bonds or bond funds?

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margeinoferror
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bonds or bond funds?

Post by margeinoferror »

I don't understand bond funds, so my 401k contributions go into a stock fund.
I'm thinking about diversifying. I'd like to make sure that $$ going into bonds will make make gains.

Since bond funds can lose money, I shy away from them. I'm not sure if I can buy bonds directly (with, say, 5k). I'm more inclined, then, to put that $$ into CDs.

I'd like to know from those of you who hold bond funds why you do so? What are the pros and cons? Are they better that CDs?

Thanks,
Marge
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Kevin M
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Re: bonds or bond funds?

Post by Kevin M »

Welcome to the forum, Marge!

Individual bonds can lose money too if you evaluate them in a way that's consistent with the way they're valued in a bond fund. A bond fund is just a collection of individual bonds, so if you owned a collection of individual bonds similar to the bond fund, you'd make or lose about the same amount of money as the bond fund.

You can buy Treasuries with as little as $1,000, so yes, you could buy some individual bonds with $5,000.

If in a taxable account and if you pay state income tax, Treasuries could have a higher after-tax yield than CDs of the same maturity. For me this is true out to about 3-year maturity. I am favoring 1-year Treasuries in my taxable accounts. I plan to buy some 1-year Treasuries at the next auction, which should occur later this month.

In a tax-advantaged account, like an IRA, CD yields beat Treasury yields at 2-year maturity and beyond. I am favoring 2-year CDs in my IRAs, but also buying some 3-year CDs.

Bond funds are fine if you're OK with the duration (term risk, aka interest-rate risk) and credit risk (aka default risk) of the fund. Bond funds are more convenient than buying individual bonds or CDs.

I own both, but have been putting new cash in individual Treasuries and munis in taxable (currently would stick with Treasuries), and CDs in IRAs. I like the ability to keep my maturities shorter than most bond funds in the current environment, with steep yield curves at shorter maturities and relatively flat yield curves at intermediate maturities. I also like the yield premiums of 2-year and 3-year CDs relative to 2-year and 3-year Treasuries.

I'd say the vast majority of Bogleheads stick with bond funds though.

Kevin
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danielc
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Re: bonds or bond funds?

Post by danielc »

margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I don't understand bond funds, so my 401k contributions go into a stock fund.
I'm thinking about diversifying. I'd like to make sure that $$ going into bonds will make make gains.

Since bond funds can lose money, I shy away from them. I'm not sure if I can buy bonds directly (with, say, 5k).
Yes, you can. For example, with a broker like Fidelity you can buy treasuries in units or $1k, and with TreasuryDirect you can buy them in steps of $100. My bond allocation is in the form of treasuries bought at the (weekly) auctions through my broker (Fidelity).
margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I'm more inclined, then, to put that $$ into CDs.
I like CDs, but it's worth realizing that CDs are basically bonds too. If you could trade a CD in the open market, its price would fluctuate the same way that bonds do. So a CD is basically a bond with a put option. A put option means that you have the right to sell them to the issuer (in this case, your bank) at a given price. If a put option is important to you, you might also want to look at I-Bonds. They are also issued by the US Treasury. You are required to hold them for at leat 1 year, but after that you can sell them back to the Treasury with a smaller penalty than CDs, and you can hold them for up to 30 years.
margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I'd like to know from those of you who hold bond funds why you do so? What are the pros and cons? Are they better that CDs?
I don't hold bond funds. I think neither option is obviously better. They have pros and cons. A CD or I-Bond has a type of built-in safety in the form of a put option and you pay a price for that safety in the form of lower returns. To continue with my argument that one should not distinguish so much between CDs and bonds, consider that you can also buy CDs in the open market through your broker. Those "brokered CDs" typically have higher yields than the regular bank CD, but in turn they go up and down in price just as much as bonds do. In fact, they are worse than bonds because they are generally much less liquid (translation: you lose more money to the bid/ask spread).

Edit: Read this page - CDs vs bonds
averagedude
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Re: bonds or bond funds?

Post by averagedude »

CD's are better in a rising interest rate environment. Bond's are better when interest rates are flat or in a lowering interest rate environment. Interest rates typically run in cycle's and we had been in a 35 year period of lowering interest rates. Right now, interest rates have been rising and the fed has plans to make further hikes in the short term future. Me personally, i think 1 to 2 year CD's are better right now and i would advise to stay clear of any long duration bonds because the interest rate risk is too large for such a small amount of yield. Of course i don't really know what interest rates are going to do in the long term, and no one else does either.
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Re: bonds or bond funds?

Post by danielc »

Marge,

Just to clarify a bit on what @averagedude said:

Bonds drop in value when interest rates rise. Imagine you have a $1,000 bond that will pay $1,030 next year (i.e. return of 3%). Now imagine that interest rates increase to 4%. Someone investing $1,000 today will get $1,040 next year. They are not willing to buy your bond for the $1,000 that you paid for it. If you want to sell your bond, you have to sell it at $990 so that the buyer still gets the 4% return. That's how bonds can go down in value.

The reason why "CD's are better in a rising interest rate environment" is the put option that I told you. You know you can always sell your $1,000 CD back to the bank and without losing any money, and then buy a new CD for $1,000.

