Bond prices vs yields

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BarbBrooklyn
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Bond prices vs yields

Post by BarbBrooklyn » Fri Nov 09, 2018 7:54 pm

I want to admit to being totally confused by bonds. The yield appears to be putting money in my virtual pocket as the price appears to be depleting my bottom line.

Would anyone care to explain?
BarbBrooklyn | "The enemy of a good plan is the dream of a perfect plan."

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arcticpineapplecorp.
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Re: Bond prices vs yields

Post by arcticpineapplecorp. » Fri Nov 09, 2018 8:13 pm

what do you want to know exactly? Bond prices and interest rates on bonds are inversely related. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.

It's way more complicated than that. But maybe read up on the point of indifference:

viewtopic.php?t=120947
viewtopic.php?t=120947

Over time if you hold your bonds and reinvest the dividends you will recover your principle and come out ahead because you're being more highly compensated with higher interest than you were before.

Make sure to hold for the long term, usually at least as long as the duration of the bond fund you hold. Otherwise go shorter term or something else like CDs if you're concerned about rising rates.

there are lots of posts on bogleheads already about this. do some searching and reading on what happens when bond prices fall.
"Invest we must." -- Jack Bogle | “The purpose of investing is not to simply optimise returns and make yourself rich. The purpose is not to die poor.” -- William Bernstein

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Re: Bond prices vs yields

Post by ladycat » Fri Nov 09, 2018 8:16 pm


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Ricchan
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Re: Bond prices vs yields

Post by Ricchan » Sat Nov 10, 2018 1:49 pm

BarbBrooklyn wrote:
Fri Nov 09, 2018 7:54 pm
I want to admit to being totally confused by bonds. The yield appears to be putting money in my virtual pocket as the price appears to be depleting my bottom line.

Would anyone care to explain?
On Monday, I offer you a bond for $1,000 that pays 5% interest over 2 years. That's going to be worth $1,000 + ($50 * 2) = $1,100 after 2 years.

On Tuesday, I offer you a new bond for $1,000 that pays 10% interest over 2 years. That's going to be worth $1,000 + ($100 * 2) = $1,200 after 2 years.

The difference between Monday's bond and Tuesday's bond's final payout is ($1,200 - $1,100) = $100. It makes sense, then, that people who own a Monday bond would be willing to sell it for $900.01 or more to buy a Tuesday bond, since they would still come out ahead in 2 years. In effect, the price of Monday's bond dropped by $100 because of the rise in interest rate of Tuesday's bond.

A bond fund owns a mixed bag of Monday and Tuesday bonds, for example. So, going from Monday to Tuesday, the average yield of that mixed bag of bonds increased, while the average price decreased.

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Re: Bond prices vs yields

Post by Ben Mathew » Sat Nov 10, 2018 2:26 pm

To understand this apparent contradiction, consider a bond that pays you $100 twenty years from now.

If the interest rate is 3%, the bond will cost $55.37 today. Why? Because at an interest rate of 3%, $55.37 compounds to $100 twenty years from now. So that's what people will pay for the bond.

Let's say you pay $55.37 and buy this bond. But shortly after you buy it, the interest rate increases to 5%. The price of the bond now drops to $37.68. Why? Because at this new interest rate of 5%, it takes only $37.68 to compound to $100 twenty years from now.

Your portfolio balance drops from $55.37 to $37.68. But did you lose money? It depends. If you sell your bond now, yes, you did lose $17.69. But, if you hold the bond to maturity, you will still get what you expected to get before: $100 twenty years from now. The new interest rate doesn't affect you. So the risk of a bond depends on the match between your bond maturity and your consumption (i.e. when you need the money). If you perfectly match your bond maturities with your consumption needs, then you have no additional risk after you've bought the bond. You'll get exactly what you expected to get when you bought the bond regardless of whether interest rates go up or down, and regardless of what your portfolio balance says. (Note that if you bought nominal bonds, then there will still be inflation risk: i.e. the $100 twenty years from now might mean more or less than what you thought it meant when you bought the bond.)
Last edited by Ben Mathew on Sat Nov 10, 2018 3:32 pm, edited 1 time in total.

