What is the purpose of bonds?

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jb1
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What is the purpose of bonds?

Post by jb1 » Mon May 01, 2017 11:34 am

Hey all, getting into finalizing my "lazy 3" have 70% in VGTSX, VTSAX, and 30% in VBMFX.

In regards to bonds, what is the purpose? They dont really fluctuate much even if you look at VBMFX since 2007. Is the purpose just to receive the dividends and reinvest?

BogleMelon
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Re: What is the purpose of bonds?

Post by BogleMelon » Mon May 01, 2017 11:39 am

jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

jb1
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Re: What is the purpose of bonds?

Post by jb1 » Mon May 01, 2017 11:41 am

BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?

How do bonds make a average return of say 4% a year?

zuma
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Re: What is the purpose of bonds?

Post by zuma » Mon May 01, 2017 11:43 am

jb1 wrote:
BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?
You make money off your whole portfolio. Bonds dilute the risk of your portfolio.

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Gort
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Re: What is the purpose of bonds?

Post by Gort » Mon May 01, 2017 11:53 am

jb1 wrote:
BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?

How do bonds make a average return of say 4% a year?


Good question that I also don't quite understand.
In a stock fund such as TSM, when distributions are paid to the shareholder, the net asset value (NAV) of the stock fund is reduced to a point where there is no increase in the value of your holdings after the distribution is paid. You do end up with more shares. Is this the same with a bond fund such as TBM? When a bond fund does a distribution, is the NAV of that fund reduced?

BogleMelon
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Re: What is the purpose of bonds?

Post by BogleMelon » Mon May 01, 2017 12:02 pm

Gort wrote:
jb1 wrote:
BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?

How do bonds make a average return of say 4% a year?


Good question that I also don't quite understand.
In a stock fund such as TSM, when distributions are paid to the shareholder, the net asset value (NAV) of the stock fund is reduced to a point where there is no increase in the value of your holdings after the distribution is paid. You do end up with more shares. Is this the same with a bond fund such as TBM? When a bond fund does a distribution, is the NAV of that fund reduced?
http://blog.fundx.com/blog/2012/11/29/h ... ributions/
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

jb1
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Re: What is the purpose of bonds?

Post by jb1 » Mon May 01, 2017 12:10 pm

For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?

zuma
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Re: What is the purpose of bonds?

Post by zuma » Mon May 01, 2017 12:15 pm

jb1 wrote:For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?
That's the average yearly return for the period between 1926 and 2015. Interest rates fluctuated a lot during that period.

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Re: What is the purpose of bonds?

Post by jb1 » Mon May 01, 2017 12:20 pm

zuma wrote:
jb1 wrote:For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?
That's the average yearly return for the period between 1926 and 2015. Interest rates fluctuated a lot during that period.
Sorry if Im coming off like a doofus! Im just really trying to understand it. But 5% is very good considering 100% stocks averaged only 10%

Elbowman
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Re: What is the purpose of bonds?

Post by Elbowman » Mon May 01, 2017 12:22 pm

jb1 wrote:For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?
Bonds will not be returning 5.4% any time soon. In the past the dividends were higher, which is how they returned 5.4% (plus the value of old bonds go up if the return of new bonds goes down). What you can expect them to return going forward is the "SEC yield", which you can find on the Vanguard page. Right now for Vanguard Total Bond Market, the SEC yield is 2.33%. You mentioned that your $8000 investment is returning $16/month, and conveniently $16/month x 12 months / $8000 = 2.4%, just about the SEC yield.

lack_ey
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Re: What is the purpose of bonds?

Post by lack_ey » Mon May 01, 2017 12:23 pm

Gort wrote:Good question that I also don't quite understand.
In a stock fund such as TSM, when distributions are paid to the shareholder, the net asset value (NAV) of the stock fund is reduced to a point where there is no increase in the value of your holdings after the distribution is paid. You do end up with more shares. Is this the same with a bond fund such as TBM? When a bond fund does a distribution, is the NAV of that fund reduced?
Bond fund capital gains work like that. How underlying interest is treated can work like a stock fund (interest gets absorbed into NAV, NAV drops upon paying out), but many bond funds accrue interest daily into a separate pool and then pay out monthly or quarterly based on the days the fund investor held the fund. So no, a lot of bond funds don't see NAV drops from fund dividend distributions.

