Rising Interest and bond funds

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YikesHighFees
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Rising Interest and bond funds

Post by YikesHighFees »

I am interested in anyone's take on the philosophy of rising interest rates and the risk to bond funds and whether a bond ladder is the place to be. I understand the mechanics of why bond funds can take a hit when interet rates rise but don't bond fund managers proactively consider interet rates whan managing their bond funds? Is anyone selling their bond funds to get into a bond ladder?
jebmke
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Re: Rising Interest and bond funds

Post by jebmke »

There is a section of the wiki that discusses funds vs. ladders.
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Phineas J. Whoopee
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Re: Rising Interest and bond funds

Post by Phineas J. Whoopee »

In the spirit of not biting recent joiners, said article is here: Rolling ladders versus bond funds.
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Tyler Aspect
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Re: Rising Interest and bond funds

Post by Tyler Aspect »

There are two views on rising yield.

One view is to ignore the temporary loss in a bond fund's net asset value, because the higher yield will eventually earn back the difference over many years. As long as you have the patience, steady waiting will do the job.

An alternative view is to move to short term US Treasury positions to avoid losing money, waiting for the top of the yield curve before moving back to intermediate term bond funds. Of course you could fail to detect the top of the yield curve as it happens, and end up worse than patient waiting.
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stocknoob4111
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Re: Rising Interest and bond funds

Post by stocknoob4111 »

Yield is rising as well so not too much of an issue, you will eventually recoup it if you wait long enough. Also tax loss harvest it towards the end of the year and you will recoup the tax hit from the higher yield. All in all, once you do the math I think it's not too big of a deal. Unfortunately the press makes it seem like the sky is falling.
TropikThunder
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Re: Rising Interest and bond funds

Post by TropikThunder »

YikesHighFees wrote: Wed Apr 25, 2018 4:05 pm I am interested in anyone's take on the philosophy of rising interest rates and the risk to bond funds and whether a bond ladder is the place to be. I understand the mechanics of why bond funds can take a hit when interet rates rise but don't bond fund managers proactively consider interet rates whan managing their bond funds? Is anyone selling their bond funds to get into a bond ladder?
Yes and no. The Vanguard Total Bond Market (TBM) fund follows an index, so it doesn't "manage" term risk, it accepts the term risk of the index. Active bond funds likely do manage term risk by, for example, shortening duration during rising rates to turn their holdings over faster. As far as an individual investor switching to a bond ladder, in my opinion it's not worth the time and oversight if your investing horizon is longer than the average duration of the bonds in your bond fund. As Tyler alludes to, increased rates will mean increased coupons in the newer bonds the fund buys in the future. Turnover in a bond fund with a defined duration (like Vanguard TBM) acts like a ladder in essence anyways.
billfromct
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Re: Rising Interest and bond funds

Post by billfromct »

Here's how my IRA is set up for the start of required minimum distributions (RMDs) starting next year. I will probably have the RMD taken from my short term bond fund & rebalance accordingly. When interest rates normalize, I will move the assets of the MM fund into the ST Bond Fund.
-10 years of RMDs in fixed income (61% of IRA)
-2.5 years in money market
-3.0 years in short term bond fund (2.8 years duration)
-4.5 years in intermediate term bond fund (4.4 years duration)

I will have Vanguard distribute the RMD in January to my taxable MM fund in order to get it out of the way. This will make it easy for my beneficiaries should something happen to me during the year.

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aristotelian
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Re: Rising Interest and bond funds

Post by aristotelian »

The overall expected return of a bond ladder would be exactly the same as an index fund which is a collection of bond ladders. With the ladder, you have no principal risk but you are locked into the lower yield of the original bond. With the index fund, you have principal risk but the yield rises as interest rates rise. If a bond ladder without principal risk gives you psychological comfort, go for it.
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Phineas J. Whoopee
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Re: Rising Interest and bond funds

Post by Phineas J. Whoopee »

aristotelian wrote: Wed Apr 25, 2018 6:30 pm The overall expected return of a bond ladder would be exactly the same as an index fund which is a collection of bond ladders. With the ladder, you have no principal risk but you are locked into the lower yield of the original bond. With the index fund, you have principal risk but the yield rises as interest rates rise. If a bond ladder without principal risk gives you psychological comfort, go for it.
I'm afraid the market values of already-issued bonds change exactly as much whether held directly or through a fund, and the yields, if not otherwise specified conventionally meaning Yield to Maturity, YTM, change just the same as well.

