"Get out of bond funds"

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rgb73
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Re: "Get out of bond funds"

Post by rgb73 » Wed Nov 06, 2013 3:44 pm

He's also reduced the maturity of Berkshire's bond portfolio considerably - cognizant of the fact that long duration bonds will incur greater losses if interest rates rise.

protagonist
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Re: "Get out of bond funds"

Post by protagonist » Sat May 10, 2014 10:10 am

nisiprius wrote:People in Bogleheads say "tune out the noise."

"The noise" is the ebb and flow of memes, like hit tunes or clothing fashions or a joke that is going the rounds. The investing community is like a huge auditorium with the gain in the PA system turned up a bit too much--not only do you get reverberating echoes but they feed on themselves and get louder and louder. If 130/30 funds are a hot topic, then every columnist gets questions about them, every columnist has to write a column about it, it gets hotter, and you say "Gee, 'everyone' is talking about 130/30 funds."

(Maybe you haven't heard of 130/30 funds. I picked them because they were a hot topic around 2007-2008, Merrill Lynch was predicting they would reach $1 trillion by 2012 and "everybody" was saying they would become an important, mainstream fund category.)

Tuning out the noise is not easy to do. "The noise" is always compelling because it always contains a convincing kernel of truth in it. The truth is always some messy complex on-the-one-hand, on-the-other hand thing. In the echo chamber each echo becomes louder and more distorted. It also becomes twisted for self-serving purposes. For example, someone who, for whatever reason, has an interest in promoting stocks, will always diss bonds, but in order to keep the message fresh will seize on anything new that supports the message. The message is never "bonds suck." The message is always "sure, bonds used to be sorta OK, but because of totally new crushing fact X they suck now."

So, the truth is that it's really hard to predict anything, including interest rates, and even when "everyone" expect X to happen, a lot of the time Y will happen instead. And the truth is also that if everyone expects X to happen, then X is priced in, so if X does happen, it doesn't matter.

The consensus view--i.e. what I happen to think myself--is that very likely bonds will have a considerably lower return going forward for the next few decades than they did for the last few.

The noise is "Get out of bond funds" or "Bonds could lose 91%, just the way they (DIDN'T) do 1940-1980," or "Interest rates can only go ☝☝☝UP, and when they do your bonds will go ☟☟☟DOWN, and it will be whoa nellie, katy bar the door." The truth is
  • there are some fairly convincing reasons for thinking bonds won't be doing as well as they used to, but there are also reasons for thinking stocks won't, either, so it's not clear why your asset allocation should change;
  • bonds are always going to be more stable than stocks, so if you are going to get out of bonds you need to explain what has happened that makes you more risk-tolerant than you used to be;
  • to the extent that you can plan your withdrawals and stick to the plan, a portfolio of individual bonds may indeed be preferable to a bond fund, but it probably doesn't make that much difference as long as you are holding the bond fund for a period of time that's long compared to its duration. In either case, if you need to make an unplanned large withdrawal, if bonds are down, they're down.
  • People who make money when you buy bond funds and not when you buy a bank CD--which would include a) mutual fund companies, and b) many advisors--are not going to give you a fair comparison between bond funds and bank CDs. Typically they simply will not mention bank CDs as an alternative. It's unlikely that there's any big difference between bond funds and the best bank CDs and all sorts of hard-to-evaluate factors could tip the balance either way.
I just found this post, a bit late, and it is excellent. I am highlighting it to be read by others.
ps...I'm almost completely out of bond funds and in CDs instead. Who knows if I am right?

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nedsaid
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Re: "Get out of bond funds"

Post by nedsaid » Sat May 10, 2014 10:28 am

FDIC Insured CD's at a bank are an excellent alternative to bond funds. If you are worried about fluctuation of principal, this is the place to be.

I have posted many times that a younger investor invested in bond funds should be unconcerned about changes in interest rates as long as he or she will reinvest the dividend payments and let their investment ride. It is a retiree or a near retiree that should be more concerned about this. For them, CD's look awfully good. If you are at Vanguard, you could use their brokerage service to purchase CD's. You could split your fixed income portfolio between Vanguard bond funds and CD's.

The great Boglehead Bond Crash of 2013 saw most Intermediate Term investment Grade Bond funds down 2-3%. TIPS were down about 9% and International Bonds down maybe 5%. Uncomfortable but hardly a disaster. Stocks had a great year. But those who sold would have locked in their losses and by golly bond funds are up so far in 2014!!
A fool and his money are good for business.

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LH
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Re: "Get out of bond funds"

Post by LH » Sat May 10, 2014 11:31 am

Manks wrote:I am fairly new to the Boglehead investment way of doing things but have loved learning from the wiki and this forum. Before, I was 100% in equity index funds. Now, I have moved things around to 85/15 (I am 27 years old). I am still attempting to learn as much as I can about bonds since they are new to me. I have been hearing Warren Buffets advice on bonds and saw Suze Orman recommend getting out of bond funds on her show last night.

I am not really asking if this is good advice or not. Rather, I would appreciate some clear explanations as to what would make someone give this specific advice in the current state of the economy. For example, how exactly will the 'impending interest rises' affect bond funds influencing people to shy away from or leave this asset class.

It took a lot for me to make the move into my current AA, especially without fully grasping how bonds were and are influenced by interest changes. Thanks for the clarifications!

Basically, if you have a bond fund with a duration of 5 years:

Interest rates jump up 2 percent.

Two things then happen.
1) the bond fund would drop in value ten percent, duration X change in rate = 10.
That's bad.
2) the bond funds new bonds will start earning two percent more.
That's good.

At some point, these two countervailing forces equal out....., where would that be?

Basically at 5 years, the duration. After 5 years, you would pull ahead of where you would have been if no interest rate hike occurred!

Now, how to avoid the bad, and get the good?

Well timing of Course!

Before, buying bonds was good, now it's bad, so just time it! Trouble is, it does not work, if it did, active bond funds where timing experts work, would win. They do not.

Stay the course.
Yes, at some point, I really really really hope, savers like me will get compensated for being savers again, and yeah, interest rates will rise, yeah, existing bonds will fall, but over time, that's what passive savers WANT, we want out of the financial repression.

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Re: "Get out of bond funds"

Post by FinancialDave » Sat May 10, 2014 6:08 pm

LH wrote:
Basically, if you have a bond fund with a duration of 5 years:

Interest rates jump up 2 percent.

Two things then happen.
1) the bond fund would drop in value ten percent, duration X change in rate = 10.
That's bad.
2) the bond funds new bonds will start earning two percent more.
That's good.

At some point, these two countervailing forces equal out....., where would that be?

Basically at 5 years, the duration. After 5 years, you would pull ahead of where you would have been if no interest rate hike occurred!

Stay the course.
Yes, at some point, I really really really hope, savers like me will get compensated for being savers again, and yeah, interest rates will rise, yeah, existing bonds will fall, but over time, that's what passive savers WANT, we want out of the financial repression.
I see just one problem with this, if you are holding a bond fund when interest rates go up by 2% your distributions from the bonds are NOT going to change right away because some bonds need to mature or new money flow into the fund for this to happen.

