So... long term investors should IGNORE a bond fund's NAV?

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RandyAdams1978
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So... long term investors should IGNORE a bond fund's NAV?

Post by RandyAdams1978 » Mon Jul 29, 2013 6:35 am

I'm still trying to wrap my head around the individual bond vs bond fund argument. I just read the Boglehead wiki on this. Honestly, my eyes glazed over on some points. But here's my current understanding:

For short term needs, say if you need X amount of dollars in 4 to 5 years for college expenses, an individual bond (or a portfolio of individual bonds) would be a better choice than a bond fund. This is because a bond funds NAV can fluctuate, and, in a rising interest rate environment (which we may or may not be entering), will go down.

There are several challenges with individual bonds, however. One is diversity. Clearly, a bond fund overs a much more diverse portfolio than an individual could likely attain. Another issue with individual bonds is the opportunity cost --- what to do with the dividends once they are handed over to you. This is not an issue with bond funds as they can be re-invested automatically.

But .... and here's where things get muddy for me ..... if you're a long term investor --- say 15-20 years away from retirement ---- a falling NAV shouldn't worry you? The theory is .... what? That, as interest rates rise, the fund will be replacing older, lower-yielding bonds with newer higher-yielding ones? OK. But ... if interest rates KEEP rising over that 15-20 year period ...... aren't you ... at some point ... throwing good money after bad?

I read one thread on this where a poster seemed OVERJOYED that his bond funds NAV was falling, because that gave him (or her) the opportunity to buy the bonds --- in the poster's words --- "on sale". My initial reaction to the "on sale" comment was ..."Whoa... these are NOT stocks. The bond fund NAV may KEEP falling".

But now I'm not so sure. The convenience, diversification, and professional management of a bond fund certainly is an advantage. But what if those NAV's DO keep falling? At what point ARE you throwing good money after bad? Can this be calculated?

Color me confused. Can someone try to straighten me out here?

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Re: So... long term investors should IGNORE a bond fund's NA

Post by dickenjb » Mon Jul 29, 2013 6:57 am

I'll try.

When one buys a 5 year CD, one locks in a certain return. Say 1.5% over 5 years. If rates on 5 year CD's go up to 2%, no one would buy a 1.5% 5 year CD at face value. The value of your CD has just fallen, but it does not show up on the statement you get from the bank. People feel good seeing their $10,000 CD is still worth $10,000 (even though it is not).

Bonds (and bond funds) are liquid. Therefore they get marked to market and you can see the fall in value, because (unlike CD's) there is a secondary market for same. People freak out because their $10,000 in a bond fund is now worth $9,600.

If you hold a bond fund for its duration, or a bond to maturity, you will get your principal back plus the interest you signed up for. If you hold the bond fund for its duration, you will be more or less indifferent to interest rate changes that occurred during the holding period.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by nisiprius » Mon Jul 29, 2013 6:58 am

Assuming it is a high-grade bond fund and that default isn't at issue, yes, I ignore the Vanguard Total Bond Fund's NAV.

I do this for two reasons. First, a bond fund pays out its par value when it matures. This means that the "NAV" of a bond is $1,000 when it is issued and $1,000 when it matures. In between, my mental model is that the value of the bond is tied to that $1,000 by a Bungee cord--long and stretchy for a long-term bond, short and firm for a short-term bond--and that by and large, the value of a big pack of miscellaneous bonds maturing at various times isn't going to get too far away from $1,000. And that when it does, it will tend to return, not because of any hand-waving about "mean reversion," but because it's a bond.

Second, if I look at the NAV of any high-grade bond fund, well, if you step back and squint at it, it's level. I am going to display this two ways. Each of them can be regarded as putting a bit of "spin" on it but here goes. Here are some long-term price charts. First I'm going to spin it my way by displaying the bond chart together with for a stock fund. The stock fund forces Morningstar to plot percentages rather than dollars per share, and it gives us a scale big enough to handle stock fluctuations, which, of course, makes the bond fund fluctuations look small--as they are.

Image

Now, let's look at Total Bond by itself:

Image

Here, the problem is the other way around--the chart magnifies the X axis and suppresses the zero. But look at it. During its entire 27-year history, you could ask "So, what's the share price of Total Bond?" and I could answer, without even looking, "Oh, something like ten bucks a share" and I'd always be close.

Look, it is what is is and we see in it what we want to see. If we are willing to take a long-term view of stocks and think of them as having an historical growth rate of 6-7% real per year, the same degree of long-term thinking, of stepping back and squinting, would justify the idea that "long-term investors should ignore the NAV."
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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 7:09 am

Yes, an investor can safely ignore a bond funds NAV.

The best predictor of bond fund future return is its current SEC yield. You will likely earn very close to this yield if you hold the fund for its duration.

For money that you need in 4 or 5 years, you can probably find a CD with returns that are comparable to a similar duration bond fund.

For money with a long or indefinite holding period, an intermediate term bond fund is probably your best bet.

If you can not tolerate NAV fluctuations, then you do not belong in a bond fund.

It is not mathematically possible for the NAV of a bond fund to keep dropping. The future value of the bonds in the fund are fully known in advance. It is only the present value that is affected by interest rate changes.