BarbBrooklyn
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Re: Bond prices vs yields

Post by BarbBrooklyn » Sat Nov 10, 2018 2:41 pm

I really very much appreciate this guidance. I'm going to stick to my AA (50/50, retiring in 2 weeks) and not listen to noise!
BarbBrooklyn | "The enemy of a good plan is the dream of a perfect plan."

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Ricchan
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Re: Bond prices vs yields

Post by Ricchan » Sat Nov 10, 2018 4:56 pm

Ben Mathew wrote:
Sat Nov 10, 2018 2:26 pm
So the risk of a bond depends on the match between your bond maturity and your consumption (i.e. when you need the money). If you perfectly match your bond maturities with your consumption needs, then you have no additional risk after you've bought the bond. You'll get exactly what you expected to get when you bought the bond regardless of whether interest rates go up or down, and regardless of what your portfolio balance says.
I get that this makes sense for individual bonds, but what about bond funds that continually buy and sell bonds to maintain an average maturity of a certain length?

Take Total Bond Market Index, for example, with an average effective maturity of 8.6 years. Suppose someone buys this with the intent to start withdrawing in 8.6 years. Then 8 years later, interest rates suddenly rise. The current price of BND at that point reflects unrealized increases in future income due to the higher interest rates. The person who bought BND 8 years ago is now faced with the dilemma of selling at a price that reflects future income they will never receive.

Are people supposed to gradually rebalance towards shorter term bond funds and eventually money markets as they near their planned withdrawal date?

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Re: Bond prices vs yields

Post by Dulocracy » Sun Nov 11, 2018 9:29 am

Ricchan wrote:
Sat Nov 10, 2018 4:56 pm
Ben Mathew wrote:
Sat Nov 10, 2018 2:26 pm
So the risk of a bond depends on the match between your bond maturity and your consumption (i.e. when you need the money). If you perfectly match your bond maturities with your consumption needs, then you have no additional risk after you've bought the bond. You'll get exactly what you expected to get when you bought the bond regardless of whether interest rates go up or down, and regardless of what your portfolio balance says.
I get that this makes sense for individual bonds, but what about bond funds that continually buy and sell bonds to maintain an average maturity of a certain length?

Take Total Bond Market Index, for example, with an average effective maturity of 8.6 years. Suppose someone buys this with the intent to start withdrawing in 8.6 years. Then 8 years later, interest rates suddenly rise. The current price of BND at that point reflects unrealized increases in future income due to the higher interest rates. The person who bought BND 8 years ago is now faced with the dilemma of selling at a price that reflects future income they will never receive.

Are people supposed to gradually rebalance towards shorter term bond funds and eventually money markets as they near their planned withdrawal date?
You hit the nail on the head. If you hold a bond to maturity, you are not impacted. If, however, you hold a bond fund, as interest rates rise, you lose value. Bonds in a rising interest rate environment are not overly risky. Bond funds in a rising interest rate environment can hold significant risk because of the activity of the bond fund.

Personally, a slow guaranteed leak scares me much more than a crash from which I anticipate an eventual recovery. This is why I use the method that used to be in the wiki described as a reverse Bond strategy.

Before I even go into the details, it is worth noting that this strategy is not recommended for anyone who has not already maximized their tax-advantaged space. Using this method before maximizing tax-advantaged space will put you at an eventual disadvantage, as any small loss from bond funds would be far outweighed by the loss of tax protection of growth or the ability to use this space in the future. Once lost, tax advantage space is forever lost. Another major Risk by this strategy is that it has liquidity risk. Rebalancing and buying during downturns will not be possible. If rebalancing is a major part of your investment strategy, then this method is not for you. If you cannot handle being illiquid with your bonds for a very long time, read no further.