Let's take a simple example VBIIX Intermediate Bond Fund - 97% of the individual bonds in this fund have a maturity between 5-10 years. It's average duration is actually reported as 6.5 years. So if no big inflows happen here, your income is not going to change much, especially if you don't re-invest the dividends (because you are spending the money in retirement). Even if you do re-invest the dividends, that 2.5% interest payment is not going to move the needle much. In fact the income may continue to go down as it did in 2013.

fd
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ogd
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Re: "Get out of bond funds"

Post by ogd » Sat May 10, 2014 6:36 pm

FinancialDave wrote: I see just one problem with this, if you are holding a bond fund when interest rates go up by 2% your distributions from the bonds are NOT going to change right away because some bonds need to mature or new money flow into the fund for this to happen.

Let's take a simple example VBIIX Intermediate Bond Fund - 97% of the individual bonds in this fund have a maturity between 5-10 years. It's average duration is actually reported as 6.5 years. So if no big inflows happen here, your income is not going to change much, especially if you don't re-invest the dividends (because you are spending the money in retirement). Even if you do re-invest the dividends, that 2.5% interest payment is not going to move the needle much. In fact the income may continue to go down as it did in 2013.
Actually, bond yields adjust instantly whether you sell them or not. You can look at WSJ's Treasury quotes for example, to confirm this: http://online.wsj.com/mdc/public/page/2 ... asury.html .

What you're missing is the change in the value of bonds going forward. If the bonds are low coupon, their value takes a hit, their coupons don't change, but the capital appreciation accelerates to make up the difference. If the bonds are old, high coupon bonds, their premium value will depreciate less going forward than it would have. Basically, the sum of coupons and value appreciation / depreciation equals the market yield for that maturity date.

The other thing you're missing is that the typical conservative bond fund trading in liquid markets has turnover in the neighborhood of 70% - 100%. So it's quite normal for a fund to sell some bonds, buy some others, to maintain the desired shape of distributions vs NAV. The IRS also has a lot to say about how much can be distributed vs taken as capital gain, for obvious reasons.

Anyways, there isn't a lot you can glean from looking at bond maturities that's not already captured in the SEC yield and duration. One thing that's certain vs the original thread subject is that after that increases last summer bond fund returns have been pretty great, even better as expected, in spite of the yield curve not changing much. More on this in http://www.bogleheads.org/forum/viewtop ... 0&t=132601 .

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Re: "Get out of bond funds"

Post by Jack FFR1846 » Sat May 10, 2014 7:54 pm

Stay the course. 2013, everything went way up.

YTD, S&P 500 2.17%, Fidelity spartan advantage US Bond (what I hold) 3.21%

What will the future hold? I wouldn't be asking some game show host. I'll let the bonds even out the crazyness of the stocks, thank you very much.
Bogle: Smart Beta is stupid

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LH
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Re: "Get out of bond funds"

Post by LH » Sun May 11, 2014 2:22 am

FinancialDave wrote:
LH wrote:
Basically, if you have a bond fund with a duration of 5 years:

Interest rates jump up 2 percent.

Two things then happen.
1) the bond fund would drop in value ten percent, duration X change in rate = 10.
That's bad.
2) the bond funds new bonds will start earning two percent more.
That's good.

At some point, these two countervailing forces equal out....., where would that be?

Basically at 5 years, the duration. After 5 years, you would pull ahead of where you would have been if no interest rate hike occurred!

Stay the course.
Yes, at some point, I really really really hope, savers like me will get compensated for being savers again, and yeah, interest rates will rise, yeah, existing bonds will fall, but over time, that's what passive savers WANT, we want out of the financial repression.
I see just one problem with this, if you are holding a bond fund when interest rates go up by 2% your distributions from the bonds are NOT going to change right away because some bonds need to mature or new money flow into the fund for this to happen.

Let's take a simple example VBIIX Intermediate Bond Fund - 97% of the individual bonds in this fund have a maturity between 5-10 years. It's average duration is actually reported as 6.5 years. So if no big inflows happen here, your income is not going to change much, especially if you don't re-invest the dividends (because you are spending the money in retirement). Even if you do re-invest the dividends, that 2.5% interest payment is not going to move the needle much. In fact the income may continue to go down as it did in 2013.

fd
well, yeah.

but if the duration is 6.5 years, at 6.5 years you break even if rates go up, and thereafter you make more money than you would have. The mechanics of it are that when the fund drops because the interest change and the funds duration, that change breaks even right at the duration, that is basically exactly how much that needle is moved.

What you see is reality, but its not a problem, its just reality... We may be talking past each other, I dunno.....

This works both ways. Bond funds went UP in value with the interest rate drops, but the coupons steadily went down. Now, if interest rates rise, bond funds will go down in value, but coupons will rise........

Overtime, one gets an average return from
1)the coupons
2)the worth of the fund

Its two sides of the same coin.

To get out of bonds funds, one has to get into something else.... What is that something else? Cash? Guaranteed 1 percent or so loss currently? Stocks, you take way more risk......

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Re: "Get out of bond funds"

Post by linenfort » Sun May 11, 2014 10:49 am

The original post is a half-year old now, but since it's being revived, I wonder if anything has changed since I started reading warnings about bond funds in 2012.
Manks wrote: (Re: "Get out of bond funds") I am not really asking if this is good advice or not. Rather, I would appreciate some clear explanations as to what would make someone give this specific advice


Remember this article from the WSJ?
The New Bond Market
A change in the way corporate bonds are traded is resulting in murkier prices, more volatility and less differentiation among individual bonds. The result: Experts say investors should expect more risk and potentially less return from such bonds in the future, and rethink how they assemble their entire bond portfolios.
The experts' recommendation within the article is to buy at least $20,000 blocks of bonds from at least 20 different issuers. Good luck doing that if you're the OP's age (twenties) and don't have 400K to invest in bonds. It does go on to say that, well, many investors can't afford to do this, so we're back to square one / bond funds and ETFs are the only alternative.

However, it was good to read about the risks. A single example:
As the steadying influence of banks wanes, the bond market is more vulnerable to swings in investor sentiment, experts say.
Prices today are being driven more by the whims of investors buying and selling funds and ETFs and less by the fundamentals of the bonds themselves, says Mr. Simons of Bianco Research.


Sounds like more than just noise to me. This is a good reminder to young & new investors that an instrument is not automatically safe because it has the word "bond" in it. A ten-year treasury note is not a corporate bond is not a corporate bond fund is not a high-yield corporate bond fund...

I still hold VCIT (Vanguard intermediate corporate bond etf) but I don't think of those shares as safe or as ballast that would protect me from a stock market plunge.
Is it too early for an all-bond-portfolio thread?

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Re: "Get out of bond funds"

Post by TSR » Sun May 11, 2014 11:13 am

nisiprius wrote:
john94549 wrote:Fishnskiguy, in Colorado? Reminds me of the standing joke our senior enlisted had when asked where they might retire. "I'm going to start walking across the country with an anchor on my shoulder. When the first person says 'what's that', that's where I'll retire."
Everyone's aware that that is straight out of the Odyssey?
Samuel Butler, translating Homer wrote:"You shall go to bed as soon as you please," replied Penelope, "now that the gods have sent you home to your own good house and to your country. But as heaven has put it in your mind to speak of it, tell me about the task that lies before you...."

"My dear," answered Ulysses, "...I will not conceal it from you, though you will not like it... Teiresias bade me travel far and wide, carrying an oar, till I came to a country where the people have never heard of the sea, and do not even mix salt with their food. They know nothing about ships, nor oars that are as the wings of a ship.... He said that a wayfarer should meet me and ask me whether it was a winnowing shovel that I had on my shoulder. On this, I was to fix my oar in the ground and sacrifice a ram, a bull, and a boar to Neptune; after which I was to go home and offer hecatombs to all the gods in heaven, one after the other. As for myself, he said that death should come to me from the sea, and that my life should ebb away very gently when I was full of years and peace of mind, and my people should bless me.
There are no jokes like the old jokes.
Please stay on topic. The question is whether one ought to hold hecatombs or hecatomb funds.

