Bond Funds vs. Individual Bonds: Can someone quanitfy?

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rbrb
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Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by rbrb » Tue Sep 18, 2018 10:26 am

Hello all. I invest heavily in Vanguard's Total Bond Market Fund and have tried for years to really understand how bond funds compare to buying individual bonds and for as much as I've read, I still feel lost. I understand on a theoretical level that holding an individual bond for say 10 years with rising interest rates means that you loose out on the rising rates or you sell your bond for a loss in order to gain higher rates. So worse case scenario for individual bonds is that after 10 years you get your principal back and you maybe only earned a low % return on the bond and lost all the interest on interest from reinvestment income (both from having less interest income to reinvest and because reinvesting with individual bonds is much more time consuming than with a bond fund) -- which over 10 years can be very large.

With bond funds, when interest rates rise the value of the fund goes down. If I invest $100,000 in a bond fund and interest rates rise my value may go down to $95,000. While I will eventually gain a greater % return with the higher rates, I only make the higher % on $95,000 rather than $100,000. After 10 years, bonds could still be down so my "principal" could be less, but I have theoretically made that up with higher interest payments and better reinvestment returns. Does that really in the end do better than individual bonds?

Can anyone out there who loves making graphs, show a realistic comparison of potential returns on bond funds vs. individual bonds for a couple of different changes to the bond market? It would help me to visualize what's going on.

Thanks so much.

aristotelian
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by aristotelian » Tue Sep 18, 2018 10:30 am

rbrb wrote:
Tue Sep 18, 2018 10:26 am
Does that really in the end do better than individual bonds?
No, they would do the same (assuming you were able to buy a representative group of individual bonds roughly equivalent to the index you are following).

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by HEDGEFUNDIE » Tue Sep 18, 2018 10:35 am

Vanguard Total Bond Market holds 8486 individual bonds, and is constantly buying new ones as old ones mature.

How many individual bonds could you practically buy to match the duration and risk profile of the fund?

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vineviz
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by vineviz » Tue Sep 18, 2018 12:08 pm

rbrb wrote:
Tue Sep 18, 2018 10:26 am
Can anyone out there who loves making graphs, show a realistic comparison of potential returns on bond funds vs. individual bonds for a couple of different changes to the bond market? It would help me to visualize what's going on.
One challenge in making such a comparison in a fair way is that most individuals manage their bond portfolios differently than most bond funds.

Many individual investors who purchase individual bonds tend to hold them to maturity. This means that the average effective duration of the bond portfolio slowly decreases over time.

Most bond funds, on the other hand, manage the portfolio of bonds to keep either duration or maturity relatively constant through time. For example, an intermediate bond fund might buy bonds as soon as they have a maturity of less than 10 years but then sell them as soon as they have a maturity of less than 3 years.

As a result, if we assume the individual bonds are treasury bonds and all start out being 10 years from maturity, the individuals portfolio will start will an average duration of 9.1 years or so but then slowly drop to zero when the bonds mature. An intermediate bond fund will maintain something like a 5 year average duration forever.

So further assumptions would be necessary to make an apples to apples comparison. Set all things equal, and the return of the two strategies probably works out to be virtually identical. The bond fund can buy and sell bonds much more effectively, and typically has lower cash drag. On the other hand, even for a bond index you are paying the manager. Practically speaking, it likely cancels out.

The primary advantage of owning individual bonds isn't going to be higher returns, but rather greater certainty about future cash flows. The primary advantages of owning a bond fund are simplicity and liquidity.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by daveydoo » Tue Sep 18, 2018 12:19 pm

vineviz wrote:
Tue Sep 18, 2018 12:08 pm
The primary advantage of owning individual bonds isn't going to be higher returns, but rather greater certainty about future cash flows. The primary advantages of owning a bond fund are simplicity and liquidity.
Also, there is a lot of yield-chasing when buying individual bonds and this can lead to excessive default risk unless the portfolio is big. It's like stock-picking. I have seen this with my own eyes (and dollars).

