Another look at corporate bonds

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Doc
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Re: Another look at corporate bonds

Post by Doc »

jjface wrote:Just wondering if there is some place for other types of bonds considering that any rebalancing will only be done with a portion of bonds. If you look at the portfolio as a whole too then some rebalancing could also be done into corporates or other bonds that fall during stock market crashes - ie from treasuries into these bonds
That's the basis for what I described in the last post. In a situation like the '08 crash one would use Treasuries to rebalance and then when the crisis has passed "rebalance" the FI sectors overtime. In a similar vein rebalancing equities in more normal times can be done with all the bonds segments taken as a whole. Or taking them in rotation if that meets your needs.

One reason I don't use CD's is that you don't get the price rise (mark to market) in a flight to quality situation that you get with Treasuries.
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Re: Another look at corporate bonds

Post by larryswedroe »

Doc
While you don't get the flight to liquidity rise, with secondary CDs you do get the rise due to falling interest rates, so you get a rebalancing benefit, though not quite as strong typically
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Re: Another look at corporate bonds

Post by ANC »

larryswedroe wrote:Few thoughts
B) when comparing HY to stock mix, while for simplicity reason even I have used S&P 500 but HY stocks are typically not those stocks, but riskier smaller and valuey companies with higher expected returns.
If you are not convinced this will persist, there is a common-sense counterargument. There are junk stocks and for some of them you may be better off with senior debt in the junk bond instead. If you mix in some senior loans with the high-yield bonds, you can avoid some of the high concentration in the energy sector.
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Re: Another look at corporate bonds

Post by Kevin M »

The idea that using a high-yield bond fund is similar to an LMP strategy seems absurd to me, since the cash flows are not reliable, as kolea seems to think. I have a small holding of Vanguard's high-yield bond fund, but I don't consider it as part of my really safe assets that I can think of as part of my LMP; that comes more from my CDs.

To investigate this, I looked at the income return and capital return for Vanguard High-Yield Corporate Fund (VWEHX) from 2001 through 2015. There has been a cumulative capital return of -16.8% (that's negative), and the income return has fallen from 8.9% in 2001 to 5.3% in 2015. If you think of this as an annual cash flow return on your original investment, the combination of a lower income return on a decreased amount of capital results in a net cash flow return of 4.7% on the original investment amount. Of course this assumes you are spending your income distributions instead of reinvesting them, which I assume would be the case if you're focused on cash flow.

In dollar terms, on an original investment of $100,000 at the beginning of 2001, your annual cash flow has declined from about $8.9K to about $4.7K, and of course this is in nominal terms, so in real terms it's worse. And with the high-yield fund you don't have price appreciation due to lower rates to help compensate for the lower cash flows, as you do with bond funds that have less credit risk (or none). Instead you have price depreciation, compounding the issue of lower cash flows.

By contrast, you can generate reliable nominal cash flow with a CD or nominal Treasury ladder, and of course you can generate reliable real cash flow with a TIPS ladder.

It seems really ineffective to me to refuse to think in terms of total return, and to try and hand-wave away the gradual degradation of capital inherent in a high-yield bond fund. If you want to own this asset class, best not to fool yourself about the risks.

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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote:
jjface wrote:Just wondering if there is some place for other types of bonds considering that any rebalancing will only be done with a portion of bonds. If you look at the portfolio as a whole too then some rebalancing could also be done into corporates or other bonds that fall during stock market crashes - ie from treasuries into these bonds
That's the basis for what I described in the last post. In a situation like the '08 crash one would use Treasuries to rebalance and then when the crisis has passed "rebalance" the FI sectors overtime. In a similar vein rebalancing equities in more normal times can be done with all the bonds segments taken as a whole. Or taking them in rotation if that meets your needs.

One reason I don't use CD's is that you don't get the price rise (mark to market) in a flight to quality situation that you get with Treasuries.
But you really don't get much flight-to-quality price increase from your short term Treasuries either. You get more from intermediate-term, and the most from long-term--at least that's what we saw in 2008, and to a lesser extent in other minor flight-to-quality events since then.

So we agree that one can do better than TBM by breaking it into components, and using those components in a way that best optimizes the overall portfolio. This would include using the long-term Treasury component for rebalancing in flight-to-safety events, as well as using tax-efficient asset location, as you've mentioned. It also allows more flexibility to avoid segments that have characteristics that you don't like, like the negative convexity of MBS, and more relevant to this thread, the higher equity-like risk in long-term corporate bonds.

But I would rather use CDs with a 100 basis point yield premium over Treasuries of comparable maturity as a replacement for the short-term and intermediate-term Treasuries in TBM. And with the early withdrawal option of direct CDs, you don't have to bother holding any maturities of less than five years to reduce term risk. Then you can use more targeted bond funds to get whatever term risk and credit risk you want, including a dab of long-term Treasuries for flight-to-safety rebalancing, if that's what you want.

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Re: Another look at corporate bonds

Post by WasabiOsbourne »

grunching here........ really enjoy larry's work and his general helpfulness..

i think the corporate bonds are outstanding investment if you have major aversion to stock market for some reason. i.e. they are great within world of fixed income; 2) income investments.... i am talking IG corporate bonds, not so much HY - never really understood the returns pattern of HY.

i think in comparison to a 75%/25% mix of stocks/LT T-bonds then maybe IG corporate bonds don't look so good.

seems like for many reasons alot of people want nothing to do with the stock market.
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Re: Another look at corporate bonds

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Kevin M wrote:
Doc wrote: One reason I don't use CD's is that you don't get the price rise (mark to market) in a flight to quality situation that you get with Treasuries.
But you really don't get much flight-to-quality price increase from your short term Treasuries either. You get more from intermediate-term, and the most from long-term--at least that's what we saw in 2008, and to a lesser extent in other minor flight-to-quality events since then.

So we agree that one can do better than TBM by breaking it into components, and using those components in a way that best optimizes the overall portfolio. This would include using the long-term Treasury component for rebalancing in flight-to-safety events, as well as using tax-efficient asset location, as you've mentioned. It also allows more flexibility to avoid segments that have characteristics that you don't like, like the negative convexity of MBS, and more relevant to this thread, the higher equity-like risk in long-term corporate bonds.

But I would rather use CDs with a 100 basis point yield premium over Treasuries of comparable maturity as a replacement for the short-term and intermediate-term Treasuries in TBM. And with the early withdrawal option of direct CDs, you don't have to bother holding any maturities of less than five years to reduce term risk. Then you can use more targeted bond funds to get whatever term risk and credit risk you want, including a dab of long-term Treasuries for flight-to-safety rebalancing, if that's what you want.

Kevin
Flight-to-quality for different maturity Treasuries IIRC is not consistent over all bears. I think though in general the longer the better. I have short and intermediate funds and also a ~10 yr ladder in my Treasury pile so I get to chose what's best when the bear comes. (And to "roll the curve" if the opportunity presents itself, usually those that mature shortly.) I don't use long Treasuries because I don't want the inflation risk over a long time and TIPS didn't work well in '08. Younger, not retired investors might have a different view. All that being said, any of the Treasury durations probably do better than CDs in similar situations. (See Larry's comment upthread.)
Kevin M wrote:... but I don't consider it as part of my really safe assets that I can think of as part of my LMP; that comes more from my CDs.
OK Kevin, didn't mother ever tell you that you can't have your cake and eat it to? Are your CD's for a LMP or to rebalance the

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Re: Another look at corporate bonds

Post by larryswedroe »

ANC
That only addresses the concentration risk in that sector, none of the other issues against corporate, especially high yield.
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Re: Another look at corporate bonds

Post by msi »

But if today's interest rates are at unprecedentedly low levels, and treasuries are affected by market forces that never existed before, then why base the point on the past 90 years? It also seems like the timeframe ends with a bond bubble, which would lead to misleading conclusions.
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Re: Another look at corporate bonds

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msi wrote:But if today's interest rates are at unprecedentedly low levels, and treasuries are affected by market forces that never existed before, then why base the point on the past 90 years? It also seems like the timeframe ends with a bond bubble, which would lead to misleading conclusions.
The low current rates may not have that big an effect. We are talking about 1) the spread (difference) between Treasuries and Corporates and 2) how the price of the two react with the rest of the portfolio. Again if the yield on Treasuries goes down in the stock "crisis and" the price therefore goes up which we like if we are the sellers, it makes little difference if the yield before the crisis is 2% or 1% if the yield changes by 1/2% in either case.

Start and end points are always a problem in looking at historical data. That's why I like to use rolling return data instead of a 30 year or whatever, start/stop point. Another way to eliminate the start/stop question is to use variable time periods based on market cycles. I've seen this used in equities but don't recall the same idea applied to FI or portfolios n total.
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Re: Another look at corporate bonds

Post by grog »

stlutz wrote:Hi Larry,

Currently the option-adjusted spread for BBB corporates is 1.97% (https://fred.stlouisfed.org/series/BAMLC0A4CBBB). At what spread would you currently consider corporate bonds to be "worth it"?

