I don't understand bonds

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2020 ButClassic
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I don't understand bonds

Post by 2020 ButClassic »

I have a good understanding of stocks but not so much bonds.

Stock are simple. You owe a chunk of a company. It is easy to understand how companies prosper or fail.

Supporters of bonds confuse me. They say I'll make money when bonds go up. And I shouldn't worry about bonds going down because I earn interest. So, the hard core bond advocates seem to see no downside. But that couldn't be true, tight?

Please help me understand, perhaps by using medium term bonds as an example.
Northern Flicker
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Re: I don't understand bonds

Post by Northern Flicker »

Risk is not a guarantor of return.
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zarci
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Re: I don't understand bonds

Post by zarci »

You're not alone in that :beer
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Re: I don't understand bonds

Post by zarci »

From the article:
Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.
Did not known that! Now, since I'm European and social security payments will play a large role during retirement that would heavily affect my retirement planning.

Do American citizens receive a lump sum or something? In Europe you receive a monthly stipend until the day you die.
rossington
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Re: I don't understand bonds

Post by rossington »

2020 ButClassic wrote: Fri Aug 14, 2020 1:19 am I have a good understanding of stocks but not so much bonds.

Stock are simple. You owe a chunk of a company. It is easy to understand how companies prosper or fail.

Supporters of bonds confuse me. They say I'll make money when bonds go up. And I shouldn't worry about bonds going down because I earn interest. So, the hard core bond advocates seem to see no downside. But that couldn't be true, tight?

Please help me understand, perhaps by using medium term bonds as an example.
Northern Flicker wrote: Fri Aug 14, 2020 1:55 am Have you read the wiki entry?

https://www.bogleheads.org/wiki/Category:Bonds
+1
Do this first, then:

Search for "I don't understand bonds" (or something similar) in the Google search box at the top right of this page.
It's time to do what we all do and research what you need to know. It takes time and patience.

"Is VBTLX a good investment" is one I would recommend to search for as part of your research. See the 3 fund portfolio: viewtopic.php?f=10&t=88005
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
L82GAME
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Re: I don't understand bonds

Post by L82GAME »

I suggest you read “Why Bother With Bonds” - Rick Van Ness.

Also check out his videos on bonds here: https://financinglife.org/?s=bonds
“Simplicity is the ultimate sophistication.” - Lao Tzu
Seasonal
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Re: I don't understand bonds

Post by Seasonal »

zarci wrote: Fri Aug 14, 2020 2:32 am From the article:
Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.
Did not known that! Now, since I'm European and social security payments will play a large role during retirement that would heavily affect my retirement planning.

Do American citizens receive a lump sum or something? In Europe you receive a monthly stipend until the day you die.
American Social Security is also a monthly payment that continues until you die. Many, if not most, disagree with the view that you should count the value of future pension or Social Security payments as a bond. The better view is that such payments reduce the amount of expenses you need to cover from your portfolio. There are many posts here on the subject.
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Re: I don't understand bonds

Post by mrspock »

2020 ButClassic wrote: Fri Aug 14, 2020 1:19 am I have a good understanding of stocks but not so much bonds.

Stock are simple. You owe a chunk of a company. It is easy to understand how companies prosper or fail.

Supporters of bonds confuse me. They say I'll make money when bonds go up. And I shouldn't worry about bonds going down because I earn interest. So, the hard core bond advocates seem to see no downside. But that couldn't be true, tight?

Please help me understand, perhaps by using medium term bonds as an example.
For many investors, bonds are the difference between capitulation during a market crash, and staying the course. During those times -- when you can stare at large amounts of capital which allow you to do something actionable like rebalancing INTO a crash -- they will pay you back many, many times over: for the upside you get on the rebalancing, and their ability to help you stay the course. For accumulators, interest and growth are bonus.

