Maximum upside of bonds?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
pradador
Posts: 156
Joined: Thu Jun 14, 2012 9:20 pm
Contact:

Maximum upside of bonds?

Post by pradador » Tue Feb 18, 2014 12:52 am

Let's say I buy a $1,000 of 10 year treasuries at 2.75%. It will pay $27.50 every year for 10 years at which point I get my $1,000 back. Assuming I held the bond to maturity, my return would be $1,275 for a CAGR of 2.46%.

If immediately after purchase the interest rate of 10 year bonds dropped to 0.01% (my assumed minimum interest and best case scenario?) the bond could be sold at $1,274 for a one year CAGR of 27.4%. However, I'd have to reinvest at 0.01% myself and after 9 years I'd end up with $1,2750 making my CAGR over 10 years 2.46% once again.

What am I missing in this picture? It seems like bond returns are always talked about in terms of historical total return with bonds appraising in value as rates have decreased. But do they not have a maximum upside thus limiting the future return potential?

User avatar
ogd
Posts: 4854
Joined: Thu Jun 14, 2012 11:43 pm

Re: Maximum upside of bonds?

Post by ogd » Tue Feb 18, 2014 1:31 am

Yes, people often get this wrong. You do get a bonus in the short term, but over the long term the lower interest rates will hurt more than that bonus. So when you hear about the great 30 year bond bull market, remember that investors would have been rewarded 3-4 times as much if rates hadn't decreased at all (all other things equal including inflation, which is of course unlikely).

What really does help, though, is if the rate fall happens at the same time when your stocks are dropping. Then you can use the money from the increase to either live on or buy more stocks (rebalance). While the historical record only promises zero correlation, not negative correlation, this zig-zag has held up lately, the rates tend to drop (or be dropped) when the economy is in trouble.

The opposite is true of rate increases: painful in the short term, leading to higher rewards in the long term (except in the case of inflation).

z3r0c00l
Posts: 1241
Joined: Fri Jul 06, 2012 11:43 am
Location: NYC
Contact:

Re: Maximum upside of bonds?

Post by z3r0c00l » Tue Feb 18, 2014 6:47 am

If you sell as soon as rates drop, then they go up to 7% the next day. The world economy collapses, but you can buy back the same bonds cheaply and earn great returns. Then when it goes back down to .01%, you sell again. Never going to happen, but a man can dream. More realistically, the rates will slowly go up over time and you will keep buying in with new money and just about beat inflation. No one said bonds would be exciting, but they are predictable. Inflation is less predictable.

User avatar
nisiprius
Advisory Board
Posts: 37075
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Maximum upside of bonds?

Post by nisiprius » Tue Feb 18, 2014 7:56 am

As a buy-and-hold investor, even if there are small departures in practice, the way I think about bonds is in terms of holding to maturity. To me, fluctuations in value are just a nuisance. To take advantage of an "upside" in bonds involves speculation. I don't even think of bonds as having an upside. As far as I'm concerned, bonds make money through interest payments, not through capital appreciation. Capital appreciation when it does occur is just an accident and isn't important.

If you plan to throw away all the interest payments, then I don't much point in holding bonds unless you are capable of playing psych-out-the-market head games and score speculative wins over other investors who are trying to do the same thing to you.

The big problem is that, if I do notice that the value of a bond is up, what exactly do I do? If I sell the bond, what can I buy with it? Bond math guarantees that any similar bond I want to buy will be elevated in price, too.

There's no way to exploit the upside. Well, you can rebalance of course, sell bonds that are up to buy stocks that are down. Sophisticated investors can swap back and forth along the yield curve. But it's all pretty much small potatoes.

In theory the upside would depend as you say on your assumptions about possible movements in interest rates and the maximum depends on what you assume are the maximum possible interest rate movements... and since there is technically no conceivable limit, it's all judgement. If you look at the actual price chart for something like the Vanguard Long-Term Treasury fund, certainly movements of 20% over periods of a few years have occurred...

Image

...but plot it along with price movements for a stock fund and and you see that compared to stocks it pretty well amounts to nothing.

Image

Meanwhile, if you look at the end of last year, over the same period of time that the price of the bond fund was briefly up 40%, the total return of the bond fund to a buy and hold investor grew to 9 times its original value.

Image

In other words, the bond fund added 800% to its original value, of which about 760% was from interest payments and 40% was through capital appreciation (of which 20% has recently been lost).
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
Peculiar_Investor
Posts: 1161
Joined: Thu Oct 20, 2011 12:23 am
Location: Calgary, AB
Contact:

Re: Maximum upside of bonds?