The total return on a bond fund is entirely predictable (with the exception of defaults), the proportion of the total return that is NAV vs. interest rate return can change with one compensating for the other.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by IlliniDave » Mon Jul 29, 2013 7:42 am

The principal of the bond is the principal of the bond, so the NAV of that bond is the same at issue and at redemption (TIPS excluded). Gains in passive bond holdings all come from the interest payments (which can purchase new bonds/shares, or be deployed in some other way). In between issue and maturity the price/NAV of the bond/fund can wiggle around some.

The pictures nisiprius provided illustrate that pretty well.

In a more actively managed fund it gets trickier since the manager may sell/buy bonds at various premiums/discounts and I'm sure there are scenarios where such tactics can result in out- or under-performing the aggregate coupon rate, and even losing money outright. But if you're in index or passive-managed non-index funds for a period of time much greater than the term of the bonds you'll pretty much get the average yield over the timespan you hold. There may be a bit of a hitch when you go to sell, depending on whether the bonds in aggregate are selling at a premium or discount at that particular day, but at the end of a long run the effect on your cumulative growth should be pretty modest (barring extraordinary circumstances).

For relatively short-term considerations it seems a short-term fund would not entail excessive risk, but you could presumably do better on yield if you bought individual bonds that matched your term.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by linuxizer » Mon Jul 29, 2013 7:56 am

Great answers so far.

Here's another way of looking at it. Imagine you hold a rolling bond ladder, where you have 10 bonds which mature in 1,2,3...,9,10 years. Interest rates go up in year 1, so your ladder is worth less (since there's an opportunity cost to holding bonds paying a lower rate when if you bought them new you could make a higher rate). Your 1-year bond matures, and a year has passed, meaning you're now holding 9 bonds with 1,2,3...8,9 year maturities. You buy a 10-year bond to keep your rolling ladder rolling.

Year 2, interest rates go up again, so your ladder is worth less. Your 1-year bond (originally the 2-year bond) now matures. Do you buy another 10-year to keep your ladder rolling?

If you can envision yourself buying that extra bond every year to keep taking advantage of the higher interest rates, then you should be totally comfortable in a bond fund. If you've got a 20-year investment horizon, then you should *definitely* be comfortable doing so. The bonds you're buying in years 2-15 (the ladder has a duration of a little under 5 years) will be grabbing extra interest for their full lives.

Of course, there might be some strategy where you buy short term bonds and then shift into longer term bonds once interest rates stabilize. If you figure out that strategy do let me know! But if you're wrong there's a cost, and even if you're right--just no more right than the market's estimate of the optimal strategy--you will merely break even, because that's why the yield curve changes in the first place.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by dbr » Mon Jul 29, 2013 8:01 am

For an investor holding bonds for an indefinite period of time as a component of a portfolio, what matters is the return and the variability of the return at every moment in time. The return is the sum of yield paid out and change in NAV. So, no, you certainly don't ignore the NAV and changes in the NAV. This seems to me to be fundamental and as simple as it gets. If you want to forecast what that return is likely to be over some future period, the best guess is probably the current SEC yield. To do better than that you have to be able to forecast the future course of interest rates for the bonds in which you are invested. If you want to estimate the variability of the return, you can consider the duration and the credit quality of the investment. This is the picture that applies to most of us for most of our investment in bonds.

If you are using bonds to hold money saved for a specific purpose at a specific time, not too far off, then the tenents of investing above do not apply. In this case you would invest in individual bonds, CDs, savings bonds, etc. that are configured to deliver back a certain amount of money at a certain time along with a definite payout of interest along the way. In this case you would not care about the market value of your investment, if it even has one. There can be risk in so doing that your plans to only take the money at a time and to need exactly that amount of money might go awry. Naturally very short duration bond funds of low risk bonds have variability of return that is low enough that you might meet the needs of a short term use with such funds. That would be a judgement call.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 8:05 am

dbr: Over any indefinite holding period the sum of the NAV changes goes to zero. Ignore it.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by statsguy » Mon Jul 29, 2013 8:09 am

It is my understanding that Bogleheads ignore bond NAV because they hold bonds to mute the volatility of their portfolio. So you own enough bonds to sleep well at night. It has little to do with being a long-term investor

Stats

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 8:17 am

The change of the NAV are almost meaningless in the big picture. $10,000 invested in TBM on 12/11/86 grew to $53,261 as of Fridays close. It opened at an NAV of $10 and closed Friday at $10.68. That's $680 for the NAV change, $52,581 in interest.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by livesoft » Mon Jul 29, 2013 8:20 am

It boils down to this:

Yes, Virginia, you can lose money in bond funds.

Once you accept that fact you will stop worrying about it.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by dbr » Mon Jul 29, 2013 8:21 am

I don't know where this is coming from in this thread, but I certainly tabulate the asset value of my portfolio from time to time, and that includes reading off the NAV of my bond fund shares, marked to market as they are. Among other things I do have rules for rebalancing the portfolio that require marking the asset value in bonds at any time.

Why does anyone think "Bogleheads ignore the NAV of bond funds"?

