Help finding the best bond strategy?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
peterinjapan
Posts: 523
Joined: Fri May 15, 2015 8:41 am
Location: Japan!

Help finding the best bond strategy?

Post by peterinjapan » Wed Dec 21, 2016 10:52 am

Like a lot of investors, I've been nervous about the future of my bond holdings, and reading things like "ponds are expected to yield zero over the next few years" even on this esteemed website, has caused me to reduce my bond holdings slightly. I'm trying to understand what options are available to me, and it seems like they fit into several categories.

a) index funds like BND or AGG, which are very broad, will yield on the low end, and be "safer" in times of rising rates, declining by less.

b) longer-term corporate options like CRED or LQD, which yield more yet will decline more when rates rise

c) high-yield junk bonds like HYG

d) Looking for individual bond issues that I would be okay holding to maturity, possibly building a bond ladder. (It's my impression that Bogleheads really don't like this approach.)

My question is, what approach do you think is best? I'm trying to decide on a approach and stick with it, and would like to hear feedback on the various types of bonds that are out there. Should I stick with the broadest indexes and never think about them? What are folks here doing about their bonds?

Currently I've got about 80% of my funds in U.S. equities (some individual stocks but mostly broad ETFs), 10% in international, and 8% in bonds, BND and a little LQD. Most money is held in taxable.

User avatar
BolderBoy
Posts: 4526
Joined: Wed Apr 07, 2010 12:16 pm
Location: Colorado

Re: Help finding the best bond strategy?

Post by BolderBoy » Wed Dec 21, 2016 1:52 pm

peterinjapan wrote:Like a lot of investors, I've been nervous about the future of my bond holdings, and reading things like "ponds are expected to yield zero over the next few years" even on this esteemed website, has caused me to reduce my bond holdings slightly...and 8% in bonds, BND and a little LQD. Most money is held in taxable.
You have a 92/8 AA portfolio and you're worried about your bond exposure?

What am I missing here?
"Never underestimate one's capacity to overestimate one's abilities" - The Dunning-Kruger Effect

stlutz
Posts: 5505
Joined: Fri Jan 02, 2009 1:08 am

Re: Help finding the best bond strategy?

Post by stlutz » Wed Dec 21, 2016 2:15 pm

a) index funds like BND or AGG, which are very broad, will yield on the low end, and be "safer" in times of rising rates, declining by less.

b) longer-term corporate options like CRED or LQD, which yield more yet will decline more when rates rise

c) high-yield junk bonds like HYG
There are two keys risks that we need to keep separate here.

1) Duration risk. This is the risk you are concerned about [temporarily] if rates go up and the risk you benefit from [temporarily] if rates go down. A fund with a duration of, say, 10 is basically twice as risky as one with a duration of 5.

2) Credit risk. This is the risk that the creditor won't be able to pay back the principal and interest in full.

These two risks are not very correlated to each other. For example, in 2008 long-term treasury bonds (lots of duration risk, no credit risk) went way up. Short-term corporate bonds (little duration risk, more credit risk) went down.

One additional note on duration risk. For an investor with a long-term horizon, your bond holding will be better off if rates to up. The duration is basically telling you what your "point of indifference" is. Suppose a fund has a duration of 5. Rates go up today and then stay unchanged for the next 10 years. Before 5 years, you will be worse off because of the rate change. After 5 years, you will be better off (because higher rates are better over the longer term).

People here generally favor intermediate term bonds as offering a balance between the higher yields you can get from some duration risk while not making you wait too long to make up for the losses if rates go up.

Finally, what makes you think rates will continue to go up? Yes, rates have gone up over the past few months. If it was guaranteed that they were going to rise another 2%, it already would have happened. When putting your portfolio together, it's better to make strategic decisions about the types of risks you want to take overall as opposed to trying to time the bond market, which is notoriously difficult.

Elbowman
Posts: 507
Joined: Tue Apr 03, 2012 2:25 pm

Re: Help finding the best bond strategy?

Post by Elbowman » Wed Dec 21, 2016 2:33 pm

If you only have 8% bonds, I'd focus less on returns (which will be dominated by your 92% stocks) and more on diversifying behavior. Compare the performance of BND, LQD, and HYG in 2008. LQD lost 25%, HYG lost 35%... whats the point? You might as well be 100% stocks.

When you have <= 10% bonds, I think the real decision is do you go with BND (or intermediate term treasuries) for low risk and zero correlation with your stocks, or do you go with something like EDV (extended duration treasuries) to get high risk but negative correlation with your stocks. Right now I'm opting for BND, but I'm going to keep my eye on EDV as rates increase.

Regarding d), bond funds are collections of individual bonds, and I've yet to hear a convincing argument for why holding the individual bonds yourself is worth the effort.
Last edited by Elbowman on Thu Dec 22, 2016 1:57 pm, edited 1 time in total.

User avatar
Aptenodytes
Posts: 3763
Joined: Tue Feb 08, 2011 8:39 pm

Re: Help finding the best bond strategy?

Post by Aptenodytes » Wed Dec 21, 2016 2:35 pm

I agree with BolderBoy that your low bond allocation means that you have the luxury of paying attention only to volatility and not worrying about return.

If you are looking for a long-term strategy, to be used even as your bond holdings increase, then you should be comforted by the fact that long-term investors don't have to worry about the short term trends, which is what seems to have you spooked.

