Another look at corporate bonds

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patrick013
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Re: Another look at corporate bonds

Post by patrick013 »

Kevin M wrote:
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.

Kevin
Not calculating duration, just noticed that the bond price when applying
given duration gives the same result as calculating price by changing the
YTM and solving. Say the YTM is 4 and I change it to 5, I get a new price.
If I use duration and calc the new price for a 1% increase in yield the resulting
price is the same as the price resulting from using the YTM calculator.
age in bonds, buy-and-hold, 10 year business cycle
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Kevin M
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Re: Another look at corporate bonds

Post by Kevin M »

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 ending March 26, 2015, Vanguard’s High-Yield fund (VWHEX) returned 6.39 percent, outperforming their Intermediate Investment Grade Corporate Fund (VFICX) by just 0.05 percent, and outperforming their Intermediate Treasury Fund (VFITX) by just 0.58 percent.
I thought it would be useful to look at these three funds over what seems to be Larry's favorite time period: the longest time period for which we have data. This is Nov 1993 through Jun 2016 Using PortfolioVisualizer. Below is the table of results--it's a bit fuzzy, but you can view it directly on PV by clicking this link: PV Results.

Portfolio 1: VFITX (Treasury)
Portfolio 2: VFICX (investment grade)
Portfolio 3: VWEHX (high yield)

Image

Note that taking the amount of credit risk in the investment grade fund (VFICX, portfolio 2) paid off with higher return and without increasing risk as measured by standard deviation. So VFICX ended up with the highest Sharpe ratio at 0.72 compared to 0.63 for VFITX (Treasury, portfolio 1) and 0.54 for VWEHX (high yield, portfolio 3).

US stock market correlation for VFICX was slightly positive at about 0.2 vs. slightly negative correlation for VFITX at about -0.2, but note the much higher positive market correlation of VWEHX at about 0.6. You can ding VFICX for a max drawdown of a little more than twice that for VFITX, which is consistent with its slightly positive correlation with US stocks, and obviously occurred in 2008 when credit risk became more highly correlated with equity risk.

Note how much riskier VWEHX is for every risk-related measure, with significantly higher SD, and max drawdown more than twice that for VFICX, none of which is surprising given the high correlation to US stocks.

I'd say this mostly supports Larry's points, except that VFICX held up pretty well compared to VFITX. Disclosure: I own a bit of the former (Admiral shares) but none of the latter (preferring CDs for my really safe pile), and I also own a bit of the high yield fund (Admiral shares).

Kevin
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lack_ey
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Re: Another look at corporate bonds

Post by lack_ey »

Kevin M wrote:I thought it would be useful to look at these three funds over what seems to be Larry's favorite time period: the longest time period for which we have data. This is Nov 1993 through Jun 2016 Using PortfolioVisualizer. Below is the table of results--it's a bit fuzzy, but you can view it directly on PV by clicking this link: PV Results.
See my previous post earlier, examining assets in context of portfolio:
viewtopic.php?f=10&t=195397&start=50#p2982253

Showing slightly better returns when adding Vanguard's high-yield corporate over 1992-present (slightly higher CAGR and slightly lower SD when choosing weightings ex-post at least):
https://www.portfoliovisualizer.com/bac ... tion4_3=18

(adjusts slightly for differences in duration)

Despite the higher correlation, was different enough and had high enough returns over the period to help. Similar story for investment-grade corp.

Again, results particular to that period of time and these particular funds. In any case, there doesn't seem to be an obvious difference that comes out of this particular data. Longer-run data still stands and at least the traditional Fama-French analysis does show very little credit risk premium (not adjusting for duration, which you may agree or disagree with).
Random Walker
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Re: Another look at corporate bonds

Post by Random Walker »

Kevin,
Great informative post above. Your post doesn't say it explicitly, but I'm guessing that the correlations between investment grade corporate and equity and high yield and equity increased at the wrong times. I bet the worst year draw down for high yield was also in a real bad equity year.
The sharpe and sortino ratios in isolation I don't think mean a lot. I think worst year drawdown does mean a lot. What I do think would be interesting is how each of the three types of bonds would affect the sharpe and sortino ratios of an equity heavy portfolio over the same time period. I bet the differences are amplified.

Dave
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Re: Another look at corporate bonds

Post by Random Walker »

Oops, looks like I'd better go read lack_ey's prior post. For that matter, I should have read Larry's article first! :-)

Dave
Last edited by Random Walker on Thu Jul 21, 2016 2:26 pm, edited 1 time in total.
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Doc
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:I thought it would be useful to look at these three funds over what seems to be Larry's favorite time period: the longest time period for which we have data. This is Nov 1993 through Jun 2016 Using PortfolioVisualizer. Below is the table of results--it's a bit fuzzy, but you can view it directly on PV by clicking this link: PV Results.

Portfolio 1: VFITX (Treasury)
Portfolio 2: VFICX (investment grade)
Portfolio 3: VWEHX (high yield)
I like to look at either price charts or rolling return charts as well as the long term stats that Kevin addressed.

Price chart:

Imageupload img
http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

So while the long term picture shows not that much difference, the short term picture is dramatically different. The high yield did poorly in the two equity "crashes" we had during the period, the investment grade only had the poor performance in the Lehman crisis and the Treasury was stellar throughout.

I think this data supports Larry's Treasury preference. Of course if you are never going to buy equities in a stock marker crash it doesn't matter. And the data still begs the Treasury/CD question that Kevin and I went around ad nauseum.
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Kevin M
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Re: Another look at corporate bonds

Post by Kevin M »

Random Walker wrote:Kevin,
Great informative post above. Your post doesn't say it explicitly, but I'm guessing that the correlations between investment grade corporate and equity and high yield and equity increased at the wrong times. I bet the worst year draw down for high yield was also in a real bad equity year.
Actually, I did kind of say it explicity.
Kevin M wrote: You can ding VFICX for a max drawdown of a little more than twice that for VFITX, which is consistent with its slightly positive correlation with US stocks, and obviously occurred in 2008 when credit risk became more highly correlated with equity risk.
I didn't note it explicitly, but this was even more the case for high yield, which is obvious if you click the link and look at the chart--or just look at Doc's price chart. Worst time for credit risk was late 2008 when stocks were plunging. Or you might say that late 2008 was a great time to be buying bond funds with credit risk, since it was handsomely rewarded subsequently, and you didn't have to wait long. Of course the counter-argument always is that you would have done even better by increasing your allocation to stocks a a bit. I was buying both stocks and investment-grade bonds then, not having the guts to just buy even more stocks.

Kevin
If I make a calculation error, #Cruncher probably will let me know.
Trader/Investor
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Re: Another look at corporate bonds

Post by Trader/Investor »

Kevin M wrote:
Random Walker wrote:Kevin,
Great informative post above. Your post doesn't say it explicitly, but I'm guessing that the correlations between investment grade corporate and equity and high yield and equity increased at the wrong times. I bet the worst year draw down for high yield was also in a real bad equity year.
Actually, I did kind of say it explicity.
Kevin M wrote: You can ding VFICX for a max drawdown of a little more than twice that for VFITX, which is consistent with its slightly positive correlation with US stocks, and obviously occurred in 2008 when credit risk became more highly correlated with equity risk.
I didn't note it explicitly, but this was even more the case for high yield, which is obvious if you click the link and look at the chart--or just look at Doc's price chart. Worst time for credit risk was late 2008 when stocks were plunging. Or you might say that late 2008 was a great time to be buying bond funds with credit risk, since it was handsomely rewarded subsequently, and you didn't have to wait long. Of course the counter-argument always is that you would have done even better by increasing your allocation to stocks a a bit. I was buying both stocks and investment-grade bonds then, not having the guts to just buy even more stocks.

Kevin
December 16, 2008 2:15 PM the greatest buying opportunity past, present, and future in junk bond funds. Fundamentally junk bonds had been predicting a default rate in excess of 20%, far above the 16% of the Great Depression. All that was needed was a technical spark and that arrived in the form of the minutes from the Fed and their infamous statement that day. Even better you had that one day lag in full force as this event came later in the day and too late for the open end funds to react. The junk ETFs soared in late day trading. So you could buy the open ends on the 16th and exploit that one day lag ( somewhat akin to datelining international funds in the 80s and 90s) The open end funds' reaction came a day later and junk bonds had one of their largest ever % gains in so short a time over the next few weeks. While junk bonds came back a bit in the first quarter they held their lows unlike equities which didn't not bottom until March 9.

