Long term bond performance question

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Radjob4me
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Long term bond performance question

Post by Radjob4me »

I have been reading about bonds and learning more as I go, although so far the nitty-gritty seems more complex than stocks, especially when it comes to bond "funds" over individual bonds.

But can someone explain - hopefully in simple terms - how the recent performance of Long term bonds index funds is possible - take Fidelity Spartan Long-term treasury index - FLBAX, which is up over 19% in the last year? I just don't quite understand how there can be this level of return in a bond index fund...
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Aptenodytes
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Re: Long term bond performance question

Post by Aptenodytes »

Yields on long-term bonds have been falling, which raises the price of the bonds. The price effect is biggest on longer-term bonds. The mutual fund is buying new long-term bonds at very low rates, which has the effect of depressing overall returns. But it is holding onto other long-term bonds that it bought earlier, some of them a long time earlier, when yields were higher. The price of those bonds is shooting up, which more than offsets the impact of the low yields on newly-purchased bonds.
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ogd
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Re: Long term bond performance question

Post by ogd »

Radjob4me wrote:I have been reading about bonds and learning more as I go, although so far the nitty-gritty seems more complex than stocks, especially when it comes to bond "funds" over individual bonds.

But can someone explain - hopefully in simple terms - how the recent performance of Long term bonds index funds is possible - take Fidelity Spartan Long-term treasury index - FLBAX, which is up over 19% in the last year? I just don't quite understand how there can be this level of return in a bond index fund...
The simplified explanation is that due to changes in the bond market, the fund has front-loaded a portion of its long-term return in a short few months.

With simplified numbers: imagine you buy a bond or fund with duration about 20 years and 3% yield (which let's say was the market yield in January). You can think of this as, approximately, entering a contract to receive 3% over 20 years. Now the market yield drops to 2% for that type of bonds. New buyers are entering a contract to receive 2% over 20 years.

Clearly, the January buyers got a much better deal. How much better? About 20% better, over the lifetime of the contract. The market price of their contract is now 20% higher than when they bought it, to equalize their rewards with market yields. If the price was any cheaper, new buyers would prefer buying those 3% contracts rather than the 2% contracts they find in the market. After a 20% price hike, the two types of contracts are about the same.

The 3% contracts do deliver on their promise of 3% yearly over 20 years -- except that in this case they delivered about 1% of that almost immediately, due to changes in the market. The remainder of 2% per year will be delivered over time, at the now slower pace of market yields. That's why I called them "front-loaded returns" rather than just "outperformance".

The recent return is nothing to celebrate if you haven't bought the fund yet -- you'd be getting a much worse deal than January buyers. For bonds, the dictum "Past performance is not an indication of future returns" is much stronger than even for stocks. If you have bought the fund before this period, it's generally a good thing because so much of your contract got delivered early and you are free to redeploy to other opportunities. However, if you look past the 20 year period it begins to look worse because 2% ongoing is not a happy place for fixed income investors.

(The math is a little more complicated, for reasons having to do mainly with dividend reinvestment, which factors into the price calculations, that's why I sprinkled the word "about" everywhere. But the basic idea is there -- that the reason a 3% yield can lead to a 20% short term return is that yield changes get amplified by the duration of the fund / bond, and a long fund can have quite a large multiple of changes. This goes both ways of course, and long bond holders in 2013 were not happy including on this forum).
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arcticpineapplecorp.
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Re: Long term bond performance question

Post by arcticpineapplecorp. »

ogd wrote:
Radjob4me wrote:I have been reading about bonds and learning more as I go, although so far the nitty-gritty seems more complex than stocks, especially when it comes to bond "funds" over individual bonds.

But can someone explain - hopefully in simple terms - how the recent performance of Long term bonds index funds is possible - take Fidelity Spartan Long-term treasury index - FLBAX, which is up over 19% in the last year? I just don't quite understand how there can be this level of return in a bond index fund...
The simplified explanation is that due to changes in the bond market, the fund has front-loaded a portion of its long-term return in a short few months.

With simplified numbers: imagine you buy a bond or fund with duration about 20 years and 3% yield (which let's say was the market yield in January). You can think of this as, approximately, entering a contract to receive 3% over 20 years. Now the market yield drops to 2% for that type of bonds. New buyers are entering a contract to receive 2% over 20 years.

