The 'Hold Bonds to Maturity' Problem

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Phineas J. Whoopee
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The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 12:41 pm

Hi everyone,

I've observed with keen interest thread after thread and post after post positing individually-held bonds are risk free because they can be held to maturity, while bond funds are risky because there is no specific maturity date. I presume others have as well. I've been thinking about that, and I bet I'm not alone.

What's your opinion on this here three-paragraph statement I just writ down right here right now:

As Bogleheads often write, bond funds are equivalent to rolling ladders of the same credit quality and average duration. Assets have market values, whether or not their owners want to pay attention to them. Posters who claim they're avoiding risk by buying and rolling a ladder with each bond held to maturity are under an illusion. The problem is, you can't hold all of them to maturity unless you pick an end date. Otherwise you have to keep rolling them and rolling them until eventually you go on a journey far far away where bonds will be of no use.

If a person is spending the interest from the bonds then that's what they're doing whether individually-held or in a fund. If they're selling bonds, or selling shares in a fund, they're taking the principal or the price the market offers, either of which stops the roll. Unless they can predict with precision their date of death they will never know when it's time to to cap their ladder.

A non-rolling ladder is genuinely different from rolling ladders and funds, but if one is using diversification to moderate risk, rather than a liability-matching strategy, a person can't reliably tell when to stop rolling.

Did I get it partly right? Any suggestions for improvement?

[Edited once to add the blue bit, after I thought further about nisi's and some others' points.]

PJW
Last edited by Phineas J. Whoopee on Tue Dec 03, 2013 11:38 am, edited 1 time in total.

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Re: The 'Hold Bonds to Maturity' Problem

Post by linenfort » Mon Dec 02, 2013 12:45 pm

I'm not positive, but it sounds like you're talking about reinvestment risk.
Even if you're not, it is a risk to which bond holders are exposed.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 12:47 pm

linenfort wrote:I'm not positive, but it sounds like you're talking about reinvestment risk.
Not at all. I'm talking about the oft-stated claim that holding bonds to maturity is less risky than holding a fund. I explicitly accounted for spending the interest (or dividends in the case of a fund) rather than reinvesting it.
PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Mon Dec 02, 2013 12:49 pm

Yes, I think that is essentially correct. Those afraid of NAV loss are reacting irrationally. I would expect that professional bond fund managers will outperform a do it yourself rolling bond ladder where every bond is held to maturity. A bond index fund reflects the sum total of all transactions in the market, which are largely being made by professionals trying to extract every last cent of total return.

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Re: The 'Hold Bonds to Maturity' Problem

Post by linenfort » Mon Dec 02, 2013 12:50 pm

Phineas J. Whoopee wrote:
linenfort wrote:I'm not positive, but it sounds like you're talking about reinvestment risk.
Not at all. I'm talking about the oft-stated claim that holding bonds to maturity is less risky than holding a fund. I explicitly accounted for spending the interest (or dividends in the case of a fund) rather than reinvesting it.
PJW
Well, in the non-rolling example, yes. But, I figured that most of us have to keep rolling.
I'll have to reread.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 12:54 pm

linenfort wrote:
Phineas J. Whoopee wrote:
linenfort wrote:I'm not positive, but it sounds like you're talking about reinvestment risk.
Not at all. I'm talking about the oft-stated claim that holding bonds to maturity is less risky than holding a fund. I explicitly accounted for spending the interest (or dividends in the case of a fund) rather than reinvesting it.
PJW
Well, in the non-rolling example, yes. But, I figured that most of us have to keep rolling.
I'll have to reread.
We may mean different things by the term reinvestment risk. I mean the definition Investopedia uses, which is about reinvesting the coupons, not investing the principal in some other bond once it's returned.
PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by linenfort » Mon Dec 02, 2013 12:57 pm

You're right, PJW. I was too hasty with my reply.
Time for me to back away from the keyboard for a bit. :-)

I am interested in this because I hold a lot of bonds directly, but
I have VCIT (corp bond index fund) as well.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Raybo » Mon Dec 02, 2013 1:06 pm

I think your description is correct if you are replacing a fund with a rolling bond ladder. I'm not sure anyone here advocates that.

Where I see buying and holding bonds suggested is in Liability Matching threads where one buys a bond to cover a shortfall of income in some future year. In this instance, the "rolling" nature of funds doesn't really address the problem.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Call_Me_Op » Mon Dec 02, 2013 1:06 pm

I am not sure what people are thinking when they say that holding individual bonds is safer than holding similar bonds in a mutual fund. However, there seems to be an additional risk in a fund versus a rolling ladder of individual bonds (with the exception of nominal treasuries, which are highly liquid at all times). We have often discussed this risk on the board - and it is called "sell-off risk" or "redemption risk." It appears to be a function of the difference in price between (illiquid) bonds sold intra-day (perhaps during a panic) and their end-of-day value that is used to compute the NAV. There is a theoretical risk here, where those who continue to hold the fund eat a loss that is caused by the sellers of the fund. Nobody (to my knowledge) has quantified this risk - but that doesn't mean it is non-existent.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Ketawa » Mon Dec 02, 2013 1:11 pm

This is one of the common errors on Bogleheads, even though it's pretty thoroughly debunked in the Individual bonds vs a bond fund wiki article.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 1:18 pm

Call_Me_Op wrote:I am not sure what people are thinking when they say that holding individual bonds is safer than holding similar bonds in a mutual fund. However, there seems to be an additional risk in a fund versus a rolling ladder of individual bonds. We have often discussed this risk on the board - and it is called "sell-off risk" or "redemption risk." It appears to be a function of the difference in price between (illiquid) bonds sold intra-day (perhaps during a panic) and their end-of-day value that is used to compute the NAV. There is a theoretical risk here, where those who continue to hold the fund eat a loss that is caused by the sellers of the fund. Nobody (to my knowledge) has quantified this risk - but that doesn't mean it is non-existent.
Interesting point Call_Me_Op. Presumably that risk is greatest in a concentrated fund, setting aside US Treasuries, and least in a very broadly-based fund.

