Clearing Up Misconceptions on ST Corporate Bonds

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Robert T
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Post by Robert T »

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Larry,

Thanks for the detailed explanation.

Robert
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larryswedroe
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Post by larryswedroe »

Robert
My pleasure
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SmallHi
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Robert --

Post by SmallHi »

You are correct about the early 80s ML 1-3YR Treasury series that I had. I instead looked at the Lehman 1-3YR Gov't series and found slightly different numbers...and where necessary, I updated previous posts in red.

I was able to strech some of my examples a year or so longer (longer return series on the new index), so in this case as well I have updated some numbers...

About all I have on the topic for the moment...thanks for your contributions.

sh
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Post by OptionAl »

SmallHi, thanks for a great post. Amazing it hasn't been presented here before, at least not as clearly.
Anybody got a % suggested mix (ST corp, IT, TIPS) based on equity %?
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SmallHi
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Post by SmallHi »

OptionAL,

I find for any equity percentage, ST Corporate bonds provide the best combination of risk reduction (volatility), downside protection, inflation senstitivity, total return, and risk factor diversification.

With that being said, at bond %s of 0-20%, it aint gonna matter much...almost all short-intermediate high quality (AAA/AA to Treasury) indexes coupled with a global equity portfolio produce same risk/return characteristics.

As I mentioned above, at 60/40 stock/bond allocations, 1-3YR Corporates set themselves apart by as much as 0.2% to 0.3% on a volatility adjusted basis.

Where 1-3YR Corps really become attractive (relatively speaking) is at fixed income %s of 50% or more. (40/60 allocations find equity/1-3YR corp allocations as much as 0.5% ahead of other bond options)

sh
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Post by OptionAl »

SamllHi, thanks for the clarification, though I find "0/60 allocations find equity/1-3YR corp allocations as much as 0.5% ahead of other bond options)" very counterintuitive.
Pardon my obtuseness, but do you mean that if 60% is bonds, the best total portfolio return is 1-3 year corporates? What about 70%-80%?
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SmallHi
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Post by SmallHi »

Yes,

without producing 8 - 10 different portfolio simulations:

At 80/20 stock+bond...

Any reasonable fixed income allocation has produced similar results (portfolio risk/return is dominated by equities)

At 60/40...

Portfolios with 1-3YR Corporate bonds have been mildly more mean variance efficient (ST Corporates do not hedge short term downturns as well as treasuries), and have been more inflation sensitive (with slightly better implied after tax returns -- as you needed less % in 1-3YR Corporates than, say, 1-5YR Treasuries or 5-10YR Treasuries)

At 40/60...

Portfolios with 1-3YR Corporate bonds improve risk adjusted returns by as much as 0.5%, and are very hard to argue against, as at this level, your bond results tend to dictate your portfolio results in many years.

sh

PS: there are no hard and fast rules. Bernstein makes a compelling case that value oriented investors wishing to hedge periods of poor relative value returns should opt for longer term bonds (treasuries)...and investors particularly sensitive to losses may still want to opt for short to medium term treasuries (short treasuries hedged downturns better from mid 60s to mid 90s, with intermediate term treasuries working better since)
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gbs
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Post by gbs »

Best Mixes for the 1977-2007 period.

TSM- total stock market
FFSV- small value
STT- short term treasuries
ITT- intermdiate term treasuries
TIPS - treasury inflation protected securities
Corp - short term corporate bonds
IFA100 - IFA portfolio 100

Here is what the data shows for best mixes 1977-2007:

20% TSM, 34% Corp, 6% ITT, 40% TIPS
40% TSM, 16% ITT, 44% TIPS

no Corps after 30% TSM

20% FFSV, 15% Corp, 23% ITT, 42% TIPS
40% FFSV, 24% ITT, 36% TIPS

no Corps after 23% SV

20% IFA100, 44% Corp, 1% STT, 9% ITT, 26% TIPS
40% IFA100, 26% STT, 12% ITT, 22%TIPS

no Corps after 36% IFA 100.

For the 1977-2007 period short term corporate bonds were useful at very low stock allocations < 35%.

gbs
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SmallHi
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Post by SmallHi »

GBS,

What I did was look at stock/bond combinations at 3 different levels (about 80/20, about 60/40, and about 40/60), and observed the volatility of each portfolio (annualized based on monthly observations).

I assumed each investor would choose the IFA 100% Equity Allocation, with either: 1-3YR Corporate Bonds, 1-3YR Treasury Bonds, 1-5YR Treasury Bonds, 1-10YR Corporate Bonds, or 1-10YR Treasury Bonds.

I figured most investors were interested in which individual strategy seemed to work best, not what combination of strategies. I don't think much of that simulated TIPS series, as regular TIPS month to month results vary considerably from CPI +2.5% or whatever metric you choose.
(looking at the 1997 to 2008 period, you would need to assign a 4.4% annual nominal yield to CPI to mimic the LEH 1-30YR TIPS return series...or a nominal yield of 0.37% per month. Not too long ago, the annual nominal yield was 0.37% or so!)

