Bonds - The Little Book of Common Sense Investing

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Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

One of my favorite investment books. Most investors would be well served to read this book.

I thought it would be good to look at Jack's advice regarding bonds.
1) Page 138 - While a seemingly infinite number of factors influence the stock market and each individual stock that is traded there, a single factor influences the bond market and the money market (and for that matter, each individual fixed-income security) far more than any other: the prevailing level of interest rates. Mangers of fixed-income funds can't do much, if anything, to influence rates.

2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.

3) Page 206 - The all U.S. bond market portfolio remains the bond investment of choice.

3) Page 207 - Inflation linked bonds provide excellent protection against the long term erosion of the purchasing power of the dollar.
When an investor has questions or concerns, I have found that it always works to go back to the authoritative source, such as Jack Bogle, who knows more about investing than any of us, to get clarification and answers.

Thank you Mr. Bogle!
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.

If people could remember this one it would hold down the endless parade of bond panic threads.

Rising rates are a cause for celebration, not panic.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

billyt wrote:2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.

If people could remember this one it would hold down the endless parade of bond panic threads.

Rising rates are a cause for celebration, not panic.
Indeed. I have said this exact quote to my folks who in retirement have more in fixed income than I do. They understand and are fine with the monthly dividend income.

This is why I am perplexed with the Short Term TIPS fund and possibly the Intermediate Term Fund but that pays more dividend income.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

Not sure why you are perplexed about short term TIPS. The yield is negative. That means you are steadily losing money, not making it.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

billyt wrote:Not sure why you are perplexed about short term TIPS. The yield is negative. That means you are steadily losing money, not making it.
I guess in terms of folks investing in these funds at this time....
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Re: Bonds - The Little Book of Common Sense Investing

Post by dbr »

abuss368 wrote:
billyt wrote:Not sure why you are perplexed about short term TIPS. The yield is negative. That means you are steadily losing money, not making it.
I guess in terms of folks investing in these funds at this time....
They are investing because they want an asset that is insensitive to inflation in real value and because for whatever reason they abhor seeing the fund change in value as real interest rates change. The price paid for the latter is zilch return and no cash flow. Presumably those investors are not trying to get a cash flow from that investment alone, or, if they are, they will have failed and should know so.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

Yes, I agree. I gather the argument is that you are buying inflation protection for 1% a year. Makes no sense to me as a long term investment. After 10 years, you have lost 10%. Not a good bet in my opinion.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

billyt wrote:Yes, I agree. I gather the argument is that you are buying inflation protection for 1% a year. Makes no sense to me as a long term investment. After 10 years, you have lost 10%. Not a good bet in my opinion.

That is exactly where I am on this. The fund was established in 2000 and the yield environment back then was much different. The duration is 8.5+- so in a decade of decreasing rates, the fund out performed the Total Bond Index. Now the fortunes are fast reversing the other way. Is this what is often called reversion to the mean?
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

I am fine with the regular Vanguard TIPS fund. I have been accumulating in this fund for years and the returns are attractive, even after this years 8%+ hit to the NAV. Returns will vary year to year as the NAV goes up and down. Makes no difference whatsoever in the long run. The return comes from the interest (in this case real interest, not nominal). NAV changes will sum to zero over investing life time. I am very happy to see the real yields going up, and no longer negative.

The short term TIPS fund makes no sense to me at negative real yields.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

This book was written before the launch of the Vanguard Total International Bond Index fund.

However, unless I am mistaken, Jack Bogle has recommended to not invest in this fund.
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Re: Bonds - The Little Book of Common Sense Investing

Post by Code Commit »

abuss368 wrote:This book was written before the launch of the Vanguard Total International Bond Index fund.
However, unless I am mistaken, Jack Bogle has recommended to not invest in this fund.
Is that the deciding criteria why you shouldn't hold it (that Jack Bogle does not recommend it?)? If so, could you name three of your own holdings that he would not recommend holding or overweighting?