Vanguard, as also often discussed here, says in its prospectuses it has the right to delay payment for a week, or even to redeem in kind. I've far less experience with non-Vanguard bond funds (PIMCO Total Return and Real Return in a 401(k) - I did for years hold non-Vanguard equity funds, like Dreyfus Midcap Index back when Vanguard offered no indexed complement to S&P 500 and until shortly after Mellon [reference to a fastener] it up).

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 1:22 pm

Ketawa wrote:This is one of the common errors on Bogleheads, even though it's pretty thoroughly debunked in the Individual bonds vs a bond fund wiki article.
I see the distinction between rolling and non-rolling ladders, but not anything about the point I raised, that one can't tell when to stop rolling. If I missed it: A) you or some other helpful poster will point it out; and B) I think I'll have to make an appointment with my optometrist. :happy
PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by ogd » Mon Dec 02, 2013 1:26 pm

PJW: I like to show this by making a three way comparison between cash, individual bonds and bond funds after a rate hike.. Suppose three investors hold the following at rates of 2% / 5 years:

Investor A holds cash, in some form that's immediately accessible.
Investor B holds a fresh 5 year Treasury at par (duration 4.77 years, or slightly longer to bring duration to 5)
Investor C holds a Treasury fund with duration 5 years.

Now if rates double to 4% overnight:
Investor A: if needs money tomorrow, no loss. If they want to buy bonds, they can make 4% over 5 years.
Investor B: if needs money tomorrow, 10% loss. If they hold steady, they make 2%/yr over 5 years before having a chance to reinvest at 4%.
Investor C: if needs money tomorrow, 10% loss. If they hold steady, they make 2%/yr over 5 years provided interest rates stop growing, 4% thereafter. If they're afraid of the further hikes and want a guarantee, they can sell their fund, buy the same treasury as B at the 10% discounted price, and make a guaranteed 2% on the original purchase amount.

So investor B, as much as they'd like to think that they're in the same boat as investor A, are in the same boat as investor C. The day after what you might call Bond Armageddon by historical standards (2% hike overnight), the portfolios of B and C are still interchangeable. B's holding individual bonds got him no protection at all, although it probably got him a lot of extra work. It only protected him from seeing the 10% loss, depending on exactly how their bond portfolio is displayed (I'm guessing a "Portfolio Watch" type of view would kill that illusion).

The other thing I like to point out when people talk about the guaranteed returns of ladders as if they stop reinvesting the instant that rates rise: why in the world would you do that? Buy the ladder at 2% yields, but not at 4% yields? It makes absolutely no sense, barring a most unusual need for precisely timed distributions that match the natural lumpiness of a ladder. Most of us use bonds as a counterweight to stocks on a long-term, ongoing basis; in any event, provisioning future distributions is better done by using zero coupon bonds that bear little or no resemblance to a ladder.

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Re: The 'Hold Bonds to Maturity' Problem

Post by nisiprius » Mon Dec 02, 2013 1:28 pm

Now, let me be honest and say I don't do this in any very disciplined way... the truth is that I started buying individual TIPS before I knew of the existence of TIPS funds--I think I bought the first before there WERE any TIPS funds--and it got to be a habit.

But, in theory, you stop rolling when the bond maturity matches the planned-for obligation. For example, for the income you need in 2020, you use the proceeds from the bonds that mature in 2020, rather than selling bonds that will mature at some other time. Plus the interest from the whole ladder.

Of course, longevity risk is a problem, but that is a problem in any case.
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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Mon Dec 02, 2013 1:29 pm

I am pretty sure that so called "sell off risk" is a myth. There have been very significant redemptions in bond funds this year with no evidence for it. If intra-day bond transactions during a down day in the bond market can hurt NAV, then transactions during an up day must help NAV. One would think long term that its a wash.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 1:34 pm

nisiprius wrote:Now, let me be honest and say I don't do this in any very disciplined way... the truth is that I started buying individual TIPS before I knew of the existence of TIPS funds--I think I bought the first before there WERE any TIPS funds--and it got to be a habit.

But, in theory, you stop rolling when the bond maturity matches the planned-for obligation. For example, for the income you need in 2020, you use the proceeds from the bonds that mature in 2020, rather than selling bonds that will mature at some other time. Plus the interest from the whole ladder.

Of course, longevity risk is a problem, but that is a problem in any case.
Thanks for this. You're talking about a non-rolling ladder. I'm talking about rolling vs. funds. I agree, and said in my OP, rolling and non-rolling ladders are fundamentally different, but that if one is using bonds for diversification one never knows when to start doing what you're talking about. I didn't mention, and maybe I should have, that "if one is using diversification to moderate risk" is a different strategy from using a liability-matching portfolio.