My understanding is that you are simply pointing out that investors have not been rewarded adequately for credit risk in the past. But there has to be a level where your view would change--am I right?
Right, this is how I was thinking about it. So really Larry is saying that the spreads are and have been inadequate when you account for defaults, taxes, and positive stock correlation. But if the spreads truly are chronically insufficient and corporate bonds "should" pay more of a premium, then I think you need some kind of behavioral story or something to explain why investors accept those spreads and why the markets clear with a credit risk premium that's "too low."

Larry focuses on the corporate bonds within a stock/bond portfolio, but I would suspect that a large chunk of the corporate bond market is not held in that context. Pension funds and insurance companies are fairly large players and I would guess they are constrained somewhat in their ability to meet their liability and capital requirements with equities and therefore are going to tend toward corporate bonds over treasuries. So maybe they are driving the corporate spreads "too low" for individual investors holding classic portfolios. Just a thought.
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Re: Another look at corporate bonds

Post by saltycaper »

grog wrote:
stlutz wrote:Hi Larry,

Currently the option-adjusted spread for BBB corporates is 1.97% (https://fred.stlouisfed.org/series/BAMLC0A4CBBB). At what spread would you currently consider corporate bonds to be "worth it"?

My understanding is that you are simply pointing out that investors have not been rewarded adequately for credit risk in the past. But there has to be a level where your view would change--am I right?
Right, this is how I was thinking about it. So really Larry is saying that the spreads are and have been inadequate when you account for defaults, taxes, and positive stock correlation. But if the spreads truly are chronically insufficient and corporate bonds "should" pay more of a premium, then I think you need some kind of behavioral story or something to explain why investors accept those spreads and why the markets clear with a credit risk premium that's "too low."

Larry focuses on the corporate bonds within a stock/bond portfolio, but I would suspect that a large chunk of the corporate bond market is not held in that context. Pension funds and insurance companies are fairly large players and I would guess they are constrained somewhat in their ability to meet their liability and capital requirements with equities and therefore are going to tend toward corporate bonds over treasuries. So maybe they are driving the corporate spreads "too low" for individual investors holding classic portfolios. Just a thought.
I think the point always goes back to framing the question not as "Treasury Bonds vs. Corporate Bonds" but rather "Treasury Bonds + Stocks vs. Corporate Bonds." If the spread increases much, equities probably have declined. The spread could be 10%, but does that mean it's preferable to divert money that would have gone to stocks, which probably just suffered a severe decline, and instead allocate it to corporate bonds? The "take my risk on the equity side" camp would say, "no." In a way, it doesn't really matter what the spread is, at least not by itself.
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Re: Another look at corporate bonds

Post by lack_ey »

grog wrote:
stlutz wrote:Hi Larry,

Currently the option-adjusted spread for BBB corporates is 1.97% (https://fred.stlouisfed.org/series/BAMLC0A4CBBB). At what spread would you currently consider corporate bonds to be "worth it"?

My understanding is that you are simply pointing out that investors have not been rewarded adequately for credit risk in the past. But there has to be a level where your view would change--am I right?
Right, this is how I was thinking about it. So really Larry is saying that the spreads are and have been inadequate when you account for defaults, taxes, and positive stock correlation. But if the spreads truly are chronically insufficient and corporate bonds "should" pay more of a premium, then I think you need some kind of behavioral story or something to explain why investors accept those spreads and why the markets clear with a credit risk premium that's "too low."

Larry focuses on the corporate bonds within a stock/bond portfolio, but I would suspect that a large chunk of the corporate bond market is not held in that context. Pension funds and insurance companies are fairly large players and I would guess they are constrained somewhat in their ability to meet their liability and capital requirements with equities and therefore are going to tend toward corporate bonds over treasuries. So maybe they are driving the corporate spreads "too low" for individual investors holding classic portfolios. Just a thought.
I've always thought that was the main explanation you could point to, but does this match the evidence looking back through history of what percentage of corp bond holders/traders are those kinds of entities? I haven't seen the data on that. Or are the levels, whatever they are, sufficient regardless to push prices through history to where they are?
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Re: Another look at corporate bonds

Post by larryswedroe »

stlutz
First, I don't want to be in that business of guessing what spread would be enough.
Second, if the spread widens it's highly likely the ERP and style premia have also widened since the risks are correlated, so basically would not matter anyway
Third, you still have all that asymmetric risks which also show up at the wrong time, and you must use funds and incur expenses , and you also get the extra yield from CDs
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Re: Another look at corporate bonds

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Doc wrote:All that being said, any of the Treasury durations probably do better than CDs in similar situations. (See Larry's comment upthread.)
No, no, no. This completely misses the point. You earn so much more yield on direct 5-year CDs with good early withdrawal terms than on short-term Treasuries, and at about the same risk, that it just doesn't pay the retail investor to hold short-term Treasuries. Heck, you can even earn 1% on a savings account, which currently is almost as much yield as you get on a 5-year Treasury.

So at least cut out the short-term Treasuries, and go at least intermediate-term where you're at least getting half the yield of a good 5-year CD to compensate you for the potential flight-to-safety benefit (i.e., you're paying less for this insurance).
Doc wrote:
Kevin M wrote:... but I don't consider it as part of my really safe assets that I can think of as part of my LMP; that comes more from my CDs.
OK Kevin, didn't mother ever tell you that you can't have your cake and eat it to? Are your CD's for a LMP or to rebalance the

Image
The CDs are not the first thing I'd look to for rebalancing into stocks in a bear market, although they could come into play. That's what the slug of long-term Treasuries would be for if you wanted to optimize this potential benefit in flight-to-safety scenarios (based on recent history anyway), or go with a slug of intermediate-term Treasuries if you prefer.

First thing to keep in mind is that you're probably only going to use a portion of your fixed income to rebalance into stocks. So why give up a yield premium of 100 basis points with no credit risk and minimal term risk (limited to the early withdrawal penalty) for the much larger portion of your fixed-income that will not be used to rebalance?

Since I don't go the Treasury route, the first place I look to for rebalancing is cash, which doesn't give a flight-to-safety bump, but at least doesn't drop in value in a crisis. With the yield on cash to retail investors at 1%, which now is almost as the yield on a 5-year Treasury, cash isn't so bad to hold now.

Keep in mind that the cash allocation can temporarily surge due to proceeds from maturing CDs. With enough CDs, as I have, it's not unlikely that a CD will be maturing at some point after stocks have dropped a lot, so this is a likely source for rebalancing.

Next I look to my (non-Treasury) bond funds. My California muni and investment-grade bond funds actually increased in value during the stock swoon in the first 1.5 months of this year, reaching a local peak right when stocks reached bottom in early February. So between the proceeds from maturing CDs and my bond funds there was plenty of fodder for doing a little rebalancing into international stocks earlier in the year.

Finally, if the values of my bond funds do decline by more than 1% or so when stocks really tank, then doing an early withdrawal from a CD, and paying a penalty of 1% or so, does become an option to consider. So in this sense, yes, CDs can play the role of both an LMP and as a rebalancing partner for stocks--assuming that you have enough of them to fulfill both roles.

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Re: Another look at corporate bonds

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Kevin M wrote:The idea that using a high-yield bond fund is similar to an LMP strategy seems absurd to me, since the cash flows are not reliable, as kolea seems to think. I have a small holding of Vanguard's high-yield bond fund, but I don't consider it as part of my really safe assets that I can think of as part of my LMP; that comes more from my CDs.

To investigate this, I looked at the income return and capital return for Vanguard High-Yield Corporate Fund (VWEHX) from 2001 through 2015. There has been a cumulative capital return of -16.8% (that's negative), and the income return has fallen from 8.9% in 2001 to 5.3% in 2015.
Kevin, the point here is to ignore return on capital. I have not argued that bonds yield a stable cash flow, my argument is that it is more stable than cash flow derived from capital gains. Yes, cash flow is going to decrease as interest rates fall. That is no different than any other bond. In fact everything I have said can be applied to investment grade corporate bonds. The idea of looking at cash flow rather than return on capital is the same in either case. HY bonds are just an extreme case of that. My comments here are specific to bonds and not to the case of cash flow from dividends on equities. The latter is fundamentally different than an interest payment on a loan.
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Re: Another look at corporate bonds

Post by larryswedroe »

Kolea
Kevin, the point here is to ignore return on capital. I have not argued that bonds yield a stable cash flow, my argument is that it is more stable than cash flow derived from capital gains
this is exactly the kind of incorrect thinking that gets people in trouble. This argument is totally incorrect. The reason is simple that you can generate the same type cash flows from a total return approach, but do so in more efficient manner. It's just an illusion on the part of the person who is thinking about two separate pockets instead of one, a psychological error of framing the problem. It's the same math that I've shown over and over again about the illusions of dividends and cash flow.

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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:Doc wrote:
All that being said, any of the Treasury durations probably do better than CDs in similar situations. (See Larry's comment upthread.)

No, no, no. This completely misses the point. You earn so much more yield on direct 5-year CDs with good early withdrawal terms than on short-term Treasuries, and at about the same risk, that it just doesn't pay the retail investor to hold short-term Treasuries. Heck, you can even earn 1% on a savings account, which currently is almost as much yield as you get on a 5-year Treasury.