Plus, the hidden service charge on individual bonds, when buying and selling, is substantial. Bond "guys" love to buy and sell your bonds. This is why.

Also, there is a fair bit of drag when individual bonds are called and you're stuck trying to find a good replacement in real time. So with a big enough ladder to reduce default risk, there is a fair amount of self-generated churn between maturation and calls. Between these factors and interest payments, I often saw a fair amount of inert cash (think 5% or higher) if I stopped paying attention.

Now I just watch my money go down in bond index funds. :D Way more satisfying.
"I mean, it's one banana, Michael...what could it cost? Ten dollars?"

rbrb
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by rbrb » Tue Sep 18, 2018 12:50 pm

Thank you so much everyone for your replies. I guess I just wish I completely understood the math and could be completely convinced that bond funds are the way to go. I recognize that I don't really have a good alternative because I am not going to create and manage my own very diversified portfolio of bonds. But it is hard to watch investments in bonds go down (albeit not a lot) knowing that if my plan was to buy bonds and hold them for their duration, they would not go down. I remember reading somewhere that when bond funds fall it takes several years to make up the difference with the rising interest rates but in the end you are better off. Again, I just wish I could see it on a chart.

Thx again everyone.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Cyclesafe » Tue Sep 18, 2018 1:30 pm

rbrb wrote:
Tue Sep 18, 2018 12:50 pm
But it is hard to watch investments in bonds go down (albeit not a lot) knowing that if my plan was to buy bonds and hold them for their duration, they would not go down.
But even if you hold your bonds to maturity, in the interim they do indeed go down. The bonds go down as a function of interest rate decline and duration, but as duration decreases with time, their value goes up to face value (upon maturity).

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by aristotelian » Tue Sep 18, 2018 1:31 pm

rbrb wrote:
Tue Sep 18, 2018 12:50 pm
Thank you so much everyone for your replies. I guess I just wish I completely understood the math and could be completely convinced that bond funds are the way to go. I recognize that I don't really have a good alternative because I am not going to create and manage my own very diversified portfolio of bonds. But it is hard to watch investments in bonds go down (albeit not a lot) knowing that if my plan was to buy bonds and hold them for their duration, they would not go down. I remember reading somewhere that when bond funds fall it takes several years to make up the difference with the rising interest rates but in the end you are better off. Again, I just wish I could see it on a chart.

Thx again everyone.
The point is, the charts for an index and an apples to apples collection of bonds are going to look exactly the same, because they are the same. An index fund is nothing but a collection of individual bonds. At any given point in time, they will have the same market value. Over time they will have the same total return. If interest rates increase, you will either be stuck holding a long bond at a lower interest rate, or you can have a bond index with lower price. Choice is yours, result is the same. If seeing the price fluctuate bothers you, do a ladder of individual bonds. Many Bogleheads do it. If you are unsure, do a little of each.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by NYCPete » Tue Sep 18, 2018 1:40 pm

rbrb wrote:
Tue Sep 18, 2018 12:50 pm
Thank you so much everyone for your replies. I guess I just wish I completely understood the math and could be completely convinced that bond funds are the way to go. I recognize that I don't really have a good alternative because I am not going to create and manage my own very diversified portfolio of bonds. But it is hard to watch investments in bonds go down (albeit not a lot) knowing that if my plan was to buy bonds and hold them for their duration, they would not go down. I remember reading somewhere that when bond funds fall it takes several years to make up the difference with the rising interest rates but in the end you are better off. Again, I just wish I could see it on a chart.

Thx again everyone.
I don't know that this is exactly what you're looking for, but I find looking at the returns of bond funds in the mid 90s to be informative. On October 25th, 1993, the Federal Funds rate sat at 3.03%. The Federal Reserve began agressively raising interest rates over the next year, and the Fed Funds rate hit 6.30% on March 27th, 1995. In other words, in 16 months interest rates more than doubled, something that will negatively affect the value of bond funds.