I should apologize a bit for getting this thread off topic. I am sure Larry and everyone is correct about junk bonds having their flaws as an investment tool. But trading-wise it is an entirely different story. And no, trading and timing the markets are two entirely different disciplines. Like most here, I don't believe markets can be predicted or forecasted with any accuracy whatsoever. I know I sure can't!
chatbotte
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Re: Another look at corporate bonds

Post by chatbotte »

larryswedroe wrote:http://www.etf.com/sections/index-inves ... rate-bonds

Hard to see the argument for them

Larry
Larry, could you please elaborate on who this advice applies to? Does it apply to retail investors in general? And who takes the other side of the trade if retail investors sell, and why? Thank you.
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote: So while the long term picture shows not that much difference, the short term picture is dramatically different.
<snip>
And the data still begs the Treasury/CD question that Kevin and I went around ad nauseum.
Thinking about this a little more. Although it's clear that you got a rebalancing bonus if you rebalanced from Treasuries into stocks in late 2008, most of us didn't lump-sum into our portfolios when Treasuries were at their high yields / low prices shortly before the crash, and then liquidate our portfolios when Treasury yields returned to their pre-crisis levels. So I wondered how much you'd have to "zoom out" for this effect to disappear. In other words, how long was the investing horizon at which the rebalancing bonus becomes trivial or no longer pays off at all?

To examine this, I looked at various time periods surrounding 2008 for 60/40 portfolios combining total stock (VTSMX) with either intermediate-term Treasuries (VFITX) or intermediate-term investment grade (VFICX). Just for kicks I also included a 60/40 portfolio if VTSMX and VWEHX (high yield corporate bonds). I used 5/25 rebalancing bands (the rebalancing approach preferred by Larry and many of us).

So let's start by looking at just Jan 2008 through Dec 2008. The portfolio with Treasuries had a return of -18.73%, followed by the portfolio with investment-grade bonds at -25.33%, and of course last was the portfolio with high-yield bonds at -30.74%. So yeah, Treasuries really helped over this short, one-year period, with a 6.6 percentage point lead over the portfolio with investment-grade bonds. Backtest Portfolio Asset Allocation: 2008.

Next, let's look at the 3-year period from January 2007 through December 2009. Sure enough, the portfolio with the Treasuries (VFITX) did best, with a small positive return (0.58% annualized), followed by the portfolio with investment-grade bonds (VFICX) that had a small negative return (-0.38%), with the portfolio with high yield bonds (VWEHX) coming in last with a slightly larger negative return of -1.19%. So we still see a rebalancing bonus for this 3-year period including the year before 2008 and the year after, but dramatically smaller than just looking at 2008. Still, one percentage point of additional annual return (compared to using investment-grade bonds) is not bad. Backtest Portfolio Asset Allocation: 2007 - 2009

If we add another year on each side, so Jan 2006 through December 2010, the rebalancing bonus shrinks, with the Stock/Treasury portfolio earning 4.94%, the Stock/Invesment-Grade portfolio earning 4.71%, and the Stock/High-Yield portfolio earning 4.49%. So over this five-year period only a rebalancing bonus of about 20 basis points as you move from one portfolio to the next. Backtest Portfolio Asset Allocation: 2006 - 2010.

If you zoom out to the most recent 10-year period, from July 2006 through June 2016, a 60/40 portfolio of VTSMX and VFICX had a slightly higher return than a 60/40 portfolio of VTSMX and VFITX, and the 60/40 portfolio using VWEHX had an even slightly higher return. So over the most recent 10-year period, the rebalancing bonus due to holding Treasuries has disappeared completely. Backtest Portfolio Asset Allocation: 10 years ending June 2016.

Was the standard deviation lower and the Sharpe higher for the portfolio with VFITX? Of course. But as a long-term investor (with a strong enough stomach), do I really care about monthly or annual volatility, which is what the SD and Sharpe are based on? I don't think we should care much about it (as long-term investors), which is one reason most of us include stocks in our portfolios. Having said that, I do care about the uncertainty of my long-term returns, which is why I don't hold 100% stocks (not being in the camp that believes stocks are safe in the long run).

Then the next question might be, "if the portfolio with Treasuries did almost as well, why take the extra risk of corporate bonds?", which of course is the main point of Larry's article. But my point is not to use just corporate bonds instead of Treasuries, but to use the much-higher yielding CDs instead of Treasuries for a large portion of your fixed-income. Over a 5-year or 10-year period at an average yield premium of 100 basis points or more, you are guaranteed to make more on this portion of your fixed income than if you held this portion in Treasuries of the same maturity.

Then, as I've been saying, you could hold a portion of your fixed income in Treasuries for the more speculative return possibilities of being able to rebalance into stocks in a flight-to-safety scenario, or getting some extra return due to falling yields or rolling your bonds over a steep portion of the yield curve.

Separating your return into speculative and non-speculative components crystallizes the benefit of CDs from a pure yield perspective (not even considering the reduction in term risk due to the early withdrawal option). Being able to earn a yield premium of 100 basis points or more (my average is higher) gives you a much higher non-speculative return than Treasuries of the same maturity. The only possibility for higher return from Treasuries comes from purely speculative factors, all related to term risk being rewarded.

I do not want to count on speculative returns with the bulk of my fixed income.

Kevin
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larryswedroe
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Re: Another look at corporate bonds

Post by larryswedroe »

chatbotte
Quick comment

One reason IMO corporate bonds are in general "overpriced" in the same way that "lottery tickets" are overpriced persistently is the fact that there are regulations on capital management for companies like insurers. So they have to hold more capital against equity risk than bond risks. So they often "cheat" by trying to raise returns by moving more from the SAFEST bonds to less safe bonds which have equity like risks but don't count as much against capital requirements. This is a little discussed issue but well known. I sat on board of insurer.

Another good example is preferreds where companies get a tax break on the dividends that individuals don't get.



Larry
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:Thinking about this a little more. Although it's clear that you got a rebalancing bonus if you rebalanced from Treasuries into stocks in late 2008, most of us didn't lump-sum into our portfolios when Treasuries were at their high yields / low prices shortly before the crash, and then liquidate our portfolios when Treasury yields returned to their pre-crisis levels. So I wondered how much you'd have to "zoom out" for this effect to disappear. In other words, how long was the investing horizon at which the rebalancing bonus becomes trivial or no longer pays off at all?
We are coming at this question from entirely different viewpoints. You said "most of us didn't lump-sum into our portfolios". Well I did and I have stated several times that if you don't have the chutzpah to buy stocks when the stock market is crashing of if you only rebalance on your mother in law's birthday then the correlation between fixed income sectors and stocks in a market crash has very little meaning for you. This is apparently your philosophy and you are making attempts to justify that philosophy by making longer term "rebalancing bonus" calculations. You don't need to do that. If you IPS or your personal ideas are not to buy into the crash you don't need any other justification. Just don't do it. Then there is little need to consider how your FI interacts with the rest of your portfolio.

That being said your calculations are somewhat cherry picked. Both of us have said in several different threads that you don't need all of your FI in the "best sector" during a market crash. But the basis for your elaborate calculations do just that. If you want an unbiased comparison I think you should use something like a 60/20/20 mix of (Equities)/(Treasuries or CD's)/(Other FI sectors). But then you need to look at other ratios and at several "other sectors" and in more than jut one time period.

Ironically if you don't want to rebalance in a stock market crash your best FI sector would be a HY portfolio with a perfect 1.0 correlation with equities. That way your AA will always be in perfect balance. :twisted:
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Re: Another look at corporate bonds

Post by Tanelorn »

Maybe consider a fixed income allocation that varies between safer (treasuries) and riskier (HY) based on your medium term prospect of a crash and hence a rebalancing bonus actually being realized? Stock valuations, VIX levels, etc, might indicate that. Not sure if those are sufficiently forward-looking to be useful.
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Re: Another look at corporate bonds

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Kevin M wrote:I do not want to count on speculative returns with the bulk of my fixed income.
Neither do I. I "need" only about 20% of my FI to be in Treasuries to handle a 40% bear. I have about 30% because that's convenient and tax efficient for our mix of accounts/brokers. Our total FI portfolio is modeled on the BarCap Intermediate (1-10) Government/Credit Index which has ~50% Treasuries. The "missing" other 20% Treasuries we have in diversified funds that yield a whole lot more than CD's. (And which have higher credit risk.)
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote:
Kevin M wrote:<snip>most of us didn't lump-sum into our portfolios when Treasuries were at their high yields / low prices shortly before the crash, and then liquidate our portfolios when Treasury yields returned to their pre-crisis levels.
<snip>Well I did and I have stated several times that if you don't have the chutzpah to buy stocks when the stock market is crashing of if you only rebalance on your mother in law's birthday then the correlation between fixed income sectors and stocks in a market crash has very little meaning for you.
I think you're misunderstanding my comment, as well as the analysis. I'm not saying that you don't rebalance from bonds into stocks during the crash, which is exactly why I used 5/25 rebalancing bands in the analysis instead of annual rebalancing (thank you PortfolioVisualizer for adding this feature!). Since no one can identify the bottom of a crash until afterwords, the rational way to rebalance during a crash is with some sort of pre-determined, non-time-based rebalancing strategy, as is the case with rebalancing bands.

Using 5/25 bands probably would have had you rebalancing into stocks several times on the way down, and rebalancing out of stocks several times on the way up. Maybe one of your rebalancing events was near the bottom, but there's no way you could know that ex-ante, only ex-post, so catching the bottom would simply have been luck.

