Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

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nisiprius
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by nisiprius »

Scooter57 wrote: Sun Jun 13, 2021 5:35 pm...it is not impossible that rates could go up 1% a year for 6 years or more.
Yes.
And if that happened, your bond fund will always be working on getting back to even...
No.

Here's the specific scenario you proposed. Same as the two-year chart, rolling bond ladder, 6.2-year duration, interest rate starts at 1.3% but continues rising at 1% per year for six years instead of two. That is, ending at 7.3%.

Image

And here is the scenario where the interest never stops rising. By the end of the chart, it is has been rising for 25 years and is now 26.3%.

Image

It is certainly not a wonderful scenario. On the other hand, the maximum drawdown was only -9%. And Vanguard suggests that Total Bond "may be appropriate for investors with medium-term investment horizons (4 to 10 years)," and the time to get back to even from the start of the rise was about 8 years.

And this matches actual historical experience with actual bond funds, which did make money during a long period of rising interest rates. At least, according to Morningstar. Here is an actual bond fund that still exists, the Putnam Income Fund, PINCX, and Morningstar's category average for "intermediate core-plus bond funds."

Image

From 11/1954 through 9/1981, the ten year Treasury rate
rose from to 2.66% to 15.32%
= 12.66% in 26.8 years
= an average of 0.47% per year.

During that period of time, according to Morningstar,

the average "intermediate core-plus bond fund" grew $10,000 to $36,256
= in real terms $10,370 in year-1954 dollars = real 0.14%/year annualized

--the actual Putnam Income Fund grew $10,000 to $56,548
= in real terms $16,173 in year-1954 dollars = real 1.81%/year

That means that the according to Morningstar the average fund kept up with inflation and the Putnam fund beat it.

No, it is not good when interest rates rise. But talk of permanent losses or never getting back to even are wrong, unless you are looking only at price and throwing away the coupon payments.
Last edited by nisiprius on Mon Jun 14, 2021 7:25 am, edited 3 times in total.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by nisiprius »

To restate the dynamics, I think of this in terms of forces.
  • Rising interest rates exert a downward pressure on bond prices. The pressure is related to the rate of rise. If interest rates keep rising at, say, 1% per year, the pressure doesn't keep increasing, it is a constant pressure.
  • Bond prices respond to that pressure by moving downward.
  • Because a bond pays back its face value at maturity, its market value must rise to face value at maturity. A bond whose value is down must rise. You can think of this as an upward pull, often called the "pull to maturity."
  • The more depressed a bond price is, the more it has to rise in order to get back to face value.
  • That means that the more depressed the bond price is, the stronger the upward tug.
  • There is a balance of forces. Rising rates push down. The always-approaching maturity pulls up.
  • A forever-rising interest rate does not create a forever-falling declining bond price.
  • As the bond price declines, the pull to maturity becomes stronger and stronger, until an equilibrium is reached.
  • In other words, if the first 1% interest rate rise creates a -6.2% fall in the bond price, that does not mean the second, third, fourth etc. create further -6.2% falls.
  • The relationship, price fall = interest rate rise x duration is only true for a single instantaneous rise. It is not cumulative for long-term continouusly-rising interest rate, or a series of rises.
  • The bond price stabilizes, but coupon payments continue.
Unlike stocks, bonds make virtually all their money from coupon payments. "Capital appreciation" in a bond or bond fund only occurs as a result of favorable timing with market fluctuations. The price of the Vanguard Total Bond Market fund since inception has only grown from $10/share to $11.31/share, yet a $10,000 investment would have grown, not to $11,310 but to $68,000. Therefore, any analysis that is looking only at bond prices is missing the whole point of owning bonds, and is seriously misleading for anything but very short periods of time.
Last edited by nisiprius on Mon Jun 14, 2021 7:42 am, edited 2 times in total.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Explorer »

nisiprius wrote: Mon Jun 14, 2021 7:00 am To restate the dynamics, I think of this in terms of forces.
  • Rising interest rates exert a downward pressure on bond prices. The pressure is related to the rate of rise. If interest rates keep rising at, say, 1% per year, the pressure doesn't keep increasing, it is a constant pressure.
  • Bond prices respond to that pressure by moving downward.
  • Because a bond pays back its face value at maturity, its market value must rise to face value at maturity, so if a bond whose value is down must rise. You can think of this as an upward pull, often called the "pull to maturity."
  • The more depressed a bond price is, the more it has to rise in order to get back to face value.
  • That means that the more depressed the bond price is, the stronger the upward tug.
  • There is a balance of forces. Rising rates push down. The always-approaching maturity pulls up.
  • A forever-rising interest rate does not create a forever-falling declining bond price.
  • As the bond price declines, the pull to maturity becomes stronger and stronger, until an equilibrium is reached.
  • In other words, if the first 1% interest rate rise creates a -6.2% fall in the bond price, that does not mean the second, third, fourth etc. create further -6.2% falls.
  • The relationship, price fall = interest rate rise x duration is only true for a single instantaneous rise. It is not cumulative if there is a long-term steadily-rising interest rate.
  • The bond price stabilizes, but coupon payments continue.
Unlike stocks, bonds make virtually all their money from coupon payments. "Capital appreciation" in a bond or bond fund only occurs as a result of favorable timing with market fluctuations. The price of the Vanguard Total Bond Market fund since inception has only grown from $10/share to $11.31/share, yet a $10,000 investment would have grown, not to $11,310 but to $68,000. Therefore, any analysis that is looking only at bond prices is missing the whole point of owning bonds, and is seriously misleading for anything but very short periods of time.
nisiprius - THIS post is perhaps the most prophetic and simple summary of how to view bonds. Thank you for capturing the essence in one single post. :sharebeer
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by tipswatcher »

This reminded me of a question I had about Vanguard's Ultra-Short Bond fund (VUSFX) and its new ETF version (VUSB), both with a duration of about 1.0 years.

If interest rates rise 1%, the value of the fund declines by 1%, but the interest rate will rise by 1% over the year. If interest rates rise 2%, the fund's value drops by 2%, but its yield will rise 2% over the year. It will more or less balance out. Although the total value will dip early on, it will return to at least the original value in about a year after the higher yields kick in.

(This is a corporate bond fund and I understand there are other risks involved. Just trying to grasp what a 1-year duration really means for a real-world fund.)
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by dbr »

tipswatcher wrote: Mon Jun 14, 2021 7:13 am This reminded me of a question I had about Vanguard's Ultra-Short Bond fund (VUSFX) and its new ETF version (VUSB), both with a duration of about 1.0 years.

If interest rates rise 1%, the value of the fund declines by 1%, but the interest rate will rise by 1% over the year. If interest rates rise 2%, the fund's value drops by 2%, but its yield will rise 2% over the year. It will more or less balance out. Although the total value will dip early on, it will return to at least the original value in about a year after the higher yields kick in.

(This is a corporate bond fund and I understand there are other risks involved. Just trying to grasp what a 1-year duration really means for a real-world fund.)
More than that, the fund will then go on to accumulate to higher value than it would have had if interest rates had stayed unchanged.