Here are the specifics from 77-07:

Relative 80/20 allocations (SD of 11.0) Annualized Returns:

Code: Select all

1-3YR Gov = +14.57%
1-3YR Corp = +14.69%
1-5YR Trea = +14.61%
1-10YR Corp = +14.63%
1-10 YR Trea = +14.66%
Relative 60/40 allocations (SD of 8.5) Annualized Returns:

Code: Select all

1-3YR Gov = +12.91%
1-3YR Corp = +13.16%
1-5YR Trea = +13.00%
1-10YR Corp = +13.03%
1-10 YR Trea = +13.02%
Relative 40/60 allocations (SD of 6.0) Annualized Returns:

Code: Select all

1-3YR Gov = +11.18%
1-3YR Corp = +11.56%
1-5YR Trea = +11.21%
1-10YR Corp = +10.92%
1-10 YR Trea = +11.19%
Like I said, at high equity levels, it doesn't much matter. At balanced stock/bond levels, ST Corps get a small nod, and at conservative stock/bond levels, ST Corps are comfortably ahead.

Do note, this was overwhelmingly a period of falling rates (thus higher LT bond returns). If we see a prolonger period of higher rates, 1-3YR Corps will likely shine even more...(from 1977 to 1982, Equity/1-3YR Corp portfolios had noticeably better results than all other stock/bond combos).

sh
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Post by RaleighStClaire »

Excellent post SH, as always. I had never thought about ST Corps like this before. You think most investors are interested in which individual strategy worked best? Because I would prefer to see the best combination. Ferri recommends a 60/20/20 mix of TBM, tips, HY Corps -- what do you recommend?
Where's that red one gonna go?
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SmallHi
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Post by SmallHi »

You think most investors are interested in which individual strategy worked best?
No, I guess that didn't come out right. I was interested in which individual strategy worked out best.

Ultimately, other than adding TIPS (that are fundamentally different from nominal rate bonds), I don't know if coupling 2 or 3 different fixed income strategies does much more than giving you a weighted average risk/return of the holdings...especially going forward.

Bottom line, adding (for example) longer term treasuries to a ST corporate foundation would just provide an average of the risk and returns of two portfolios, one that uses just corps, the other that just uses treasuries.

I guess I was/am more interested in which single strategy works best. I am not, for example, a fan of a "DFA approach" to fixed income that uses One Year Fixed, Two Year Global, Five Year Gov't, and Five Year Global. Theoretically, Five Year Global can go and do everything the other 3 can do and then some...so why not just hold DFGBX? (or DFSHX). At Vanguard, I think you should just hold ST Investment Grade. With ETFs? Just 1-3YR Corporate (obviously).

we are arguing minuta, however...I realize that.

sh
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Post by gbs »

In terms of individual strategies and only Corps vs Treasuries. Using the data from Simba's table. The efficient frontier for Corps looks exactly the same as the one from Short term treasuries. The Intermediate term treasuries provide for a slightly better return for allocation of 50% IFA100 or more.

Image

In terms of efficient frontier allocation and excluding tips we have this.

Image

Were the IFA100 allocation moves from 8% to 44% and corps from 63% to 0% as they are replaced by treasuries.

Regards, gbs
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SmallHi
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Post by SmallHi »

GBS,

I eyeballed your figures, and they just don't correspond to the data. At the levels you indicate, choosing any combo of Equity & ST/Int'd Treasuries or only Int'd Treasuries has not improved mean variance efficiency over an Equity & ST Corporate Index...especially not at low equity levels.

Only at equity > 80% is it a toss up (and most would still choose ST Corporates because they should prefer to be more diversified by risk factor, they are inflation sensitive, and naturally prefer not to concentrate all of their debt holdings to one issuer -- even US Treasury...as I mention before, downside capture is only one form of risk. For many, losing an extra 1% twice a decade is preferable so as to potentially make an extra 0.25% annually).

At 60% Equity or less, a strong case can be made that investors should avoid treasuries.

Certainly, if you choose to use only annual standard deviations, or rolling 3YR standard deviations, the outcomes maybe different. But last time I checked, investor statements come monthly, and that is the time interval (annualized, of course) that is preferable. The simba system maybe more simplistic, opting for calendar year annual figures?

sh
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gbs
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Post by gbs »

Hi,

I used the Corporate returns that you posted, short term treasuries and intermediate treasuries from Simba's spreadsheet and IFA 100 returns from ifa website. All are annual returns.

