Why intermediate term bond/funds?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
Crow Hunter
Posts: 995
Joined: Wed Jun 27, 2012 12:05 pm

Why intermediate term bond/funds?

Post by Crow Hunter »

This isn't in reference to the current low interest rate environment but more an in theoretical sense.

Why is the recommendation that investors should hold intermediate term bonds as their allocation to "safe" investments?

One of the key points of ballast is that you don't want it shifting around. If bonds are for "ballast", wouldn't a short term bond fund which is generally more stable (although lower returns) in all situations be better?

Can someone explain the reasoning?
Call_Me_Op
Posts: 8098
Joined: Mon Sep 07, 2009 2:57 pm
Location: Milky Way

Re: Why intermediate term bond/funds?

Post by Call_Me_Op »

Basically, it's because IT bonds have provided the best trade-off between risk and return. You have been able to get almost the same return as long-term bonds with much lower volatility.

But rates today are much lower and the yield curve flatter than has been the case historically. Therefore, I have no problem with the idea of limiting bond holdings to short term. This does not mean that (I expect that) short-term bonds will beat IT bonds. But this approach is more likely to avoid a significant loss in real value.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
Triple digit golfer
Posts: 6267
Joined: Mon May 18, 2009 5:57 pm

Re: Why intermediate term bond/funds?

Post by Triple digit golfer »

Many people do use short term bond funds.

The purpose of bonds for most is to be a ballast in a stock-heavy portfolio. Some feel that safer is better. Others are willing to take a bit more risk for a bit more return.

Intermediate term bond funds will behave similarly to the entire bond market, including short, intermediate, and long term. For people who value a total market approach, an intermediate term index does the job pretty well.
User avatar
nisiprius
Advisory Board
Posts: 42613
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why intermediate term bond/funds?

Post by nisiprius »

If the purpose of bond funds is safety and stability, it makes sense to roughly match the duration of the bond fund to the expected holding period. If you believe that risk and return go together, and that the yield curve usually rises, then short-term bond funds will give you lower return and more stability than you actually need.

The reason for this is that investment-grade bonds actually have an almost-predictable future; less so for bond funds, but in any case the relative safety of a bond fund, when the holding period is equal or greater than its duration, is much more certain than the loosey-goosey sort-of tendencies toward mean reversion in stocks.

Vanguard says that Total Bond "may be appropriate for investors with medium-term investment horizons (4 to 10 years)."

If we look at actual historic results, we see that over 5-year periods, since inception the Vanguard Short-Term Bond Market Index Fund has never lost money even once. But neither has the Total Bond Market Index Fund, and on a $10,000 investment over five years it earned an average of $3,453, while the short-term fund only averaged $2,199. Foregoing over a third of the return in exchange for increased safety didn't buy you much safety, because over five-year holding periods, Total Bond was very safe to begin with.

Now, over time periods of a single year,
Total Bond lost money in 38 out of 384 overlapping twelve-month periods, about one time in ten,
while Short-term bond index only lost money in 11/297, about one time in thirty.

So if your holding period is one year, and your goal is stability, there is a good reason to use short-term bond funds.

But if your holding period is Vanguard's "4-10 years," it's pretty safe to go out to intermediate-term bond funds.

A good way to explore this for yourself is to put together a reasonably realistic portfolio similar to the one you really plan to hold, and decide on the number of years you hope to hold it. Then go into PortfolioVisualizer and backtest versions of that portfolio, first with intermediate-term and then with short-term bond funds. What I expect you will see is that in a portfolio with stocks, the volatility is so dominated by stocks that it really would have made very reduction in volatility to go to short term bonds, but there would have been a noticeable loss of return.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
Posts: 42613
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why intermediate term bond/funds?

Post by nisiprius »

P.S. Mutual fund companies and advisors have a bias in favor of finding mutual fund answers to all problems. They want you to invest your money with them, not with a bank. So the other answer to this question is that you always need to ask the question of how bond mutual funds compare with bank products such as CDs. In my personal opinion, at this time it is hard to make the case for a short-term bond fund being better than a bank savings account or CD.