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 8:26 am

You do not need to know the NAV for rebalancing decisions, just look at the total values of the stock and bond portions for example. The total value of your bonds will reflect almost entirely what you put in and the interest earned, unless your portfolio is brand new. NAV change is meaningless.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by dbr » Mon Jul 29, 2013 8:42 am

billyt wrote:You do not need to know the NAV for rebalancing decisions, just look at the total values of the stock and bond portions for example. The total value of your bonds will reflect almost entirely what you put in and the interest earned, unless your portfolio is brand new. NAV change is meaningless.
In my portfolio, which is bond funds, Value = # shares * NAV , so I am confused. Past interest earned has either been invested in something else, has been reinvested to buy more shares, is accounted for in the NAV, or there may be a small amount accrued that will be paid out soon but is not yet in the NAV. It is hard for me to understand what other scheme of accounting would make much sense except perhaps below . . .

If a person holds individual bonds one could mark them at value at maturity under the assumption that one is not going to leave the investment before then. That, of course, means accounting for one's present situation using numbers that will be accurate at a different time. If you hold TIPS you can't do that because the value at maturity will include an as yet unknown increment for future inflation. Otherwise, yes, this might be a simplification that is reasonable.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by nisiprius » Mon Jul 29, 2013 8:42 am

statsguy wrote:It is my understanding that Bogleheads ignore bond NAV because they hold bonds to mute the volatility of their portfolio. So you own enough bonds to sleep well at night. It has little to do with being a long-term investor.
The long-term part comes in because bonds exhibit short-term volatility. You can "ignore the NAV" if your investment time frame is about the same as, or longer than, the bond fund's duration. This is why Vanguard, for example, says, in so many words, that Total Bond and other investments at "risk potential level 2" as "may be appropriate for investors with medium-term investment horizons (four to ten years)." Vanguard is saying that if you need the money in less than four years no, you can't ignore the fluctuations of the NAV, but at some indefinite period of time, certainly by ten years... you can.
RandyAdams1978 wrote:That, as interest rates rise, the fund will be replacing older, lower-yielding bonds with newer higher-yielding ones? OK. But ... if interest rates KEEP rising over that 15-20 year period ...... aren't you ... at some point ... throwing good money after bad?
No, actually not. I've been trying for a long time to fund some humble physical analogy and I haven't succeeded, but bear with me. This is a very inaccurate and distorted model, but it may counter some prevalent distortions in the other direction.

The thing to be clear on is that if you have a steadily rising rate that never stops rising, the NAV does lose value and as long as the rate rises that loss remains constant. Get that? The loss is permanent, if you like (with "permanent" meaning "as long as the rate keeps rising.") It does not keep increasing. On a $10,000 investment, it is a loss of a certain number of dollars.

Well, it is a bond, and bonds pay interest. Against that loss of X dollars, you have interest coming in at a rate of X dollars PER YEAR, and if the interest rate is rising, the rate at which interest comes in ACCELERATES.

OK, bad analogy ahead.

Suppose you are sitting in a car that is driving thirty mph. Suddenly the driver floors the accelerator, and accelerates to 50 mph. When the acceleration begins, you are pushed back in your seat. Let's say it's a very squishy seat and you actually are forced one foot deep into the cushioning. That's analogous to loss of NAV. When it ends, at a steady 50 mph, you are no longer pushed back in your seat; the NAV has recovered, and you are now better off than before because you are going 50 mph instead of 30.

Now, suppose you are sitting in a car that is driving thirty mph. Suddenly the driver floors the accelerator, and never stops accelerating. You are pushed back into your seat constantly. But, you are still better off than if the car had not accelerated, because you have lost one foot of distance, but you are gaining feet per second.
Last edited by nisiprius on Mon Jul 29, 2013 8:48 am, edited 3 times in total.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 8:44 am

dbr: There is your difficulty. Past interest earned is decidedly not part of the NAV. Look at the data I posted for TBM above.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by dbr » Mon Jul 29, 2013 8:52 am

billyt wrote:dbr: There is your difficulty. Past interest earned is decidedly not part of the NAV. Look at the data I posted for TBM above.
Oh please. I don't have a difficulty and I didn't say past interest was part of NAV. The explicit statement was that past interest was invested in additional shares of something, often reinvested in more shares of the same fund. The case where past interest is part of NAV is just the little bit that does accumulate in the NAV of some bond funds that do their bookkeeping that way from dividend payout to dividend payout. I think the Vanguard TIPS fund does that.

I think I am done here.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 8:56 am

OK dbr, my apologies if I misinterpreted what you were trying to say. The fact remains that over any reasonable holding period, your returns are determined by interest rates, not NAV changes. NAV change is short term noise that should be ignored if you are investing long term.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Riprap » Mon Jul 29, 2013 9:52 am

billyt wrote:OK dbr, my apologies if I misinterpreted what you were trying to say. The fact remains that over any reasonable holding period, your returns are determined by interest rates, not NAV changes. NAV change is short term noise that should be ignored if you are investing long term.
I for one would be very cautious about instructing dbr and I myself don't want to put words in dbr's mouth. That said, what I think dbr is attempting to say is that NAV is fundamental in determining the values of broad classes of assets like stocks and bonds. Without knowing the relative valuations it would be impossible to direct earnings to the appropriate class and maintain a desired asset allocation. So no, NAV should not be ignored, but one should not lose sleep over fluctuations.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Doc » Mon Jul 29, 2013 9:56 am

The reason these bond threads get so confusing is that currently many people are looking at their FI portfolio in isolation while in more "normal" times people tend to look at FI as part of their entire portfolio using the modern portfolio theory concept.
billyt wrote: The fact remains that over any reasonable holding period, your returns are determined by interest rates, not NAV changes. NAV change is short term noise that should be ignored if you are investing long term.
There is more than one situation even for the long term investor. dbr addressed these two situations.
dbr wrote:For an investor holding bonds for an indefinite period of time as a component of a portfolio, what matters is the return and the variability of the return at every moment in time. The return is the sum of yield paid out and change in NAV. So, no, you certainly don't ignore the NAV and changes in the NAV. This seems to me to be fundamental and as simple as it gets. ... This is the picture that applies to most of us for most of our investment in bonds.