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Corp     VFITX     VFISX     IFA100
 6.07     1.4       3.7       22.5
 3.9      3.5       5.5       25.2
 6.17     4.1      10.4       21.2
 9.99     3.9      14.1       28.2
12.92     9.4      18.9        4
22.24    29.1      19.5       17.3
10.69     7.4       8.6       32.1
14.05    14        12.8        3.2
14.79    20.3      13.2       28.7
11.01    15.1      11.9       26.6
 6.03     2.9       6          9.3
 7.71     6.1       5.9       25.8
11.6     13.3       8.7       28.4
 9.09     9.7       8.9      -16.2
13       15.3      10.7       33.5
 7.82     7.78      6.75      10.3
 7.06    11.43      6.41      29.7
 1.17    -4.33     -0.58       1.2
11.71    20.44     12.11      21
 5.7      1.92      4.39      15.9
 7.16     8.96      6.39      13.3
 7.21    10.61      7.36       2.3
 3.9     -3.52      1.85      23.5
 7.6     14.03      8.83       1.3
 9.58     7.55      7.8        2.6
 6.52    14.15      8.02     -11.3
 5.35     2.37      2.38      48.7
 1.82     3.4       1.03      22.4
 1.86     2.32      1.77      11.9
 4.7      3.14      3.77      22.1
 5.67     9.98      7.89       2.5

gbs
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SmallHi
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Post by SmallHi »

GBS,

you are introducing your own return series here. Lets stick with the actual indexes, and pick a certain point on your chart (the far right hand side):

40 DFA Equity, 40% Lehman 1-5YR Treasury, 20% Lehman 1-30YR Treasury. Supposedly, that is on the efficient frontier?

Not exactly. Over the 1977 to 2007 period, a 40% DFA Equity, 60% Lehman 1-3YR Corporate had 0.12% annalized higher returns (11.56% vs 11.44%), and less volatility...

Actually, on a monthly basis, you only need 42% Equity/ 58% 1-3YR Corp to match your EF allocation above, and this portfolio return has about 0.3% higher annual return.

sh
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Post by gbs »

Sh,

I would implement the TIPS/Treasuries strategy using Vanguard funds. How would you implement the corporate strategy?

gbs
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Post by SmallHi »

iShares 1-3YR Corporate.
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gbs
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Post by gbs »

What do you make of the fact that Vanguard short and intermediate treasury funds returns from Simba's spreadsheet are as good or better than the Corporate Index ?

I remember you being against sampling. The fund you recommend has 107 holdings compared with 550 for the index. Any comments?

gbs
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Robert T
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Post by Robert T »

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Few thoughts to throw out there…

1. Sampling error risk and negative skewness of corporate bonds:

Negative skewness in coporate bonds is IMO higher than in treasuries (i.e. limited upside but unlimited downside [or at least a fat downside tail]). The downside risk is highlighted in the 16 investment grade issuer defaults in 2002 (a historically high number). For holders of these bonds there is no chance of recovery. If an index fund sampling screens overweighted these issuers relative to the corporate bond index they likely significantly underperformed (as I think happened with the Vanguard ST bond index fund illustrated below – the fund holds about 900 of 1800 issues).

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           Global              Vanguard
       Investment grade      ST Bond Index
       Issuer Default       Tracking Error
1995         0                   0.0
1996         0                  -0.1
1997         0                  -0.1
1998         1                   0.0
1999         1                   0.0
2000         4                  -0.1
2001         4                  -0.1

2002        16                  -2.0

2003	      0                   0.0
2004	      0                  -0.2
2005	      2                  -0.1
2006	      0                  -0.1
2007	      0                   0.0

IMO it seems difficult to hold the entire universe of bonds in an index, as seems to be the case in all Vanguard and iShares bond index funds. Some may view 2002 as an outlier (once in a lifetime event) so it’s not likely to happen again (but as Taleb would likely say – it will never happen again until it does). Will the iShares 1-3 credit fund with a 107 of 550 issuer sample or the Vanguard ST Corporate bond fund with a 800 of 1200 issuer sample be immune to these ‘outliers’ - time will tell.

2. Diversification of issuer:

Issuers in the top 13 iShares 1-3 Credit fund holdings include:
  • General Electric
    Bank of America
    Citigroup
    Wells Fargo
Issuers included in the top 13 iShares Russell 1000 Value holdings include:
  • General Electric
    Bank of America
    Citigroup
    Wells Fargo
So from the above, the issuers of stocks and corporate bonds in a portfolio are often the same company. Some could argue that for relatively low bond allocations, US treasuries provides more diversification of issuer at the portfolio level, than corporates. Does it matter. IMO yes – just ask the stock and bond holders of Enron and Worldcom.

3. Inflation protection:

IMO for those who want inflation protection, its difficult to beat Treasury inflation protected securities bought and held to maturity.