P.S. I have nothing for or against international bond fund. I don't own it. But I think we all read/follow various authors (Bogle, Swensen, Ferri, Larimore, Bernstein, Swedroe, etc.), but in the the end, make our own choices. I believe Bogle himself said during Bogleheads 11 - "If there's one place I don't want people to take my advice, it's international. I want you to think it through for yourself." I agree with him.
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Re: Bonds - The Little Book of Common Sense Investing

Post by 500Kaiser »

I appreciate the reminder of what Mr. Bogle has advised. It has served me personally well for over 20 years, and helps me keep focused with all the noise around. Thanks for posting.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

500Kaiser wrote:I appreciate the reminder of what Mr. Bogle has advised. It has served me personally well for over 20 years, and helps me keep focused with all the noise around. Thanks for posting.
No problem.

Happy New Year!
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Re: Bonds - The Little Book of Common Sense Investing

Post by denovo »

billyt wrote:2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.

If people could remember this one it would hold down the endless parade of bond panic threads.

Rising rates are a cause for celebration, not panic.
Not true. Rising interest rates hurt bond prices. It may not matter for an accumulator, but if you are in the stage where you are drawing from these funds to pay for your retirement expenses, spikes in interest rates will hurt.
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Re: Bonds - The Little Book of Common Sense Investing

Post by dimbmw »

abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

I thought it would be good to look at Jack's advice
2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.
How long is this "long run" ? It's not the first thread where I see this phrase, but I think it was never supported by any calculation.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

The confusion here stems from focusing on the mark to market values of the bond price; the NAV.

Bonds are issued with a fixed coupon and a par value. It is issued at par and redeemed at par. In between, the face value of a bond is determined by the prevailing interest rates.

So if you buy at issue and hold to maturity, the par value has no impact at all on your return, in spite of the fact that the value will fluctuate while you are holding it.

All of the return is from the coupon (interest).

A bond fund is a rolling bond ladder and its behavior, on average, is similar to the underlying investments. Virtually all of the return comes from the interest payments, any gain or loss from NAV changes averages out to zero in the long run.

What is the long run? For a bond fund, approximately 1x to 2x duration.

An investing lifetime is 50-60 years or about 10x the duration of an intermediate term bond fund. Sometimes you will purchase at higher than average NAV and sometimes lower than average. Same for selling. Both the buy and sell NAV vary to a small degree around the par value of the bond. Over time the average difference between the buy and sell NAV is zero.

Yes, when interest rates rise, it can be distressing to see the market value of your bond fund suddenly drop. The key to remember is that the expected return of your bond fund has just increased.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

P.S. If you want a more coherent and elegant explanation, read Jack's book. He does a much better job than I do.
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Re: Bonds - The Little Book of Common Sense Investing

Post by dimbmw »

billyt:

sometimes a small calculation helps much more than a thousand of words.

I am not sure if your phrase that when one's bond fund nav drops, he/she should be happy with the increased return makes sense to me, because I calculate my returns in comparison with my initial investment, and not current nav.
So if I invest $1M now in the intermediate bond fund returning just 2%, I will be unhappy if the NAV of my fund will suddenly drop to, say, $500K, with the yield increase from 2% to 4%. And it will take about 25 years for the NAV to just return to the initial $1M.
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Re: Bonds - The Little Book of Common Sense Investing

Post by CWRadio »

dimbmw wrote:billyt:

sometimes a small calculation helps much more than a thousand of words.

I am not sure if your phrase that when one's bond fund nav drops, he/she should be happy with the increased return makes sense to me, because I calculate my returns in comparison with my initial investment, and not current nav.
So if I invest $1M now in the intermediate bond fund returning just 2%, I will be unhappy if the NAV of my fund will suddenly drop to, say, $500K, with the yield increase from 2% to 4%. And it will take about 25 years for the NAV to just return to the initial $1M.
Is there a APP that you put the fund current NAV in, and it will watch the interest rate of the fund, and then tell you in the number of years when the NAV will return to its initial amount? Thanks
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

Sure. The simplistic calculation is that the NAV will shift by the duration for a 1% increase in interest rates.

To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.

That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.

By the end of the 5th year, you have $110, the as you expected from $100 at 2%.

By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.

When interest rates rise, your rate of return is increased.
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Re: Bonds - The Little Book of Common Sense Investing

Post by Tom_T »

We've all either read about, or posted, the rule-of-thumb that says a bond's NAV will drop 1% for every year of average duration, given a 1% rate hike. But, that's not how things generally work. Changes don't generally happen that suddenly.