Of course interest rates change up (and down) every day, so you will see a variable response.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Northern Flicker »

tipswatcher wrote: If interest rates rise 1%, the value of the fund declines by 1%, but the interest rate will rise by 1% over the year.
To be precise, if interest rates rise instantaneously by 1 percentage point, the fund value goes doen by 1%. If the rise in rates takes place over the course of the year, the fall in price will be offset by coupon payments and turnover of maturing bonds at par.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Scooter57 »

KlangFool wrote: Sun Jun 13, 2021 8:14 pm
millennialinvestor wrote: Wed Jun 09, 2021 8:16 pm So when should one get into bonds assuming rates are going up?
millennialinvestor,

If you know this, so does everyone else. So, why won't the bond issuer and bond buyer price this into their purchases? They do. They are no dummies.

KlangFool
Today's bond buyers are no dummies, but they are no buy and hold investors, either.

Bond prices are set by bond traders who make their money on the daily rises and falls in bond prices. They can profit mightily if bond prices go up a few basis points here and there. But they are not buying the bonds to preserve capital over longer periods of time.

The large buyers who do buy for longer terms are insurance companies. What I have read is that they have been switching away from bonds towards alternative investments because the current low rates combined with inflation could be a huge hit to their business.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Scooter57 »

nisiprius wrote: Mon Jun 14, 2021 6:38 am
Scooter57 wrote: Sun Jun 13, 2021 5:35 pm...it is not impossible that rates could go up 1% a year for 6 years or more.
<snip>

Image

And here is the scenario where the interest never stops rising. By the end of the chart, it is has been rising for 25 years and is now 26.3%.

Image

It is certainly not a wonderful scenario. On the other hand, the maximum drawdown was only -9%. And Vanguard suggests that Total Bond "may be appropriate for investors with medium-term investment horizons (4 to 10 years)," and the time to get back to even from the start of the rise was about 8 years.
That is all fine and good, but the investor is looking at 8 years where if they need to withdraw their money for some unforseen reason there is less of it than when they started. Eight years is a long time. Wouldn't that investor do a lot better invested in much shorter duration vehicles that keep up with the rate changes? I just can't see risking having to wait 8 years to get back to even for a lousy 1.something percent yield.

This is particularly important for retirees who might find themselves needing large amounts of money for any number of horrible health issues that can arise or for assisted living and/or skilled nursing care whose costs are going to surge with any inflation. (Already surging as they are having to raise wages from their dismal minimum levels to find people to staff the places.)

For someone in the accumulation phase it possibly isn't a big deal. But for older people whose savings are all they have it looks pretty serious to me.
nisiprius wrote: Mon Jun 14, 2021 6:38 am And this matches actual historical experience with actual bond funds, which did make money during a long period of rising interest rates. At least, according to Morningstar. Here is an actual bond fund that still exists, the Putnam Income Fund, PINCX, and Morningstar's category average for "intermediate core-plus bond funds."

Image

From 11/1954 through 9/1981, the ten year Treasury rate
rose from to 2.66% to 15.32%
= 12.66% in 26.8 years
= an average of 0.47% per year.

During that period of time, according to Morningstar,

the average "intermediate core-plus bond fund" grew $10,000 to $36,256
= in real terms $10,370 in year-1954 dollars = real 0.14%/year annualized

--the actual Putnam Income Fund grew $10,000 to $56,548
= in real terms $16,173 in year-1954 dollars = real 1.81%/year

That means that the according to Morningstar the average fund kept up with inflation and the Putnam fund beat it.

No, it is not good when interest rates rise. But talk of permanent losses or never getting back to even are wrong, unless you are looking only at price and throwing away the coupon payments.
Looking at those Morningstar numbers, they seem a bit deceiving. The average must be calculated in a way that ignored the years of negative yield that would have preceded the years when extremely high rates provided very fast doublings. If there was a smooth 1.81% a year return, a real 1954 $10,000 would have turned into $16,009.36 nominal dollars by 1980. One wonders in what that bond fund was investing and what measures it was using to boost yield.

And even while the bond fund theoretically might have kept up with some measure of inflation, good luck trying to buy a house with the money you set aside in 1956. The house that was $19K in 1956 was somewhere north of $100K in 1980. (Real numbers from comps to a house my parents had bought.) That real 1.81% a year would not have kept up with housing prices. Or college prices.

One last point, rates today are half what they were in 1954 and the bond index funds hold a far higher percentage of Treasuries than any bond fund would have held in 1954 (or for that matter, 1980). Both have a downward impact on return. Not to mention the quality of the corporate bonds in those index funds, half of which are hovering at the lower border of investment grade due to having taken out enormous amounts of debt.

Are we comparing apples and oranges here when we resort to this kind of back test?
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Robot Monster »

nisiprius wrote: Thu Jun 10, 2021 8:49 am This assumes real interest rates rise from 0% to 2% over a period of two years. For this calculation I tweaked the bond maturities to get a slightly longer duration, 8 years, to roughly match the 7.4-year duration of the Vanguard VIPS fund, VAIPX.

Image

This is not a greed-inspiring picture, but it's not terrifying. We are seeing a -13% drawdown...
Lots of incredibly valuable explanations of bonds in this thread by nisiprius, especially the one that "restates the dynamics," but this one about the Vanguard TIPS fund was the crown jewel for me, as it eased my fears enough to finally, finally pull the trigger on a large amount of cash that has been forever languishing in money markets. It was not an easy thing to do, and my inclination was not to do it. Two things allowed me to:
-- Seeing an illustration of the initial pain I'd be facing if rates did rise, as well as the recovery. Actually seeing it--graphically--helped a lot.
-- Willthrill's post about "Inconsistencies with the Boglehead principles?", the belief among some here that "you cannot market time stocks, but you can market time bonds". link

A shout-out to vineviz's excellent thread about duration matching...matching the average duration of one's bond holdings with one's investment horizon. link
Last edited by Robot Monster on Mon Jun 14, 2021 3:44 pm, edited 1 time in total.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Northern Flicker »

I don't think that insurance companies matching bonds to nominal liabilities are suddenly switching to alternative assets.

And short-term traders contribute to short-term bond volatility, but not much to medium-term or long-term returns.

You can do bond arithmetic on a CD to calculate the notional loss of value when interest rates rise. If you buy a 5-yr CD at 2% and a year later you could buy a 4-yr CD at 3% then your 5-yr CD now has a notional value that is less than par. This assumes no early withdrawal penalty, which is an option that would also need to be priced. But keep in mind that a bank or credit union usually has the contractual option to revoke early withdrawal privileges, so they are not taking any risk of underpricing the option.

If CD rates are higher than duration-matched treasury yields, they are a good alternative to bonds. But bond fund portfolio managers outperform individuals managing bond ladders, generally. And if you hold in a taxable account, and live in a state with income tax, treasury bond interest is state-tax-free. CD interest is not.
Last edited by Northern Flicker on Mon Jun 14, 2021 5:49 pm, edited 3 times in total.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Northern Flicker »

Scooter57 wrote: That is all fine and good, but the investor is looking at 8 years where if they need to withdraw their money for some unforseen reason there is less of it than when they started. Eight years is a long time. Wouldn't that investor do a lot better invested in much shorter duration vehicles that keep up with the rate changes? I just can't see risking having to wait 8 years to get back to even for a lousy 1.something percent yield.

This is particularly important for retirees who might find themselves needing large amounts of money for any number of horrible health issues that can arise or for assisted living and/or skilled nursing care whose costs are going to surge with any inflation. (Already surging as they are having to raise wages from their dismal minimum levels to find people to staff the places.)

