Explain why long-term bonds aren't awesome

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Tamalak
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Explain why long-term bonds aren't awesome

Post by Tamalak » Mon Feb 12, 2018 5:11 pm

Stupid question as I'm an equity guy and don't understand bonds well. Forgive me.

I'm specifically looking at the BLV ETF product from Vanguard. Why is the return so high compared to other bond types? Is 7.5% a realistic forward-looking return?

The return seems more wobbly than most bond types but I don't see any drop worse than 10-12% or so. It didn't even twitch during the disaster of 2008, which says to me that this asset is uncorrelated with the stock market, which would make it really good paired with equities. Is this just a particularly good decade?

Chuck
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Re: Explain why long-term bonds aren't awesome

Post by Chuck » Mon Feb 12, 2018 5:18 pm

The yield you should expect is the SEC yield, which is currently 3.73%.

The average duration is 15 years, so it should be extremely volatile.

alex_686
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Re: Explain why long-term bonds aren't awesome

Post by alex_686 » Mon Feb 12, 2018 5:26 pm

Look up duration, which is a measurement of risk in bonds. Very simply, you multiple the change in rates by duration to get the change in NAV.

For example, assume that rates went up by 1%. A short term bond fund where bonds mature in 1 year would have a duration of 1 and would fall by 1%. A long term bond fund where bonds matured in 15 years would have a duration of 15 and fall by 15%.

Much more complex than that but that should give you a taste. Risk and return are linked. If you are seeing a high return try to figure out where the risk lies.

JBTX
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Re: Explain why long-term bonds aren't awesome

Post by JBTX » Mon Feb 12, 2018 5:28 pm

The return was high because of its long term duration and historically falling interest rates.

With a duration of 14 if interest rates go up 1% your portfolio goes down 14%. If interest rate goes up 2% it goes down 28%, etc.

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nisiprius
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Re: Explain why long-term bonds aren't awesome

Post by nisiprius » Mon Feb 12, 2018 5:29 pm

The average effective maturity in that fund is 24 years. That means you are locking yourself into a specific interest payment rate for about that long. To anyone who lived through the inflation of the late 1970s, that is an awfully long commitment. Between 1971 and 1986, the value of the dollar was cut to 1/3rd of what it had been. 24 years earlier, neither you nor the market would have been likely to see that coming.

And while you say that you are not bothered by the fluctuations, the duration is 15 years (compared to 6 for the VanguardTotal Bond Market Index Fund) so you are talking about 2.5X the interest rate risk of Total Bond. And even Total Bond has enough interest risk to be spooking at least some posters in this forum.

I wouldn't do it.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Tamalak
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Re: Explain why long-term bonds aren't awesome

Post by Tamalak » Mon Feb 12, 2018 5:31 pm

So if I understand right.. rising interest rates are BAD for those already holding bonds, because you've already locked yourself in to a lower rate of return. And falling interest rates are GOOD for those holding bonds because you've locked yourself into a better return than is in the present?

So will the price of bond funds "try" to remain constant in the long run, and the average long-term return just be the SEC yield?

Catfish Plumber
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Re: Explain why long-term bonds aren't awesome

Post by Catfish Plumber » Mon Feb 12, 2018 5:42 pm

My current total AA is 80/20 stocks/bonds. The bulk of my bonds is in BLV and VBLTX (etf and mutual fund versions of the same thing).

I think posting this will generate some advice on how total bond market would be better. But as things stand so far I am happy with my set up and plan to continue with it for the near future.

Until this post it’s felt like my own dirty little secret that goes against general boglehead philosophy. Pretty sure it’s a carryover from yield chasing days. I have a mental bond yield “floor” of 3.53%, the guaranteed rate of EE savings bonds if held 20 years, and I can’t bring myself to accept anything lower.

I have also recently found myself trying to recreate BLV with a combo of long term corporate and treasuries in some accounts that would otherwise charge for directly buying BLV. I believe BLV is split 40% treasuries vs 60% corporate. As time goes on I find myself wanting to buy more long term government as opposed to corporate, the idea being a recession could greatly harm stocks and corporate bonds but long term treasuries would do well. As bad as locking in 3% nominal for 30 years seems, it could be the best option if interest rates move down and stay low for an extended period of time due to poor economic conditions.