If you are using bonds to hold money saved for a specific purpose at a specific time, not too far off, then the tenents of investing above do not apply. In this case you would invest in individual bonds, CDs, savings bonds, etc. that are configured to deliver back a certain amount of money at a certain time along with a definite payout of interest along the way. In this case you would not care about the market value of your investment, if it even has one.
To paraphrase:

1) If you are looking at the long term return and stability of your portfolio as a whole you need to consider the NAV of your FI portfolio because it is needed to complement the equity portion.

2) If you look at FI as a stand alone investment either to merely produce income or to meet a future fixed cash flow obligation you don't need to worry about the NAV of the FI at all in the long term or only at the fixed future time you need to meet your known cash flow obligation in the shorter term.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by Erwin » Mon Jul 29, 2013 10:21 am

Can anyone discuss the situation of an investor in the distribution phase (retired!) who withdraws the dividends monthly.
Erwin

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Doc » Mon Jul 29, 2013 10:45 am

mpt follower wrote:Can anyone discuss the situation of an investor in the distribution phase (retired!) who withdraws the dividends monthly.
It makes no difference to management of the portfolio as a whole. It is only what is easier for you personally from a bookkeeping sense.

I have never reinvested dividends directly but let them accumulate in a MM or short bond fund until the amount was large enough to reinvest in a cost efficient way. It would then typically all go into one investment either FI or equity depending on my AA at the time. In withdrawal I do just the opposite. Withdrawals all come automatically from a MM account which holds at max about three month requirements. It take 3 to 6 months to deplete depending on interest and dividend flows and then I replenish from FI or equity again based on my AA at the time. I don't use a TBM type fund for other reasons so I always have a number of sources of FI to sell when/if the need arises. Tax considerations are a factor on whether I choose to realize a gain or a loss but the fact that I may have a "loss" in FI is completely irrelevant otherwise.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by Erwin » Mon Jul 29, 2013 10:50 am

Doc wrote:
mpt follower wrote:Can anyone discuss the situation of an investor in the distribution phase (retired!) who withdraws the dividends monthly.
It makes no difference to management of the portfolio as a whole. It is only what is easier for you personally from a bookkeeping sense.

I have never reinvested dividends directly but let them accumulate in a MM or short bond fund until the amount was large enough to reinvest in a cost efficient way. It would then typically all go into one investment either FI or equity depending on my AA at the time. In withdrawal I do just the opposite. Withdrawals all come automatically from a MM account which holds at max about three month requirements. It take 3 to 6 months to deplete depending on interest and dividend flows and then I replenish from FI or equity again based on my AA at the time. I don't use a TBM type fund for other reasons so I always have a number of sources of FI to sell when/if the need arises. Tax considerations are a factor on whether I choose to realize a gain or a loss but the fact that I may have a "loss" in FI is completely irrelevant otherwise.
Doc,

Thank you. However, ou would agree that in a rising rates environment, like today, by withdrawing all the dividends, you are destroying capital (NAV). Right?
Erwin

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 11:29 am

The NAV fluctuates up and down over a limited range (+/- 10%; see Nisi's chart). The reason for this is simple, and has nothing to do with the dividends. The value of the bonds in the fund approach par as they approach maturity. The total return of a bond fund is almost totally accounted for by the dividends collected over time. The current SEC yield is a very good predictor for the return on funds invested today 5 and 10 years out. Yes, technically total return is the sum of the interest collected and the NAV change, but the NAV change is a negligible part of the total return, and can be neglected. If you don't reinvest the dividends, you will lose out on compounding (interest on interest). This will not affect the NAV of the fund, but will affect your total return, because you are reducing interest.

The key things you need to know in making decisions about bonds in your portfolio are SEC yield and duration. What the NAV is, or what you think it might be in the future has little relevance. Match your need for the funds to the duration, that is, do not put any funds in an intermediate term bond fund that you will need in less than 5 years or so.

If you really don't want any fluctuation in the NAV, stay out of bond funds.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by SimpleGift » Mon Jul 29, 2013 11:40 am

mpt follower wrote:Can anyone discuss the situation of an investor in the distribution phase (retired!) who withdraws the dividends monthly.
For a retiree who spends the monthly bond fund dividends, it helps to have a total portfolio plan. In other words, stocks are in the portfolio primarily for long-term real returns, while bonds are there to reduce portfolio volatility and provide current income. Folks get confused when they mix these up and focus on the capital losses or gains in their bond funds — that's not what bond funds are for, in my view.