My advice would be to build a $1m+ portfolio, go 80% equities, and see if you panic after the next 40% drop -- watching $300-400k evaporate before your eyes. You'll find out real quick just how well you do or don't understand bonds then. On paper 100% stock seems obvious and easy, during a crash, it's anything but. The mountains of "going to cash" threads we see on here after every 20% are a testament to just who how much of a mind job crashes can be when you have fairly large portfolio. Logic and pretty historical charts go right out the window for some investors when emotions and "feelings" take over.
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zarci
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Re: I don't understand bonds

Post by zarci »

Seasonal wrote: Fri Aug 14, 2020 4:23 am The better view is that such payments reduce the amount of expenses you need to cover from your portfolio. There are many posts here on the subject.
That's exactly how I've been including social security in my financial planning. Thanks
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Re: I don't understand bonds

Post by Valuethinker »

2020 ButClassic wrote: Fri Aug 14, 2020 1:19 am I have a good understanding of stocks but not so much bonds.

Stock are simple. You owe a chunk of a company. It is easy to understand how companies prosper or fail.

Supporters of bonds confuse me. They say I'll make money when bonds go up. And I shouldn't worry about bonds going down because I earn interest. So, the hard core bond advocates seem to see no downside. But that couldn't be true, tight?

Please help me understand, perhaps by using medium term bonds as an example.
Bonds have lower volatility but also lower return than stocks. There can be years when bonds overall pay negative returns (1994, 1981) but generally the interest payments at least compensate for any fall in price of the bonds. That may be less true going forward given how low bond coupons are (and Yields to Maturity).

A bond is a fixed claim on the assets of a company in the event of default. In return for that investors accept a lower return - made up of coupon payments of interest plus, assuming no default, a return of par value of the bond at maturity.
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Re: I don't understand bonds

Post by Dude2 »

What's not to understand about bonds? Take, for example, a Certificate of Deposit (CD) at a bank. The bank takes your money for a set amount of time and pays you a little bit for your trouble. That's a bond. The bank uses your money to fund other loans to other customers. Businesses of all kinds use bonds to fund their business needs.

You may be confused about Bond funds. That's just a collection of bonds no different in concept to the CD example, but on a forward looking basis in the face of ever changing interest rates across the yield curve (long rates, medium rates, short rates), the Net Asset Value (NAV) of the fund will fluctuate because people are trading bonds out and buying new bonds into the fund.

When you consider the spectrum of risky versus safe assets, bonds are firmly on the safe side, despite whatever harrowing headlines are trying to grab reader's attention by claiming otherwise. People hold bonds, in general, to lower the overall risk level of the portfolio.

For people that are anti-bond, i.e. pro 100% stock, I always wonder how they conceptualize the "value" of their portfolio. If they have 1 million dollars worth of stock today, do they apply some kind of fudge factor, i.e. "fuzzy logic", to generally get the feeling they have 750,000 to 1.25 million dollars of value? Stock value fluctuates, in other words. It may drop. It may come back. It may rise, etc. There is nothing to firmly attach to its value. A bond is exactly the opposite. Most people exist in a range from around 25% to 75% of stocks AND bonds, depending on their willingness and need to take risk. Nothing wrong with risk. With risk, hopefully, comes reward.
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Re: I don't understand bonds

Post by nisiprius »

2020 ButClassic wrote: Fri Aug 14, 2020 1:19 am I have a good understanding of stocks but not so much bonds.

Stock are simple. You owe a chunk of a company. It is easy to understand how companies prosper or fail.
It is easy to understand how companies prosper or fail? Really?

Bonds are just as simple.

You lend an issuer $1,000 and they promise to pay you specific numbers of dollars on specific days, and then pay you back the $1,000 on a specific day. The promise is a legally enforceable contract. If they don't break the contract, you make money.

The payments are like other bills the company must pay. If the company has a lousy year but manages to stay in business and keep the lights on, stockholders lose money and you make a little money. If the company has a great year, stockholders make a ton of money and you make a little money.

So whereas a stock is tightly linked to the particular details of how much money the company made this quarter, bonds are only linked to the broad question of whether the company can manage to stay in business or whether it will go bankrupt. It's at least as easy to understand that as to guess how much money they will make or lose, and the ratings agencies have already done the heavy lifting. An "investment grade" rating--and core bond funds like Vanguard Total Bond are investment grade--means the ratings agency looked at the books and believes the company has a fat safety margin and has an almost negligible chance of defaulting on the bonds.

That's all there is to it.

