despite everyone thinking it's imminent. I will just say that market timing interest rates is like market timing the stock market—people think they can do it, but they generally can't. It's really hard. Don't bank on it.

retiredjg
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Re: I just don't understand bonds...

Post by retiredjg » Wed Jun 10, 2015 1:00 pm

When people say "stocks and bonds", what they really should mean is "stocks and fixed income assets". Fixed income assets include bonds, cash, money market, and CDs (and maybe other things I have not thought of). So as long as you have a reasonable allocation to some kind of fixed income asset, you are headed in the right direction.

As for what kind of fixed income asset is best, that changes from time to time and it also varies because people have different preferences. In the long run, bonds will pay you more than cash. That is almost a certainty. In the short run…anything could happen.

I suggest that you experiment with different types of fixed income assets and see what you like.

Also realize that comparing .78% YTD to 1% annually is apples and oranges because "YTD" means "year to date" - meaning that the whole year has not passed yet. In other words, by the time it gets to a year, it is likely to be more than 1%.

HotRod
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Re: I just don't understand bonds...

Post by HotRod » Wed Jun 10, 2015 1:05 pm

OK, those are all good points.

In general as I just start to get ramped up on all of this it seems that I'm looking at a short window of time and assuming that what I see through my small window represents the entirety of the investing world.

I'll stick with the recommended allocations that I have and hold tight.

Thanks for your time, I'm glad I found this forum !!

Chadnudj
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Re: I just don't understand bonds...

Post by Chadnudj » Wed Jun 10, 2015 1:18 pm

Also, I'd be careful relying on the Yahoo! return numbers for BND.....not sure, but could those just be price appreciation, and not include the dividends (or whatever the payments on bonds are called)?

If so, you're ignoring a huge component of a bond's return.

asif408
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Re: I just don't understand bonds...

Post by asif408 » Wed Jun 10, 2015 1:25 pm

SteveB1 wrote:Hi All,

I have posted before about allocating between stocks and cash instead of between stocks and bonds, and at the risk of being dense, I still dont get the stocks and bonds idea.

I know it's only one day, but as I write this the S&P 500 is up 1.27%. I have allocated some to BND (Vanguard total bond) which is down 0.13% and BSV (Vanguard short term Bond) which is down 0.03%

In fact BND has returned 0.78% YTD, but my Ally savings account is returning 1%. According to Yahoo Finance BND's 3 year avg return is 2%. I don't know what Ally paid over the last 3 years, but all in all I just don't see bonds as being a huge benefit over cash.

I've read an awful lot of literature on allocation and everything I've ever read recommends stocks and bonds. I know that I'm not smarter than all the experts :) so, what am I missing ?

I'm not writing to challenge anyone, I'm asking so that I can better understand.

Thanks, as always !!
Steve,

Compare the returns of Vanguard Total Stock Market (VTSMX) to Vanguard Total Bond (VBMFX) and Vanguard Short Term Bond (VBISX) during the years where stocks have performed poorly or flat:

2000: VTSMX -10.57% VBMFX: +11.39% VBISX: +8.84%
2001: VTSMX -10.97% VBMFX: +8.43% VBISX: +8.88%
2002: VTSMX -20.96% VBMFX: +8.26% VBISX: +6.10%
2008: VTSMX -37.04% VBMFX: +5.05% VBISX: +5.43%
2011: VTSMX +0.96% VBMFX: +7.56% VBISX: +2.96%

This is why I hold bonds. Cash won't go up when stocks go down.

IPer
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Re: I just don't understand bonds...

Post by IPer » Wed Jun 10, 2015 1:42 pm

Chadnudj wrote:Also, I'd be careful relying on the Yahoo! return numbers for BND.....not sure, but could those just be price appreciation, and not include the dividends (or whatever the payments on bonds are called)?

If so, you're ignoring a huge component of a bond's return.
Since the NAV on BND has decreased within this year if the return is .78% that must be a yield adjusted return. I have not found any
gross discrepancies with Yahoo! numbers.
Read the Wiki Wiki !

Austintatious
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Re: I just don't understand bonds...