Yes, you're right, longevity risk is precisely the problem. That's why nobody (or at least very few, and those who can are the sad cases) can decide when to change from diversification to liability matching.

Now, institutions live forever (or at least have no built-in aging mechanism) but not so we little boys. They have their problems, but they're different from ours.

PJW
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Re: The 'Hold Bonds to Maturity' Problem

Post by Call_Me_Op » Mon Dec 02, 2013 1:38 pm

billyt wrote:I am pretty sure that so called "sell off risk" is a myth. There have been very significant redemptions in bond funds this year with no evidence for it.
How can you tell?

Larry Swedroe has indicated to me that the risk is real, and Annette Thau discussed it in "The Bond Book", but does not explain it. I agree with you that over a long period of time, it should average-out. But then it is still a risk in the sense that currency risk is a risk. It would theoretically increase volatility of returns.
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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Mon Dec 02, 2013 1:41 pm

You can tell because changes in NAV are in line with that expected from the interest rate changes and the fund durations. Where is the excess NAV drop that can be attributed to sell of losses?

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Re: The 'Hold Bonds to Maturity' Problem

Post by Call_Me_Op » Mon Dec 02, 2013 1:46 pm

billyt wrote:You can tell because changes in NAV are in line with that expected from the interest rate changes and the fund durations. Where is the excess NAV drop that can be attributed to sell of losses?
This effect may only be evident in major liquidity events - such as occurred in 2008. I have not studied the 2008 data to look for this.

It does seem that most claims that this risk is significant are accompanied by a lot of hand-waving. I'd still like to hear Larry elaborate.
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Re: The 'Hold Bonds to Maturity' Problem

Post by thx1138 » Mon Dec 02, 2013 1:52 pm

@Call_Me_Op and billyt

The "sell off" risk in funds came up in an early thread. Looking back at any bond funds a Boglehead would actually hold (i.e. broad based index funds) there didn't seem to be any sign at all of "permanent NAV loss" during the 2008 crash. It seems to very much be a theory that might apply to a small fund full of low liquidity bonds held by panicky investors with no trading restrictions in place. The reality seems to be that not one Vanguard fund saw any signs of this happening during the crash of the century.

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Re: The 'Hold Bonds to Maturity' Problem

Post by LH » Mon Dec 02, 2013 2:44 pm

my conceptual problem is not with holding bonds to maturity, its what exactly is happening inside a bond fund....

A bond fund like AGG, will have what, a duration around 6 years, but will have 80 percent turnover annually or something.

Then, if the NAV of the fund drops, then what?

Are you basically, since you did not sell the fund, still conceptually holding all the bonds to maturity (or whatever the "equivalent" is since there is 80 percent turnover to begin with, obviously, its a somewhat sythnetic thing to begin with, they are not holding much to maturity in reality with 80 percent turnover).

Say a bond fund just bought 100 bonds. did not sell any. You bought 1 dollar of the fund, spread out amongst the 100 bonds. If thats all they did, and held to maturity, if you did not sell, then you basically held the bonds to maturity, even though the NAV is bouncing around... right? Its the same thing as holding an individual bond, the bond price will jump around if you marked it to market.

2) But with a bond fund, you have to sell at some point, and you CANNOT sell individual bonds at maturity to exit it. You have to just sell all mixes of bonds at once whenever you take any money out. So

2a)when you buy a bond fund, you are buying multiple bonds at a marked to market price.

2b)when you exit, you are selling multiple bonds at a marked to market price

Versus a ladder, where you can sell ONLY when the bond matures if you choose, and reality/need does not get in the way.
Last edited by LH on Mon Dec 02, 2013 2:53 pm, edited 1 time in total.

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Re: The 'Hold Bonds to Maturity' Problem

Post by LH » Mon Dec 02, 2013 2:50 pm

nisiprius wrote:Now, let me be honest and say I don't do this in any very disciplined way... the truth is that I started buying individual TIPS before I knew of the existence of TIPS funds--I think I bought the first before there WERE any TIPS funds--and it got to be a habit.

But, in theory, you stop rolling when the bond maturity matches the planned-for obligation. For example, for the income you need in 2020, you use the proceeds from the bonds that mature in 2020, rather than selling bonds that will mature at some other time. Plus the interest from the whole ladder.

Of course, longevity risk is a problem, but that is a problem in any case.
Yeah, the theory of matching, is hard to apply in reality to a single individual, as you have both run over by a truck tomorrow risk, longevity risk, as well as need a whole bunch of money now to buy a liver on the grey market risk.

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Re: The 'Hold Bonds to Maturity' Problem

Post by ogd » Mon Dec 02, 2013 3:05 pm

LH wrote:2) But with a bond fund, you have to sell at some point, and you CANNOT sell individual bonds at maturity to exit it. You have to just sell all mixes of bonds at once whenever you take any money out. So

2a)when you buy a bond fund, you are buying multiple bonds at a marked to market price.

2b)when you exit, you are selling multiple bonds at a marked to market price

Versus a ladder, where you can sell ONLY when the bond matures if you choose, and reality/need does not get in the way.
LH: I'd put it this way:

While you want to stay invested in bonds, you might as well hold the fund instead of the ladder. Getting par value for a maturing bond only to put it back in bonds doesn't make a material difference. If anything, with the current yield curve it means you're holding very short bonds yielding nothing with a significant portion of the money, instead of having it in a 1% savings account.