So at least cut out the short-term Treasuries, and go at least intermediate-term where you're at least getting half the yield of a good 5-year CD to compensate you for the potential flight-to-safety benefit (i.e., you're paying less for this insurance).
I don't think its that easy. In the last 2 months of 2008 the price of Vg Intermediate Term Treasury fund rose by 10%. If that type of thing occurred once every 10 years you get a "flight to quality" boost of some 100 bps. That wipes out the current 70 bps advantage of a 5 yr CD over a 5 yr Treasury. This is somewhat better than what you implied.

On the short end comparing the price of Vg Short Term Treasury fund with the same five year CD you only get about a 20 bps "flight to quality" boost so the CD does comes out ahead.

But I'm not going to buy the short term Treasury fund. I'm going to use a 1-5 ladder. The newer rungs are going to have a higher boost. Again back to 2008 the on the run five had 70 bps boost which then equals the CD advantage even ignoring the early withdrawal penalty.

I'm actually not even going to use a 1-5 ladder but more like a 3-10. (I'm likely going to sell before maturity either to capture roll yield or to to convert ordinary income into LTCG.) Therefore I am going to have a lot of flexibility.

For me using direct CD's would be difficult because of the nature of our accounts. I'm not familiar with brokered CD's but my impression is that even in normal times the bid/asked spread would erase much of the benefit of the current CD/Treasury yield spread if you had to "cash out" early. Is your analysis strictly applicable to direct CD's?
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:The CDs are not the first thing I'd look to for rebalancing into stocks in a bear market, although they could come into play. That's what the slug of long-term Treasuries would be for if you wanted to optimize this potential benefit in flight-to-safety scenarios (based on recent history anyway), or go with a slug of intermediate-term Treasuries if you prefer.

First thing to keep in mind is that you're probably only going to use a portion of your fixed income to rebalance into stocks. So why give up a yield premium of 100 basis points with no credit risk and minimal term risk (limited to the early withdrawal penalty) for the much larger portion of your fixed-income that will not be used to rebalance?
We are more in alignment with this aspect. I think it's important to give yourself some estimate of how much you will need to rebalance in a bear crisis. Like you I would use Treasuries for the actual rebalancing. Right now we would need ~20% of our FI in Treasuries to cover my bear estimate and we have ~30% so I still have some flexibility.

Unlike you for the rest of the FI portfolio I am willing to take on some credit risk by using investment grade corporate bond funds. These may not be very good during the flight to quality period but seem to recover within a few years. So I'm good with that if I don't need the money in the meanwhile. And that is unlikely since I have that extra 10% in Treasuries. Given your analysis maybe that 10% should go into CD's but that would limit my flexibility in avoiding wash sales in a TLH situation.
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Re: Another look at corporate bonds

Post by triceratop »

Kevin M wrote:
Doc wrote:
Kevin M wrote:... but I don't consider it as part of my really safe assets that I can think of as part of my LMP; that comes more from my CDs.
OK Kevin, didn't mother ever tell you that you can't have your cake and eat it to? Are your CD's for a LMP or to rebalance the

Image
The CDs are not the first thing I'd look to for rebalancing into stocks in a bear market, although they could come into play. That's what the slug of long-term Treasuries would be for if you wanted to optimize this potential benefit in flight-to-safety scenarios (based on recent history anyway), or go with a slug of intermediate-term Treasuries if you prefer.

First thing to keep in mind is that you're probably only going to use a portion of your fixed income to rebalance into stocks. So why give up a yield premium of 100 basis points with no credit risk and minimal term risk (limited to the early withdrawal penalty) for the much larger portion of your fixed-income that will not be used to rebalance?

Since I don't go the Treasury route, the first place I look to for rebalancing is cash, which doesn't give a flight-to-safety bump, but at least doesn't drop in value in a crisis. With the yield on cash to retail investors at 1%, which now is almost as the yield on a 5-year Treasury, cash isn't so bad to hold now.

Keep in mind that the cash allocation can temporarily surge due to proceeds from maturing CDs. With enough CDs, as I have, it's not unlikely that a CD will be maturing at some point after stocks have dropped a lot, so this is a likely source for rebalancing.

Next I look to my (non-Treasury) bond funds. My California muni and investment-grade bond funds actually increased in value during the stock swoon in the first 1.5 months of this year, reaching a local peak right when stocks reached bottom in early February. So between the proceeds from maturing CDs and my bond funds there was plenty of fodder for doing a little rebalancing into international stocks earlier in the year.

Finally, if the values of my bond funds do decline by more than 1% or so when stocks really tank, then doing an early withdrawal from a CD, and paying a penalty of 1% or so, does become an option to consider. So in this sense, yes, CDs can play the role of both an LMP and as a rebalancing partner for stocks--assuming that you have enough of them to fulfill both roles.

Kevin
(emphasis mine)

This is true, but in order to keep a fixed allocation before and after rebalancing, you will need to rebalance into the bumped-up treasuries. You will probably do something like:

treasuries -> stocks
CDs -> treasuries (post bump)

I don't think you forgot about this, but in my opinion it's worth repeating that you are still giving up part of that bump. The CD premium is likely still more significant than this lack of optimality, but it's hard to directly compare the benefits of each of yield and flight-to-safety.
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Re: Another look at corporate bonds

Post by Kevin M »

kolea wrote: Kevin, the point here is to ignore return on capital.
A main point I raised was about return OF capital, not just return ON capital. The point is that with high-yield bonds your capital erodes over time, and even falling interest rates do not save you from this. Looking at the max period available on Google Finance, from Jan 14, 2000 through July 15, 2016, VWEHX (high yield) share price fell by more than 20%, while VWITX (int-term Treasury) share price increased by more than 15%. So with the Treasury fund you can make up for some of the lower income distributions by selling shares at an appreciated price, and now we are back to considering total return, not just income distributions.

Having said that, VWEHX has had higher total return than VWITX since 2001, as well as over the longest period we can look at on PortfolioVisualizer (May 1985 through June 2016). So over this fairly long period, the credit risk has indeed been rewarded, but of course Larry will argue that you could have achieved the same result more efficiently with a higher stock allocation and safe bonds.
kolea wrote: I have not argued that bonds yield a stable cash flow, my argument is that it is more stable than cash flow derived from capital gains. Yes, cash flow is going to decrease as interest rates fall.
But you did argue that when you compared high yield bonds to an LMP. For an LMP we want reliable cash flows, ideally in real terms.
kolea wrote:That is no different than any other bond. In fact everything I have said can be applied to investment grade corporate bonds. The idea of looking at cash flow rather than return on capital is the same in either case. HY bonds are just an extreme case of that.
Again, the difference is the erosion of capital with high-yield bonds, even during a period of falling interest rates when we would expect bond fund prices to increase. VFICX (int-term inv-grade) share price increased almost 10% since January 2000, compared to the 20% loss in VWEHX. So they're not the same.

For the longest period we can look at, VWEHX had a slightly higher return than VFICX since November 1993, but the Sharpe ratio for VFICX was significantly higher at 0.72 compared to 0.54 for VWEHX.

Interestingly, the Sharpe ratio for VFICX is higher than that for VFITX at 0.59 (Treasuries) over this period. So here the risk-adjusted winner for a 100% bond portfolio was intermediate-term investment-grade. Credit risk was rewarded, but you got most of the reward with intermediate-term investment-grade bonds, and only incremental reward for taking significantly more risk in high-yield bonds.

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Re: Another look at corporate bonds

Post by Doc »

triceratop wrote:
Kevin M wrote:
First thing to keep in mind is that you're probably only going to use a portion of your fixed income to rebalance into stocks.

Kevin
(emphasis mine)

This is true, but in order to keep a fixed allocation before and after rebalancing, you will need to rebalance into the bumped-up treasuries. You will probably do something like:

treasuries -> stocks
CDs -> treasuries (post bump)

I don't think you forgot about this, but in my opinion it's worth repeating that you are still giving up part of that bump. The CD premium is likely still more significant than this lack of optimality, but it's hard to directly compare the benefits of each of yield and flight-to-safety.
triceratop, I think you are addressing Kevin but let me see if I understand your point.

First if we sell bumped up Treasuries at some time later presumably when the markets "normalize" those Treasuries need to be replaced (rebalanced) with other FI. In Kevin's plan he needs to sell some of his CD's thus he loses some of their benefit. Likewise in my plan I lose some of the benefit from the corporates which I need to rebalance. But maybe neither has to occur. We simply wait until the equity market recovers and then use stocks to rebalance our FI sectors.

Do I have your idea right?
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Re: Another look at corporate bonds

Post by triceratop »

Doc wrote:
triceratop wrote:
Kevin M wrote:
First thing to keep in mind is that you're probably only going to use a portion of your fixed income to rebalance into stocks.