You say most of your "money" is in taxable, but not where your bonds are. Normally you'd be aiming to have as much of the bonds in tax-free accounts as possible.
a) index funds like BND or AGG, which are very broad, will yield on the low end, and be "safer" in times of rising rates, declining by less.
This is not the way I'd put it. BND is diversified, yes. But that doesn't mean its yields will be "low" or "safer in times of rising rates." It depends on what you compare it to. There are instruments with lower expected yields than BND and there are instruments that are safer in times of rising rates. The main play for BND is diversification and not-having-to-think-about-all-this.
b) longer-term corporate options like CRED or LQD, which yield more yet will decline more when rates rise
Also not quite the way I'd put it. Going long and going corporate each expose you to their own separate kinds of risk. Long bonds will fall in value more than short bonds when rates rise. But I don't think that applies to Corporates. What Corporates expose you to is greater default risk.
c) high-yield junk bonds like HYG
Ferri likes 'em. They are in BND in very small percentage. Swedroe doesn't like 'em. Too bad we don't have polls anymore, but I'd guess a significant minority here hold them (maybe 25% or so?). They are going to be more volatile than almost any other bond category, so you have to have really thought this one through before you jump in, so you'll be able to tolerate the downward dips.
d) Looking for individual bond issues that I would be okay holding to maturity, possibly building a bond ladder. (It's my impression that Bogleheads really don't like this approach.)
I don't think people are opposed to it in principle, for the most part. The thing is to think through your objectives. Ladders aren't magic, so they won't bring you higher returns than bond funds. Don't gravitate to ladders if you think they are going to bring you such magic. They are good for liability matching, that is providing a certain sum at a certain time. And Swedroe seems to especially like individual bonds for municipals held in a taxable account -- search his posts on the topic here to read more (and check if my memory is right).
My question is, what approach do you think is best? I'm trying to decide on a approach and stick with it, and would like to hear feedback on the various types of bonds that are out there. Should I stick with the broadest indexes and never think about them? What are folks here doing about their bonds?
There's nothing wrong with letting your bond approach evolve over time, as long as you aren't erratic, fickle, yield-chasing, fad-chasing, etc. about it. E.g. you could go 100% BND for the time being, and then in a few years or so you could add a new bond category or two after you've had time to read and cogitate more. I think it is better to have an approach that changes over time and only includes asset categories you fully understand at each stage, than to start out with a mix that in theory makes sense for the long term but includes asset categories you don't understand. But everyone's foibles are different and you have to craft an approach that is resilient to your own.

User avatar
Portfolio7
Posts: 698
Joined: Tue Aug 02, 2016 3:53 am

Re: Help finding the best bond strategy?

Post by Portfolio7 » Wed Dec 21, 2016 5:19 pm

Elbowman wrote:If you only have 8% bonds, I'd focus less on returns (which will be dominated by your 92% stocks) and more on diversifying behavior. Compare the performance of BND, LQD, and HYG in 2008. LQD lost 25%, HYG lost 35%... whats the point? You might as well be 100% stocks.

When you have <= 10% stocks, I think the real decision is do you go with BND (or intermediate term treasuries) for low risk and zero correlation with your stocks, or do you go with something like EDV (extended duration treasuries) to get high risk but negative correlation with your stocks. Right now I'm opting for BND, but I'm going to keep my eye on EDV as rates increase.

Regarding d), bond funds are collections of individual bonds, and I've yet to hear a convincing argument for why holding the individual bonds yourself is worth the effort.
This.

It doesn't matter what returns your bonds get overall so much. It matters more whether your bonds zig when equities zag. Do portfolio modeling with annual rebalancing, and you'll see this makes a difference over time to both risk and return. When you carry an 8% bond allocation, I think LT Treasuries balance high equity portfolios nicely during most downturns, and I expect portfolio results will be stronger than, say, with LT Corporates over most time periods even if corporates have better total returns. Your portfolio will still lose money at times, but less than with most non-Treasury and most shorter duration bonds. Yes, LT Treasuries will be a drag if rates do rise further - but you are 92% equities.

Think of your portfolio as a single entity. If the idea of losing 2% of your portfolio (likely worst case, 25% decline on 8% of your portfolio) really is just too much, then your risk tolerance and your 92/8 asset allocation may be out of synch. Maybe you convert some equity to a high yield stable value fund if available, or you change your bond allocation to 15% intermediates... just options. I'm a natural optimizer too, and understand where you are coming from, but if you really want to fine tune it I suggest you do research based on your specific portfolio, since correlations will depend on which asset classes & how much of each you choose. Then you have to allow for the future being different than the past.

The best question ever, is 'what if you're wrong?'. The best answer ever is that you don't care... because long term your risks are balanced, your investments work well together, and your portfolio will therefore weather pretty much any storms in the market without giving you heart burn.
"An investment in knowledge pays the best interest" - Benjamin Franklin

nance
Posts: 40
Joined: Fri Feb 06, 2009 3:45 pm

Re: Help finding the best bond strategy?

Post by nance » Thu Dec 29, 2016 3:03 am

Over the last 3 months BND is -4.5%.

Does it make sense to go with the shorter duration BSV that has lost less? (-1.9%)

Duration 5.9 years vs 2.8 years

SpaceCowboy
Posts: 893
Joined: Sun Aug 12, 2012 12:35 am

Re: Help finding the best bond strategy?

Post by SpaceCowboy » Thu Dec 29, 2016 5:21 am

Still think CDs are the superior choice to bond funds in current market.
But in your 92/8 case, I'm with @Elbowman. Long term Treasuries like TLT probably make the most sense. You need the diversification effects. Why not increase bonds to 20%, which will probably give you a better Sharpe ratio?

Post Reply