But to steal a closing line I saw someone else use: “I know nothing.”

alex_686
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Re: Explain why long-term bonds aren't awesome

Post by alex_686 » Mon Feb 12, 2018 5:45 pm

Tamalak wrote:
Mon Feb 12, 2018 5:31 pm
So if I understand right.. rising interest rates are BAD for those already holding bonds, because you've already locked yourself in to a lower rate of return. And falling interest rates are GOOD for those holding bonds because you've locked yourself into a better return than is in the present?

So will the price of bond funds "try" to remain constant in the long run, and the average long-term return just be the SEC yield?
The math behind bond investing is fun and complex. Much more interesting than individual stocks in my opinion.

Bond prices already have all of the expected changes in the interest rates baked in. Duration is for unexpected changes. Then there is the yield curve, because short term and long term rates can move differently. Lots of fun.

Bond funds try to maximize their "Total Return", by maximize yield and price appreciation while managing risk. There are trade offs between these. Bond returns are not stable. We have been in a falling interest rate environment since 2008. This has caused huge price returns for those who held long term bonds while crushing those wanted yield. We are about as low as we can go and everybody is expecting rates to go up. However we have been expecting this for quite some time so I can't reassure you here.

It might help if you started with a new thread with your investment goals and your risk tolerance. We could then attack the issue top down. Now we are just scratching the technical details There is a standardized format out there.

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nisiprius
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Re: Explain why long-term bonds aren't awesome

Post by nisiprius » Mon Feb 12, 2018 5:50 pm

Tamalak wrote:
Mon Feb 12, 2018 5:31 pm
So if I understand right.. rising interest rates are BAD for those already holding bonds, because you've already locked yourself in to a lower rate of return. And falling interest rates are GOOD for those holding bonds because you've locked yourself into a better return than is in the present?
No, it is more complicated than that. For a sudden interest rate rise, the duration tells you your "point of indifference." If the duration is 15 years, then the value of your bond fund holding, including reinvested interest, will fall, but over 15 years it will gradually rise because of a) interest being paid out, and b) the value of a bond rising to its face value when it matures. Up to 15 years you are worse off than if interest rates had remained stable. At 15 years, you are neither better nor worse off. After 15 years, you are better off because the bonds you are holding are paying higher interest.

If the interest rate rise is gradual, then the loss is not as bad, but the time to be "back on track" is even longer.

Thus, Vanguard says that Total Bond, with a duration of 6 years, "may be" suitable for an investor with a 4-10 year time horizon. There are no absolutes because there's no limit to what you can imagine interest rates doing, but for reasonable scenarios there isn't much danger if you are prepared to hold for 4-10 years. But for the long-term bond fund, you would need to be prepared to hold for 15 years or more.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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nisiprius
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Re: Explain why long-term bonds aren't awesome

Post by nisiprius » Mon Feb 12, 2018 5:51 pm

The Vanguard Total Bond Market Index Fund is a reasonable starting point. You may decide that is not your preferred bond fund, but do not be too quick to assume that any other bond fund is far better, "awesome." If you think you see something that is far better, you missed something, you are overlooking something.

Don't forget that in the fundamental meaning of the two words, "awesome" and "awful" basically mean the same thing!
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Tamalak
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Re: Explain why long-term bonds aren't awesome

Post by Tamalak » Mon Feb 12, 2018 5:58 pm

Thank you all. That illuminated a lot of my questions, including some unasked ones (like why long-term bonds holds any drawbacks at all over short-term ones if the ETFs for both are totally liquid).

I see now that a lot of the risks involved with long-term bonds did not materialize in the last 10 years so that 10 year chart makes them look a lot safer than they are.
It might help if you started with a new thread with your investment goals and your risk tolerance. We could then attack the issue top down. Now we are just scratching the technical details There is a standardized format out there.
I'm 100% equities (VTI/VXUS at world cap) for years and comfortable with them. As Warren Buffett says "Never invest in a business you cannot understand," and I understand exactly what they are, which makes sudden drops like the most recent one much less scary.