Kevin
(emphasis mine)

This is true, but in order to keep a fixed allocation before and after rebalancing, you will need to rebalance into the bumped-up treasuries. You will probably do something like:

treasuries -> stocks
CDs -> treasuries (post bump)

I don't think you forgot about this, but in my opinion it's worth repeating that you are still giving up part of that bump. The CD premium is likely still more significant than this lack of optimality, but it's hard to directly compare the benefits of each of yield and flight-to-safety.
triceratop, I think you are addressing Kevin but let me see if I understand your point.

First if we sell bumped up Treasuries at some time later presumably when the markets "normalize" those Treasuries need to be replaced (rebalanced) with other FI. In Kevin's plan he needs to sell some of his CD's thus he loses some of their benefit. Likewise in my plan I lose some of the benefit from the corporates which I need to rebalance. But maybe neither has to occur. We simply wait until the equity market recovers and then use stocks to rebalance our FI sectors.

Do I have your idea right?
I'm not certain what you mean by "normalize", but typically with an asset allocation you want to rebalance back to your portfolio pre-crisis. So you're using bumped-up treasuries to buy depressed stocks (and elevated stocks to buy depressed treasuries). My point is that when you sell bumped-up treasuries to buy stocks, you need to also buy bumped-up treasuries with CDs, and that this is non-optimal. You need to do this because you have a static FI sub-allocation between treasuries and CDs.

Similar argument applies for corporates.

If you're waiting for the market to recover, then you no longer have a static allocation. This is fine, but the comparison is not really possible.
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Re: Another look at corporate bonds

Post by Doc »

triceratop wrote:I'm not certain what you mean by "normalize", but typically with an asset allocation you want to rebalance back to your portfolio pre-crisis. So you're using bumped-up treasuries to buy depressed stocks (and elevated stocks to buy depressed treasuries). My point is that when you sell bumped-up treasuries to buy stocks, you need to also buy bumped-up treasuries with CDs, and that this is non-optimal. You need to do this because you have a static FI sub-allocation between treasuries and CDs.

Similar argument applies for corporates.

If you're waiting for the market to recover, then you no longer have a static allocation. This is fine, but the comparison is not really possible.
Yes I don't have a static allocation in FI sectors. I don't buy Treasuries with CD's (or Corporates) during the equity crisis. I let my FI sector allocation drift wherever it may go. (Hard to tell up front because Treasury prices are going up, Corporate prices are going down and (bank) and CD's are static.) Sometime later when the FI market has "normalized" I rebalance my FI sectors. In the Lehman debacle for example it took about a year for the Vanguard Intermediate-Term Investment-Grade fund price to get back to where it was at the start. This is a lot shorter period than the S&P 500 recovery. In the meantime I am also directing new investments and income into the underweighted Treasuries(Doc)/CD's(Kevin?) as is my normal practice.

In general I don't actively rebalance sectors either FI or equity. I am aware if a sector is underweight or overweight. If I need to rebalance my overall AA I sell/buy my overweight/underweight sectors as appropriate. Ditto with investment income or new contributions.
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote: I don't think its that easy. In the last 2 months of 2008 the price of Vg Intermediate Term Treasury fund rose by 10%. If that type of thing occurred once every 10 years you get a "flight to quality" boost of some 100 bps. That wipes out the current 70 bps advantage of a 5 yr CD over a 5 yr Treasury. This is somewhat better than what you implied.
I don't think this is the right way to look at it. The bump in price was temporary, mostly given back by May 2009 (and only 10% if you cherry pick low and high price--less for more realistic case). So you only benefited to the extent you rebalanced into stocks at just the right time. In other words, you did not book a 10% gain in the bond fund unless you sold at the peak and bought at the trough; i.e., your market timing skills were superb (or you were lucky).

The fair comparison for bonds that you are going to hold is buying and holding a 5-year security to maturity, in which case a 5-year CD with 100 bps yield premium is going to provide a cumulative return benefit of about five percentage points over five years. To put it another way, if you're looking at a 2% CD vs. a 1% Treasury or a 3% CD vs. a 1.5% Treasury, you earn double the return on the CD.
Doc wrote:On the short end comparing the price of Vg Short Term Treasury fund with the same five year CD you only get about a 20 bps "flight to quality" boost so the CD does comes out ahead.
So we agree that a 5-year CD is a better deal than a short-term Treasury, since not only does the CD provide much higher yield, but has roughly the same risk as a short-term Treasury. And again, you probably aren't going to book most of that 20 bps boost unless your timing is exquisite.
Doc wrote:I'm not going to buy the short term Treasury fund. I'm going to use a 1-5 ladder. The newer rungs are going to have a higher boost. Again back to 2008 the on the run five had 70 bps boost which then equals the CD advantage even ignoring the early withdrawal penalty.
Again, probably not going to book it. My CD ladder generated more than 100 bps more than the Treasury ladder (not 70 bps). If I wanted to count on 5-year Treasuries for a flight-to-safety boost (which I don't), maybe I would roll 5-year CDs annually, book the roll yield (as long as yield curve doesn't flatten or 4-year rates otherwise increase enough to eliminate it), and do just what you'd do with the newer rungs of the 1-5 year Treasury ladder in a crisis.
Doc wrote:I'm actually not even going to use a 1-5 ladder but more like a 3-10. (I'm likely going to sell before maturity either to capture roll yield or to to convert ordinary income into LTCG.) Therefore I am going to have a lot of flexibility.
OK, for the part of your fixed income you're holding for a possible flight-to-safety benefit, this makes more sense than the intermediate-term Treasury fund, since you hold bonds in the same maturity range, but can sell just the bonds that get the biggest bump. Of course the "roll yield" you intend to capture is purely speculative, and could easily be more than wiped out by increasing yields or flattening yield curve. From 1972-1981 roll yield was negative, and you earned more by just sitting in cash. I'd be careful about being lulled into complacency about roll yield due to recency bias.
Doc wrote:For me using direct CD's would be difficult because of the nature of our accounts. I'm not familiar with brokered CD's but my impression is that even in normal times the bid/asked spread would erase much of the benefit of the current CD/Treasury yield spread if you had to "cash out" early. Is your analysis strictly applicable to direct CD's?
If you have IRA accounts, you can easily do direct CDs, but you're probably not going to want to use them as your first option for rebalancing with bands, since it takes 2-4 weeks to do an IRA transfer back into an account in which you can buy stocks. For time-based rebalancing it would be just fine, since you could structure your CD maturities to match your rebalancing schedule, but we're not talking about that here.

In taxable accounts, it only takes a few days to do an early withdrawal and have the proceeds transferred into an account in which you can buy stocks. If you have a savings or checking account at the same bank or credit union linked to a Vanguard account, you could buy stocks within one day of doing an early withdrawal and having the proceeds deposited into the savings or checking account.

True that the bid/ask on brokered CDs makes it less attractive to sell before maturity, but even with a spread of 1%-2%, you earn that in 1-2 years with a CD premium of 100 bps, so unless you're going to plan on stocks dropping enough to tap them every few years for rebalancing, you probably still come out ahead with the CDs. Or you can plan on holding CDs to maturity, book the yield premiums, and keep your Treasury ladder for possible rebalancing benefits.

I personally have been sticking with direct CDs over the last 5.5 years, due to the huge benefit of the early withdrawal option (and often higher yields), essentially giving me intermediate-term or even long-term yields with short-term type term risk. But I would prefer brokered CDs to Treasuries for fixed income I could plan to hold to maturity, getting liquidity from somewhere else, like my bond funds or cash, or if you prefer, a Treasury ladder of some sort.

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Re: Another look at corporate bonds

Post by patrick013 »

I would love to have a 5 year CD ladder. With each year
a 5 year CD would mature and be renewed with a new 5
year CD. What could be better than that for ST fixed
income. HY bonds and even high quality Preferred stocks
aren't AAA.
age in bonds, buy-and-hold, 10 year business cycle
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Re: Another look at corporate bonds

Post by Doc »

Kevin, I'll hit just a few points to highlight some misconceptions and possible differences of opinion.
Kevin M wrote:I don't think this is the right way to look at it. The bump in price was temporary, mostly given back by May 2009 (and only 10% if you cherry pick low and high price--less for more realistic case). So you only benefited to the extent you rebalanced into stocks at just the right time. In other words, you did not book a 10% gain in the bond fund unless you sold at the peak and bought at the trough; i.e., your market timing skills were superb (or you were lucky).
No I'm not lucky. I just rebalance my equities during an equity bear according to my 5% bands. I do concede that my illustration was a bit cherry picked. And I will/did rebalance my FI sectors when the bond market "normalized".

