Help - Which of these bond funds are best for my bond allocation?

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JustinR
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Help - Which of these bond funds are best for my bond allocation?

Post by JustinR » Fri Jan 20, 2017 10:44 pm

I don't know anything about bonds. I've narrowed it down to these bond funds for my HSA as they're largely exempt from state taxes (CA treats HSAs as taxable accounts). Which of these are appropriate for my bond allocation to hold until retirement?

Current portfolio:
Equities:
25% Total Stock Market Admiral (VTSAX)
25% Total International Admiral (VTIAX)
25% Small-Cap Value Admiral (VSIAX)
25% FTSE All-World Small-Cap Investor (VFSVX)

Bonds:
Metropolitan West Total Return Bond Fund Plan Class (MWTSX) in 401k


I've narrowed it down to these 5 (all ETFs). Which would you pick?



mhalley
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by mhalley » Sat Jan 21, 2017 12:59 am

First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.

dbr
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by dbr » Sat Jan 21, 2017 9:02 am

mhalley wrote:First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.


I think that is a reasonable answer.

Rodc
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by Rodc » Sat Jan 21, 2017 10:04 am

dbr wrote:
mhalley wrote:First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.


I think that is a reasonable answer.


This is what I would do.

Unfortunately for some reason it was eliminated from my 401K last year as one of my no fee to buy options so I now have vanguard's TBM.

Not my first choice but good enough that I lose no sleep over it.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

JustinR
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by JustinR » Sat Jan 21, 2017 2:53 pm

mhalley wrote:First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.

Thank you!

Is SEC Yield% the number I look at for bond performance?

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Kevin M
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by Kevin M » Sat Jan 21, 2017 3:32 pm

mhalley wrote:First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.

I think with this reasoning, assuming that you know interest rates are going to rise, you would pick one of the short-term funds. Here are SEC yields for the three Vanguard government bond funds:

2.93% Long
1.94% Inter
1.14% Short

So you drop less yield in going from intermediate to short than in going from long to intermediate, and if you know interest rates are going to increase by a certain amount, total return for the short-term fund will be higher.

Duration of the intermediate fund is 5.2 years, and for short term it's 1.9 years, so a parallel yield increase of 30 basis points would knock off about 1.56% of return from the intermediate-term fund and about 0.57% from the short-term fund, giving total expected returns of 0.57% for short-term and 0.38% for intermediate-term. So if you expect a parallel yield increase of 30 basis points or more over the next year, you are better off with the short-term fund.

EDIT: The point at which the short-term fund starts to pull ahead of the intermediate term fund is a parallel yield increase of about 25 basis points.

I personally do not know that rates are going to increase, and if so by how much, and how any increases might be different across the yield curve. I think the typical BH position is to go with high quality intermediate term bond funds regardless of any economic outlook (but that's not what I do).

Kevin
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Kevin M
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by Kevin M » Sat Jan 21, 2017 3:53 pm

You can look at Q4 2016 performance to see how the yield increases then affected these funds. For the three Vanguard government bond funds, total returns were:

VGSH: -0.16%
VGIT: -3.66%
VGLT: -11.99%

Source: Backtest Portfolio Asset Allocation

Worst month was November, and VGSH actually recovered most of its Nov loss in Dec, while the other two funds lost a bit more in Dec.

If we expand the time period to all of 2016, the long-term fund actually did slightly better than the short-term fund, with the intermediate-term fund trailing the pack:

VGSH: 1.10%
VGIT: 0.84%
VGLT: 1.22%

Source: Backtest Portfolio Asset Allocation

The Sharpe ratio for VGSH, 0.78, is much higher than that for the other two (0.17 for VGIT and 0.14 for VGLT), which indicates that you might be better off using VGSH and bumping up your equity allocation a bit.

Kevin
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JustinR
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by JustinR » Sat Jan 21, 2017 4:18 pm

Kevin M wrote:You can look at Q4 2016 performance to see how the yield increases then affected these funds. For the three Vanguard government bond funds, total returns were:

VGSH: -0.16%
VGIT: -3.66%
VGLT: -11.99%

Source: Backtest Portfolio Asset Allocation

Worst month was November, and VGSH actually recovered most of its Nov loss in Dec, while the other two funds lost a bit more in Dec.

If we expand the time period to all of 2016, the long-term fund actually did slightly better than the short-term fund, with the intermediate-term fund trailing the pack:

VGSH: 1.10%
VGIT: 0.84%
VGLT: 1.22%

Source: Backtest Portfolio Asset Allocation

The Sharpe ratio for VGSH, 0.78, is much higher than that for the other two (0.17 for VGIT and 0.14 for VGLT), which indicates that you might be better off using VGSH and bumping up your equity allocation a bit.

Kevin

Now I'm even more confused. Looks like VGLT won when backtested from almost every year...

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Kevin M
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by Kevin M » Sat Jan 21, 2017 7:32 pm

JustinR wrote:Now I'm even more confused. Looks like VGLT won when backtested from almost every year...

VGLT has higher expected return and higher risk, so in good years it will return much more, and in bad years it will return much less. In an environment of generally decreasing yields it will do even better, since it's much longer duration allows it to benefit more. Of course the converse is true, so when longer-term yields increase, it will lose much more than the other funds will when intermediate-term or short-term yields increase by the same amount.

You can see all of this by comparing the three funds with PV for the longest period available, which is since Feb 2010. Yes, VGLT had a much higher return over that period, but also was much more volatile with much larger maximum drawdowns.

Max Drawdowns:

VGSH: -0.71%
VGIT: -3.94%
VGLT: -16.10%

Source: Backtest Portfolio Asset Allocation

I think the common wisdom is that it's more efficient to take more risk with stocks and less with bonds, so I think most people go with short-term or intermediate-term bonds and look to their stocks for higher returns.

Kevin
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Quark
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by Quark » Sat Jan 21, 2017 8:00 pm

mhalley wrote:First thing is to eliminate the long term bond funds as we know interest rates are going to rise. Then you eliminate the short term ones due to the extremely low yield, leaving vgit.

What makes you think current market prices and yields don't already take into account this knowledge about the future of interest rates?

mhalley
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Re: Help - Which of these bond funds are best for my bond allocation?

Post by mhalley » Sun Jan 22, 2017 5:28 pm

Perhaps my reasoning is faulty, or my explanation too glib. Interest rates have been expected to rise for many years now. The fact is, we don't know WHEN this is actually going to happen, or by how much. There is no way the market has figured this out exactly. You could do many things with your bonds right now. You could give up on them, and just buy cds. You could go short, and just buy short term bonds. Or you could STAY THE COURSE, and buy Intermediate term bonds, which are the ones most recommended here and by many other of the financial gurus. As long as your investment period is longer than the duration of your bond fund, you should be better off in the long run if interest rates do rise.
For most people, what the bonds do in the next 5 years is not important. They are there to add some ballast to the overall portfolio. Over time, the decrease in nav will be made up for by the increase in yield. From a Vanguard White paper:
https://personal.vanguard.com/pdf/s807.pdf
"Although, going forward, the risk of loss in bonds in
the short term has rarely been higher, what should
matter most to investors who are diversified in
stocks and bonds is the return of their total portfolio,
not just the return of the bonds within it. For a
diversified investor, the main source of risk and
return over the long term is equities, while the role
of bonds is to narrow the dispersion of potential
returns."

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