4. Downside risk protection:

I have not yet managed to download the long-term index data from the iShares site (I think I have to change my registration type to do it – not sure). I did manage to download shorter-term data from the ‘index returns charts’ section. FWIW – interesting numbers (although only for a short time period). At least we can say one thing – intermediate term treasuries have worked very well over the last year. When value and small cap stocks declined significantly – higher quality bonds (treasuries) generally did better than lower quality bonds (corporates), and longer term treasuries did better than shorter term treasuries. Obviously no guarantees of this pattern repeating in the future.

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As at 6/2/08

Index                                            Jan-08    Nov-07    Jul-07     Last 12 months
Lehman Brothers 1-3 Year Treasury Index            1.74      1.73      0.89          7.78
Lehman Brothers 1-3 Year U.S. Credit               1.85      0.97      0.62          6.43
					
Lehman Brothers 3-7 Year U.S. Treasury             2.93      3.26      1.64         11.43
Lehman Brothers 7-10 Year Treasury Index           3.36      3.78      2.16         12.61
					
Russell MidCap Value Index                        -4.56     -5.27     -5.58        -12.78
S&P SmallCap 600/Citigroup Value Index            -3.74     -7.04     -5.92        -14.80
Russell Microcap(R) Index                         -7.69     -8.61     -7.01        -20.06
					
MSCI EAFE Value Index                             -9.27     -4.60     -2.13         -9.13
MSCI EAFE Small Cap Index                         -9.46     -6.57     -0.73        -11.01
MSCI Emerging Markets Index(SM)                  -12.48     -7.09      5.28    	  19.45

Robert
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craigr
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Post by craigr »

There is a risk in corporate bonds in very bad markets. Moody's has a report covering their bond default rates going back to 1920:

http://www.moodyskmv.com/research/files/wp/21727.pdf

The report includes statements such as:
The next period, from mid-1929 through December 1939, witnessed the heaviest default activity of the period examined in this report. The Great Depression generated a 77-year high, one-year corporate default rate of 9.2% in July 1932, indicating that nearly one in 10 Moody’s-rated corporate issuers defaulted over the following year.
During the Great Depression, the economy experienced the most severe contraction of this century while deflation increased the real value of fixed debt obligations, placing even highly credit worthy borrowers at considerable risk of default.
(emphasis added)

The report has a lot of interesting observations of default rates of various credit ratings. The takeaway lesson is that highly rated corporate bonds do carry risks and junk bonds carry considerable risks during bad markets. If you're going to own corporate bonds you should stick to the highest rating possible and definitely index to diversify among many companies.
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Post by OptionAl »

Nothing is exempt from black swans, not even Treasuries.

High quality corporates are not that scary, but scary enough for me to stick to short-term funds and put only a part of fixed income money there.
In the study, I'm seeing three year default rates of 0% for Aaa issues from 1970-1996. When you include the Depression years, from 1920-1996, the one year default rate on Baa and up is about .1%, and the five year default rate is about 2%. Your "expected loss" in high quality instruments is a reduction in return of less than 0.5% annually, peaking at a true loss of about 5% in the worst Depression year. The risk premium is there for a reason.

If we have a Depression, high quality bonds will be the least of our worries. The last time, unemployment was 25%. Stocks fell more than 90%. The real black swan risk is equities.
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Post by dumbmoney »

Since we're splitting hairs...the stock/bond rebalancing method usually goes unstated (annual?), but this could affect the results. I would expect a portfolio using treasuries to be more sensitive to the rebalancing method.
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Post by BlueEars »

Craig, thanks for the link to that default history.

I have a good chunk of my FI currently in Vang. Sh Term Investment Grade and note that about 16% of VFSTX is in Baa debt. Moody's defines this grade as:
Bonds that are rated Baa are considered as medium grade obligations, i.e., they are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well.
I'm very glad I had a big helping of 10yr TIPS when things started going south last fall as it cushioned the portfolio. Used to think I'd be able to spot a decline and move towards safer treasuries but it can be like a frog in slowing boiling water. Seems there are at least 2 wars to fight: inflation and possible deflation. It's not easy for investors to decide which one deserves the most attention when reading about huge derivative exposures, etc.
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Robert T
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Post by Robert T »

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FWIW – here's what some of my favorite authors have to say on the subject (in alphabetical order):
Robert
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Sammy_M
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What if you don't have a good ST Corp available?

Post by Sammy_M »

Outstanding thread and something I've been wondering about for some time. Problem that I, and perhaps others, face is their 401k doesn't provide a ST Corp fund - only Intermediates.

For example, I have two options, Pimco Total Return (0.90 ER w LW) with a duration of 5.4 yrs or Franklin Govt (0.72 ER w LW) with a duration of 3.2 yrs. Is the PIMCO active mgd fund close enough to be used in place of a ST Corp, or would one be better off sticking with Govt option?
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Robert T
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Post by Robert T »

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Out of interest I took a quick look at the ‘risk exposure’ of total bond market index funds (tracking the LB Aggregate Index) of several fund families.

