Bond funds: am I getting it?

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PB
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Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 6:01 pm

Hey everyone,

I'm relatively new to the Forum, which BTW, is truly an amazing resource - thank you.

I'm posting because even with recent threads on bond funds and TIPS, I'm not sure I'm getting it. So I appreciate a reality check. I'll try to be brief, and also hope not to nitpick the numbers (e.g., if they're off 1/10th of 1%; it's the basic concepts that are important).

First, my understanding is that, according to the reference included below, the current CPI is 1.9%. That's year-to-year per the Oct report.

Second, here are the SEC yields for several Vanguard bond funds, as noted today on their website:

TIPS Adm: -0.91%
Short-Term Investment Grade: 1.12%
Total Bond: 1.60%
Intermediate Investment Grade: 2.04%
Hi-Yield Tax Exempt: 2.42%

So, given these numbers, are my conclusions basically correct, at least for today?

1. Real yields for Total Bond and Short-Term Investment Grade are negative. Setting aside NAV for a moment (all other things being equal), these funds are not keeping up with inflation. The real yield for Short-Term Investment Grade is approximately -0.7.

2. The Intermediate Investment Grade fund is basically breaking even, with a real return of 0.14%.

3. The real return for Hi-Yield Tax Exempt is about .5%, but it comes with default risk. And most importantly:

4. The real yield for the TIPS fund is approximately -1%. But it comes with protection against unexpected inflation, which is nothing to sneeze at for retired and other conservative investors.

So what am I missing? Or is this basically why Larry Swedroe was talking about CD's in a recent thread? That unless you want or need to pay 1% a year for unexpected inflation protection, bond funds don't look great right now. And for most investors, the main reason for staying the course with bond funds is not to make money; it's not to lose a lot of money when their equities invariably go down.

Am I getting it, or am I missing something?

And thanks in advance for any clarity, corrections and/or encouragement for staying the course.

Reference
_____________________________________________________________________________________
The Consumer Price Index increased by 0.2% in October 2012; it rose by 1.9% year-on-year
Prices index – October 2012
Monthly change: +0.2% ; Year-on-year: +1.9%


The Consumer Price index (CPI) rose by 0.2% in October 2012, after a decline by 0.3% in September this year. The CPI annual inflation stands at 1.9% in October, as it was in September. Seasonally adjusted, CPI rose also by 0.2% in October (+1.9% year-on-year). Most of the upward pressure to the CPI in October came from a substantial increase in tobacco prices (+6.7% over a month; +9.9% year-on-year). Excluding tobacco, the CPI increased more moderately (+0.1% over a month; +1.7% year-on-year) and was mainly due to an acceleration of fresh food prices. Besides, the smaller rise in other food prices has been off-set by a new decline in energy prices (especially petroleum products prices). The slight increase in service prices in October has been also compensated by a decrease in manufactured good prices.
Last edited by PB on Sun Nov 25, 2012 7:02 pm, edited 2 times in total.

livesoft
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Re: Bond funds: am I getting it?

Post by livesoft » Sun Nov 25, 2012 6:20 pm

PB wrote:...
1. Real yields for Total Bond and Short-Term Investment Grade are negative. Setting aside NAV for a moment (all other things being equal), these funds are not keeping up with inflation. The real yield for Short-Term Investment Grade is approximately -0.7.
...
CDs will not experience any capital gains. Bond funds have a chance to experience cap gains. Your "these funds are not keeping up with inflation" should be changed to "the SEC yield for these funds are not keeping up with inflation." What was the total return of some of these funds? But I guess that is not setting aside NAV as you requested.

Sure, one cannot expect cap gains going forward and maybe should expect cap losses. Or maybe not?
Last edited by livesoft on Sun Nov 25, 2012 6:37 pm, edited 1 time in total.
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PB
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Re: Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 6:30 pm

Thanks, Livesoft - your point is well taken. Short-Term Investment Grade has the lowest total returns, but still roughly 4% YTD, 1 year, 5 year and 10 year. Very consistent, and certainly better than CD's right now. Thank you.

