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Lauren Vignec
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Post by Lauren Vignec » Wed Oct 29, 2008 12:24 pm

Hello Bogleheads,

I have not written very many posts on this forum but I contributed many posts to the old forum. This is, however, the first thread I have ever started. I wanted to put most of what I know about fixed income in one place. I apologize if some similar post has already been written.

This is a post about bonds.

For most investors, bonds primarily serve to reduce risk. So it is necessary to understand the various kinds of bonds, and to know which kinds of bonds protect against which kinds of risk. Understanding the fundamentals of bond investment requires understanding which kinds of bonds can be expected to do well in inflationary or deflationary environments, and during serious financial crises. This post will not go into the various fixed income instruments that are developed specifically for taxable investors; the post will be long enough without that additional element. Here only three basic types of bonds will be discussed--Treasuries, TIPS and corporate bonds. Additionally, these types of bonds will be compared to cash and the total bond market.

The first bond asset class is Treasuries. These fixed income instruments are backed by the full faith and credit of the US Government. Investors in Treasuries do not face credit or call risk, and Treasuries are the bonds that institutional investors flee to in most crises. They are expected to have their best returns relative to other asset classes during recessions, financial meltdowns, global panics, and depressions. Treasuries can basically be divided into short-term, intermediate-term and long-term Treasuries, and each type has slightly different characteristics.

Short-term Treasuries are basically a step up from cash, and there is not so much a risk-premium associated with short-term Treasuries as there is a liquidity (or patience) premium. Essentially, since holders of short-term Treasuries take only limited interest-rate risks they are mostly being compensated for giving up the liquidity of cash. Short-term Treasuries ought to just plod along during either deflationary or inflationary recessions.

Even short-term Treasuries can go down though, and this often happens when the institutional investors who hold them are forced to sell them under conditions of extreme duress. When the largest investors place bad, leveraged bets on other asset classes and must meet margin calls, they have to sell whatever they have that anyone will buy. During such liquidations (and liquidation is the most precise term in this case), even short-term Treasuries can lose value as they are sold for less than they are worth. Short-term Treasuries can also lose value if interest rates unexpectedly rise fast enough. But if an investor only wants one bond fund, short-term Treasuries are usually the best choice, and should be the default choice for investors seeking such a recommendation.

Long-term and intermediate-term Treasuries are expected to perform the best (relative to other asset classes) during deflationary recessions or when fears of deflation are rampant. They also tend to hold up well in financial crises. However, they often perform poorly during periods of unexpected inflation, and of course they perform poorly when interest rates rise rapidly.

Treasury Inflation-Protected Securities, or TIPS, are in some ways the mirror image of intermediate-term Treasuries. These bonds pay the investor a specified rate plus the rate of inflation over the life of the bond. So TIPS are expected to perform very well in periods of unexpected inflation, but they provide no protection against the inflation everyone already expects. They are expected to perform poorly during deflationary periods.

In the old days, Treasury Bills used to be considered the "risk-free" asset by academics. Lately, some academics have started arguing that TIPS are the "risk-free" asset because an investor can guarantee a life-time of inflation-adjusted income with a TIPS ladder. However, this new view of fixed income has serious problems. First, TIPS are expected to lose value when investors fear deflation, whereas cash is simply expected to go nowhere in real terms no matter what happens. So it is difficult to see how anything can be less risky than cash. More importantly, the inflation rate faced by any real, individual investor is not going to be the same as the inflation rate as measured by the CPI. So for some investors, TIPS cannot provide a life-time of inflation-adjusted income.

Corporate bonds include call and credit risks not found in instruments backed by the full faith and credit of the US government. As a result, they often have their worst returns when investors most need good returns. They can perform poorly during financial crises and deflationary recessions. High-yield bonds are particularly risky, and should basically be considered a stock asset class when constructing a portfolio.

So that is the theory. Let's see how the theory held up during the worst global financial crisis since the Great Depression.

From 10/10/2007 until 10/10/2008 the global developed stock markets lost well over forty percent, and emerging markets lost over fifty percent. During that time there were, at first, fears of inflation which turned into fears of deflation. Here are the returns of the various types of bonds as represented by Vanguard funds for this rather frightening twelve month period.

