Hedging interest rate risk?

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unbiased
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Hedging interest rate risk?

Post by unbiased »

Anyone making any adjustments to their bond allocations to hedge rising rates or are you planning to just "roll with it" when it happens.

What scares me about the medium term for bonds is that I've never in my 20+ investing career experienced a sustained rising rate environment. Sure, we had a taste in 2018 but that was short lived.

Alternatively, nothing bad may happen--just like after 2008 when everyone said "rates can only go up" etc. Bonds did fine.

So, anyone make any changes? Shorten duration? Nothing? Just wondering what the smart people around here are doing/not doing about this realistic, but not certain, possibility.
000
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Re: Hedging interest rate risk?

Post by 000 »

I am staying the course with my cash allocation inspired by the Permanent Portfolio.
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vineviz
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Re: Hedging interest rate risk?

Post by vineviz »

unbiased wrote: Sun Sep 06, 2020 7:31 pm So, anyone make any changes? Shorten duration? Nothing? Just wondering what the smart people around here are doing/not doing about this realistic, but not certain, possibility.
The only sure way to keep yourself from being exposed to interest rate risk is to match the duration of your bond holdings as closely as you can to your investment horizon. An investor who might live for 40-50 years more should be in long-term, not short-term, bonds if their goal is reduce interest rate risk.
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alex_686
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Re: Hedging interest rate risk?

Post by alex_686 »

You will want to unpack what you are trying to do.

First, why do you want to hedge? What risk are you exposed to? I will point out that banks need to hedge interest rate risk. They have a fair amount of assets and liabilities that are interest rate sensitive. It makes sense here. And banks can, to a certain extent, create natural hedges. Options for individual investors are scarce. Getting a 30 year mortgage is one of the few choices out there?

Or are you trying to maximize portfolio return?

So are you trying to actively time the market? Not only do you need to correctly predict that interest rates are low but when they are going to rise. There is no reason why interest rates could not stay at the current rock bottom yields for another 10 years.

Or are you trying to say that the risk-adjusted returns for bonds are unattractive. But what are they unattractive against? Equities? This has been my choice - decreasing bond exposures for more equity. I think it is a good choice, but not the safe choice.

Sorry, no easy options here.
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Re: Hedging interest rate risk?

Post by whodidntante »

Some of us say that we will be compensated for taking term risk. When the compensation is not available, we buy investments with no term risk.
Semantics
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Re: Hedging interest rate risk?

Post by Semantics »

You may want to look into IVOL. It aims to hedge the risk of an increase in rates and/or inflation. It's a fairly new ETF and I don't know much about it, and the expense ratio is high at 0.99%, so I've been waiting for some of the more knowledgeable folks around here to take an interest before I seriously consider it. As far as I can tell, it's mostly TIPS, with a small portion allocated to call options on yield curve steepness; so maybe the way to think of it is a TIPS fund that won't decline if the 10-year yield go up. That is fairly intriguing, but if inflation stays close to 2% long-term and interest rates don't rise for a long time then I'd be paying the expense ratio for nothing.
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unbiased
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Re: Hedging interest rate risk?

Post by unbiased »

alex_686 wrote: Sun Sep 06, 2020 8:23 pm You will want to unpack what you are trying to do.

First, why do you want to hedge? What risk are you exposed to? I will point out that banks need to hedge interest rate risk. They have a fair amount of assets and liabilities that are interest rate sensitive. It makes sense here. And banks can, to a certain extent, create natural hedges. Options for individual investors are scarce. Getting a 30 year mortgage is one of the few choices out there?
Good questions and thanks for asking. Not trying to predict or time, just defend. In my retirement allocation (still a few years out), I am building out 10 years of expenses in cash/bonds to manage the risk of a potential decade of low stock returns. My fear is a rising rate/declining stock market environment where my bonds + stocks are suffering and I may be faced with selling "low."

For at least a couple years of expenses, what I've done personally to "hedge" (so-to-speak) is the following:
Cash
Bond Ladder
VRP (floating rate preferred stock)
FLRN (floating rate corporate bonds)
VWSTX (short term)
VTIP (potentially)

However, with the exception of VRP these are all VERY low-return investments and I don't want to over-allocate based on fear. I'm just curious what others are doing, if anything, or if there is something I've missed.
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Re: Hedging interest rate risk?