A reverse Bond strategy is simple. You pay down your mortgage by the amount that you should be paying into bonds. Your portfolio is much more volatile, as you have all stocks in the portfolio, but if you track it properly you are not 100% stocks. How do you track it properly to make sure that you are not 100% stocks? You must make sure that once your mortgage is paid off that you continue to make the entire mortgage payment into bonds until such time as that mortgage would have been paid off. The money for the principal and for the interest of the mortgage that you saved are all a part of your bond fund. The recapture of your bond investment into your mortgage is essential, otherwise you really are just going 100% stocks. This method requires a great deal of discipline both in making sure that you recapture and in making sure that you do not panic when the markets are down.

I suspect that the combination of risks that someone might panic, that there is liquidity risk, and that rebalancing is not possible combined with the fact that very few people will actually qualify for this strategy because they have not maximize their tax advantage space... Are the reasons that this strategy is no longer in the wiki. (Or it moved, and I cannot find it.)

I am glad that I saw it when I did, as it has been great for me. If I did not know about this strategy, the very concerns that you raised would mean that I would have chosen to be 100% stock. I am incredibly disciplined when it comes to money and have stuck to every goal that I have had despite what markets have done or despite what opportunities I may have had to spend that money in ways that would have been really nice or potentially profitable.

Now that I have discussed all of the negatives of this method, the positives for me are huge. People talk about a swan portfolio (sleep well at night). The idea of the constant drip out of bond funds in a rising interest rate environment made it such that I simply could not bring myself to buy bond funds. That may be completely misguided, but just as I am disciplined, I do not take own strategies that I do not feel disciplined enough to stick with. I never would have had a bond allocation without the strategy. It provides me with greater interest rates than I would have in similar duration bond funds. My return is a little under 4%, and with the new law on taxes I get much less of a tax benefit from owning a home. I know that this value will not change drastically, and it allows me to skip a portion of time where interest rates will be rising, hopefully slowly. They may also fall during this time or fluctuate, but my goal is not to maximize profit off of bonds, but to provide stability with them. Therefore, in addition to a good rate, I am also getting the ability to skip a long segment of time in the bond market. Will things be volatile at that time? Maybe. However I will be coming out of it with a solid return that I will recapture at the end of my mortgage. I cannot avoid volatility of the bond market forever if I ever wish to invest in bonds, but this strategy allows me to skip a certain period of time where I can see Bond rates slowly creeping up and bond values constantly dripping. I have steeled myself to the idea that this may happen again in the future, and it may be a slow drip that I have to take on at that point in time, as I am not willing to go 100% stocks. I hope that information was helpful or thought-provoking to someone, and if someone does decide to take that route I hope that they consider well the risks, and sincerely commit to the recapture at the end required for this strategy to actually be a strategy.

Of course, the other thing that one could do would be to buy individual tips in a retirement account. This would provide tax protected individual bonds that if held-to-maturity would have a guaranteed post inflation value.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

longinvest
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Re: Bond prices vs yields

Post by longinvest » Sun Nov 11, 2018 10:17 am

Dulocracy wrote:
Sun Nov 11, 2018 9:29 am
If you hold a bond to maturity, you are not impacted. If, however, you hold a bond fund, as interest rates rise, you lose value. Bonds in a rising interest rate environment are not overly risky. Bond funds in a rising interest rate environment can hold significant risk because of the activity of the bond fund.

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

Most of us invest for the long term, even in retirement. We might retire at 55, 60, 65, or even 70, yet we'll continue investing util our death or our spouse's death. As much as 2.8% of U.S. women are still alive at the venerable age of 100, see this post for details and references. We won't liquidate our portfolio at retirement; we'll simply start taking withdrawals. The investment horizon of the vast majority of retirees is far longer than the average duration (6 years) of the total nominal bond market.

New bond investors can often have trouble distinguishing between distinct risks of nominal bond funds. So, I'll just copy a recent post I've made on another thread. Interested readers can go back and read the entire thread for a deeper discussion:

Good explanation of how bond funds don't get crushed in rising rate environment
longinvest wrote:
Fri Nov 09, 2018 8:09 am
To get back to the main topic of this thread, which was about nominal bonds in general (e.g. something like a total bond market index fund), let's distinguish two cases:

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund will experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%. This isn't 0%, but it's quite smaller than the 50% that stocks could easily lose in a very short period of time.