Of course you can make it complicated by bringing in bonds in which the contracts are complicated, like callable bonds or mortgage-backed securities or convertible debentures. You can also make it complicated by bringing in low quality bonds--junk bonds, "high yield" bonds, and the so-called "credit space" in which the whole point is to buy the bonds of shaky companies that are likely to default, and to play competitive mind games and price games as you stake wits against other players trying to guess the odds of default. Or international bonds, without currency hedging where you are not really investing in bonds, you are investing in foreign currency with some bond interest icing on the cake.

Where the complexity, and IMHO sometimes the obfuscation comes, is when you deal with the issue of market fluctuations between issue and maturity. Between issue and maturity you have no claim on the company other than the coupon interest payments; you can't take your principal out, you can't put more money in. If you don't want to wait, your only option is to trade the bond on a fluctuating market, and that's just as mysterious as any other market.

Individual investors like me do confront this problem when we use bond funds, because (most) bond funds hold a constantly rotating bond portfolio, in which most of the bonds are somewhere between issue and maturity and are affected by market fluctuations. Vanguard and Morningstar calculate the "average duration" of a bond fund and skipping over technical details, you cannot say it is literally impossible, but it is very unlikely that an investment-grade bond fund, held for that period of time, will lose money.

Based on such considerations, Vanguard says that the Vanguard Total Bond Market Index Fund
may be appropriate for investors with medium-term investment horizons (4 to 10 years).
Is this reliable advice? Since Vanguard suggests holding for at least 4 years, we can look at 48-month holding periods. It is an historic fact that from 2/1987 through 3/2020, in 351 overlapping 48-month time periods, the Vanguard Total Bond Index Fund never lost money in any of them. Not one. Made money 351 times out of 351.

The worst 48-month period that has ever occurred in Total Bond's history was 12/2014 through 11/2018. Over that time period, an investment of $10,000 in the fund would have made a total of $485. Not only would it have made money, it would have made more than a money market fund (orange) and more than most bank accounts.

Source

Image

By the way, don't be fooled by the vertical axis on the chart--Morningstar automatically scales all charts so that everything looks as volatile as everything else. If we add a stock fund (green) to the same chart so that we can see bond fund volatility relative to stocks, it looks like this:

Image

Stocks were riskier and more volatile but had much higher return. Bonds had much less return but also had much less risk. Money market funds had the lowest risk and lowest return of all. Just like every investment book has always said to expect.
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Harry Livermore
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Re: I don't understand bonds

Post by Harry Livermore »

mrspock wrote: Fri Aug 14, 2020 5:16 am
For many investors, bonds are the difference between capitulation during a market crash, and staying the course.
Yes, it certainly had that effect on me during the correction in March! I'm in my early 50s and we are pretty close to the finish line.
When I was in my 20s I was basically 100/0. Yes, I had an emergency fund so maybe it was 98/0/2.
During both the tech wreck and the GFC, I was something like 85/10/5 but the steep declines had no effect on me- I knew that the money would be needed many years from that moment and trusted that the market would continue its march upwards. Now, perhaps that was naive and I just got lucky, I don't know. But it's really only been in the last 6 years or so that I have switched up my AA and am now very bond heavy.
I've basically slept well throughout all those phases.
I've bought corporate bonds a few times and held to maturity, if the company seemed to be on solid footing and the interest attractive... but a half-dozen times or fewer in my life. I also have a small stash of iBonds. The vast majority of my bond investing has been through various VG funds.
I performed an interesting exercise during the correction and rebound (since I was sitting at home anyway) by recording the indexes and my taxable portfolio several times each day, sort of like journaling. If a stock on my watch list seemed to be a bargain, I jotted it down. I looked at what I already owned and would record any outsize price action. There was no real rhyme or reason, just a sort of stream of consciousness. On Saturday mornings, I would not only update my spreadsheet (as is my usual practice) but save it as a PDF for future reference. I also recorded, in the journal, percentage losses to date (from Jan.1) of the major indexes and my portfolio. Because I'm now so bond-heavy, my losses were always less, usually MUCH less, than the broad indexes, And that's where I think the difference lies: if your losses are less than everyone else, you feel pretty good.
The result of my slightly haphazard study was that I felt perfectly calm and secure in my AA; an interesting sidebar was for the first time in my life, I appreciated the effect that Mr. Spock points out (I was rattled during the Covid correction because I could not work and my income went to 0, so I did not deploy the money I had been saving to use during market corrections ("dry powder") but that's different than capitulation)
Cheers
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Re: I don't understand bonds