Post by jimkinny »

whodidntante wrote: Sun Sep 06, 2020 8:29 pm Some of us say that we will be compensated for taking term risk. When the compensation is not available, we buy investments with no term risk.
I agree.
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Re: Hedging interest rate risk?

Post by jeffyscott »

It's not even about the possibility that rates may rise someday. If they just stay where they are, then a 10 year treasury will earn 0.72% and 5 year 0.30%. Why accept that when I can, even now, get a 5 year CD at about 1.5%? Even 5 year corporates yields are only about 1-1.1%, based on BulletShares 2025 Corporate Bond ETF.

Treasury prices may go up even more, dropping rates even further, but that is not something that I want to count on. I'd rather take advantage of anomalies like direct CD rates (others that may be appropriate and available for some are I-bonds, EE bonds, maybe stable value).
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Re: Hedging interest rate risk?

Post by Robot Monster »

Why Own Bonds When Yields Are So Low?
https://www.schwab.com/resource-center/ ... cmp=em-QYD
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Noobvestor
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Re: Hedging interest rate risk?

Post by Noobvestor »

20K/year (max per person allowed) into Series I and EE savings bonds. No rate risk. Liquid after one year. I tracks inflation; EE doubles in 20 years.
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Re: Hedging interest rate risk?

Post by Robot Monster »

unbiased wrote: Sun Sep 06, 2020 7:31 pm What scares me about the medium term for bonds is that I've never in my 20+ investing career experienced a sustained rising rate environment. Sure, we had a taste in 2018 but that was short lived.
Let's turn the clock back then, and see how bonds performed in the late 70's, when yields were on the rise. From '77-81, the 10yr jumped from about 7.60% to 13.9%, which is a 6.3% rise.

Let's say it's 1977, and you're going to match your duration to your investment horizon. You buy an intermediate treasury fund (duration I'm guessing is five years).

Year -- Bond%/Cash% allocation: Inflation adjusted CAGR
1977 -- 100%/0%: -5.31%
1978 -- 80%/20%: -6.06%
1979 -- 60%/40%: -5.19%
1980 -- 40%/60%: -3.62%
1981 -- 20%/80%: +4.76%

On the other hand, if you had just been 100% cash all this time, you would have had an inflation adjusted CAGR of +0.02%

Conclusion = cash is king? :wink:
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Re: Hedging interest rate risk?

Post by columbia »

Those are some grim real returns.
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Re: Hedging interest rate risk?

Post by nisiprius »

I don't like the word "hedge." I think there are sophisticated nonlinear financial tools with insurance-like characteristics, in which you can pay a stiff "insurance premium" in order for payoff that happen only if some financial number goes out of bounds.

But I don't believe there is some cheap, easy thing you could add to a portfolio that would just eliminate interest rate risk.
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Re: Hedging interest rate risk?

Post by 000 »

nisiprius wrote: Mon Sep 07, 2020 5:54 pm I don't like the word "hedge." I think there are sophisticated nonlinear financial tools with insurance-like characteristics, in which you can pay a stiff "insurance premium" in order for payoff that happen only if some financial number goes out of bounds.

But I don't believe there is some cheap, easy thing you could add to a portfolio that would just eliminate interest rate risk.
Duration match bonds?
Keep cash for short term needs?

Seems cheap and easy to me.
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telemark
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Re: Hedging interest rate risk?

Post by telemark »

I have some money in a stable value fund in an old 401K, buy mostly I rely on stocks to hedge against the bond market.

And, of course, bonds to hedge against the stock market...
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Re: Hedging interest rate risk?

Post by MikeG62 »

jeffyscott wrote: Mon Sep 07, 2020 10:28 am ...I'd rather take advantage of anomalies like direct CD rates...
^This is what I have been doing (instead of increasing exposure to bonds).

I've not been selling bond funds per se (although I did liquidate all of my holdings in ICSH in late February as I become concerned about commercial paper). I've been moving very quickly when I find CD anomalies (5-year CD ladder at La CU with yields ranging from 1.45% to 2.10% as one very recent example). Admittedly, they seem to be getting harder and harder to find.
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Re: Hedging interest rate risk?

Post by Doc »

nisiprius wrote: Mon Sep 07, 2020 5:54 pm But I don't believe there is some cheap, easy thing you could add to a portfolio that would just eliminate interest rate risk.
T-Bills.
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Re: Hedging interest rate risk?