The 10-year Treasury went from 1.75% to 3% during the whole of 2013. A year ago, there were many people who fretted over what would happen to their intermediate-term bond fund if rates went up 125 basis points in a year. What happened to Vanguard Intermediate-Term Treasury? The NAV dropped from 11.67 to 11.12, or- 4.7%. Its total return for 2013 was around -3%. That's not exactly a bloodbath.

And, if we saw the same type of rise this year, it would probably be less painful because you're getting a higher rate of interest.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

The important point to remember is that a bond fund is just a collection of bonds and will behave like the underlying investment (a bond fund is a rolling bond ladder).

For bonds held to maturity, all the income comes from the interest.

For a bond fund held for a few multiples of duration, almost all of the return comes from the interest.

Bonds are issued at face value and mature at face value, changes in NAV are only realized when if you sell before maturity.

Bond funds NAV's fluctuate around the underlying bonds face value. Sometimes you will buy higher, sometimes lower. Same when you sell. On average the buy and sell NAV will sum to zero.

All of the return comes from the interest.
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Re: Bonds - The Little Book of Common Sense Investing

Post by ogd »

dimbmw wrote:So if I invest $1M now in the intermediate bond fund returning just 2%, I will be unhappy if the NAV of my fund will suddenly drop to, say, $500K, with the yield increase from 2% to 4%. And it will take about 25 years for the NAV to just return to the initial $1M.
dimbmw: for rates increasing 2% to 4%, TBM will drop about 10.9% (2% times duration 5.45), which will take a little less than 3 years to recover.

A drop of 50% would only happen for an interest increase to more than 12%, which is impossible in the current climate and in the foreseeable future. Even then, it will only take about 4 years to get your money back.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

dimbmw wrote:
abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

I thought it would be good to look at Jack's advice
2) Page 139 - So let's be clear: In the long run, virtually 100 percent of the return on any bond fund or money market fund is accounted for by the net interest income it generates for its shareholders.
How long is this "long run" ? It's not the first thread where I see this phrase, but I think it was never supported by any calculation.
I would consider writing a letter to Mr. Bogle, who knows more about investing than any of us, at his research center on the Vanguard campus. Perhaps he can provide a "calculation".
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Re: Bonds - The Little Book of Common Sense Investing

Post by Stonebr »

abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

Thank you Mr. Bogle!
This is actually my favorite of all the Bogle, Boglehead, Malkiel, Graham, Ellis books. It cuts through the crap and boils this investment philosophy down to its essence. It gives a first impression of being the simplest and most elementary of Bogle's books, but its zen-like directness makes it the most advanced.
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Re: Bonds - The Little Book of Common Sense Investing

Post by guymo »

billyt wrote: To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.
That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.
By the end of the 5th year, you have $110, the as you expected from $100 at 2%.
By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.
Probably a stupid question (first post, forgive me) but how does the bond fund suddenly start returning $3 annually when interest rates rise?

If it had a collection of bonds yielding $2 annually the day I bought it, I don't see how it can start to produce $3 without selling the old bonds and buying new ones -- but selling my now-$95-worth of 2% bonds and buying 3% bonds will not return me $3 annually.
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Re: Bonds - The Little Book of Common Sense Investing

Post by ogd »

guymo wrote:Probably a stupid question (first post, forgive me) but how does the bond fund suddenly start returning $3 annually when interest rates rise?

If it had a collection of bonds yielding $2 annually the day I bought it, I don't see how it can start to produce $3 without selling the old bonds and buying new ones -- but selling my now-$95-worth of 2% bonds and buying 3% bonds will not return me $3 annually.
The answer is the bonds lose a part of their value (worth below 100), then start regaining it as they approach maturity. The sum of coupon and par payments jumps to 3% annualized. An example I posted in another thread, from current Treasury pricing:

Maturity Coupon Bid Asked Chg Asked yield
5/15/2023 1.750 90.2109 90.2734 -0.0703 2.944

This bond is a close approximation to the 10 year Treasury lows this year, 1.750 in April. Now that the Treasury yields are 3%-ish, the bond has adjusted to approximately that YtM (2.944%, but it's a 9.5 year bond by now), at the cost of a 10% drop in value. It doesn't matter whether the fund waits until maturity or not, that final $100 payment is always factored into the price.

