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.