In other words, interest rate risk and inflation risk are two distinct risks of nominal bonds. A bond fund of intermediate duration has a moderate amount of both risks.

Referring to my earlier posts in this thread, it's also important to always be aware at all times of the difference between current yields and recent inflation. Leaving money invested into securities that yield less than inflation will cause a permanent loss of purchase power.
Let me insist on the fact that an individual nominal bond or CD isn't immune to inflation risk; holding it to maturity won't protect it from a loss of purchase power.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. But, it should be a long-term choice. The Bogleheads philosophy tells us to never try to time the market. This principle applies to fixed income too, not only to stocks.
Last edited by longinvest on Sun Nov 11, 2018 10:57 am, edited 3 times in total.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic / international) stocks / domestic (nominal / inflation-indexed) long-term bonds | VCN/VXC/VLB/ZRR

UpperNwGuy
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Re: Bond prices vs yields

Post by UpperNwGuy » Sun Nov 11, 2018 10:25 am

Thank you, longinvest, for such a clear explanation.

Dulocracy
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Re: Bond prices vs yields

Post by Dulocracy » Sun Nov 11, 2018 11:07 am

longinvest wrote:
Sun Nov 11, 2018 10:17 am

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

This is patently false. A bond held to duration and a fund of bonds which are not held to duration but regularly purchased and sold must be treated differently by the investor. By the very fact that bond funds buy and sell all the time, they are changing the way a regular investor would look at bonds and locking in certain losses. As the point of this post is to question what will happen with bonds, we are going to muddy the waters if we somehow pretend that bond funds and individually held bonds which are held to duration or in any way the same. If someone comes to me with a bond fund that promises to never sell until after the bonds reach maturity, then I will be happy to discuss that particular unusual asset.

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.


There is no way to say this except that a bond purchased today May recover in time, but a bond fund purchased when it is cheaper will produce more money in time. We are in an unusual situation where holding off on purchasing new bonds may actually be financially beneficial in the long term. This is not to say that it would be wrong to continue to invest or to use an alternate strategy, but that we have to acknowledge this if we are to understand our investments.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%

A 5 to 10% drop is not modest, but if you consider it to be modest, what happens if there is a spike in interest rates rather than a slow increase? Also, you are discussing only the inflation for that drop which does not consider increases in interest rates, a separate risk.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

absolutely a bond fund is much more convenient than managing individual bonds. I do not know anyone that would disagree with that. That does not change the fact that the individual managing that fund is buying and selling individual bonds before maturity to meet arbitrary goals of the general bond fund and not of the individual investor.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. agreed. However it is essential to understand those Investments if one is going to stay the course. Panicked selling happens when someone see significant drops and they do not understand why.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: Bond prices vs yields

Post by vineviz » Sun Nov 11, 2018 11:13 am

Ricchan wrote:
Sat Nov 10, 2018 4:56 pm
Ben Mathew wrote:
Sat Nov 10, 2018 2:26 pm
So the risk of a bond depends on the match between your bond maturity and your consumption (i.e. when you need the money). If you perfectly match your bond maturities with your consumption needs, then you have no additional risk after you've bought the bond. You'll get exactly what you expected to get when you bought the bond regardless of whether interest rates go up or down, and regardless of what your portfolio balance says.
I get that this makes sense for individual bonds, but what about bond funds that continually buy and sell bonds to maintain an average maturity of a certain length?

Take Total Bond Market Index, for example, with an average effective maturity of 8.6 years. Suppose someone buys this with the intent to start withdrawing in 8.6 years. Then 8 years later, interest rates suddenly rise. The current price of BND at that point reflects unrealized increases in future income due to the higher interest rates. The person who bought BND 8 years ago is now faced with the dilemma of selling at a price that reflects future income they will never receive.