When you decide to exit bonds over N years and spend it or put it in something else, you could switch from the fund to the equivalent ladder with no additional loss since both are marked to the same market. Of course, at that point you might find that a different shape of distributions makes the best sense. The point is -- you don't really have to prepare for the exit and hold a ladder preemptively, you can make that switch when the exit is imminent and meanwhile enjoy your extra free time that you didn't spend researching bond quality and such. (Yes, I am aware that the convenience argument is much diminished with Treasuries).

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Mon Dec 02, 2013 3:09 pm

LH wrote:my conceptual problem is not with holding bonds to maturity, its what exactly is happening inside a bond fund....
Sure, let's talk.
LH wrote:A bond fund like AGG, will have what, a duration around 6 years, but will have 80 percent turnover annually or something.
They're maintaining average duration and credit quality, which I specified in my OP would have to be equivalent for a rolling ladder to be the same as any particular bond fund.
LH wrote:Then, if the NAV of the fund drops, then what?
Assuming an open-ended fund, it's exactly the same as what would happen to the market value of your individually-held bond portfolio on that day. I acknowledged that some asset owners might not want to pay attention to changing values, but they change just the same. Or, if I may paraphrase a well-regarded thinker, and yet it fluctuates.
LH wrote:Are you basically, since you did not sell the fund, still conceptually holding all the bonds to maturity (or whatever the "equivalent" is since there is 80 percent turnover to begin with, obviously, its a somewhat sythnetic thing to begin with, they are not holding much to maturity in reality with 80 percent turnover).
No. You are not. You are rolling your ladder with 80% turnover. As long as credit quality and average duration are the same there's little difference. Short- to intermediate-term bond prices just don't change all that much, especially over mere year-long periods of time (turnover is measured on a per-year basis).
LH wrote:Say a bond fund just bought 100 bonds. did not sell any. You bought 1 dollar of the fund, spread out amongst the 100 bonds. If thats all they did, and held to maturity, if you did not sell, then you basically held the bonds to maturity, even though the NAV is bouncing around... right?
Yup.
LH wrote:2) But with a bond fund, you have to sell at some point, and you CANNOT sell individual bonds at maturity to exit it. You have to just sell all at once whenever you take any money out. So
2a)when you buy a bond fund, you are buying multiple bonds at a marked to market price.
2b)when you exit, you are selling multiple bonds at a marked to market price
Yup, except that's precisely my point. If you maintain a rolling ladder, it behaves the same as a bond fund. If you stop it rolling, you're putting a limit on the time you keep up the strategy.

You yourself don't "have to sell at some point." You can keep rolling (or hold the fund) from here until you shuffle off this mortal coil.

If you know in advance when you're going to graduate from Earthly life, you can just sell your bond fund when you find out, and buy bonds on the open market to mature between now and then. You're not gaining or losing anything, because the bond market prices all the bonds like, well, what? Like bonds at that moment. The fund's net asset value is based on the prices of the underlying bonds. If you sell your bonds (via the fund), and purchase equivalent bonds but now with an intent to roll no more, you neither gain nor lose, aside from spreads and commissions and the like.

Does that help with the concept? If not, ask again and I'll try to further clarify the issues for you.

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by Ketawa » Mon Dec 02, 2013 3:17 pm

LH wrote:Then, if the NAV of the fund drops, then what?

You are compensated with a higher yield.

Are you basically, since you did not sell the fund, still conceptually holding all the bonds to maturity (or whatever the "equivalent" is since there is 80 percent turnover to begin with, obviously, its a somewhat sythnetic thing to begin with, they are not holding much to maturity in reality with 80 percent turnover).

Say a bond fund just bought 100 bonds. did not sell any. You bought 1 dollar of the fund, spread out amongst the 100 bonds. If thats all they did, and held to maturity, if you did not sell, then you basically held the bonds to maturity, even though the NAV is bouncing around... right? Its the same thing as holding an individual bond, the bond price will jump around if you marked it to market.

It's not the same as holding one individual bond. It is about the same as holding a ladder of invidual bonds with a constant duration.

2) But with a bond fund, you have to sell at some point, and you CANNOT sell individual bonds at maturity to exit it. You have to just sell all mixes of bonds at once whenever you take any money out. So

2a)when you buy a bond fund, you are buying multiple bonds at a marked to market price.

2b)when you exit, you are selling multiple bonds at a marked to market price

Versus a ladder, where you can sell ONLY when the bond matures if you choose, and reality/need does not get in the way.

If you're not selling, you're buying, and all the other invidual bonds in your portfolio are being "bought" at whatever price they are currently worth.

If someone is actively making the decision not to reinvest a maturing bond, then we're talking about someone who has decided to have a declining duration, not a constant duration. You can also make your duration decline by rebalancing between two bond funds with different durations.
Last edited by Ketawa on Mon Dec 02, 2013 3:19 pm, edited 1 time in total.

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Mon Dec 02, 2013 3:19 pm

Bond managers also sell bonds when it is clear that reinvesting the proceeds will improve total return beyond what can be earned by holding to maturity. Index funds follow the market consensus. Holding to maturity is generally a low-return strategy.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Swivelguy » Mon Dec 02, 2013 3:24 pm

ogd wrote:PJW: I like to show this by making a three way comparison between cash, individual bonds and bond funds after a rate hike.. Suppose three investors hold the following at rates of 2% / 5 years:

Investor A holds cash, in some form that's immediately accessible.
Investor B holds a fresh 5 year Treasury at par (duration 4.77 years, or slightly longer to bring duration to 5)
Investor C holds a Treasury fund with duration 5 years.