Personally, as a retiree myself with a balanced portfolio, I don't expect ANY real returns from the bond funds in my portfolio over my remaining lifetime — and will depend on the stock funds in the portfolio to provide all the real returns and inflation protection for my entire portfolio (including my bond funds). If one has a total portfolio outlook and plan, then losses or zero real returns in one part of it are not as much a concern.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by scrabbler1 » Mon Jul 29, 2013 12:53 pm

mpt follower wrote:Can anyone discuss the situation of an investor in the distribution phase (retired!) who withdraws the dividends monthly.
As an early retiree, this is the main part of my plan. About 35% of my total portfolio (including an IRA which I can't really touch for a while) is in a bond fund whose monthly dividends I use to cover my monthly expenses with a small amount left over to reinvest. The rest of the dividends and cap gain distributions from investments in my taxable account get reinvested automatically. Most of that is in a stock fund but some of it is in muni bond funds, a holdover from my working days (but has been reduced greatly). The IRA is around 50/50 and all dividends and cap gain distributions get reinvested. I look at the stock portions in each account as inflation guards along with reinvesting any excesses from the bond funds which can always be used to supplement my monthly income if I needed it.

I don't care much about the NAV of the bond fund because the monthly dividend I receive is a funciont of the number of shares I have in the fund and the monthly dividends per share (i.e. 30 daily mil rates). Most of the shares I bought in that fund I bought at bargain-basement prices back in late 2008, so my personal average cost per share is about 20% lower than today's NAV.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by hoops777 » Mon Jul 29, 2013 5:40 pm

It is easy to say ignore the nav.In oct I plunked down a good amount of money in the GNMA fund which in hindsight was not a smart thing to do.I am currently 8000 down reinvesting the dividends.A year from now I expect to be 15000 down or so.It could be 5 years before I am back to even.The Vang GNMA fund has been a great fund for many years.I am thinking of getting out now but am torn.Regardless of what anyone says it is painful to be losing money hand over fist in a bond fund especially when one considers the predictions by most even on this site about the price of bonds moving forward.
K.I.S.S........so easy to say so difficult to do.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Mon Jul 29, 2013 6:18 pm

hoops: I sympathize about your losses. I would encourage you not to lock in your short term losses by selling. GNMA is down less than 2% year over year, that is less than 1 years interest. If you really want out, go ahead, but I would wait and see.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by jef » Mon Jul 29, 2013 10:30 pm

This is an excellent discussion on bond funds. It has improved my understanding of how these funds work. Thanks to all who have contributed.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Kevin M » Mon Jul 29, 2013 11:30 pm

RandyAdams1978 wrote: For short term needs, say if you need X amount of dollars in 4 to 5 years for college expenses ...

There are several challenges with individual bonds, however. One is diversity. Clearly, a bond fund overs a much more diverse portfolio than an individual could likely attain. Another issue with individual bonds is the opportunity cost --- what to do with the dividends once they are handed over to you. This is not an issue with bond funds as they can be re-invested automatically.
Randy, for the type of goal you mention a CD with a matching term to maturity, purchased directly from a bank or credit union (non brokered), is a perfect solution, and has none of the weaknesses you mention. With federal insurance (FDIC/NCUA), there is no credit risk, and therefore no need for diversification (this also is true of treasuries). I own many such CDs, and they all allow reinvesting the dividends at the original rate, so that solves that issue. A brokered, FDIC insured, CD is just as good with respect to having no credit risk, but you still have the interest-reinvestment issue (but at current low rates, it's not a very big deal).

Also, you can find CDs that have much higher yields than short-term bond funds, higher yields than intermediate-term treasury bond funds, and yields that are comparable to something like the (riskier) Total Bond Market fund.
RandyAdams1978 wrote:But .... and here's where things get muddy for me ..... if you're a long term investor --- say 15-20 years away from retirement ---- a falling NAV shouldn't worry you?
I think you've already received pretty much the full spectrum of answers that this type of question always receives. A few people present very extreme, strongly stated, and one-sided views, but if you kind of blend and average all the answers, you should have a pretty good sense of our understanding as a group.

Here's my twist.

It is widely accepted that there are two main risk factors for bonds: credit risk and term (interest-rate) risk. You are asking about term risk; i.e., the variability of returns (dispersion of expected returns) based on changes in interest rates. Term risk is real, but as with any risk, it can result in higher than expected gains as well as higher than expected losses.

Rates are historically very low now. I read a Vanguard paper in which the bond manager, who's been around quite awhile, said he'd never seen anything like the low-rate environment we're in today. Can rates go lower? Sure they can, but not by much. 0% is pretty much a practical lower bound (and yes, I know there are exceptions, but they are not very relevant to us). Can they go higher? Of course, and possibly by quite a lot.

So my view is that the dispersion of expected returns for taking term risk is quite lopsided, or asymmetrical, now. The closer rates are to 0%, the less potential reward for taking term risk, yet the potential loss remains as high as ever. But if we don't take some term risk, and probably some credit risk too, our expected real (after inflation) return is negative. Are there any other alternatives?