Long-term Treasuries +9.79%
Intermediate-term Treasuries +9.81%
Short-term Treasuries +7.61%
Cash +2.84%
TIPS +2.69%
Total Bond Index +2.58%
Short-term investment grade corporates -1.39%
High-yield -20.79%

Notice that over the period, corporate bonds, even the highest-grade short term bonds, lost money. In particular, high-yield bonds had a stock-like losing year. Notice that Treasuries had their best year when everything else was plummeting. TIPS had done well until deflationary fears arose, but then their value dropped and dropped quickly. Notice that the total bond index, during the time when investors most needed good returns from their bonds, could not even keep up with a money-market account.

As people have become more afraid of deflation and the credit crisis has deepened, the performance of various asset classes has become more extreme. Here are the last three month returns as of 10-28-2008.

Long-term Treasuries +1.13%
Intermediate-term Treasuries +1.18%
Short-term Treasuries +1.50%
Total bond index -2.24%
Short-term investment grade corporates -5.45%
TIPS -11.11%
High-Yield -21.05%

The two periods of time overlap, but that only serves to underscore the spectacularly poor performance of TIPS and corporates as deflation has emerged as a serious threat.

The performance of TIPS and long or intermediate term Treasuries will reverse, though, if inflation again becomes the more serious threat. That is one of the many reasons why one cannot protect against the next big down-turn by studying the previous one.

The Great Depression was a deflationary recession. The market downturn of the late sixties and seventies was marked by high inflation. Bond portfolios that did the best during the Great Depression had horrible returns during the seventies. The point is that any investor who looked to the Great Depression for guidance on how to survive the seventies would have been completely wrong.

The past does not predict the future. That is why it is necessary to understand the fundamentals of each asset class. No one who understood the fundamentals of the various asset classes was too surprised at how each asset class reacted in this recent financial collapse, and understanding the fundamentals is the first step towards constructing an appropriate portfolio.


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Post by Chad S » Wed Oct 29, 2008 1:33 pm

Thank you, that was a helpful summary.

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Post by chaz » Wed Oct 29, 2008 1:39 pm

Lauren Vignec, Thanks for a very nice post.
Chaz | | “Money is better than poverty, if only for financial reasons." Woody Allen | |

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great post

Post by hollowcave2 » Wed Oct 29, 2008 2:03 pm

Thanks for a very nice, well-thought post.

There is one statement you made that I am not sure is true:
For most investors, bonds primarily serve to reduce risk.
Many investors also consider the income stream from bonds to be very important, and obviously, this also adds to total return, whether the income is reinvested or not.

Now with overnight rates falling to 1%, investors needing income from their investments may be in a bind.


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Post by keving » Wed Oct 29, 2008 2:33 pm

What are your thoughts on advantages/disadvantages about Intermediate Bond Index vs Intermediate Treasury Index besides the latter being backed by the govt.?

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Post by jiclemens » Wed Oct 29, 2008 3:46 pm

Thank you Lauren. Could you further explain "the fundamentals?" Or maybe could you respond with what is an ideal mix of funds in a deflationary and inflationary period? I gathered that you feel TIPS and Intermediate Treasuries are a good mix during inflationary periods but not deflationary times. Is Cash king during deflationary times? Are these periods easy to identify such that "trading" into different bond investments is possible and advisable or is there an ideal "all weather" mix?

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Lauren Vignec
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some hard questions

Post by Lauren Vignec » Wed Oct 29, 2008 6:26 pm

Hello Again,

OK there are some hard questions here but I will try to answer them. But first, thank you for the thank yous!

The bond portfolio is part of the whole portfolio, so it is not possible to give a one-size-fits-all-weather bond portfolio. However, in general I am actually happy with the rather common recommendation to use a mix of intermediate-term Treasuries and TIPS. The last three months are only one snapshot representing what can happen. TIPS should protect against unexpected inflation while the Treasuries protect against deflation, and both should do pretty well in most kinds of market downturns. So a mix of Treasuries and TIPS makes a good all-weather bond portfolio.