I don't recommend trying to predict where the interest rates are going to go. But one rule of thumb I've heard in this forum is that you should expect to get paid at least an extra 0.2% for every additional year that you have to wait. For example, if I go to the CapitalOne website right now I see that they offer a 1-year CD at 2.30% interest and a 3-year CD at 2.55% interest. So they are offering you an extra 0.25% for waiting an extra 2 years. Compute 0.25% / 2 = 0.125%. So it looks like CapialOne is not offering you a good compensation for locking your money for 3 years. You can use this rule of thumb to help guide your decisions.

averagedude wrote: Mon Jul 02, 2018 5:14 pm CD's are better in a rising interest rate environment. Bond's are better when interest rates are flat or in a lowering interest rate environment. Interest rates typically run in cycle's and we had been in a 35 year period of lowering interest rates. Right now, interest rates have been rising and the fed has plans to make further hikes in the short term future. Me personally, i think 1 to 2 year CD's are better right now and i would advise to stay clear of any long duration bonds because the interest rate risk is too large for such a small amount of yield. Of course i don't really know what interest rates are going to do in the long term, and no one else does either.
Last edited by danielc on Mon Jul 02, 2018 8:06 pm, edited 1 time in total.
VaR
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Re: bonds or bond funds?

Post by VaR »

For most investors, there is no practical difference between investing in individual bonds and investing in bond funds except for convenience.

I allocate to fixed income (e.g. bonds) because they diversify and reduce the risks in my portfolio. I don't really care that much about the daily mark-to-market value of the bond funds I'm invested in, as long as over the long haul they return my principal and reduce the overall risk of my portfolio.

Note: People often write here about how you can "lose money" invested in a bond due to the fact that you can get a daily report of its market value. What isn't often written about is that that bond will ultimately return 100% of its principal upon maturity. (Caveat: Except for the edge case where it defaults and you get back, say 50%)

I invest in bond funds for convenience and because I also want the diversification of high grade corporate bonds that, for all practical purposes for the individual investor, is only available in bond funds.
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Re: bonds or bond funds?

Post by z3r0c00l »

margeinoferror wrote: Mon Jul 02, 2018 3:40 pm so my 401k contributions go into a stock fund.

Since bond funds can lose money, I shy away from them.
Just to be clear, you avoid bond funds because they sometimes lose a few percent per year and put all your money into stock funds which have lost 25% in one day on two occasions, and can easily drop 50% in a year? The worst US stock decline in the past century was 90%.

Avoiding bonds in favor of stocks is an odd choice for someone who is risk-averse.

That isn't to say CDs are a poor choice. In fact they are essentially a kind of bond. Just that the volatility in most bond funds is almost insignificant compared to stocks.
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Kevin M
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Re: bonds or bond funds?

Post by Kevin M »

danielc wrote: Mon Jul 02, 2018 6:39 pm The reason why "CD's are better in a rising interest rate environment" is the put option that I told you. You know you can always sell your $1,000 CD back to the bank and without losing any money, and then buy a new CD for $1,000.
Generally, this is not true. Direct CDs (bought directly from banks or credit unions) generally impose an early withdrawal penalty, so generally, you will lose some money if you do an early withdrawal. However, this can still be an advantage over a brokered CD or a bond of same maturity, because the early withdrawal penalty could be less than what you'd lose if you sold the brokered CD or bond before maturity if interest rates rose enough.

There are exceptions. Some credit unions allow penalty-free withdrawals from IRA CDs (CDs in an IRA) if you are age 59 1/2 or older. I recently was able to take advantage of this to do a penalty-free early withdrawal from CDs at 2.7% and reinvest in new 5-year CD at 4.2% (at the same credit union).

Kevin
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Re: bonds or bond funds?

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Re: bonds or bond funds?

Post by danielc »

Kevin M wrote: Mon Jul 02, 2018 7:35 pm Generally, this is not true. Direct CDs (bought directly from banks or credit unions) generally impose an early withdrawal penalty, so generally, you will lose some money if you do an early withdrawal.
I was trying to keep the story simple. I thought that my post was too long as it was. But perhaps I should have mentioned the ealy withdrawal fees. I think they're usually 3 months of interest for 1-2 year CDs (depending on the bank) and 6 months thereafter. Ally has penalty-free CDs up to 11 months.
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Re: bonds or bond funds?

Post by danielc »

jalbert wrote: Mon Jul 02, 2018 7:44 pm If you don’t want there to be a possibility of investments you hold to lose money, why do you hold stocks?
It is entirely reasonable to want to mix a risky investment with a risk-free investment. The risky vs free allocation is the most fundamental decision in asset allocation. If you believe in taking the risk on the equity side, it is entirely reasonable to pick something like a CD for your bond allocation. I use short-term treasuries.
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Re: bonds or bond funds?

Post by Tyler Aspect »


Patient Waiting a solution to Yield Increases

Patient waiting is a possible solution to the net asset loss associated with possible bond fund yield increase. 7 years of extra dividend equalizes an upfront net asset value loss for an intermediate term bond fund. You just have to hold the bond fund for 7 years after the fund's yield reaches the highest point.
Past result does not predict future performance. Mentioned investments may lose money. Contents are presented "AS IS" and any implied suitability for a particular purpose are disclaimed.
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Kevin M
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Re: bonds or bond funds?