Now if rates double to 4% overnight:
Investor A: if needs money tomorrow, no loss. If they want to buy bonds, they can make 4% over 5 years.
Investor B: if needs money tomorrow, 10% loss. If they hold steady, they make 2%/yr over 5 years before having a chance to reinvest at 4%.
Investor C: if needs money tomorrow, 10% loss. If they hold steady, they make 2%/yr over 5 years provided interest rates stop growing, 4% thereafter. If they're afraid of the further hikes and want a guarantee, they can sell their fund, buy the same treasury as B at the 10% discounted price, and make a guaranteed 2% on the original purchase amount.
This is a small nit to pick that doesn't affect your conclusion, but wouldn't it be more accurate to say that B and C both lose 10% overnight and then proceed to earn 4% of their now-reduced holding? After 5 years it is equivalent to having made 2% on the original price, but that's not what's actually happening in the interim.

Another point to make is that a bond ladder held to maturity is not analogous to a single bond fund. A ladder will have a flat distribution of duration between 0 and the buy-in-duration, while bond funds typically maintain a bell-curve of duration centered on some target value. If you aren't someone who would hold 60-day T-bills, then you shouldn't be holding an individual T-bond until maturity either, you should sell it at 60 days.

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Re: The 'Hold Bonds to Maturity' Problem

Post by ogd » Mon Dec 02, 2013 3:50 pm

Swivelguy wrote: This is a small nit to pick that doesn't affect your conclusion, but wouldn't it be more accurate to say that B and C both lose 10% overnight and then proceed to earn 4% of their now-reduced holding? After 5 years it is equivalent to having made 2% on the original price, but that's not what's actually happening in the interim.
Swivelguy: I agree that that's the best way to look at it -- it's arguably even more important to know what you're really earning in the other case, rates dropping, when you're no longer making the 4% written on your coupon. But individual bond advocates will usually insist that they don't care about the market. So I worded it as earnings on the original amount, in all three cases (yes, even cash -- which is obviously in a privileged position).
Swivelguy wrote:Another point to make is that a bond ladder held to maturity is not analogous to a single bond fund. A ladder will have a flat distribution of duration between 0 and the buy-in-duration, while bond funds typically maintain a bell-curve of duration centered on some target value. If you aren't someone who would hold 60-day T-bills, then you shouldn't be holding an individual T-bond until maturity either, you should sell it at 60 days.
I'd call the bell curve "maturities" rather than "duration" and keep the later focused on the overall portfolio, but yes -- I agree that the short maturities are terrible (and briefly mentioned that). For the purpose of the argument though, doesn't make much difference. The equal duration portfolios will be pretty much interchangeable.

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Re: The 'Hold Bonds to Maturity' Problem

Post by docneil88 » Mon Dec 02, 2013 8:02 pm

Phineas J. Whoopee wrote:As Bogleheads often write, bond funds are equivalent to rolling ladders of the same credit quality and average duration. Assets have market values, whether or not their owners want to pay attention to them. Posters who claim they're avoiding risk by buying and rolling a ladder with each bond held to maturity are under an illusion. The problem is, you can't hold all of them to maturity unless you pick an end date. Otherwise you have to keep rolling them and rolling them until eventually you go on a journey far far away where bonds will be of no use.
Individual investors often opt for a CD ladder, which is similar to a bond ladder, except that CDs usually have a sizable penalty if you do not hold till maturity. Sometimes one must cash out early due to unexpected liquidity needs. If that happens after interest rates have gone down, you end up losing out on the higher interest rate you locked in, besides having to pay the penalty. Best, Neil

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Re: The 'Hold Bonds to Maturity' Problem

Post by jdb » Mon Dec 02, 2013 8:49 pm

docneil88 wrote:
Phineas J. Whoopee wrote:
The problem is, you can't hold all of them to maturity unless you pick an end date. Otherwise you have to keep rolling them and rolling them until eventually you go on a journey far far away where bonds will be of no use.
Good point PJW. I may be case in point, have accumulated over past 7 years or so an individual muni bond ladder with varying maturities over next 25 years, average duration around 8 years, with which I am happy. But now that I am approaching full ss age and retirement am no longer rolling bond proceeds from maturities into more long term bonds, since am comfortable with ladder as it exists and no longer want to go long term with individual bonds and do not intend to sell any individual bonds prior to maturity. Am still buying a few shorter term individual munis from time to time, but not exceeding 7 years maturity. Most of proceeds now being placed into short term Vanguard bond funds and equity index funds in accordance with my asset allocation.
Last edited by jdb on Tue Dec 03, 2013 12:16 pm, edited 2 times in total.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Svensk Anga » Mon Dec 02, 2013 9:25 pm

Phineas J. Whoopee wrote: I see the distinction between rolling and non-rolling ladders, but not anything about the point I raised, that one can't tell when to stop rolling.
PJW
I know when to stop rolling. It is 2030. That is the year we plan for my wife to take SS with delayed retirement credits. I will have done so the year prior. At that point, SS and our pensions will cover most expenses. We will be liquidating bonds until then, so avoiding fluctuating NAV's will be attractive. All the more so since presumably Fed policy will have shifted and NAV's will very likely fluctuate mostly downward for a period. We cannot be assured that the timing and extent of a rate shift will be such that higher coupons will fully compensate for the devalued capital.