Post by willthrill81 »

Doc wrote: Tue Sep 08, 2020 11:30 am
nisiprius wrote: Mon Sep 07, 2020 5:54 pm But I don't believe there is some cheap, easy thing you could add to a portfolio that would just eliminate interest rate risk.
T-Bills.
Very short-term bonds largely eliminate market price risk but leave long-term investors greatly exposed to coupon reinvestment risk, as noted in this thread.
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Re: Hedging interest rate risk?

Post by Doc »

willthrill81 wrote: Tue Sep 08, 2020 12:05 pm
Doc wrote: Tue Sep 08, 2020 11:30 am
nisiprius wrote: Mon Sep 07, 2020 5:54 pm But I don't believe there is some cheap, easy thing you could add to a portfolio that would just eliminate interest rate risk.
T-Bills.
Very short-term bonds largely eliminate market price risk but leave long-term investors greatly exposed to coupon reinvestment risk, as noted in this thread.
Ain't got no darn coupons to reinvest so no risk. :D
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RetiredCSProf
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Re: Hedging interest rate risk?

Post by RetiredCSProf »

In the mid-1980's, I was saving for a downpayment on a house and put the savings into taxable bond fund. I started house-hunting in 1987. Mortgage interest rates were hovering around 7%. I saw a house that I wanted on a Friday and considered making an offer. The following Monday, mortgage rates rose to 9%, and all the interest that I had gained on my taxable bond fund was erased.

My current bond portfolio (in tax-deferred) is positioned more toward protecting against interest rate risk than credit risk. The downturn in the market in March of this year (2020) made me rethink this.

Here's what the manager of one of my actively managed bond funds wrote in a report published in late May (The Fund had been handily outperforming its benchmark for nearly a decade):
"A potential rise in interest rate has long been the primary risk we have sought to mitigate when managing the fund. Entering the fiscal year ... we were comfortable substituting credit risk in place of interest-rate risk in the search for a competitive return. ... Unfortunately, this was precisely the wrong allocation to have ... in March. ... We feel there is simply too much uncertainty regarding the lasting damage to the economy from the shutdown ... We believe competitors and benchmarks that rely on large government allocations will be challenged ...

In other words, people who do this for a living (bond fund managers) are uncertain about the outlook in balancing credit risk against interest rate risk.
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Re: Hedging interest rate risk?

Post by occambogle »

RetiredCSProf wrote: Mon Sep 21, 2020 9:39 am
Here's what the manager of one of my actively managed bond funds wrote in a report published in late May (The Fund had been handily outperforming its benchmark for nearly a decade):
Curious.... which fund/manager was that? Thanks....
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Re: Hedging interest rate risk?

Post by Uncorrelated »

If you want a hedge against asset class X, then the obvious answer is to purchase less of X and more of other assets.

If you want a hedge against risk X, then the obvious answer is to purchase less of the asset that gives you that specific risk. However, the investor should be extremely careful this is actually what they want. It often happens that investors embark on a quest to minimize a specific risk (sequence of returns risk, interest rate risk, inflation risk, tracking error risk). But this is not what investors should do, investors should not minimize one specific risk, investors should maximize their expected utility which is equivalent to finding a global minimum of all possible risks. Examining one specific risk frequently leads to tunnel vision.

Unless you are talking about real assets that cannot be diversified away (your residence which is at risk of fire, your income which is at risk of disappearing when you are hit by a bus), it is very unlikely that purchasing a hedge is the right choice. Don't lose sight of your actual goals.
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Re: Hedging interest rate risk?

Post by Valuethinker »

unbiased wrote: Sun Sep 06, 2020 7:31 pm Anyone making any adjustments to their bond allocations to hedge rising rates or are you planning to just "roll with it" when it happens.

What scares me about the medium term for bonds is that I've never in my 20+ investing career experienced a sustained rising rate environment. Sure, we had a taste in 2018 but that was short lived.

Alternatively, nothing bad may happen--just like after 2008 when everyone said "rates can only go up" etc. Bonds did fine.

So, anyone make any changes? Shorten duration? Nothing? Just wondering what the smart people around here are doing/not doing about this realistic, but not certain, possibility.
As long as you keep the duration of your bond portfolio at or around the duration of your cash flow needs, you should be OK. Your mismatch comes if say you hold the US Treasury Bond index (duration about 8 years?)but need the cash in 4 years.

To be honest, I am more scared about a Japan-type scenario of long term low global interest rates. Barely positive or indeed negative yield on government bonds.