If you just think about coupons, lots of things don't make sense about bonds, since the repayment of principal is such a big part of a bond's life.
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Re: Bonds - The Little Book of Common Sense Investing

Post by dimbmw »

guymo wrote:
Probably a stupid question (first post, forgive me) but how does the bond fund suddenly start returning $3 annually when interest rates rise?

If it had a collection of bonds yielding $2 annually the day I bought it, I don't see how it can start to produce $3 without selling the old bonds and buying new ones -- but selling my now-$95-worth of 2% bonds and buying 3% bonds will not return me $3 annually.

I think you understand it right. The fund will sell your bonds that lost their NAV at a loss for you. And then you will have to wait years hoping to recover losses by earning interest the fund pays.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

dimbmw:
What? Where do you get that from? ogd has it right.

The formula that I gave you is approximately correct. Duration times interest rate rise equals NAV loss and the new interest rate applies immediately.

This is a simplification of what actually happens.

In reality, the NAV hit is temporary paper loss that is only realized if you sell the fund.

Bonds are a promise of payment of future principal and interest. The future value never changes, only the present value.

Yes, if rates rise the present value goes down, but with each passing day the present value approaches the future value asymptotically. The NAV recovers all on its own. Holding to maturity is almost never optimal in terms of return.

In the simplified formula I gave you, resetting the interest rate immediately effectively approximates this effect.
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Re: Bonds - The Little Book of Common Sense Investing

Post by Taylor Larimore »

Stonebr wrote:
abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

Thank you Mr. Bogle!
This is actually my favorite of all the Bogle, Boglehead, Malkiel, Graham, Ellis books. It cuts through the crap and boils this investment philosophy down to its essence. It gives a first impression of being the simplest and most elementary of Bogle's books, but its zen-like directness makes it the most advanced.
Abuss and Stonebr:

Well said!

I once heard that Mr. Bogle's Little Book of Common Sense Investing is the best seller of all his books. These are excerpts:

http://socialize.morningstar.com/NewSoc ... spx#196005

Best wishes.
Taylor
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Re: Bonds - The Little Book of Common Sense Investing

Post by ogd »

dimbmw wrote:I think you understand it right. The fund will sell your bonds that lost their NAV at a loss for you. And then you will have to wait years hoping to recover losses by earning interest the fund pays.
The main activity of the fund is selling a bond and replacing it with a bond of longer maturity, with a higher YtM, so as to keep average duration constant vs the passage of time. It doesn't matter, except for arcane tax purposes, whether the bond is depreciated or trading at par or premium. Look at these two bonds:

Maturity Coupon Bid Asked Chg Asked yield
3/31/2018 0.750 97.2578 97.2734 0.1406 1.415
3/31/2018 2.875 106.0391 106.0703 0.0781 1.395

One is quite depreciated, one is quite premium, yet they will make me pretty much the same money (the second pays slightly more slightly sooner, hence the small difference). Does it matter which one I sell to replace with a 10 year bond yielding 3%? The interest rate increase recently caused a "loss" on the first one and a "smaller gain" on the second, but it doesn't matter which one I "realize" because by the nature of the bond market these two are nearly indistinguishable. All I care about is that the replacement transaction makes me more money and keeps me on my desired duration / return tradeoff.

It's clear to me that you're working with a primitive understanding of bond pricing. Until you really understand this, I beg of you, don't go playing with $2M in individual bonds like you're considering in the other thread. Get an honest advisor if you must, or better yet a fund. Otherwised you will get fleeced, particularly in the muni market, or at best make less than you should by holding far too much in lower maturities earning you less than a savings account (a problem with ladders of bonds held to maturity).
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

Taylor Larimore wrote:
Stonebr wrote:
abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

Thank you Mr. Bogle!
This is actually my favorite of all the Bogle, Boglehead, Malkiel, Graham, Ellis books. It cuts through the crap and boils this investment philosophy down to its essence. It gives a first impression of being the simplest and most elementary of Bogle's books, but its zen-like directness makes it the most advanced.
Abuss and Stonebr:

Well said!

I once heard that Mr. Bogle's Little Book of Common Sense Investing is the best seller of all his books. These are excerpts:

http://socialize.morningstar.com/NewSoc ... spx#196005

Best wishes.
Taylor
Thank you for the link Taylor!

That is a great book!
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Re: Bonds - The Little Book of Common Sense Investing

Post by guymo »

billyt wrote:dimbmw:
What? Where do you get that from? ogd has it right.