After 2030, whatever FI allocation I decide to have will probably be in bond funds. At that point, we will be investing largely for the heirs, so the time horizon will be long. Amount and timing of cash needs will be unpredictable.

Some recent research from Wade Pfau finds that sequence of returns risk can be mitigated by starting retirement with a low equity allocation. One then lets the equity allocation rise over the years, contrary to the old age in bonds dictum, to guard against inflation risk. If one knows they will be spending down their FI principle, I think it is better to avoid letting the market trash that principle just before it is needed. An inflation spike could do it. You cannot be sure that real yields on a TIPS fund will not rise at an inopportune time. A TIPS ladder looks safest.

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Re: The 'Hold Bonds to Maturity' Problem

Post by TheTimeLord » Mon Dec 02, 2013 9:38 pm

Personally, I definitely prefer a ladder constructed over 10 years.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Archie Sinclair » Mon Dec 02, 2013 9:59 pm

thx1138 wrote:@Call_Me_Op and billyt

The "sell off" risk in funds came up in an early thread. Looking back at any bond funds a Boglehead would actually hold (i.e. broad based index funds) there didn't seem to be any sign at all of "permanent NAV loss" during the 2008 crash. It seems to very much be a theory that might apply to a small fund full of low liquidity bonds held by panicky investors with no trading restrictions in place. The reality seems to be that not one Vanguard fund saw any signs of this happening during the crash of the century.
It's not a risk that Vanguard lists in the prospectus, so Vanguard's institutional view must be that it is not worth mentioning.

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Re: The 'Hold Bonds to Maturity' Problem

Post by dmcmahon » Mon Dec 02, 2013 10:03 pm

Some funds may internally sell bonds before maturity, at the short end of their internal ladder. This is a source of cap gains when interest rates are falling, but a source of losses on the way back up. Moreover, funds are more likely to be forced to sell bonds to meet redemptions - investors seeing a funds NAV sinking may head for the exits forcing the managers to sell bonds.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 11:41 am

Even though I did mean to draw a distinction between a diversification strategy and anything else, the liability matching comments convinced me to add a few words to the final paragraph in my statement. It now reads:
A non-rolling ladder is genuinely different from rolling ladders and funds, but if one is using diversification to moderate risk, rather than a liability-matching strategy, a person can't reliably tell when to stop rolling.
The font color points up where the edit occurred in my OP.

Not meaning to cut anything off, but thanks everyone for the interesting comments and discussion so far.

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by FillorKill » Tue Dec 03, 2013 12:13 pm

Phineas J. Whoopee wrote:
Call_Me_Op wrote:I am not sure what people are thinking when they say that holding individual bonds is safer than holding similar bonds in a mutual fund. However, there seems to be an additional risk in a fund versus a rolling ladder of individual bonds. We have often discussed this risk on the board - and it is called "sell-off risk" or "redemption risk." It appears to be a function of the difference in price between (illiquid) bonds sold intra-day (perhaps during a panic) and their end-of-day value that is used to compute the NAV. There is a theoretical risk here, where those who continue to hold the fund eat a loss that is caused by the sellers of the fund. Nobody (to my knowledge) has quantified this risk - but that doesn't mean it is non-existent.
Interesting point Call_Me_Op. Presumably that risk is greatest in a concentrated fund, setting aside US Treasuries, and least in a very broadly-based fund.

Vanguard, as also often discussed here, says in its prospectuses it has the right to delay payment for a week, or even to redeem in kind. I've far less experience with non-Vanguard bond funds (PIMCO Total Return and Real Return in a 401(k) - I did for years hold non-Vanguard equity funds, like Dreyfus Midcap Index back when Vanguard offered no indexed complement to S&P 500 and until shortly after Mellon [reference to a fastener] it up).

PJW
As an informational note, VG bond fund holders are less susceptible to redemption risk because VG bond funds have an SEC approved exemption allowing them to participate in VGs interfund loan program whereby VG funds can lend to other VG funds for temporary or emergency purposes, subject to certain limitations/restrictions.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 12:30 pm

BBL wrote:...
As an informational note, VG bond fund holders are less susceptible to redemption risk because VG bond funds have an SEC approved exemption allowing them to participate in VGs interfund loan program whereby VG funds can lend to other VG funds for temporary or emergency purposes, subject to certain limitations/restrictions.
Thanks very much for that BBL. Although I have always voted when given the chance with Vanguard, and therefore must have read the proposal (suggestion: use the search or find tool in your browser for "interfund lending"), I completely forgot about it, or at least missed its significance. It seems to me as if, fifteen years ago, I would have voted no. I'd probably make the opposite choice today.

In 1998, the year of the proposal, I was at the peak of success of my small business, such success as I ever achieved at least, and just starting to notice the cliff ahead of me, so I'll be compassionate toward myself and think, although I should have known, it's understandable why I didn't.

(If you follow the second link scroll all the way to the bottom.)

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 2:45 pm

Svensk Anga wrote:
Phineas J. Whoopee wrote: I see the distinction between rolling and non-rolling ladders, but not anything about the point I raised, that one can't tell when to stop rolling.
PJW
I know when to stop rolling. It is 2030. That is the year we plan for my wife to take SS with delayed retirement credits. I will have done so the year prior. At that point, SS and our pensions will cover most expenses. We will be liquidating bonds until then, so avoiding fluctuating NAV's will be attractive. All the more so since presumably Fed policy will have shifted and NAV's will very likely fluctuate mostly downward for a period. We cannot be assured that the timing and extent of a rate shift will be such that higher coupons will fully compensate for the devalued capital.