Yes. Again, non-brokered (NB) CDs. These CDs typically have an early withdrawal option, where you pay a penalty to withdraw before maturity. For the last CD I bought, earning 2%, this comes to about 1%. So contrary to what one poster said, these CDs do not fluctuate in value with changes in interest rates. They are always worth the stated value (what you see on your statement) plus accrued interest not yet reinvested, minus the early withdrawal penalty (EWP). So I view these as having limited term risk (limited to the EWP). They have no credit risk. And again, you can find these CDs with yields that are much higher than comparable treasuries, and in the ballpark of Total Bond market index fund.

Of course there are some shortcomings. They are not as liquid as a bond fund, you can't own them in an employer sponsored retirement plan, and some people are concerned that the early withdrawal terms may not be honored. And owning them requires having more accounts.

At any rate, my solution has been to gradually shift from bond funds to CDs as interest rates continued to fall, so that I now have about 2/3 of my fixed income in non-brokered CDs and 1/3 in intermediate-term investment-grade and muni bond funds. I'm taking more credit and term risk with the bond funds, offset by no credit risk and very little term risk with the CDs.

Hope that helps and doesn't muddle things even more for you.

Kevin
Last edited by Kevin M on Tue Jul 30, 2013 1:14 pm, edited 1 time in total.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by island » Tue Jul 30, 2013 2:48 am

I'm new to the Bogleheads site and wow this thread has been so informative! Thank you all for sharing your expertise. I look forward to hearing more.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by RandyAdams1978 » Tue Jul 30, 2013 5:15 am

Great responses. Thank you all.

I'm still in muddy waters though. I'm trying to illustrate to myself the effect of rising interest rates on a bond fund like Total Bond.
Here's my first feeble attempt.

Image

I know this is flawed in a number of ways, but it might be useful for a rough illustration? I think I need to get the funds turnover rate calculated in here. Obviously, the fund's yield will not increase by the same amount that interest rates rise. It's NEW purchases will be affected, but it will have a certain number of holdings that still maintain the old returns.

Has someone already done this? I hate re-inventing the wheel.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Tue Jul 30, 2013 5:34 am

Yes, that kind of a model involves some approximations, so it is not entirely correct, but it does illustrate the broader point. Continuously rising rates drive the NAV lower. In spite of that effect, after holding for the duration, you end up with a total return that reflects the interest rate when you invested. The total return is driven almost entirely by the interest rate, not the NAV change.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by RandyAdams1978 » Tue Jul 30, 2013 5:35 am

billyt said "It is not mathematically possible for the NAV of a bond fund to keep dropping."
Why do you say this? I don't understand why this is not possible.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by RandyAdams1978 » Tue Jul 30, 2013 5:43 am

And here's another thing driving me batty about bond funds:
1) You can make money in a DE-creasing interest rate environment (witness the last 30 years)
2) You can make money in an IN-creasing interest rate environment (provided you hold longer than the bond fund's duration).
3) You lose money in an increasing interest rate environment if you sell prior to the duration.

So ... why not just move bond holdings to cash, wait until interest rates are higher than the fund's duration, then dive back into bonds?

I'm missing something, right? There's more to it than this, yes? Bonds are complicated. I'm pretty simple.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Tue Jul 30, 2013 6:18 am

OK, if you want a hypothetical where interest rates continue to increase forever, using the approximations that you used, yes the NAV will continue to fall.

As Nisi's chart above shows, that is not the case in the real world. In spite of a significant drop in rates from 1986 to today, NAV has not continuously increased. So I think you are coming up against the limitations of your simple model. One thing that happens is that increasing rates lower the duration.

Yes, you could try to time the market. A case could be made that you might want to sit in cash as long as you can earn similar rates to bonds, or try to asses when the short term reward (yield) outweighs the short term risk (duration times potential rate increase). You will only know if you made the right move in retrospect.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Tue Jul 30, 2013 6:59 am

A little more about my understanding of the approximations you used. For a bond, its face value and coupon are fixed, and its future value at any point is known with certainty. What can change is its present value, if interest rates change. A bond fund is a rolling ladder of bonds, and its properties are those of the underlying investments. For an instantaneous change in rates, the NAV change is approximately rate change times duration. However, absent any other changes, the NAV will recover on its own as bonds held in the fund approach face value as they approach maturity. For a fund, any interest rate income change phases in slowly as the ladder is rolled. However, based on the changed NAV that increase in income is instantaneous. Therefore, the total returns you model are not an unreasonable estimate. However, the portions of total return that are allocated to NAV change in the model are overestimated and that from accrued interest is underestimated. The reality is that total return over longer time periods (longer than the duration) are largely driven by interest rates, not NAV changes.

If you think about the big picture, over your investing lifetime you will earn the average interest income from a bond fund. The higher the average rate, the better the return. This is why I say that bond investors will ultimately benefit from rising rates.

The longer the holding period, the more negligible impact NAV changes are on your total return. This is why I say you should ignore the NAV and its changes.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Tom_T » Tue Jul 30, 2013 7:42 am

RandyAdams1978 wrote:And here's another thing driving me batty about bond funds:
1) You can make money in a DE-creasing interest rate environment (witness the last 30 years)
2) You can make money in an IN-creasing interest rate environment (provided you hold longer than the bond fund's duration).
3) You lose money in an increasing interest rate environment if you sell prior to the duration.

So ... why not just move bond holdings to cash, wait until interest rates are higher than the fund's duration, then dive back into bonds?