Post by Kevin M »

danielc wrote: Mon Jul 02, 2018 7:57 pm
Kevin M wrote: Mon Jul 02, 2018 7:35 pm Generally, this is not true. Direct CDs (bought directly from banks or credit unions) generally impose an early withdrawal penalty, so generally, you will lose some money if you do an early withdrawal.
I was trying to keep the story simple. I thought that my post was too long as it was. But perhaps I should have mentioned the ealy withdrawal fees. I think they're usually 3 months of interest for 1-2 year CDs (depending on the bank) and 6 months thereafter. Ally has penalty-free CDs up to 11 months.
Let's knock off the Ally no-penalty CD first. It was a good deal some months ago, but is not in the current fixed-income environment. The rate now ranges from 1.30% to 1.85%, depending on the minimum opening deposit, but you can earn 2.04% now in Vanguard Prime money market (and I recently opened a savings account with a 2.26% APY, but it's no longer available at that rate).

For the shorter-term CDs with lower early withdrawal penalties (EWPs), the EWP is not particularly valuable, since you take a relatively big hit for a relatively small benefit. You're going to be able to roll the CD over relatively quickly, so you're not exposed to much term risk even without the early withdrawal option.

Until the last year or so, one could find a good direct 5-year CD with an EWP of six months of interest, and also with a large yield premium relative to a 5-year Treasury. Yield premiums could easily be 100 basis points or even 150 basis points (so say 5-year Treasury was at 1.5%, CD would be at 2.5% to 3.0%). This combination of hefty yield premium plus low EWP made for very attractive fixed-income investments.

Unfortunately, these types of deals have been extremely rare lately. Yield premiums generally are much smaller, and the EWP for a 5-year CD now is more likely to be one year of interest instead of six months. This has made direct CDs much less attractive than they were when I was buying them heavily from late 2010 to 2017 or so.

I'm now preferring 2-year to 3-year brokered CDs in IRAs, as the yield premiums over Treasuries are 20-35 basis points, and the term risk is not enough to worry about early withdrawal options. I'll just hold these to maturity.

As I said, I'm now preferring 1-year Treasuries in taxable due to steep yield curve out to one year, so a 1-year Treasury beats a 1-year brokered CD on an after-tax basis for me. Even at 2-year and 3-year maturity, Treasuries are about the same as brokered CDs after tax for me, so I would prefer Treasuries in a taxable account. And as mentioned, these terms are too short for the early withdrawal option of a direct CD to provide much downside protection against rising rates.

The yield curves are too flat beyond 3-year maturity to justify taking the extra term risk (for me).

Kevin
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patrick013
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Re: bonds or bond funds?

Post by patrick013 »

Looking at a 12 year Farm Credit Bond (no state tax).
Coupon 4% at par. If 5% I'd grab it in an instant.

If I buy rate increases could push future issuances to
yield 5%. Too soon right now.

If markets correct or crash yields would likely fall and
I'd be sitting good for awhile collecting the 4% with no
state tax.

Not a TRSY but I would consider very creditworthy. Farm
yields are up. What a decision. Probably wait till next year
for something at that maturity.
age in bonds, buy-and-hold, 10 year business cycle
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Re: bonds or bond funds?

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Re: bonds or bond funds?

Post by danielc »

jalbert wrote: Mon Jul 02, 2018 10:07 pm
danielc wrote: Mon Jul 02, 2018 8:01 pm
jalbert wrote: Mon Jul 02, 2018 7:44 pm If you don’t want there to be a possibility of investments you hold to lose money, why do you hold stocks?
It is entirely reasonable to want to mix a risky investment with a risk-free investment. The risky vs free allocation is the most fundamental decision in asset allocation. If you believe in taking the risk on the equity side, it is entirely reasonable to pick something like a CD for your bond allocation. I use short-term treasuries.
Yes, the part of my post you did not quote back said pretty much the same thing.
It is never my intention to quote unfairly. You asked "why do you hold stocks?", as if it was somehow unreasonable to mix something very safe with something very risky. I felt that a reference to Grok's rule was appropriate. I do not think that the part of your post that I did not quote said the same thing, but we can agree to disagree.
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Re: bonds or bond funds?

Post by aristotelian »

Why do you think individual bonds can't lose value but buckets of individual bonds can?
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Re: bonds or bond funds?

Post by gold-rabbit »

Hi everyone,

I have a similar question. about 6 months ago I sold SCHO (Schwab Short-Term U.S. Treasury ETF) and SCHR (Schwab Intermediate-Term U.S. Treasury ETF) because I was reading news that interest rates would go up which I assumed meant that the price of the ETF would fall (and it has slightly). It looks like interest rates will still keep going up over time so I assume the price of the ETF will continue to fall.

Here's my questions:

1. Why buy SCHO or SCHR ETFs if the price will fall? It seems like I will lose money.

2. Does the interest rate and reinvesting the dividend make up for the loss in the price?

3. Am I understanding this right? Please correct me if I've made any mistakes in my assumptions (I'm still trying to learn).