After 2030, whatever FI allocation I decide to have will probably be in bond funds. At that point, we will be investing largely for the heirs, so the time horizon will be long. Amount and timing of cash needs will be unpredictable.

Some recent research from Wade Pfau finds that sequence of returns risk can be mitigated by starting retirement with a low equity allocation. One then lets the equity allocation rise over the years, contrary to the old age in bonds dictum, to guard against inflation risk. If one knows they will be spending down their FI principle, I think it is better to avoid letting the market trash that principle just before it is needed. An inflation spike could do it. You cannot be sure that real yields on a TIPS fund will not rise at an inopportune time. A TIPS ladder looks safest.
Nisiprius, of all people ( :wink: ) wrote about that, maybe back when I was still just a lurker. His position, if I understood and recall correctly, is one's plan must account for adverse events. He used simulators, Monte Carlo and perhaps otherwise, to model poor stock market performance, and concluded that, with accuracy but naturally less precision, bad stock market outcomes were similar to ordinary, and much less dispersed, bond market outcomes. The conclusion, I believe, was to save as if you're going to retire on all bonds, and be happy if your personal outcome is better.

I took that advice to heart, and with respect to my asset allocation decisions (as I've written recently in a different thread), assume my total portfolio keeps up with inflation and nothing more. In fixed income I hold a large dallop of TIPS.

Your plan to use bond funds beyond 2030 means you intend to roll a ladder, although perhaps with different credit quality and average duration than exhibited by the portfolio of bonds you hold directly today.

With all due deference to Dr. Pfau, it doesn't seem so much to me that his reasoning leads to the conclusion of holding a larger percentage of one's portfolio in bonds early in retirement, as that one should hold an adequate quantity of bonds at the beginning and plan not to spend as much. Maybe that's because I'm not trying to optimize for maximum spending, but rather for minimum risk consistent with meeting my own future financial needs and, within reason, wants.

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Tue Dec 03, 2013 3:48 pm

The real problem with holding a bond to maturity is that you make next to nothing in those last few years. Short term rates are truly pitiful, and negative after inflation, so you are losing money holding that bond to maturity.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 3:54 pm

billyt wrote:The real problem with holding a bond to maturity is that you make next to nothing in those last few years. Short term rates are truly pitiful, and negative after inflation, so you are losing money holding that bond to maturity.
Today, yes. As a general principle over time, no.
PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Tue Dec 03, 2013 3:59 pm

Inverted yield curves are rare and a special case. The rest of the time the interest rate falls and the bond price rises as it slides down the yield curve. It almost never makes sense to continue holding a bond for the last 20-30% of its lifetime unless you want to shorten your duration. It is not uncommon for short term interest rates to be less than the inflation rate.
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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 4:05 pm

billyt wrote:Inverted yield curves are rare and a special case. The rest of the time the interest rate falls and the bond price rises as it slides down the yield curve. It almost never makes sense to continue holding a bond for the last 20-30% of its lifetime unless you want to shorten your duration.
I was objecting to your words in the 40th :oops: 39th post in this thread:
billyt wrote:The real problem with holding a bond to maturity is that you make next to nothing in those last few years. Short term rates are truly pitiful, and negative after inflation, so you are losing money holding that bond to maturity.
With respect to the yield curve, you're correct that inversion is rare. It is not rare, however, for short-term yields to be more than "nothing," not to be "truly pitiful," not to be "negative after inflation," and for one not to "lose money," as distinguished from bearing opportunity cost which will always happen to all of us.

Choosing an average duration for one's fixed income portfolio is very important, and there are perfectly good reasons for an individual, as opposed to blanket advice meant for everyone, to go short under their then-current circumstances.

I like what you say, billyt. Let's not get into an argument over one set of words by replacing it with another. Pax?

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Tue Dec 03, 2013 4:09 pm

Sure. No argument from me if someone deliberately wants to go for a non-rolling bond ladder to systematically shorten duration. I was just pointing out that holding bonds to maturity is often sub-optimal for total return.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 4:10 pm

billyt wrote:Sure. No argument from me if someone deliberately wants to go for a non-rolling bond ladder to systematically shorten duration. I was just pointing out that holding bonds to maturity is often sub-optimal for total return.
That wasn't what I was talking about. I was talking about short duration, not a non-rolling bond ladder. The latter is important in the thread, and in my OP, but was not part of my response to your two prior posts.
PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by nisiprius » Tue Dec 03, 2013 4:18 pm

Phineas J. Whoopee wrote:...His position, if I understood and recall correctly, is one's plan must account for adverse events. He used simulators, Monte Carlo and perhaps otherwise, to model poor stock market performance, and concluded that, with accuracy but naturally less precision, bad stock market outcomes were similar to ordinary, and much less dispersed, bond market outcomes. The conclusion, I believe, was to save as if you're going to retire on all bonds, and be happy if your personal outcome is better....
Yes. My mental model is that roughly... if we taking "the usual statistics" at face value--projecting 1926-2013 forward and ignore "black swan" events--the paradox is that the low end of outcomes for stocks and bonds is about the same. Therefore, the prudently pessimistic investor cannot plan on stocks doing better than bonds. Therefore, I think stocks are somewhat like "free lottery tickets" with a decent chance of hitting a worthwhile jackpot.