For someone in the accumulation phase it possibly isn't a big deal. But for older people whose savings are all they have it looks pretty serious to me.
Yes, you should match the duration of assets to the expected case or worst case duration of liabilities. The reason bond fund prices fluctuate is that they are marked to market daily to provide daily liquidity, something you may not have with a CD ladder.
My postings are my opinion, and never should be construed as a recommendation to buy, sell, or hold any particular investment.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by 000 »

KlangFool wrote: Sun Jun 13, 2021 8:14 pm If you know this, so does everyone else. So, why won't the bond issuer and bond buyer price this into their purchases? They do. They are no dummies.
You assume too much. Bond market participants don't necessarily have the same goals as individual investors so the bond market may not be pricing bonds in a way that is attractive to individual investors. As a specific example, life insurers using bonds to fund nominal policies don't care about inflation so they aren't pricing inflation risk into their purchasing decision.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

000 wrote: Mon Jun 14, 2021 3:55 pm
KlangFool wrote: Sun Jun 13, 2021 8:14 pm If you know this, so does everyone else. So, why won't the bond issuer and bond buyer price this into their purchases? They do. They are no dummies.
You assume too much. Bond market participants don't necessarily have the same goals as individual investors so the bond market may not be pricing bonds in a way that is attractive to individual investors. As a specific example, life insurers using bonds to fund nominal policies don't care about inflation so they aren't pricing inflation risk into their purchasing decision.
000,

Are you claiming the folks that issues the billions of new bonds are not trying to get the lowest interest rate possible? Ditto, the folks that buying billions of bonds are not trying to get the highest interest rate possible. And, they do not take into account of inflation? And, this happened everyday. And, the bond market is a lot bigger than the stock market. The US bond market is about 46 trillions.

You are right that they are not individual investors. They are professionals being paid millions to trade billions of bonds.

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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by 000 »

KlangFool wrote: Mon Jun 14, 2021 4:07 pm 000,

Are you claiming the folks that issues the billions of new bonds are not trying to get the lowest interest rate possible? Ditto, the folks that buying billions of bonds are not trying to get the highest interest rate possible. And, they do not take into account of inflation? And, this happened everyday. And, the bond market is a lot bigger than the stock market. The US bond market is about 46 trillions.

You are right that they are not individual investors. They are professionals being paid millions to trade billions of bonds.

KlangFool
Many participants in the bond market have no choice other than to buy bonds due to regulatory or other requirements beyond their control.

Of course they want the best interest rate possible. But the fact that they are participating in bonds as a general asset class does not necessarily mean they think bonds are preferable to alternatives for those able to choose alternatives nor that interest rates necessarily reflect inflation expectations.

To your arguments about scale, what about the commodities markets? Those are huge. Doesn't mean we ought participate in them.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by nisiprius »

Scooter57 wrote: Mon Jun 14, 2021 2:55 pm...That is all fine and good, but the investor is looking at 8 years where if they need to withdraw their money for some unforeseen reason there is less of it than when they started.
Yes, there is an eight-year long period of time in which they would have less than when they. But only -9% less. It's not great, but it's hardly the end of the world.
Wouldn't that investor do a lot better invested in much shorter duration vehicles that keep up with the rate changes?
It's a hypothetical scenario. There's no limit to how extreme a situation you can imagine so no limit what could happen. But someone asked about a 1% per year rate of rise, double what happened historically, so that's what I showed.

Vanguard says that the total bond fund "may be appropriate for investors with medium-term investment horizons (4 to 10 years)." 8 years happens to be within that range. If you will be in serious trouble if your bond fund declines -9% and takes 8 years to get back to even, then you probably shouldn't invest in this fund--not just now, but at any time.
Wouldn't that investor do a lot better invested in much shorter duration vehicles that keep up with the rate changes?
Possibly. But I think probably not. Your comment sounds a lot like one that was made in the forum in 2009:
I see the total bond fund and intermediate treasuries recommended a lot on here. I know people don't like to market time but interest rates are currently zero and whether rates rise in 2010 or 2011 or 2015, eventually they will rise and intermediate term bonds will get hit. So isn't it wise to go short in this environment where rates can only go up?
If, on the date of that posting, investor A had put $10,000 into the Vanguard Short-Term Bond Index Fund (blue line) and investor B had put $10,000 into the Vanguard Total Bond Market Index Fund (orange) this is how they would have fared.
Source

Image

Would the same thing happen today? Maybe, maybe not. But it's not a given that you "would do a lot better investing in much shorter duration vehicles." Everyone has to strike their own balance between risk and return. I think it is overwhelmingly likely that over the next decade or so there will be a normal yield curve much of the time, and that medium-term bond funds will earn quite a bit more than short-term bond funds--just as they did from 2009. If not, then what? Well, Vanguard says Total Bond "may be appropriate for an investor medium-term investment horizons (4 to 10 years)." I think I do have that investment horizon. If Total Bond declines -9% and doesn't get back to even for eight years we'll be OK.

If you think short-term bonds, or money market mutual funds, or bank CDs are better than Total Bond, I won't argue. A couple of years ago the local bank was offering 2.2% on CDs and I bought some. (Too bad it didn't last). Maybe Total Bond will turn out to be a suboptimal choice. But I don't think it will turn out to be a horrible choice.
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Sun Jun 13, 2021 8:20 pm Folks,

Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase. Ditto for expected inflation increase.

Folks are paid millions to issue billions of bonds regularly. Ditto, folks are paid millions to buy billions of bonds. They are no dummies.

This is the same like the stock price. It only goes up when it beats EXPECTATION. Or, it goes down when it is below EXPECTATION.

I know that I know nothing. And, everything that I know so does everyone else. So, I know that I have no better prediction power than anyone else.

KlangFool
What is the mechanism to do this? If I buy a nominal bond I know what my total nominal return will be at maturity. If interest rates change, then I could sell the bond for more or less than expected along the way, but why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 6:33 am
KlangFool wrote: Sun Jun 13, 2021 8:20 pm Folks,

Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase. Ditto for expected inflation increase.

Folks are paid millions to issue billions of bonds regularly. Ditto, folks are paid millions to buy billions of bonds. They are no dummies.

This is the same like the stock price. It only goes up when it beats EXPECTATION. Or, it goes down when it is below EXPECTATION.

I know that I know nothing. And, everything that I know so does everyone else. So, I know that I have no better prediction power than anyone else.

KlangFool
What is the mechanism to do this? If I buy a nominal bond I know what my total nominal return will be at maturity. If interest rates change, then I could sell the bond for more or less than expected along the way, but why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?
AnEngineer,

<<why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?>>

You buy bond at price X with the market expectation of interest rate Y. If the market expectation changes that the interest rate would go up higher than Y in future, why would they buy your bond at price X? They would only buy at a price lowered than X.

This is the same as the stock price. Stock price is forward looking. Earning expectation goes up. Stock price goes up.

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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Wed Jun 16, 2021 6:55 am
AnEngineer wrote: Wed Jun 16, 2021 6:33 am
KlangFool wrote: Sun Jun 13, 2021 8:20 pm Folks,

Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase. Ditto for expected inflation increase.

Folks are paid millions to issue billions of bonds regularly. Ditto, folks are paid millions to buy billions of bonds. They are no dummies.