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Re: Bond funds: am I getting it?

Post by livesoft » Sun Nov 25, 2012 6:39 pm

My preference nowadays is to go up on the risk scale a little bit and use the Vanguard short-term corporate bond index fund instead of CDs or other short-term bond funds.
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nedsaid
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Re: Bond funds: am I getting it?

Post by nedsaid » Sun Nov 25, 2012 6:42 pm

I would say that you are getting it. There is always more to learn.

You are correct when comparing yields to the inflation rate. This makes your yields range from slightly positive to negative when adjusting for inflation.

What you are leaving out is that changes in the market rate of interest affect the net asset value of your fund. If interest rates continue to drop, the underlying value of the bonds in the fund will increase and thus add to the return of your fund. Conversely if interest rates rise from here, the underlying value of the bonds in your fund will decrease and detract from the return of your fund.

You were correct in noting default risk. "Hi-Yield" means junkier bonds.

So you have three elements. The yield generated by the fund itself and the appreciation or depreciation in the value of the bonds caused by changes in interest rates. There is the risk of default of bonds within the portfolio held by the fund.

You should invest in the amount of bonds appropriate for your age regardless of what the bond market is doing right now. If interest rates go up, your bond funds decline in value but your yield will go up. If you reinvest your dividends, over time this should not matter to you. Normally, you will get back to even in less than three years.

Keep in mind, bonds are less volatile than stocks and that is why you put them in a portfolio. You are correct in noting that bonds are pretty expensive right now. TIPS are really expensive. I would not pile into them right now, but buy them as part of your plan of making regular investments.

If you are near retirement and are worried about principal loss, you probably should move a lot of your bonds into the short term funds. Once retired, one would presume that you are drawing on the interest to live on and not reinvesting it.

If you want to draw interest without the market risk of the value of your bonds going up and down, then Certificates of Deposit at a Bank are your best bet. This must be why Larry Swedroe mentioned them. You just draw your interest and hold the CD until maturity. Upon maturity, you roll your principal into another CD. No market risk but the principal in the CD will lose purchasing power.

Yes, I would say you are getting it.
A fool and his money are good for business.

PB
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Re: Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 6:57 pm

Thanks for the thoughtful reply, Nedsaid. I am indeed nearing retirement, in that I'm in my mid-50's, not mid-20's. And I am very conservative, so my allocation to fixed income is much higher than most. That's why I'm paying attention and trying to learn.

I do think I'm getting it, at least for nominal bonds if not TIPS. (TIPS are still somewhat confusing, and I do hold some, which is a little unnerving. But so far I'm holding on to them.)

Anyway, thanks again - appreciate it.

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Re: Bond funds: am I getting it?

Post by Call_Me_Op » Sun Nov 25, 2012 7:05 pm

livesoft wrote: CDs will not experience any capital gains.
Untrue. Brokerage CD's can experience capital gains or losses, just like any (other) bond.
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Re: Bond funds: am I getting it?

Post by Call_Me_Op » Sun Nov 25, 2012 7:07 pm

PB wrote:Thanks, Livesoft - your point is well taken. Short-Term Investment Grade has the lowest total returns, but still roughly 4% YTD, 1 year, 5 year and 10 year. Very consistent, and certainly better than CD's right now. Thank you.
Be careful. Performance over the past year is largely due to a drop in interest rates, and highly unlikely to be repeated.

I'm not sure what "better than CD's" means. The yield may be a little higher, but that is accompanied by increased risk.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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nedsaid
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Re: Bond funds: am I getting it?

Post by nedsaid » Sun Nov 25, 2012 7:13 pm

I understand how TIPS work. What puzzles me a bit is what factors are involved in how they trade. How to fairly value a TIPS Bond seems more complicated than for a regular bond. More moving parts.

If you are puzzled by TIPS, you are not alone. I am still learning.
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nedsaid
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Re: Bond funds: am I getting it?