While they all claim to be index funds of the same benchmark there are differences in risk exposure across the funds. The iShares, Schwab, and Fidelity funds have higher credit risk exposure than the Vanguard and T. Rowe Price funds (duration risk across all funds are similar). The former seem to take on more credit risk than the benchmark – perhaps to try to more closely track the benchmark (to off-set fees, and other cost) or to try to demonstrate ‘value added’. In my view this adds a level of agency risk (active management risk) that investors who buy index funds try to avoid (granted its not huge but IMO still important).

I also noted that the Vanguard fund credit risk exposure in 2002 was closer to 75%, 2%, 11%, 12% in AAA,AA,A,BBB rated issuers respectively. This seems to be a greater overweight to lower quality bonds than the LB aggregate index, particularly in A rated issuers. In 2002 this included the likes of WorldCom which went from an A rating to default in about 3 months.

So sampling error (as discussed in earlier posts in the thread) and agency risk (higher credit exposure than the index) perhaps contributed to the 2 percent underperformance of the Vanguard TBM index against its benchmark in 2002. Don’t get me wrong I think the Vanguard TBM index is the best TBM index fund available – but it has not been immune to sampling error and agency risk. In my view both risks are lower with the Vanguard Treasury funds.

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Benchmark Gaming

Total Bond Market Index Funds with Same Benchmark (LB Aggregate Index) but Different Levels of Risk

          Lehman
         Brothers
        Aggregate             T. Rowe
          Index    Vanguard    Price   iShares      Schwab   Fidelity   

AAA         79        80         79       76           75        73   
AA           5         5          5        7            6         4
A            8         8          9       10            7         7
BBB          7         7          7        7            7        11
BB           0         0          0        0            2         1
B            0         0          0        0            0         0
Not Rated    0         0          0        1            3         4

Duration   4.7       4.4        4.3      4.6          4.6       4.4

Source: M*
Robert
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alec
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Post by alec »

So sampling error (as discussed in earlier posts in the thread) and agency risk (higher credit exposure than the index) perhaps contributed to the 2 percent underperformance of the Vanguard TBM index against its benchmark in 2002. Don’t get me wrong I think the Vanguard TBM index is the best TBM index fund available – but it has not been immune to sampling error and agency risk. In my view both risks are lower with the Vanguard Treasury funds.
I think it had less to do with sampling than with Vanguard's active management strategy of substituting some corporate bond for some treasury bonds. Of course, all this was disclosed in the prospectus. :wink:

I didn't see this practice in the current prospectus for VBMFX, so I think they discontinued it.
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"It doesn't matter much."

Post by Taylor Larimore »

Hi Bogleheads:

Stock funds are on a roller-coaster ride with Capital Value's 12 month decline of (-26.19%) and Precious Metal's +36.59% gain (a 63% difference). Meanwhile we are into the second page of trying to figure out which bonds funds are best.

It may help (and maintain perspective) to look at the record of Vanguard's taxable bond funds with 10-year returns ending 5-31-08. Worst return since 2000 is shown in parenthesis:

SHORT-TERM BOND FUNDS:

Short-Term Bond Index-----4.98%---(+1.3%)
Short-Term Federal----------5.03%---(+1.4%)
Short-Term Invest-Gr-------4.89%---(+2.1%)
Short-Term Treasury--------4.96%---(+1.0%)

Hi/Lo difference--------------0.14%-----(1.1%)


INTERMEDIATE-TERM BOND FUNDS:

GNMA Fund-------------------5.60%---(+2,5%)
Inter-Term Bond Index-----6.10%---(+1.8%)
Inter-Term Invest-Gr-------5.73%---(+2.0%)
Inter-Term Treasury--------6.14%---(+2.3%)
Total Bond Market----------5.50%---(+2.4%)

Hi/Lo difference-------------0.64%-----(0.7%)


LONG-TERM BOND FUNDS:

Long-Term Bond Index-----6.48%---(+2.7%)
Long-Term Invest-Gr-------5.64%---(+2.9%)
Long-Term Treasury--------6.59%---(+1.7%)

Hi/Lo difference-------------0.95%-----(1.2%)

CONCLUSION: "It doesn't matter much." Any good quality Vanguard bond fund should provide income and safety in a portfolio.

Best wishes.
Taylor
Last edited by Taylor Larimore on Thu Jun 05, 2008 11:14 am, edited 1 time in total.
OptionAl
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Post by OptionAl »

Without duration/maturity and quality indicators, these numbers don't mean much IMO - except where the obviously safer ones outperform.
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Robert T
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Post by Robert T »

.
Taylor,

Thanks for the post. I agree it doesn’t matter nearly as much as differences in equity asset class returns. I also agree that the difference in the annualized return over a 10 yr period for funds within each category is small.

But do think that the correlation of bond returns with equity returns, particularly when equity returns are negative, is important to consider – especially IMO for those with large domestic small value tilts (which IMO is higher risk, so downside protection is important).