I don't anticipate ever adding bonds to my portfolio but I think it was time for me to stop being completely ignorant about them.

pascalwager
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Re: Explain why long-term bonds aren't awesome

Post by pascalwager » Mon Feb 12, 2018 8:30 pm

nisiprius wrote:
Mon Feb 12, 2018 5:50 pm
Tamalak wrote:
Mon Feb 12, 2018 5:31 pm
So if I understand right.. rising interest rates are BAD for those already holding bonds, because you've already locked yourself in to a lower rate of return. And falling interest rates are GOOD for those holding bonds because you've locked yourself into a better return than is in the present?
No, it is more complicated than that. For a sudden interest rate rise, the duration tells you your "point of indifference." If the duration is 15 years, then the value of your bond fund holding, including reinvested interest, will fall, but over 15 years it will gradually rise because of a) interest being paid out, and b) the value of a bond rising to its face value when it matures. Up to 15 years you are worse off than if interest rates had remained stable. At 15 years, you are neither better nor worse off. After 15 years, you are better off because the bonds you are holding are paying higher interest.

If the interest rate rise is gradual, then the loss is not as bad, but the time to be "back on track" is even longer.

Thus, Vanguard says that Total Bond, with a duration of 6 years, "may be" suitable for an investor with a 4-10 year time horizon. There are no absolutes because there's no limit to what you can imagine interest rates doing, but for reasonable scenarios there isn't much danger if you are prepared to hold for 4-10 years. But for the long-term bond fund, you would need to be prepared to hold for 15 years or more.
The VG Target Retirement Income Fund includes 37.3% Total Bond Market Index Fund. How do you leave TBM alone for 4-10 years if you're regularly withdrawing living expenses from the TR Fund?

In reality, you may take an interest rate loss on all of the TR fund bond components if rates are rising during retirement.

RRAAYY3
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Re: Explain why long-term bonds aren't awesome

Post by RRAAYY3 » Mon Feb 12, 2018 8:36 pm

feels like bonds are pretty much as risky as equity without the return potential ...

[100/0 guy that knows nothing about bonds, accumulation phase]

venkman
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Re: Explain why long-term bonds aren't awesome

Post by venkman » Mon Feb 12, 2018 8:58 pm

RRAAYY3 wrote:
Mon Feb 12, 2018 8:36 pm
feels like bonds are pretty much as risky as equity without the return potential ...
Since 1993, the worst calendar year return for Vanguard's Total Stock Market Index was -37%.

The worst calendar year return for VG's Total Bond Index was -2.66%.

chevca
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Re: Explain why long-term bonds aren't awesome

Post by chevca » Mon Feb 12, 2018 9:03 pm

Long term bonds can definitely be considered risky. The duration risk is high. Take risk on the equity side, IMO.

Long term bonds were awesome back in the day. Those that bought them back in the '80s made out nicely.

RRAAYY3
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Re: Explain why long-term bonds aren't awesome

Post by RRAAYY3 » Mon Feb 12, 2018 9:14 pm

venkman wrote:
Mon Feb 12, 2018 8:58 pm
RRAAYY3 wrote:
Mon Feb 12, 2018 8:36 pm
feels like bonds are pretty much as risky as equity without the return potential ...
Since 1993, the worst calendar year return for Vanguard's Total Stock Market Index was -37%.

The worst calendar year return for VG's Total Bond Index was -2.66%.
cool. how about best calendar year returns ... or returns in general since then ... or the current environment's impact on bond performance ...

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Re: Explain why long-term bonds aren't awesome

Post by neurosphere » Mon Feb 12, 2018 9:20 pm

pascalwager wrote:
Mon Feb 12, 2018 8:30 pm

The VG Target Retirement Income Fund includes 37.3% Total Bond Market Index Fund. How do you leave TBM alone for 4-10 years if you're regularly withdrawing living expenses from the TR Fund?