Post by nedsaid » Sun Nov 25, 2012 7:20 pm

PB, my comments are assuming that you are in short-term and medium-term bond funds. Long-term bond funds can really get killed if interest rates rise dramatically.

Most people should stick to medium and short term bonds.

The longer term the bonds, the more volatile they are with changes in interest rates. Long-term bonds and long-term bond funds are too risky for me. A big reason to invest in bonds in the first place is to reduce volatility. Longer term stuff defeats that purpose.
A fool and his money are good for business.

PB
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Re: Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 7:32 pm

First, I understand that brokered CD's can fluctuate in NAV, but if you hold them to maturity, then your principle is protected. So I understand this key difference.

Second, Nedsaid et al: I am currently on the lower duration side, so I understand this aspect too. Overall (for better or for worse - that's what I'm trying to figure out!), my fixed income is spread across one brokered CD at 3.35%; then some in Total Bond; some in Intermediate Investment grade; a small slice of Muni's; then some managed bonds as part of my Wellesley holding (I know, I know, it's not indexed but that's for another post 8-) .) And finally, some in TIPS. They're all Vanguard funds, so all low fee.

It's interesting because some posters suggest that diversifying across bond fonds is essentially noise, and they might be right. But just like my equity diversification, I feel a little better psychologically spreading the bonds a touch too.

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nedsaid
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Re: Bond funds: am I getting it?

Post by nedsaid » Sun Nov 25, 2012 7:52 pm

PB, you are light years beyond most investors.

The stuff you have looks pretty good. There are many different opinions of how bond investing should be done. What you should be concerned with is if you have good stuff and if it is age appropriate. Make sure you aren't doing crazy stuff with your retirement. It looks like you are on the right track on your thinking. You are asking excellent questions.

Sounds to me that you need hand holding and reassurance. I am the same way. Many investors like to "call their money" and talk to somebody.

I use Vanguard funds and ETF's but don't have a Vanguard account. You might want to go through a portfolio review with a planner at Vanguard. People with accounts at Vanguard can tell you all about this and what it costs. If it costs you $500, it might be worth it to you for peace of mind.

Keep in mind, you do not have to get this exactly right. Get things 90-95% right and you will be fine. There is no final exam upon retirement.

I am mostly a do it yourself investor, but I have sought advice.
A fool and his money are good for business.

PB
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Re: Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 8:05 pm

Hey Nedsaid, thank you. I appreciate your encouragement and advice.

Like you, I'm doing it myself too, since the crash, like a lot of people. I've read all the recommended books, lurk in the forum, etc, and it remains that some days I just don't know, especially with TIPS. But I think Mr. Bogle himself said that this is the most challenging environment he's ever seen.

Bottom line: I'm taking zero risk with increased equities. I'm taking a little extra risk with the intermediate term investment grade fund, and the Wellesley bond portfolio. I may even take some risk with High-Yield, though I doubt it.

And so far I've held onto my TIPS, and my major decision right now is whether to increase TIPS going forward. I still don't know, but either way, it's nothing like getting sucked into increased equities, which I have no plans to do.

Thanks again for the input and encouragement.

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Archie Sinclair
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Re: Bond funds: am I getting it?

Post by Archie Sinclair » Sun Nov 25, 2012 10:25 pm

If these are taxable investments, remember to adjust the yields for federal and state taxes.

I think the best route is hunting a little bit for a good CD rate at a good credit union.

PB
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Re: Bond funds: am I getting it?

Post by PB » Sun Nov 25, 2012 10:46 pm

Thanks, Archie. Except for the muni's, they're all tax-advantaged.

Right now I'm leaning towards staying with the shorter-term bond funds. But appreciate your vote for the CD's as I learn my way through... it's helpful to hear the different points of view.

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Re: Bond funds: am I getting it?