So when I say that most of us didn't lump sum into and out of our portfolios just before and after the crash I'm not talking about rebalancing between stocks and bonds, but moving everything from or to cash to or from a stock/bond portfolio at the most opportune times, which is the only way simply looking at something like the return for only 2008 would be relevant from a purely financial perspective (i.e., ignoring the emotional component). Much more likely that you went into 2008 with a portfolio that you had grown over preceding years and held onto for the subsequent years. The analysis was intended to come closer to examining the rebalancing bonus benefit from a slightly longer-term perspective than just focusing on a few months surrounding late 2008.

I honestly did not cherry pick the start and end points to make things look worse for the rebalancing bonus. I just started by adding the same number of years before and after 2008, and when I got to a five-year period I got bored and just jumped to the most recent 10-year period. This was my way of "zooming out" to get a longer-term perspective. We already saw from lacky_ey's excellent analysis that when looking at the longest period available for Vanguard funds, and adjusting for duration (more sophisticated than my analysis), that there was no significant rebalancing bonus in using Treasuries instead of corporate bonds. I was just wondering how long a period it took for the apparent rebalancing bonus to disappear. The answer seems to be a little more than five years, and clearly for the most recent 10-year period.

Since PV doesn't support modeling a portfolio including direct CDs, and with a rebalancing policy like "rebalance from Treasuries into stocks until the Treasuries are gone, and just hold the direct CDs", or maybe even adding "continue rebalancing from the direct CDs after Treasuries are gone, and incorporate the early withdrawal penalty into the results", I just used the data and tools available as best I could. The final piece supporting CDs is just some approximate thinking based on the CD yield premium of 100+ basis points over Treasuries, keeping in mind that rebalancing could be accomplished with cash, corporate bonds, a slug of Treasuries, or even CDs (brokered with the bid/ask spread hit, or direct with the EWP), or some combination of those. Agreed that it would be better to model this more precisely, but I haven't ginned up the motivation to try and do that yet.

Kevin
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote:
Kevin M wrote:I do not want to count on speculative returns with the bulk of my fixed income.
Neither do I.
Ah, but you do!
Doc wrote:Our total FI portfolio is modeled on the BarCap Intermediate (1-10) Government/Credit Index which has ~50% Treasuries. The "missing" other 20% Treasuries we have in diversified funds that yield a whole lot more than CD's. (And which have higher credit risk.)
So you are counting on what I'm now calling speculative returns with all of your intermediate-term and long-term Treasuries, as well as with all of your corporate bonds, which is the majority of your fixed-income portfolio! CDs provide a higher safe return than Treasuries or corporate bonds, providing much higher yields than Treasuries of same maturities, much less term risk than intermediate-term or long-term Treasuries, and no credit risk as you have in corporate bonds.

Your repeated justification for holding Treasuries is the speculative component that you might receive if we have another financial crisis on the order of 2008 in our lifetimes. Another component that is mentioned frequently is the "roll yield" or roll return, which is another purely speculative component that may or may not be realized. Remove these speculative components and you are left with yields that are about half of what you can get in CDs of comparable maturity, at least up to 5-year maturity, and perhaps up to 10-year maturity if you bring brokered CDs into the mix (or find a really good deal on a direct CD, like the 7-year at 3% I just bought more of).

With the corporate bonds we are simply being rewarded (perhaps) for taking credit risk, which has worked out OK in recent years (yay!), but as Larry points out has not been rewarded enough over longer time periods to justify taking the extra risk. You and I both go against the grain on this one, but I limit my exposure here to 20%-25% of fixed income, whereas you pile the credit risk on top of the term risk you are taking in Treasuries.

We've had this conversation enough times that I know I won't change your mind, and you probably know you won't change mine, but hopefully our dialogue will help some others make better decisions with their fixed income.

Kevin
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:I think you're misunderstanding my comment, as well as the analysis. I'm not saying that you don't rebalance from bonds into stocks during the crash, which is exactly why I used 5/25 rebalancing bands in the analysis instead of annual rebalancing (thank you PortfolioVisualizer for adding this feature!). Since no one can identify the bottom of a crash until afterwords, the rational way to rebalance during a crash is with some sort of pre-determined, non-time-based rebalancing strategy, as is the case with rebalancing bands.

Using 5/25 bands probably would have had you rebalancing into stocks several times on the way down, and rebalancing out of stocks several times on the way up. Maybe one of your rebalancing events was near the bottom, but there's no way you could know that ex-ante, only ex-post, so catching the bottom would simply have been luck.
I thought up thread that you said/implied that you didn't rebalance in '08. Maybe I misunderstood. I understood in your recent portfolio visualizer calcs that you did rebalance.
Kevin M wrote:So when I say that most of us didn't lump sum into and out of our portfolios just before and after the crash I'm not talking about rebalancing between stocks and bonds, but moving everything from or to cash to or from a stock/bond portfolio at the most opportune times, which is the only way simply looking at something like the return for only 2008 would be relevant from a purely financial perspective (i.e., ignoring the emotional component). Much more likely that you went into 2008 with a portfolio that you had grown over preceding years and held onto for the subsequent years. The analysis was intended to come closer to examining the rebalancing bonus benefit from a slightly longer-term perspective than just focusing on a few months surrounding late 2008
OK I did misunderstand "didn't lump sum into and out of our portfolios just before and after the crash". I thought you meant that "most" didn't rebalance during the period because they just didn't do it or were using time frames instead of bands.
Kevin M wrote:I honestly did not cherry pick the start and end points to make things look worse for the rebalancing bonus
Not what I meant by "cherry picking". I meant that you "cherry picked" the bond segment. You used the entire bond portfolio as one sector. Not just that part "devoted" to rebalancing. That distorts the results.
Kevin M wrote:Agreed that it would be better to model this more precisely, but I haven't ginned up the motivation to try and do that yet.
I don't think it makes any difference. My "problem" with the analysis is that the whole things involves return. The purpose of rebalancing is to maintain a risk profile not to maximize return. The CD/Treasury discussion is in essence the cost of the insurance of only that part of the FI portfolio that is involved. CD's have a higher return but that is counterbalanced by the short term spike in Treasury prices and the cost of the EWP and maybe taxes as well. That is a hard balance to calc and the inputs are highly dependent on our individual circumstances. (For example if all your assets were in tax advantaged it would be difficult to rebalance with direct CD's in a timely manner.)

OK now I will read out other post. At first glance it looks like you jabbed at me. :D
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:So you are counting on what I'm now calling speculative returns with all of your intermediate-term and long-term Treasuries, as well as with all of your corporate bonds, which is the majority of your fixed-income portfolio! CDs provide a higher safe return than Treasuries or corporate bonds, providing much higher yields than Treasuries of same maturities, much less term risk than intermediate-term or long-term Treasuries, and no credit risk as you have in corporate bonds.
Now you are misunderstanding me. I don't own any long term bonds of any stripe. (I might go long TIPS if the real yield was very good.) I agree that CD's likely produce higher returns than comparable duration Treasuries. But if you cannot hold them to maturity you need to consider the EWP as well as liquidity and tax considerations. If my AA was 10/90 the 90 might have no Treasuries at all.
Kevin M wrote:Your repeated justification for holding Treasuries is the speculative component that you might receive if we have another financial crisis on the order of 2008 in our lifetimes
We've had two in the first eight years of this century. I intend to live longer than eight years even at my advanced age. My house hasn't burned down in 40 years either but I am still going to buy fire insurance. In the world of investing in stocks and bonds the bonds at least in part are the fire insurance.
Kevin M wrote:Another component that is mentioned frequently is the "roll yield" or roll return, which is another purely speculative component that may or may not be realized. Remove these speculative components and you are left with yields that are about half of what you can get in CDs of comparable maturity, at least up to 5-year maturity, and perhaps up to 10-year maturity if you bring brokered CDs into the mix (or find a really good deal on a direct CD, like the 7-year at 3% I just bought more of).
If you're going to price the cost of insurance you need to have some consideration to the possible plusses for Treasuries that CD's don't have. Just ignoring the EWP because it may never happen is not realistic. Likewise ignoring state taxes if your insurance is in a taxable account is akin to cherry picking.
Kevin M wrote:With the corporate bonds we are simply being rewarded (perhaps) for taking credit risk, which has worked out OK in recent years (yay!), but as Larry points out has not been rewarded enough over longer time periods to justify taking the extra risk. You and I both go against the grain on this one, but I limit my exposure here to 20%-25% of fixed income, whereas you pile the credit risk on top of the term risk you are taking in Treasuries.
Huh? Our portfolio is currently 25.7% corporates. And the duration is 4.3 years. The longest duration asset we own is a ten year TIPS with a 2% coupon. The next highest duration asset is 6.5 years.

I do need to look at CD's vs corporate yield. But since almost all of the intermediate corporates are in tax advantaged and I tend to use them for TLH to avoid wash sales using direct CD's is problematic. And that part in taxable is the "car" fund that gets new investments every month.

The reason we go around in circles is that you look at your FI as a source of return and I look it only as a source of risk reduction. Also only about half of our portfolio is tax sheltered which I think is unusual in the 401k/IRA age. We just have different objectives.