4. I've been holding cash instead of buying bonds. I didn't do the math but I'm starting to think at least the bonds are returning dividends and the price decrease was small so they are better than cash

I'm asking these questions because I'm thinking I should go back into bonds and I'm not sure if cash is the best choice.

Thanks!
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Re: bonds or bond funds?

Post by Kevin M »

gold-rabbit wrote: Tue Jul 03, 2018 9:09 am Here's my questions:

1. Why buy SCHO or SCHR ETFs if the price will fall? It seems like I will lose money.
Because no one knows for sure that yields will increase and prices will fall. Many Bogleheads prefer to just pick a bond fund (or several bond funds) and just hold them.
2. Does the interest rate and reinvesting the dividend make up for the loss in the price?
Eventually, yes. How long it takes depends on the duration of the fund, and the pattern of the increases in yields.
4. I've been holding cash instead of buying bonds. I didn't do the math but I'm starting to think at least the bonds are returning dividends and the price decrease was small so they are better than cash
No one can say for sure which will earn more over a specific time period. In recent months, cash has earned more than bonds, because yields have generally increased, and not enough time has passed for bonds to recover.

Since mid-May, Treasury yields have generally decreased (so prices have increased). We don't know if they'll continue decreasing, stay flat for awhile, or resume the upward trend that was running since early September 2017.

Just because there's a high probability of more Fed funds rate increases doesn't mean that any but the shortest-term yields will follow.
I'm asking these questions because I'm thinking I should go back into bonds and I'm not sure if cash is the best choice.
For longer holding periods, bonds have higher expected returns, but no one can say for sure that they will do better over a particular time period. No one is good at forecasting interest rates, so no one can say which is the best choice.

I'd say the majority of Bogleheads would say to just pick a short-term or intermediate-term bond fund that you're comfortable with, and stick with it.

Some of us do other things that we think have a better risk/return trade-off, but that's more complicated. For example, a 2-year or 3-year new-issue brokered CD has a higher yield than a 2-year or 3-year Treasury in a tax-advantaged account (e.g., IRA), so if held to maturity, you will for sure earn more with the CDs.

However, in a taxable account, the Treasuries could earn more or about the same if you pay state income tax, due to the state tax exemption. So one might prefer the CDs in an IRA and Treasuries in taxable.

Some of us think the yield curve is too flat to extend maturity beyond two or three years, while others think that using the yield curve as a guide to targeting maturities isn't likely to have any benefit.

Kevin
Last edited by Kevin M on Wed Jul 04, 2018 1:53 pm, edited 2 times in total.
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Topic Author
margeinoferror
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Re: bonds or bond funds?

Post by margeinoferror »

aristotelian wrote: Mon Jul 02, 2018 11:21 pm Why do you think individual bonds can't lose value but buckets of individual bonds can?
My understanding is that if you hold them to maturity, you get back the principal plus interest.
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margeinoferror
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Re: bonds or bond funds?

Post by margeinoferror »

jalbert wrote: Mon Jul 02, 2018 7:44 pm If you don’t want there to be a possibility of investments you hold to lose money, why do you hold stocks?
I hold stocks in my 401k because I understand them. I don't understand bond funds, andI didn't want to invest in something that I know little about.
I'm gaining some knowledge here, though (thanks, all).
jalbert wrote: Mon Jul 02, 2018 7:44 pm Ultimately, the risk and return characteristics of the whole portfolio is what you should care about. If you post the bond, money-market, and stable-value fund options in your 401K we can offer some suggestions if you are interested. Include expense ratios of bond funds, and yields or crediting rates of money market or stable value funds.
I may do just that - thanks for the offer.
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Re: bonds or bond funds?

Post by aristotelian »

margeinoferror wrote: Tue Jul 03, 2018 1:53 pm
aristotelian wrote: Mon Jul 02, 2018 11:21 pm Why do you think individual bonds can't lose value but buckets of individual bonds can?
My understanding is that if you hold them to maturity, you get back the principal plus interest.
Correct. But the bond fund will also hold an index of individual bonds to maturity. It never loses money on any individual bond, either. What you "see" is a lower price with higher yield, but if you hold to maturity the net effect is the same.
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Re: bonds or bond funds?

Post by dbr »

margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I don't understand bond funds, so my 401k contributions go into a stock fund.
I'm thinking about diversifying. I'd like to make sure that $$ going into bonds will make make gains.

Since bond funds can lose money, I shy away from them. I'm not sure if I can buy bonds directly (with, say, 5k). I'm more inclined, then, to put that $$ into CDs.

I'd like to know from those of you who hold bond funds why you do so? What are the pros and cons? Are they better that CDs?

Thanks,
Marge
It is almost beyond comprehension why someone would invest mainly in stocks that lose lots of money on frequent intervals but feel they cannot invest in bonds that can lose relatively much less money on frequent intervals.

The answer to your question is that a portfolio is supposed to be designed to target an expected return and an expected variability in that return within the bounds of how investments can be configured to target those numbers. In general the more return one tries to target the more variability one will get. The highest end of both is all equities and the lowest end of both is all bonds, at least bonds that are not too long in duration or too risky to default. So bonds are added to adjust one's position on a continuum of risk and return. That bonds can and do lose money from time to time is utterly irrelevant to the long term investor in a portfolio of stocks and bonds.

