Talking about Bond Investing - For Safety, not Yield

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Rajsx
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Talking about Bond Investing - For Safety, not Yield

Post by Rajsx » Sat Mar 31, 2018 11:38 pm

I have a question, and want to understand this better -

If we say Bond Investing is first for safety & not Yield, (& to go to Stocks for yield), following the same thinking, why does the Short Term Bond Index VBIRX NOT become the main Bond Fund in the Portfolios discussed here & substitute the Total Bond Index Fund VBTLX .

Thanks for weighing in your thoughts on this ---
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SimpleGift
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Re: Talking about Bond Investing - For Safety, not Yield

Post by SimpleGift » Sun Apr 01, 2018 12:05 am

What should govern the choice of bond maturity in one's portfolio is risk-adjusted return — not notions of safety or yield.

The two charts below were prepared years ago by William Bernstein, and show various mixes of stocks with 30-day T-bills, 5-year and 20-year Treasuries. Over most of its range, the 5-year maturity curve lies above the other two curves, indicating that each degree of risk has historically yielded more return. This result has been fairly consistent over various time periods.
Thus for most portfolio mixes of stocks and bonds, especially where stocks make up the majority of one's total portfolio, intermediate-term bonds have historically provided the best return per unit of risk (portfolio standard deviation).
Cordially, Todd

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Re: Talking about Bond Investing - For Safety, not Yield

Post by mega317 » Sun Apr 01, 2018 12:40 am

You could take your question a step further--why not treasuries, or CDs, or stable value funds? Many people do just that. There have been some very thoughtful discussions on this question previously.

My own answer is some combination of:
1. Total bond funds are simple and widely available (my work plan has nothing like VBIRX, for example),
2. I am comfortable with a little bit more risk and a little bit more return (demonstrated nicely above),
3. I kind of like speaking the same language as a plurality of posters here--even when people don't use VBTLX, it is often used as a frame of reference for a conversation,
4. It really truly doesn't matter to me. Trying to optimize around a 1% performance difference in a fraction of my portfolio seems unnecessary.

OP: I see from a recent post your allocation is 46/54, so you are perhaps more of an optimizer than me. But in another recent post you seemed to have difficulty deciding within the 40-50% stock range. So these questions are much more important that what (investment-grade) fixed-income you hold, and I think you have demonstrated nicely that you can't "get it right", at least not without hindsight.

Rajsx
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Rajsx » Sun Apr 01, 2018 8:35 am

Thank you Simplegift & Mega for very insightful & helpful posts.
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Valuethinker » Sun Apr 01, 2018 9:35 am

Rajsx wrote:
Sat Mar 31, 2018 11:38 pm
I have a question, and want to understand this better -

If we say Bond Investing is first for safety & not Yield, (& to go to Stocks for yield), following the same thinking, why does the Short Term Bond Index VBIRX NOT become the main Bond Fund in the Portfolios discussed here & substitute the Total Bond Index Fund VBTLX .

Thanks for weighing in your thoughts on this ---
From a portfolio perspective, one thing which equities are exposed to is long term deflation scenarios. In those scenarios, as Japan has encountered since 1990, companies will struggle to grow sales, profits, earnings per share. Equities may do very badly.

Turns out Long Term US Treasury Bonds are the best hedge of that. They are credit risk free, and have very long duration.

Thus the optimal portfolio hedge for a deflationary scenario, particularly if the portfolio is equity heavy, is to hold long term bonds. A better diversifier than ST or IT bonds.

I cannot remember whether it is David Swensen, Larry Swedroe (or both) or AN Other who makes this point.

Most of us probably hold short to intermediate term bonds. The bond indices themselves tend to tilt that way. An important exception is the UK, where gilts (govt bonds) have a very long average duration (something like 13.9 years, from memory). Because actuarial rules require UK pension funds and insurance companies to match their long term liabilities, it has created a stable demand for very long term securities (50 years in a couple of cases) which the DMO (part of the UK Treasury) has met.