Post by Austintatious » Wed Jun 10, 2015 2:10 pm

Earlier today, I came across this Market Watch article written by Paul Merriman, in which he characterizes bonds as the "most important asset class". Whether or not bonds are the most important asset class, the article might be some help to a better understanding of the role of bonds in one's investment portfolio.

http://www.marketwatch.com/story/why-bo ... =countdown

HotRod
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Re: I just don't understand bonds...

Post by HotRod » Wed Jun 10, 2015 2:25 pm

Austintatious wrote:Earlier today, I came across this Market Watch article written by Paul Merriman, in which he characterizes bonds as the "most important asset class". Whether or not bonds are the most important asset class, the article might be some help to a better understanding of the role of bonds in one's investment portfolio.

http://www.marketwatch.com/story/why-bo ... =countdown
That's a very interesting article, I'm going to bookmark it. Thanks for sharing.

retiredjg
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Re: I just don't understand bonds...

Post by retiredjg » Wed Jun 10, 2015 3:50 pm

Austintatious wrote:Earlier today, I came across this Market Watch article written by Paul Merriman, in which he characterizes bonds as the "most important asset class". Whether or not bonds are the most important asset class, the article might be some help to a better understanding of the role of bonds in one's investment portfolio.

http://www.marketwatch.com/story/why-bo ... =countdown
This is a good article. And timely.


Also, there are entire decades where bonds outperform stocks. Hard to believe, but it happened not too long ago.

Dandy
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Re: I just don't understand bonds...

Post by Dandy » Thu Jun 11, 2015 6:37 am

it is on the surface relatively easy

Stocks go up and down - often a lot. But because of that risk they usually return more over time to compensate for that risk

Bonds go up and down - less than stocks, usually, and are mostly affected by changes in interest rates. When rates go up
people want the new higher rate bonds so they pay less for the lower interest rate bonds. Also, bonds can drop because there is a concern about whether the issuer might fail to pay off the bonds - i.e. defaults.

FDIC savings have almost no risk* so they pay the lowest amount (usually). If they paid more than stocks or bonds nobody would by stocks and bonds - why take a risk if no risk pays better. * the real risk is that inflation and taxes could make you seem like you have no risk but you are actually losing purchasing power.

There is really no safe place to put your money. You have to choose the risk(s) vs reward that meets your needs. Most people feel some stocks and some bonds are worth the risk because the rewards out weigh the risks.

Boglegrappler
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Re: I just don't understand bonds...

Post by Boglegrappler » Thu Jun 11, 2015 6:59 am

People don't understand bonds because they don't have a frame of reference to use in thinking about them.

Bonds are capital that has been "rented out" at some rate. They have a term (the maturity), and a coupon (the interest rate, or annual rental). This is all determined when they are issued.

After they are issued, market interest rates can still fluctuate--and they will. If rates fall, it makes the old bond you bought more valuable, because you have your rate "locked in". If rates rise, it makes your old bond less valuable, because someone will prefer a newly issued bond at the higher rates to your old bond at the lower coupon.......so your bond will drop in price to make it equally attractive. Sometimes people are under a mistaken belief that the rate on their bond changes. It doesn't. At least not the coupon, or annual payment. What does change is its value in the market place, as the price fluctuates with any changes in rates.

How large these value fluctuations are depends on the term of the bond. The longer you've rented your capital for (term of the bond), the more its price will move in response to interest rate movements. Its very similar to owning a commercial property. If you've rented it (leased it out) to someone for a fixed rent for 30 years, and rents fall, your property becomes more valuable because of the lease. If rents rise steadily, your property becomes less valuable because of the long-term, below-market lease. If you've only leased it for a year, the impact of the lease rate on the value of the property is not that great, and a change in rents during the year doesn't affect the value of what you own by very much because at the end of the lease you can renegotiate the rental rate or find a new tenant who'll pay the higher rent. Its the same with a one year bond, since you get the principal back in a year to invest at the rates that will prevail then. So when people talk about "interest rate risk", they are speaking about the impact on the market value of their bonds if there is a shift in interest rates. This risk is essentially non-existent for short-term bonds, and becomes important for bond maturities over say 7-8 years. If you look at very long maturities such as 30 or 40 year bonds, there is a lot of change in value for a given shift in interest rates.