There are other uses for bonds where the question of how much money might be lost at any point in time is important. The people that need to care about that should know who they are. This is not me and probably not you.

Oh, and to directly answer your question, I am about 50/50 stocks/bonds because I don't need the higher returns of 100% stocks while I would like my long term financial prospects to be more certain than 100% stocks will hand me. There is also a sort of meta-reasoning that in principal holding a more diverse portfolio with respect to asset types will result in less disaster is some one asset, stocks or bonds, experiences some rare but large disaster. Part of not needing the higher returns of stocks comes from the observation that for people in retirement withdrawing from a portfolio the chances of failure are not much affected by having more in stocks. Of course, the range of wealth one might have when one dies is larger and higher with more stocks, but that is not a large concern for me. It could be for someone else.
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Re: bonds or bond funds?

Post by patrick013 »

aristotelian wrote: Tue Jul 03, 2018 2:07 pm
margeinoferror wrote: Tue Jul 03, 2018 1:53 pm
aristotelian wrote: Mon Jul 02, 2018 11:21 pm Why do you think individual bonds can't lose value but buckets of individual bonds can?
My understanding is that if you hold them to maturity, you get back the principal plus interest.
Correct. But the bond fund will also hold an index of individual bonds to maturity. It never loses money on any individual bond, either. What you "see" is a lower price with higher yield, but if you hold to maturity the net effect is the same.
Assuming the interest rates rise as per scheduled if you target dated that
you will receive a 1% increase in yield or slightly more, you'll get it a year
or 2 earlier, and without a capital loss to do so, when the new bonds are
bought at the target date. Risk is information risk.

Duration is a passive strategy. You'll get the SEC yield or slightly higher per
the duration term. You won't get the increased YTM till a few years later
when new bonds are purchased by the fund. Target dating like above is a
semi-active strategy.

People invest for diversification in stock funds for a percent or more return.
Why not target date a few bonds for a percent or more return. It's really not
that hard.
age in bonds, buy-and-hold, 10 year business cycle
aristotelian
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Re: bonds or bond funds?

Post by aristotelian »

patrick013 wrote: Tue Jul 03, 2018 2:48 pm
Assuming the interest rates rise as per scheduled if you target dated that
you will receive a 1% increase in yield or slightly more, you'll get it a year
or 2 earlier, and without a capital loss to do so, when the new bonds are
bought at the target date. Risk is information risk.

Duration is a passive strategy. You'll get the SEC yield or slightly higher per
the duration term. You won't get the increased YTM till a few years later
when new bonds are purchased by the fund. Target dating like above is a
semi-active strategy.

People invest for diversification in stock funds for a percent or more return.
Why not target date a few bonds for a percent or more return. It's really not
that hard.
Not sure what you mean by "target dating". My point is, a bond fund is an aggregation of individual bonds, so even though there is risk of principal loss in the short term, each individual bond within the fund does not lose principal. Therefore, over time, the expected return of a bond fund vs regularly purchasing individual bonds is exactly the same.
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Re: bonds or bond funds?

Post by ROIGuy »

Any type of savings can lose money. However, bond funds may lose in a year what a stock fund could lose in a week. Bonds are basically the ballast of your portfolio.
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Re: bonds or bond funds?

Post by patrick013 »

aristotelian wrote: Tue Jul 03, 2018 5:34 pm Not sure what you mean by "target dating". My point is, a bond fund is an aggregation of individual bonds, so even though there is risk of principal loss in the short term, each individual bond within the fund does not lose principal. Therefore, over time, the expected return of a bond fund vs regularly purchasing individual bonds is exactly the same.
Instead of duration term just have bonds mature when cash needed by date
or "target date". So if I bet some bond will be for sale in 2021 then my bonds
mature in 2021. A duration term isn't quite exact but an estimate. VG ST
Corp VFSUX might due the trick. Duration is 2.6. Not the worse 2nd choice.
But I think using actual maturity is to the dollar then.
age in bonds, buy-and-hold, 10 year business cycle
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Re: bonds or bond funds?

Post by gold-rabbit »

Thanks for your reply Kevin. This makes sense and I think it pretty much aligns with what I understand. I will do a little more research about CDs and get back into bonds and/or CDs with my cash.
Kevin M wrote: Tue Jul 03, 2018 12:51 pm
gold-rabbit wrote: Tue Jul 03, 2018 9:09 am Here's my questions:

1. Why buy SCHO or SCHR ETFs if the price will fall? It seems like I will lose money.
Because no one knows for sure that yields will increase and prices will fall. Many Bogleheads prefer to just pick a bond fund (or several bond funds) and just hold them.
2. Does the interest rate and reinvesting the dividend make up for the loss in the price?
Eventually, yes. How long it takes depends on the duration of the fund, and the pattern of the increases in yields.
4. I've been holding cash instead of buying bonds. I didn't do the math but I'm starting to think at least the bonds are returning dividends and the price decrease was small so they are better than cash
No one can say for sure which will earn more over a specific time period. In recent months, cash has earned more than bonds, because yields have generally increased, and not enough time has passed for bonds to recover.