For example, as I write this, VBIRX, the short-term bond index fund, is showing an SEC yield of 0.29% and a duration of 2.8 years. Just as a very rough comparison, I have a savings account at an Internet bank, Capital One 360, with an 0.40% API, and one at a brick-and-mortar bank with 0.55% (because I have a high balance). If you think bank rates are going to go down and are serious about a 3-year holding period and want to lock something in, depositaccounts.com is showing a pretty good number of FDIC-insured 3-year CD's paying over 1.00%.

I personally believe that convenience, simplicity, and avoiding having our money scattered over too many different financial institutions. But apart from that, I fail to see any appeal in short-term bond funds and money market mutual funds. Apart from specific situations, e.g. you are talking about seven-figure balances and it's too hard to get it all FDIC-insured, or you're in a sufficiently high tax bracket that the value of municipal bonds becomes evident.

In other words, if you are uncomfortable with the mild degree of risk presented by an intermediate-term bond fund, you should at least consider just putting that money in a bank.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
Topic Author
Crow Hunter
Posts: 995
Joined: Wed Jun 27, 2012 12:05 pm

Re: Why intermediate term bond/funds?

Post by Crow Hunter »

Thank you Nisiprius for that information. That makes sense.

I have all my bonds (that aren't in individual inherited bonds) in VBTLX or the Fidelity equivalent. But I was just pondering if bonds are for "ballast" and something with a duration of 6+ years will likely be more "unstable" than something that has a shorter duration so I was wondering why Intermediate bonds were always the recommendation for portfolio "ballast".

I appreciate it. :sharebeer
NPT
Posts: 44
Joined: Sat Jul 01, 2017 12:25 pm

Re: Why intermediate term bond/funds?

Post by NPT »

nisiprius wrote: Tue Jan 12, 2021 11:34 am A good way to explore this for yourself is to put together a reasonably realistic portfolio similar to the one you really plan to hold, and decide on the number of years you hope to hold it. Then go into PortfolioVisualizer and backtest versions of that portfolio, first with intermediate-term and then with short-term bond funds. What I expect you will see is that in a portfolio with stocks, the volatility is so dominated by stocks that it really would have made very reduction in volatility to go to short term bonds, but there would have been a noticeable loss of return.
That may be a good way to get a feel for the expected volatility of a portfolio, but I would be very careful about using Portfolio Visualizer to try to understand how bonds, or portfolios containing bonds, behave in a more general sense. It can only go back to 1972 (when evaluating asset classes) or 1985 (when evaluating specific funds), and that is not a long enough time period to cover even a single full cycle in the bond market.

A good illustration is this chart from When bonds are riskier than stocks:
Image

The orange line represents bonds, and it shows clearly that a backtest would need to use much longer periods than 1972/1985 to 2020 in order to show the full picture. I am not suggesting that Portfolio Visualizer isn’t useful, but I believe it is important to point out this issue to beginners.
NPT
Posts: 44
Joined: Sat Jul 01, 2017 12:25 pm

Re: Why intermediate term bond/funds?

Post by NPT »

Crow Hunter wrote: Tue Jan 12, 2021 12:23 pm [...] I was wondering why Intermediate bonds were always the recommendation for portfolio "ballast".
Using intermediate-term (or total) bonds is not “always” the recommendation, it is just the most popular one. There is a respectable and not very small minority of sources that recommends short-term bonds instead, and another minority that, for stock-heavy portfolios, recommends long-term bonds.

I don’t believe there is anything wrong with the usual recommendation of using a low-cost total bond market fund for all of one’s bond needs, but if you are interested in the topic, then I suggest you read up on the alternative ideas and explanations as well. (I don’t have the time to dig up the sources right now, but they are not very difficult to find with the help of Internet search engines, or perhaps someone else can provide a few pointers.)
User avatar
arcticpineapplecorp.
Posts: 7117
Joined: Tue Mar 06, 2012 9:22 pm

Re: Why intermediate term bond/funds?