Using those exact dates as a start and end point, here is the total return of the Vanguard Intermediate Term Treasury Fund Investors shares (VFITX) during that time.

Image

Now here is that same fund, with an end date of March 27th, 1997. In other words, the same chart, but two more years after that interest rate spike.

Image

Note that this was a managed fund, not an index fund, as Vanguard did not create a bond index fund until 1994. However, some relevant indexes are also on these charts. Also note that past performance isn't indicative of future performance.

Hope this is helpful in your thinking.

Best,
Peter
To the extent that a fool knows his foolishness, | He may be deemed wise | A fool who considers himself wise | Is indeed a fool. | | Buddha

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by inbox788 » Tue Sep 18, 2018 2:10 pm

rbrb wrote:
Tue Sep 18, 2018 10:26 am
Many individual investors who purchase individual bonds tend to hold them to maturity. This means that the average effective duration of the bond portfolio slowly decreases over time.
...
The primary advantage of owning individual bonds isn't going to be higher returns, but rather greater certainty about future cash flows. The primary advantages of owning a bond fund are simplicity and liquidity.
Good points. In some ways, this is a self-correcting glidepath if you believe younger folks can hold longer term/duration bonds and retired folk should hold intermediate or shorter bonds. Similarly, when you buy a home and get a first mortgage, you're selling a long term bond. Over time, you're buying back the bond as you pay off your mortgage. At the same time, you're going from highly leveraged to no leverage when you're done paying, reducing your risk.

IMO, risks and management of individual bonds is more difficult for me, and I will adjust my own glidepath using bond funds (or just pick a fix AA and stick with it -- e.g. total bond/intermediate bond).

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by ThisDinosaur » Tue Sep 18, 2018 2:36 pm

rbrb wrote:
Tue Sep 18, 2018 12:50 pm
I remember reading somewhere that when bond funds fall it takes several years to make up the difference with the rising interest rates but in the end you are better off. Again, I just wish I could see it on a chart.
https://www.pragcap.com/the-biggest-myt ... ates-rise/

Image

The duration of the bond or fund is the number of years you have to wait such that you'd make your lost principal back in interest payments after rates start rising.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by ThisDinosaur » Tue Sep 18, 2018 2:40 pm

vineviz wrote:
Tue Sep 18, 2018 12:08 pm
The primary advantage of owning individual bonds isn't going to be higher returns, but rather greater certainty about future cash flows. The primary advantages of owning a bond fund are simplicity and liquidity.
Is it true that a treasury bond index fund is more liquid than a treasury bond? I would think it would be easier to find buyers of treasuries than fund shares in the kind of environment that you'd likely be selling.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by vineviz » Tue Sep 18, 2018 3:00 pm

ThisDinosaur wrote:
Tue Sep 18, 2018 2:40 pm
Is it true that a treasury bond index fund is more liquid than a treasury bond? I would think it would be easier to find buyers of treasuries than fund shares in the kind of environment that you'd likely be selling.
I don't want to oversell the difference in liquidity for individual treasury bonds versus funds. My guess is that a reasonable investor could do whatever they needed to in either case. For corporate or municipal bonds, though, liquidity for individual issues can definitely be scant at times.

Still, a treasury mutual fund can be redeemed in a matter of hours and a treasury ETF in a matter of seconds any time the market is open. This will be true no matter whether you are selling $100 or $1,000,0000 worth of your fund.