Since mid-May, Treasury yields have generally decreased (so prices have increased). We don't know if they'll continue decreasing, stay flat for awhile, or resume the upward trend that was running since early September 2017.

Just because there's a high probability of more Fed funds rate increases doesn't mean that any but the shortest-term yields will follow.
I'm asking these questions because I'm thinking I should go back into bonds and I'm not sure if cash is the best choice.
For longer holding periods, bonds have higher expected returns, but no one can say for sure that they will do better over a particular time period. No one is good at forecasting interest rates, so no one can say which is the best choice.

I'd say the majority of Bogleheads would say to just pick a short-term or intermediate-term bond fund that you're comfortable with, and stick with it.

Some of us do other things that we think have a better risk/return trade-off, but that's more complicated. For example, a 2-year or 3-year new-issue brokered CD has a higher yield than a 2-year or 3-year Treasury in a tax-advantaged account (e.g., IRA), so if held to maturity, you will for sure earn more with the CDs.

However, in a taxable account, the Treasuries could earn more or about the same if you pay state income tax, due to the state tax exemption. So one might prefer the CDs in an IRA and Treasuries in taxable.

Some of us think the yield curve is too flat to extend maturity beyond two or three years, while others think that using the yield curve as a guide to targeting maturities isn't likely to have any benefit.

Kevin
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Re: bonds or bond funds?

Post by rimfire »

Hi margeinoferror,

Think the thing to understand about the the difference between bond funds and actual individual bonds is the reason most people buy "bonds" in the first place, for the certainty.
A bond fund has no certainty it could lose money for a very long time if rates rise for a very long time. Sure a short term bond fund may have less loss because it could reinvest as rates raise.
Actual bonds are different in that they have a definite maturity date and a definite rate if held to maturity. (this assumes we have removed the default risk by buying only extremely high quality bonds as we are after the certainty after all) So the two things you buy bonds for are missing in bond fund, rate and date = certainty You cannot pull bond funds apart and sell the individual bonds. You can however build you own "bond fund" with individual bonds and pull it apart and sell the individual pieces. You probably won't ever do that because the market is too efficient and will cream you almost every time you attempt to out smart it. I can't really understand the necessity to be able to sell CD's( proxies for bonds) before maturity to try and take advantage of interest rate moves. The market will out smart you and most likely eat your lunch. Sure you may need to sell a CD or a bond before maturity to use the cash for another purpose, like something personal, or the stock market is tanking and you see the opportunity to add to your equity holdings on the cheap.(I know you can't time the market but you sure can price it at times)
Never bought a bond fund in 50 years of investing and probably never will. Haven't owned bonds for probably 10 years or more. Cash yes, it is sometimes a good investment as it gives you the opportunity to make changes without suffering losses except maybe for the opportunity cost.
My suggestion would be to read other inteligent forums besides this one as it it can be a little one sided in its outlook at times.

Thanks jb
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Re: bonds or bond funds?

Post by danielc »

gold-rabbit wrote: Tue Jul 03, 2018 9:09 am 4. I've been holding cash instead of buying bonds. I didn't do the math but I'm starting to think at least the bonds are returning dividends and the price decrease was small so they are better than cash
Can you clarify what you mean by cash? Are we talking about a checking account? Saving account? Money market? ... I think that at a bare minimum you should put the money in a money market account or CDs or one of those online high-interest savings accounts.
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Re: bonds or bond funds?

Post by danielc »

dbr wrote: Tue Jul 03, 2018 2:31 pm It is almost beyond comprehension why someone would invest mainly in stocks that lose lots of money on frequent intervals but feel they cannot invest in bonds that can lose relatively much less money on frequent intervals.
I think that the notion of only investing in things that you understand has a lot of merit. The OP did not say that 100% of her life savings are in stocks. Clearly she knows about CDs and it is not hard to imagine that she might have some. In that case, her fixed income allocation would be CDs which is a reasonable choice. Now she is on a web forum seeking to learn more about bonds and bond funds. It all looks very logical to me.
dbr wrote: Tue Jul 03, 2018 2:31 pm There are other uses for bonds where the question of how much money might be lost at any point in time is important. The people that need to care about that should know who they are. This is not me and probably not you.
This sounds a lot like "you don't need to understand X". I don't like that kind of answer. I think it is unhelpful. I also don't agree with your opinion. For example, someone who wants to use bonds to save for a predictable expense (e.g. downpayment for a house) would be well served in learning about duration.

I have spent a lot of time in this forum asking a lot of detailed questions about how various securities work (including bonds) and I feel that I have benefited greatly from the help that I have received. So I sympathize with the OP wanting to understand how bonds and bond funds work.

Just my $0.02
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Re: bonds or bond funds?

Post by gold-rabbit »

danielc wrote: Wed Jul 04, 2018 1:01 am
gold-rabbit wrote: Tue Jul 03, 2018 9:09 am 4. I've been holding cash instead of buying bonds. I didn't do the math but I'm starting to think at least the bonds are returning dividends and the price decrease was small so they are better than cash
Can you clarify what you mean by cash? Are we talking about a checking account? Saving account? Money market? ... I think that at a bare minimum you should put the money in a money market account or CDs or one of those online high-interest savings accounts.
When I say cash, I literally mean having cash in the brokerage account. It might technically be in a money market but I'm not sure. I see your point though and I'm leaning to going back into bonds.
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Re: bonds or bond funds?