Are people supposed to gradually rebalance towards shorter term bond funds and eventually money markets as they near their planned withdrawal date?
Yes, that's exactly what they are supposed to do.

But keep in mind that the duration should match the investment horizon, and "investment horizon" doesn't mean the time until the FIRST withdrawal. It's the AVERAGE time of ALL the expected withdrawals. A 60 year old investor who is 8 years from retirement doesn't have an investment horizon of 8 years but rather an investment horizon of something like 15 years (assuming average life expectancy and complete depletion of the portfolio before death).
Last edited by vineviz on Sun Nov 11, 2018 11:17 am, edited 1 time in total.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

longinvest
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Re: Bond prices vs yields

Post by longinvest » Sun Nov 11, 2018 11:15 am

Dulocracy wrote:
Sun Nov 11, 2018 11:07 am
longinvest wrote:
Sun Nov 11, 2018 10:17 am

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

This is patently false. A bond held to duration and a fund of bonds which are not held to duration but regularly purchased and sold must be treated differently by the investor. By the very fact that bond funds buy and sell all the time, they are changing the way a regular investor would look at bonds and locking in certain losses. As the point of this post is to question what will happen with bonds, we are going to muddy the waters if we somehow pretend that bond funds and individually held bonds which are held to duration or in any way the same. If someone comes to me with a bond fund that promises to never sell until after the bonds reach maturity, then I will be happy to discuss that particular unusual asset.

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.


There is no way to say this except that a bond purchased today May recover in time, but a bond fund purchased when it is cheaper will produce more money in time. We are in an unusual situation where holding off on purchasing new bonds may actually be financially beneficial in the long term. This is not to say that it would be wrong to continue to invest or to use an alternate strategy, but that we have to acknowledge this if we are to understand our investments.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%

A 5 to 10% drop is not modest, but if you consider it to be modest, what happens if there is a spike in interest rates rather than a slow increase? Also, you are discussing only the inflation for that drop which does not consider increases in interest rates, a separate risk.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

absolutely a bond fund is much more convenient than managing individual bonds. I do not know anyone that would disagree with that. That does not change the fact that the individual managing that fund is buying and selling individual bonds before maturity to meet arbitrary goals of the general bond fund and not of the individual investor.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. agreed. However it is essential to understand those Investments if one is going to stay the course. Panicked selling happens when someone see significant drops and they do not understand why.

You have cut important parts of my post. Here it is:
longinvest wrote:
Sun Nov 11, 2018 10:17 am
Dulocracy wrote:
Sun Nov 11, 2018 9:29 am
If you hold a bond to maturity, you are not impacted. If, however, you hold a bond fund, as interest rates rise, you lose value. Bonds in a rising interest rate environment are not overly risky. Bond funds in a rising interest rate environment can hold significant risk because of the activity of the bond fund.

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

Most of us invest for the long term, even in retirement. We might retire at 55, 60, 65, or even 70, yet we'll continue investing util our death or our spouse's death. As much as 2.8% of U.S. women are still alive at the venerable age of 100, see this post for details and references. We won't liquidate our portfolio at retirement; we'll simply start taking withdrawals. The investment horizon of the vast majority of retirees is far longer than the average duration (6 years) of the total nominal bond market.

New bond investors can often have trouble distinguishing between distinct risks of nominal bond funds. So, I'll just copy a recent post I've made on another thread. Interested readers can go back and read the entire thread for a deeper discussion:

Good explanation of how bond funds don't get crushed in rising rate environment
longinvest wrote:
Fri Nov 09, 2018 8:09 am
To get back to the main topic of this thread, which was about nominal bonds in general (e.g. something like a total bond market index fund), let's distinguish two cases:

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund will experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%. This isn't 0%, but it's quite smaller than the 50% that stocks could easily lose in a very short period of time.

In other words, interest rate risk and inflation risk are two distinct risks of nominal bonds. A bond fund of intermediate duration has a moderate amount of both risks.