Clearly, the January buyers got a much better deal. How much better? About 20% better, over the lifetime of the contract. The market price of their contract is now 20% higher than when they bought it, to equalize their rewards with market yields. If the price was any cheaper, new buyers would prefer buying those 3% contracts rather than the 2% contracts they find in the market. After a 20% price hike, the two types of contracts are about the same.

The 3% contracts do deliver on their promise of 3% yearly over 20 years -- except that in this case they delivered about 1% of that almost immediately, due to changes in the market. The remainder of 2% per year will be delivered over time, at the now slower pace of market yields. That's why I called them "front-loaded returns" rather than just "outperformance".

The recent return is nothing to celebrate if you haven't bought the fund yet -- you'd be getting a much worse deal than January buyers. For bonds, the dictum "Past performance is not an indication of future returns" is much stronger than even for stocks. If you have bought the fund before this period, it's generally a good thing because so much of your contract got delivered early and you are free to redeploy to other opportunities. However, if you look past the 20 year period it begins to look worse because 2% ongoing is not a happy place for fixed income investors.

(The math is a little more complicated, for reasons having to do mainly with dividend reinvestment, which factors into the price calculations, that's why I sprinkled the word "about" everywhere. But the basic idea is there -- that the reason a 3% yield can lead to a 20% short term return is that yield changes get amplified by the duration of the fund / bond, and a long fund can have quite a large multiple of changes. This goes both ways of course, and long bond holders in 2013 were not happy including on this forum).
Had to see for myself...the long term bond index (Vanguard) VBLTX lost 9.13% (in blue below) while Vanguard's total stock market index funds (admiral) VTSAX went up 33.52% (in orange below). Of course one's a stock and one's a bond (apples and oranges). But looking at the green line below is the total bond market index fund admiral (VBTLX), which is described as an intermediate bond fund (though it holds bonds of differing duration, but it has an average duration of 5.7 years) and it lost just 2.15%.

Image
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Radjob4me
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Re: Long term bond performance question

Post by Radjob4me »

Thanks for the replies. I haven't bought the fund at Fidelity but rather was just looking at the options. Bonds are more interesting than I have given them credit for in the past...
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Christine_NM
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Re: Long term bond performance question

Post by Christine_NM »

ogd wrote:
Radjob4me wrote:I have been reading about bonds and learning more as I go, although so far the nitty-gritty seems more complex than stocks, especially when it comes to bond "funds" over individual bonds.

But can someone explain - hopefully in simple terms - how the recent performance of Long term bonds index funds is possible - take Fidelity Spartan Long-term treasury index - FLBAX, which is up over 19% in the last year? I just don't quite understand how there can be this level of return in a bond index fund...
The simplified explanation is that due to changes in the bond market, the fund has front-loaded a portion of its long-term return in a short few months.

With simplified numbers: imagine you buy a bond or fund with duration about 20 years and 3% yield (which let's say was the market yield in January). You can think of this as, approximately, entering a contract to receive 3% over 20 years. Now the market yield drops to 2% for that type of bonds. New buyers are entering a contract to receive 2% over 20 years.

Clearly, the January buyers got a much better deal. How much better? About 20% better, over the lifetime of the contract. The market price of their contract is now 20% higher than when they bought it, to equalize their rewards with market yields. If the price was any cheaper, new buyers would prefer buying those 3% contracts rather than the 2% contracts they find in the market. After a 20% price hike, the two types of contracts are about the same.

The 3% contracts do deliver on their promise of 3% yearly over 20 years -- except that in this case they delivered about 1% of that almost immediately, due to changes in the market. The remainder of 2% per year will be delivered over time, at the now slower pace of market yields. That's why I called them "front-loaded returns" rather than just "outperformance".

The recent return is nothing to celebrate if you haven't bought the fund yet -- you'd be getting a much worse deal than January buyers. For bonds, the dictum "Past performance is not an indication of future returns" is much stronger than even for stocks. If you have bought the fund before this period, it's generally a good thing because so much of your contract got delivered early and you are free to redeploy to other opportunities. However, if you look past the 20 year period it begins to look worse because 2% ongoing is not a happy place for fixed income investors.