Post by Peculiar_Investor » Tue Feb 18, 2014 8:13 am

pradador wrote:Let's say I buy a $1,000 of 10 year treasuries at 2.75%. It will pay $27.50 every year for 10 years at which point I get my $1,000 back. Assuming I held the bond to maturity, my return would be $1,275 for a CAGR of 2.46%.
What about any return generated by reinvesting the annual interest payments. Obviously the future reinvestment rate is unknown. Doesn't bond math therefore make the assumption that you'll be able to reinvest the annual interest payments at the original rate of 2.75%, so your Yield-to-Maturity is 2.75%.
Normal people… believe that if it ain’t broke, don’t fix it. Engineers believe that if it ain’t broke, it doesn’t have enough features yet. – Scott Adams

Buffetologist
Posts: 336
Joined: Sun Aug 22, 2010 8:58 am

Re: Maximum upside of bonds?

Post by Buffetologist » Tue Feb 18, 2014 9:49 am

In Bogle On Mutual Funds, he shows that the dominant factor of the return on investment in a bond or a bond fund is the initial coupon rate or the initial yield.

Therefore, original poster, you are correct. The expected return on bonds is puny. The 30 year return is irrelevant.

Personally, I own no medium to long bond funds. They make little sense to me. It's just not enough extra return to bear the interest rate risk. I have a 2.75% mortgage which has 9 years to go, which if I ever feel inclined to go "long" on bonds, I can make prepayments and is still better than anything currently offered.

For the fixed income portion of my portfolio, I have Ally CDs paying 2.95% that I bought in 2010, but those will mature next year, and Ally no longer offers those with a 60 day early withdrawal penalty, so new CD's kind of lock you in which makes them really intermediate term. If rates don't improve by maturity, I might just throw them into the mortgage.

I max out on I-bonds which currently pay 1.38%

From about 2008-2013, I could find FDIC banks that were paying more after-tax than I could get in a Vanguard short-term bond fund. However, with Ally eliminating the 60 day early withdrawal penalty, that situation has deteriorated, and 3 year returns accounting for the early withdrawal penalty are comparable, and you have to deal with the risk that the bank doesn't let you out before maturity. Currently Barclays 5 year CDs seem like the best deals if you can bear that risk.

I have recently started putting new money into Vang Limited Term Tax Free and Vang Short Term Corporate, whichever has a higher after tax SEC yield on the day I make the investment. In my bracket, they keep switching. I'm always on the lookout for something better though. After tax returns are still less than 1%.

pradador
Posts: 156
Joined: Thu Jun 14, 2012 9:20 pm
Contact:

Re: Maximum upside of bonds?

Post by pradador » Tue Feb 18, 2014 5:07 pm

nisiprius wrote:As a buy-and-hold investor, even if there are small departures in practice, the way I think about bonds is in terms of holding to maturity. To me, fluctuations in value are just a nuisance. To take advantage of an "upside" in bonds involves speculation. I don't even think of bonds as having an upside. As far as I'm concerned, bonds make money through interest payments, not through capital appreciation. Capital appreciation when it does occur is just an accident and isn't important.
I think this is my thinking as well and I'm trying to reconcile this with the role of bonds in my portfolio. In a buy and hold scenario, it sounds like interest payments will be the primary driver for my bond returns. However, I constantly see discussions on the board about bond diversification and returns in the 5-10% range. Are these returns not impossible now with bonds so close to 0%?

Looking at another common bond proxy on the board, the 5-year treasury. It currently sits at 1.46% and had historic lows around 0.54%. In the same dates, bank CDs and savings accounts have had higher rates than that. I start thinking that maybe I should sit in cash while bond yields rise but then it all starts sounding like market timing and what not.

So I guess my real question then is... with a 35+ year horizon, isn't inflation risk very high with bonds at these levels? Bonds sound safe but having 30%-40% of my savings lose in real returns feels riskier than the alternatives.

User avatar
greg24
Posts: 3304
Joined: Tue Feb 20, 2007 10:34 am

Re: Maximum upside of bonds?

Post by greg24 » Tue Feb 18, 2014 5:13 pm

MUCH lower than stocks. 100% stocks is the only answer.

User avatar
ogd
Posts: 4854
Joined: Thu Jun 14, 2012 11:43 pm

Re: Maximum upside of bonds?