As I have said before we never had these types of discussions before the Fed ran the real interest rate to zero. I don't think we should have discussions like this now. More important perhaps is that if we decide that interest rates are not going to return to "normal" in ten years or so then do we need to rethink our whole asset allocation not just our bond sectors. I think that would be a more productive discussion.
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Re: Another look at corporate bonds

Post by Kevin M »

Doc wrote:
Kevin M wrote:So you are counting on what I'm now calling speculative returns with all of your intermediate-term and long-term Treasuries, as well as with all of your corporate bonds, which is the majority of your fixed-income portfolio! CDs provide a higher safe return than Treasuries or corporate bonds, providing much higher yields than Treasuries of same maturities, much less term risk than intermediate-term or long-term Treasuries, and no credit risk as you have in corporate bonds.
Now you are misunderstanding me. I don't own any long term bonds of any stripe. (I might go long TIPS if the real yield was very good.)
You're responding to the tree and ignoring the forest. Simply strike long-term Treasuries from the what I said, and the basic argument is the same. Intermediate-term Treasuries have much more term risk than direct CDs of same maturity.
Doc wrote:I agree that CD's likely produce higher returns than comparable duration Treasuries. But if you cannot hold them to maturity you need to consider the EWP as well as liquidity and tax considerations.
Of course you do. So knock off 20 basis points from the 2% CD yield for a 10% state tax, and you're still looking at a huge yield premium. And I don't look at the EWP as a negative; rather I look at it as a small price to pay (maybe) to reinvest at a higher rate if rates increase, or even if a better CD deal comes along. Contrast that to the much higher loss on a 5-year Treasury if rates increase by as little as one percentage point. And you're not going to find a much better 5-year Treasury deal (as you might with CDs) without paying a much larger price in the form of capital loss due to higher yields.
Doc wrote:
Kevin M wrote:Your repeated justification for holding Treasuries is the speculative component that you might receive if we have another financial crisis on the order of 2008 in our lifetimes
We've had two in the first eight years of this century. I intend to live longer than eight years even at my advanced age. My house hasn't burned down in 40 years either but I am still going to buy fire insurance. In the world of investing in stocks and bonds the bonds at least in part are the fire insurance.
I don't think that the last eight years is necessarily a good statistical sampling, and even the chart you shared showed that corporate bonds held up well in the first of these two crises.

The fire-insurance analogy is horrible on multiple levels. It doesn't take much thought to see why. About the only thing that is comparable is thinking of the guaranteed return you're giving up in choosing Treasuries over CDs as the insurance premium. There's much more to it than that.

What's the analogy to the capital loss suffered in Treasuries when yields increase? With fire insurance you're not trading off one risk for another, which is what you're doing with Treasuries. With Treasuries you take the risk of loss due to rising rates in return for mitigating the risk of stock losses a bit better than with cash or CDs. It's not like cash or CDs don't mitigate stock risk at all. So it's not like having fire insurance or not having it.

And historically US and global stocks have recovered from their losses. Your house doesn't rebuild itself after a fire.

Horrible analogy.
Doc wrote:If you're going to price the cost of insurance you need to have some consideration to the possible plusses for Treasuries that CD's don't have.
Of course you do (despite the horrible analogy), which is why I keep saying that I can see holding a dollop of Treasuries for the exact reasons you champion on top of having the bulk of your fixed income in higher yielding AND safer CDs.
Doc wrote:Just ignoring the EWP because it may never happen is not realistic. Likewise ignoring state taxes if your insurance is in a taxable account is akin to cherry picking.
I do not ignore the EWP, since the early withdrawal option is one of the key benefits to direct CDs, and the possibility of paying the EWP only comes into play for me if the reward of higher yield outweighs the cost of the EWP. Benefit, not downside. And although I don't talk about state taxes much, they just aren't a big enough concern to have significant impact on the huge yield advantage of CDs, and of course are not a factor at all in a tax-advantaged account.
Doc wrote:
Kevin M wrote:With the corporate bonds we are simply being rewarded (perhaps) for taking credit risk, which has worked out OK in recent years (yay!), but as Larry points out has not been rewarded enough over longer time periods to justify taking the extra risk. You and I both go against the grain on this one, but I limit my exposure here to 20%-25% of fixed income, whereas you pile the credit risk on top of the term risk you are taking in Treasuries.
Huh? Our portfolio is currently 25.7% corporates. And the duration is 4.3 years. The longest duration asset we own is a ten year TIPS with a 2% coupon. The next highest duration asset is 6.5 years.
The point still applies, since you're still taking much more term risk with your Treasuries than I'm taking with my CDs. So I'm only taking credit risk OR significant term risk with 20%-25% of my fixed income.

Earlier you had mentioned using a 50/50 corporate/Treasury benchmark, and talked about adding 20% of diversified bond funds in Treasuries to the 30% you hold directly. That leaves about 50% in corporate bonds. Are you switching between talking about percentages of fixed income and percentages of portfolio? This is just a detail, and is not significant to the conceptual risk/return tradeoffs we're discussing; it impacts the magnitude but not the nature of the risks.
Doc wrote:I do need to look at CD's vs corporate yield. But since almost all of the intermediate corporates are in tax advantaged and I tend to use them for TLH to avoid wash sales using direct CD's is problematic. And that part in taxable is the "car" fund that gets new investments every month.
Practical issues definitely come into play. People who have most of their portfolios in a 401k or 403b don't even have the option of holding direct CDs, and very probably don't even have the option of holding just Treasuries, as they may only have one or two diversified bond funds to choose from.

Regarding corporate bonds vs. CDs, you can get a quick, rough overview by looking at the Fidelity or Vanguard fixed income overview. What I see at Vanguard is 1.43% for 5-year "Corporates highest grade", 1.95% for 5-year "Corporates high grade", up to 3.72% for 5-year "Corporates investment grade". So unsurprisingly you get an increasing yield premium for increasing credit risk, with a good direct 5-year CD at 2% or better still having a slight yield premium over "corporates high grade". So CDs have a higher risk-adjusted yield, as must be the case as long as we consider credit risk a real risk.
Doc wrote:The reason we go around in circles is that you look at your FI as a source of return and I look it only as a source of risk reduction.
How in the world do you come to this conclusion??? I always talk about the risk/return trade-off of CDs in discussing their advantages over bonds or bond funds, so I do look at the risk-mitigation aspects of CDs in addition to the return aspects. The beauty of direct CDs is that they provide a higher guaranteed return (ignoring potential speculative return) than Treasuries while being exposed to even less term risk due to the early withdrawal option. So risk reduction is a huge component of what I look for in my fixed income.

The only thing I give up is the possible slight reduction in portfolio loss over a relatively short time period (at least historically). So if you define risk as maximum portfolio drawdown over a one or two-year period, then yeah, Treasuries have been a winner in recent times, with long-term Treasuries (which you don't like) being the best of all. But as I've shown, this benefit has evaporated if you look at slightly longer time periods of recent history, with corporate bonds doing almost as well if you increase your investment horizon to as little as five years surrounding the 2008 crisis.
Doc wrote:As I have said before we never had these types of discussions before the Fed ran the real interest rate to zero. I don't think we should have discussions like this now. More important perhaps is that if we decide that interest rates are not going to return to "normal" in ten years or so then do we need to rethink our whole asset allocation not just our bond sectors. I think that would be a more productive discussion.
The Fed did not drive the real interest rate to zero, the economy did, but that's another discussion (see Bernanke's blog posts on this). We are living in the times we're living in, so I think it's great that we're having discussions relevant to our time.

Maybe you couldn't get the yield premiums we're seeing for CDs ten years ago, but you can now, and now is the only time we can make investment decisions that matter.

Since no one has demonstrated any consistent ability to accurately predict interest rates, I don't see much point in speculating much on that. If rates remain low, we do the best we can to get an edge, and as long as FDIC-insured deposit accounts give us yield premiums of 100 basis points, that's an edge for the retail investor.

Kevin
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Re: Another look at corporate bonds

Post by Doc »

Kevin M wrote:Doc wrote:
The reason we go around in circles is that you look at your FI as a source of return and I look it only as a source of risk reduction.

How in the world do you come to this conclusion??? I always talk about the risk/return trade-off of CDs in discussing their advantages over bonds or bond funds, so I do look at the risk-mitigation aspects of CDs in addition to the return aspects. The beauty of direct CDs is that they provide a higher guaranteed return (ignoring potential speculative return) than Treasuries while being exposed to even less term risk due to the early withdrawal option. So risk reduction is a huge component of what I look for in my fixed income.
Kevin, you made my point for me. You are looking at CD's and their risk aspects with respect to "their advantages over bonds or bond funds." There is no argument there. I am in complete agreement. I'm addressing how different FI sectors react with the equity portion of the portfolio. And you seem to be completely ignoring that aspect except for a "dollup".

My "dollop" is 30%. I only really need 20%. The extra 10% is working capital. Some of the latter could be in CD's. The other 20% of Treasuries is in diversified bond funds and aren't very useful for rebalancing in a market crash. (Unfortunately there are also some MBS and asset-backed securities in there too which is why my numbers above don't add to 100.)