If you are worried about long term rising interest rate risk, you are in effect worrying about long term inflation risk, and holding a weighting in TIPS hedges that (on the assumption interest rates will rise because inflation is rising). That would hedge you against a repeat of the 1945-1980 period. A "barbell" portfolio of say US T Bonds of greater than 15 years maturity and US TIPS would hedge you against interest rate/ inflation moves in either direction.
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Re: Hedging interest rate risk?

Post by Robot Monster »

Valuethinker wrote: Tue Sep 22, 2020 4:37 am To be honest, I am more scared about a Japan-type scenario of long term low global interest rates. Barely positive or indeed negative yield on government bonds.

If you are worried about long term rising interest rate risk, you are in effect worrying about long term inflation risk, and holding a weighting in TIPS hedges that (on the assumption interest rates will rise because inflation is rising). That would hedge you against a repeat of the 1945-1980 period. A "barbell" portfolio of say US T Bonds of greater than 15 years maturity and US TIPS would hedge you against interest rate/ inflation moves in either direction.
Indeed, should we worry about Japan-style low inflation, which would favor nominals, or should we fear inflation finally coming to life, which would favor TIPS? Since "no one knows nothing," why not be afraid of both -- your barbell portfolio suggestion appears to make a lot of sense.

Of interest, as to possible things we could see:

Stanley Druckenmiller fears the possibility of either high inflation (5-10%) or 3%-4% deflation.
https://seekingalpha.com/news/3612423-a ... ts-on-cnbc
BlackRock expects inflation, as measured by US CPI, to average 2.5% to 3% from 2025-2030. "Rising global production costs are the trigger," with companies remapping supply chains, engaging in less offshoring & potentially seeing widespread deglobalization
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Re: Hedging interest rate risk?

Post by ScubaHogg »

Fixed interest-only 20 or 30 year mortgage if you can find one.
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Re: Hedging interest rate risk?

Post by Kevin K »

Robot Monster wrote: Mon Sep 07, 2020 12:38 pm Why Own Bonds When Yields Are So Low?
https://www.schwab.com/resource-center/ ... cmp=em-QYD
I read this Schwab article when it came out and I don't find their arguments very compelling. This short piece refutes (among other things) the boilerplate advice that bonds zig when stocks zag:

https://movement.capital/the-bond-offer-you-can-refuse/

As was pointed out earlier in this thread, we're not being rewarded for taking on duration risk. I can see the sense of shortish (1-5 year) CD's and of course 10K in iBonds per person is a no-brainer but I don't see many other options if you take the Fed at its word.
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Re: Hedging interest rate risk?

Post by vineviz »

Kevin K wrote: Tue Sep 22, 2020 10:31 am This short piece refutes (among other things) the boilerplate advice that bonds zig when stocks zag:

https://movement.capital/the-bond-offer-you-can-refuse/
The "zig/zag" analogy is merely that (an analogy) so I don't know how one would go about "refuting" it. Certainly I see nothing in that article that successfully does so.

Whether the expected correlation of a particular bond asset with stocks is strictly negative or simply near zero isn't actually all that crucial in the end.
Kevin K wrote: Tue Sep 22, 2020 10:31 am As was pointed out earlier in this thread, we're not being rewarded for taking on duration risk. I can see the sense of shortish (1-5 year) CD's and of course 10K in iBonds per person is a no-brainer but I don't see many other options if you take the Fed at its word.
There is no such thing as a universal "duration risk": bond investors face "interest rate risk" that is based on the gap between their investment time horizon and their bond duration.

And with long-term bonds yielding over 2.2% and short-term bonds yielding less than 0.4%, a long-term investor who buys short-term bonds is taking on more interest rate risk AND lower expected returns at the same time.
"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: Hedging interest rate risk?

Post by Kevin K »

vineviz wrote: Tue Sep 22, 2020 11:44 am
Kevin K wrote: Tue Sep 22, 2020 10:31 am This short piece refutes (among other things) the boilerplate advice that bonds zig when stocks zag:

https://movement.capital/the-bond-offer-you-can-refuse/
The "zig/zag" analogy is merely that (an analogy) so I don't know how one would go about "refuting" it. Certainly I see nothing in that article that successfully does so.