Post by arcticpineapplecorp. »

here's a good article by Rick Ferri titled "The Risk of Short-Term Bond Funds":

https://www.forbes.com/sites/rickferri/ ... a3658ff67b

he makes the argument persuasively I think that the sweet spot is intermediate. works for me.
It's "Stay" the course, not Stray the Course. Buy and Hold works. You should really try it sometime. Get a plan: www.bogleheads.org/wiki/Investment_policy_statement
Topic Author
Crow Hunter
Posts: 995
Joined: Wed Jun 27, 2012 12:05 pm

Re: Why intermediate term bond/funds?

Post by Crow Hunter »

Thanks for that info NPT and artic.
secondopinion
Posts: 145
Joined: Wed Dec 02, 2020 1:18 pm

Re: Why intermediate term bond/funds?

Post by secondopinion »

Crow Hunter wrote: Tue Jan 12, 2021 9:19 am This isn't in reference to the current low interest rate environment but more an in theoretical sense.

Why is the recommendation that investors should hold intermediate term bonds as their allocation to "safe" investments?

One of the key points of ballast is that you don't want it shifting around. If bonds are for "ballast", wouldn't a short term bond fund which is generally more stable (although lower returns) in all situations be better?

Can someone explain the reasoning?
Short-term bonds act like cash investments; because the actual return is very variable (albeit relatively constant with principal), it is hardly anything that a bond is expected to behave like (almost-guaranteed fixed return over extended periods).

On the long-term side, we have the long-term fixed returns; but it is very variable with the principal, which makes many panic during rising rates.

Since most seek to get the best of both worlds (and limiting the downsides that both present), they elect to hold a total bond market fund ("hold the haystack") or an intermediate bond fund.

Bond-heavy portfolios cannot afford to have short-term bonds only. Stock-heavy portfolios can afford to have short-term bonds only.
Call_Me_Op wrote: Tue Jan 12, 2021 9:22 am Basically, it's because IT bonds have provided the best trade-off between risk and return. You have been able to get almost the same return as long-term bonds with much lower volatility.

But rates today are much lower and the yield curve flatter than has been the case historically. Therefore, I have no problem with the idea of limiting bond holdings to short term. This does not mean that (I expect that) short-term bonds will beat IT bonds. But this approach is more likely to avoid a significant loss in real value.
I cannot say that intermediate bonds are nearly are the same as long-term bonds in returns; is this factoring in rolling returns as well? But the risk and return picture could be a good argument regardless.

Sadly, we cannot predict the interest rates; so, go with intermediate bonds if we can hold them for their duration or more.
It is better to be half-wrong than have a 50% chance of being all-wrong. With the former, you will learn and have money to try again. Otherwise, you will never learn and will have nothing eventually.
User avatar
nisiprius
Advisory Board
Posts: 42613
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why intermediate term bond/funds?

Post by nisiprius »

NPT wrote: Tue Jan 12, 2021 12:26 pm...That may be a good way to get a feel for the expected volatility of a portfolio, but I would be very careful about using Portfolio Visualizer to try to understand how bonds, or portfolios containing bonds, behave in a more general sense. It can only go back to 1972...
If we look at nominal dollars, and that's a big "if" and I want to make that clear it up front, it is still true that over the 89-year time period 2/1926-5/2020, there has never been a five-year period in which intermediate-term bonds lost money. Specifically, it has not happened in any of 1,073 overlapping sixty-month periods, using the "intermediate government bonds" SBBI data series.

I hasten to add that it has lost real value, failed to keep up with inflation, in 301/1,073 of those periods.

The original poster was assuming you would invest in bonds, and asking "why intermediate-term?" My answer had to do with relative risk of dollar loss for short-term and intermediate-term bonds. Over an intermediate-term holding period, the risk of dollar loss for intermediate-term bonds is very small, and therefore there is no improvement to be had by going shorter.

There isn't any SBBI series for "short-term" bonds, but there is for Treasury bills. In fact, with respect to real value (inflation-adjusted), over the same time period, Treasury bills lost real value in 474/1,074 five-year periods, so the chances of loss of real value were actually less for intermediate-term bonds than for Treasury bills.