The three diversified/investment grade bond funds that I use have trailing 12 month yields of 3.0, 3.2 and 4.7 and SEC yields of 2.4, 3.5 and 2.5. (One in each of three IRA's at different brokers.) I belive that those yields are higher than your CD's but they do have more credit risk and more term risk than the CD's. But they are not part of my dollop. And I am not at all concerned about how they correlate with equities because they will never be sold in a market crash.

We are on different streets and going in different directions. But that's ok because we are not trying to get to the same place. :sharebeer
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Re: Another look at corporate bonds

Post by chatbotte »

larryswedroe wrote:chatbotte
Quick comment

One reason IMO corporate bonds are in general "overpriced" in the same way that "lottery tickets" are overpriced persistently is the fact that there are regulations on capital management for companies like insurers. So they have to hold more capital against equity risk than bond risks. So they often "cheat" by trying to raise returns by moving more from the SAFEST bonds to less safe bonds which have equity like risks but don't count as much against capital requirements. This is a little discussed issue but well known. I sat on board of insurer.

Another good example is preferreds where companies get a tax break on the dividends that individuals don't get.



Larry
Larry, thank you for the explanation.
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Re: Another look at corporate bonds

Post by Tanelorn »

Are brokered CDs marginable? If you could find a broker where this was true, perhaps they could be a middle ground between offering higher yield on the fixed income side (although not as high as seeking out the best bank or credit union deal out there) and offering a measure of access to liquidity during a market panic in the way treasuries do. They wouldn't be negatively correlated like treasuries in a crash, but maybe the chance to rebalance and higher yield would offer a better combination than just low yield treasuries or just high yield, illiquid CDs.
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Re: Another look at corporate bonds

Post by SeeMoe »

Interesting article and one to consider when bond shopping. I like lots of short and intermediate Corporate bonds in our IRA's as well as High Yield too! Plus total international bonds for diversity. Also have some total bond index funds. Not changing that AA either as it works for us. More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...

SeeMoe.. :shock:
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Re: Another look at corporate bonds

Post by mptfan »

SeeMoe wrote:More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...
I agree. People who say that high yield corporate bonds are too risky are being inconsistent if they simultaneously hold stock funds because the riskiest of high yield bond funds is safer than the safest of stock funds.

Now I've been down this road before, and here is how the conversation goes...the response is "but bonds are for safety, you should take your risks on the equity side"... my response to that is "says who? Where is it written than I have to only take risks with stocks and I should not take risks with bonds?" My answer is nowhere, unless of course you count anything written by Larry Swedroe. ;)
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Re: Another look at corporate bonds

Post by Bonnan »

Amen mptfan! I'm nearing the end of a 60 year investment time frame and have done well taking that so-called risk in bonds.
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Re: Another look at corporate bonds

Post by SeeMoe »

mptfan wrote:
SeeMoe wrote:More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...
I agree. People who say that high yield corporate bonds are too risky are being inconsistent if they simultaneously hold stock funds because the riskiest of high yield bond funds is safer than the safest of stock funds.

Now I've been down this road before, and here is how the conversation goes...the response is "but bonds are for safety, you should take your risks on the equity side"... my response to that is "says who? Where is it written than I have to only take risks with stocks and I should not take risks with bonds?" My answer is nowhere, unless of course you count anything written by Larry Swede. ;)
Thanks, I needed that! I've been an investor for over three decades now and continue to buy corporates or hold on to what we have in our tax deferred accounts. Have municipals in the taxable with some "lonG" term Pennsylvania bonds. If the roof caves in on corporate bonds, then I think everything else will be in trouble too, including treasuries...

SeeMoe.. :mrgreen:
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Re: Another look at corporate bonds

Post by Trader/Investor »

SeeMoe and Bonnan Not fair! You are not allowed to bring reality based on your positive personal experiences with junk bonds to this thread.
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Re: Another look at corporate bonds

Post by saltycaper »

mptfan wrote:
SeeMoe wrote:More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...
I agree. People who say that high yield corporate bonds are too risky are being inconsistent if they simultaneously hold stock funds because the riskiest of high yield bond funds is safer than the safest of stock funds.

Now I've been down this road before, and here is how the conversation goes...the response is "but bonds are for safety, you should take your risks on the equity side"... my response to that is "says who? Where is it written than I have to only take risks with stocks and I should not take risks with bonds?" My answer is nowhere, unless of course you count anything written by Larry Swedroe. ;)
I don't know all of the places it is written--probably not on subway walls and tenement halls--but definitely more places than books by Larry Swedroe. And the point isn't that bonds are for safety--I dislike that phrase too--but rather whether certain types of risk have been rewarded sufficiently and how different parts of a portfolio have worked together to produce a better risk-adjusted return. I'm sure the irony of your post is not lost on Larry and others, given that your name is mptfan. :shock:
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Re: Another look at corporate bonds

Post by nedsaid »

SeeMoe wrote:Interesting article and one to consider when bond shopping. I like lots of short and intermediate Corporate bonds in our IRA's as well as High Yield too! Plus total international bonds for diversity. Also have some total bond index funds. Not changing that AA either as it works for us. More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...

SeeMoe.. :shock:
I am in the camp that I am willing to take on a bit more volatility in my bonds for a bit more return. Whereas a Larry Swedroe bond portfolio would be short and intermediate term nominal Treasuries, I am willing to hold Investment Grade Intermediate Term Treasuries, TIPS, Corporates, and Agency bonds. To me, the extra risk was well worth the extra return. My bond funds rode through the 2008-2009 financial crisis fairly well but with a bit more volatility than nominal treasuries.

Looking at how my bond funds (Diversified Bond, Vanguard US Total Bond Market, Fidelity GNMA) performed over the last 10 years compared to Vanguard Intermediate Term Treasury; the returns were almost identical. I can see what Larry was talking about. See my posts above on this. I took a bit of extra risk and at least over the last 10 years was not rewarded for it. I think this is because of the flight to quality in Treasuries, in more normal times I would have received a premium.

The point is that we are big boys and big girls around here. We invest with our eyes open. I am indebted to Larry Swedroe and others for better explaining the risks that we are taking. In some cases, the risks are larger than what most investors perceived.

Really, the return on your bond is the effective yield when you buy it assuming the bond is held to maturity. So if you buy a junk bond with a 12% yield, held to maturity you will get the 12%. The problem with junk is default risk. So a junk bond fund should have returns that are in effect coupon minus defaults. The trick is to buy these things in recession and you get a boost as the economy improves and credit quality improves. You will have a decreasing default risk. So junk should get you higher returns than Treasuries assuming that your bonds don't default. That is a big assumption. If you hold junk bond funds long enough, you should get your premium though there will be greater volatility.

For me, the volatility of junk bonds are high enough that I would rather be in equities. If I owned them, I would consider them as part of my equity allocation as really that is what they are, stocks in drag. But as long as you know the risks you are taking, I have no problems with you and others holding High-Yield or junk bonds as part of your portfolio.
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Re: Another look at corporate bonds

Post by mptfan »

saltycaper wrote: I don't know all of the places it is written--probably not on subway walls and tenement halls--but definitely more places than books by Larry Swedroe.
Could you cite those places?
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Re: Another look at corporate bonds

Post by SeeMoe »

nedsaid wrote:
SeeMoe wrote:Interesting article and one to consider when bond shopping. I like lots of short and intermediate Corporate bonds in our IRA's as well as High Yield too! Plus total international bonds for diversity. Also have some total bond index funds. Not changing that AA either as it works for us. More risk for sure. But so is our Stock Market holdings. And stocks are much riskier in my opinion, but nobody is saying don't own the market now , are they,...

SeeMoe.. :shock:
I am in the camp that I am willing to take on a bit more volatility in my bonds for a bit more return. Whereas a Larry Swedroe bond portfolio would be short and intermediate term nominal Treasuries, I am willing to hold Investment Grade Intermediate Term Treasuries, TIPS, Corporates, and Agency bonds. To me, the extra risk was well worth the extra return. My bond funds rode through the 2008-2009 financial crisis fairly well but with a bit more volatility than nominal treasuries.

Looking at how my bond funds (Diversified Bond, Vanguard US Total Bond Market, Fidelity GNMA) performed over the last 10 years compared to Vanguard Intermediate Term Treasury; the returns were almost identical. I can see what Larry was talking about. See my posts above on this. I took a bit of extra risk and at least over the last 10 years was not rewarded for it. I think this is because of the flight to quality in Treasuries, in more normal times I would have received a premium.

The point is that we are big boys and big girls around here. We invest with our eyes open. I am indebted to Larry Swedroe and others for better explaining the risks that we are taking. In some cases, the risks are larger than what most investors perceived.