This, by the way, make stocks a very good risky investment, much better than other risky investments, and warrants a judgement that most investors really ought to hold some meaningful allocation to stocks.

I "discovered" this when I was running Fidelity's Retirement Income Planner. It would predict that my portfolio had a certain chance of lasting so many years. It would then specifically advise me to raise my stock allocation to improve those chances. Yet, when I took its advice and ran the simulation again with its suggested higher stock allocation, the chances of portfolio survival were virtually the same, although the average terminal value was higher. This planner didn't use anything like "worst case scenarios," but it did use "10th-percentile" stock market performance. Other Monte Carlo simulators give similar results.

(Now, the next question is: if I actually believe that, then why am I not 100% in stocks? Or 200%, or 300%, or 500%? I have a number of answers to this (!) but they aren't really germane here. The big one is that the more aggressive and riskier we are, the less accurate we are at estimating that risk. LTCM, after its collapse, attribute its demise to a "ten-sigma event." If true, that means an event that would have happened once in 100,000,000,000,000,000,000,000 times. Do you believe that? Which do you think is more likely, they were really hit by an event that should have happened once a billion universe-lifetimes, or that they were wrong about the probability of the event and that it was really only, maybe, a two-sigma event?)
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Re: The 'Hold Bonds to Maturity' Problem

Post by Phineas J. Whoopee » Tue Dec 03, 2013 5:01 pm

One in a hundred sextillions? Well, in a 13.8 billion year old universe; with a hundred or two billions of galaxies; averaging hundreds of billions of stars each; many with planets; an unknown quantity of which but certainly more than "several" in the so-called circumstellar habitable zone: it could conceivably happen.

That those people at that time at that place would experience it? Probably not.

They may even know it. I like to imagine they do, but are using an incorrect distribution model to deflect blame from themselves. How many of us here on bogleheads.org can define Student's T-distribution without looking it up? The expression "ten sigma," which includes a Greek letter and a number, is pretty intimidating, and probably sounds scary to people who'd prefer not to ask precisely what that means. After all, everybody's heard of, and hates all the paperwork associated with, six-sigma, so ten-sigma must be truly monstrous.

Full disclosure: I recall the distribution, but I looked up all the numbers except the age of the universe, which I only remembered because I recently read a story saying the estimate had been upped by 100 million years.

[Edited to add] At the outside-the-Hayden-planetarium-dome-itself display in the Rose Center for Earth and Space, at the American Museum of Natural History, in the powers-of-ten exhibit, the estimated age of the universe is inscribed in metal as the number 13, and the word "billion" an inch or two behind that, with a plug of metal in between. It used to say .7. I realize only now that the purpose of using a separate plug in a hole was so they can update the third digit whenever the estimate, as it must with new information always coming in, changes.

I think I just blew my own mind.

PJW

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Re: The 'Hold Bonds to Maturity' Problem

Post by jdb » Wed Dec 04, 2013 10:16 am

billyt wrote:Inverted yield curves are rare and a special case. The rest of the time the interest rate falls and the bond price rises as it slides down the yield curve. It almost never makes sense to continue holding a bond for the last 20-30% of its lifetime unless you want to shorten your duration. It is not uncommon for short term interest rates to be less than the inflation rate.
Have read this type of comment many times, including that bond funds routinely sell short duration bonds to avoid total return problem, but does not translate to real life in my opinion. In my muni bond ladder the bonds that are doing best per market options are the longer term bonds which have burned off to just a short duration. For example, 7 years ago bought 10 year bond with 4% fixed coupon. Now three years left on duration. Still of course yielding 4% tax free. Comparable three year duration bonds yielding much less than 2%. I certainly have no reason to sell the 4% bond prior to maturity. Indeed, it is with a bit of regret that I see some of longer term bonds coming nearer to redemption or maturity since cannot replicate the yields without going out for lot longer term than am willing to go today. And certainly will not sell any of these good fixed yields prior to maturity.

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Wed Dec 04, 2013 10:54 am

jdb: You are fooling yourself. Your bond is not earning 4%, but the same as any new 3 year issue of the same quality. The difference in total return between selling that 7 year old bond today for above par value and holding onto it and collecting the 4% coupon and then the par value is negligible and exactly equal to buying a 3 year muni of the same credit quality. The bond traders know how to do the math. Fixed income is fixed at issue, both the par value and coupon are fixed and known. The present value of the bond reflects todays interest rates, not the interest rates at the time of issue.

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Re: The 'Hold Bonds to Maturity' Problem

Post by Buster65 » Wed Dec 04, 2013 10:55 am

I much prefer a laddered bond portfolio vs bond funds. I have a basket of 2/3 munis spattered with a few higher yielding corporates (1/3) and I hold to maturing and then re-up. I never worry about the price going up or down because I hold to maturity and always get my principal back. In my book this is the best way to buy bonds. I also buy full allotment of iBonds every year.

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Re: The 'Hold Bonds to Maturity' Problem

Post by billyt » Wed Dec 04, 2013 10:59 am

If you want to build your own ladder go right ahead. Just realize that there is no difference in principle between your rolling ladder and a bond fund. Furthermore, you are betting that you know more than all those bond professionals that routinely sell before maturity. Consider who you are betting against.

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