Post by nisiprius »

P.S. Don't make the mistake of looking at price charts for a bond fund. I think most people understand how misleading it is to look at stocks in terms of share price only and ignore the effect of dividends. Well, it is just the same for bonds only much much more so, because in Boglehead-style investing, we are holding bonds in order to make money from coupon interest, not to surf the speculative waves of market fluctuations.

We expect to make money from coupon interest payments accumulating in the fund and available as fund dividend payments. We don't expect to make money from capital appreciation; if it happens, nice, but it is not how we expect to make it. Capital appreciation is where stocks make most of their money, but it's not where we expect to make it in bonds.

The performance of Total Bond is not this. This is the performance of Total Bond if you choose to donate all the fund dividend payments to charity or something. It gives a false appearance that the fund has only made a cumulative gain of +16.70% in 34 years. Less than 0.5% per year. Meh. Who wants that?

Image

This is the performance of Total Bond if you keep the money it makes and reinvest it.

Image

Multiplied investors' money almost by seven in 34 years. That's about 5.7% per year. That's not like stocks, but it's not bad.

The effect of declining interest rates and the leveling off of that decline can be seen clearly in the way the line curves and becomes less steep at the end. Declining interest rates were a tailwind. But bonds are steamship, not a sailing ship--it always better to have the wind behind you, but that is not the only thing driving bond returns.
Last edited by nisiprius on Fri Aug 14, 2020 7:18 am, edited 4 times in total.
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zarci
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Re: I don't understand bonds

Post by zarci »

nisiprius wrote: Fri Aug 14, 2020 7:09 am P.S. Don't make the mistake of looking at price charts for a bond fund.
Thank you for the informative posts on this forum. I've learned a lot by reading your clear explanations.
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Re: I don't understand bonds

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*delete*
Last edited by Superleaf444 on Thu Aug 27, 2020 9:45 am, edited 1 time in total.
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zarci
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Re: I don't understand bonds

Post by zarci »

nisiprius wrote: Fri Aug 14, 2020 6:43 am Or international bonds, without currency hedging where you are not really investing in bonds, you are investing in foreign currency with some bond interest icing on the cake.
I'm European and currently invest in a Euro Treasury index. Would you recommend exposure to an Euro-hedged US treasury fund? In my understanding, the US Treasury is a bit more reliable than European treasuries, but I'm unsure what the effect of euro-hedging would be.
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Re: I don't understand bonds

Post by zarci »

Superleaf444 wrote: Fri Aug 14, 2020 7:16 am +1

I mean, I understand them on paper, but not actual practice. And bonds funds make zero sense to me even on paper. Prolly shouldn't have them in my portfolio but alas...
I wonder if there's investors out there that capitulated because of a bond allocation that's "too high" and FOMO versus the more classic stock allocation that's "too high" and sleepless nights :D
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Re: I don't understand bonds

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zarci wrote: Fri Aug 14, 2020 2:32 am From the article:
Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.
Did not known that! Now, since I'm European and social security payments will play a large role during retirement that would heavily affect my retirement planning.
Despite Jack Bogle's godlike status on this forum (or at least among some people on this forum), many people here disagree with him on valuing one's Social Security in terms of an equivalent sum of bonds and including it in one's investment asset allocation.

The "standard" way to take SS into account is to subtract the income that it will provide (and any income from private pensions) from one's spending needs in retirement, and use the resulting "residual spending" to help determine one's retirement-asset needs and allocation.
Do American citizens receive a lump sum or something? In Europe you receive a monthly stipend until the day you die.
In the US, Social Security provides an inflation-adjusted stream of monthly payments for life. There is no option to "cash it out" as a lump sum. There is a small exception: if I remember correctly, when one claims SS benefits, one can optionally receive a lump sum equal to (maximum) six months of payments as if the claim had been made six months earlier. This reduces the future monthly payments accordingly.