I'm missing something, right? There's more to it than this, yes? Bonds are complicated. I'm pretty simple.
What if interest rates stay in a range, instead of going straight up? What if rates go up, but not by a lot? Meanwhile, your cash is earning nothing.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by learning_head » Tue Jul 30, 2013 9:06 am

Here are my thoughts...

I think you can break down your bond fund investment into 3 steps: purchase, holding, sale. Purchase and sale are "short-term" events which can be affected by the changes in NAV. Holding period should produce the prevailing yield for the fund's kinds of bonds overall.

NAV can change say +/-10% in relatively short period of time to adjust to yield changes or other scares / exuberances at the time. This may affect your purchase and sale prices in the short term.

In the long term, since bonds get rolled over, NAV / yield will self-adjust accordingly. So, for example if you had 2% bonds and prevailing rates go to 5%, maturing bonds will get rolled over, and the longer you hold the fund, the better it will reflect the "appropriate" / "prevailing" market rates for the fund (since you would hold 5% bonds longer vs 2% bonds you might have started with, for example). That's why in general recommendation to hold the fund longer than duration makes sense, since that's when you should get something close to prevailing market rates from the fund.

So, overall, you should expect to get approximately "market" yield on the bonds +/- 20% for purchase/sale NAV changes.

Few more points that follow from this:
- for longer duration funds, the price jumps are larger (because yield variations are greater), and you have to hold them longer to get market rates; but the upside is: these "prevailing" market rates are higher as a result for such funds.
- if you have a lot of smaller purchases / sales spread over time instead of 1 large purchase / sale, the relatively random +/-20% jumps will more likely cancel each other out since they will be combinations of many more random "samples", each of smaller amount
- "prevailing" market rates you get by holding the fund does not mean they are "good" rates. For example, CD rates may very well be BETTER than the "prevailing" market rates you'd get from your bond funds (and safer in that they don't have the +/-20% factor for larger amounts invested at one time).

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Doc » Tue Jul 30, 2013 9:34 am

RandyAdams1978 wrote:And here's another thing driving me batty about bond funds:
1) You can make money in a DE-creasing interest rate environment (witness the last 30 years)
2) You can make money in an IN-creasing interest rate environment (provided you hold longer than the bond fund's duration).
3) You lose money in an increasing interest rate environment if you sell prior to the duration.
Start you thought process with a single bond. It is Fixed Income. It is a contract between you and the borrower. You give the borrower some amount of dollars up front and he promises to give you some amount of dollars at various times in the future. Excluding default that promise will be fulfilled regardless of future changes in market interest rates. If rates do change and you decide to sell your contract you will get more or less than your original investment but receive less or more in interest payments if you reinvest the proceeds in an instrument with the same risk. Based on your initial contract you do not gain or lose anything. All you do is change the timing of the cash flows. (This can have beneficial tax effects but that get into the weeds.)

When you buy a fund your are letting the fund manager act in you place to make that sell and reinvest decision for you. Each time he does that he enters into a new contract which may be to your liking or not but that's what happens in a fund. What you do know is that if you hold the fund for the duration you are indifferent to any market rate changes in the interim.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by longinvest » Tue Jul 30, 2013 11:43 am

Let say that I put $1000 in a total market index fund. If let my money sit in it and reinvest the dividends for duration + N years, I would be able to sell it and get more than $1000, no matter what happened to the interest rates just before I sell.

Did I understand correctly?
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Re: So... long term investors should IGNORE a bond fund's NA

Post by dbr » Tue Jul 30, 2013 12:15 pm

longinvest wrote:Let say that I put $1000 in a total market index fund. If let my money sit in it and reinvest the dividends for duration + N years, I would be able to sell it and get more than $1000, no matter what happened to the interest rates just before I sell.

Did I understand correctly?
In practice that would likely be the case. In theory, the interest rate could be low enough, N small enough, and the interest rate change large enough that some combination of the numbers could be found where you would not get as much as $1000 when you sell.

For example, VBMFX currently yields 2%, SEC, which we will take as an estimate of future return for this illustration. The duration is 5.5 years. Lets hold for 7.5 years (N=2). The $1000 would grow to $1160. If the interest rate increased by 3% just before redemption, the fund value would lose 15.5% and end up at $969 (doing the arithmetic in simplified terms). The illustration depends completely on hypothesizing an unlikely 3% rise at end of term. I don't have a general computation, but certainly there are theoretical combinations of interest rate changes that could, at an arbitrary point in time, result in a net loss.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by longinvest » Tue Jul 30, 2013 12:30 pm

dbr wrote:
longinvest wrote:Let say that I put $1000 in a total market index fund. If let my money sit in it and reinvest the dividends for duration + N years, I would be able to sell it and get more than $1000, no matter what happened to the interest rates just before I sell.

Did I understand correctly?
In practice that would likely be the case. In theory, the interest rate could be low enough, N small enough, and the interest rate change large enough that some combination of the numbers could be found where you would not get as much as $1000 when you sell.