The formula that I gave you is approximately correct. Duration times interest rate rise equals NAV loss and the new interest rate applies immediately.

This is a simplification of what actually happens.

In reality, the NAV hit is temporary paper loss that is only realized if you sell the fund.



In the simplified formula I gave you, resetting the interest rate immediately effectively approximates this effect.
Thanks: the clarification that you were giving a simplified approximation was all I needed -- I think I now have figured it out. The key point that I overlooked was that at the 5-year point in your example the position was the same ($110 total) as it would have been with no change in interest rate. So overall, what happened in the example you gave is essentially equivalent to what happens if you buy a 5-year 2% bond, hold it to maturity, and then replace it with a 3% bond.
Holding to maturity is almost never optimal in terms of return.
Would you mind explaining that a bit please? If I haven't got my head on backwards I would guess that selling a bond before maturity is like betting that interest rates will rise --- is that right?

Thanks again.
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

If you hold to maturity, your are forgoing interest that could be earned by selling prior to maturity and investing in a longer-term higher yielding bond.

Look at today's Treasury yields (approximately):

10 yr 3%; 5 yr 1.7%, 2 yr .4%, 1 yr .1%.

Assuming yield curve doesn't change: You buy a 10 year treasury, and its present value increases as it slides down the yield curve. Why does its present value increase? Think about it: Which would you pay more for: a brand new 5 year treasury with a 1.7% coupon or a 5 year old 10 year treasury with a 3% coupon? After 5 years, you could continue to hold and collect 1.7% for the next 5 years, or sell it at a profit and buy another 10 year earning 3%. Somewhere between the 5th an 8th year, you will only collect 1% addition by holding to maturity, or sell at a profit and reinvest at 3%.

Holding to maturity reduces your earnings. This is why longer duration bond funds have higher rates of return.
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Re: Bonds - The Little Book of Common Sense Investing

Post by denovo »

billyt wrote:Sure. The simplistic calculation is that the NAV will shift by the duration for a 1% increase in interest rates.

To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.

That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.

By the end of the 5th year, you have $110, the as you expected from $100 at 2%.

By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.

When interest rates rise, your rate of return is increased.
What if you are using bonds for current income, then the scenario is not so rosy.
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Re: Bonds - The Little Book of Common Sense Investing

Post by pingo »

abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

Thank you Mr. Bogle!
abuss368 wrote:That is a great book!
Stonebr wrote:This is actually my favorite of all the Bogle, Boglehead, Malkiel, Graham, Ellis books. It cuts through the crap and boils this investment philosophy down to its essence. It gives a first impression of being the simplest and most elementary of Bogle's books, but its zen-like directness makes it the most advanced.
Taylor Larimore wrote:I once heard that Mr. Bogle's Little Book of Common Sense Investing is the best seller of all his books.
As it should be!

I love that Little Book Of Common Sense Investing! It is my all time favorite argument concerning the merits of index fund investing, although I'll tip my hat to Common Sense On Mutual Funds since The Little Book Of Common Sense Investing would not exist without John Bogle's earlier work. In a choice between the two, I always recommend John Bogle's Little Book.
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Re: Bonds - The Little Book of Common Sense Investing

Post by peppers »

The Gotrocks Family :)
"..the cavalry ain't comin' kid, you're on your own..."
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Re: Bonds - The Little Book of Common Sense Investing

Post by ogd »

denovo wrote:What if you are using bonds for current income, then the scenario is not so rosy.
It's the above minus X% per year. The X% has to come from somewhere, in any scenario, right? You wouldn't compare a scenario in which you spend with a scenario (say, cash) in which you don't.

It's not ideal if the X% is large and bites into your capital, much like selling any depreciated asset before it has time to recover. It would be best, and quite realistic for most portfolios, to spend from stocks when bonds are down (rebalance via spend), or prepare for large short-term withdrawals by shifting into lower duration / cash proactively.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

peppers wrote:The Gotrocks Family :)
That was a great introduction to the book in the first chapter. Own all the business and collect the profits. That chapter really put a lot in perspective for me. Once the family started hiring advisors and trading companies it makes one think and reflect.
John C. Bogle: “Simplicity is the master key to financial success."
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

pingo wrote:
abuss368 wrote:One of my favorite investment books. Most investors would be well served to read this book.