(The math is a little more complicated, for reasons having to do mainly with dividend reinvestment, which factors into the price calculations, that's why I sprinkled the word "about" everywhere. But the basic idea is there -- that the reason a 3% yield can lead to a 20% short term return is that yield changes get amplified by the duration of the fund / bond, and a long fund can have quite a large multiple of changes. This goes both ways of course, and long bond holders in 2013 were not happy including on this forum).
Here's a bump and thanks for a timely reply. I was beginning to wonder why I was not in long term bonds. Now I know and intermediate will do fine.
16% cash 49% stock 35% bond. Retired, w/d rate 2.5%
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cfs
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Re: Long term bond performance question

Post by cfs »

Good information.

Good conversation with plenty of good information; thanks to all participants.

Thanks for reading.
~ Member of the Active Retired Force since 2014 ~
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DWesterb2iz2
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Re: Long term bond performance question

Post by DWesterb2iz2 »

Radjob4me wrote:I have been reading about bonds and learning more as I go, although so far the nitty-gritty seems more complex than stocks, especially when it comes to bond "funds" over individual bonds.

But can someone explain - hopefully in simple terms - how the recent performance of Long term bonds index funds is possible - take Fidelity Spartan Long-term treasury index - FLBAX, which is up over 19% in the last year? I just don't quite understand how there can be this level of return in a bond index fund...
Thank you for asking this. I've been wondering that very thing myself.
Engineer250
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Re: Long term bond performance question

Post by Engineer250 »

ogd wrote:With simplified numbers: imagine you buy a bond or fund with duration about 20 years and 3% yield (which let's say was the market yield in January). You can think of this as, approximately, entering a contract to receive 3% over 20 years. Now the market yield drops to 2% for that type of bonds. New buyers are entering a contract to receive 2% over 20 years.

Clearly, the January buyers got a much better deal. How much better? About 20% better, over the lifetime of the contract. The market price of their contract is now 20% higher than when they bought it, to equalize their rewards with market yields. If the price was any cheaper, new buyers would prefer buying those 3% contracts rather than the 2% contracts they find in the market. After a 20% price hike, the two types of contracts are about the same.

The 3% contracts do deliver on their promise of 3% yearly over 20 years -- except that in this case they delivered about 1% of that almost immediately, due to changes in the market. The remainder of 2% per year will be delivered over time, at the now slower pace of market yields. That's why I called them "front-loaded returns" rather than just "outperformance".
I still don't understand the bolded bit about the 1% getting paid out up front, but I can't thank you enough for the first two paragraphs. I feel like I'm finally beginning to understand bond fund prices versus bond yields versus gains and losses in the bond market. I wonder how many people are hugely invested in bonds and still don't understand them.
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ogd
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Re: Long term bond performance question

Post by ogd »

Engineer250 wrote:I still don't understand the bolded bit about the 1% getting paid out up front, but I can't thank you enough for the first two paragraphs. I feel like I'm finally beginning to understand bond fund prices versus bond yields versus gains and losses in the bond market. I wonder how many people are hugely invested in bonds and still don't understand them.
Thanks! I don't think a deep understanding is required for every bond investor, when there are funds available that pretty much do the right thing without you looking.

Let me try to elaborate on that "1% upfront". So when you entered into your 3% contract, you expected to get 3% a year at a steady pace. You wait one year, you get 3%, wait another, another 3%, etc. This would indeed be the case if there were no changes in the market and the yield curve was flat (which is anther complication, but we don't need to go into that here). But when market yields drop to 2% very early in the contract, the minute by minute total return of your contract looks like this: 22% in the first year, then 2% every year thereafter. The 1% advantage you now have over the market is prorated over the 20 years and made available to you immediately. If you choose to sit on the contract and just make dividends, you still get 3%/year as before, but now you have the option of selling the bond and making that 20% right away, then buying a 2% bond and getting 2% thereafter; or you might decide to do something else with the money entirely. For a portion of your promised 3%/year, you no longer need to wait. This is good, particularly when "something else" can be a small investor deal like a bank CD, or rebalancing into stocks.

I also want to emphasize that this isn't some oddity of how the bond market works. If the market is liquid (i.e. one can get close to fair value when trading bonds), it has to work that way mathematically. If the premium were less than 20%, holders of those 3% bonds would be unwilling to part with them because they can't replace them with market bonds. If it were more, buyers would rather buy the new 2% bonds than overpay for the 3% bonds. For the two to meet in the middle, the price has to be about +20%.
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