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Re: Talking about Bond Investing - For Safety, not Yield

Post by Marketman » Sun Apr 01, 2018 9:57 am

I agree that a major reason to include longer term high grade bonds over shorter term bonds (or cash) is they are a great hedge agains deflation. That being said however, I still like intermediate term high grade bonds as a compromise.

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Re: Talking about Bond Investing - For Safety, not Yield

Post by Doc » Sun Apr 01, 2018 9:58 am

Valuethinker wrote:
Sun Apr 01, 2018 9:35 am
I cannot remember whether it is David Swensen, Larry Swedroe (or both) or AN Other who makes this point.
Probably Swenson.
Swedroe & Hempen wrote:Purchase assets with maturities that are short to intermediate in term, avoiding long-term bonds.
The Only Guide to a Winning Investment Strategy You'll Ever Need: The Way Smart Money Invests Today First Ed 2006 p213

According to Market Watch, Swensen's Lazy Portfolio is 15% long nominal Treasuries and 15% intermediate TIPS (Vanguard Inflation-Protected Securities Fund) https://www.marketwatch.com/lazyportfol ... -portfolio
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Doc » Sun Apr 01, 2018 10:01 am

Question: Why would we worry about deflation with a retirement portfolio? OK maybe the equity assets shrink but so do our expenses.
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Re: Talking about Bond Investing - For Safety, not Yield

Post by dbr » Sun Apr 01, 2018 10:03 am

Rajsx wrote:
Sat Mar 31, 2018 11:38 pm
I have a question, and want to understand this better -

If we say Bond Investing is first for safety & not Yield, (& to go to Stocks for yield), following the same thinking, why does the Short Term Bond Index VBIRX NOT become the main Bond Fund in the Portfolios discussed here & substitute the Total Bond Index Fund VBTLX .

Thanks for weighing in your thoughts on this ---
The premise bond investing is for safety is wrong or more exactly meaningless. As others are pointing out one invests in stocks and bonds and the properties of the whole are what matters. How safe the whole is depends on the proportion between stocks and bonds more than on the specific bonds. Also a portfolio that does not earn the return needed to meet objectives will certainly fail, which is hardly safe. The most dangerous portfolio for a retiree to hold is one that does not have enough stocks in it, unless the withdrawals are minimal. I would not invest by aphorism.

Rajsx
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Rajsx » Sun Apr 01, 2018 3:57 pm

The intense noise in the media has swayed many towards the Shorter term Bond (Funds), including me.

Last several few years I started investing in the Vanguard Short Term Investment Grade rather than my automatic go to Total Bond Index.

Bond investing has long been an enigma for me, I do a little bit of this & a little bit of that resulting in a mix of increasing number of Bond Funds causing the Mutual Fund Creep.

I am wanting to simplify the Portfolio, & may go back to the tried & true Total Bond Index Fund, although I see it has been losing, blowing out the safety propaganda, although I know it was being used as relative to Stock Funds.
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Re: Talking about Bond Investing - For Safety, not Yield

Post by SimpleGift » Sun Apr 01, 2018 4:13 pm

Rajsx wrote:
Sun Apr 01, 2018 3:57 pm
I am wanting to simplify the Portfolio, & may go back to the tried & true Total Bond Index Fund...
There's no reason one can't combine an intermediate-term bond index (like Total Bond Index) and a high-quality, short-term bond index to reduce the duration of one's overall bond portfolio:
  • 50% Vanguard Total Bond Index……….6.1 years
    50% Vanguard Short Bond Index….……2.7 years
    Overall Bond Portfolio…………………….4.4 years
But one has to be convinced that this is the right long-term allocation for one's needs, and resist the temptation to tinker with it, based on the changing direction of forecasted interest rates. Just my two cents.
Cordially, Todd

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Re: Talking about Bond Investing - For Safety, not Yield

Post by chevca » Sun Apr 01, 2018 4:22 pm

I think "safety" is a bit subjective when used about the bond side of a portfolio. Total Bond is surely safer than a stock index fund, but that doesn't mean it is safe from losing money sometimes. It just won't get hit as hard as a stock fund. As Taylor brings up from time to time, Total Bond has had very few losing years over the long term. It's pretty safe.