The difference in performance when small value returns are negative can be fairly large (IMO) as in the table below.

Code: Select all


Over the last 10 years when SV had negative annual returns:
                                                                                 
                                         2007          2002            1998      

Vanguard Small Value                    -7.07        -14.20          -12.47* (-5.06**)         

SHORT-TERM BOND FUNDS: 

Short-Term Bond Index                    7.22          6.10            7.63
Short-Term Federal                       7.43          7.61            7.22 
Short-Term Invest-Gr                     5.86          5.22            6.57
Short-Term Treasury                      7.89          8.02            7.36

High-Low difference                      2.03          2.80            1.06


INTERMEDIATE-TERM BOND FUNDS: 

GNMA Fund                                7.01          9.68            7.14  
Inter-Term Bond Index                    7.61         10.85           10.09
Inter-Term Invest-Gr                     6.14         10.28            8.30 
Inter-Term Treasury                      9.98         14.15           10.61 
Total Bond Market                        6.92          8.26            8.58

High-Low difference                      3.84          5.89            3.47


LONG-TERM BOND FUNDS: 

Long-Term Bond Index                     6.59         14.35           11.98 
Long-Term Invest-Gr                      3.75         13.22            9.21
Long-Term Treasury                       9.24         16.67           13.05  

High-Low difference                      5.49          3.45            3.84

High-Low difference (across all funds)   4.12         11.45            6.48

* From fund inception on 05/21/1998 
** S&P Small 600/Barra Value return in 1998

Obviously no guarantees this pattern will continue.

Robert
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Taylor Larimore
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Changing correlations, volatility and returns?

Post by Taylor Larimore »

Hi Robert:

But do think that the correlation of bond returns with equity returns, particularly when equity returns are negative, is important to consider.

"Over the long-run a percentage point in increase in volatility is meaningless; a percentage point increase in return is priceless." -- Jack Bogle
Best wishes
Taylor
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SmallHi
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Post by SmallHi »

I think the primary issue here is that we seem to be placing an inordinate amount of emphasis on "performance during downturns" in evaluating bond solutions. Imagine a 60/40 balanced portfolio that chose Vanguard ST Investment Grade over ST Treasury. In 3 of the last 10 years, they would have lost 0.4% to 1.1% more than had they stuck with treasuries. THATS IT! 0.4% to 1.1%!! If that extra bit really makes you feel that much better/worse about your situation, you are probably:

a)giving far too much attention to your ST results

and

b)not versed well enough on the reality that downturns are part of the long term investing process

There is far more than just that issue to consider...(again, probably due to recency bias) regarding the longer term/treasury solution, there seems to be no thought given to:

INFLATION
(longer term bonds, and probably balanced portfolios overall with LT bonds, will get crushed during rising inflation periods) -- from 1977 to 1981, the "high inflation years", 1-3YR Corps bested Int'd Treasuries by almost 270bps per year. Because that risk hasn't showed up lately, we discount it as less of a concern.

INCONSISTENT RESULTS
not sure how many can stick with a pure Treasury solution -- short/medium/or long over a period of 5 to 7 years when all other bonds are doing considerably better...yes the stock side should also be doing well, but the risk of "reaching" at just the wrong time seems like a major one for the average investor. ST Corporate bonds offer a "happy medium" during (+) and (-) markets, IMO.

INCOME CONSIDERATIONS
this point matters if you are in the distribution phase and tend to sell bond assets (income and principal) to meet monthly/quarterly income requirements (rebalancing out of stocks every few years back into bonds to replenish your stash). You are not as concerned with downside hedging as you are higher, and more consistent results....

UNDERSTATED DOWNSIDE HEDGING
the fact that ST credit portfolios are almost as effective as ST treasury portfolios at hedging downturns (longer term credit starts to get you in trouble)..as a matter of fact, during the 43 rolling 12 month periods since 1977 where IFA 100 declined, 1-3YR Corp outpaced 1-3YR Gov't on average by 0.2%.

MONETARY POLICY AND MULTIFACTOR RESULTS

Some academic evidence points to the fact that size/value premiums are only positive and significant during periods of falling interest rates. ST fixed income better hedges portfolios when monetary policy is working against size/value premiums.

PERIOD DEPENDENCY
Robert's chart above, while no doubt accurate, has only highlighted the last 3 annual downturns for SV. If we look at the the period of 1964 to 1990 and all 12 month rolling periods, 1YR bonds beat 5YR and 20YR bonds during the majority of SV losses (ave ret during (-) SV year =
1YR +7.9%;
5YR +5.8%;
20YR +2.2%)

Finally, there were some excellent points brought up above:

Vanguard's inability to target credit risk effectively, and the overlap between corporate bond holdings and LV stock holdings. My thoughts:

use iShares instead of ST Corporate exposure (IMO they are better bond indexers), and, don't use the Russell 1000 Value to tilt! Stick with Russell Mid/Small Value or S&P 400/600 Value (and realize that is one small part of a diversified allocation).