This is the same like the stock price. It only goes up when it beats EXPECTATION. Or, it goes down when it is below EXPECTATION.

I know that I know nothing. And, everything that I know so does everyone else. So, I know that I have no better prediction power than anyone else.

KlangFool
What is the mechanism to do this? If I buy a nominal bond I know what my total nominal return will be at maturity. If interest rates change, then I could sell the bond for more or less than expected along the way, but why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?
AnEngineer,

<<why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?>>

You buy bond at price X with the market expectation of interest rate Y. If the market expectation changes that the interest rate would go up higher than Y in future, why would they buy your bond at price X? They would only buy at a price lowered than X.

This is the same as the stock price. Stock price is forward looking. Earning expectation goes up. Stock price goes up.

KlangFool
I get the stock case. If the market makes $X more than expected, all else being equal, owners have more than expected. Also, while a company may only be making a certain amount now, if they expect to grow that's priced in to the value, even though it hasn't happened yet.

However, in the case of a bond, while expectation may affect the terms of the bond at purchase, they are fixed at that point in time. The (nominal) bond itself does not respond to anything in the market. If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. The interest rate for that time that the market expected when I bought the bond no longer relevant.
KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 7:38 am
KlangFool wrote: Wed Jun 16, 2021 6:55 am
AnEngineer wrote: Wed Jun 16, 2021 6:33 am
KlangFool wrote: Sun Jun 13, 2021 8:20 pm Folks,

Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase. Ditto for expected inflation increase.

Folks are paid millions to issue billions of bonds regularly. Ditto, folks are paid millions to buy billions of bonds. They are no dummies.

This is the same like the stock price. It only goes up when it beats EXPECTATION. Or, it goes down when it is below EXPECTATION.

I know that I know nothing. And, everything that I know so does everyone else. So, I know that I have no better prediction power than anyone else.

KlangFool
What is the mechanism to do this? If I buy a nominal bond I know what my total nominal return will be at maturity. If interest rates change, then I could sell the bond for more or less than expected along the way, but why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?
AnEngineer,

<<why would I compare expected interest rates instead of actual interest rates (my bond vs the market at equal remaining duration)?>>

You buy bond at price X with the market expectation of interest rate Y. If the market expectation changes that the interest rate would go up higher than Y in future, why would they buy your bond at price X? They would only buy at a price lowered than X.

This is the same as the stock price. Stock price is forward looking. Earning expectation goes up. Stock price goes up.

KlangFool
I get the stock case. If the market makes $X more than expected, all else being equal, owners have more than expected. Also, while a company may only be making a certain amount now, if they expect to grow that's priced in to the value, even though it hasn't happened yet.

However, in the case of a bond, while expectation may affect the terms of the bond at purchase, they are fixed at that point in time. The (nominal) bond itself does not respond to anything in the market. If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. The interest rate for that time that the market expected when I bought the bond no longer relevant.
AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
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AnEngineer
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Wed Jun 16, 2021 7:52 am AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
Exactly my point: you're comparing my bond with a new bond. Where does the expected interest rate "now" from when I bought my bond five years ago affect the price you're willing to pay for my bond?
KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 7:58 am
KlangFool wrote: Wed Jun 16, 2021 7:52 am AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
Exactly my point: you're comparing my bond with a new bond. Where does the expected interest rate "now" from when I bought my bond five years ago affect the price you're willing to pay for my bond?
AnEngineer,

And, to someone looking to buy a new 5 years bond, there is no difference between your 10 years bond maturing in 5 years versus the new 5 years bond. So, why should they pay more for your bond? That is the point that you are missing.

KlangFool
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AnEngineer
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Wed Jun 16, 2021 10:05 am
AnEngineer wrote: Wed Jun 16, 2021 7:58 am
KlangFool wrote: Wed Jun 16, 2021 7:52 am AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
Exactly my point: you're comparing my bond with a new bond. Where does the expected interest rate "now" from when I bought my bond five years ago affect the price you're willing to pay for my bond?
AnEngineer,

And, to someone looking to buy a new 5 years bond, there is no difference between your 10 years bond maturing in 5 years versus the new 5 years bond. So, why should they pay more for your bond? That is the point that you are missing.

KlangFool
That's not the topic I'm trying to discuss. Recall that you said that the change in rates compared to expectation when I bought my bond matters.
KlangFool wrote: Sun Jun 13, 2021 8:20 pmBond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase.
I am contesting that and saying the expectation doesn't matter after purchase.

Let's look at the following 4 scenarios:
A) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are indeed 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
B) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are only 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
C) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are 4% and I sell my bond to you below par value (so you end up the same as if you bought a 5-year bond with 4% interest).
D) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are indeed 4% and I sell my bond to you below par value (same price as scenario C).

You were saying that the price I sell to you should be different in A&B (and also different in C&D), or that my prices in scenarios B&D are wrong. Please explain how the above is not correct or how I misunderstood you.
KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 12:28 pm
KlangFool wrote: Wed Jun 16, 2021 10:05 am
AnEngineer wrote: Wed Jun 16, 2021 7:58 am
KlangFool wrote: Wed Jun 16, 2021 7:52 am AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
Exactly my point: you're comparing my bond with a new bond. Where does the expected interest rate "now" from when I bought my bond five years ago affect the price you're willing to pay for my bond?
AnEngineer,

And, to someone looking to buy a new 5 years bond, there is no difference between your 10 years bond maturing in 5 years versus the new 5 years bond. So, why should they pay more for your bond? That is the point that you are missing.

KlangFool
That's not the topic I'm trying to discuss. Recall that you said that the change in rates compared to expectation when I bought my bond matters.
KlangFool wrote: Sun Jun 13, 2021 8:20 pmBond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase.
I am contesting that and saying the expectation doesn't matter after purchase.

Let's look at the following 4 scenarios:
A) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are indeed 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
B) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are only 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
C) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are 4% and I sell my bond to you below par value (so you end up the same as if you bought a 5-year bond with 4% interest).
D) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are indeed 4% and I sell my bond to you below par value (same price as scenario C).

You were saying that the price I sell to you should be different in A&B (and also different in C&D), or that my prices in scenarios B&D are wrong. Please explain how the above is not correct or how I misunderstood you.
AnEngineer,

I am saying in (B) and (C), the price would be different because expected future interest rate is difference than the current interest rate.

In (B), the expectation is interest rate is going up. So, the buyer will ask for a lower price for the possibility of the interest going up to 4% and the bond drop further. Buying assuming 2% is not going

In (C), the seller would not sell assuming 4%. The seller can hold up for a better price because the expectation is the interest rate could drop to 2% and the bond could go up.

KlangFool
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AnEngineer
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Wed Jun 16, 2021 1:08 pm
AnEngineer wrote: Wed Jun 16, 2021 12:28 pm
KlangFool wrote: Wed Jun 16, 2021 10:05 am
AnEngineer wrote: Wed Jun 16, 2021 7:58 am
KlangFool wrote: Wed Jun 16, 2021 7:52 am AnEngineer,

<< If I want to sell a bond to you, you'd look at the interest rate of my bond compared to what else is available at that time. >>

And, whatever may be available is the new bond. Your 10 years bond is maturing in 5 years. I can buy a new bond maturing in 5 years with a higher interest rate. Unless you sell your bond to me at a lower price, why should I buy your bond?