For example, VBMFX currently yields 2%, SEC, which we will take as an estimate of future return for this illustration. The duration is 5.5 years. Lets hold for 7.5 years (N=2). The $1000 would grow to $1160. If the interest rate increased by 3% just before redemption, the fund value would lose 15.5% and end up at $969 (doing the arithmetic in simplified terms). The illustration depends completely on hypothesizing an unlikely 3% rise at end of term. I don't have a general computation, but certainly there are theoretical combinations of interest rate changes that could, at an arbitrary point in time, result in a net loss.
Thanks. So, there is some risk, but not much. I would have to be very unlucky, and have a large unexpected expense. Money for an expected expense should have already been put into an appropriate CD. I see.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by Erwin » Tue Jul 30, 2013 12:36 pm

The question not being discussed at all is the miserably low yield. A 2% annual is less than inflation. Is that acceptable?
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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Tue Jul 30, 2013 12:40 pm

2% is miserably low, but is it less than inflation? My I-bond is paying 1.18%.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by Erwin » Tue Jul 30, 2013 1:14 pm

If I understand, investing in a bond fund with a SEC yield of 2% with a 5 year duration, locks the yield no matter what the future inflation is. The problem is that the very low current inflation is not guaranteed to continue. However, your I bond is inflation guaranteed
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Re: So... long term investors should IGNORE a bond fund's NA

Post by longinvest » Tue Jul 30, 2013 1:22 pm

mpt follower wrote:If I understand, investing in a bond fund with a SEC yield of 2% with a 5 year duration, locks the yield no matter what the future inflation is. The problem is that the very low current inflation is not guaranteed to continue. However, your I bond is inflation guaranteed
My understanding is thatyou're right, but usually, nominal bond holders are rewarded for taking inflation risk.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by billyt » Tue Jul 30, 2013 1:31 pm

mpt: I totally agree that the possibility of future inflation is a serious concern with rates this low. I was just pointing out that the current 2% return of TBM appears to be higher than inflation, so there is currently a real yield. The real yield on 5-year TIPS is negative. Ten year TIPS offer a positive real yield, but not by much. I do hope that real rates continue to rise a bit more from here.

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Re: So... long term investors should IGNORE a bond fund's NA

Post by nisiprius » Tue Jul 30, 2013 1:48 pm

These charts show the total value (including reinvestment) and the NAV for a rotating bond ladder. It's not clear how real-world mutual funds actually compare to a rotating bond ladder, but it's at least a rough approximation. It's assumed that the bonds have a ten-year term (meaning the ladder has about a 5-year duration), that interest rates begin at 0.5%, that ALL the bonds in the ladder begin with an interest rate of 0.5%. After two years, interest rates begin rising, forever, at a rate of 0.5% per year. New bonds enter the ladder with the current interest rate. Coupon payments are reinvested in the entire portfolio, i.e. it's assumed they are used to buy more of all of the bonds that are already the ladder, on the secondary market, at market prices.

Not sure what assumptions and/or bugs make this different from RandyAdams1978 spreadsheet. I would say that a sustained interest rate rise of 1%/year seems awfully high to me; it averaged about 0.5%/year from 1940 through 1980.

The most important caveat is that these charts are way too optimistic because it's almost inconceivable that you could have a real interest rate of 15-20%, i.e. an interest rate of 15-20% implies that you have high inflation, and the nominal dollar values are therefore misleading.

Total value, with reinvestment:

Image

Price/NAV only:

Image

An endless interest rate rise can push the NAV down and hold it down, but it doesn't make the NAV continue to decline endlessly.
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Re: So... long term investors should IGNORE a bond fund's NA

Post by Kevin M » Tue Jul 30, 2013 1:55 pm

RandyAdams1978 wrote: So ... why not just move bond holdings to cash, wait until interest rates are higher than the fund's duration, then dive back into bonds?

I'm missing something, right? There's more to it than this, yes? Bonds are complicated. I'm pretty simple.
Randy, I provided you with my solution above, but you did not respond. Did you see it?

First, I don't use cash (much; as an alternative to bonds), I use CDs, which pay interest comparable to the aggregate bond market. Incidentally, I don't know what retail investors are earning 0% on their cash, but I'm earning closer to 1% on most of mine, and in a few days will be earning 3% on $20K of it (reward checking account).

Second, I didn't dive out of bond funds into CDs, I waded out/in, and not all the way, since I like to hedge my bets. Rates could stay low for a long time, so earning 3%-4.5% in some bond funds hedges for the possibility of prolonged low rates, while earning 2%-3.75% in CDs hedges for a rising rate scenario. The possibility of a prolonged low interest rate environment is the argument against moving everything to cash.

Third, I won't dive back into bonds, I'll wade back in once rates rise enough above where I stopped wading out, since we won't know how much interest rates will increase or when. But the higher rates go, the higher the potential reward from taking interest-rate risk.

Here is a thread in which I explained my reasoning in more detail, even assuming an early withdrawal was not allowed: Bogleheads • View topic - CD vs. Bond Fund: what if no early withdrawal?

I used a simple model very similar to yours, except that I assumed rates changed steadily throughout each year, so assumed an average of the start rate and end rate to calculate the year's interest. If you read the linked thread you'll see much good discussion about this simplified analysis and its flaws. After all of the discussion, I still had confidence in my CD strategy.

Note that if the early withdrawal option is utilized, which I assume it will be if rates increase enough, the CD scenario looks much better. Also note in the linked thread I used a lower-yielding CD with a much lower early withdrawal penalty, so using a more competitive CD rate under the assumption of no early withdrawal also makes the CD scenario better.

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