Referring to my earlier posts in this thread, it's also important to always be aware at all times of the difference between current yields and recent inflation. Leaving money invested into securities that yield less than inflation will cause a permanent loss of purchase power.
Let me insist on the fact that an individual nominal bond or CD isn't immune to inflation risk; holding it to maturity won't protect it from a loss of purchase power.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. But, it should be a long-term choice. The Bogleheads philosophy tells us to never try to time the market. This principle applies to fixed income too, not only to stocks.
In particular, you have cut the parts about investment horizon and about the inflation risk of individual nominal bonds and CDs.

You might be interested to read this post for a mathematical justification of my statements.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic / international) stocks / domestic (nominal / inflation-indexed) long-term bonds | VCN/VXC/VLB/ZRR

Ben Mathew
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Re: Bond prices vs yields

Post by Ben Mathew » Sun Nov 11, 2018 12:03 pm

Ricchan wrote:
Sat Nov 10, 2018 4:56 pm
Ben Mathew wrote:
Sat Nov 10, 2018 2:26 pm
So the risk of a bond depends on the match between your bond maturity and your consumption (i.e. when you need the money). If you perfectly match your bond maturities with your consumption needs, then you have no additional risk after you've bought the bond. You'll get exactly what you expected to get when you bought the bond regardless of whether interest rates go up or down, and regardless of what your portfolio balance says.
I get that this makes sense for individual bonds, but what about bond funds that continually buy and sell bonds to maintain an average maturity of a certain length?

Take Total Bond Market Index, for example, with an average effective maturity of 8.6 years. Suppose someone buys this with the intent to start withdrawing in 8.6 years. Then 8 years later, interest rates suddenly rise. The current price of BND at that point reflects unrealized increases in future income due to the higher interest rates. The person who bought BND 8 years ago is now faced with the dilemma of selling at a price that reflects future income they will never receive.

Are people supposed to gradually rebalance towards shorter term bond funds and eventually money markets as they near their planned withdrawal date?
Yes, since the maturity of the bonds held by a bond fund won't match your consumption needs, you will be exposed to interest rate risk. And if the bonds are nominal, you will be exposed to inflation risk as well. If you're interested in eliminating both these risks, you can build a TIPS ladder. This involves buying TIPS (inflation protected bonds) with maturities matching your planned consumption. Once you've bought the bonds, you'll know exactly what you'll get in the future. There are still some sources of uncertainty left:

(1) Until you've bought the bonds, you're still subject to interest rate risk. You don't know today how much your future savings will buy you because that depends on future interest rates. So until you're done building the TIPS ladder, you won't know exactly how much you'll have in retirement.

(2) Your consumption needs may be greater than expected--a medical event, for example.

(3) TIPS is indexed to official measures of inflation, which or may not match your personal experience of inflation. Your personal consumption basket may be different from the official one.

But all in all, a TIPS ladder will buy you a lot more certainty about the future than the typical bond fund.

Here's a Forbes article on building TIPS ladders. And searching this forum for "TIPS ladder" will yield many useful posts.

longinvest
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Re: Bond prices vs yields

Post by longinvest » Sun Nov 11, 2018 12:21 pm

Ben Mathew wrote:
Sun Nov 11, 2018 12:03 pm
Yes, since the maturity of the bonds held by a bond fund won't match your consumption needs, you will be exposed to interest rate risk. And if the bonds are nominal, you will be exposed to inflation risk as well. If you're interested in eliminating both these risks, you can build a TIPS ladder. This involves buying TIPS (inflation protected bonds) with maturities matching your planned consumption. Once you've bought the bonds, you'll know exactly what you'll get in the future. There are still some sources of uncertainty left:

(1) Until you've bought the bonds, you're still subject to interest rate risk. You don't know today how much your future savings will buy you because that depends on future interest rates. So until you're done building the TIPS ladder, you won't know exactly how much you'll have in retirement.

(2) Your consumption needs may be greater than expected--a medical event, for example.

(3) TIPS is indexed to official measures of inflation, which or may not match your personal experience of inflation. Your personal consumption basket may be different from the official one.