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ogd
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Re: "Get out of bond funds"

Post by ogd » Sun May 11, 2014 6:55 pm

linenfort wrote:The experts' recommendation within the article is to buy at least $20,000 blocks of bonds from at least 20 different issuers. Good luck doing that if you're the OP's age (twenties) and don't have 400K to invest in bonds. It does go on to say that, well, many investors can't afford to do this, so we're back to square one / bond funds and ETFs are the only alternative.
This is truly bad advice, particularly with the low[ish] rated example. So you are under-diversified, are likely to get gipped by institutional players (as they themselves warn below), and have to become your own credit analyst, all for the privilege of being able to pretend that market prices and yields don't exist. Don't do this. The time and risk are much better spent on the equity side.

The blabbering about the influence of moody investors through ETFs is the same type of scaremongering we hear about indexing destroying the market. As if the buyers of BND are the ones prone to making massive, risky, short-term bets on bonds. Right.

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linenfort
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Re: "Get out of bond funds"

Post by linenfort » Sun May 11, 2014 10:42 pm

ogd wrote:
linenfort wrote:The experts' recommendation within the article is to buy at least $20,000 blocks of bonds from at least 20 different issuers. Good luck doing that if you're the OP's age (twenties) and don't have 400K to invest in bonds. It does go on to say that, well, many investors can't afford to do this, so we're back to square one / bond funds and ETFs are the only alternative.
This is truly bad advice ... Don't do this. The time and risk are much better spent on the equity side.
You mean to buy individual bonds? I agree. It looks extremely difficult.
ogd wrote:The blabbering about the influence of moody investors through ETFs is the same type of scaremongering we hear about indexing destroying the market. As if the buyers of BND are the ones prone to making massive, risky, short-term bets on bonds. Right.
Oh, I doubt they were referring to total bond market ETFs like BND. The article is for the most part about investment grade and high-yield bonds and funds.
Is it too early for an all-bond-portfolio thread?

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ginmqi
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Re: "Get out of bond funds"

Post by ginmqi » Mon May 12, 2014 2:08 pm

linenfort wrote:
ogd wrote:
linenfort wrote:The experts' recommendation within the article is to buy at least $20,000 blocks of bonds from at least 20 different issuers. Good luck doing that if you're the OP's age (twenties) and don't have 400K to invest in bonds. It does go on to say that, well, many investors can't afford to do this, so we're back to square one / bond funds and ETFs are the only alternative.
This is truly bad advice ... Don't do this. The time and risk are much better spent on the equity side.
You mean to buy individual bonds? I agree. It looks extremely difficult.
What about if one only wants to hold Treasuries and TIPS? I am still learning about how to invest in bonds and I am not convinced of the bond fund route. I dislike corporate/foreign/muni bonds and my philosophy is that I am already in equity so that's the risky, growth portion of the portfolio. So why play the game? (as Bernstein says) So for me who only want the safest individual bonds available, and buying them from TreasuryDirect would completely bypass the complex bond market, maybe it makes sense to avoid bond funds and just ladder short to intermediate term treasuries?

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linenfort
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Re: "Get out of bond funds"

Post by linenfort » Mon May 12, 2014 2:17 pm

ginmqi wrote:What about if one only wants to hold Treasuries and TIPS? I am still learning about how to invest in bonds and I am not convinced of the bond fund route. I dislike corporate/foreign/muni bonds and my philosophy is that I am already in equity so that's the risky, growth portion of the portfolio. So why play the game? (as Bernstein says) So for me who only want the safest individual bonds available, and buying them from TreasuryDirect would completely bypass the complex bond market,
- Treasurys are the safest. No doubt about that.
- You don't have to buy them from Treasury Direct, though, ginmqi. You can buy them from the auctions, commission-free, at both Vanguard and Fidelity. You can also buy and sell them on the secondary market at those brokerage houses.
maybe it makes sense to avoid bond funds and just ladder short to intermediate term treasuries?
I guess the duration is a whole other topic outside of this thread's scope, but you do want to scrutinize treasury funds to see what, if any, non-treasury instruments are held therein. I think BlackRock has some weird stuff going on that I don't quite understand, which is why I swapped TLT (long bond ETF) out for real bonds when I found out about it.
Is it too early for an all-bond-portfolio thread?

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ogd
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Re: "Get out of bond funds"

Post by ogd » Mon May 12, 2014 2:22 pm

ginmqi wrote:What about if one only wants to hold Treasuries and TIPS? I am still learning about how to invest in bonds and I am not convinced of the bond fund route. I dislike corporate/foreign/muni bonds and my philosophy is that I am already in equity so that's the risky, growth portion of the portfolio. So why play the game? (as Bernstein says) So for me who only want the safest individual bonds available, and buying them from TreasuryDirect would completely bypass the complex bond market, maybe it makes sense to avoid bond funds and just ladder short to intermediate term treasuries?
Treasuries and TIPS are one market where you can do this without hurting yourself much, because credit is universally good and it's very liquid.

However, "bypassing the complex bond market" is merely an Ostrich effect. The market exists and it gives you signals that you are choosing to ignore. One way in which this is bad for you is that you might in fact need to sell those Treasuries before maturity, e.g. in case of job loss or equity crash, so you'll want to tap into the market that you previously ignored. It's nice to know at all times how much money you can count on.

The other way this is bad for you is the pricing effects you are ignoring. This is an example I give over and over: if you're sitting on a Treasury, even an extremely high coupon 30 year, 10%+, bought in the fabled times of the past, that's maturing in 1-2 years, you should sell it and put the money in a savings account, because that Treasury is only making you in the neighborhood of 0.1%. In general, it's not currently worth holding any Treasuries below 3 years or so if you have the option to put the money in a good bank.

The other pricing effect is this: http://www.bogleheads.org/forum/viewtop ... 0&t=132601 . You'd be giving that up and sitting on old bonds uselessly.

Now add to that the time wasted being a part-time bond manager and I don't see why you'd do it. But it's your money, your time and your comfort. The balance between those is ultimately up to you.

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Re: "Get out of bond funds"

Post by linenfort » Mon May 12, 2014 2:59 pm

ogd wrote: if you're sitting on a Treasury, even an extremely high coupon 30 year, 10%+, bought in the fabled times of the past, that's maturing in 1-2 years, you should sell it and put the money in a savings account, because that Treasury is only making you in the neighborhood of 0.1%. In general, it's not currently worth holding any Treasuries below 3 years or so if you have the option to put the money in a good bank.
Could you elaborate, ogd? Let's say you have 2 years left on a bond, so 4 interest payments left that are the same dollar amount as they always were. When you say it's only making ~ 0.1%, does that mean the value of that bond has soared as interest rates have fallen so (same old interest)÷(new high value) = 0.1% and you should sell before rates rise and the value goes down? Or..something else? I think I have this wrong, because you're only talking about stuff maturing within a year or two. And, even a "good" bank doesn't pay much interest. :?:
Is it too early for an all-bond-portfolio thread?