KlangFool
Exactly my point: you're comparing my bond with a new bond. Where does the expected interest rate "now" from when I bought my bond five years ago affect the price you're willing to pay for my bond?
AnEngineer,

And, to someone looking to buy a new 5 years bond, there is no difference between your 10 years bond maturing in 5 years versus the new 5 years bond. So, why should they pay more for your bond? That is the point that you are missing.

KlangFool
That's not the topic I'm trying to discuss. Recall that you said that the change in rates compared to expectation when I bought my bond matters.
KlangFool wrote: Sun Jun 13, 2021 8:20 pmBond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase.
I am contesting that and saying the expectation doesn't matter after purchase.

Let's look at the following 4 scenarios:
A) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are indeed 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
B) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are only 2% and I sell my bond to you at par value (same price as a new 5-year bond at 2% interest).
C) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 2% right now. Right now interest rates are 4% and I sell my bond to you below par value (so you end up the same as if you bought a 5-year bond with 4% interest).
D) I bought a 10-year nominal bond 5 years ago at 2% interest and the expectation was that interest rates on a 5-year bond would be 4% right now. Right now interest rates are indeed 4% and I sell my bond to you below par value (same price as scenario C).

You were saying that the price I sell to you should be different in A&B (and also different in C&D), or that my prices in scenarios B&D are wrong. Please explain how the above is not correct or how I misunderstood you.
AnEngineer,

I am saying in (B) and (C), the price would be different because expected future interest rate is difference than the current interest rate.

In (B), the expectation is interest rate is going up. So, the buyer will ask for a lower price for the possibility of the interest going up to 4% and the bond drop further. Buying assuming 2% is not going

In (C), the seller would not sell assuming 4%. The seller can hold up for a better price because the expectation is the interest rate could drop to 2% and the bond could go up.

KlangFool
I'm not talking about the future, I'm talking about right now. There is no possibility of future rates that's relevant. You're buying a bond right now, you can buy a new bond, or one from me. How does anything other than the interest rates of the two bonds affect the price you're willing to pay me for mine vs. a new one?
KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 2:05 pm
I'm not talking about the future, I'm talking about right now. There is no possibility of future rates that's relevant. You're buying a bond right now, you can buy a new bond, or one from me. How does anything other than the interest rates of the two bonds affect the price you're willing to pay me for mine vs. a new one?
AnEngineer,

1) Are you claiming that future earning expectation does not affect current stock price? It does.

2) Then, how could you claim that future interest rate expectation does not affect current bond price?

https://finance.yahoo.com/m/b322e238-5b ... yptr=yahoo

3) Bond and stock price changes today because the Fed unexpectedly signaled it expect two interest rate hikes in 2023.

KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool wrote: Wed Jun 16, 2021 2:08 pm Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase.
When you said this, did you mean that if there's an expected interest rate increase then that does not affect bond prices?
aristotelian
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by aristotelian »

millennialinvestor wrote: Wed Jun 09, 2021 8:16 pm So when should one get into bonds assuming rates are going up?
The market already knows whatever you know about rates going up and has set bond prices/yields accordingly. If you had a crystal ball you could know when rates are going up more than market expectations but there is no way to know that in advance. Therefore, you should simply hold bonds according to a set allocation based on your risk tolerance rather than predictions about interest rates.
KlangFool
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by KlangFool »

AnEngineer wrote: Wed Jun 16, 2021 2:14 pm
KlangFool wrote: Wed Jun 16, 2021 2:08 pm Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase.
When you said this, did you mean that if there's an expected interest rate increase then that does not affect bond prices?
Correct!

KlangFool
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AnEngineer
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by AnEngineer »

KlangFool,

After too much thinking about this, I think I know where you're coming from and why we have a disconnect. You're saying when I buy a bond, there's a market assumption of what interest rates will do for the duration of the bond and thus you could predict the value of the bond at any point in the future. This is somewhat amorphous, because it's actually a whole bunch of people setting bond yields, and they don't necessarily have the same expectation, but they combine to create the interest rate for current bonds.

I was starting from a perspective closer to say how series EE savings bonds work (ignoring the doubling at 20 years). When I buy a bond, I know the terms, so I'll $X dollars at maturity including my interest payments. Here, the value of my bond only changes if it does not match the interest rates of new issue bonds with duration equal to what's left of my bond.

I think the disconnect is that it sounded like you were saying changing in expectation, independent of changes in the current interest rate, affect the value of my bond. However, changes in expectation of interest rates help determine the current interest rate, so there is not independence. Thus, when I saw that bond prices are controlled by new issue bond yields (in turn affected by expected future rates), I'm in essence talking about the same thing.
GoneOnTilt
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by GoneOnTilt »

KlangFool wrote: Sun Jun 13, 2021 8:20 pm Folks,

Bond price drop when there is an UNEXPECTED interest rate increases. Any expected and known interest rate increase will be priced into any newly issued bond and bond purchase. Ditto for expected inflation increase.

Folks are paid millions to issue billions of bonds regularly. Ditto, folks are paid millions to buy billions of bonds. They are no dummies.

This is the same like the stock price. It only goes up when it beats EXPECTATION. Or, it goes down when it is below EXPECTATION.

I know that I know nothing. And, everything that I know so does everyone else. So, I know that I have no better prediction power than anyone else.

KlangFool
Very helpful. Thank you KlangFool.
Prudence
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Prudence »

nisiprius wrote: Mon Jun 14, 2021 7:00 am To restate the dynamics, I think of this in terms of forces.
  • Rising interest rates exert a downward pressure on bond prices. The pressure is related to the rate of rise. If interest rates keep rising at, say, 1% per year, the pressure doesn't keep increasing, it is a constant pressure.
  • Bond prices respond to that pressure by moving downward.
  • Because a bond pays back its face value at maturity, its market value must rise to face value at maturity. A bond whose value is down must rise. You can think of this as an upward pull, often called the "pull to maturity."
  • The more depressed a bond price is, the more it has to rise in order to get back to face value.
  • That means that the more depressed the bond price is, the stronger the upward tug.
  • There is a balance of forces. Rising rates push down. The always-approaching maturity pulls up.
  • A forever-rising interest rate does not create a forever-falling declining bond price.
  • As the bond price declines, the pull to maturity becomes stronger and stronger, until an equilibrium is reached.
  • In other words, if the first 1% interest rate rise creates a -6.2% fall in the bond price, that does not mean the second, third, fourth etc. create further -6.2% falls.
  • The relationship, price fall = interest rate rise x duration is only true for a single instantaneous rise. It is not cumulative for long-term continouusly-rising interest rate, or a series of rises.
  • The bond price stabilizes, but coupon payments continue.
Unlike stocks, bonds make virtually all their money from coupon payments. "Capital appreciation" in a bond or bond fund only occurs as a result of favorable timing with market fluctuations. The price of the Vanguard Total Bond Market fund since inception has only grown from $10/share to $11.31/share, yet a $10,000 investment would have grown, not to $11,310 but to $68,000. Therefore, any analysis that is looking only at bond prices is missing the whole point of owning bonds, and is seriously misleading for anything but very short periods of time.
Nisi: great post. Does the VG total bond market fund keep all its bonds to maturity? If not, would that change your general thesis (that the pressure is related to the rate of the rise)? If the fund possessed a significant percentage of bonds with very low (e.g. near zero) coupons or yields, would that change your general thesis?
Scooter57
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Scooter57 »

With the Fed buying immense amounts of bonds based on considerations very different from what the future may hold, is it still valid to consider bond prices a good gauge of what the Market expects going forward? I have read that the Treasury now holds about 30% of all mortgage bonds. The amount of treasury debt they have bought doubled from what it had ever been as a result of the pandemic. The Fed also bought up billions of dollars of corporate debt during the pandemic.