Thank you Mr. Bogle!
Stonebr wrote: This is actually my favorite of all the Bogle, Boglehead, Malkiel, Graham, Ellis books. It cuts through the crap and boils this investment philosophy down to its essence. It gives a first impression of being the simplest and most elementary of Bogle's books, but its zen-like directness makes it the most advanced.
Taylor Larimore wrote:I once heard that Mr. Bogle's Little Book of Common Sense Investing is the best seller of all his books.
As it should be!

I love that Little Book Of Common Sense Investing! It is my all time favorite argument concerning the merits of index fund investing, although I'll tip my hat to Common Sense On Mutual Funds since The Little Book Of Common Sense Investing would not exist without John Bogle's earlier work. In a choice between the two, I always recommend John Bogle's Little Book.
I like all of Mr. Bogle's books. I have about 4 or 5 more on my shelf to read yet.
John C. Bogle: “Simplicity is the master key to financial success."
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

denovo wrote:
billyt wrote:Sure. The simplistic calculation is that the NAV will shift by the duration for a 1% increase in interest rates.

To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.

That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.

By the end of the 5th year, you have $110, the as you expected from $100 at 2%.

By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.

When interest rates rise, your rate of return is increased.
What if you are using bonds for current income, then the scenario is not so rosy.
I would expect a lot of retirees use the monthly bond dividends for income.
John C. Bogle: “Simplicity is the master key to financial success."
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Re: Bonds - The Little Book of Common Sense Investing

Post by denovo »

abuss368 wrote:
denovo wrote:
billyt wrote:Sure. The simplistic calculation is that the NAV will shift by the duration for a 1% increase in interest rates.

To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.

That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.

By the end of the 5th year, you have $110, the as you expected from $100 at 2%.

By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.

When interest rates rise, your rate of return is increased.
What if you are using bonds for current income, then the scenario is not so rosy.
I would expect a lot of retirees use the monthly bond dividends for income.
Exactly my point.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

denovo wrote:
abuss368 wrote:
denovo wrote:
billyt wrote:Sure. The simplistic calculation is that the NAV will shift by the duration for a 1% increase in interest rates.

To the nearest dollar: Invest $100 in a bond fund paying 2% with a 5 year duration, and interest rates rise to 3% the day after you invest.

That 1% increase in rates means a 5% hit to your NAV: Your investment is now worth $95, but it is now earning 3%.

By the end of the second year, you are back to $101.

By the end of the 5th year, you have $110, the as you expected from $100 at 2%.

By the end of the 10th year you have about $128, more than the $122 dollars you expected from $100 at 2%.

When interest rates rise, your rate of return is increased.
What if you are using bonds for current income, then the scenario is not so rosy.
I would expect a lot of retirees use the monthly bond dividends for income.
Exactly my point.
That is one of my sticking points with TIPS. The income, if any (review Vanguard's distribution history on it's website), is very irregular and sometimes none at all for a quarter. That has to impact a retiree.
John C. Bogle: “Simplicity is the master key to financial success."
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Re: Bonds - The Little Book of Common Sense Investing

Post by dimbmw »

ogd wrote:
dimbmw wrote:I think you understand it right. The fund will sell your bonds that lost their NAV at a loss for you. And then you will have to wait years hoping to recover losses by earning interest the fund pays.
The main activity of the fund is selling a bond and replacing it with a bond of longer maturity, with a higher YtM, so as to keep average duration constant vs the passage of time. It doesn't matter, except for arcane tax purposes, whether the bond is depreciated or trading at par or premium. Look at these two bonds:

Maturity Coupon Bid Asked Chg Asked yield
3/31/2018 0.750 97.2578 97.2734 0.1406 1.415
3/31/2018 2.875 106.0391 106.0703 0.0781 1.395

One is quite depreciated, one is quite premium, yet they will make me pretty much the same money (the second pays slightly more slightly sooner, hence the small difference). Does it matter which one I sell to replace with a 10 year bond yielding 3%? The interest rate increase recently caused a "loss" on the first one and a "smaller gain" on the second, but it doesn't matter which one I "realize" because by the nature of the bond market these two are nearly indistinguishable. All I care about is that the replacement transaction makes me more money and keeps me on my desired duration / return tradeoff.