So my answer continues to be if you are planning a) to hold bonds, b) for an intermediate-term holding period, it is appropriate to use intermediate-term bonds.
Last edited by nisiprius on Tue Jan 12, 2021 6:33 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
aristotelian
Posts: 8644
Joined: Wed Jan 11, 2017 8:05 pm

Re: Why intermediate term bond/funds?

Post by aristotelian »

What matters is overall portfolio volatility, not the volatility of each asset class. If the assets are non-correlated, there is a good chance that your bonds will be going up when stocks are going down, and vice versa, which means overall your portfolio is less volatile. Short bonds give you low volatility within the asset class but if they don't go up to counteract a stock crash, your portfolio is actually more volatile than one with intermediate or even long bonds. When in doubt, you could hold some of each and split the difference. Or, arguably, intermediate bonds are already splitting the difference between short and long.
scrabbler1
Posts: 2531
Joined: Fri Nov 20, 2009 2:39 pm

Re: Why intermediate term bond/funds?

Post by scrabbler1 »

From other threads, I know others, like me, use an intermediate-term bond fund as something resembling an emergency fund. For me, it is an intermediate-term muni bond fund serving as a second-tier EF. It has a better return than a short-term fund, and less price volatility than a longer-term fund. Also, being a muni fund, most of its earnings are tax-free.
Last edited by scrabbler1 on Wed Jan 13, 2021 10:57 am, edited 1 time in total.
carolinaman
Posts: 4450
Joined: Wed Dec 28, 2011 9:56 am
Location: North Carolina

Re: Why intermediate term bond/funds?

Post by carolinaman »

nisiprius wrote: Tue Jan 12, 2021 11:34 am If the purpose of bond funds is safety and stability, it makes sense to roughly match the duration of the bond fund to the expected holding period. If you believe that risk and return go together, and that the yield curve usually rises, then short-term bond funds will give you lower return and more stability than you actually need.

The reason for this is that investment-grade bonds actually have an almost-predictable future; less so for bond funds, but in any case the relative safety of a bond fund, when the holding period is equal or greater than its duration, is much more certain than the loosey-goosey sort-of tendencies toward mean reversion in stocks.

Vanguard says that Total Bond "may be appropriate for investors with medium-term investment horizons (4 to 10 years)."

If we look at actual historic results, we see that over 5-year periods, since inception the Vanguard Short-Term Bond Market Index Fund has never lost money even once. But neither has the Total Bond Market Index Fund, and on a $10,000 investment over five years it earned an average of $3,453, while the short-term fund only averaged $2,199. Foregoing over a third of the return in exchange for increased safety didn't buy you much safety, because over five-year holding periods, Total Bond was very safe to begin with.

Now, over time periods of a single year,
Total Bond lost money in 38 out of 384 overlapping twelve-month periods, about one time in ten,
while Short-term bond index only lost money in 11/297, about one time in thirty.

So if your holding period is one year, and your goal is stability, there is a good reason to use short-term bond funds.

But if your holding period is Vanguard's "4-10 years," it's pretty safe to go out to intermediate-term bond funds.

A good way to explore this for yourself is to put together a reasonably realistic portfolio similar to the one you really plan to hold, and decide on the number of years you hope to hold it. Then go into PortfolioVisualizer and backtest versions of that portfolio, first with intermediate-term and then with short-term bond funds. What I expect you will see is that in a portfolio with stocks, the volatility is so dominated by stocks that it really would have made very reduction in volatility to go to short term bonds, but there would have been a noticeable loss of return.
+1. Excellent explanation of risk/reward of ST and IT bonds. Thanks
User avatar
Munir
Posts: 2767
Joined: Mon Feb 26, 2007 4:39 pm
Location: Oregon

Re: Why intermediate term bond/funds?

Post by Munir »

We glorify diversification so why cann't that apply to bond funds too? For those of us having to take an RMD (Required Minimum Distribution) annually from our IRA, I assume I would have more flexibility in deciding which bond fund to tap for that RMD withdrawal if I have both intermediate and short bond funds to choose from. I don't use equities usually for RMD withdrawals.
Post Reply