This is very different from a market where buyers and sellers set prices by bidding at auction.

Also, the argument that bonds approach face value as they approach maturity is soothing, except that many of the bonds held in large bond funds have very long maturities. Almost 20% of the holdings of the Vanguard Total Bond Market have maturities of 15-20 years to Over 25 years.

And even 2-3% inflation sustained over 20 years would eat away 33-45% of the buying power of your original dollar. So the return of your nominal dollar is cold comfort.

The disconnect between rates and the CPI has never been so large. And I'm using CPI which many people feel underestimates the true impact of inflation. Before the Fed's massive intervention it was typical for treasury rates to run at least 2% above the inflation rate shown by the CPI--often much higher--and for CD rates to run another 1% or so above Treasury rates. Now interest rates have completely decoupled from CPI.

This very interesting table of year end CPI and Fed Funds rate is worth a look. https://www.thebalance.com/u-s-inflati ... st-3306093

We are still in the midst of a very long, very massive experiment in financial engineering, the results of which are unknown. All we know for sure is that the kind of market academics backtest against and the principles we were all instructed to invest with are based on assumptions that probably no longer hold true. What does is a complete mystery.
Prudence
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Prudence »

Scooter57 wrote: Thu Jul 08, 2021 12:27 pm With the Fed buying immense amounts of bonds based on considerations very different from what the future may hold, is it still valid to consider bond prices a good gauge of what the Market expects going forward? I have read that the Treasury now holds about 30% of all mortgage bonds. The amount of treasury debt they have bought doubled from what it had ever been as a result of the pandemic. The Fed also bought up billions of dollars of corporate debt during the pandemic.

This is very different from a market where buyers and sellers set prices by bidding at auction.

Also, the argument that bonds approach face value as they approach maturity is soothing, except that many of the bonds held in large bond funds have very long maturities. Almost 20% of the holdings of the Vanguard Total Bond Market have maturities of 15-20 years to Over 25 years.

And even 2-3% inflation sustained over 20 years would eat away 33-45% of the buying power of your original dollar. So the return of your nominal dollar is cold comfort.

The disconnect between rates and the CPI has never been so large. And I'm using CPI which many people feel underestimates the true impact of inflation. Before the Fed's massive intervention it was typical for treasury rates to run at least 2% above the inflation rate shown by the CPI--often much higher--and for CD rates to run another 1% or so above Treasury rates. Now interest rates have completely decoupled from CPI.

This very interesting table of year end CPI and Fed Funds rate is worth a look. https://www.thebalance.com/u-s-inflati ... st-3306093

We are still in the midst of a very long, very massive experiment in financial engineering, the results of which are unknown. All we know for sure is that the kind of market academics backtest against and the principles we were all instructed to invest with are based on assumptions that probably no longer hold true. What does is a complete mystery.
So, Scooter57, you are saying that I can't rely on Nisi's analysis going forward because the assumptions no longer hold true, right?
UpperNwGuy
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by UpperNwGuy »

000 wrote: Mon Jun 14, 2021 5:44 pm
KlangFool wrote: Mon Jun 14, 2021 4:07 pm 000,

Are you claiming the folks that issues the billions of new bonds are not trying to get the lowest interest rate possible? Ditto, the folks that buying billions of bonds are not trying to get the highest interest rate possible. And, they do not take into account of inflation? And, this happened everyday. And, the bond market is a lot bigger than the stock market. The US bond market is about 46 trillions.

You are right that they are not individual investors. They are professionals being paid millions to trade billions of bonds.

KlangFool
Many participants in the bond market have no choice other than to buy bonds due to regulatory or other requirements beyond their control.

Of course they want the best interest rate possible. But the fact that they are participating in bonds as a general asset class does not necessarily mean they think bonds are preferable to alternatives for those able to choose alternatives nor that interest rates necessarily reflect inflation expectations.

To your arguments about scale, what about the commodities markets? Those are huge. Doesn't mean we ought participate in them.
@000, where have you been? We haven't seen you here on bogleheads in several weeks. Is everything ok?
powercherry5
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by powercherry5 »

Scooter57 wrote: Thu Jul 08, 2021 12:27 pm With the Fed buying immense amounts of bonds based on considerations very different from what the future may hold, is it still valid to consider bond prices a good gauge of what the Market expects going forward? I have read that the Treasury now holds about 30% of all mortgage bonds. The amount of treasury debt they have bought doubled from what it had ever been as a result of the pandemic. The Fed also bought up billions of dollars of corporate debt during the pandemic.

This is very different from a market where buyers and sellers set prices by bidding at auction.

Also, the argument that bonds approach face value as they approach maturity is soothing, except that many of the bonds held in large bond funds have very long maturities. Almost 20% of the holdings of the Vanguard Total Bond Market have maturities of 15-20 years to Over 25 years.

And even 2-3% inflation sustained over 20 years would eat away 33-45% of the buying power of your original dollar. So the return of your nominal dollar is cold comfort.

The disconnect between rates and the CPI has never been so large. And I'm using CPI which many people feel underestimates the true impact of inflation. Before the Fed's massive intervention it was typical for treasury rates to run at least 2% above the inflation rate shown by the CPI--often much higher--and for CD rates to run another 1% or so above Treasury rates. Now interest rates have completely decoupled from CPI.

This very interesting table of year end CPI and Fed Funds rate is worth a look. https://www.thebalance.com/u-s-inflati ... st-3306093

We are still in the midst of a very long, very massive experiment in financial engineering, the results of which are unknown. All we know for sure is that the kind of market academics backtest against and the principles we were all instructed to invest with are based on assumptions that probably no longer hold true. What does is a complete mystery.
I do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds. There is no "real" market when it's govt subsidized. e.x. Our college debt crises is partially because the debt is backstopped by govt.

On the other hand, maybe we are confused. Isn't the fed buying bonds the reason for the low interest rates. So when they stop buying, there will in fact be repercussions, but it is literally what we have been discussing (rising interest rates!). So trying to account for the FED buying bonds and distorting the "market" would literally just mean accounting for interest rates being low and able to rise at any time.
Scooter57
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by Scooter57 »

powercherry5 wrote: Thu Jul 08, 2021 6:42 pm
I do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds. There is no "real" market when it's govt subsidized. e.x. Our college debt crises is partially because the debt is backstopped by govt.

On the other hand, maybe we are confused. Isn't the fed buying bonds the reason for the low interest rates. So when they stop buying, there will in fact be repercussions, but it is literally what we have been discussing (rising interest rates!). So trying to account for the FED buying bonds and distorting the "market" would literally just mean accounting for interest rates being low and able to rise at any time.
The Fed's buying has gone way beyond trying to control longer Treasury interest rates once they started buying Corporate bond ETFs. They have been buying now to stabilize markets that had threatened to completely dry up. At this point they are such a big player that any withdrawal from their current approach would disturb markets. No one knows what they will do next or how they would respond if rates were allowed to rise and it caused another "taper tantrum."