Whether the expected correlation of a particular bond asset with stocks is strictly negative or simply near zero isn't actually all that crucial in the end.
Kevin K wrote: Tue Sep 22, 2020 10:31 am As was pointed out earlier in this thread, we're not being rewarded for taking on duration risk. I can see the sense of shortish (1-5 year) CD's and of course 10K in iBonds per person is a no-brainer but I don't see many other options if you take the Fed at its word.
There is no such thing as a universal "duration risk": bond investors face "interest rate risk" that is based on the gap between their investment time horizon and their bond duration.

And with long-term bonds yielding over 2.2% and short-term bonds yielding less than 0.4%, a long-term investor who buys short-term bonds is taking on more interest rate risk AND lower expected returns at the same time.
You're talking about corporate bonds that have both interest rate and credit risk, while I (and the article I posted the link to) are talking about Treasuries, and it shows how limited and infrequent the benefit of even the highest-quality bonds have been during major losses for the S & P. Schwab meanwhile is saying that a primary reason to own bonds is for protection during stock market panics. That doesn't always work for Treasuries, and just about never does for the corporate bonds you're recommending.
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Re: Hedging interest rate risk?

Post by Dennisl »

I hold intermediate bond funds. Riding it out. TIPS to address inflation and EE bonds to address deflation.
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Re: Hedging interest rate risk?

Post by vineviz »

Kevin K wrote: Tue Sep 22, 2020 12:28 pm
vineviz wrote: Tue Sep 22, 2020 11:44 am
Kevin K wrote: Tue Sep 22, 2020 10:31 am This short piece refutes (among other things) the boilerplate advice that bonds zig when stocks zag:

https://movement.capital/the-bond-offer-you-can-refuse/
The "zig/zag" analogy is merely that (an analogy) so I don't know how one would go about "refuting" it. Certainly I see nothing in that article that successfully does so.

Whether the expected correlation of a particular bond asset with stocks is strictly negative or simply near zero isn't actually all that crucial in the end.
Kevin K wrote: Tue Sep 22, 2020 10:31 am As was pointed out earlier in this thread, we're not being rewarded for taking on duration risk. I can see the sense of shortish (1-5 year) CD's and of course 10K in iBonds per person is a no-brainer but I don't see many other options if you take the Fed at its word.
There is no such thing as a universal "duration risk": bond investors face "interest rate risk" that is based on the gap between their investment time horizon and their bond duration.

And with long-term bonds yielding over 2.2% and short-term bonds yielding less than 0.4%, a long-term investor who buys short-term bonds is taking on more interest rate risk AND lower expected returns at the same time.
You're talking about corporate bonds that have both interest rate and credit risk, while I (and the article I posted the link to) are talking about Treasuries, and it shows how limited and infrequent the benefit of even the highest-quality bonds have been during major losses for the S & P. Schwab meanwhile is saying that a primary reason to own bonds is for protection during stock market panics. That doesn't always work for Treasuries, and just about never does for the corporate bonds you're recommending.
The yields I mentioned were for aggregate bonds, not just corporate bonds. And I’m not recommending anything, just pointing out that long duration bonds currently (and almost always) offer higher yields than short duration bonds.

If I recommend any bonds it’s usually Treasury bonds or savings bonds, but I’m not making any recommendation here just clearing up some misconceptions.

The Movement Capital blog post tells us that one guy thinks Treasury bonds are a bad investment, but not much more than that.

The bottom line in my view is that a long term investor who primarily holds cash or short term bonds is taking on a combination of greater internet rate risk and lower expected return that is hard to justify under any rational framework.
"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: Hedging interest rate risk?

Post by RetiredCSProf »

occambogle wrote: Tue Sep 22, 2020 1:51 am
RetiredCSProf wrote: Mon Sep 21, 2020 9:39 am
Here's what the manager of one of my actively managed bond funds wrote in a report published in late May (The Fund had been handily outperforming its benchmark for nearly a decade):
Curious.... which fund/manager was that? Thanks....
occambogle: I was referring to a quote from the fund manager of Thompson Bond fund (THOPX), which currently follows a US Gov/Credit 1-5 year index and has a lot of latitude in its composition. I omitted the name of the bond fund to avoid any suggestion that I was recommending (or not) the fund.

My understanding is that, in general, shorter bond fund durations reduce the risk of rising interest rates but that the investor's time horizon should determine the duration of their core bond portfolio. It is unclear how this applies to a bond portfolio in a tax-deferred account where the investor is retired and their intent is to withdraw a portion of their funds annually over an extended time frame.
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