Some interesting thoughts, no doubt! I just feel that, while ST credit bonds aren't perfect, they are more effective in a number of different roles than either ST Treasuries, Int'd Treasuries, or a combo of the two...

sh
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Robert T
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Post by Robert T »

.
Sh,
There is far more than just that issue to consider...(again, probably due to recency bias) regarding the longer term/treasury solution, there seems to be no thought given to:
  • INFLATION: As indicated earlier, for inflation protection IMO its hard to beat Treasury inflation protected securities bought and held to maturity. I like and use a combination of inflation protected securities:nominal treasuries. And in high inflation periods small value stocks should outperform (if we believe Bernstien’s earlier article)

    INCONSISTENT RESULTS (tracking error relative to other bond classes): IMO this applies as much to short-term corporate bonds as it does to intermediate treasuries – there will be relative tracking error no matter what asset class is used.

    INCOME CONSIDERATIONS: There are also other things to consider in the distribution phase – including longevity risk (which can be hedged with an annuity), inflation risk (which can be hedged with inflation protected securities), and bequest risk (if want to leave money for others – it has asset allocation implications IMO).

    UNDERSTATED DOWNSIDE HEDGING (of short-term corporates): Time will tell. Some authors have strong views on this:
    “Even if investors justify holding short-term bonds with the most thoughtfully articulated rationale imaginable, the potential cost of undermining the protective role of the fixed income portfolio preclude holding assets other than long-term bonds.”…”Only high-quality, long-term bonds perform well in times of severe stress, allowing investors to view the opportunity costs of holding bonds as an insurance premium incurred to insulate portfolio’s from extreme conditions.” From Swensen's Pioneering Portfolio Management.
    My sense is Swensen views long-term to include ‘intermediate’ as the Yale benchmark for fixed income is the US Treasury Index. He seems to think theory (including fundamental characteristics) and his observations of historical data and of managing the Yale endowment are on his side. May be, may be not but I have appreciated his fundamental assessment of the differences between treasury and corporate bonds. Obviously no guarantees going forward

    PERIOD DEPENDENCY: Maybe…here are the cumulative returns for the most severe period for which we have data:

    From peak to trough: Sept 1929 – June 1932 (cumulative return)

    FF Small Value.........................-88.4%
    1-yr T-notes*.............................5.7%
    5-yr T-notes*...........................11.7%
    20 yr Government bonds..........14.3%
    20 yr Corporate bonds...............8.7%

    * From IFA website
    Unfortunately no ST corporate data but my gues is they underperformed 1-yr T-notes (could be wrong).
Finally – my preferred allocation is a combination of inflation protected securities and intermediate treasuries (which I think is more effective than ST corporates) – however I do own some short-term corporate bonds through the WV 529 plan given the choices.

Its been an interesting discussion - thanks.

Robert
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Edit: Just saw the addition:
MONETARY POLICY AND MULTIFACTOR RESULTS

Some academic evidence points to the fact that size/value premiums are only positive and significant during periods of falling interest rates. ST fixed income better hedges portfolios when monetary policy is working against size/value premiums.
Others suggest that rising rates are more harmful to growth than value stocks.

http://www.efficientfrontier.com/ef/701/value.htm
http://www.efficientfrontier.com/ef/401/fisher.htm

From the first linked article:
The observation that higher interest rates are more harmful to growth than value stocks is not new, but there has been surprisingly little attention devoted to this in the growth-versus-value debate, particularly from a historical perspective.
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BlueEars
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Post by BlueEars »

Robert T wrote:...Finally – my preferred allocation is a combination of inflation protected securities and intermediate treasuries (which I think is more effective than ST corporates) – however I do own some short-term corporate bonds through the WV 529 plan given the choices.
Robert, good post and great data. I am curious why you would choose both TIPS and intermediate treasuries. My thinking: if we have inflation then TIPS would be best and if we have deflation intermediate treasuries would probably be best if both have same maturity *but* you can more easily hold longer maturity TIPS then nominal treasuries (because nominals are so much more disadvantaged by inflation) so your longer maturity TIPS will work for deflation too. For example, 10yr TIPS might easily be competitive with 5yr treasuries in a deflationary environment.
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Robert T
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Post by Robert T »

.
Les,

You are right in that you still get a real return on TIPS during deflation (with interest paid on the deflation adjusted principle – with return of original principal at maturity). With nominal bonds – its very easy to get negative real returns in high inflation periods). But IMO nominal bonds will still provide significantly higher returns than TIPS (even if longer duration) during deflation periods. For example the real return of 5-yr nominal T-Notes between 1929 and 1932 ranged between 5.8 and 21.3 percent per year (according to Ibbotson) IMO higher than the likely real return on TIPS. So over this period of significant equity decline, nominal bonds would probably have provided more downside protection. Nevertheless if inflation is more a concern (for future consumption/and during distribution) then perhaps a higher allocation to TIPS relative to nominal bonds may makes sense.