If one wants as safe as possible, by definition, then as Mr. Swedroe (brought up earlier here) said in his bond book one should go as short and safe as possible. I.E. we should use a short term treasury fund. Now that would be safe, right?

I also think it has something to do with Total Bond or a similar fund being available in many 401k or IRAs out there, so it's just the most common fund for it's purpose. That has it more recommended... it's just easy... and it's index like, and we're indexers... and... :happy

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Re: Talking about Bond Investing - For Safety, not Yield

Post by Valuethinker » Mon Apr 02, 2018 7:19 am

Doc wrote:
Sun Apr 01, 2018 10:01 am
Question: Why would we worry about deflation with a retirement portfolio? OK maybe the equity assets shrink but so do our expenses.
For the same reason that rises in sales have a geared effect on the profits of companies-- the sales will increase faster than the costs, and the profits are X multiplied.

Thus, a fall in price (even if volume is static) will have a negative effect on sales revenue, and the impact on profits is geared on the downside.

The prices of what you consume will not fall as fast as the profits of the firms in which you are invested. The stock market in Japan has fallen a lot more than consumer prices have.

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Re: Talking about Bond Investing - For Safety, not Yield

Post by Doc » Mon Apr 02, 2018 7:33 am

Valuethinker wrote:
Mon Apr 02, 2018 7:19 am
Doc wrote:
Sun Apr 01, 2018 10:01 am
Question: Why would we worry about deflation with a retirement portfolio? OK maybe the equity assets shrink but so do our expenses.
For the same reason that rises in sales have a geared effect on the profits of companies-- the sales will increase faster than the costs, and the profits are X multiplied.

Thus, a fall in price (even if volume is static) will have a negative effect on sales revenue, and the impact on profits is geared on the downside.

The prices of what you consume will not fall as fast as the profits of the firms in which you are invested. The stock market in Japan has fallen a lot more than consumer prices have.
Thanks.

Personally I'm not going to worry. But maybe I have too much faith in the modern Fed.
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Re: Talking about Bond Investing - For Safety, not Yield

Post by cfs » Mon Apr 02, 2018 8:24 am

"Bonds are for safety" . . . I am not a member of the bonds are for safety church. Good luck y gracias por leer / cfs
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Re: Talking about Bond Investing - For Safety, not Yield

Post by triceratop » Mon Apr 02, 2018 8:48 am

You can ask the same question about the corporate part of your bond portfolio — why hold them rather than treasuries?
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Kevin K » Mon Apr 02, 2018 9:31 am

Lots of thoughtful replies to the OP's question but all of them seem to me to reflect long-term bond market history rather than the Fed-induced ultra low interest rate environment we've been in since the '08 crisis.

Historically yes 5 year Treasuries have pretty much been the "sweet spot" for risk:return. As for the safety vs. yield question I've most often read the prescription to take risk only on the equity side from those who recommend pronounced tilts on the equity side (e.g. the so-called "Larry" portfolio and others inspired by it that increase exposure to small/value/EM etc. whilc reducing the allocation to equities and offsetting volatility with a slug of short(er) duration Treasuries.

I've already posted the link to Todd Tresidder's articles on asset bubbles and in particular bonds elsewhere here so I won't do so again but do think this excerpt from the bond piece is worth considering:

"There is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio. This problem is further exacerbated by the fact that current low interest rates would cause a modest rise in rates to cause disproportionately large losses that could dwarf any income received in the interim.

For example, as of this writing, a mere 1% rise in interest rates on the Treasury long bond should equate to a roughly 20% price decline, wiping out 7 years of income at current interest rates.

Do you think it’s reasonable to expect a mere 1% increase in interest rates from these historically low levels over the next seven years as the above example illustrates? After all, far worse has occurred in the past when markets were less volatile.