That's just a matter of accounting, though. Either way, the fund is just a (fair) way to access a portfolio of underlying bonds.



The point of bonds is to get a return above cash, one that isn't reliant on the same forces that drive the stock market. You can readily have situations where stock prices fall or perceptions of economic prospects darken, where most bond issuers have no problems meeting their obligations and giving you that return. It's not going to be 4% a year now, not with current market pricing. But it's probably going to be better than cash. Bond fund SEC yield is a reasonable first-level approximation of forward return for a bond fund with low credit risk (in nominal terms, before tax), though the actual return in a given year may deviate a few or several percent from that in either direction owing to changes in price. For some bond funds the fluctuations can be higher than that.

Under most conditions, economic theory, most all asset pricing models, and empirical evidence would suggest that stocks should return more than bonds. But there is always a chance that it won't happen over any given period of time. Many markets have been negative for decades at a time. If you want to diversify to mitigate the impact of stock market risk, bonds are an alternative source of return and represent a huge and well-established asset class that's even larger than the stock market. Bonds have their own risks and have limited upside, so it's not all good, but fundamentally the structure and behavior are different from what you get in stocks.

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TheTimeLord
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Re: What is the purpose of bonds?

Post by TheTimeLord » Mon May 01, 2017 12:25 pm

jb1 wrote:For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?
These articles are likely going to freak you out so sit down before reading them. BTW, looks like no matter what you did as long as you were invested for the period October 1981-September 2011 you came out a winner, AA was pretty irrelevant. Might want to tuck that fact away when people are bragging about portfolio performance.
Long-term Treasury securities have outperformed the Standard & Poor's 500 stock index for the past 10 years. The SPDR S&P 500 ETF (SPY) has gained an average 7.27% over the past decade, according to Morningstar Inc. But the iShares 20+ Year Treasury Bond ETF has gained an average 9.31% during the same period.

From a very long-term historical perspective, this is an anomaly. Long-term government bonds have earned an average 5.64% a year since 1926, while large-company stocks have gained an average 10.01% a year. (Both figures assume reinvested interest and dividends.)
This isn't the first time that bonds have beaten stocks over a 10-year period. Bonds outperformed stocks in the 10 years ended 2012, 2011, 2010, 2009, 2008, 2007, 2002, 1978, 1977, 1974, 1940, 1939, 1938, and 1937, according to Morningstar/Ibbotson data. Typically, those periods coincide with stretches of wretched stock market performance, such as the period following the technology meltdown from 2000-2001, the 1972-1973 bear market, and the Great Depression.
http://www.investmentnews.com/article/2 ... d-it-right
For the period October 1981-September 2011, the S&P 500 Index returned an annualized 10.8 percent, compared to the 11.5 percent annualized return on long-term (20-year) Treasury bonds. Should you be surprised? Yes. It certainly shouldn't have been the expected outcome. However, the right perspective is that it should have been a possible outcome.
http://www.cbsnews.com/news/bonds-beat- ... s-so-what/
Last edited by TheTimeLord on Mon May 01, 2017 12:27 pm, edited 1 time in total.
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NiceUnparticularMan
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Re: What is the purpose of bonds?

Post by NiceUnparticularMan » Mon May 01, 2017 12:27 pm

The primary purpose of buying bonds is you want to lend some entity money.

Why might you want to do that? You don't need the money now, they do, so they are willing to pay you some sort of fee in exchange for using your money in the meantime. Rationally this fee will be tied to how long they want the money, what you expect inflation will look like over that time, and what else you could do with that money instead. And you are going to rationally take into account various risks--like the possibility they won't pay you back, or the possibility inflation will be higher than you expect. In light of these risks, your fee might be a little higher, or perhaps much higher (if, say, the possibility they won't pay you back is higher than typical). And then your returns might be higher or lower than expected depending on which risks materialize. Bond pricing tends to be quite efficient, however, which means usually as far as we know, the bets on either side are roughly fair.

In terms of financial planning, usually bonds are primarily used to match known liabilities or spending plans. I know I am going to need $5000 in 5 years for some spending or some liability. So I lend someone enough to get back $5000 in 5 years, aka buy such a bond. You can do this contingently too--I MIGHT need $5000 to spend in the next 5 years, so I buy a suitable bond or set of bonds.