So I have no idea how this affects the bond market going forward, only that it does suggest to an informed mind that this time IS different. The Fed buying bonds was new after 2009. Buying corporate bonds was new in 2020. Backtesting against periods when the Fed's only intervention was to change the overnight lending rate to banks therefore could be misleading.
sureshoe
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by sureshoe »

In these various bond posts, I think the biggest problem people are struggling with is this: We want a good return with no chance of loss. That's hard to come by, particularly in today's market.
BJJ_GUY
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by BJJ_GUY »

powercherry5 wrote: Thu Jul 08, 2021 6:42 pm I do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds. There is no "real" market when it's govt subsidized. e.x. Our college debt crises is partially because the debt is backstopped by govt.

On the other hand, maybe we are confused. Isn't the fed buying bonds the reason for the low interest rates. So when they stop buying, there will in fact be repercussions, but it is literally what we have been discussing (rising interest rates!). So trying to account for the FED buying bonds and distorting the "market" would literally just mean accounting for interest rates being low and able to rise at any time.
Interest rates can rise if inflation picks up and accelerates as market participants suddenly believe in the threat. While I agree strongly that central bank actions have artificially reduced interest rates, and also cause massive inflation in the form of asset prices, I think it's worth noting that increasing rates isn't always a result of Fed action.

Also, when you mention accounting for bond buying and distorting the market, keep in mind that there are knock on effects that have materially impacted things well beyond the bond market. Equity prices are at historical levels and real estate well above historical averages (and wide spread at that). The second, third, and fourth order effects of central bank and other government activities since 2009 go beyond just thinking about the bond and stock market.
seajay
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by seajay »

powercherry5 wrote: Thu Jul 08, 2021 6:42 pmI do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds.
Much was a straight debt restructuring. Take the UK for instance, pre 2008 financial crisis and the debt was around 500Bn (Pounds), costing around 5% (coupon yield). Then the central bank (Bank of England) printed 500Bn to in effect buy up all of that debt, and returns all interest it receives on those bonds back to the Treasury, whilst the Treasury sold 1000Bn of new debt (Treasuries) with coupon yields of 2% and spread out over more years before maturity. So whilst the debt expanded three-fold from 500 to 1500 that looked bad, in practice it was costing less to service that debt and with greater scope for time devaluation of the debt (inflation). The consequence of such a big buyer in the market is that bond prices rose/yields declined, resulting in the tendency for pension funds to reduce bonds, buy more stocks, so stock valuations also rose.

When many other countries also did similar sorts of debt restructuring then low/no inflation occurs.

The main 'risk' is that when each bond matures when the Treasury will have to decide whether to roll into a new issue, or repay the money. Interest rates at that time will have a bearing on that decision, but where the decisions are spread out over perhaps 50 years or more of repeated individual bond series maturing - time diversified 'risk'.

It's wasn't a insane action to do that, rather it was because interest rates had been lowered to the floor that QE had to be adopted as the alternative to otherwise having to set negative interest rates.

A factor is that such policies have tended to drive high prices, larger gains than what might otherwise have been seen. 14% annualized real gains since 2009 type US stock gains for instance. After such great gains potentially the next 12 years might see 0% real rewards, such that the the broader average over 24 years might average 6% or 7% real type 'average' rewards. Such is life. Prior to the Wall Street Crash the "Roaring 20's" saw stock prices double, double again and double yet again over a relatively short time period. Similar for Japan 1970's/1980's when the likes of Yamaha, Sony ...etc. became global household names. After fantastic gains its not unreasonable to anticipate lower subsequent rewards or even declines back down again - to more broader overall sustainable levels.
000
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by 000 »

UpperNwGuy wrote: Thu Jul 08, 2021 5:42 pm @000, where have you been? We haven't seen you here on bogleheads in several weeks. Is everything ok?
Drifted away as I feel that moderation policies are stifling interesting discussion.
User avatar
big bang
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by big bang »

nisiprius wrote: Mon Jun 14, 2021 7:00 am To restate the dynamics, I think of this in terms of forces.
  • Rising interest rates exert a downward pressure on bond prices. The pressure is related to the rate of rise. If interest rates keep rising at, say, 1% per year, the pressure doesn't keep increasing, it is a constant pressure.
  • Bond prices respond to that pressure by moving downward.
  • Because a bond pays back its face value at maturity, its market value must rise to face value at maturity. A bond whose value is down must rise. You can think of this as an upward pull, often called the "pull to maturity."
  • The more depressed a bond price is, the more it has to rise in order to get back to face value.
  • That means that the more depressed the bond price is, the stronger the upward tug.
  • There is a balance of forces. Rising rates push down. The always-approaching maturity pulls up.
  • A forever-rising interest rate does not create a forever-falling declining bond price.
  • As the bond price declines, the pull to maturity becomes stronger and stronger, until an equilibrium is reached.
  • In other words, if the first 1% interest rate rise creates a -6.2% fall in the bond price, that does not mean the second, third, fourth etc. create further -6.2% falls.
  • The relationship, price fall = interest rate rise x duration is only true for a single instantaneous rise. It is not cumulative for long-term continouusly-rising interest rate, or a series of rises.
  • The bond price stabilizes, but coupon payments continue.
Unlike stocks, bonds make virtually all their money from coupon payments. "Capital appreciation" in a bond or bond fund only occurs as a result of favorable timing with market fluctuations. The price of the Vanguard Total Bond Market fund since inception has only grown from $10/share to $11.31/share, yet a $10,000 investment would have grown, not to $11,310 but to $68,000. Therefore, any analysis that is looking only at bond prices is missing the whole point of owning bonds, and is seriously misleading for anything but very short periods of time.
nisiprius, Thank you for the analogy.
Your explanation makes it very clear.
(1) save a lot, (2) select an asset allocation containing both stock and bond asset classes, (3) buy low cost, widely diversified funds, (4) allocate funds tax-efficiently, and (5) stay the course.
BJJ_GUY
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by BJJ_GUY »

seajay wrote: Fri Jul 16, 2021 6:36 pm
powercherry5 wrote: Thu Jul 08, 2021 6:42 pmI do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds.
Much was a straight debt restructuring. Take the UK for instance, pre 2008 financial crisis and the debt was around 500Bn (Pounds), costing around 5% (coupon yield). Then the central bank (Bank of England) printed 500Bn to in effect buy up all of that debt, and returns all interest it receives on those bonds back to the Treasury, whilst the Treasury sold 1000Bn of new debt (Treasuries) with coupon yields of 2% and spread out over more years before maturity. So whilst the debt expanded three-fold from 500 to 1500 that looked bad, in practice it was costing less to service that debt and with greater scope for time devaluation of the debt (inflation). The consequence of such a big buyer in the market is that bond prices rose/yields declined, resulting in the tendency for pension funds to reduce bonds, buy more stocks, so stock valuations also rose.

When many other countries also did similar sorts of debt restructuring then low/no inflation occurs.

The main 'risk' is that when each bond matures when the Treasury will have to decide whether to roll into a new issue, or repay the money. Interest rates at that time will have a bearing on that decision, but where the decisions are spread out over perhaps 50 years or more of repeated individual bond series maturing - time diversified 'risk'.