Really, the return on your bond is the effective yield when you buy it assuming the bond is held to maturity. So if you buy a junk bond with a 12% yield, held to maturity you will get the 12%. The problem with junk is default risk. So a junk bond fund should have returns that are in effect coupon minus defaults. The trick is to buy these things in recession and you get a boost as the economy improves and credit quality improves. You will have a decreasing default risk. So junk should get you higher returns than Treasuries assuming that your bonds don't default. That is a big assumption. If you hold junk bond funds long enough, you should get your premium though there will be greater volatility.
For me, the volatility of junk bonds are high enough that I would rather be in equities. If I owned them, I would consider them as part of my equity allocation as really that is what they are, stocks in drag. But as long as you know the risks you are taking, I have no problems with you and others holding High-Yield or junk bonds as part of your portfolio.
Disagree! A retirees deferred folios should be all bonds and, as you know, Vanguard High Yield bonds are of better quality, and they are bonds despite the tired old saw " they sometimes act Ike stocks". Stocks should remain in the taxable folio. Don't know what you mean about being " big boys and girls" or the glowing reference to big name contributors to this sight either. It's as if you are implying that one is somehow disloyal if in disagreement? Sometimes charts and long winded dissertations on a subject are to much to digest without a drink of reality water. Thanks for your scholarly blurb..

SeeMoe.. :annoyed
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Re: Another look at corporate bonds

Post by nedsaid »

SeeMoe wrote: Disagree! A retirees deferred folios should be all bonds and, as you know, Vanguard High Yield bonds are of better quality, and they are bonds despite the tired old saw " they sometimes act Ike stocks". Stocks should remain in the taxable folio. Don't know what you mean about being " big boys and girls" or the glowing reference to big name contributors to this sight either. It's as if you are implying that one is somehow disloyal if in disagreement? Sometimes charts and long winded dissertations on a subject are to much to digest without a drink of reality water. Thanks for your scholarly blurb..

SeeMoe.. :annoyed
What are you talking about?

I referred to your post in part because you are doing many of the same things I was doing. You were making many of the arguments I was making.

When I said that we are big boys and big girls, what I meant is that we are all adults and can make our own investment decisions. We take the risks and get the benefits and whatever consequences result. If someone wants to deviate from what folks like Larry Swedroe recommend, I assume that they have their own reasons for doing so. As for myself, I have said that I want more than nominal treasuries in my bond portfolio. I am willing to take a bit more risk than Mr. Swedroe in my bond portfolio. Others may want to take more risk than I.

I did make a comment, and it wasn't pointed at you, that investors often don't understand the risks they are taking. I see this when people want to chase yield and when they want to chase performance. Believe it or not, there are folks who buy whatever yields the most. You are not in that camp as you have a very diversified bond portfolio. An example of this is me realizing that even investment grade corporates have some equity-like risk. In the 2008-2009 bear market, stocks tanked 50%, corporates down about 10%, while treasuries were up.

What I was reacting to is that our own observations and experience are dismissed as anecdotal. I guess we aren't supposed to believe what our own eyes and ears tell us. I admit that I get annoyed with Larry over this not only on this thread but others. Hence my comment that we are big boys and girls.

What I was commending Larry Swedroe for was educating us on the risks we are taking in our bond portfolios. I then said that I could see his point as my mix of bond funds, despite the extra risk I was taking, returned about the same as an all nominal treasury bond portfolio. I got the results right off the Morningstar website. I posted the results above. I also said that the premium that I should have had disappeared because of the extraordinary flight to quality in the aftermath of the financial crisis.

The reason that I posted the results from the funds that I personally own is for honesty and transparency. When I ran the results, I expected that Diversified Bond, Fidelity GNMA, and Vanguard Total Bond Index would have higher returns commensurate with the extra risk I was taking. Instead, the results of my three funds compared to Vanguard Intermediate-Term Treasury were virtually identical. So I posted the results even though they were different than what I expected and supported Larry's argument and not mine. At least for the previous 10 year time period, I was wrong.

As far as High Yield Bonds and whether or not people should invest in them, I could go either way on them. I view them as very equity like and that given the level of risk involved that I would rather have equities. I do view High Yield Bonds as "stocks in drag." Vanguard's High Yield Corporate Bond fund is rather conservatively run and owns higher quality bonds than what competing fund companies own in their High Yield Corporate Bond funds. If I was to buy such a fund, I would buy Vanguard's.

You own a very diversified bond portfolio and I have absolutely no quarrel with what you are doing. If your bonds were 100% junk, I would disagree strongly. But you have short and intermediate term Corporates, High Yield, Total International Bond Index, and US Total Bond Index. If that isn't diversification, I don't know what is.

Sorry if I gave the impression that I was picking on you. I was not. You also use the Vanguard Advisory Service and I assume that what you own is not far from what Vanguard recommends.
Last edited by nedsaid on Wed Jul 27, 2016 12:23 am, edited 1 time in total.
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Re: Another look at corporate bonds

Post by nedsaid »

Just for fun let's look at the four bond funds and compare, three of which I own personally. This time, let's look at the last 15 years rather than the last 10 and see if that makes a difference. My thesis is that Intermediate Term Treasuries did exceptionally well since the 2008-2009 financial crisis because of flight to quality. I should see the excess returns over 15 years that I didn't get over the last 10 years. The time period is from 7/26/2001 to 7/25/2016. I am using Morningstar's Growth of $10,000 chart.

Surprise, surprise, surprise. First was the Vanguard Intermediate Term Treasury at $20,941.10. I have to say I am pretty surprised. My theory didn't hold up. Second was my Diversified Bond Fund at $20,314.24. Not bad. Third was Vanguard Total Bond Market Index Plus at $20,148.20. Fourth, was Fidelity Ginnie Mae at $19,906.27. Hate to say it, Larry Swedroe was right. Darn it.

Just for fun, let's look at Vanguard High Yield Corporate. Over that 15 year period, $10,000 grew to $25,990.76. That was a 6.43% return with an 8.14 standard deviation over those 15 years. Vanguard Intermediate Term Treasuries returned 5.21% return with a 4.87 standard deviation over 15 years.

Okay, I view High Yield as stocks in drag. What did the Vanguard 500 Index return over that 15 years? The return was 5.63% and the Standard Deviation was 14.69. Hmmm. My untrained eye would say that High Yield had higher returns than the S&P 500 with much less volatility. Hmmm. Well, maybe Vanguard High Yield has a tartan, bagpipe, and kilt but isn't in drag. Not what I expected. Certainly more volatility than the Intermediate Term Treasuries but a lot less than equities. So I was probably 1/2 wrong here.

So over that 15 year period, did the extra returns of Vanguard High Yield Corporate over Vanguard Intermediate-Term Treasuries justify the extra volatility? My untrained eye would say, maybe. If I did the same risk/reward comparison between High Yield Corporate and the S&P 500, I would say that High Yield did great. More return for less volatility.

What my untrained eye would tell me is that based on this 15 year period, High Yield Corporates would have a place in an investor's portfolio. My best guess based on what I saw here is that High Yield Bonds would have a place in the equity part of the portfolio, boosting returns and decreasing volatility at the same time. Does that make it a better diversifier than REITs? I will let someone else answer that question.

Note that I picked the last 15 years. Results will vary depending on what time period you pick. It was interesting.
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Re: Another look at corporate bonds

Post by stlutz »

What my untrained eye would tell me is that based on this 15 year period, High Yield Corporates would have a place in an investor's portfolio. My best guess based on what I saw here is that High Yield Bonds would have a place in the equity part of the portfolio, boosting returns and decreasing volatility at the same time.
I've always found both the Swedore and Ferri approaches to High Yield to be defensible. Larry is right that portfolios (not just individual assets) backtested with with any bonds but treasuries don't show any advantage to the extra risk. On the other hand, I do agree with Rick that high yield bonds are a legitimate financial asset and that it's illogical to say to that they always have been, are, and always will be priced incorrectly.

Now, a 100% High Yield portfolio may have outperformed both of their recommended portfolios, but I guess I'd chalk that up as the risk of holding a diversified portfolio.
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Re: Another look at corporate bonds

Post by chatbotte »

I don't think price is the (only) issue here. Corporate bond prices may well be "correct", but you're not the average investor, because some market participants (e.g. insurers) are incentivized to hold corporate bonds rather than safer bonds (treasuries). As an individual, you might be better off by taking the opposite stance: dump corporate bonds and buy treasuries. That way, both you and insurers get the best deal.
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Re: Another look at corporate bonds

Post by saltycaper »

mptfan wrote:
saltycaper wrote: I don't know all of the places it is written--probably not on subway walls and tenement halls--but definitely more places than books by Larry Swedroe.
Could you cite those places?
Not going to look it up to cite chapter and verse, but just in Boglehead-land, Swensen and Bernstein have made similar arguments. Papers on credit risk abound. I'm sure you could even find some that do not fully support Swedroe's position, but he is certainly not alone, and there is nothing inconsistent about holding stocks and avoiding corporate bonds. FWIW, I myself do hold corporate bonds, some short, some intermediate. Corporate bonds were once my favorite asset class, especially int-term, but I have been shortening up a little lately, and I'm not as enamored with them as I used to be. If someone wants to hold corporate bonds, that's their prerogative, but I think it's wise to understand the warnings. See the data. Hear the arguments. We can all make up our own minds on how to put together our portfolios, but I for one am not so convinced by an argument founded on the simple principle, "It has performed well for me." Just not very compelling. On the other hand, whether or not an investor owns some corporate bonds, particularly investment-grade, is unlikely to tip their portfolio from "good enough" territory into "will fail to meet investment goals."
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mptfan
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Re: Another look at corporate bonds

Post by mptfan »

saltycaper wrote:
mptfan wrote:
saltycaper wrote: I don't know all of the places it is written--probably not on subway walls and tenement halls--but definitely more places than books by Larry Swedroe.
Could you cite those places?
Not going to look it up to cite chapter and verse,
I see.
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Re: Another look at corporate bonds

Post by larryswedroe »

fyi
Swensen in his book Unconventional Success
Well-informed investors avoid the no-win consequences of high-yield fixed income investing
.
Larry
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SeeMoe
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Re: Another look at corporate bonds

Post by SeeMoe »

nedsaid wrote:
SeeMoe wrote: Disagree! A retirees deferred folios should be all bonds and, as you know, Vanguard High Yield bonds are of better quality, and they are bonds despite the tired old saw " they sometimes act Ike stocks". Stocks should remain in the taxable folio. Don't know what you mean about being " big boys and girls" or the glowing reference to big name contributors to this sight either. It's as if you are implying that one is somehow disloyal if in disagreement? Sometimes charts and long winded dissertations on a subject are to much to digest without a drink of reality water. Thanks for your scholarly blurb..