Note I haven't talked yet about short-term portfolio volatility. That is a controversial topic--to the extent you care about that because you might be withdrawing money, that can be a serious concern. To the extent you care about that because you check your net worth daily and when it goes down it makes you feel bad, and then you might do something adverse to your long run interests . . . maybe you should start with not checking your net worth daily, as opposed to changing your investments.

And finally there is "rebalancing". Overall there isn't going to be an expected benefit to rebalancing. But, under some particular circumstances, there might be a benefit. If in those particular circumstances it would be particularly nice to get such a benefit, you might hold a bit of the right sort of bonds for that purpose.
Last edited by NiceUnparticularMan on Mon May 01, 2017 12:29 pm, edited 1 time in total.

zuma
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Re: What is the purpose of bonds?

Post by zuma » Mon May 01, 2017 12:28 pm

jb1 wrote:
zuma wrote:
jb1 wrote:For example, if you go to Vanguards "asset mix" it will say that a portfolio of 100% bonds has averaged a 5.4% return. How?
That's the average yearly return for the period between 1926 and 2015. Interest rates fluctuated a lot during that period.
Sorry if Im coming off like a doofus! Im just really trying to understand it. But 5% is very good considering 100% stocks averaged only 10%
Here are some future projections to keep in mind:

https://www.bogleheads.org/wiki/Histori ... re_returns

For example, John Bogle expects 4% nominal returns from US stocks and 2.6% nominal returns from US bonds over the next ten years.

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Re: What is the purpose of bonds?

Post by aristotelian » Mon May 01, 2017 12:36 pm

Same reason the bank will loan you money to buy a house. They believe the interest rate on the loan is a good investment relative to the credit risk. They also believe the market interest rate is the highest that they can get.

When you purchase bonds or funds of bonds, you are in effect making loans. You are making the same calculation whether you are willing to accept lower returns in exchange for less risk, and if so, can you find a better interest rate with the same credit risk?

jb1
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Re: What is the purpose of bonds?

Post by jb1 » Mon May 01, 2017 12:36 pm

Thank you everyone for the responses. Finally is there a certain amount of time I must keep the bonds in place for? Not that Ill need the money, but for future references.

And lastly, Im going to keep a 70/30 stock to bond ratio for now and gradually adjust it as I get older. Thank you again for the help.

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Re: What is the purpose of bonds?

Post by Hogan773 » Mon May 01, 2017 1:16 pm

jb1 wrote:Thank you everyone for the responses. Finally is there a certain amount of time I must keep the bonds in place for? Not that Ill need the money, but for future references.

And lastly, Im going to keep a 70/30 stock to bond ratio for now and gradually adjust it as I get older. Thank you again for the help.
If you are buying a bond FUND then you don't need to keep it invested for any period of time (overlooking any short term limits imposed by Vanguard such as you can't buy and sell within 30 days or 3 months or whatever....I assume you are not asking about that question). The FUND holds a large number of bonds and is liquid. If you were to buy INDIVIDUAL BONDS then you could hold them to maturity (or you could sell them but that could get expensive) but as an investor with $8,000 you shouldn't be considering buying individual bonds. Transaction costs would be too high and you wouldn't be diversified enough.

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HomerJ
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Re: What is the purpose of bonds?

Post by HomerJ » Mon May 01, 2017 1:31 pm

jb1 wrote:
BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?
So, back in the 20's or 30's, no idea when, but Groucho Marx walked into the NY Stock Exchange for a tour.

As he was walking around one of the traders on the floor asked him: "Groucho, how do you invest your money?"

Groucho Answered: "All in bonds."

To which the trader replied: "But Groucho, they don't pay much return."

And Groucho Answered: "They do when you have a lot of em!"

You're making $192 a year from $8000 in bonds. That's 2.4%. I assuming you are reinvesting those dividends right back into the bond fund, so it will slowly grow. Plus you will add new savings into it.

Indeed, a goal can be someday to have $1 million in bonds, kicking out $24,000 a year or $2000 a month. Or more. Or less. Depending on interest rates.