Post by ogd » Tue Feb 18, 2014 5:51 pm

pradador wrote:Looking at another common bond proxy on the board, the 5-year treasury. It currently sits at 1.46% and had historic lows around 0.54%. In the same dates, bank CDs and savings accounts have had higher rates than that. I start thinking that maybe I should sit in cash while bond yields rise but then it all starts sounding like market timing and what not.
See also my recent thread http://www.bogleheads.org/forum/viewtop ... 0&t=132601 . Treasury funds, or 5 year-ish Treasuries rolled manually, are on track for returning in the range of 2.5% - 3% a year without any change in rates, because of those risks. They do not get unrewarded. The intellectual basis for not trying to market time is that the market also sees what you see coming, faster and more precisely, and prices it in. In my mind, the only valid reason for shifting fixed income is finding investments that the general market doesn't have access to, that are unusually good, and often times CDs and savings accounts do qualify.

As a side note, that thread and line of thinking also shows why market pricing of bonds matters.
pradador wrote:So I guess my real question then is... with a 35+ year horizon, isn't inflation risk very high with bonds at these levels? Bonds sound safe but having 30%-40% of my savings lose in real returns feels riskier than the alternatives.
Both current inflation and the market's prediction thereof are very low for at least the next decade. One consolation is that unlike a year ago, you can get positive real yields now starting at about 7 years duration.

User avatar
Aptenodytes
Posts: 3751
Joined: Tue Feb 08, 2011 8:39 pm

Re: Maximum upside of bonds?

Post by Aptenodytes » Tue Feb 18, 2014 6:01 pm

pradador wrote:I constantly see discussions on the board about bond diversification and returns in the 5-10% range. Are these returns not impossible now with bonds so close to 0%?
5-10% returns might occur briefly, but over the long run, which is where we live, they are impossible. If you wanted to be tantalized by unsustainable yields, why cap at 10%? The right foreign bond in the right interest rate and currency environment could go up 100%.

I plan for a a little under 2% real return on my fixed income investments.

RNJ
Posts: 767
Joined: Mon Apr 08, 2013 9:06 am

Re: Maximum upside of bonds?

Post by RNJ » Tue Feb 18, 2014 6:10 pm

pradador wrote:
Looking at another common bond proxy on the board, the 5-year treasury. It currently sits at 1.46% and had historic lows around 0.54%. In the same dates, bank CDs and savings accounts have had higher rates than that. I start thinking that maybe I should sit in cash while bond yields rise but then it all starts sounding like market timing and what not.

So I guess my real question then is... with a 35+ year horizon, isn't inflation risk very high with bonds at these levels? Bonds sound safe but having 30%-40% of my savings lose in real returns feels riskier than the alternatives.
I posed a related question on another thread (http://www.bogleheads.org/forum/viewtop ... 0&t=133174) and have these very same concerns - I'm sure many of us do. My IPS currently calls for a sizable purchase of short-term treasuries and I couldn't pull the trigger (a first for me) precisely because of the locked-in real loss (inflation rate - yield). So, with all the talk of shortening bond duration, the coming bond-bust, etc., etc., etc., I've decided to go a bit longer in duration and sticking with US treasuries (I want as close to zero credit risk as I can find) in the 5-ish year range, which is already about 1/3 of my bond allocation. Why? Because it roughly matches the current inflation rate and too many people smarter than I (e.g., Larry, Wbern, et. al.) have warned strongly against going longer. And the primitive calculations I'm able to to do suggest that this is where I get the most bang for the buck at the individual-asset level. The research seems to suggest that 5 yrs works well enough at the portfolio levels, too (with EM and SV exposure). I'll hold a wee bit more cash (1%).

I'm not smart enough to make a bet on future interest rates, inflation, etc. 5 years seems to be a reasonable, middle of the road duration that gives my funds (VFIUX, IEI, FSIYX, plus some CDs and BMBIX in taxable) some time to recover if inflation picks up unexpectedly, and I have a little more protection from de-flation, to which I have substantial exposure in the form of a 28 year fixed-rate mortgage.

Ultimately, we own our ignorance, do the best with what little knowledge we have, keep our heads down and try to avoid big mistakes. And given the durations and funds we're talking about, this is all strikes me as being within the realm of the reasonable and not terribly self-destructive either way we go.
Last edited by RNJ on Tue Feb 18, 2014 11:29 pm, edited 1 time in total.

User avatar
nisiprius
Advisory Board
Posts: 37075
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Maximum upside of bonds?