One thing I have noticed over the past several years is that financial journalists and even those people in the markets are getting sloppy in the way they talk about bond price movements. They are not clear when they are speaking about yields (rates) vs speaking about prices. It used to be that comments about "bonds being up" or "bonds being down" was understood to refer to bond prices. Now I hear such terms used when they are referring to yields. The latter should always be expressed explicitly by saying that "bond yields are up" (or down). I find myself constantly having to double check what's being said on CNBC and other places because the announcers don't understand the confusion that they're sowing. Bond yields and prices always move in opposite directions. If rates (yields) rise, prices fall. If prices are rising, yields fall.
Last edited by Boglegrappler on Sat Jul 18, 2015 12:55 pm, edited 3 times in total.

retiredjg
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Re: I just don't understand bonds...

Post by retiredjg » Thu Jun 11, 2015 7:16 am

Boglegrappler wrote:People don't understand bonds because they don't have a frame of reference to use in thinking about them.
That was a very good explanation! Thanks.

dbr
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Re: I just don't understand bonds...

Post by dbr » Thu Jun 11, 2015 10:53 am

retiredjg wrote:
Boglegrappler wrote:People don't understand bonds because they don't have a frame of reference to use in thinking about them.
That was a very good explanation! Thanks.
I agree. Should be very helpful.

You are right about some of the comments in the press. The worst of it though is when you start hearing about "bubbles" or a "blood-bath" in bonds. Those would be paradigms for what not to listen to.

One nuance that might be added to the mechanics of bonds is the fact that one might well buy a bond at a price different from its face value. That has some subtle effects on how the return works out. However, it is indeed important to realize that the coupon is exactly what it is for the life of the bond, a good point.

k1_level
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Re: I just don't understand bonds...

Post by k1_level » Mon Feb 15, 2016 9:48 pm

A major reason why bonds are negatively correlated with equities is because of the Fed historically lowering interest rates in a recession. With interest rates already near 0, if there's another crash, can we still expect bond prices to rise as substantially as in past downturns?

magneto
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Re: I just don't understand bonds...

Post by magneto » Tue Feb 16, 2016 6:50 am

Like yourself OP this investor did not get bonds :!:
and simply held stocks, (real estate) and cash

Having learnt so much about bonds from the threads on this forum, we do now hold bonds alongside substantial cash.
The decision doesn't have to be simply bonds or cash.
Why not hold both. :?:

With the recent downturn in stocks it was interesting to note the "flight to safety" surge in bonds. This provided us with an opportunity to top-slice bonds and top-up stocks. That top-slicing opportunity wouldn't have presented itself with cash alone.

The Larry Swedroe book mentioned above is excellent.
Would also recommend 'The Bond Book' by Annette Thau for further reading.

All Best
'There is a tide in the affairs of men ...', Brutus (Market Timer)

cheesepep
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Re: I just don't understand bonds...

Post by cheesepep » Tue Feb 16, 2016 7:14 am

I also don't understand bonds, so I don't buy any. I own "bond stocks," such as T and VZ instead.

beezar
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Re: I just don't understand bonds...

Post by beezar » Thu Feb 18, 2016 12:29 am

I've tried so hard to invest more in bonds, but I can't bring myself to do it as it makes zero sense to me if you have a somewhat longer (>10 years) horizon and you are disciplined enough to not sell stocks when the market goes down. I am 40 and my allocation is 95% stocks, 5% bonds, and an emergency cash fund. I'm still wondering why I am keeping even that 5% in bonds, other than the fact that people tell you you should have bonds. May have to convert them to stocks when the stock market goes down.

Am I missing something here? I never sell stocks even when the market takes a big dive.

Bfwolf
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Re: I just don't understand bonds...

Post by Bfwolf » Thu Feb 18, 2016 12:57 am

beezar wrote:I've tried so hard to invest more in bonds, but I can't bring myself to do it as it makes zero sense to me if you have a somewhat longer (>10 years) horizon and you are disciplined enough to not sell stocks when the market goes down. I am 40 and my allocation is 95% stocks, 5% bonds, and an emergency cash fund. I'm still wondering why I am keeping even that 5% in bonds, other than the fact that people tell you you should have bonds. May have to convert them to stocks when the stock market goes down.