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ogd
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Re: "Get out of bond funds"

Post by ogd » Mon May 12, 2014 3:11 pm

linenfort wrote:
ogd wrote: if you're sitting on a Treasury, even an extremely high coupon 30 year, 10%+, bought in the fabled times of the past, that's maturing in 1-2 years, you should sell it and put the money in a savings account, because that Treasury is only making you in the neighborhood of 0.1%. In general, it's not currently worth holding any Treasuries below 3 years or so if you have the option to put the money in a good bank.
Could you elaborate, ogd? Let's say you have 2 years left on a bond, so 4 interest payments left that are the same dollar amount as they always were. When you say it's only making ~ 0.1%, does that mean the value of that bond has soared as interest rates have fallen so (same old interest)÷(new high value) = 0.1% and you should sell before rates rise and the value goes down? Or..something else? I think I have this wrong, because you're only talking about stuff maturing within a year or two. And, even a "good" bank doesn't pay much interest. :?:
You should sell before "the value goes down", to par value, even if rates don't change.

Concrete example from today's pricing.

Maturity Coupon Bid Asked Chg Asked yield
8/15/2015 10.625 113.1563 113.1797 -0.0234 0.148

If you have 1000x of this bond, you could hold, make another $13280 in interest, get $100K at maturity, for a grand total of $113280. Or you could sell for $113150, put the money in a 1% savings account, make another $1414 in interest, for a total of $114564. That $1284 difference is the price of you not paying attention to the bond market, which is willing to give you almost all of your remaining interest now without requiring you to wait it out. In other words, that yield number of 0.148 is the truth, not the coupon.

For "good" banks for the purposes of this discussion, see http://www.depositaccounts.com.

I'm talking the extreme examples of old Treasuries very close to maturity to illustrate the extreme difference between coupons and reality without having to dissect quarterly payments. But this applies to any Treasury below 3 years, which is roughly where the yield curve intersects 1%.

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linenfort
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Re: "Get out of bond funds"

Post by linenfort » Mon May 12, 2014 3:22 pm

Very clear, thank you!
Is it too early for an all-bond-portfolio thread?

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Re: "Get out of bond funds"

Post by gips » Mon May 12, 2014 10:15 pm

ogd wrote:
linenfort wrote:
ogd wrote:

Concrete example from today's pricing.

Maturity Coupon Bid Asked Chg Asked yield
8/15/2015 10.625 113.1563 113.1797 -0.0234 0.148

If you have 1000x of this bond, you could hold, make another $13280 in interest, get $100K at maturity, for a grand total of $113280. Or you could sell for $113150, put the money in a 1% savings account, make another $1414 in interest, for a total of $114564. That $1284 difference is the price of you not paying attention to the bond market, which is willing to give you almost all of your remaining interest now without requiring you to wait it out. In other words, that yield number of 0.148 is the truth, not the coupon.
hmmm... it seems to me in an efficient market the bond price would adjust to account for early sales. are you sure you haven't missed any key factors in your model?

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ogd
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Re: "Get out of bond funds"

Post by ogd » Mon May 12, 2014 10:20 pm

gips wrote:hmmm... it seems to me in an efficient market the bond price would adjust to account for early sales. are you sure you haven't missed any key factors in your model?
It does, and that's the point. Market yield for 1.25 years are around 0.15%, and all bonds maturing at that time have that yield, regardless of what's written on the coupon. The market can do the math and realize that at any lower price, this old bond would be a killer deal.

What's not efficient is the 1% savings account. If the market had access to that, they'd beat it down to 0.1% or thereabouts. Fortunately for us, they don't.

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Re: "Get out of bond funds"

Post by gips » Mon May 12, 2014 10:42 pm

I see...for an apples to apples comparison, wouldn't you want to consider the income from investing the coupons at 1% were one to hold on to the bond?

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Re: "Get out of bond funds"

Post by ogd » Mon May 12, 2014 11:16 pm

gips wrote:I see...for an apples to apples comparison, wouldn't you want to consider the income from investing the coupons at 1% were one to hold on to the bond?
Sure, but those coupons are only $13280, so you'd get another ~$85 over their average lifespan, give or take a few. An order of magnitude too little, in any case. This isn't surprising, because it's the entire amount that gets priced at market yields not just the coupons, and you can get far better than market yields for the entire amount.

Incidentally, this is why the higher-coupon bonds yield ever so slightly less than their low-coupon counterparts, because they do frontload the money to a degree. But the differences are tiny at low maturities (the reinvestment assumed in the pricing is, as always, the almost zero market yield).

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Re: "Get out of bond funds"

Post by z3r0c00l » Tue May 13, 2014 6:11 am

garlandwhizzer wrote: Vanguard estimates that nominal high quality bond returns over the next decade to be somewhere around 2%, which is likely to be at or below the 10 year inflation rate. That is to say about a zero real return for a decade. Why lock up dead money for a decade when you're early in the accumulating phase and you're got several decades to recuperate from any stock bear markets?
Except that none of that is knowable, even if it is possible to make an educated guess. I don't see how matching inflation = dead money. It is actually a worthy achievement, such as in iBonds. That is what we hope for bonds to do, match or slightly beat inflation. Why should they do much more than that anyway? There are a very low risk investment and should have a lower return.

After a decade, stocks could be down quite a bit. Would that have been dead money then?

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Re: "Get out of bond funds"

Post by ginmqi » Tue May 13, 2014 8:24 am

ogd wrote:
gips wrote:I see...for an apples to apples comparison, wouldn't you want to consider the income from investing the coupons at 1% were one to hold on to the bond?
Sure, but those coupons are only $13280, so you'd get another ~$85 over their average lifespan, give or take a few. An order of magnitude too little, in any case. This isn't surprising, because it's the entire amount that gets priced at market yields not just the coupons, and you can get far better than market yields for the entire amount.

Incidentally, this is why the higher-coupon bonds yield ever so slightly less than their low-coupon counterparts, because they do frontload the money to a degree. But the differences are tiny at low maturities (the reinvestment assumed in the pricing is, as always, the almost zero market yield).
I do see your point. And I do understand where it is coming from. Basically, the market is willing to pay slightly more for your high yield bond thats maturing soon in a low interest rate environment. But this seems like an active game playing with bonds. Continually monitoring the interest rate and sell as needed.

I wonder if this is better than a simple hold to maturity and rebuying next rung in the ladder strategy. Over a period of say 30-40 years, how would an "active" bond buying/selling strategy compare to selling the bond when the market is willing to pay slightly more?

One problem is unknown interest rates. And since that's essentially tied to economic outlook (ie, bad economic times = low rates) how would one look?

I'm not interesting in a few years of increased earning by selling high coupon bonds in a low rate environment. Can this be analyzed over 30-40 years for long-term retirement investors?

Regarding need for quick liquidity, that's what emergency funds are for. Though again bonds could be used in this regard as well.

I do agree with you in the being part time amateur bond manager. If one has the experience know-how and can calculate the opportunity cost then maybe. Otherwise I wonder about that as well.

So maybe it would be interesting to compare these 3 strategies long-term:
-Buy and hold a bond fund
-Buy and active sell individual bonds strategically in a low interest environment
-Buy and hold bond ladders, "ignoring" the market

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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 11:46 am

ginmqi: it isn't active in the sense of trying to guess the future. You're just comparing two numbers, the yields inside the bond market and the yields outside, making no assumptions about the future. In my example, the selling was the right thing to do regardless of what happens in the market over the remainder of the bond.

I don't think the opportunity cost is large over the long term, because the current situation with higher yields outside the market, is after all rare, but it does sometimes pop up and when it does it shows you why you should be on top of what your bonds are worth and what they are making you.