Interest rates are really low today. That's why bonds are currently only paying 2.4%. But as interest rates rise, companies and the U.S. government will have to sell bonds that pay more. So maybe in 5-10-20 years, they will be paying 5%, or $4000 a month on that $1 million on bonds.
How do bonds make a average return of say 4% a year?
If you are talking the average return over the past 50-100 years, interest rates haven't always been this low. People were getting 6% not that long ago.

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Re: What is the purpose of bonds?

Post by rkhusky » Mon May 01, 2017 1:34 pm

jb1 wrote:Thank you everyone for the responses. Finally is there a certain amount of time I must keep the bonds in place for? Not that Ill need the money, but for future references.
There are characteristic time frames for bond funds. The most important is the average duration of the fund. You will notice that funds with higher duration generally pay more than short duration funds. It is a matter of risk vs reward.

There is a rule of thumb that if interest rates rise by p%, than your bond fund price (NAV) will drop by p% x duration (e.g. your fund has duration of 6 years, interest rates rise by 1%, your fund drops by 6%).

Another rule of thumb is that the duration is also the length of time you would need to wait until your fund's increased dividends equals the drop in price (e.g. your fund has duration of 6 years, interest rates rise by 1%, your fund drops by 6%, you wait 6 years and the increased dividends will have made up for the fund's drop of 6%).

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Gort
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Re: What is the purpose of bonds?

Post by Gort » Mon May 01, 2017 1:43 pm

BogleMelon wrote:
Gort wrote:
jb1 wrote:
BogleMelon wrote:
jb1 wrote:They dont really fluctuate much
That is the whole purpose actually. To reduce the risk thus reduce overall fund fluctuation, and make your "roller coaster ride" is more tolerable.
But how do you make money off them then? I have 8k in VBMFX, about 800 shares. VBMFX pays about .02 per share, so thats only $16 per month. Is the whole point to just reinvest to the point where you can possible get a dividend of say $500 per month?

How do bonds make a average return of say 4% a year?


Good question that I also don't quite understand.
In a stock fund such as TSM, when distributions are paid to the shareholder, the net asset value (NAV) of the stock fund is reduced to a point where there is no increase in the value of your holdings after the distribution is paid. You do end up with more shares. Is this the same with a bond fund such as TBM? When a bond fund does a distribution, is the NAV of that fund reduced?
http://blog.fundx.com/blog/2012/11/29/h ... ributions/


BogleMelon, very informative link - Thanks!

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Gort
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Re: What is the purpose of bonds?

Post by Gort » Mon May 01, 2017 1:45 pm

lack_ey wrote:
Gort wrote:Good question that I also don't quite understand.
In a stock fund such as TSM, when distributions are paid to the shareholder, the net asset value (NAV) of the stock fund is reduced to a point where there is no increase in the value of your holdings after the distribution is paid. You do end up with more shares. Is this the same with a bond fund such as TBM? When a bond fund does a distribution, is the NAV of that fund reduced?
Bond fund capital gains work like that. How underlying interest is treated can work like a stock fund (interest gets absorbed into NAV, NAV drops upon paying out), but many bond funds accrue interest daily into a separate pool and then pay out monthly or quarterly based on the days the fund investor held the fund. So no, a lot of bond funds don't see NAV drops from fund dividend distributions.

That's just a matter of accounting, though. Either way, the fund is just a (fair) way to access a portfolio of underlying bonds.



The point of bonds is to get a return above cash, one that isn't reliant on the same forces that drive the stock market. You can readily have situations where stock prices fall or perceptions of economic prospects darken, where most bond issuers have no problems meeting their obligations and giving you that return. It's not going to be 4% a year now, not with current market pricing. But it's probably going to be better than cash. Bond fund SEC yield is a reasonable first-level approximation of forward return for a bond fund with low credit risk (in nominal terms, before tax), though the actual return in a given year may deviate a few or several percent from that in either direction owing to changes in price. For some bond funds the fluctuations can be higher than that.

Under most conditions, economic theory, most all asset pricing models, and empirical evidence would suggest that stocks should return more than bonds. But there is always a chance that it won't happen over any given period of time. Many markets have been negative for decades at a time. If you want to diversify to mitigate the impact of stock market risk, bonds are an alternative source of return and represent a huge and well-established asset class that's even larger than the stock market. Bonds have their own risks and have limited upside, so it's not all good, but fundamentally the structure and behavior are different from what you get in stocks.
Thanks lack_ey. Very helpful.

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