Re: Short/Intermediate/Long: No argument. I'm going to hold a 1-10 Treasury position. That's my IPS. I'll do it with both funds and individual bonds. I prefer individual bonds. I don't need a fund for Treasuries. Why pay the e/r. But I will hold some Treasury funds for convenience. (I will hold long TIPS if the real yield is attractive.) The price of different maturity Treasuries may perform differently in the next bear than they did in '08. I will pick the best ones the next time because I will have a choice at the time. CD's will all have the same price spike - zero. No flexibility.
Kevin M wrote:If you have IRA accounts, you can easily do direct CDs, but you're probably not going to want to use them as your first option for rebalancing with bands, since it takes 2-4 weeks to do an IRA transfer back into an account in which you can buy stocks. For time-based rebalancing it would be just fine, since you could structure your CD maturities to match your rebalancing schedule, but we're not talking about that here.
When I do a TLH in international I do the trades between 30 minutes after market open in NY and 30 minutes before market close in Europe. I am not emotionally capable of waiting 2-4 weeks to complete a trade pair. :wink:
Kevin M wrote:Again, probably not going to book it. My CD ladder generated more than 100 bps more than the Treasury ladder (not 70 bps). If I wanted to count on 5-year Treasuries for a flight-to-safety boost (which I don't), maybe I would roll 5-year CDs annually, book the roll yield (as long as yield curve doesn't flatten or 4-year rates otherwise increase enough to eliminate it), and do just what you'd do with the newer rungs of the 1-5 year Treasury ladder in a crisis.
OK. But I may not need to sell the whole position. Just the best rung(s). I get to cherry pick after the fact. With CD's there are no cherries. They are all applesauce. (They all sell at 100,)
Kevin M wrote:In taxable accounts, it only takes a few days to do an early withdrawal and have the proceeds transferred into an account in which you can buy stocks. If you have a savings or checking account at the same bank or credit union linked to a Vanguard account, you could buy stocks within one day of doing an early withdrawal and having the proceeds deposited into the savings or checking account.
OK. (We already have 7 brokerage accounts and three bank accounts. I don't want any more unless it gives me a whole lot more return than we are talking about. I don't have a long lifetime ahead to compound a few ten of basis points on only 20% of my portfolio. :( )
Kevin M wrote:True that the bid/ask on brokered CDs makes it less attractive to sell before maturity, but even with a spread of 1%-2%, you earn that in 1-2 years with a CD premium of 100 bps, so unless you're going to plan on stocks dropping enough to tap them every few years for rebalancing, you probably still come out ahead with the CDs.
Don't know. Right now Vanguard is showing only 1 of 20 bid/ask quotes on the first screen and that spread is 2%. The bond markets are very calm today. We are not in a flight to quality situation. Do you know what the bid/ask was in November '08?
Kevin M wrote:I personally have been sticking with direct CDs over the last 5.5 years, due to the huge benefit of the early withdrawal option (and often higher yields), essentially giving me intermediate-term or even long-term yields with short-term type term risk
Lehman was in 2008 and we are in 2016. That is 8 years. Doc diagnoses Kevin with a case of recency bias. I prescribe more :beer
Kevin wrote:But I would prefer brokered CDs to Treasuries for fixed income I could plan to hold to maturity, getting liquidity from somewhere else, like my bond funds or cash, or if you prefer, a Treasury ladder of some sort.
We're talking about selling to rebalance in a stock market crash. Holding to maturity is irrelevant in that scenario. The hold to maturity choice should be between CD's and corporates which becomes "only" a credit risk trade off with nothing to do with ursus arctos horribilis and that is a completely different discussion.

Good discussion. I think a lot of "what is best" is more a matter of emotional fortitude than hard calculations. Both guts and market predictions are subject to high standard deviation.
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote: Unlike you for the rest of the FI portfolio I am willing to take on some credit risk by using investment grade corporate bond funds. These may not be very good during the flight to quality period but seem to recover within a few years. So I'm good with that if I don't need the money in the meanwhile.
Actually we're kind of on the same page here, since I too take some credit risk with the 20%-25% of fixed income that is not in CDs or cash. Although I see the merit of holding some intermediate-term or long-term Treasuries for potential rebalancing bonus during big stock downturns, I don't actually do it, because Treasury yields always have seemed too low to me, compared to CDs, over the last 5+ years.

So I just accept that I'm not going to get the flight-to-safety bump, but the closer yields get to 0%, the less potential there is for much of that, unless you believe that yields could go well below 0%. With a 5-year Treasury at about 1%, you're looking at less than 5% price appreciation if the yield goes to 0%. So you're not going to get the 8% bump you could have gotten (with perfect timing) when the 5-year yield fell from about 3% at the peak in mid-October 2008 to about 1.3% at the bottom in mid-December 2008, with the potential to have gotten as much as 15% if 5-year yields had fallen to 0% back then.

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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:So I just accept that I'm not going to get the flight-to-safety bump, but the closer yields get to 0%, the less potential there is for much of that, unless you believe that yields could go well below 0%. With a 5-year Treasury at about 1%, you're looking at less than 5% price appreciation if the yield goes to 0%. So you're not going to get the 8% bump you could have gotten (with perfect timing) when the 5-year yield fell from about 3% at the peak in mid-October 2008 to about 1.3% at the bottom in mid-December 2008, with the potential to have gotten as much as 15% if 5-year yields had fallen to 0% back then.
Just speculation here but I don't think the "flight to safety" concept has anything to do with interest rates. The price/rate/duration concept is a mathematical construct about the yield curve. The "flight to safety" is an emotional thing. "Oh sith the stock market is dropping out the bottom I need to sell and put everything in something safe. Screw yield." In that situation you probably only need a small percent of market participants to move the bond market at least for a short time.

Where's Larry?
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Re: Another look at corporate bonds

Post by Kevin M »

triceratop wrote: This is true, but in order to keep a fixed allocation before and after rebalancing, you will need to rebalance into the bumped-up treasuries. You will probably do something like:

treasuries -> stocks
CDs -> treasuries (post bump)

I don't think you forgot about this, but in my opinion it's worth repeating that you are still giving up part of that bump.
As I've said, I don't actually do this, but have suggested holding CDs and longer-term Treasuries as a possibly superior alternative to just holding a Treasury bond fund, if what you're looking for is a potential rebalancing bonus during a financial crisis. With the CD+Treasury combination you get the much higher yields from the CDs, while maintaining a potential flight-to-safety rebalancing bonus from the Treasuries.

If I did do this, I wouldn't restock my Treasury allocation from CDs during a financial crisis, since the net effect would be that I've used my CDs (with no bump) to buy stocks, and just maintained my Treasury allocation. I would do something more like Doc has described, and use the Treasuries to rebalance into stocks based on some rebalancing band approach, and just hold my CDs, maintaining my stock/fixed-income allocation, but not worrying about maintaining a fixed CD/Treasury allocation. Once I'd shot my Treasury wad, I'd just wait for the opportunity to rebalance from stocks back into Treasuries.

As mentioned, I personally have not employed this approach, and don't hold Treasuries at all (other than the small amount in my investment-grade bond funds), because yields have seemed to low relative to the alternatives. Yields don't have much further to fall until there's no juice at all left in this strategy, unless you believe yields can fall significantly below 0%.

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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote:
Kevin M wrote:So I just accept that I'm not going to get the flight-to-safety bump, but the closer yields get to 0%, the less potential there is for much of that, unless you believe that yields could go well below 0%. With a 5-year Treasury at about 1%, you're looking at less than 5% price appreciation if the yield goes to 0%. So you're not going to get the 8% bump you could have gotten (with perfect timing) when the 5-year yield fell from about 3% at the peak in mid-October 2008 to about 1.3% at the bottom in mid-December 2008, with the potential to have gotten as much as 15% if 5-year yields had fallen to 0% back then.
Just speculation here but I don't think the "flight to safety" concept has anything to do with interest rates. The price/rate/duration concept is a mathematical construct about the yield curve. The "flight to safety" is an emotional thing. "Oh sith the stock market is dropping out the bottom I need to sell and put everything in something safe. Screw yield." In that situation you probably only need a small percent of market participants to move the bond market at least for a short time.

Where's Larry?
It has everything to do with interest rates (yields), since what we've been talking about is taking advantage of a price increase in Treasuries during a financial crisis to rebalance into stocks, and price and yield are two sides of the same coin. With yield at 0%, you're only going to get significant bump in price if yields fall well below 0%. Without the potential for significantly negative yields, Treasuries with yields close to 0% have little more benefit in a financial crisis than a CD that simply maintains its value.

If you want to hold a 3-year Treasury with a yield of about 0.8% and a maximum price gain potential of about 2.4%, and with the possibility of a price decline of more than 2.4%, go ahead. I'll continue to prefer a 5-year CD with a yield of 2% and maximum downside of 1%. I'll give up the remote possibility of a 2% gain for the guaranteed incremental 1.2% per year income. Either one will provide the safety I'm looking for in fixed income, but the CD will provide more guaranteed income, and only gives up a low-probability speculative gain component.

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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:It has everything to do with interest rates (yields), since what we've been talking about is taking advantage of a price increase in Treasuries during a financial crisis to rebalance into stocks, and price and yield are two sides of the same coin. With yield at 0%, you're only going to get significant bump in price if yields fall well below 0%. Without the potential for significantly negative yields, Treasuries with yields close to 0% have little more benefit in a financial crisis than a CD that simply maintains its value.
Kevin, I just find the price/yield relationship in a Lehman type crisis to be just irrelevant. In the three week period in late September through early November 2008 the S&P 500 was dropping at a rate of 1.5% a day. And you are telling me that a negative yield of 1% on a five year note is a significant factor. Interest rates are driven by economic conditions with a little Fed tinkering. Bond prices adjust accordingly. In normal times interest rates are the independent variable. But the drop in the stock market had nothing to do with the economy. Treasury prices rose because of a flight to quality not a drop of 2% in the five year Treasury rate caused of some Zombie apocalypse that destroyed all the businesses in the country in a three week period. The operative would here is flight. Irrational behavior not a duration x rate change equation. Besides the Treasury yield recovered much faster than the stock market. The yield on the five was back at its mid-September starting point by June of the following year. The S&P didn't recover until some 15 months after that.