Post by vineviz »

rimfire wrote: Tue Jul 03, 2018 11:13 pm A bond fund has no certainty it could lose money for a very long time if rates rise for a very long time.
Theoretically, maybe. The longest losing streak for intermediate government bonds in the past 100 years is six months of consecutive losses, with a total return of a whopping -0.55%.
rimfire wrote: Tue Jul 03, 2018 11:13 pm Actual bonds are different in that they have a definite maturity date and a definite rate if held to maturity. (this assumes we have removed the default risk by buying only extremely high quality bonds as we are after the certainty after all) So the two things you buy bonds for are missing in bond fund, rate and date = certainty
A bond fund is nothing but a portfolio of individual bonds.

Some investors might be buying bonds in order to gain absolute certainty about the amount and timing of future cash flows, and for that usage individual bonds might be a better choice than a bond fund. It is important to remember, though, that there is more than one kind of risk. Holding individual bonds instead of a bond fund reduces uncertainty about the timing and amounts of future cash flows but ADDS other forms of risk (inflation risk, reinvestment risk, liquidity risk, etc.) that holding a bond fund can help reduce.

For most investors, holding a bond fund with an average duration which is less than the investor's investment horizon is going to be the smarter bet: they can immunize their future liabilities more efficiently and cheaply with a bond fund than with individual bonds.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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Re: bonds or bond funds?

Post by scrabbler1 »

I have owned bond funds for the last 28 years, from munis to investment grade corporate to borderline investment-grade corporate. I buy them for the income, not for any capital appreciation or loss. I rarely make any redemptions (sales), so whatever I make or lose in those sales is secondary and usually pretty small. Another thing which mitigates any gain or loss on a redemption are the cap gain taxes due. If I happen to sell at a loss, the loss can cancel out gains elsewhere.

Some bond funds allow checkwriting privileges although that has become more rare over the years. I use one which has checkwriting as a second-tier emergency fund, giving me some extra liquidity. It's a national intermediate-term muni, so its price doesn't vary much and it earns in the 2%-2.5% range (mostly tax-free) which I like.

The monthly dividends from one corporate bond fund provide most of my income for my current retirement, as I have been retired for the last 10 years (I am 55 now). I like bond funds.
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Re: bonds or bond funds?

Post by Kevin M »

Kevin M wrote: Tue Jul 03, 2018 9:09 am No one can say for sure which will earn more over a specific time period. In recent months, cash has earned more than bonds, because yields have generally increased, and not enough time has passed for bonds to recover.

Since mid-May, Treasury yields have generally decreased (so prices have increased). We don't know if they'll continue decreasing, stay flat for awhile, or resume the upward trend that was running since early September 2017.
To follow up on this, I thought it would be useful to show the chart of some Treasury yields over the last year. I chose the 7-year as a proxy for an intermediate-term fund and the 3-year as a proxy for a short-term fund.

Image
The rising yields that people seem to have been mostly focused on are evident for most of the year, but we also see periods of falling or flat yields. Most recently, we see a very steep drop in yields from May 21 through May 29, with a gradual recovery of yields through June 13, then gradually falling yields since then. If anything, the trend since May 21 has been down.

Having charted the yields, I thought it would be interesting to model price change and total return for 7-year and 3-year Treasuries bought at the beginning of the 1-year period and held for one year. When I started working on this, yields were available through 6/29/2018, so I modeled bonds bought on 6/29/2017. Since this is a model to illustrate concepts, I make some simplifying assumptions.

One assumption is that the bonds are bought at par, which means price = 100 (100% of face value) and coupon rate = yield. So on 6/29/2017 the 7-year bond was bought at 100 with a yield of 2.1% and a coupon rate of 2.1%, and the 3-year was bought at 100 with yield and coupon rate of 1.53%.

The model is for individual bonds, so the 7-year maturity declines to 6-year maturity over the year, and the 3-year declines to 2-year maturity. At the end of the year, what was a 7-year bond is now a 6-year bond, so the 6-year yield is what is used to price the bond at the end of the 1-year period. Between the start and end dates, linear interpolation is used to get the yield; for example, halfway through the year, the yield of the 7->6 year bond will be halfway between the 6-year and 7-year yields.

There is no yield published for 6-year maturity, so I use linear interpolation between the 5-year and 7-year yields to estimate the 6-year yield. Good enough for this exercise.

First, here is a chart of just the price changes for the bonds:

Image

As expected, this looks something like the inverse of the yield chart, with prices increasing when yields decrease, and vice versa. We also see the larger volatility of the yield for the 7->6 year bond due to higher duration than the 3->2 year bond.

For the entire period, we see a decrease in price of about 3.7% for the 7->6 year bond and a decrease of about 1.9% for the 3->2 year bond.

So the individual bonds have lost value over the last year, whether held in a bond fund or held individually. Of course price will return to 100 at maturity, so if held to maturity you will recover the lost principal, and you will end up earning about the original yield. This also is true for a fund that holds bonds to maturity, although a fund may not hold the bonds to maturity.