For example, the 30 year Treasury yield rose 240 basis points in just 9 months back in 1994. Just imagine what a 2 – 3% rise (or more) would mean to investor portfolios given the above example.

This is critically important because fixed income’s traditional position within asset allocation is as a “safe investment“.

In fact, we have entered one of those rare points in history where the risk/reward analysis on bonds could conceivably be more dangerous than equities, because the historically low coupon implies historically unprecedented volatility and downside price risk.

In other words, capital loss risk to bonds is highest when starting yields are lowest. Given that yields are at all time historical lows, many historical benchmarks for capital losses in bonds are unrealistically conservative. The future could easily be far worse than the past.

For example, according to Welton Investment Corporation the deepest (-15.3%) and longest (8+ years) Aaa corporate bond drawdown occurred from 1954-1963 because of a tiny 1.8% increase in interest rates – a hiccup by today’s volatile standards. The reason is because the starting yield in 1954 was an equally tiny 2.85%.

For example, Welton also analyzed what could happen to Aaa corporate bonds under different interest rate increase scenarios:

A 6% increase spread over 5 years would result in a 36.2% drawdown and a 6.4% annual loss.

2. A 4% increase in just 1 year would result in a whopping 34.8% drawdown and a 34.8% annual loss.

Even a modest increase spread over many years could cause zero return (or worse) for more than a decade.

These losses may not look horrific by equity market standards, but it’s important to note the money parked in top quality bonds is considered “low or no risk”. That is clearly no longer the case, and it has serious implications for traditional asset allocation models.

Some might argue that if you hold the bonds to maturity then price risk is only a temporary problem, but that’s a dangerous half-truth. Today’s investors frequently hold their bonds in diversified pools of mutual funds and ETF’s, giving up any ability ride out the downturn and hold a specific bond to maturity. The losses can become permanent."

I'm not enthralled with Tresidder's the-sky-is-falling tone or his recommendation to stay out of bonds altogether but I do think the argument for keeping durations short and quality high are compelling, especially given sky-high equity valuations (domestically, anyway), sharp increases in the national debt and an ongoing loosening of the relatively few restrictions put in place post -2008.

A substantial allocation to Treasuries - long-duration ones in particular - saved some portfolios in 2008 but if nothing else Tresidder's comments make it clear that that's unlikely to happen again given all of the "quantitative easing" that's happened since.

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Re: Talking about Bond Investing - For Safety, not Yield

Post by Doc » Mon Apr 02, 2018 10:24 am

Kevin K wrote:
Mon Apr 02, 2018 9:31 am
A substantial allocation to Treasuries - long-duration ones in particular - saved some portfolios in 2008 but if nothing else Tresidder's comments make it clear that that's unlikely to happen again given all of the "quantitative easing" that's happened since.
I think that Kevin and I are in agreement on this one.

You did get more for your buck in '08 with long Treasuries (light green) than with intermediate (orange) but was the difference enough to take the term risk with long T's if nothing happened?

Price Chart:

Image

But if you had say a 80% plus equity allocation I think maybe I would go with the long T's.
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Re: Talking about Bond Investing - For Safety, not Yield

Post by Marketman » Mon Apr 02, 2018 12:19 pm

Kevin, another school of thought about possible future interest rates (disclosure: I'm the worlds worst at forecasting interest rates!) is that the Fed will not to be able to raise interests rates much before the next recession hits. With interest rates so low they won't be able to cut them much when they need to. Hence, there is an increased risk that we could reenter a deflationary (or very low inflationary) environment.

Also, historically one is best off doing what is hardest to do - stay short in a steep yield curve, go long in a flat or inverted yield curve. Everyone says this time is different because the Fed is manipulating rates. Maybe. I've been around long enough to see the yield curve often tell the future.

My point is that forecasting interest rates is no sure thing in my opinion. Six months from now the Fed may be cutting rates again. We just don't know. Therefore, for fixed income, I like intermediate term, high grade bonds.

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