Post by Call_Me_Op » Mon Nov 26, 2012 7:15 am

PB wrote:First, I understand that brokered CD's can fluctuate in NAV, but if you hold them to maturity, then your principle is protected. So I understand this key difference.
Minor clarification; NAV (net asset value) is a term typically used to describe the value of a share of a mutual fund. A brokered CD is not a mutual fund, and what fluctuates is the secondary market value of the CD. If held to maturity, your principal is indeed protected.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Bond funds: am I getting it?

Post by STC » Mon Nov 26, 2012 9:45 am

Keep in mind the role bond's play within your strategy. In mine, they are a dampener of volatility and represent a staged rebalance response to large runs in both directions. I am far less concerned about keeping up with inflation.

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Re: Bond funds: am I getting it?

Post by garlandwhizzer » Mon Nov 26, 2012 12:34 pm

[quote nedsaid said: If interest rates go up, your bond funds decline in value but your yield will go up. If you reinvest your dividends, over time this should not matter to you. Normally, you will get back to even in less than three years. [/quote]

This is misleading. First of all the expected drop in principal value of a bond fund is equal to its average duration times the percentage rise in interest rates. If inflation heats up (and it will one day) interest rates might easily rise 2% or more in 5 years. Based on current SEC yields and average durations, both TBM and especially ITT funds would suffer nominal losses in that scenario over 3 years. In addition, the point that bond lovers never seem to mention is: what is the loss not in nominal dollars but in REAL INFLATION ADJUSTED DOLLARS. Bond investors during the period on rising inflation in the US in late 60s, 70s, and early 80s suffered losses in real dollars and real purchasing power for more than a decade. Likewise in England post-WW2, when like now in the US, interest rates started out artificially low due to governmental policy, bond investors lost real purchasing power for over a decade.

Stocks can also lose money over a decade, but generally after they do, the spring back is much more dramatic than with bonds, witness the bull market from 1982 to 1999, when the S&P gained more than 500% in REAL dollars even excluding dividends which during most of that period were considerable.

I'm not opposed to bonds. Every portfolio must contain them for stability and capital preservation, but it is important to have realistic expectations about bond returns going forward in this low yield environment in real rather than nominal dollars. Over the past 30 years bond returns have been pumped up by principal increases due to a continuous cycle of lowering interest rates. That cycle at some point in the not too distant future is likely to reverse and the principal value of bond funds will do just the opposite. Losses in real dollars will be limited in severity, unlike the situation in more volatile stocks which tank in a bear market, but you're very unlikely to make any considerable gains in purchasing power in bonds for a long spell of years. If your asset base is large enough now to satisfy all future needs, investing a huge percentage of assets or even everything in bonds is safe. If you're planning to make the same kind of killing in the bond market over the next decade or two as has been the case in the recent decade or two, I believe you're in a for a sad awakening. That, at least, is how I see it.

Garland Whizzer

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Re: Bond funds: am I getting it?

Post by Call_Me_Op » Mon Nov 26, 2012 12:44 pm

GW,

Well said.
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Re: Bond funds: am I getting it?

Post by Munir » Mon Nov 26, 2012 2:06 pm

I understand the emphasis that most people have on the stability of bond funds, and to a lesser extent the yield, duration, and credit risk, but somehow I rarely see any consideration of the total return numbers and how they compare for similar-type funds. I also understand that the future of bond funds is not too bright and no one is going to make a killing in the bond market, but including total return seems signifcant enough that it should be included in the discussion on which fund(s) one wants to own.

When I include total return numbers in my evaluation of bond funds for my IRA as a retiree, and taking into consideration all the factors mentioned above, I find myself gravitating to increasing my ownership of intermediate investment grade corporate funds (which Jack Bogle is tilting towards lately but for a longer duration than I feel comfortable with). I know they took a transient dip in 2008 but recovered quickly and kept rising since. Somehow, many BHs keep poor-mouthing them :? . What gives?

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Re: Bond funds: am I getting it?