Individual treasury bonds are still very liquid relative to other bonds, but liquidating might conceivably be more time consuming if you had a small or odd quantity of bonds of an unpopular maturity. And some brokers might require you to speak to someone on the bond desk, which could be time-consuming if you had a large portfolio of individual issues.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

rbrb
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by rbrb » Wed Sep 19, 2018 11:13 am

Thank you everyone, especially Peter for the graph of an actual bond fund during interest rate increase. I've realized that at least in terms of finance I appear to be a visual learner.

aristotelian, you say that the charts would look the same but I just have a hard time still understanding exactly why. I think I am stuck on the point that a 10 $1000 bond earning 1% would at the end of ten years be worth $1000 plus my interest. A bond fund purchased for $1000 may be worth less than $1000 at the 10 year mark and may not have actually earned enough more in interest to make up the shortfall. Maybe I am stuck on a timing issue and not recognizing that if interest rates all of a sudden jumped to 3%, I would be crazy to hold on to my $1000 bond and I should of course sell it for less than face value in order to earn the higher interest. In that case, however, with one single bond, I would be calculating to make sure that I would earn more money by selling for less and buying a new lower valued bond but getting higher interest than if I just held on to my 1% bond. Similar calculation as to whether it is worth the fees to remortgage a house with lower interest. In the case of a bond fund, those decisions are being made on the aggregate so I am left as an investor of trying to figure out the proper time to sell the fund. Or maybe I've finally just answered my own question which is that you don't invest in a bond fund ever planning on getting out of the fund. Its a hold forever thing. Is that how most people view it?

Thanks again everyone for taking the time to try to explain bond funds -- I know similar questions get asked a lot. So again, thank you.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by galeno » Wed Sep 19, 2018 5:55 pm

We carry our groceries in bags and our bonds in 3 ETFs.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by pascalwager » Wed Sep 19, 2018 6:07 pm

In a bond fund you have redemption risk related to market turmoil and, in general, there's no guarantee of getting your principal back unlike individual bonds as long as you wait for maturity.

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galeno
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by galeno » Wed Sep 19, 2018 6:15 pm

Holding individual bonds subjects you to a lot more more DEFAULT risk. Unless you're only willing to hold US treasuries.

Bags are very cheap. I can carry a lot of groceries in a bag vs just using my two hands.
pascalwager wrote:
Wed Sep 19, 2018 6:07 pm
In a bond fund you have redemption risk related to market turmoil and, in general, there's no guarantee of getting your principal back unlike individual bonds as long as you wait for maturity.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by vineviz » Wed Sep 19, 2018 9:51 pm

rbrb wrote:
Wed Sep 19, 2018 11:13 am
A bond fund purchased for $1000 may be worth less than $1000 at the 10 year mark and may not have actually earned enough more in interest to make up the shortfall.
Going back to the middle of the Depression, in 1930, a constant maturity fund of 10-year bonds has never lost money over ANY 10-year period. That might provide some comfort.

You may see us discussing bond duration from time-to-time, and one reason is that this is a VERY useful way of evaluating the interest rate risk of holding bonds and bond funds.

As long as the average duration of your bond fund is less than or equal to your investment horizon, a period of rising interest rates will NOT hurt you: the benefits you get from the fund reinvesting its money in higher yielding bonds work out to be GREATER than the price hit you take from higher interest rates.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Jacobkg » Thu Sep 20, 2018 3:42 am

To be clear you want to compare:

i) Buying a 10 year bond and holding to maturity

ii) Buying a bond fund and holding it for 10 years?

If so i can make you a graph

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by rbrb » Thu Sep 20, 2018 8:31 am

Jacobkg, I'd love such a graph. Thx.
vineviz wrote:
Wed Sep 19, 2018 9:51 pm
Going back to the middle of the Depression, in 1930, a constant maturity fund of 10-year bonds has never lost money over ANY 10-year period. That might provide some comfort.
Is that really true? If so, that does provide comfort and alleviates all my nagging worries!

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by UpperNwGuy » Thu Sep 20, 2018 8:55 am

Jacobkg wrote:
Thu Sep 20, 2018 3:42 am
To be clear you want to compare:

i) Buying a 10 year bond and holding to maturity

ii) Buying a bond fund and holding it for 10 years?