Don't get me wrong: I don't want to manage my bond portfolio. That's why I pay somebody a modicum of money to do it for me, and I "tell them" (by choice of funds) to stop at the short maturities where it's not worth it.

Besides the inherent strangeness of the proposition that "I don't understand the bond market, therefore I will become my own bond manager", the question I am really addressing is what does that buy you? It's clear to me that you're not making extra money, and sometimes make less. So what are you getting? The opportunity to ignore market prices for long periods of time? But why? Is it that important to you? Is it even a healthy way to go about investing? Look at the other downsides, too: with large enough interest rate moves, your bond portfolio will be all over the place, perhaps too heavily weighed on the long end, or perhaps it has become too small relative to stocks, but you wouldn't know that because you never use market prices. Using a portfolio analyzer, like everyone should be doing once in a while, would be anathema with this mentality. If you absolutely need to sell something tomorrow, you will [wrongly] not touch the old, premium bond because you think it's an irreplaceable deal with its high coupon, whereas sometimes (equity crash) this is the first thing you should be selling even ignoring the savings account comparison.

All it takes to free yourself from this waste of time and mind games is either to understand bond prices once and for all (spend a few days with a book and pencil and paper and buy and sell scenarios), or a leap of faith to the effect that bond funds are equivalent to the bonds they contain because the prices and yields of both always move in unison; this doesn't seem like a large leap of faith to me at all. Then you can be on your merry way, doing things that actually make a difference; maybe you want to play with stock allocations to small value, or simply make & save more money.

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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 12:53 pm

gips wrote:
ogd wrote:
linenfort wrote:
ogd wrote:

Concrete example from today's pricing.

Maturity Coupon Bid Asked Chg Asked yield
8/15/2015 10.625 113.1563 113.1797 -0.0234 0.148

If you have 1000x of this bond, you could hold, make another $13280 in interest, get $100K at maturity, for a grand total of $113280. Or you could sell for $113150, put the money in a 1% savings account, make another $1414 in interest, for a total of $114564. That $1284 difference is the price of you not paying attention to the bond market, which is willing to give you almost all of your remaining interest now without requiring you to wait it out. In other words, that yield number of 0.148 is the truth, not the coupon.
hmmm... it seems to me in an efficient market the bond price would adjust to account for early sales. are you sure you haven't missed any key factors in your model?
Ogd,

I guess I am not sure of your point here - other than there are times (like now) when it makes good sense to SELL your bond funds and invest in something better??

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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 1:08 pm

FinancialDave wrote:I guess I am not sure of your point here - other than there are times (like now) when it makes good sense to SELL your bond funds and invest in something better??
fd: read more carefully and try to see my point not yours. I am saying that it makes little sense currently to hold Treasuries close to maturity, regardless of vintage, a point that someone who doesn't mark bonds to market would miss.

This applies to short bond funds as well and I'd only hold 3 years and up (intermediate duration), but it's a very secondary point.

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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 1:29 pm

Let's say you buy a block of $100,000 5 year bond with 2% coupon, just to make the math easy.

Neglecting the commissions - over the 5 years you will earn $25,000 in interest and then get back your $100,000.

You spend the income because you are retired and living off the bond.

Doesn't matter what the yield on this coupon is during the 5 years, as it will vary based on time to maturity and prevailing interest rates - however your income will continue to be $5,000 per year and there is really little you can do about that if you want to keep the same maturity date for the investment (maybe you want to buy a winter cottage at the end of the 5 years.)

Even if interest rates jump up 2% (100% increase) - selling the bond and buying an equal maturity date bond will not help you, as you will have less money to buy it with and the duration of the bond you buy will be less. So barring the argument over the shape of the yield curve and any mispricing of the bonds, when you invest in a bond you get what you pay for. If interest rates jump up it doesn't improve in any meaningful manner your yield on your investment.

In other words your income over the 5 year period is going to be $25,000.

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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 1:33 pm

ogd wrote:
FinancialDave wrote:I guess I am not sure of your point here - other than there are times (like now) when it makes good sense to SELL your bond funds and invest in something better??
fd: read more carefully and try to see my point not yours. I am saying that it makes little sense currently to hold Treasuries close to maturity, regardless of vintage, a point that someone who doesn't mark bonds to market would miss.

This applies to short bond funds as well and I'd only hold 3 years and up (intermediate duration), but it's a very secondary point.
The reason is as simple as bonds themselves -- the duration of the bond is decreasing,

The reason is you can sell the bond say at 1 year to maturity and buy a new 10 year, which effectively extends your duration by 9 years --- you have not improved the return on your original investment, you just bought a new 9 year investment which will have a yield based on todays rate.

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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 1:40 pm

fd: at 2% it's only $10000, plus a little more from reinvestment should you choose to do that.

However, it absolutely does "matter what the yield is during the 5 years". As [a trivial modification of] my example shows, if the yield curve is like it is now you could get another $1000 - $2000 by selling the bond early and putting it in a savings account, without any additional risk at all. So you shouldn't ignore the yield curve. Once again -- the 2% is an illusion and it greatly diminishes later in the life of a bond when the yield curve is steep. The 0.1% yield is the reality and the difference between illusion and reality is $1000 less in your pocket.

I do agree that making such transactions within the bond market will not make any difference, which is why I think a bond fund will do just fine in the first place despite not holding bonds to maturity (which is no holy grail of fixed income safety). But there is a difference when it comes to realistically assessing what your money is actually making you in order to compare with alternatives outside the bond market.

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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 1:43 pm

FinancialDave wrote:The reason is you can sell the bond say at 1 year to maturity and buy a new 10 year, which effectively extends your duration by 9 years --- you have not improved the return on your original investment, you just bought a new 9 year investment which will have a yield based on todays rate.
Nope -- I was talking about a savings account with ZERO duration. I don't know why we're even arguing over this, the example is very clear.

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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 3:34 pm

ogd wrote:
FinancialDave wrote:The reason is you can sell the bond say at 1 year to maturity and buy a new 10 year, which effectively extends your duration by 9 years --- you have not improved the return on your original investment, you just bought a new 9 year investment which will have a yield based on todays rate.
Nope -- I was talking about a savings account with ZERO duration. I don't know why we're even arguing over this, the example is very clear.
I have no argument with selling bonds and putting them in something else that earns more money with equivalent risk.

I just have a problem with people who think that just because interest rates go up their income from their bond (if they sell it and buy a higher yielding bond) will change.

The other point I was making earlier was bond funds are nothing more than a bunch of bonds, when it comes to the income you will receive from them. If the bond fund is not diversified in the maturity dates of it's bonds, much like VBIIX, then you essentially have the results of a single 5 (or whatever) year bond in your portfolio. Much like if you sold your 5 year bond and reinvested the money, you would not make any more income in those 5 years. Once the bond holder get's his or her principal back, then a new investment can be made.

If a bond fund is diversified in maturity dates, then of course it always has a certain amount of money being re-invested at the current rates, even if no new money flows in (but not if outflows are greater than the maturities can handle.) OR if inflows of interest or new money is greater than the outflow, then it could purchase new bonds outright - but there is no guarantee of that.

Thirdly, to keep the duration constant (no guarantee of that over the short term), when the 5 year bond gets down to 4 years it can sell it and buy a new 5 year bond - effectively increasing the duration for a small increase in income.