FWIW - here's an earlier take: http://www.diehards.org/forum/viewtopic ... ght=#30056

Robert
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craigr
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Post by craigr »

Robert T wrote:UNDERSTATED DOWNSIDE HEDGING (of short-term corporates): Time will tell. Some authors have strong views on this:
“Even if investors justify holding short-term bonds with the most thoughtfully articulated rationale imaginable, the potential cost of undermining the protective role of the fixed income portfolio preclude holding assets other than long-term bonds.”…”Only high-quality, long-term bonds perform well in times of severe stress, allowing investors to view the opportunity costs of holding bonds as an insurance premium incurred to insulate portfolio’s from extreme conditions.” From Swensen's Pioneering Portfolio Management.
Robert brings up an important point. Longer term bonds are beneficial during times of collapsing interest rates (such as another Great Depression). During the 1930's, LT Treasury bond yields fell to 1%. ST bonds had negative interest for a time. Holders of longer issue (high quality treasury) bonds not only saw significant capital appreciation under these conditions, but were paid in much more valuable dollars as well. This would cushion the impacts of a very bad stock market.

Going short on all of your bond holdings leaves you significantly exposed to a deflationary situation that could seriously impact other parts of your portfolio. This hasn't happened in the US in 70 years, but it has happened. In Japan's deflation they still, 20 years later, have intermediate bonds yielding about 1.5% and LT bonds about 2.5%. If this situation were to repeat in the US, a portfolio that only has short-term bonds could find not only their stocks in serious decline, but their bonds not providing the anticipated protection.
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Post by larryswedroe »

Craig
That point is important. People who are more exposed to deflationary risks should consider buying longer bonds. Example, someone whose labor income is highly correlated with economic activity. People who are more exposed to inflationary risks should consider staying shorter--say someone who is retired and would actually benefit from falling prices (no labor capital at risk).

Also TIPS hedge both inflation and deflation so that solves one of the problems
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SmallHi
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Post by SmallHi »

The last few posts have correctly outlined various "goals" for fixed income, and I am for the most part in favor of that.

I think the major problem with Swenson is he is very one sided in his views. Imagine we see a slow period of rising prices and rates that exactly mirrors the declines we have seen since 1982.

Most retirees with longer term bonds and ongoing portfolio requirements would be sunk. It would matter very little how well they hedged out temporary market declines or whathaveyou...With real liabilities, these investors would have a very difficult time keeping pace.

Certainly, as Larry points out, there are different types of investors with different portfolio goals. I am a fan of ST Corporates for most (where it makes sense), but I am also a fan of avoiding one size fits all with any portfolio decisions (including my biggest pet peve -- the TSM/Int'l TSM/TBM portfolios)...

BTW, thanks to Robert T for some excellent insight in the thread. Wasn't sure I'd see 2 or 3 replies on this when I was typing it up last week, let alone 70+ (many of which were mine :wink: )

sh
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Sammy_M
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Post by Sammy_M »

Robert T wrote:Negative skewness in corporate bonds is IMO higher than in treasuries (i.e. limited upside but unlimited downside [or at least a fat downside tail])
Dead on comment.
mithrandir
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Post by mithrandir »

Indeed, a lot of us have now added "skewness" to our investment vocabulary. Standard deviation was a red herring all along because the distribution of investment returns was never normal. Assuming that returns follow a normal distribution was convenient but it ended being very costly for many.
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stratton
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Post by stratton »

mithrandir wrote:Indeed, a lot of us have now added "skewness" to our investment vocabulary. Standard deviation was a red herring all along because the distribution of investment returns was never normal. Assuming that returns follow a normal distribution was convenient but it ended being very costly for many.
Not quite, but with a correction: Standard deviation by itself was a red herring.

Just like Larry Swedroe states you can't look at an asset class in isolation, but how it effects the entire portfolio you can't look at Standard Deviation in isolation. An investor needs to consider other measures and still you use a little intelligence:

-Standard deviation
-Sharpe ratio
-Sortino ratio
-Drawdowns
-Indiidual asset behavior in down markets
-Judgement on "not overdoing" it with some asset classes
-Past performance is not a guarantee of future performane
-Leverage causes its own problems

The first four are right off the backtest spreadsheet. The next four are getting into jugement calls or require research, but they are needed to offset the weakness of using a tool like a backtest spreadsheet or mean variance optimization.

Our current credit crunches flight to liquidity is showing even longer term treasuries such as TIPS can lose NAV fast. It's different this time really is true about bear markets.

There are things to be said for Taylor's three fund or Rick Ferri's core four portfolios. Because they are so simple they avoid huge risks.

Paul
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