If so i can make you a graph
I'm not the OP, but it seems to me that what you just described is exactly what OP wants.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by pascalwager » Thu Sep 20, 2018 4:18 pm

vineviz wrote:
Wed Sep 19, 2018 9:51 pm
rbrb wrote:
Wed Sep 19, 2018 11:13 am
A bond fund purchased for $1000 may be worth less than $1000 at the 10 year mark and may not have actually earned enough more in interest to make up the shortfall.
Going back to the middle of the Depression, in 1930, a constant maturity fund of 10-year bonds has never lost money over ANY 10-year period. That might provide some comfort.

You may see us discussing bond duration from time-to-time, and one reason is that this is a VERY useful way of evaluating the interest rate risk of holding bonds and bond funds.

As long as the average duration of your bond fund is less than or equal to your investment horizon, a period of rising interest rates will NOT hurt you: the benefits you get from the fund reinvesting its money in higher yielding bonds work out to be GREATER than the price hit you take from higher interest rates.
What if you're retired and taking monthly redemptions from your total return managed portfolio or bond funds? Then your investment horizon is 30 days, and 6.2 years duration (TBM) is much greater than 30 days. So this common investment situation fails the "rising interest rates will NOT hurt you" test.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by jsmoove123 » Thu Sep 20, 2018 4:46 pm

pascalwager wrote:
Thu Sep 20, 2018 4:18 pm
What if you're retired and taking monthly redemptions from your total return managed portfolio or bond funds? Then your investment horizon is 30 days, and 6.2 years duration (TBM) is much greater than 30 days. So this common investment situation fails the "rising interest rates will NOT hurt you" test.
In this situation, the investment horizon of 30 days should apply to only the amount of money needed at that timepoint, i.e. your monthly redemption amount. Extrapolating this, it makes some sense for a pre-retiree to choose a bond fund (which is essentially a laddered collection bonds) with duration roughly half of his time-to-retirement, or better yet, a target/defined maturity bond fund.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by vineviz » Thu Sep 20, 2018 5:10 pm

jsmoove123 wrote:
Thu Sep 20, 2018 4:46 pm
pascalwager wrote:
Thu Sep 20, 2018 4:18 pm
What if you're retired and taking monthly redemptions from your total return managed portfolio or bond funds? Then your investment horizon is 30 days, and 6.2 years duration (TBM) is much greater than 30 days. So this common investment situation fails the "rising interest rates will NOT hurt you" test.
In this situation, the investment horizon of 30 days should apply to only the amount of money needed at that timepoint, i.e. your monthly redemption amount. Extrapolating this, it makes some sense for a pre-retiree to choose a bond fund (which is essentially a laddered collection bonds) with duration roughly half of his time-to-retirement, or better yet, a target/defined maturity bond fund.
This is partly right.

The investment horizon is basically the average time of the portfolio withdrawals, not the time to the first withdrawal.

A very rough approximation of the investment horizon would be the expected mid-point of the retirement time period. For someone who plans to retire at age 70, this mid-point might be around age 85 or so depending on life expectancy, the trajectory of withdrawals, etc. You could definitely refine that estimate, but it's not a terrible place to start.

So a pre-retiree at age 55 has an investment horizon of 30 years or so, and that's the horizon they'd (theoretically) want to match with their bond portfolio duration. More or less. Not every investor will feel comfortable doing that, obviously, but its probably the optimal approach (at least as a rough first pass) financially speaking.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by aristotelian » Thu Sep 20, 2018 5:13 pm

Jacobkg wrote:
Thu Sep 20, 2018 3:42 am
To be clear you want to compare:

i) Buying a 10 year bond and holding to maturity

ii) Buying a bond fund and holding it for 10 years?