It's clear to me that you're working with a primitive understanding of bond pricing. Until you really understand this, I beg of you, don't go playing with $2M in individual bonds like you're considering in the other thread. Get an honest advisor if you must, or better yet a fund. Otherwised you will get fleeced, particularly in the muni market, or at best make less than you should by holding far too much in lower maturities earning you less than a savings account (a problem with ladders of bonds held to maturity).


I actually don't understand what particularly did you consider a primitive understanding in my reply?

If the fund buys a bond at, say, $100, and the next day it's NAV drops to,say, $90 because of interest rates increase, then yes, you lost money, your $10, and then you start to recover your losses by getting a higher interest rate (with the same bond or with the one that the fund will decide to buy instead of this one).

on the same page 139 of the Bogle's book, just the next phrase after the one quoted above: "The only way for a manager to add an increment to that return is to make interest rate bets-for example, by selling bonds when he expects rates to go up (and prices down), and then buying bonds when the reverse is expected to happen".
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Re: Bonds - The Little Book of Common Sense Investing

Post by billyt »

One part that you are missing is that the NAV recovers on its own, as the bonds slide down the yield curve.
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Re: Bonds - The Little Book of Common Sense Investing

Post by pingo »

abuss368 wrote:This book was written before the launch of the Vanguard Total International Bond Index fund.
However, unless I am mistaken, Jack Bogle has recommended to not invest in this fund.
Code Commit wrote:Is that the deciding criteria why you shouldn't hold it (that Jack Bogle does not recommend it?)? If so, could you name three of your own holdings that he would not recommend holding or overweighting?

P.S. I have nothing for or against international bond fund. I don't own it. But I think we all read/follow various authors (Bogle, Swensen, Ferri, Larimore, Bernstein, Swedroe, etc.), but in the the end, make our own choices. I believe Bogle himself said during Bogleheads 11 - "If there's one place I don't want people to take my advice, it's international. I want you to think it through for yourself." I agree with him.
+1

Nothing I have ever read or heard from John Bogle's has led me to believe anything but the following: his statements about international investing is a simple question of his philosophy, willingness, need and tolerance for risk which are of paramount importance for anyone to consider when investing. He doesn't care for international investing because he's risk averse to it! He loves his great country. There he has prospered and he will always have a personal, internal sense (not just calculations) concerning the U.S. economic and investment environment. He continues to have great faith in the future of the U.S. and is willing and only willing to accept U.S. market risk. For him, it is enough and I respect him for saying so.
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Re: Bonds - The Little Book of Common Sense Investing

Post by pingo »

billyt wrote:Not sure why you are perplexed about short term TIPS. The yield is negative. That means you are steadily losing money, not making it.
abuss368 wrote:This is why I am perplexed with the Short Term TIPS fund and possibly the Intermediate Term Fund but that pays more dividend income.
It has as much to do with philosophy and conviction in order to stay the course as anything else. A steady stream of dividend income is a comfort and less abstract way to see that one's investments are producing a return from which one may live comfortably.

I agree with abuss368 that a Barclay's aggregate bond index fund or "total bond fund" is, or can be enough, although it seems to have fallen a little out of favor with Mr. Bogle lately. I agree that all the handwringing about bonds and where to put bond money and worries about interest rates have driven too many investors to worry about things over which they still very little control. Most investors would be well served, perhaps even best served, by a Total Bond fund. One would be hard pressed to find a better or more appropriate fund for the bond portion of the portfolio. And as stated in another discussion:
[url=http://www.bogleheads.org/forum/viewtopic.php?f=10&t=129426]In this post[/url] abuss368 wrote:[It] is amazing that our parents generation (and others) invested and retired quite fine without TIPS! Makes one put things into perspective a little better.
If the idea of convexity in Total Bond makes one restless, I guess one uses intermediate-term treasuries. I also think that Short-Term TIPS can make perfect sense for some investors. For example, if one wants...

1. The opportunity for relative principal protection for a portion of the portfolio.
2. Relative stability.
3. Relative safety via high quality instruments, i.e. treasuries so there is no credit risk.

...all of which are relative anyway and which relate to each other in one way or another, then Short-Term TIPS can be a simple, hybridized way to achieve those purposes with a single fund.