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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 4:04 pm

FinancialDave wrote:I just have a problem with people who think that just because interest rates go up their income from their bond (if they sell it and buy a higher yielding bond) will change.
I agree with this one, when properly stated. The return of the bond will not change. The yield of the bond will shoot up, at the cost of a loss of value. If one sells it and buys another bond, they can actually get more coupons, at the cost of capital appreciation later on which will no longer happen; given tax treatment, this seems like a bad deal to me. In fact, I can right now trade for 10% coupons (the Treasury I mentioned), which I will pay for, dearly, when the premium bond returns to par.

When considered in terms of total return, none of these maneuvers makes a difference. The higher interest rates will only start returning more once fund duration or bond maturity elapses. I usually hear the (mistaken) opposite argument from people arguing about the perils of bond funds, who think that selling bonds before maturity is a loser. It is neither a loser nor a winner (at least if staying within the bond market -- if one is willing to go outside it can actually be a winner); the only thing it does for a fund is keep fund duration relatively constant, with all that entails.
FinancialDave wrote:If a bond fund is diversified in maturity dates, then of course it always has a certain amount of money being re-invested at the current rates, even if no new money flows in (but not if outflows are greater than the maturities can handle.) OR if inflows of interest or new money is greater than the outflow, then it could purchase new bonds outright - but there is no guarantee of that.
Here we disagree. Inflows and outflows simply don't matter when it comes to liquid bonds. A simple proof: let's take our point of agreement from before, that exchanging bonds for current ones with same maturity makes no difference to returns. Now imagine, for the sake of the argument, that a fund does this daily -- at any point in time, the entire portfolio is uniform. This takes the current vintage of the fund's bonds out of the picture; they are all new. Inflows mean multiplying the entire portfolio by a certain amount, keeping the portfolio per share the same. Outflows mean dividing it. It doesn't matter. A fund with inflows will not have any higher returns than a fund with outflows.

In the real world, there's transaction costs and liquidity and tax impacts to worry about, so the funds don't actually churn all the time, only about once every 1-1.5 years, much less in illiquid markets. But remember the theoretical equivalency above: a fund that doesn't trade at all makes the same returns as the theoretical fund which trades all the time but pays no transaction costs. Which, in turn, is insensitive to inflows and outflows.

The only way in which inflows / outflows do matter slightly is if there's a high amount of turnover in and out of a mutual fund, whereby the associated costs begin to hurt long term investors. Hence Vanguard's discouragement of frequent trading; many other fund families have similar restrictions, explicit or not. With ETFs, not even this is a problem, as the costs are borne by the trader at transaction time in the form of spreads. Given the comparable performance of comparable mutual funds and ETFs in the bond space and elsewhere, it must not be a big deal.

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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 5:28 pm

ogd,
Here we disagree. Inflows and outflows simply don't matter when it comes to liquid bonds. A simple proof: let's take our point of agreement from before, that exchanging bonds for current ones with same maturity makes no difference to returns
I actually don't think we are in disagreement, when you note the statement above in bold - "the same maturity."

Bond funds do NOT in general exchange the bonds for ones of the same maturity, as their mandate is to keep a somewhat consistent duration. If they did exchange all the bonds on a daily basis, each time they did this exchange they would have to buy a bond with a duration that was one day longer than the one they sold. In other words they would be selling bonds of duration 4 years 364 days and buying bonds with a duration of 1 day longer (5 years). If they wait a year to do this as you suggest they are selling bonds with 4 years left to maturity and buying bonds that now have 5 years to maturity.

It is not really the inflows and outflows that matter it is the "Net" between the two:

Let's say on day 1 you buy a 5 year bond fund with one brand new 5 year 5% bond in it.
Day 2 interest rates jump to 7%.
Day 3 Investors pile into the bond fund and double it's size.
Day 4 fund managers invest the new money in 5 year 7% bonds, essentially increasing the bond funds income from 5% to 6%.

Neglecting of course the effect of the 4 days change, since it is small compared to the 5 year bond.

Forgetting that the above is highly unlikely, but the end result is that inflows (in excess of outflows) do matter as they will soon need to be invested in whatever is the current yield for this duration bond.

fd
Last edited by FinancialDave on Sun May 18, 2014 9:11 pm, edited 1 time in total.
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Re: "Get out of bond funds"

Post by Sagenick48 » Tue May 13, 2014 6:07 pm

How about if we change the discussion for a minute. My bias is against bond funds because I can't control principal risk. Having said that assume you want a portfolio of 60% equities, 35% bonds! and 5% cash, with the cash being your emergency fund of say 6 months to 1 year.

Now assume you don't want bond funds(principal risk) but instead want more equities and more cash.

What is the optimal allocation?

My point is that bonds are an anchor that hold you in place in a storm, but hold you back in the good times.

Maybe a 10 or 15% cash allocation and an 85% equity allocation will have the same result as a 60/35/5 allocation.

At least it is a testable hypothesis.
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Re: "Get out of bond funds"

Post by FinancialDave » Tue May 13, 2014 6:24 pm

Sagenick48 wrote:How about if we change the discussion for a minute. My bias is against bond funds because I can't control principal risk. Having said that assume you want a portfolio of 60% equities, 35% bonds! and 5% cash, with the cash being your emergency fund of say 6 months to 1 year.

Now assume you don't want bond funds(principal risk) but instead want more equities and more cash.

What is the optimal allocation?

My point is that bonds are an anchor that hold you in place in a storm, but hold you back in the good times.

Maybe a 10 or 15% cash allocation and an 85% equity allocation will have the same result as a 60/35/5 allocation.

At least it is a testable hypothesis.
Yes, it is testable, but it would require some parameters -- such as do you want to only test it while you are accumulating or do you want to test it during retirement. What kind of bonds do you want to use - nominal bonds, or inflation index bonds (not that there is a whole lot of difference.) For how many years?

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Re: "Get out of bond funds"

Post by Sagenick48 » Tue May 13, 2014 6:28 pm

I agree that laddered individual bonds with highly rated company's is the way to go, (ask me about the Ford Motor Credit bonds I bought in 2004 that came due in 2009) but it is a lot of work and the cost of buying bonds is not transparent. So I have been there, done that, and I don't regret it(other than a few sleepless nights thanks to Ford). Right now I have very few bonds, I have let my bond ladder run its course but have 20% cash, 75% equities, and 5% bonds. I can sleep at night.
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Re: "Get out of bond funds"

Post by ogd » Tue May 13, 2014 7:37 pm

FinancialDave wrote:Let's say on day 1 you buy a 5 year bond fund with one brand new 5 year 5% bond in it.
Day 2 interest rates jump to 7%.
Day 3 Investors pile into the bond fund and double it's size.
Day 4 fund managers invest the new money in 5 year 7% bonds, essentially increasing your income from 5% to 6%.
Ah, but no. You switched once again to talking about coupons. Must be a habit :wink:

Every year going forward (assuming flat, unchanging yield curve), the original 5% bond makes 5% in coupons and 2% capital appreciation from its day 2 price of $91.62 / 100 back to 100. If the curve is not flat, the appreciation will be steeper initially, less so later. Play with a bond calculator if you don't believe me.
Every year going forward, the new bond makes 7% in income, capital appreciation zero if the curve is flat, more otherwise.

So the new investors didn't give me any more return. They possibly gave me more coupons (and conceivably robbed me of the favorable capital gains tax treatment), but the fund has some liberty to trade to equalize things. Nor do outgoing investors rob me of returns. Or any net between the two (a point I did get, btw).