SeeMoe.. :annoyed
What are you talking about?

I referred to your post in part because you are doing many of the same things I was doing. You were making many of the arguments I was making.

When I said that we are big boys and big girls, what I meant is that we are all adults and can make our own investment decisions. We take the risks and get the benefits and whatever consequences result. If someone wants to deviate from what folks like Larry Swedroe recommend, I assume that they have their own reasons for doing so. As for myself, I have said that I want more than nominal treasuries in my bond portfolio. I am willing to take a bit more risk than Mr. Swedroe in my bond portfolio. Others may want to take more risk than I.

I did make a comment, and it wasn't pointed at you, that investors often don't understand the risks they are taking. I see this when people want to chase yield and when they want to chase performance. Believe it or not, there are folks who buy whatever yields the most. You are not in that camp as you have a very diversified bond portfolio. An example of this is me realizing that even investment grade corporates have some equity-like risk. In the 2008-2009 bear market, stocks tanked 50%, corporates down about 10%, while treasuries were up.

What I was reacting to is that our own observations and experience are dismissed as anecdotal. I guess we aren't supposed to believe what our own eyes and ears tell us. I admit that I get annoyed with Larry over this not only on this thread but others. Hence my comment that we are big boys and girls.

What I was commending Larry Swedroe for was educating us on the risks we are taking in our bond portfolios. I then said that I could see his point as my mix of bond funds, despite the extra risk I was taking, returned about the same as an all nominal treasury bond portfolio. I got the results right off the Morningstar website. I posted the results above. I also said that the premium that I should have had disappeared because of the extraordinary flight to quality in the aftermath of the financial crisis.

The reason that I posted the results from the funds that I personally own is for honesty and transparency. When I ran the results, I expected that Diversified Bond, Fidelity GNMA, and Vanguard Total Bond Index would have higher returns commensurate with the extra risk I was taking. Instead, the results of my three funds compared to Vanguard Intermediate-Term Treasury were virtually identical. So I posted the results even though they were different than what I expected and supported Larry's argument and not mine. At least for the previous 10 year time period, I was wrong.

As far as High Yield Bonds and whether or not people should invest in them, I could go either way on them. I view them as very equity like and that given the level of risk involved that I would rather have equities. I do view High Yield Bonds as "stocks in drag." Vanguard's High Yield Corporate Bond fund is rather conservatively run and owns higher quality bonds than what competing fund companies own in their High Yield Corporate Bond funds. If I was to buy such a fund, I would buy Vanguard's.

You own a very diversified bond portfolio and I have absolutely no quarrel with what you are doing. If your bonds were 100% junk, I would disagree strongly. But you have short and intermediate term Corporates, High Yield, Total International Bond Index, and US Total Bond Index. If that isn't diversification, I don't know what is.

Sorry if I gave the impression that I was picking on you. I was not. You also use the Vanguard Advisory Service and I assume that what you own is not far from what Vanguard recommends.
Your explanation is accepted and, if long winded again, plausibly understood.
P.S. I am a " former" VPAS member after one year of excellent service from that fine Vanguard entity....Intend to maintain their AA and well thought out diversication plan for us , with yearly Flagship analysis' checkups.(Will return to VPAS as we age, or circumstances dictate . FYI.)

SeeMoe.. :mrgreen:
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nedsaid
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Re: Another look at corporate bonds

Post by nedsaid »

I reread through sections of a couple of Larry Swedroe's books, sections that related to High Yield Corporates (junk). Larry cited a period from 1979 to 2008, a thirty year period where Vanguard High Yield returned 6.31% a year vs. Barclays Capital US Intermediate Credit Bond Index which are investment grade that returned 8.47% a year. A pretty big penalty over a long period of time.

I also remember that Michael Milken was credited with creating the market for high yield corporates. My foggy memory recalls that these bonds helped finance leveraged buyouts and helped newer firms get started. At some point, Milken realized that most bonds, even lower quality bonds, don't default and even if they do are high enough on the capital structure that investors can often recover a lot of their investment. Or debt gets turned into equity.

I am sure that low quality bonds have always existed but the big market for these things didn't really exist until maybe the late 1970's or early 1980's or so. Thus is seems that this is for all intents and purposes a newer asset class. You would have maybe 40 years of good data.

Depending on the time periods you select, high yield corporates can look pretty good or pretty bad. I earlier called them stocks in drag, sometimes they aren't very good bonds and sometimes they aren't very good stocks either. A hybrid asset class with a mixed record as a stock substitute or a bond. It depends on when you peek.

Certainly the last 15 years look really good for Corporate High Yield. Times change and markets change and investor perceptions change. I am wondering if there has been a big change in how these are perceived by the market. In the days of Milken, this all seemed new. At the end of Milken's Wall Street career both his reputation and the reputation of junk bonds in general took a pretty big beating. It seems that the reputation of junk bonds and perhaps Milken have seen some rehabilitation.

The thing is that data is fluid and interpretations of that data are time period dependent. All of this is in flux. Asset classes have a history but that history does not obligate asset classes to behave as they did in the past. Markets change. My biggest example of this are dividends from common stocks, there was a time when stocks paid higher yields than bonds because stocks were riskier. That changed maybe in the 1920s? That was, as they say, a sea change. Perhaps the same kind of change in investor perception has happened with High Yield Corporate Bonds.
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Re: Another look at corporate bonds

Post by PandaBear »

So I'll be the first to admit that when it comes to bonds, I know nothing. I basically know what they are and that they should be part of the 3 fund portfolio in the form of a Total Bond Fund (usually).

In fact, I personally have some of my portfolio in Vanguard's Total Bond Fund and here's the reason for my post. VG's total bond fund has up to 30% in corporate bonds. If there really is no argument FOR corporate bonds, shouldn't the Boglehead recommendation for a bond fund be only government bonds (short, intermediate, and long term)? Or is there something I'm missing here.
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Re: Another look at corporate bonds

Post by lack_ey »

PandaBear wrote:So I'll be the first to admit that when it comes to bonds, I know nothing. I basically know what they are and that they should be part of the 3 fund portfolio in the form of a Total Bond Fund (usually).

In fact, I personally have some of my portfolio in Vanguard's Total Bond Fund and here's the reason for my post. VG's total bond fund has up to 30% in corporate bonds. If there really is no argument FOR corporate bonds, shouldn't the Boglehead recommendation for a bond fund be only government bonds (short, intermediate, and long term)? Or is there something I'm missing here.
If corporate bonds don't add anything valuable to an allocation of stocks and Treasury bonds (and/or CDs or other instruments with little-to-no credit risk for the investor), then you don't want them and total bond is not what you want to use.

For what it's worth, Larry Swedroe here also doesn't recommend mortgage-backed securities, another large chunk of total bond. Furthermore, he would also disagree with the Bogleheads stock allocation, at least for those who can stand tracking error and are committed to factor investing. Anyway, he's not the only one recommending against corporate bonds for individual investors. Plenty of other allocations, based on advice from David Swensen Harry Browne, don't use corporate bonds.

The Bogleheads recommendation is based on a different school of thought and as such uses total bond, though it should be stressed that most like Taylor Larimore are not very insistent on any particular bond allocation using relatively safe, investment-grade issues. The exact choice of taxable bond is not heavily stressed.

Keep in mind that overall the behavior of a total bond fund is not much different from a Treasury bond fund most of the time and this will likely be of relatively little consequence, especially if your allocation isn't heavily dominated by fixed income.
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Re: Another look at corporate bonds

Post by stlutz »

So I'll be the first to admit that when it comes to bonds, I know nothing. I basically know what they are and that they should be part of the 3 fund portfolio in the form of a Total Bond Fund (usually).