In a fund there is an expense ratio, but on the other hand the fund is probably able to negotiate narrower spreads on bonds it buys and sells than an individual could.

If one holds bonds directly one is free to pretend their market values don't change, but then again one is free to pretend the same about a mutual fund.

A mutual fund is nothing more nor less than a vehicle by which to own its underlying holdings.

I agree with your psychological comfort point.

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dwickenh
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Re: Rising Interest and bond funds

Post by dwickenh »

Phineas J. Whoopee wrote: Wed Apr 25, 2018 7:57 pm
aristotelian wrote: Wed Apr 25, 2018 6:30 pm The overall expected return of a bond ladder would be exactly the same as an index fund which is a collection of bond ladders. With the ladder, you have no principal risk but you are locked into the lower yield of the original bond. With the index fund, you have principal risk but the yield rises as interest rates rise. If a bond ladder without principal risk gives you psychological comfort, go for it.
I'm afraid the market values of already-issued bonds change exactly as much whether held directly or through a fund, and the yields, if not otherwise specified conventionally meaning Yield to Maturity, YTM, change just the same as well.

In a fund there is an expense ratio, but on the other hand the fund is probably able to negotiate narrower spreads on bonds it buys and sells than an individual could.

If one holds bonds directly one is free to pretend their market values don't change, but then again one is free to pretend the same about a mutual fund.

A mutual fund is nothing more nor less than a vehicle by which to own its underlying holdings.

I agree with your psychological comfort point.

PJW
Great points PJW. Sometimes the right words make the picture much clearer!!

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Re: Rising Interest and bond funds

Post by Clever_Username »

Tyler Aspect wrote: Wed Apr 25, 2018 6:07 pm One view is to ignore the temporary loss in a bond fund's net asset value, because the higher yield will eventually earn back the difference over many years. As long as you have the patience, steady waiting will do the job.
This is what I've been doing as my portfolio has recently grown into taxable space in the form of CA Munis (Intermed Term) fund. Even accounting for distributions, I'm down a few hundred dollars (I should stop checking, pardon the pun). But that's not money I'm going to spend for a while (I agonized over intermed vs long term for a short bit) and I'll probably notice the increased distributions more.
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jeffreyalan
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Re: Rising Interest and bond funds

Post by jeffreyalan »

I hear people say all that time that rising rates are not a problem for a bond fund as long as you hold it thru the avg duration of the bonds in the fund. Can someone help me understand that better? I understand that theory if there is just one or two rate increases and then they stop. But in a situation where we are now where we may get 3-4 rate increases this year and then another few next year, wouldn't the NAV/principal balance continue to drop with each increase and leave you in the negative until the rate increases stop and the higher interest payments finally catch up?
mptfan
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Re: Rising Interest and bond funds

Post by mptfan »

jeffreyalan wrote: Thu Apr 26, 2018 2:08 pmI understand that theory if there is just one or two rate increases and then they stop.
What makes you believe that the theory is limited to situations where there is just one or two rate increases?
jeffreyalan
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Re: Rising Interest and bond funds

Post by jeffreyalan »

Well lets say my bond fund has a 2 year avg duration. So I am told that if I hold it thru 2 years then in general I should not have much of a principal loss. However, what if in year 1 interest rates rise 3 times? And then in year 2, interest rates rise another 3 times? Doesn't the NAV of the fund decline with each rise? So that at the end of 2 years, I am still sitting on a principal loss?
mptfan
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Re: Rising Interest and bond funds

Post by mptfan »

Interest rates are not monolithic, it depends on what rates rise. The Fed is raising the fed funds rate, not longer term rates. Sure, the fed funds rate may have an impact on other rates, but it's not an automatic thing. Essentially, you have to figure out what rates are rising and see if that matches up with the average duration of the bond fund you are looking at.
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Re: Rising Interest and bond funds

Post by saltycaper »

jeffreyalan wrote: Thu Apr 26, 2018 2:31 pm Well lets say my bond fund has a 2 year avg duration. So I am told that if I hold it thru 2 years then in general I should not have much of a principal loss. However, what if in year 1 interest rates rise 3 times? And then in year 2, interest rates rise another 3 times? Doesn't the NAV of the fund decline with each rise? So that at the end of 2 years, I am still sitting on a principal loss?
If we're talking about yields on bonds within the funds you hold, and not "interest rates" in general, which is vague, then yes.
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visualguy
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Re: Rising Interest and bond funds