Post by nisiprius » Tue Feb 18, 2014 6:31 pm

pradador wrote:...with a 35+ year horizon, isn't inflation risk very high with bonds at these levels? Bonds sound safe but having 30%-40% of my savings lose in real returns feels riskier than the alternatives...
Oh, if only, if only, there were some kind of bond that was, I don't know, indexed for inflation or something like that. One could imagine a parallel universe in which there were, what could you call them? Real return bonds? Treasury inflation protected securities? I know what you'll say "Dreamer! Get your head out of the clouds! No such thing exists or could possibly exist. If they really existed, someone somewhere outside the Bogleheads forum would have mentioned them."

<Irony off>.

I cannot personally imagine buying a long-term nominal bond unless I were matching it with a long-term nominal obligation. But I do own individual TIPS. As for something like the Vanguard Total Bond Index Fund, because of the constant turnover in the portfolio, I am moderately confident that it will sorta-kinda more or less tend to roughly track inflation--which of course is all that stocks do.

I admit that I am not sure why I own any nominal bonds at all. I don't see any particular reason not to go 100% TIPS. But I'm chicken to get too far out of the mainstream.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
docneil88
Posts: 927
Joined: Mon Apr 30, 2007 3:39 pm
Location: Taxable

Re: Maximum upside of bonds?

Post by docneil88 » Tue Feb 18, 2014 7:11 pm

The US 10-year note yield has never gone negative. So that limits the upside price of a 10-year. There's also the maximum downside to consider. The US 10-year note yield reached over 14% in 1982. That would wreak utter havoc on prices. And it's not inconceivable that the US government credit quality drops dramatically or that the gov't defaults on 10-year notes in the next 10 years. With the 10-year US Treasury yield now at 2.75%, there's a lot more downside potential than upside potential. Best, Neil
Last edited by docneil88 on Tue Feb 18, 2014 7:17 pm, edited 1 time in total.

patrick
Posts: 1636
Joined: Fri Sep 04, 2009 3:39 am
Location: Mega-City One

Re: Maximum upside of bonds?

Post by patrick » Tue Feb 18, 2014 7:16 pm

If you hold to maturity and spend the interest payments when you get them, the amount you get (in nominal terms) is known in advance. But if you reinvest the interest payments, you are better off if interest rates increase. This is because even though the principal repayment is known if holding to maturity, you don't know the reinvestment price for the interest payments. If these get reinvested at higher interest rates then they leave you with more money in the end.

As a result, the hypothetically possible upside is pretty much unlimited. Imagine interest rates surging to 50000% right after you buy the bond. The first year's coupon payments on would be 2.46% of the purchase price, but you would reinvest them in a bond yielding 50000%, meaning that over the next year the interest on the interest would be enormous, and gets larger each year with more reinvested interest. The capital loss at the start (which would be nearly total) would be much smaller than the interest you collect on the reinvested interest and in any case is recovered when principal is paid at maturity. Also there could be extreme deflation in which case the purchasing power could surge dramatically even if your nominal savings amount stays the same. Which is not to say that either of these is a likely scenario...

pradador
Posts: 156
Joined: Thu Jun 14, 2012 9:20 pm
Contact:

Re: Maximum upside of bonds?

Post by pradador » Tue Feb 18, 2014 8:32 pm

nisiprius wrote:Oh, if only, if only, there were some kind of bond that was, I don't know, indexed for inflation or something like that. One could imagine a parallel universe in which there were, what could you call them? Real return bonds? Treasury inflation protected securities? I know what you'll say "Dreamer! Get your head out of the clouds! No such thing exists or could possibly exist. If they really existed, someone somewhere outside the Bogleheads forum would have mentioned them."

<Irony off>.

I cannot personally imagine buying a long-term nominal bond unless I were matching it with a long-term nominal obligation. But I do own individual TIPS. As for something like the Vanguard Total Bond Index Fund, because of the constant turnover in the portfolio, I am moderately confident that it will sorta-kinda more or less tend to roughly track inflation--which of course is all that stocks do.

I admit that I am not sure why I own any nominal bonds at all. I don't see any particular reason not to go 100% TIPS. But I'm chicken to get too far out of the mainstream.
You kid but you're right ahead of my thoughts. Real returns are what matters. Diversification makes sense. Not being in 100% stocks makes sense. Heck longer term bonds in an equity heavy portfolio make sense. But with bonds so close to this ceiling they start not making sense. Enter TIPS. Switch to long term TIPS with PIMCO's LTPZ ETF for a diversification kick without worrying about inflation. Then, why not 100% TIPS? Hmm, sounds too good to be true so what am I missing? Even if it makes sense, you said it best, I don't like "stray too far from the mainstream" risk. For now, I sit 60/20/20 PTTAX/LTPZ/BNDX while I develop a better understanding.

Post Reply