Still, I think it's misleading to say that you can't lose money with individual bonds held to maturity. Even if held to maturity, you have lost money in terms of opportunity cost, since you would have earned more by keeping the money in a money market fund or savings account, and then buying the bonds after yields had increased. Of course since we can't predict interest rates, we won't know in advance that this will be the case.

I feel the pain of the losses on the individual bonds and CDs I bought starting late last year as much as the pain on losses in my bond funds, calibrating appropriately for duration. If at maturity I simply roll the bonds or CDs into more bonds or CDs, then my return will be about the same as a fund that held similar duration bonds or CDs and rolled them at maturity (but of course there are no funds that hold CDs as far as I know, and there is no fund that matches the maturity-weighting and other characteristics of the individual bonds I own).

Next, I thought it would be useful to show the contribution of interest to the total return. To simplify, I just assume that interest is accrued throughout the one-year period, ignoring the semi-annual coupon payments. So at the end of the year the 7->6 year bond has accrued 2.10 in interest and the 3->2 year bond has accrued 1.53. Adding interest to the price change gives us total return.

Here is the chart showing price change and total return for the 7->6 year bond:

Image

We see the increasingly positive impact of the accrued interest on total return as the year progresses, with total return ending up at about 98.4 or -1.6%, compared to -3.7% for price only.

Here is the same chart for the 3->2 year bond:

Image

Here accrued interest contributes to a total return of about 99.6, or about -0.4%, compared to -1.9% for price only.

Kevin
If I make a calculation error, #Cruncher probably will let me know.
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Re: bonds or bond funds?

Post by fanmail »

Kevin, your posts on fixed income are always appreciated and educational for beginners on up to more experienced investors.
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Re: bonds or bond funds?

Post by danielc »

gold-rabbit wrote: Wed Jul 04, 2018 6:26 am When I say cash, I literally mean having cash in the brokerage account. It might technically be in a money market but I'm not sure. I see your point though and I'm leaning to going back into bonds.
It might be in a money market account. You don't have to hold bonds if you are not comfortable with them. But I suspect that there must be something that you are comfortable with that is better than literal cash. Maybe CDs, or short-term bonds, etc. There are ETFs and index funds that track short-term bonds if you are worried about bonds going down due to rising interest rates. Short-term bonds will not go down much at all.

One of the Bogleheads rules that I like most is "never take too much risk or too little". There's so much good advice in that one sentence. If the volatility of long-term bonds is more than you can tolerate, don't buy them. But if you can tolerate more volatility than a money market fund, then maybe you should consider short-term funds. Look at the ducation of the funds and pick the duration that matches your risk tolerance.

Recall: (Change in bond value) = (change in interest rates) x (duration)

As a point of reference, the Fed set the interest rate at 1.3% in Dec 2017 and from there it has increased to 1.8% in half a year. That suggests a ~1%/year change. Historically, changes larger than 1%/year have ben uncommon. So if you are comfortable with at most a 3% drop for your bond holdings in one year, you could pick a bond fund with a 3-year duration.
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Re: bonds or bond funds?

Post by nedsaid »

margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I don't understand bond funds, so my 401k contributions go into a stock fund.
I'm thinking about diversifying. I'd like to make sure that $$ going into bonds will make make gains.

Since bond funds can lose money, I shy away from them. I'm not sure if I can buy bonds directly (with, say, 5k). I'm more inclined, then, to put that $$ into CDs.

I'd like to know from those of you who hold bond funds why you do so? What are the pros and cons? Are they better that CDs?

Thanks,
Marge
Go with bond funds. The fact is that CDs fluctuate in value like everything else. Since most of us have them at the bank, they don't trade, so we don't see them fluctuate in value. Also, when held at a bank you just cash them in and take the early withdrawal penalty if you want your money out early. You would see the fluctuation of value only if you traded them on a market.

CDs are a great alternative to bond funds, be certain you get ones with FDIC Insurance on them.

CDs, bond funds, can't go wrong with either. On bond funds, go with Intermediate Term and Investment Grade and you will be fine. Make sure the expense ratio is reasonable too. A bond market index fund would be a great choice.
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Re: bonds or bond funds?

Post by abuss368 »

margeinoferror wrote: Mon Jul 02, 2018 3:40 pm I don't understand bond funds, so my 401k contributions go into a stock fund.
I'm thinking about diversifying. I'd like to make sure that $$ going into bonds will make make gains.

Since bond funds can lose money, I shy away from them. I'm not sure if I can buy bonds directly (with, say, 5k). I'm more inclined, then, to put that $$ into CDs.

I'd like to know from those of you who hold bond funds why you do so? What are the pros and cons? Are they better that CDs?

Thanks,
Marge
Welcome to the Bogleheads!

I would rather own a simple, low cost, and diversified investment grade bond fund that is short term or intermediate term than individual bonds. A bond funds return over time will be the yield as market fluctuations will wash out.

Vanguard Total Bond Index does this and has worked very well through the years. I believe the fund has only ever had two negative years that were immaterial.
John C. Bogle: “Simplicity is the master key to financial success."
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Re: bonds or bond funds?

Post by abuss368 »

As Taylor has so often said "stocks let us eat well and bonds let us sleep well.
John C. Bogle: “Simplicity is the master key to financial success."
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