On the other hand, a private employer-sponsored pension usually allows the employee, when retiring, either to take it as a lump sum (which can then be invested on one's own) or as a lifetime stream of monthly payments (usually not inflation-adjusted). In this case, it does make some sense to include the present accumulated pension value in one's current asset allocation, provided that one has worked long enough (for that employer) to be "vested" in the pension.
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zarci
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Re: I don't understand bonds

Post by zarci »

22twain wrote: Fri Aug 14, 2020 7:31 am In the US, Social Security provides an inflation-adjusted stream of monthly payments for life. There is no option to "cash it out" as a lump sum. There is a small exception: if I remember correctly, when one claims SS benefits, one can optionally receive a lump sum equal to (maximum) six months of payments as if the claim had been made six months earlier. This reduces the future monthly payments accordingly.

On the other hand, a private employer-sponsored pension usually allows the employee, when retiring, either to take it as a lump sum (which can then be invested on one's own) or as a lifetime stream of monthly payments (usually not inflation-adjusted). In this case, it does make some sense to include the present accumulated pension value in one's current asset allocation, provided that one has worked long enough for the employer to be "vested" in the pension.
As mentioned in a previous post, this provided me with a sigh of relief. Since I was subtracting SS from required retirement spending. What I do find terribly interesting now that you've mentioned it is that it's inflation-linked. It's linked to inflation here as well, so nothing special there. But I remember a Stanford professor mentioning a South-American country that had a "regular" currency and an "inflation-linked currency". Now, every single official contract (rent, insurance, tuition fees, ... ) are settled in the inflation-linked currency. Here those contracts are settled in nominal amounts, adjusted for inflation and each niche has it's own system for doing so.
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zarci
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Re: I don't understand bonds

Post by zarci »

My apologies for possibly hijacking the thread, but this is probably the right place for the question. See this summary of the history of the yield curve:

https://www.ft.com/content/80269930-40c ... 36ec32aece

One obvious observation is that the yield curve has only dropped since the 1980 from ranges close to 10% to almost zero now. This also explains why bonds have performed so well during the same period.

My question:

Since it is my understanding that bond funds can only provide positive returns when the rate drops further, how can a bond investor reasonably expect a positive return?

I'm aware there is probably a good answer to that question, but I can't answer it myself. The only theory I can come up with is rates rising causing a brief period of loss, and then fluctuating at that level providing returns for bond investors.
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Re: I don't understand bonds

Post by tadamsmar »

zarci wrote: Fri Aug 14, 2020 2:32 am From the article:
Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.
Did not known that! Now, since I'm European and social security payments will play a large role during retirement that would heavily affect my retirement planning.

Do American citizens receive a lump sum or something? In Europe you receive a monthly stipend until the day you die.
No, but Americans do receive the advice (from some other Americans) to treat that monthly stipend like it was a lump sum an some Americans try to figure out how to do this feat.
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Re: I don't understand bonds

Post by dbr »

zarci wrote: Fri Aug 14, 2020 7:52 am

Since it is my understanding that bond funds can only provide positive returns when the rate drops further, how can a bond investor reasonably expect a positive return?

No, if interest rates remain unchanged and are positive, you get a positive return.

One should distinguish real and nominal rates. With inflation one can easily have a positive nominal return and a negative real return. TIPS, for example, currently have a negative real yield and a positive nominal return.

Also, the higher long term returns of bonds are not just due to interest rates falling but also due to the very high interest rates those bonds had at the start of the period. Examples of falling interest rates boosting return would be in the very high returns of long bonds last year.

It is a valid concern that future return expectations for fixed income may not be very high. This is good for borrowers and spenders and not good for savers. So the indicated action is to borrow and spend and to not save :shock:
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Re: I don't understand bonds

Post by zarci »

dbr wrote: Fri Aug 14, 2020 8:00 am

No, if interest rates remain unchanged and are positive, you get a positive return.

One should distinguish real and nominal rates. With inflation one can easily have a positive nominal return and a negative real return. TIPS, for example, currently have a negative real yield and a positive nominal return.

Also, the higher long term returns of bonds are not just due to interest rates falling but also due to the very high interest rates those bonds had at the start of the period. Examples of falling interest rates boosting return would be in the very high returns of long bonds last year.