However, an even simpler default recommendation of short-term Treasuries will also fit the needs of many investors.

Cash is a unique asset class with its own benefits and drawbacks. It basically goes nowhere, and sometimes that is good. Most of the time attempts to move into an out of various asset classes do not work, and this is true in bonds as well as stocks. The problem is that the markets are forever over-predicting the future. So if you want to out-guess the markets it is not enough to correctly predict the future, you also have to predict how the markets will predict the future.

However, there may be some fairly robust methods that can be used by investors who are buying individual bonds and want good deals for their own situation. As Steve pointed out, often investors purchase bonds for the income stream, and yields are what they are. I think most investors who purchase individual TIPS or Treasuries can probably figure out pretty good methods.

The point is that the bond market is made up of a great diversity of participants, including institutions and foreign central banks. They don't have the same desires for their bond portfolio as you do, and the market price for a given bond may not be perfectly aligned with how you price such a bond. This discussion certainly starts to move away from the fundamentals though.

As for the intermediate-term index and intermediate-term Treasuries, here is the question to ask--What else is in the intermediate-term index that you really want to hold? What else is in there that specifically improves the risk/reward profile of the portfolio? If the answer is "nothing else", then Treasuries are a better choice.


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Post by ViperAttacks » Wed Oct 29, 2008 8:39 pm

What bond fund would you recommend for a taxable account in a state with no income tax?

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Post by Lauren Vignec » Thu Oct 30, 2008 10:09 am

Hello Viper,

I think perhaps I misunderstand your question, but it seems you are asking about tax-exempt bond funds. Tax-exempt bonds are more complex than the bonds I discussed earlier, and there cannot be a default recommendation.

There are three things investors should consider before purchasing tax-exempt bond funds. First, is the tax drag for Treasuries really all that bad? Sometimes people have a tendency to overestimate the effect of taxes. Second, will I-Bonds do the trick? If you have a sizable enough taxable account it is worth the minor inconvenience to purchase I-Bonds directly. Third, will cash do the trick? Maybe a combination of cash, Treasuries and I-Bonds is enough.

For an investors who have concluded that they really need a tax-exempt bond fund there are a few things to consider. First, it is best to stick with the highest quality bonds, as usual. Also, most investors probably will want to stick with short or intermediate term bonds. Finally, this is an area where you really should diversify. I would not be comfortable with anyone holding just one tax-exempt bond fund. Municipalities can go bankrupt, and in fact many of them can go bankrupt at around the same time.

A lot of people, like me, were surprised by how hard some municipal bond funds got hit this year. I suspect that the biggest problem was that large investors like hedge funds had to liquidate assets to meet margin calls on the bad bets they had placed, and those municipals may have been the only assets they could sell. The same thing probably happened with TIPS. But I don't want to just scare people about stuff. To the extent that a financial crisis is a liquidity crisis, this is one of the few areas where small, individual investors often have an advantage over the big boys. We can just be patient and hold on if it really is just a liquidity crisis.

There is no truly risk-free asset. Cash can lose out to inflation over long periods of time, and even the highest quality bonds can lose money over short periods of time in extreme circumstances. Some of the difficulties faced by tax-exempt bonds this year are just a reflection of the unfortunate truth that nothing is truly risk-free.


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Post by Lemon99 » Thu Oct 30, 2008 10:15 am

Hello Lauren,

Thanks for the post you made, I did find it helpful and perhaps you would offer more advice.

1. If I am a first time bond index fund purchaser going into the taxable funds and will be in the 28% fed. & 8% state tax bracket what would you suggest? Is this as good a time as any to start dollar cost averaging and if not how does beginner know what change to look for?

2. What about the lower rated bonds in the non-treasuries funds, are they worth the risk now.? The intermediate-term tax-exempt has 3.8% BBB and 11.7% A rated bonds.

Thank you very much.

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Post by InvestingMom » Thu Oct 30, 2008 10:17 am

Thanks Lauren. I was starting to think I needed to increase my TIPS fund with all of the recent posts that have indicated that TIPS are a good buy right now. Your post helped put it back in perspective for me.