It's wasn't a insane action to do that, rather it was because interest rates had been lowered to the floor that QE had to be adopted as the alternative to otherwise having to set negative interest rates.

A factor is that such policies have tended to drive high prices, larger gains than what might otherwise have been seen. 14% annualized real gains since 2009 type US stock gains for instance. After such great gains potentially the next 12 years might see 0% real rewards, such that the the broader average over 24 years might average 6% or 7% real type 'average' rewards. Such is life. Prior to the Wall Street Crash the "Roaring 20's" saw stock prices double, double again and double yet again over a relatively short time period. Similar for Japan 1970's/1980's when the likes of Yamaha, Sony ...etc. became global household names. After fantastic gains its not unreasonable to anticipate lower subsequent rewards or even declines back down again - to more broader overall sustainable levels.
I don't think what you've described is anything like a debt restructuring. In an effort to slightly reduce the cost of servicing debt the monetary base expanded (in the BOE example by the full 1500bn pounds).

Sure increased money supply does not result in inflation and higher rates, at least not directly and with predictable timing. There is some point where market participants become concerned that Treasury has no intention, or perhaps may not be able, to retire and beginning shrinking the debt.

Once doubt creeps into the market place, and a higher return is required to loan money to the government, I'm thinking some people will regret the time they thought it was a good idea to multiple the debt load in order to alleviate debt servicing for a relatively short period of time.
seajay
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by seajay »

BJJ_GUY wrote: Fri Jul 16, 2021 8:24 pm
seajay wrote: Fri Jul 16, 2021 6:36 pm
powercherry5 wrote: Thu Jul 08, 2021 6:42 pmI do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds.
Much was a straight debt restructuring....
I don't think what you've described is anything like a debt restructuring.
Approximately it is twice as much debt spread out over twice as many years that to service costs half as much as before, whilst the BoE printed money to buy up all of the former debt. Whilst that former debt/bonds still exist the BoE returns the interest, and as each bond matures so the capital payment could similarly be returned to the treasury, or that money simply torn up (QT). Debt restructured, spread out over more time where inflation can be expected to erode the value and where the government can turn around and say "look at this massive debt mountain we now have" as a excuse to increase taxes/reduce spending. And where going through that process helped prop things up at a critical time, pushed bond prices up, inducing pension funds and others to sell some bonds to buy more stocks that pushed stock prices up.

Pretty much business as usual, but where with interest rates at 0% that had to be used rather than setting negative rates. Sensible/reasonable management. Others playing the same game-plan however haven't been as sensible. The Euro for instance has opted to print to buy up government bonds, then junk bonds, then some stocks, seeing it as a opportunity to secure low cost debt to 'invest'. Some of the more socialist members would like to see that extended considerably further, continue printing to buy up all stocks, houses/land ...etc. a grand nationalisation. France takes over EU presidency next year and have ambitions in that direction (along with changing the primary language of the EU over to French). The benefit of the EU for Germany was revealed back in 2009/10, when massive amounts of its bad German debt/bets were swapped over to the ECB i.e. the rest of the Eurozone bailed Germany out. And where it can keep its otherwise own currency low, lend to other member states for them to buy its products at relatively low prices and thereby better ensure it runs with a net surplus. Trump was aware of such competitive advantage and was looking to confront that, Biden however has other ideas.

Putting all the opacity/tweaks aside the core concept is business as usual. From a individual investors perspective however and a risk is that interest rates might be kept low over a period when inflation rises. Recent negative -2% type real yields are relatively mild compared to other historic times when -10% real yields occurred when taxation is also factored in.

http://warrenbuffettoninvestment.com/ho ... -investor/
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn’t seem to notice that 6% inflation is the economic equivalent.
BJJ_GUY
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Re: Assuming inflation increases and rates climb (or are expected to) will bond funds appreciate in value?

Post by BJJ_GUY »

seajay wrote: Sat Jul 17, 2021 6:18 am
BJJ_GUY wrote: Fri Jul 16, 2021 8:24 pm
seajay wrote: Fri Jul 16, 2021 6:36 pm
powercherry5 wrote: Thu Jul 08, 2021 6:42 pmI do wonder how much the FED's buying spree affects the accuracy of the "efficient market hypothesis":

The FED is buying insane amounts of bonds.
Much was a straight debt restructuring....
I don't think what you've described is anything like a debt restructuring.
Approximately it is twice as much debt spread out over twice as many years that to service costs half as much as before, whilst the BoE printed money to buy up all of the former debt. Whilst that former debt/bonds still exist the BoE returns the interest, and as each bond matures so the capital payment could similarly be returned to the treasury, or that money simply torn up (QT). Debt restructured, spread out over more time where inflation can be expected to erode the value and where the government can turn around and say "look at this massive debt mountain we now have" as a excuse to increase taxes/reduce spending. And where going through that process helped prop things up at a critical time, pushed bond prices up, inducing pension funds and others to sell some bonds to buy more stocks that pushed stock prices up.

Pretty much business as usual, but where with interest rates at 0% that had to be used rather than setting negative rates. Sensible/reasonable management. Others playing the same game-plan however haven't been as sensible. The Euro for instance has opted to print to buy up government bonds, then junk bonds, then some stocks, seeing it as a opportunity to secure low cost debt to 'invest'. Some of the more socialist members would like to see that extended considerably further, continue printing to buy up all stocks, houses/land ...etc. a grand nationalisation. France takes over EU presidency next year and have ambitions in that direction (along with changing the primary language of the EU over to French). The benefit of the EU for Germany was revealed back in 2009/10, when massive amounts of its bad German debt/bets were swapped over to the ECB i.e. the rest of the Eurozone bailed Germany out. And where it can keep its otherwise own currency low, lend to other member states for them to buy its products at relatively low prices and thereby better ensure it runs with a net surplus. Trump was aware of such competitive advantage and was looking to confront that, Biden however has other ideas.

Putting all the opacity/tweaks aside the core concept is business as usual. From a individual investors perspective however and a risk is that interest rates might be kept low over a period when inflation rises. Recent negative -2% type real yields are relatively mild compared to other historic times when -10% real yields occurred when taxation is also factored in.

http://warrenbuffettoninvestment.com/ho ... -investor/
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn’t seem to notice that 6% inflation is the economic equivalent.
In effect, the BOE scenario you detailed reduced the coupon owed by 1% (because the BOE somehow passes income back to the Treasury).

The Treasury's outstanding liability (in principal value) increased from 500 to 1.5trn pounds. The initial 500bn of 5% coupon bonds will still need to be paid out at maturity, so either issue more debt to rollover, or actually exhaust the liability.

Also, the Fed buying the 500bn in bonds doesn't just disappear from the balance sheet. They simply swapped non-interest bearing government liabilities (currency) for interest-bearing liabilities (5% bonds). Because of this function, those bonds can't just be dissolved or forgiven at maturity.

At some point if market participants believe that you are funding all expenditures through debt, and revenues (GDP) don't appear enough to support the scheme forever, then things get really tough as debt can't be rolled over and rates increase. I guess they (collectively, we) can continue to think there is no upper band on debt load and QE etc., but it would potentially be ugly if sentiment changed and confidence in sovereigns was lost.
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