It is a valid concern that future return expectations for fixed income may not be very high. This is good for borrowers and spenders and not good for savers. So the indicated action is to borrow and spend and to not save :shock:

Just to make sure I understand correctly. If - for the sake of argument - we assume a 2% constant inflation rate going forward, then when bond yields rise to, say 2.45%, and not budge. _then_ you'd have a positive real return.
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Re: I don't understand bonds

Post by dbr »

zarci wrote: Fri Aug 14, 2020 8:16 am
dbr wrote: Fri Aug 14, 2020 8:00 am

No, if interest rates remain unchanged and are positive, you get a positive return.

One should distinguish real and nominal rates. With inflation one can easily have a positive nominal return and a negative real return. TIPS, for example, currently have a negative real yield and a positive nominal return.

Also, the higher long term returns of bonds are not just due to interest rates falling but also due to the very high interest rates those bonds had at the start of the period. Examples of falling interest rates boosting return would be in the very high returns of long bonds last year.

It is a valid concern that future return expectations for fixed income may not be very high. This is good for borrowers and spenders and not good for savers. So the indicated action is to borrow and spend and to not save :shock:

Just to make sure I understand correctly. If - for the sake of argument - we assume a 2% constant inflation rate going forward, then when bond yields rise to, say 2.45%, and not budge. _then_ you'd have a positive real return.
Yes. The complication is the timing. When rates change (rise) the NAV of a bond or bond fund falls and then eventually recovers with reinvestment of the interest and eventually exceeds what would have happened with no change in interest rate. After that time your example above becomes valid. To go through this you want to understand the concept of duration: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration

Note an implication from all of this is that savers and investors should want to see interest rates go up from today's values in support of a long term plan.

As a practical matter because interest rates are constantly changing across the yield curve and because inflation is constantly changing, it is better not to try to predict returns but rather to recognize one is invested in an uncertain venture and go from there. If one has to make a presumption about future return then probably one should just use the current SEC yield while keeping in mind that expectations in investing are uncertain.
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Re: I don't understand bonds

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There is a small exception: if I remember correctly, when one claims SS benefits, one can optionally receive a lump sum equal to (maximum) six months of payments as if the claim had been made six months earlier. This reduces the future monthly payments accordingly.
Having just done this a couple weeks ago, I believe you are only partially correct. If you file a few months after your birthday, they will pay retroactive to the birthday, and that comes in a lump sum, then the following payments are one month at a time as usual. We filed in July for a March birthday, and they paid everything due back to March in one deposit. I don't think it makes any difference in the future payments but I am not sure.
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Re: I don't understand bonds

Post by 2020 ButClassic »

Many thoughtful responses -- thank you!

I am not anti-bond. I am about to retire, and while I was 98% in stocks in my earlier days, that allocation is now 60%, so I am following the obligatory allocation for stocks.

I also invested $25k in BND in November of 2019 just to educate myself. That investment has appreciated and also given dividends so that was a good way to experience bonds. I realize this was a short period so it is not an indication of how bonds perform long term.

Someone compared bonds with CDs. And that's where I am.

My 40% non-stock is made up of 10% bonds and 30% CD ladder. The CD ladder averaged 2.5% interest a while back and now is around 2%. I understand inflation will destroy the real return but some of the loss would be recouped, presumably via the increased rates in the CD ladder system.

So, maybe to simplify, I need to have a better understanding of the opportunity cost of being in CDs as opposed to bonds.
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Re: I don't understand bonds

Post by dbr »

2020 ButClassic wrote: Fri Aug 14, 2020 2:26 pm
So, maybe to simplify, I need to have a better understanding of the opportunity cost of being in CDs as opposed to bonds.
Taken all in all CDs and different kind of bonds are relatively equivalent solutions to the same problem, so you pays your money and you takes your choice.

The point is that there is a myriad of different choices in fixed income that all come out about the same over a certain range. So you can talk forever about all those differences but then choose whatever you want and it will mostly work out. Certainly in portfolios of stocks and bonds the lever is how much is allocated to each much more than what kind of each you pick. Even that lever is relatively insensitive, but it does offer a great range of movement.
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