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Post by thorn » Thu Oct 30, 2008 10:32 am

What do people thinnk about GNMAs such as VFIIX?

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Lauren Vignec
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more questions

Post by Lauren Vignec » Thu Oct 30, 2008 10:54 am

Hello Again,

OK, now it seems that more replies and questions are coming regarding people's specific portfolios. You probably will get much, much better answers to questions about your own portfolio in the Portfolio Help section of the website. This is partly because, hopefully, more than one person will try to answer your questions.

Here is one thing that is generally true, though. *If* an asset class is right for your portfolio, and *if* you know you prefer to dollar-cost average in to that asset, now is always a good time to start.

But if you really want good advice about your own portfolio it is probably best to start a thread where people can see the whole portfolio and help you out.

Best wishes,


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Post by simplesimon » Thu Oct 30, 2008 11:05 am

For some reason, I have a feeling in the back of my mind that the questions about Treasuries vs Indexes have something to do with performance chasing. Does anybody else feel that way? I mean, what about holding all types of bonds (sans TIPS and int'l) via Total Bond Market? Does this "hold everything" concept that we have with stocks work with bonds?

I'm not as informed about holding bonds as I am about holding stocks. If we really seek safety with the bond portion of the portfolio, one could argue Treasuries/TIPS only, which makes sense. Blah, I'm not sure...

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Post by mbs » Thu Oct 30, 2008 12:49 pm

Great posts, Lauren. Thank you!

Do you have a feeling about accumulating the actual treasuries vs buying indexed ETFs (like SHY & TLT)?

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Lauren Vignec
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few more questions

Post by Lauren Vignec » Fri Oct 31, 2008 8:58 am

Hello Simon,

Your suspicions may be justified. Performance chasing is always possible, but given the year-to-date performance of TIPS it is unlikely that someone recommending TIPS and Treasuries is performance chasing. In any case, I have recommended TIPS and Treasuries for quite a while and my reasoning has not changed. The reasoning was never based on past performance.

Investors should never start with past performance when constructing a portfolio, but it is a particularly bad idea to rely on past performance when dealing with fixed income.

Bonds are radically different from stocks, and one result of this difference is that a bond portfolio really needs to be tailored to the individual investor. Even a group of investors who all decide on total market style indexing for their stocks might never-the-less make completely different choices for their bonds.

Cash is the ultimate rebalancer, does a great job of putting a hard cap on portfolio volatility, and is always there when you need it--for emergencies or for opportunities. For some young investors who are not looking for income, cash should dominate the fixed income portfolio. For other young investors whose portfolios are strongly stock-oriented and who don't fear inflation, perhaps long-term bonds should dominate the small amount allocated to fixed income.

Still other investors, with very low risk-tolerances and small but stable income needs, have a fixed income portfolio made up entirely of CD's. Other investors may prefer TIPS. I could imagine that the optimal bond portfolio for a 95 year-old widow might really be just short-term Treasuries.

As far as the difference between buying individual Treasuries and just buying a fund or ETF--well, the difference can be hard to detect. It's easier to see the benefit of buying individual TIPS than it is to see the benefit of buying individual Treasuries. Most investors aren't missing out on anything if they just stick with the funds.


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Good Post

Post by LFT_PFT » Fri Oct 31, 2008 12:08 pm

Good posts. Thank you for sharing.

This financial crisis has stimulated considerable thought towards my bond fund selections (accumulation portfolio) as the Vanguard TIPS fund, Intermediate Index Fund, and Total Bond Fund have not held up well. (Expect equities to be volatile but with bonds also declining and not 'stablizing' portfolio well ) My thoughts/concerns:

- Treasuries (have lower expected long term return but hold up well when equities decline with flight to quality. Particularly good for rebalancing from rising to declining.)

- Intermediate (higher expected long term return but may not hold up well during equity declines)

Rhetorical Q:

Does the flight to quality effect and rebalancing benefits from Treasuries more likely result in a higher future portfolio value than the use of higher expected returns from intermediate bond funds?

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