Am I missing something here? I never sell stocks even when the market takes a big dive.
What if we go through a prolonged depression and 20 years from now stocks are lower than they are today? And as we're going through a prolonged depression, you go through significant bouts of unemployment and can't save as much money as you'd like? It's unlikely but possible. An all stock long-term strategy is likely to be highly successful. But it has the possibility of being hugely, tremendously unsuccessful. Adding bonds in to a portfolio provides some ballast against the hugely, tremendously unsuccessful outcomes. They'll still be bad, but less bad. Your good outcomes become less good, but hopefully still good enough.

neomutiny06
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Re: I just don't understand bonds...

Post by neomutiny06 » Thu Feb 18, 2016 8:15 am

Bfwolf wrote:
beezar wrote:I've tried so hard to invest more in bonds, but I can't bring myself to do it as it makes zero sense to me if you have a somewhat longer (>10 years) horizon and you are disciplined enough to not sell stocks when the market goes down. I am 40 and my allocation is 95% stocks, 5% bonds, and an emergency cash fund. I'm still wondering why I am keeping even that 5% in bonds, other than the fact that people tell you you should have bonds. May have to convert them to stocks when the stock market goes down.

Am I missing something here? I never sell stocks even when the market takes a big dive.
What if we go through a prolonged depression and 20 years from now stocks are lower than they are today? And as we're going through a prolonged depression, you go through significant bouts of unemployment and can't save as much money as you'd like? It's unlikely but possible. An all stock long-term strategy is likely to be highly successful. But it has the possibility of being hugely, tremendously unsuccessful. Adding bonds in to a portfolio provides some ballast against the hugely, tremendously unsuccessful outcomes. They'll still be bad, but less bad. Your good outcomes become less good, but hopefully still good enough.
Well said. And by bonds, are we talking about Total Bond Market? Some people prefer different funds, but it seems like Bogleheads agree that BND is the way to go.

Boglegrappler
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Re: I just don't understand bonds...

Post by Boglegrappler » Thu Feb 18, 2016 4:20 pm

In theory, long term bonds are what you want in a time of drastically suppressed economic activity. In practice, there are some "twists" in this simple idea. One of them is that, for your bonds to do what you expect them to do, the issuer has to come up with the interest payments and the principal at maturity. If economic conditions get bad enough, their operating earnings could decline to the point where they couldn't make the required payments, and would seek a reorganization under the bankruptcy laws. In that case, you'll end up with something, but it could turn out to be largely the stock of the reorganized (and financially healthier) company.

What I'm implying here is that bonds that are supposed to insure a bit against a depression type scenario are not necessarily the ones that are most popular in normal times because the issuers with the highest credit ratings (read: the most stable businesses and the least amount of debt relative to their operating incomes) usually don't issue much debt, and when they do it sells at a rather low yield.

Bfwolf
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Re: I just don't understand bonds...

Post by Bfwolf » Thu Feb 18, 2016 6:15 pm

Boglegrappler wrote:In theory, long term bonds are what you want in a time of drastically suppressed economic activity. In practice, there are some "twists" in this simple idea. One of them is that, for your bonds to do what you expect them to do, the issuer has to come up with the interest payments and the principal at maturity. If economic conditions get bad enough, their operating earnings could decline to the point where they couldn't make the required payments, and would seek a reorganization under the bankruptcy laws. In that case, you'll end up with something, but it could turn out to be largely the stock of the reorganized (and financially healthier) company.

What I'm implying here is that bonds that are supposed to insure a bit against a depression type scenario are not necessarily the ones that are most popular in normal times because the issuers with the highest credit ratings (read: the most stable businesses and the least amount of debt relative to their operating incomes) usually don't issue much debt, and when they do it sells at a rather low yield.
I pulled the info below from Vanguard's website...it shows the credit rating breakdown of the bonds in their Total Bond Market index fund. 64% of the assets are US government bonds which are as risk-free as you're going to get in this world. The rest are some level of investment-grade (i.e. no junk), and while bankruptcy would impact some percentage of these in a prolonged depression, I think it's fair to say that this fund faces relatively low credit risk.