Again, the fund could simply sell the bond on day 2 and buy the 7%, no new investors required. I don't think your point about one day increase in maturity makes any particular difference; if you want, we'll simultaneously switch 1/365th of the fund to a year shorter to balance it out. If it helps you model returns, you can imagine that the fund actually does this every day; in fact, you can be pretty sure that if it helped the bond investors, they would. But of course, it makes no difference, in fact it sometimes hurts when it comes to taxes.

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Re: "Get out of bond funds"

Post by ogd » Wed May 14, 2014 11:42 am

Sagenick48 wrote:How about if we change the discussion for a minute. My bias is against bond funds because I can't control principal risk. Having said that assume you want a portfolio of 60% equities, 35% bonds! and 5% cash, with the cash being your emergency fund of say 6 months to 1 year.
...
Maybe a 10 or 15% cash allocation and an 85% equity allocation will have the same result as a 60/35/5 allocation.
A 85% stock / 15% cash allocation is most similar to 85% / 15% bonds. From a quick look at Vanguard's portfolio calculator, the allocation with cash is slightly riskier and less rewarding than the same allocation with bonds. The explanation is that the risks of bonds, such as they might be, show up at different times than stocks, and most of the time they return more than cash, particularly during market crashes when they increase in value due to the flight to quality.

Both of these are significantly riskier, but with higher returns than the 60% stock allocation.

You don't just add together the risk of two non-correlated assets, and in any event the risk coming from equities is much, much larger than any difference between cash and bonds. The proposition that replacing bonds with cash allows you to have significantly more equities doesn't hold water.

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Re: "Get out of bond funds"

Post by FinancialDave » Thu May 15, 2014 1:35 pm

ogd wrote:
FinancialDave wrote:Let's say on day 1 you buy a 5 year bond fund with one brand new 5 year 5% bond in it.
Day 2 interest rates jump to 7%.
Day 3 Investors pile into the bond fund and double it's size.
Day 4 fund managers invest the new money in 5 year 7% bonds, essentially increasing your income from 5% to 6%.
Ah, but no. You switched once again to talking about coupons. Must be a habit :wink:

Every year going forward (assuming flat, unchanging yield curve), the original 5% bond makes 5% in coupons and 2% capital appreciation...
ogd,

I think we really must be having some kind of communication problem -- or maybe what they say about those over 50 losing their brain cells is really true. :happy

When you (or a fund manager) buys a bond, what you are going to get from that bond if you hold it to maturity is known - think of it as zero coupon if that makes you feel better.

However, any way you cut it you will make $2500 on a $10,000 investment. If it is a $10k zero, you will just pay less up front, but the initial principal must be discounted to the equivalent bond yield. Does not matter where interest rates go that is what you will make.

Now everyone else buying new bonds (or even your bond) needs to make 7% in my case above.

So if they buy your bond, you now have to sell your bond at a loss, so they can earn 7%. Would not be a great deal you, the owner of your 5% bond, so sell it on day 2 at a 10% loss. But in fact it won't matter, you can essentially take your 10% loss, buy the 7% new bond and you will still earn essentially $2500 -- 5% on your original investment, while all new investors are earning 7% - either on your discounted principal or a completely new bond.

Can we agree on the above?

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Re: "Get out of bond funds"

Post by ogd » Thu May 15, 2014 2:16 pm

FinancialDave wrote:So if they buy your bond, you now have to sell your bond at a loss, so they can earn 7%. Would not be a great deal you, the owner of your 5% bond, so sell it on day 2 at a 10% loss. But in fact it won't matter, you can essentially take your 10% loss, buy the 7% new bond and you will still earn essentially $2500 -- 5% on your original investment, while all new investors are earning 7% - either on your discounted principal or a completely new bond.

Can we agree on the above?
fd: I'm not sure what we'd be agreeing on, so you'll have to forgive me for not saying yes just yet.

In one reading, the math isn't as you describe: the 7% new bond that you bought less of ($91.62 per $100, to be precise) is making you, in coupons, 6.41% on your original investment, i.e. $3206 for the 5 years. It's no longer 5% -- this is what the 8.4% loss bought you, the right to earn more going forward. You don't both take a loss and continue making the same money, it's either one or the other depending how you think of it. Many people misjudge the devaluation of bonds and funds in this crucial way, thinking you simultaneously lose value and continue making as little as you did before.

In another reading, if you incorporate the initial loss and subsequent capital gains and the coupon reinvestment rates into one big picture -- yes, you are making the same 5% total return regardless of what you do. And you are making 7% on your newly devalued capital, again regardless of what you do, or in the case of the fund how much capital flows in and out of it.

I should note that the zero coupon simplification works beautifully for this example. New and old bonds maturing on the same date have exactly the same value and are pretty much indistinguishable, so it's clear that neither transactions or inflows or outflows change anything.

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Re: "Get out of bond funds"

Post by FinancialDave » Thu May 15, 2014 3:05 pm

In another reading, if you incorporate the initial loss and subsequent capital gains and the coupon reinvestment rates into one big picture -- yes, you are making the same 5% total return regardless of what you do. And you are making 7% on your newly devalued capital, again regardless of what you do, or in the case of the fund how much capital flows in and out of it.
Ok, lets build on this common ground.

If I buy a $10,000, 5 Year bond earning 5% on day 1 - at the end of 5 years I will have $12,500, if I put all the interest in my piggy bank.
Say interest rates go up to 7% on day 2. I take another $10,000 and buy this 7% bond, from which I will essentially (forgetting the 1 day) have $13,500 at the end of 5 years. So what has happened - with an extra $10,000 "inflow" I have increased my "interest" (or coupon payments) to 6%. So as an individual investor, it seems very important to me (who only likes 5 year bonds) to have some "inflow" money if I want any chance of improving my return in a rising interest rate environment. If I don't have any additional money coming in I am stuck with the 5% return - whether I sell it or keep it - as you agreed above.


Now if you like the above, just change my name to the FinancialDave Intermediate bond fund, which at this point in it's history only has the above two bonds and one investor (FD.) Are the results any different? On day one the fund bought one $10,000 bond at 5% and on day 2 because of a large inflow it bought another $10,000 bond at 7%. It doesn't really matter how you twist it - if FD is the only investor, he will have still only earned $6,000 at the end of 5 years - 6%.

PS. nothing is re-invested in the fund.

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Re: "Get out of bond funds"

Post by ogd » Thu May 15, 2014 3:22 pm

FinancialDave wrote: Ok, lets build on this common ground.

If I buy a $10,000, 5 Year bond earning 5% on day 1 - at the end of 5 years I will have $12,500, if I put all the interest in my piggy bank.
Say interest rates go up to 7% on day 2. I take another $10,000 and buy this 7% bond, from which I will essentially (forgetting the 1 day) have $13,500 at the end of 5 years. So what has happened - with an extra $10,000 "inflow" I have increased my "interest" (or coupon payments) to 6%. So as an individual investor, it seems very important to me (who only likes 5 year bonds) to have some "inflow" money if I want any chance of improving my return in a rising interest rate environment. If I don't have any additional money coming in I am stuck with the 5% return - whether I sell it or keep it - as you agreed above.
fd -- we've been here before.

But anyway. Two things you're forgetting. The original $10K investment does not own half the fund, but only 47.8%, because at the time the second $10K came in, it bought more shares than originally (share price was $91.62 instead of $100).