In fact, I personally have some of my portfolio in Vanguard's Total Bond Fund and here's the reason for my post. VG's total bond fund has up to 30% in corporate bonds. If there really is no argument FOR corporate bonds, shouldn't the Boglehead recommendation for a bond fund be only government bonds (short, intermediate, and long term)? Or is there something I'm missing here.
If you roll back the clock 15 or 20 years, the bond solution that backtested the best in a balanced portfolio was *short* term Treasuries. Then we had the most recent 15 years with 2 major bear markets where longer term Treasuries actually would have worked much better in that portfolio.

Back in 1995 or 2000, if one had taken the Boglehead approach and simply bought Total Bond, they would have done better than than the person who only owned what backtested the best (ST Treasuries). That didn't necessarily have to be the case--it could have worked out either way. The default Boglehead approach is to simply own the market and achieve "bonus return" by simply minimizing costs and taxes. You'll never have the absolute best portfolio this way, but you know you'll always be above average (after fees and taxes).
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Re: Another look at corporate bonds

Post by freyj6 »

Good article. I agree it's difficult to find a place for corporate bonds funds that makes sense.

As mentioned by, Swedroe, Bernstein and Swensen, a couple of the major drawbacks seem to be:

-Generally poor correlation during major bear markets and sudden crashes (for this reason, higher yield isn't really rewarded).

-As Swensen mentions, there are fundamental risks. If I remember what he said correctly, in a very bad crash, failing companies are accountable to their stockholders before their bondholders. As such, a corporate bond fund really could "break open" with defaults -- however unlikely.

-Minor tax and liquidity considerations, as mentioned in the article.

An interesting way to add to (and perhaps slightly complicate) this discussion, I think, is to look visually at what's happened to different bond ETFS during the global financial crisis and recent market dips.

http://stockcharts.com/freecharts/perf. ... ,LQD,GSTGX

This, of course, isn't meant to be an extensive history, but just an illustration of behavior.

Some things to note:

1. Longer corporate bonds, like the LQD fund, generally weather crashes well but can crash badly at inopportune times, like October 2008 and as recently as this February. This would have dramatically cut into the usefulness of their excess yield if you were to strategically rebalance near the bottom of the crash. LQD was often 10-25% below safer bonds when it made the most sense to rebalance.

2. Short term corporates are interesting to consider given the prospects of rising rates, but again seem to be down -- or at least even -- at the worst possible times. As others have shown with backtesting, the yield doesn't really compensate for these correlations.

3. Short term government bonds and T-bills, of course, barely moved.

4. Perhaps most interestingly -- and this is really only relevant to bond funds and ETFS -- are the funds that falls somewhere in between. Consider the difference between the fund BSV (short term bond) and VGSH (short term government). BSV is, as expected, slightly riskier but with slightly higher return.

You'd expect the performance of BSV to be more or less a combination of VCSH (short corporate) and VGSH (short government). But it's not.

Instead, it seems to outperform both during just about every bear market or correction.

I could only speculate on what this is the case, but my guess would be that there is some "optimal" level of risk, in which an asset class can be safe enough to avoid ruin, but just volatile enough to actually benefit from a flight to quality.

As such, perhaps there's some benefit to having SOME corporate bonds tied into a fund with a fare share of government.

Perhaps, like the efficient frontier, there are efficient levels of corporate bond inclusion in bond funds.

:)
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Re: Another look at corporate bonds

Post by saltycaper »

freyj6 wrote: .

4. Perhaps most interestingly -- and this is really only relevant to bond funds and ETFS -- are the funds that falls somewhere in between. Consider the difference between the fund BSV (short term bond) and VGSH (short term government). BSV is, as expected, slightly riskier but with slightly higher return.

You'd expect the performance of BSV to be more or less a combination of VCSH (short corporate) and VGSH (short government). But it's not.

Instead, it seems to outperform both during just about every bear market or correction.

I could only speculate on what this is the case, but my guess would be that there is some "optimal" level of risk, in which an asset class can be safe enough to avoid ruin, but just volatile enough to actually benefit from a flight to quality.

As such, perhaps there's some benefit to having SOME corporate bonds tied into a fund with a fare share of government.

Perhaps, like the efficient frontier, there are efficient levels of corporate bond inclusion in bond funds.

:)
Vanguard's short-term gov is shorter than short-term corp and short-term bond so it doesn't quite make for a fair comparison. 1-3-yr yields quite low, plus you don't get much of a flight to quality effect.
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Re: Another look at corporate bonds

Post by mptfan »

larryswedroe wrote:fyi
Swensen in his book Unconventional Success
Well-informed investors avoid the no-win consequences of high-yield fixed income investing
.
Larry
That is not the statement to which I was referring, and you know that. I was referring to your belief that "bonds are for safety, investors should take their risks on the equity side." That statement not only excludes high yield bonds, but all corporate bonds, including investment grade corporate bonds, and therefore goes well beyond the Swensen quote. Does Swensen advise against owning all corporate bonds?

So I will ask again, can you or anyone else cite to another author who holds the view that investors should only invest in bonds for safety and should "take their risks on the equity side"?
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Re: Another look at corporate bonds

Post by larryswedroe »

MTPFAN
Sorry I DID NOT KNOW that.

As I have said, there is no evidence in the literature EXCEPT for fallen angels, once investment grade bonds that have fallen to non investment grade. Martin Fridson did the original research on that and it holds up for logical reasons, there is a huge liquidity premium as many institutional investors by charter must sell these on the event and prices collapse due to big market impact. This is one thing that hurts all the data on corporates, so you would have to hold the fallen angels rather than sell.

If you own the highest grade corporates and they are short term it's okay because you basically eliminate the call risk and the credit risk becomes minimal, but you still have two negatives. One is you have to pay fund manager to get diversification and second you can typically get higher yields on CDs without any credit risk at all.

Note I would be willing to take risk on bond side IF you could get well rewarded for taking the risks, and of course could hold in tax advantaged accounts (unless you are in lowest brackets).

And btw, I have owned DFAs very short term bond fund (DFEQX) as it stays at the short end and avoids the callable risks---in 401k plan where cannot buy CDs. And I have recently invested (about 5% of my portfolio) in a higher yielding fixed income fund though it's not corporate, it's consumer and small business and student loans, which has credit risk but very high margins and where risk and reward have been well rewarded historically. The duration is only about 2. It's a 40 act, though not a mutual, fund with ticker symbol LENDX.

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Re: Another look at corporate bonds

Post by soboggled »

Seems to me if you want a low equities/high fixed income AA, high quality corporate bonds of intermediate duration in lieu of higher equities exposure are defensible.
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Re: Another look at corporate bonds

Post by larryswedroe »

soboggled
Why take the incremental risk if can avoid the expenses of a fund buying CDs with comparable and often higher yields and avoid the call risk in corporates and avoid the credit risk which is equity like at the wrong time, and with direct CDs many come with very small early redemption penalties, which is a low cost option you get. If you look at the data it's hard to find a reason to buy them. As I said though if you stay with the highest quality and a low cost fund and stick to shorter term INSIDE of plans where don't have CD option it's okay IMO.
And there are worse things that one can do so I don't want to "exaggerate" the negative here. It's more like there's no positive but some negatives.
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Re: Another look at corporate bonds

Post by garlandwhizzer »

I think it's overstating the case to say that there is never any place for any type of corporate bonds in a portfolio. Treasuries look compelling on backtesting during the greatest bond market in history. But will that continue going forward from here, yielding 1.5% for ten years? They provide safety no doubt, but they're not going to provide much if anything over the next ten years in terms of real inflation adjusted gain. If your portfolio is 50% bonds can you really afford to have half your portfolio giving you no real gain at all? That is a question bond heavy portfolios should ask themselves. Investors should also remember what has happened to Treasuries in the past when increasing inflation occurs like 1940 - 1980 when they produced substantial losses in real inflation adjusted dollars for 4 decades running. They weren't safe then, just the opposite. None of that is fresh in our minds in a long bond bull market so we neglect it and concentrate instead on 2008 - 9 instead which left a deep impression on all of us. We have lived through a fabulous bond bull market and that has tainted our outlooks about the wonderfulness of Treasuries. Corporate bonds have some equity characteristics, true, but that may be to their benefit over the next decade when bonds return is expected to be essentially zero real while US equities are likely in my view to return 4%, not great but a lot better than nothing.

No one, including me, is worried at present about inflation. Rather deflation is the main concern, a situation in which bonds do well. Inflation has been decreasing in the US for 34 years but that doesn't mean it has been put to bed forever. Economic history shows that. The downside of Treasuries is first, incredibly low yields, the lowest in history, producing no expected real return over the next decade. Second, the unseen and unexpected possibility of rising inflation over a long term with increasing momentum, something that no one expects, but if and when it occurs it hits Treasuries with their lower yields harder than corporate bonds. We are always well prepared for the last war, seldom for the next one.

Bogle has a signifiant percentage of his bond allocation in corporates, Rick Ferri too, and both make good arguments in their favor. That's evidence enough for me that in the current environment corporate bonds are not an asset class for everyone to avoid like the plague in a bond portfolio.

Garland Whizzer
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