Post by Munir » Mon Nov 26, 2012 2:20 pm

Call_Me_Op wrote:GW,

Well said.
I agree that what GW stated is well-said but I don't find it applicable to me as a retiree with a shorter time span than younger investors have. Equities take sudden wide swings and are more risky than bonds. They were flat for a whole decade recently. I cannot accept such poor performance numbers and swings nor speculation as to what inflation and interest rates will do in the future. I have been expecting that famous rise in rates for a number of years and lost considerable money wating for it to happen. No more. I feel much more comfortable and sleep well at night with my age in bonds asset allocation (majority intermediate corporate and minority US government instruments & treasuries).

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Re: Bond funds: am I getting it?

Post by PB » Mon Nov 26, 2012 8:36 pm

As the OP, I just want to say thanks for the substantive discussion. I have nothing to add, though lots to learn, and it's helpful and appreciated.

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nedsaid
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Re: Bond funds: am I getting it?

Post by nedsaid » Mon Nov 26, 2012 10:26 pm

Somewhere in the memory banks somewhere, I remember reading a white paper on the Vanguard website talking about the reinvestment of dividends in a bond fund during a period of rising interest rates. If I remember right, the paper said that this would over time increase the returns of an investor in the fund. The key is reinvesting the dividends. Given enough time, the white paper would be correct.

Keep in mind that duration is an estimate of how bonds would perform with a rise in interest rates. Actual results may vary.

Please note, that I acknowledge the "real returns" of bonds which are in some cases negative. I do realize that there is a potential if not a real loss in buying power. TIPS have been bid up so much that now in many cases they represent a negative real return.

I said that normally, an investor would get back to even in three years or less in a rising interest rate environment. Of course, if inflation returned with a vengeance as in the late 1970's then all bets are off. Bonds would get crushed and it would take a long time to get back to even in nominal dollars if not real dollars. I don't see late 1970's inflation in our future. My expectation would be a normalization in interest rates, the 10 year treasury going to maybe 4 percent. Bond funds would suffer for a while but it wouldn't be a national tragedy. Unless you were in long term bonds.

This is why I am in intermediate-term bond funds. You get most of the interest you would get with longer term bonds with a lot less risk. I have a dozen years or more to reinvest dividends and I am not too concerned about the direction of interest rates. If I were close to or in retirement, I would be very concerned about a potential rise in interest rates. I wouldn't be able to recover either for lack of time or because I would need the interest to live on.

I am actually a stock guy. I am in my early 50's and realize the need to take some of the volatility out of my portfolio. In the year 2000, I was about 95% stocks and had the good sense to sell some of my stocks near the peak and go into money markets and bonds. Since then, my allocation in stocks has been between 60 and 72 percent. I am at 65 percent now. I am working that percentage down.

I am not enthusiastic about bonds now. Garland Whizzer raised good points and echoed a lot of the things I had said. I am buying them pretty much because I am getting older. Pretty much, I am holding my nose and buying them as part of a regular program and yes I am buying stocks too. I have continued to add to my retirement funds but have let my stock/bond allocation ride and not rebalanced. In theory, I should have harvested some of the gains in my stocks and put them in bonds. I have not. The reason being that I am not enthusiastic about bonds now.

I also have attempted to dampen volatility with non-correlating (and sometimes volatile) asset classes like REITs, Small Cap Value, International Stocks, International Bonds, etc. This is in the hope that all will over time go up with some zigging while others zag. Who knows if this will work or work better than just market weight indexing?

So all of this is well educated guesswork. Trying to put the odds in my favor but realizing there are no guarantees.

Historically stocks do well after long periods of flat markets. But there is no guarantee this will happen. I have my fingers crossed.
A fool and his money are good for business.

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Re: Bond funds: am I getting it?

Post by RenoJay » Mon Nov 26, 2012 10:54 pm

FYI...there are alternative fixed income investments. They're higher up the risk chain, but the incredibly better yields might make it worthwhile. For instance, I lend money via lendingclub.com. It's a lot of small, unsecured loans and the interest rates the borrowers pay are based on a credit analysis Lendingclub does. I average about 9%/year. While I certainly wouldn't put all or most of my money into this, it is a way to lift the average yield in an otherwise depressing fixed income environment.

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