But all in all, a TIPS ladder will buy you a lot more certainty about the future than the typical bond fund.
Coupons, not only maturity face values, should be taken into account when building such a TIPS ladder. Forum member #Cruncher has developed an awesome tool for this; the link is at the end of the following post: Re: How should I build a TIPS income ladder?.

There's also another significant source of uncertainty:

(4) The last rung of a non-rolling 30-year TIPS ladder might mature before the investor's death. (This is usually called longevity risk).

A non-rolling TIPS ladder that delivers level inflation-indexed payments (maturing principal + coupons, each year) for up to 30 years is an excellent investment tool to fill the gap in payments between retirement and the start of a delayed inflation-indexed pension (e.g. Social Security). But, it isn't a complete retirement solution in itself because of longevity risk. It's also important to be aware that the average duration of a non-rolling 30-year TIPS ladder will be somewhere between 10 and 15 years. As a consequence, the market value of the ladder will be more volatile, in the early years, than the volatility of the overall TIPS market (e.g. the TIP ETF) and overall nominal bond market (e.g. the BND ETF) which have a lower average duration.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic / international) stocks / domestic (nominal / inflation-indexed) long-term bonds | VCN/VXC/VLB/ZRR

Valuethinker
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Re: Bond prices vs yields

Post by Valuethinker » Sun Nov 11, 2018 12:27 pm

BarbBrooklyn wrote:
Fri Nov 09, 2018 7:54 pm
I want to admit to being totally confused by bonds. The yield appears to be putting money in my virtual pocket as the price appears to be depleting my bottom line.

Would anyone care to explain?
We had a recent thread where several posters went through this in varying degrees of detail and intuition - I was one of them.

But basically a bond pays fixed coupons and a fixed amount at maturity (usually $100 per $ 100 face value). Say the coupon is $5 p.a.

If the price of the bond drops below $100 then the buyer gets $5 pa from the coupons, but also a capital gain. Say for $90 then $10 gain. Over 10 years, that would give you a Yield to Maturity of around 5.5% pa (5% coupon + $10 capital gain averaged over 10 years).

Say though instead you buy it at $120. Then you would be gaining 10 x $5 = $50 of income, but losing $20. Your return would be something between 3 and 4%, say 3.5% pa for 10 years (you'd still get your $50 coupons so $50 - 20 = $30 about 3% pa over 10 years) - that would be your Yield To Maturity.

So with a bond fund, the bonds in it are still paying you their fixed coupons, all the way until maturity (or when the fund sells them). Meanwhile the price (which gives the NAV of the fund) is fluctuating up and down all the time, depending on which way the market thinks interest rates are going. If interest rates fall, the fixed coupons are more attractive, so the bond price rises. If interest rates rise (like now) then the other way. that drives the fluctuation in NAV/ fund price.

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Ricchan
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Re: Bond prices vs yields

Post by Ricchan » Sun Nov 11, 2018 1:29 pm

Just wanted to say thanks for the replies to my earlier question and the follow up discussions. There were some very helpful comments and links to other useful posts.

I appreciate the point made about the the typical retirement being a slow decumulation over a long period of time. There seems to be a lot more reading to be done about withdrawal strategies and the role bonds play in them. I suppose my earlier question would be more pertinent to the case of, say, someone putting money aside for a large planned future expenditure like the purchase of a home.

Anyway, I hope I didn't derail this thread too much. :)

Dulocracy
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Re: Bond prices vs yields

Post by Dulocracy » Wed Nov 21, 2018 8:31 pm

longinvest wrote:
Sun Nov 11, 2018 11:15 am
Dulocracy wrote:
Sun Nov 11, 2018 11:07 am
longinvest wrote:
Sun Nov 11, 2018 10:17 am

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

This is patently false. A bond held to duration and a fund of bonds which are not held to duration but regularly purchased and sold must be treated differently by the investor. By the very fact that bond funds buy and sell all the time, they are changing the way a regular investor would look at bonds and locking in certain losses. As the point of this post is to question what will happen with bonds, we are going to muddy the waters if we somehow pretend that bond funds and individually held bonds which are held to duration or in any way the same. If someone comes to me with a bond fund that promises to never sell until after the bonds reach maturity, then I will be happy to discuss that particular unusual asset.