If so i can make you a graph
I'm not sure what the OP wants but an apples to apples comparison would be a bond ladder vs bond fund. If you buy one bond to hold for 10 years, you are taking a massive risk that interest rates have peaked.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by jsmoove123 » Thu Sep 20, 2018 5:48 pm

vineviz wrote:
Thu Sep 20, 2018 5:10 pm
jsmoove123 wrote:
Thu Sep 20, 2018 4:46 pm
pascalwager wrote:
Thu Sep 20, 2018 4:18 pm
What if you're retired and taking monthly redemptions from your total return managed portfolio or bond funds? Then your investment horizon is 30 days, and 6.2 years duration (TBM) is much greater than 30 days. So this common investment situation fails the "rising interest rates will NOT hurt you" test.
In this situation, the investment horizon of 30 days should apply to only the amount of money needed at that timepoint, i.e. your monthly redemption amount. Extrapolating this, it makes some sense for a pre-retiree to choose a bond fund (which is essentially a laddered collection bonds) with duration roughly half of his time-to-retirement, or better yet, a target/defined maturity bond fund.
This is partly right.

The investment horizon is basically the average time of the portfolio withdrawals, not the time to the first withdrawal.

A very rough approximation of the investment horizon would be the expected mid-point of the retirement time period. For someone who plans to retire at age 70, this mid-point might be around age 85 or so depending on life expectancy, the trajectory of withdrawals, etc. You could definitely refine that estimate, but it's not a terrible place to start.

So a pre-retiree at age 55 has an investment horizon of 30 years or so, and that's the horizon they'd (theoretically) want to match with their bond portfolio duration. More or less. Not every investor will feel comfortable doing that, obviously, but its probably the optimal approach (at least as a rough first pass) financially speaking.
Right, should have stated the duration would roughly match half the "time-to-death" or "time-to-last redemption", though as you point out, it's a rough first pass and varies depending on the withdrawal trajectory.

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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Stormbringer » Thu Sep 20, 2018 6:58 pm

HEDGEFUNDIE wrote:
Tue Sep 18, 2018 10:35 am
Vanguard Total Bond Market holds 8486 individual bonds, and is constantly buying new ones as old ones mature.
I don't think VBTLX generally holds bonds to maturity. They have a 54.6% turnover ratio, suggesting that they are constantly selling bonds at market value (i.e. a capital loss in a rising rate environment) and buying replacements. My guess is that they do this to keep the duration of the portfolio tightly distributed around some target.
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Kevin M » Thu Sep 20, 2018 7:07 pm

rbrb wrote:
Thu Sep 20, 2018 8:31 am
vineviz wrote:
Wed Sep 19, 2018 9:51 pm
Going back to the middle of the Depression, in 1930, a constant maturity fund of 10-year bonds has never lost money over ANY 10-year period. That might provide some comfort.
Is that really true? If so, that does provide comfort and alleviates all my nagging worries!
Unfortunately, this would be false comfort, since your spending is in real dollars, but the quote you're referencing is only true for nominal dollars. Using data from the Simba/siamond backest spreadsheet, for the 10-year period from 1972-1981, a simulated intermediate-term Treasury fund lost about 34% in cumulative real (inflation-adjusted) value. The approximately 50% cumulative nominal return would not have been of much comfort if your purchasing power declined by 34%.

The much bigger long-term risk for nominal bonds intended to fund retirement consumption is unexpected inflation, not increasing interest rates.

But back to your original question, the same decline in purchasing power would have occurred for a rolling ladder of individual Treasuries that were in the same maturity range as the Treasury fund (3-10 years). It probably would have been somewhat better for a 10-year rolling ladder with the bonds held to maturity, since the average maturity would have been less, and short-term Treasuries suffered smaller real losses during that period.

It makes more sense to compare a bond fund to a rolling bond ladder, since they are basically the same thing if the maturity and risk profiles are similar. As others have said, a single bond has a continuously declining maturity/duration, while a fund maintains approximately the same average maturity/duration.

There are ways you can optimize your fixed-income portfolio with individual securities (CDs, Treasuries, munis, etc.), but it doesn't sound like this is something of interest to you, so probably no point in going into the details.