The second is the difference between "interest" and "return". Looking at total return: the 5% part of the fund makes $12500. The 7% part of the fund makes $13500. After 5 years, the fund has returned $26000, ignoring reinvestment. Of this, the share of the original investor is $12428 which is about the same as the $12500 that they would have made otherwise, the small difference being due to the increased opportunity for coupon reinvestment that we left out of the picture.

The inflows did not provide higher returns. They may or may not have temporarily increased the coupon share of total return, until (in practice) the fund turns the bonds over. This is important because on the other side of the coin, outflows do not cause losses to the remaining shareholders either. Which is a big deal if you want to feel safe investing in a fund subject to the whims of its investors.

This is much more clear if you make it a fund of zero coupon bonds, btw. Coupons only muddy the picture with their complex pricing and reinvestment.

I don't know how else to argue this, sorry. If you still have a disagreement, we'll have to leave it at that.

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Re: "Get out of bond funds"

Post by FinancialDave » Thu May 15, 2014 3:54 pm

I am trying to simplify the math for both of us (or maybe just me).

The example above is for brand new bonds. Call them a zero coupon if you like but I think the income is the same - except of course that you don't pay $10k for a zero, you would discount the price, but the effect is you still earn 5% or 7% (un-compounded)

You are trying to make the example much more complex than it needs to be.

If you need to go back to the single investor and think of the money he is putting in his piggy bank.
He gets one check for $250 every 6 months.
The second bond bought later when rates went up to 7% is sending him a check of $350 every six months, can't be simpler than that.

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Re: "Get out of bond funds"

Post by ogd » Thu May 15, 2014 4:22 pm

fd -- in your simplification you have lost track of capital returns, which are significant for an interest rate move this large, as the depreciated bond slowly returns to par value and recovers that 8.4% loss within 5 years.

My math is as complex as it needs to be to represent reality and draw correct conclusions about the effects of inflows and outflows. I only left out coupon reinvestment, which is indeed not that significant over 5 years. As you can see from your side of the argument, further simplification would change the conclusion so it's clear that something got lost.

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Re: "Get out of bond funds"

Post by FinancialDave » Thu May 15, 2014 5:05 pm

ogd wrote:fd -- in your simplification you have lost track of capital returns, which are significant for an interest rate move this large, as the depreciated bond slowly returns to par value and recovers that 8.4% loss within 5 years.

My math is as complex as it needs to be to represent reality and draw correct conclusions about the effects of inflows and outflows. I only left out coupon reinvestment, which is indeed not that significant over 5 years. As you can see from your side of the argument, further simplification would change the conclusion so it's clear that something got lost.
What get's lost is how bonds work when you "muddy" up the water by re-investing the dividends. Maybe it is you who needs to look at it from a zero coupon perspective. I know you are just trying to add a touch of reality to the picture, but I truly think you are missing my point.

My point is that if all investors take the coupon payments out of the bond or bond fund and spend them, the math becomes very simple. No new money is created and the return on a 5% bond is going to be 5% (un-compounded) at the end of it's maturity. Does not matter where the interest rates go -- this is what you agreed to earlier - that essentially if you purchase a 5% / 5 year bond and you stay invested to the maturity date you will get your 5% back, even if rates are 10% because all that bond knows is a coupon payment of $500 per year.

Re-investing the dividends is just someone's choice to invest their income in a low yielding bond fund. The investors of the FD bond fund have chosen to invest the income elsewhere.

I think you are getting too hung up on bond funds - just think of the income that is going to come from a single 5% bond over its life - zero coupon or otherwise - from a single owner.


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Re: "Get out of bond funds"

Post by ogd » Thu May 15, 2014 5:20 pm

fd -- like I was saying, I too left out dividend reinvestment from the picture. This isn't the problem.

What you left out is the capital return, which is a much bigger sin as it's 8.4% over the 5 years to maturity. This is the key piece that makes the old bond just as good as the new bond going forward, meaning that the new investors don't bring a better bond to the fund, just one with a different shape of distributions. If we were talking about zero coupons, the new bonds would be precisely identical to the old bonds, i.e. the same price.

This all means that inflows and outflows don't matter for a fund's returns, modulo the effects of trading expenses and fund size on the ER. It's not useful to think of this by analogy with a savings deposit where there isn't anyone joining your deposit at a different share price. And it's incomplete to think about it in terms of coupons alone. It just doesn't work. I gave my total return argument above, if you find fault with it (as opposed to a simplification) then we have a discussion.

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Re: "Get out of bond funds"

Post by FinancialDave » Thu May 15, 2014 5:47 pm

ogd,

You don't seem to be reading my threads as they continue to get simpler until I can get some agreement.

My current FD bond fund has ONE 5% bond in it with a 5 year maturity. It has one investor (or 100) but at the end of 5 years the bond will have returned the original investment ($10,000 or $10 million) plus 5% x 5 years - no matter where interest rates go.

Of course the duration of the bond fund will be zero at the end of the 5 years in this particular example, as no buys or sells were done.

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Re: "Get out of bond funds"

Post by dl7848 » Thu May 15, 2014 8:04 pm

Call_Me_Op wrote: She said to get out of bond funds. She was, by the way, talking about how to protect your money in light of the debt-ceiling issue in Washington. She felt that interest rates would be going up because people will spurn US Government debt, and that bond funds would be a bad place to be under this scenario.
What's really interesting is what happened in 2011 when S&P downgraded US sovereign debt for the first time. It was stocks that plunged, and US Government bonds -- the very thing that was downgraded -- became a flight to safety.

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Re: "Get out of bond funds"

Post by FinancialDave » Fri May 16, 2014 12:18 pm

ogd wrote:fd -- like I was saying, I too left out dividend reinvestment from the picture. This isn't the problem.

<The second is the difference between "interest" and "return". Looking at total return: the 5% part of the fund makes $12500. The 7% part of the fund makes $13500. After 5 years, the fund has returned $26000, ignoring reinvestment. Of this, the share of the original investor is $12428 which is about the same as the $12500 that they would have made otherwise, the small difference being due to the increased opportunity for coupon reinvestment that we left out of the picture.>


What you left out is the capital return, which is a much bigger sin as it's 8.4% over the 5 years to maturity. This is the key piece that makes the old bond just as good as the new bond going forward, meaning that the new investors don't bring a better bond to the fund, just one with a different shape of distributions. If we were talking about zero coupons, the new bonds would be precisely identical to the old bonds, i.e. the same price.

This all means that inflows and outflows don't matter for a fund's returns, modulo the effects of trading expenses and fund size on the ER. It's not useful to think of this by analogy with a savings deposit where there isn't anyone joining your deposit at a different share price. And it's incomplete to think about it in terms of coupons alone. It just doesn't work. I gave my total return argument above, if you find fault with it (as opposed to a simplification) then we have a discussion.
Ok, Let's do it your way with zero coupon bonds. Let's also forget about bond funds for the moment and think like an investor.

Investor 1 spends $10,000 for a zero that will pay him $12,500 after 5 years. He needs to spend the $12,500 at the end of 5 years.

Before even the end of the day interest rates just up 2% - he can do the following:
1. Nothing, in which case he still gets $12,500 at the end of 5 years even though everyone else that puts new money to work is making more.
2. He can sell the zero at a loss, buy a new zero with the same maturity date and still (barring costs and any mis-pricing in the market) end up with $12,500 at the end of 5 Years. Whether he gets the $12,500 from interest or capital appreciation is of no interest (except for a "possible" tax consequence.)

Is this not a true representation?
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