Kevin, I think we are in agreement that in a flight to quality situation Treasuries especially long ones, outperform CD's. The open question is if the cost associated with the better performance is worth it. The "insurance premium" if you like. We also agree that you don't have to have all your FI portfolio in the single best sector for an equity crash. It seems to me that what we should be addressing is if the rest of the portfolio should be CD's or Corporates. Maybe we should take "Another look at corporate bonds".
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Re: Another look at corporate bonds

Post by saltycaper »

Doc wrote:
. . . I think we are in agreement that in a flight to quality situation Treasuries especially long ones, outperform CD's. The open question is if the cost associated with the better performance is worth it.
Been wondering the same thing since I asked on page one. At what spread would you all start preferring Treasuries?
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Re: Another look at corporate bonds

Post by soboggled »

The only real advantages of Treasury bonds over FDIC insured CDs are 1) exemption from state income taxes, 2) much less risk of premature maturity due to failure of issuer, 3) availability in mutual funds, including automatic reinvestment and 4) possibly more liquidity.
I think 2) and 4) are minor considerations for most individuals. If you are willing to buy them yourself, the primary advantage is in 2), so figure out the better yield after taxes, unless you want the convenience, diversification and reinvestment of mutual funds. Of course a mutual fund may realize capital gains or losses, so that may affect taxes and complicate matters, while CDs and individual bonds may be laddered to provide a completely predictable stream of income.
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Re: Another look at corporate bonds

Post by larryswedroe »

First, the advantage of no state taxes for Treasuries isn't an advantage for most people, in fact disadvantage because it drives T yields lower and for most investors in taxable accounts should be holding munis, unless in lowest bracket.

And here's a word of caution re corporates: Fitch Ratings’ Fitch Fundamental Index (FFI) dropped in the second quarter, primarily due to weakening corporate credit quality. Moody’s also released a recent report that suggested credit quality failed to show improvement. Moody’s noted that although the pool of lowest rated issues shrunk it the second quarter, it was actually because more of those companies are defaulting rather than improving credit worthiness.
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Re: Another look at corporate bonds

Post by Trader/Investor »

larryswedroe wrote:First, the advantage of no state taxes for Treasuries isn't an advantage for most people, in fact disadvantage because it drives T yields lower and for most investors in taxable accounts should be holding munis, unless in lowest bracket.

And here's a word of caution re corporates: Fitch Ratings’ Fitch Fundamental Index (FFI) dropped in the second quarter, primarily due to weakening corporate credit quality. Moody’s also released a recent report that suggested credit quality failed to show improvement. Moody’s noted that although the pool of lowest rated issues shrunk it the second quarter, it was actually because more of those companies are defaulting rather than improving credit worthiness.
A word of caution? Marty Fridson now says the overvaluation in junk bonds is staggering. Of course he first noted this extreme overvaluation in February (see second link) Best to just listen to the action of the market. Been a whole lot of upside since February.

http://blogs.barrons.com/incomeinvestin ... hp_blog_ii

http://wolfstreet.com/2015/04/23/strate ... y-fridson/
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Re: Another look at corporate bonds

Post by nedsaid »

Doc wrote: Regarding comparing funds in isolation: Right Larry, I am already in your choir. I was joshing nedsaid. Just for fun. :D
Doc, what I posted regarding three funds that I actually own compared to Vanguard Intermediate-Term Treasury fund reinforces the point that Larry made.

Diversified Bond and Vanguard Total Bond Market are similar funds, they are diversified intermediate-term investment grade bond funds that hold treasuries, agency bonds, and corporates but in different proportions. Diversified Bond will change the proportions of treasuries, agency bonds, and corporates according to market conditions and manager decisions. Diversified Bond will also make adjustments in the maturities and make small interest rate bets. These two funds had nearly identical results to the Vanguard Intermediate-Term Treasury fund.

I also own the Fidelity GNMA fund which I have owned since 1999 and have been extremely pleased with. It has a similar characteristic to Treasuries in that there is no default risk. But GNMAs have a call risk as homeowners tend to refinance as interest rates drop. Treasuries don't have a call risk. The GNMA fund had almost an identical 10 year record to Vanguard Intermediate-Term Treasury.

Backing Larry's point, the Vanguard Intermediate-Term Treasury fund spiked up during the 2008-2009 financial crisis whereas Diversified Bond, Vanguard Total Bond Index, and Fidelity GNMA actually showed small temporary losses. The diversification benefits of treasuries really kicked in an the precise time that you needed them, that is during a time stocks were getting crushed. Treasuries went up when stocks were down. The three funds that I own were all down just a tiny bit.

So what I was trying to do was to show a real life example of what Larry was talking about. If you had a bit of fun with my post, I guess that is okay. The moderators allow fun around here, but not very much. Too much fun gets the thread locked. ;o)
Last edited by nedsaid on Wed Jul 20, 2016 2:07 am, edited 1 time in total.
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Re: Another look at corporate bonds

Post by nedsaid »

Kevin M wrote:
It seems really ineffective to me to refuse to think in terms of total return, and to try and hand-wave away the gradual degradation of capital inherent in a high-yield bond fund. If you want to own this asset class, best not to fool yourself about the risks.

Kevin
Kevin, I consider you, lack_ey, and Larry Swedroe among the best posters on this forum. I really enjoy reading your posts and you made the above point rather well.

There is a family member who likes to chase yield. This person will say, "I am getting 8% (or whatever the higher yield is)!" I always reply that 8% of zero is still zero.

The point is that many higher yielding assets tend to be somewhat self-liquidating over time. You get high yield but the principal value just keeps dropping. This happens with corporates as credit quality declines over time, with many preferred stocks, with high-yield bond funds, with certain Master Limited Partnerships, and it has even happened with a few high dividend stocks. What good is it if the yield is high but your principal keeps dropping? One hand gives and the other hand takes away. The yield giveth and the principal taketh away.

I don't own Vanguard High-Yield Bond but I did follow it for a short time for that family member. Over time, with dividend reinvestment, the value of the investment kept rising though the Net Asset Value seemed to keep dropping.

Thank you Kevin for making this point. It cannot be over emphasized.
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Re: Another look at corporate bonds

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Doc wrote: Kevin, I just find the price/yield relationship in a Lehman type crisis to be just irrelevant.
This statement just baffles me--especially coming from someone who has seemed so sharp on "bond math" in other posts. The price/yield relationship for bonds is invariable--it always applies. You tell me the yield (and other relevant parameters, such as coupon, maturity and settlement), I can tell you the price. You tell me the price, along with the other relevant parameters, and I can tell you the yield. I'm sure you could do the same. End of story (at least it should be).
Doc wrote:In the three week period in late September through early November 2008 the S&P 500 was dropping at a rate of 1.5% a day. And you are telling me that a negative yield of 1% on a five year note is a significant factor.
If what you're asking is whether or not I think the 5-year Treasury yield could drop significantly below 0%--like -1%, -2% or further--then I guess my answer is that I don't know, but it's something we have not yet seen in this country, so it would be unprecedented. In all of my comments on this topic, my qualifier has been something like, "unless you think rates can fall significantly below 0% ...". So sure, to the extent that you think this is probable, continuing to hold intermediate-term or long-term Treasuries even as yields approach 0%, for a flight-to-safety hedge, could continue to make sense. I hope we don't see this occur, but hope is not a good basis for an investing strategy. And as Larry reminds us, we should not confuse the improbable with the impossible.
Doc wrote:Interest rates are driven by economic conditions with a little Fed tinkering. Bond prices adjust accordingly. In normal times interest rates are the independent variable.
Agree with the first two statements, but not necessarily the last. You can think of either price or yield as dependent or independent variable for a bond. They are just two ways of expressing bond value. I recall that I could enter a limit order to buy or sell a bond at Fidelity by specifying either price or yield, which is completely consistent with the way I think about bond price and yield now.

Having said that, I think the way people commonly think about it is as you describe. An example is the common way of expressing the duration rule of thumb as a percent change in price (dependent variable) given a one percentage point change in yield (independent variable). There are many other similar examples. But when it comes to the actual bond math, this is not the correct way to think about it. One starts to view it more the way it is after using enough PRICE and YIELD formulas in a spreadsheet.
Doc wrote:But the drop in the stock market had nothing to do with the economy. Treasury prices rose because of a flight to quality not a drop of 2% in the five year Treasury rate caused of some Zombie apocalypse that destroyed all the businesses in the country in a three week period.
Well, the first statement seems bizarre to me, but that's not directly relevant to this discussion, so I'll leave it alone. But just as you say Treasury prices rose because of a flight to quality, you could say with equal accuracy that Treasury yields fell because of a flight to quality. Again, just two ways to measure the same thing.