U.S. Government 64.1%
Aaa 5.6%
Aa 3.9%
A 12.0%
Baa 14.4%
< Baa 0.0%
Total 100.0%
Characteristics as of 01/31/2016

If one wants even lower credit risk, there's the Vanguard Intermediate-Term Treasury Fund which is 100% US govt bonds, though the SEC yield is a full 1% below Total Bond Market and not much better than a 1% interest savings account.

TomCat96
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Re: I just don't understand bonds...

Post by TomCat96 » Thu Feb 18, 2016 6:37 pm

beezar wrote:I've tried so hard to invest more in bonds, but I can't bring myself to do it as it makes zero sense to me if you have a somewhat longer (>10 years) horizon and you are disciplined enough to not sell stocks when the market goes down. I am 40 and my allocation is 95% stocks, 5% bonds, and an emergency cash fund. I'm still wondering why I am keeping even that 5% in bonds, other than the fact that people tell you you should have bonds. May have to convert them to stocks when the stock market goes down.

Am I missing something here? I never sell stocks even when the market takes a big dive.
I'm in the same position as you. As far as my analysis is able to derive, bonds = cash with interest.

What I mean by that is in the context of a portfolio where one must decide on an allocation, not going all in on stocks allows you to adapt to changing market conditions by allowing you to rebalance back in. The question then is, for the part of your portfolio not being invested--the cash--can we earn something better than a zero percent interest rate. And the answer is yes, supposedly with bonds.

I have not had anyone challenge me on bonds effectively being a "something better than cash" function as part of the portfolio.
With the yields as low as they are, that has been my conclusion thus far. In an ideal world, if bonds are negatively correlated with stocks, you can do even better during your rebalancing.

From what I gather, bonds by themselves don't really make sense to young investors, which you are if you are only 40. I'm 34, so it seems like even more of a hinderance to long term gains to me. But your perspective on time is going to be different from people here who are retired.

From your vantage point waiting out dips, even year long recessions is a simple matter. But for those who are already in retirement, bonds make much more sense when week to week drops in your portfolio value can be equivalent in number to what you made in a year during your working career, when you don't have time to see things recover.

With the $$ in my portfolio, if stocks drop as much as 90%, I would be fine. Because even a 100% stock allocation is unlikely to see anything even close to that level of volatility, bonds seem a bit useless to me. Within 3 years of working, I could recover the value of my portfolio.
Not so with the retiree carrying 3 million in the portfolio, where risk seems more intolerable, and where bonds protective power would be more valued.

SouthernCPA
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Re: I just don't understand bonds...

Post by SouthernCPA » Thu Feb 18, 2016 7:09 pm

Boglegrappler wrote:People don't understand bonds because they don't have a frame of reference to use in thinking about them.

Bonds are capital that has been "rented out" at some rate. They have a term (the maturity), and a coupon (the interest rate, or annual rental). This is all determined when they are issued.

After they are issued, market interest rates can still fluctuate--and they will. If rates fall, it makes the old bond you bought more valuable, because you have your rate "locked in". If rates rise, it makes your old bond less valuable, because someone will prefer a newly issued bond at the higher rates to your old bond at the lower coupon.......so your bond will drop in price to make it equally attractive. Sometimes people are under a mistaken belief that the rate on their bond changes. It doesn't. At least not the coupon, or annual payment. What does change is its value in the market place, as the price fluctuates with any changes in rates.

This explanation gives me a sick-to-my-stomach feeling as it brings me back to studying discounting and bond accounting for the CPA exam and college courses. Good explanation.

The easiest way to explain it to people is that the "market" rate of interest is what investors should expect to get as their "effective" rate of return on the bond purchased. For example a $1,000 face value bond that pays 10% interest is paying $100 in interest no matter what the market rate fluctuates to.

If you buy that bond, no matter what price it sells at, it will pay $100 a year until it matures. If the market rate of goes up to 12%, that bond would be worth less than $1,000. It would be worth around $834 (rough math) because the lower prices would make the $100 interest payment match the 12% market rate. If market rate drops to 6%, then the bond would sell at a premium around $1666 to bring the $100 interest payment to a 6% effective interest rate.

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