In reality, you may take an interest rate loss on all of the TR fund bond components if rates are rising during retirement.
Imagine you have a 30 year retirement, and you withdraw 1/30 (for the sake of argument) of your balance each year. You'd be invested in bonds for an "average" of 15 years. Much longer than the duration of the Total Bond Market Index. If rates are steadily rising throughout your retirement period of 30 years, the money which "stayed" in bonds early in retirement benefited from the early rise in rates, in the sense that they started to pay out increased interest as rates went up.

But yes, if you imagine a 30 year period of interest rate increases which starts on your retirement date, well, that could be painful. TIPS anyone? Oh wait, the TR income fund has about 17% in TIPS. In addition to a 35% equity exposure. So if there is inflation or unexpected inflation which drives bond rates, there are other components in the TR fund which will benefit. :D
-- Real name: Sotirios Keros. If you have to ask "Is a Target Retirement fund right for me?", the answer is yes.

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nisiprius
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Re: Explain why long-term bonds aren't awesome

Post by nisiprius » Mon Feb 12, 2018 9:30 pm

RRAAYY3 wrote:
Mon Feb 12, 2018 8:36 pm
feels like bonds are pretty much as risky as equity without the return potential ...



[100/0 guy that knows nothing about bonds, accumulation phase]
1) You are a movie actor. You have reason to believe that the studio is solvent and able to pay the costs of producing a film. Which is riskier? A contract to pay you a specific dollar amount? That's like a bond. Or, a share of the net profit? That's like a stock.



2) See if you can guess which four growth charts are bond funds and which four are stock funds.



Source



Image
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Dottie57
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Re: Explain why long-term bonds aren't awesome

Post by Dottie57 » Mon Feb 12, 2018 9:34 pm

venkman wrote:
Mon Feb 12, 2018 8:58 pm
RRAAYY3 wrote:
Mon Feb 12, 2018 8:36 pm
feels like bonds are pretty much as risky as equity without the return potential ...
Since 1993, the worst calendar year return for Vanguard's Total Stock Market Index was -37%.

The worst calendar year return for VG's Total Bond Index was -2.66%.
Numbers say it all.

onourway
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Re: Explain why long-term bonds aren't awesome

Post by onourway » Mon Feb 12, 2018 9:36 pm

RRAAYY3 wrote:
Mon Feb 12, 2018 9:14 pm


cool. how about best calendar year returns ... or returns in general since then ... or the current environment's impact on bond performance ...
Many investors have fabulously short memories.



1998-2012 was a fifteen year period in which bonds outperformed stocks. And without the wrenching volatility.



Image

pascalwager
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Re: Explain why long-term bonds aren't awesome

Post by pascalwager » Mon Feb 12, 2018 10:31 pm

neurosphere wrote:
Mon Feb 12, 2018 9:20 pm
pascalwager wrote:
Mon Feb 12, 2018 8:30 pm

The VG Target Retirement Income Fund includes 37.3% Total Bond Market Index Fund. How do you leave TBM alone for 4-10 years if you're regularly withdrawing living expenses from the TR Fund?

In reality, you may take an interest rate loss on all of the TR fund bond components if rates are rising during retirement.
Imagine you have a 30 year retirement, and you withdraw 1/30 (for the sake of argument) of your balance each year. You'd be invested in bonds for an "average" of 15 years. Much longer than the duration of the Total Bond Market Index. If rates are steadily rising throughout your retirement period of 30 years, the money which "stayed" in bonds early in retirement benefited from the early rise in rates, in the sense that they started to pay out increased interest as rates went up.

But yes, if you imagine a 30 year period of interest rate increases which starts on your retirement date, well, that could be painful. TIPS anyone? Oh wait, the TR income fund has about 17% in TIPS. In addition to a 35% equity exposure. So if there is inflation or unexpected inflation which drives bond rates, there are other components in the TR fund which will benefit. :D
Okay, thanks--seems reasonable. I'm setting up my own TR income fund using the same five VG funds except I'll be about 60/40, stocks/bonds. I won't be withdrawing regular income–-I have a pension.

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