Post by visualguy »

jeffreyalan wrote: Thu Apr 26, 2018 2:08 pm I hear people say all that time that rising rates are not a problem for a bond fund as long as you hold it thru the avg duration of the bonds in the fund. Can someone help me understand that better? I understand that theory if there is just one or two rate increases and then they stop. But in a situation where we are now where we may get 3-4 rate increases this year and then another few next year, wouldn't the NAV/principal balance continue to drop with each increase and leave you in the negative until the rate increases stop and the higher interest payments finally catch up?
I believe the formula is 2*d-1 where d is the duration. You may need to wait that long to get your principal back with interest based on the original yield.
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Re: Rising Interest and bond funds

Post by Hogan773 »

visualguy wrote: Thu Apr 26, 2018 4:59 pm
jeffreyalan wrote: Thu Apr 26, 2018 2:08 pm I hear people say all that time that rising rates are not a problem for a bond fund as long as you hold it thru the avg duration of the bonds in the fund. Can someone help me understand that better? I understand that theory if there is just one or two rate increases and then they stop. But in a situation where we are now where we may get 3-4 rate increases this year and then another few next year, wouldn't the NAV/principal balance continue to drop with each increase and leave you in the negative until the rate increases stop and the higher interest payments finally catch up?
I believe the formula is 2*d-1 where d is the duration. You may need to wait that long to get your principal back with interest based on the original yield.
The change in NAV is supposed to be something like (Duration * % change in rates). So for a Duration of 5 yrs and a 1% increase in interest rate (eg from 3% to 4%) the value of a bond would decline by 5%. For a duration of 10yrs, if rates rise by 10bp (2.90 to 3.00) then the NAV would drop by 1%.
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Re: Rising Interest and bond funds

Post by dbr »

Hogan773 wrote: Fri Apr 27, 2018 9:34 am
visualguy wrote: Thu Apr 26, 2018 4:59 pm
jeffreyalan wrote: Thu Apr 26, 2018 2:08 pm I hear people say all that time that rising rates are not a problem for a bond fund as long as you hold it thru the avg duration of the bonds in the fund. Can someone help me understand that better? I understand that theory if there is just one or two rate increases and then they stop. But in a situation where we are now where we may get 3-4 rate increases this year and then another few next year, wouldn't the NAV/principal balance continue to drop with each increase and leave you in the negative until the rate increases stop and the higher interest payments finally catch up?
I believe the formula is 2*d-1 where d is the duration. You may need to wait that long to get your principal back with interest based on the original yield.
The change in NAV is supposed to be something like (Duration * % change in rates). So for a Duration of 5 yrs and a 1% increase in interest rate (eg from 3% to 4%) the value of a bond would decline by 5%. For a duration of 10yrs, if rates rise by 10bp (2.90 to 3.00) then the NAV would drop by 1%.
That applies to a one time loss followed by no further change in interest rates. In the real world interest rates are continually changing and NAV changes follow. I think the formula might be for interest rate changes that are a constant linear increase, also a theoretical rather than practical case.

A more useful approach might be to recognize that the market value of bonds, whether held individually or in a portfolio, fluctuates and should be viewed as an average volatility. This can be compared to the benefit in expected return gained by taking this extra duration risk. The investor whose objective is to recover an exactly know amount of money at an exactly known time can buy an individual bond that mature at that date, the caveat being there is no interest in the value of the bond at intervening times. The investor who is concerned to be able to recover the exact value of the investment at any time should place the money in a savings account or a CD that has inviolable ability to be redeemed early. If the investor wants the amount to be recovered to be in real dollars and at any time (with a couple of qibbles) I bonds are available for that.

The question for fixed income investors is not how bonds work,which is clear enough, but to understand what one actually wants and why.
3funder
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Re: Rising Interest and bond funds

Post by 3funder »

stocknoob4111 wrote: Wed Apr 25, 2018 6:17 pm Yield is rising as well so not too much of an issue, you will eventually recoup it if you wait long enough. Also tax loss harvest it towards the end of the year and you will recoup the tax hit from the higher yield. All in all, once you do the math I think it's not too big of a deal. Unfortunately the press makes it seem like the sky is falling.
+1, although I hold bonds in tax-advantaged. Current bond fears (assuming you hold at least investment-grade intermediate-term bonds) are way overblown.
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