Does it perplex anyone that William Bernstein still recommends and uses Short-Term Treasuries, whose income stream and purpose is hardly distinguishible from that of Short-Term TIPS? Why would anyone want those either?

Bernstein: Take Risks In Stocks, Not Bonds

What's The Purpose Of Your Fixed Income Holdings?

CNNMoney: The Worst Investing Mistake

And then there's the mere fact that one's choice of bonds may be heavily influenced by what's available in one's employer retirement plan.
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Re: Bonds - The Little Book of Common Sense Investing

Post by ogd »

dimbmw wrote:
ogd wrote:
dimbmw wrote:I think you understand it right. The fund will sell your bonds that lost their NAV at a loss for you. And then you will have to wait years hoping to recover losses by earning interest the fund pays.
...snip...
I actually don't understand what particularly did you consider a primitive understanding in my reply?

If the fund buys a bond at, say, $100, and the next day it's NAV drops to,say, $90 because of interest rates increase, then yes, you lost money, your $10, and then you start to recover your losses by getting a higher interest rate (with the same bond or with the one that the fund will decide to buy instead of this one).
The part I highlighted, which is that the sale causes a loss. Consider your example, $100 depreciated to $90. I'll add yield numbers to the example: the bond started at, say, 2% for 5 years and if it depreciated to $90 the interest rates must have jumped to 4.23%. By holding the original bond to maturity I get $10 of capital appreciation, plus another $10 in coupons, total $110. Now if I sell it and replace it with a fresh bond trading at $100 and making 4.23% interest, I get no capital appreciation, but I get $90 x 5 x 4.23% = $19.03 interest; total $119.03, i.e. pretty much the same; slighly less because the fresh bond pays me more money sooner, e.g. $3.8 in the first year vs $2, which is considered more valuable because I can reinvest.

So I can sell depreciated bonds back and forth and I end up in the same place. It's not the sale that causes the loss, it's what you held at the time of the increase. If you're considering holding 5 year bonds anyway, it doesn't matter whether you hold them on your own or in an intermediate fund, they will be hit just the same and the fund's activities will not make the matters worse.

In practice, what the fund actually does is replace the 5 year bond with maybe a 10 year to keep duration constant, which at steep yield curves like today means getting maybe 5% instead of 4.25%. So the roll transaction is making me more money, not causing a loss. However, steep yield curves are not expected to persist, which brings us to your next point.
dimbmw wrote:on the same page 139 of the Bogle's book, just the next phrase after the one quoted above: "The only way for a manager to add an increment to that return is to make interest rate bets-for example, by selling bonds when he expects rates to go up (and prices down), and then buying bonds when the reverse is expected to happen".
This is true because of the curve-flattening expectation that I mentioned; this is why the SEC yield is a good predictor of returns despite the fact that rolling bonds on the current yield curve would seem to generate higher returns. But note that the bond manager in a boring conservative fund like Vanguard's is not making bets when replacing bonds, just simply keeping duration constant, because bond duration decreases every day by, well, about one day so it has to be actively kept in check.

I said "primitive understanding" when I should have perhaps used the nicer word "incomplete", so apologies there. I think the part you're missing is that prices of depreciated bonds appreciate constantly towards par at about the rate of current market yields (edit: minus the coupon rate of the original bond) for the remaining period, they don't simply stay at $90 until just before maturity and then jump to $100. So it follows that selling at any point between now and maturity is not a bone-headed decision that you could avoid if you were your own bond manager. You are simply trading one YtM for another, comparable or higher.
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Re: Bonds - The Little Book of Common Sense Investing

Post by abuss368 »

pingo wrote:
Nothing I have ever read or heard from John Bogle's has led me to believe anything but the following: his statements about international investing is a simple question of his philosophy, willingness, need and tolerance for risk which are of paramount importance for anyone to consider when investing. He doesn't care for international investing because he's risk averse to it! He loves his great country; There he has prospered and he will always have personal, internal sense (not just calculations) concerning the U.S. economic and investment environment. He continues to have great faith in the future of the U.S. and is willing and only willing to accept U.S. market risk. For him, it is enough and I respect him for saying so.
Hi pingo,

That was very nicely said.

Thanks.
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Re: Bonds - The Little Book of Common Sense Investing

Post by columbia »

I've seen a lot of hand wring over even TBM in the last week.
So what's the alternative (for long term investors)?
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