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.


There is no way to say this except that a bond purchased today May recover in time, but a bond fund purchased when it is cheaper will produce more money in time. We are in an unusual situation where holding off on purchasing new bonds may actually be financially beneficial in the long term. This is not to say that it would be wrong to continue to invest or to use an alternate strategy, but that we have to acknowledge this if we are to understand our investments.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%

A 5 to 10% drop is not modest, but if you consider it to be modest, what happens if there is a spike in interest rates rather than a slow increase? Also, you are discussing only the inflation for that drop which does not consider increases in interest rates, a separate risk.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

absolutely a bond fund is much more convenient than managing individual bonds. I do not know anyone that would disagree with that. That does not change the fact that the individual managing that fund is buying and selling individual bonds before maturity to meet arbitrary goals of the general bond fund and not of the individual investor.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. agreed. However it is essential to understand those Investments if one is going to stay the course. Panicked selling happens when someone see significant drops and they do not understand why.

You have cut important parts of my post. Here it is:
longinvest wrote:
Sun Nov 11, 2018 10:17 am
Dulocracy wrote:
Sun Nov 11, 2018 9:29 am
If you hold a bond to maturity, you are not impacted. If, however, you hold a bond fund, as interest rates rise, you lose value. Bonds in a rising interest rate environment are not overly risky. Bond funds in a rising interest rate environment can hold significant risk because of the activity of the bond fund.

A bond fund is just a collection of individual bonds. Simple logic tells us that If a single bond isn't overly risky, a collection of "not overly risky bonds" can't be more risky than each single bond it holds.

Most of us invest for the long term, even in retirement. We might retire at 55, 60, 65, or even 70, yet we'll continue investing util our death or our spouse's death. As much as 2.8% of U.S. women are still alive at the venerable age of 100, see this post for details and references. We won't liquidate our portfolio at retirement; we'll simply start taking withdrawals. The investment horizon of the vast majority of retirees is far longer than the average duration (6 years) of the total nominal bond market.

New bond investors can often have trouble distinguishing between distinct risks of nominal bond funds. So, I'll just copy a recent post I've made on another thread. Interested readers can go back and read the entire thread for a deeper discussion:

Good explanation of how bond funds don't get crushed in rising rate environment
longinvest wrote:
Fri Nov 09, 2018 8:09 am
To get back to the main topic of this thread, which was about nominal bonds in general (e.g. something like a total bond market index fund), let's distinguish two cases:

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund will experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%. This isn't 0%, but it's quite smaller than the 50% that stocks could easily lose in a very short period of time.

In other words, interest rate risk and inflation risk are two distinct risks of nominal bonds. A bond fund of intermediate duration has a moderate amount of both risks.

Referring to my earlier posts in this thread, it's also important to always be aware at all times of the difference between current yields and recent inflation. Leaving money invested into securities that yield less than inflation will cause a permanent loss of purchase power.
Let me insist on the fact that an individual nominal bond or CD isn't immune to inflation risk; holding it to maturity won't protect it from a loss of purchase power.

Holding a bond fund is generally much more convenient than managing individual bonds and CDs for an investor with a long term investment horizon.

At the end of the day, it's more important for an investor to invest into whatever will allow him to stay the course. It's OK to go with individual bonds and CDs, or with a bond fund. But, it should be a long-term choice. The Bogleheads philosophy tells us to never try to time the market. This principle applies to fixed income too, not only to stocks.
In particular, you have cut the parts about investment horizon and about the inflation risk of individual nominal bonds and CDs.

You might be interested to read this post for a mathematical justification of my statements.
I did not cut anything out. I quoted relevant portions that I was discussing. The reason that I did not quote any of the other stuff that you said is that I did not take issue with it. As you did not respond to my comments to your original post, those comments stand. Bond funds and bonds have different risks based on their structure. My comments on that, and other related things can be seen above.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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