Kevin
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Kevin M » Thu Sep 20, 2018 7:12 pm

Stormbringer wrote:
Thu Sep 20, 2018 6:58 pm
HEDGEFUNDIE wrote:
Tue Sep 18, 2018 10:35 am
Vanguard Total Bond Market holds 8486 individual bonds, and is constantly buying new ones as old ones mature.
I don't think VBTLX generally holds bonds to maturity. They have a 54.6% turnover ratio, suggesting that they are constantly selling bonds at market value (i.e. a capital loss in a rising rate environment) and buying replacements. My guess is that they do this to keep the duration of the portfolio tightly distributed around some target.
Not necessarily tightly distributed, but definitely not usually held to maturity. Easy to see from the distribution by maturity:

Code: Select all

        Under 1 Year 	0.3%
	1 - 3 Years 	24.1%
	3 - 5 Years 	18.7%
	5 - 10 Years 	39.8%
	10 - 20 Years 	3.8%
	20 - 30 Years 	12.7%
	Over 30 Years 	0.6%
Kevin
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Stormbringer
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Stormbringer » Thu Sep 20, 2018 7:22 pm

Jacobkg wrote:
Thu Sep 20, 2018 3:42 am
To be clear you want to compare:

i) Buying a 10 year bond and holding to maturity

ii) Buying a bond fund and holding it for 10 years?

If so i can make you a graph
These just seem like very, very different things:

i) In the beginning, the portfolio has a duration of 10 years, and by the end it is a portfolio with a duration of less than one year.

ii) Bond funds usually have average duration (say 6 or 7 years) and continuously sell older bonds at current market values to buy replacements at current market values to keep the duration clustered around the target. That is why bond funds have turnover ratios of 50% per year or higher.

I suspect the turnover introduces some risk of capital loss (or gains). My initial thought is that if they sell a bond at a loss, they are probably buying a replacement bond that also lost value, making it a wash. But maybe that isn't the case, because the replacement bond is farther out on the yield curve. Depending on the shape of the curve, and what happens to the shape between the time the bond is bought and is sold, it seems like capital gains or losses could happen.

If that is indeed true, it may be impossible to answer OPs original question, because it would depend on the gyrations of yield curve, which would be different over any given period of time.
"Compound interest is the most powerful force in the universe." - Albert Einstein

Kevin8696
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Kevin8696 » Thu Sep 20, 2018 7:31 pm

ThisDinosaur wrote:
Tue Sep 18, 2018 2:36 pm

The duration of the bond or fund is the number of years you have to wait such that you'd make your lost principal back in interest payments after rates start rising.
I've not heard this definition of duration before. Do you have a source that you can provide that would help to explain your assertion regarding duration and the time to recoup lost principal ?

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Kevin M
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Re: Bond Funds vs. Individual Bonds: Can someone quanitfy?

Post by Kevin M » Thu Sep 20, 2018 8:28 pm

Kevin8696 wrote:
Thu Sep 20, 2018 7:31 pm
ThisDinosaur wrote:
Tue Sep 18, 2018 2:36 pm

The duration of the bond or fund is the number of years you have to wait such that you'd make your lost principal back in interest payments after rates start rising.
I've not heard this definition of duration before. Do you have a source that you can provide that would help to explain your assertion regarding duration and the time to recoup lost principal ?
It's not stated quite correctly, but the concept is duration as the point of indifference to interest rate changes. It is explained in this Wiki article: Bonds: advanced topics.
Duration has another useful summary property, which is that if the yield curve shifts in parallel[note 1], then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss. Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen.
(Underline mine)

Note that there are several qualifiers. One is that that yields at all maturities change by the same amount (parallel yield curve shift). Another is that this applies only to a relatively quick, one-time change in yields. These are not realistic conditions, so the concept is mostly hypothetical.

In reality, the return of a bond fund over a period equal to its duration can deviate significantly from the fund's initial yield.

Kevin
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