It is more common to think of increasing demand driving prices up, so just as it may be more common to think of yields as the independent variable when discussing things like duration, it might be more comfortable to think of price as the independent variable (in terms of price and yield) when discussing the effects of supply and demand. But from the pure math perspective, we can express the change using either price or yield without attributing either one as irrefutably the independent or dependent variable.

An imperfect analogy is that we can express mileage as either miles per gallon (common) or gallons per mile (uncommon). One goes up as the other goes down (so this is similar to price and yield), yet mathematically either one can be used to express the same thing. Just because it's common to express it one way does not make the other expression incorrect.
Doc wrote:The operative would here is flight. Irrational behavior not a duration x rate change equation.
But they are not mutually exclusive! Flight to safety is the underlying behavioral cause of yield and price changing, and duration just provides an approximation that defines the relationship between change in price and change in yield. The bond math applies exactly the same whether the underlying cause of the changes is flight to safety in a financial crisis or a more gradual change in the economy.
Doc wrote:Besides the Treasury yield recovered much faster than the stock market. The yield on the five was back at its mid-September starting point by June of the following year. The S&P didn't recover until some 15 months after that.
Sorry, don't get the relevance of this. Bond math applies to bonds in all cases.
Doc wrote:Kevin, I think we are in agreement that in a flight to quality situation Treasuries especially long ones, outperform CD's. The open question is if the cost associated with the better performance is worth it. The "insurance premium" if you like.
Yes, this certainly has been true in recent years. Looking at times longer ago, short-term Treasuries (3 month) sometimes did as well as or better than longer-term Treasuries (10 year) in big market downturns--at least if you look only at annual returns. I've shared this data before, using the Damodaran returns data as a source.

Since essentially all of the return for short-term Treasuries comes from interest--certainly over a one-year period--this is essentially saying that sometimes cash has outperformed the 10-year Treasury on an annual basis in big stock market drops. Since a good 5-year CD currently provides higher interest than cash, it follows that a good direct CD would have done even better than cash in these scenarios, unless you mark your CD to a mythical market value (since there is no secondary market for direct CDs). If you object to the last part, just consider this an argument for holding some cash at 1% in an online savings account.

So we absolutely agree that based on recent history, Treasuries, especially longer-term, have provided a good hedge against falling stock prices, while at best CDs have not lost value--unless you had to do an early withdrawal to buy stocks, in which case they lost a little--on the order of 1%--still much less than the losses in corporate bonds during 2008.

But in the same breath that we say that, we also should say that CDs have consistently outperformed Treasuries if both have been held to maturity over at least the last 5-6 years, and that a good CD is guaranteed to significantly outperform a Treasury of the same maturity if both are purchased today and held to maturity. A good CD also is almost guaranteed to outperform a Treasury if rates increase enough to warrant doing an early withdrawal and paying the small penalty (the "almost" qualifier because of the remote chance that an early withdrawal will be disallowed). So that's two out of three in favor of the direct CD, leaving only the lack of potential upside to be capitalized on if selling before maturity after a decline in Treasury yields (e.g., to buy stocks). I guess your way of acknowledging this is to reference the insurance premium you're paying for Treasuries.
Doc wrote:We also agree/ that you don't have to have all your FI portfolio in the single best sector for an equity crash.
Absolutely. I'd go further and say that you don't have to have any of your FI in this asset class (Treasuries) if you're willing to give up the potential bump in a flight-to-safety scenario, which is the case for me.
Doc wrote:It seems to me that what we should be addressing is if the rest of the portfolio should be CD's or Corporates.
Of course this question doesn't apply to me, since I hold CDs and some corporates but no Treasuries (other than what's in my investment-grade bond funds).

I recall from a recent post that Larry said that his firm uses CDs almost exclusively for the tax-advantaged portion of their clients' portfolios, since the yields are so much better than Treasuries. They even use CDs in taxable accounts of wealthy clients since after-tax yields can be even higher than muni yields, especially for shorter maturities. So I'm wondering where Larry comes down on the use of Treasuries as a hedge against financial crisis--from my understanding of what he's said, it seems that he might be in the same camp that I'm in, and simply is willing to give up the potential price bump of Treasuries in return for the much higher guaranteed yields of CDs.

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Re: Another look at corporate bonds

Post by jfave33 »

Doc wrote:We also agree/ that you don't have to have all your FI portfolio in the single best sector for an equity crash.
Kevin M wrote:Absolutely. I'd go further and say that you don't have to have any of your FI in this asset class (Treasuries) if you're willing to give up the potential bump in a flight-to-safety scenario, which is the case for me.
Doc wrote:It seems to me that what we should be addressing is if the rest of the portfolio should be CD's or Corporates.

Surely though if you believe there will be an equity crash within the next 5 years (or want insurance against that) and so hold treasuries at all then it would also be wise to hold treasuries with the rest of the fixed income part of the portfolio too - if there was an equity crash then after rebalancing some treasuries into stocks you could move the rest into CDs and therefore capture any price rise from treasury bonds there as well. There could even be a lag with how quickly CD providers react to lowering rates (assuming they do during a crash) and you could move into CDs that have higher yield.

Or am I missing something? Isn't all of this really just about market timing with bonds. Those preferring CDs prefer higher yield now plus some protection against interest rate rises more than they value potential gain or protection from rate falls - therefore either consciously or subconsciously gambling on a static interest rate level/interest rate rises before any further falls? The more risk adverse position since CDs are not going to face the same downside risk.

I suppose the bogleheads way would be to diversify and to include both depending on risk appetite.
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:Doc wrote:
Kevin, I just find the price/yield relationship in a Lehman type crisis to be just irrelevant.

This statement just baffles me--especially coming from someone who has seemed so sharp on "bond math" in other posts. The price/yield relationship for bonds is invariable--it always applies. You tell me the yield (and other relevant parameters, such as coupon, maturity and settlement), I can tell you the price. You tell me the price, along with the other relevant parameters, and I can tell you the yield. I'm sure you could do the same. End of story (at least it should be).
The equation still applies. In normal times the independent variable is the rate and the rate is "set" by economic conditions like demand for capital and inflation. In a Lehman type crisis the independent variable becomes the price. Investors aren't considering the demand for capital or inflation they just want to buy something safe. Yield be damned.
Kevin M wrote: Doc wrote:
In the three week period in late September through early November 2008 the S&P 500 was dropping at a rate of 1.5% a day. And you are telling me that a negative yield of 1% on a five year note is a significant factor.

If what you're asking is whether or not I think the 5-year Treasury yield could drop significantly below 0%--like -1%, -2% or further--then I guess my answer is that I don't know, but it's something we have not yet seen in this country, so it would be unprecedented
The yield on the five on 10/31/08 was 2.8%. On 12/30/08 it was 1.3%. This is a drop of 1.5%. Today the yield on the five is 1.14%. A drop of the same 1.5% gives us a yield of -0.36%. But see the first part. When the markets are in a panic yield is not the driving force. Nobody cares about the five yield when there capital is disappearing at a rate of 40% in 3 or so week.
Kevin M wrote:Doc wrote:
Interest rates are driven by economic conditions with a little Fed tinkering. Bond prices adjust accordingly. In normal times interest rates are the independent variable.

Agree with the first two statements, but not necessarily the last.
I'm not going into economic theory. Suffice is to say that we look at our return on investment as a percent.

Kevin wrote:It is more common to think of increasing demand driving prices up, so just as it may be more common to think of yields as the independent variable when discussing things like duration ...
Stock market panics are not common. :wink:
Kevin M wrote:Doc wrote:
Besides the Treasury yield recovered much faster than the stock market. The yield on the five was back at its mid-September starting point by June of the following year. The S&P didn't recover until some 15 months after that.

Sorry, don't get the relevance of this. Bond math applies to bonds in all cases.
The bond market recovered faster than the stock market.
Kevin M wrote:Doc wrote:
We also agree/ that you don't have to have all your FI portfolio in the single best sector for an equity crash.

Absolutely. I'd go further and say that you don't have to have any of your FI in this asset class (Treasuries) if you're willing to give up the potential bump in a flight-to-safety scenario, which is the case for me.
OK. But realize with CD's you don't get the bump so you have to have more $'s in your "Lehman reserve". Also when you rebalance your FI after the crisis has passed you are going to be able to buy the Treasuries cheaper. (I may be double counting here. Or maybe it's just a yield/price thingy.)
Kevin M wrote:I recall from a recent post that Larry said that his firm uses CDs almost exclusively for the tax-advantaged portion of their clients' portfolios, since the yields are so much better than Treasuries. They even use CDs in taxable accounts of wealthy clients since after-tax yields can be even higher than muni yields, especially for shorter maturities. So I'm wondering where Larry comes down on the use of Treasuries as a hedge against financial crisis--from my understanding of what he's said, it seems that he might be in the same camp that I'm in, and simply is willing to give up the potential price bump of Treasuries in return for the much higher guaranteed yields of CDs.
At 10:43 on Monday in this thread
larryswedroe wrote:Doc
While you don't get the flight to liquidity rise, with secondary CDs you do get the rise due to falling interest rates, so you get a rebalancing benefit, though not quite as strong typically
I wonder why we heard so little about CD's before the Fed ran interest rates to nil? Now we also have high yield and dividend paying stocks discussed like never before. Oh well, this too will pass. Hopefully before we all deplete our retirement funds. At least the inflation on whiskey is at a near low. And I think I shall go perk up demand a little. :beer
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Re: Another look at corporate bonds

Post by Kevin M »

jjface wrote: Surely though if you believe there will be an equity crash within the next 5 years (or want insurance against that) and so hold treasuries at all then it would also be wise to hold treasuries with the rest of the fixed income part of the portfolio too <snip>
Sure, if you have such high certainty that an equity crash will occur before Treasury yields increase a lot and before stock values increase by more than they will crash, then I'd think you'd just hold 0% in stocks and 100% in long-term Treasuries.
jjface wrote:Or am I missing something?
I think that what you're missing is that it's a probabilities game. If I were certain that bond yields would not fall further, I'd probably have 0% in bonds, but because there's still some (limited) potential reward to term risk, and by also taking a bit of credit risk I can get higher yields than on good 5-year CDs, I have between 20% and 25% of fixed income in investment-grade and muni bonds. That percentage has drifted lower as rates have declined toward 0%, but I've also added a bit back to bonds after rates have risen. After all, the 5-year yield fell below 0.6% in 2012, so even in the 1% ballpark we're not at the historical low (unlike the 10-year yield, which is in the same ballpark as the lows in 2012--the yield curve has flattened significantly).

As I've said, I've decided to live without the hedge of having any significant fixed income in Treasuries. For someone who isn't convinced there will be an equity crash with a corresponding plunge in Treasury yields (and increase in Treasury prices), but who thinks there is a non-zero probability that it will happen without Treasury yields increasing a lot first, and who wants a more active hedge against this than I do, a chunk of intermediate-term or long-term Treasuries may be an appropriate holding.
jjface wrote:Isn't all of this really just about market timing with bonds. Those preferring CDs prefer higher yield now plus some protection against interest rate rises more than they value potential gain or protection from rate falls - therefore either consciously or subconsciously gambling on a static interest rate level/interest rate rises before any further falls? The more risk adverse position since CDs are not going to face the same downside risk.
Call it what you want, but in my view it's a decision based on one's perception of the tradeoffs between expected return and risk. In my view this tradeoff strongly favors direct CDs because of virtually guaranteed higher return, compared to a Treasury of same maturity, over a holding period matching the maturity of the CD (say five years), and the possibility of even higher returns due to the possibility of doing an early withdrawal and reinvesting at a rate high enough to more than offset the early withdrawal penalty. With the bulk of my fixed income in this super-safe asset class, I'm willing to take some term risk (and contrary to Larry's main point in this post, some credit risk) in bond funds in return for the potential of having that risk rewarded (as it has been over the last five years). The closer bond yields get to 0%, the less term risk I'm willing to take.

With respect to the gambling comment, you're always placing some sort of bet with any investment, since you're always making a bet that the types of risk you're exposing yourself to will be rewarded, or at least won't show up in a way that's very harmful to your financial well being.
jjface wrote:I suppose the bogleheads way would be to diversify and to include both depending on risk appetite.
I think that there's enough divergence in Bogleheads that any of the approaches discussed here could be considered a Bogleheads way, with the possible exception of having a lot of your fixed income in high yield bonds. I'd say that a total bond market (TBM) index fund probably is the most prototypical Boglehead bond holding--it's a pillar of Taylor's beloved 3-fund portfolio, and it's the primary bond holding of Vanguard's Target Retirement and LifeStrategy funds, yet it's a fund that neither Doc, Larry nor I prefer to own, each for our own reasons.

TBM holds corporate bonds, which Larry is arguing against in this post and the linked article, and it also holds MBS, which Larry argues against holding due to negative convexity. It holds lots of Treasuries, and Larry and I would both rather own CDs than Treasuries. Finally, it lumps everything into one fixed-income holding that neither Doc nor Larry nor I like because it does not allow us to optimize our fixed-income holdings to suit our personal preferences.

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Re: Another look at corporate bonds

Post by jfave33 »

Thanks Kevin, Doc, Larry and others - always learning something new with respect to bonds. I'd be a little more particular with my holdings if my fixed income portion was larger but for now I am happy to stick with something fairly easy and learn what I can as I go along.
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Re: Another look at corporate bonds

Post by grap0013 »

Interesting psychology in this thread. I think people who favor mental accounting tend to be more emotional than people who use more logic and reasoning in my humble opinion. When someone tells a mental accounter their methods are less than ideal they sometimes get emotional and defensive about their position. There is also a time element to this. The longer one has committed to a strategy the more fervently he/she defends it eg the longer you have invested in corporate bonds the more mentally displeasing it is to hear someone say less than rosy things about them.

These backtests tell me it does not really matter which fixed income you choose. The main thing as usual is to stay the course and you'll do just fine. If you have to rationalize your position with mental accounting and it helps you stay the course that is great. If you use more logic and math buy the treasury bonds knowing you picked the best mathematical choice.
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Re: Another look at corporate bonds

Post by drkathryn »

larryswedroe wrote:Nedsaid
To address the issue of 20 year vs. intermediate I did a quick check of my files and came up with this data for you

Over the 15-year period :oops: ending March 26, 2015, Vanguard’s High-Yield fund (VWHEX) r

Larry
High Yield only makes sense for short-term, not over years. Economic changes may lead to junk bond failure. One has to keep informed! My high yields were purchased after the 2015 rate hike and will be sold as early as December; the money going into Investment Grade Short Term, or MUNI, It is all short-term timing; if you are not willing to keep pace with Fed likely rate changes, then MUNI and higher quality bonds are a better investment
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Re: Another look at corporate bonds

Post by patrick013 »

Kevin M wrote:
and duration just provides an approximation that defines the relationship between change in price and change in yield.
I think it's interesting to note that the bond price when applying duration
to a 1% yield change is exactly the same as the bond price calculated
when the YTM is changed by 1%, or any other per cent change. I'm
kinda used to using YTM for just about everything bond related.
age in bonds, buy-and-hold, 10 year business cycle
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Re: Another look at corporate bonds

Post by Trader/Investor »

When someone tells a mental accounter their methods are less than ideal they sometimes get emotional and defensive about their position. There is also a time element to this. The longer one has committed to a strategy the more fervently he/she defends it eg the longer you have invested in corporate bonds the more mentally displeasing it is to hear someone say less than rosy things

Yes, especially when it comes from some academic researcher. Experience always trumps academic research! I have always believed in the hackneyed tenet that wealth accumulation comes from the *consistent* compounding of capital over time. Trading junk bond funds (including junk muni funds) has been the most trend persistent, least volatile asset class for me to achieve my financial goals.

Edit: Then again, I should be pleased junk bonds get no love. Being that I am not into "groupthink" that suits me just fine.
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Re: Another look at corporate bonds

Post by patrick013 »

Trader/Investor wrote: Trading junk bond funds (including junk muni funds) has been the most trend persistent, least volatile asset class for me to achieve my financial goals.
Do you buy junk bonds with some type of sector rotation or just
when a general bull market is occurring?

I stay investment grade corp even tho it could lose a per cent
or so every 5 or 10 years. If rates were higher more choices
would be available.
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Re: Another look at corporate bonds

Post by Kevin M »

patrick013 wrote:
Kevin M wrote: and duration just provides an approximation that defines the relationship between change in price and change in yield.
I think it's interesting to note that the bond price when applying duration
to a 1% yield change is exactly the same as the bond price calculated
when the YTM is changed by 1%, or any other per cent change. I'm
kinda used to using YTM for just about everything bond related.
:confused Unless otherwise specified, "yield" typically refers to yield to maturity (YTM) when discussing bonds, so I don't understand the comment. For example, YTM is the yield you plug into a duration formula. So "using YTM for just about everything bond related" makes sense, but you also need other parameters to calculate duration and price, like coupon rate.

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Re: Another look at corporate bonds

Post by Trader/Investor »

patrick013 wrote:
Trader/Investor wrote: Trading junk bond funds (including junk muni funds) has been the most trend persistent, least volatile asset class for me to achieve my financial goals.
Do you buy junk bonds with some type of sector rotation or just
when a general bull market is occurring?

I stay investment grade corp even tho it could lose a per cent
or so every 5 or 10 years. If rates were higher more choices
would be available.
I can get too wordy discussing junk bonds. We are often biased by our personal experiences. Long ago in another type venue I wrote about how my junk bond bias came to be. Anyway, in 2014, 2015, and early 2016 I was almost solely trading junk munis funds as that was where the momentum was. Now it's pretty much the junk corporates and leveraged loan/bank loan funds. Actually, the emerging markets bond funds have been the place to be but they are too volatile for my particular fund trading strategy which involves getting 100% invested incrementally.
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