bond markets defy experts

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Re: bond markets defy experts

Post by tfb » Tue May 08, 2012 1:53 am

richard wrote:The 4% may never come or may not come for a long time. You lose out on the interim interest if you stay in cash rather than earning 2%.
Who says you must stay in cash? There have been long threads about alternatives that earn just as much but without interest rate risk.
Harry Sit, taking a break from the forums.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 3:52 am

grabiner wrote:
Leesbro63 wrote:So you buy today to get 1.9%, but risk losing 6 times that if rates jump to very realistic "prior era levels"?
Yes, but only if you sell after one year. If you buy a six-year municipal bond with a 2% yield and hold it to maturity, you will earn 2% over six years no matter what happens to interest rates in the interim. If you buy a fund which holds six-year municipal bonds with a duration of slightly under six years and hold it for six years, then any change to the interest rate this year will be made up in higher returns over six years; that's what "duration" means. In my example, suppose that rates rise to 5% next year and you lose 12.57% instead of the gain of 1.9% you were expecting. You will earn 3.1% more per year over the next five years, and that makes up the 14.67% shortfall in just under five years. (And this is the definition of duration; the fund has a duration of 5.2 years, so an increase in the middle of next year will take 5.2 years to make up for a total of 5.7.)
Something doesn't pass the smell test here, but I cannot put my finger on it. Perhaps it's the risk that rates will keep rising. I guess the whole thing seems like an assymetrical risk. Plus, while I am generally not a government conspiracist, I don't really understand what our (and other) central bank is doing. But my gut tells me that zero percent interest rates cannot be real enough to last. And finally I guess I don't like the fact that the current situation has turned the "safe" portion of a traditional portfolio into a risky proposition.

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Re: bond markets defy experts

Post by Valuethinker » Tue May 08, 2012 5:43 am

Leesbro63 wrote:
grabiner wrote:
Leesbro63 wrote:So you buy today to get 1.9%, but risk losing 6 times that if rates jump to very realistic "prior era levels"?
Yes, but only if you sell after one year. If you buy a six-year municipal bond with a 2% yield and hold it to maturity, you will earn 2% over six years no matter what happens to interest rates in the interim. If you buy a fund which holds six-year municipal bonds with a duration of slightly under six years and hold it for six years, then any change to the interest rate this year will be made up in higher returns over six years; that's what "duration" means. In my example, suppose that rates rise to 5% next year and you lose 12.57% instead of the gain of 1.9% you were expecting. You will earn 3.1% more per year over the next five years, and that makes up the 14.67% shortfall in just under five years. (And this is the definition of duration; the fund has a duration of 5.2 years, so an increase in the middle of next year will take 5.2 years to make up for a total of 5.7.)
Something doesn't pass the smell test here, but I cannot put my finger on it. Perhaps it's the risk that rates will keep rising. I guess the whole thing seems like an assymetrical risk. Plus, while I am generally not a government conspiracist, I don't really understand what our (and other) central bank is doing. But my gut tells me that zero percent interest rates cannot be real enough to last. And finally I guess I don't like the fact that the current situation has turned the "safe" portion of a traditional portfolio into a risky proposition.

What the Central Bank is doing is confronting 'the Zero Interest Rate Lower Bound'. Interest rates can't go below zero, but the economies of the western world are performing well below capacity as evidenced by high unemployment, sluggish growth, quiescent inflation and very low interest rates. Also look at commercial and personal loan growth: the private sector in aggregate is still deleveraging, and the credit mechanism is still damaged. In the extreme case, you get Greece.

So more radical forms of monetary easing are being tried. The Japanese were tentative with these, and never really got anywhere. So the UK and US Central Banks are being more aggressive.

Interest rates are not actually zero. But expected real rates are negative. That tells you how depressed everything is that people would take a certain loss on US 10 year TIPS (real loss) over a less safe interest rate in something else.

If the Central Banks could convince the market that 4% inflation was a permanent feature of the future, then the whole picture changes and nominal bond holders will take a bath. But they cannot: we are not Zimbabwe.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 6:21 am

I would love to hear Dr. Bernstein's current take. Maybe someone know a recent link. Or someone who knows him can "channel" him.

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Re: bond markets defy experts

Post by FinanceFun » Tue May 08, 2012 7:49 am

In my humble opinion - the only bonds one should be out on the yield curve on are TIPS. I am writing this at 1.85% 10y tres. As the 10y starts to approach 2.5%, nominal bonds can start to tip-toe out onto the curve. Call that whatever you want, but with my SV fund paying 1.39%, it would be insane for me to take on interest rate risk for an increase of 0.46% additional yield.

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Re: bond markets defy experts

Post by GregLee » Tue May 08, 2012 8:20 am

Leesbro63 wrote:Something doesn't pass the smell test here, but I cannot put my finger on it.
In my opinion, there is an illegitimate connection being made between prospective capital losses for bond holders when interest rates rise and various profits to bond holders. If you've accumulated interest payments in the past from your bonds, you can of course choose to use this excess to compensate yourself for your losses in bond values, but you could choose to use that excess in other ways, too, perhaps buying stocks with it, or buying a new car. There isn't any intrinsic connection between the money you made in the past from bond interest and the money you're now losing due to falling bond prices. Similarly, after bond prices fall, you may find compensation in interest payments you collect subsequently, or in the rise in value of your now discounted bonds as they approach maturity, but there is no true connection between the money you lost in bonds and the gains that you make after the loss. Others can buy bonds, after the fall, if they wish to collect interest payments or have capital gains as bonds mature, but for them, the profits won't compensate for previous losses.
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Re: bond markets defy experts

Post by Tom_T » Tue May 08, 2012 9:31 am

GregLee wrote:
Leesbro63 wrote:Something doesn't pass the smell test here, but I cannot put my finger on it.
In my opinion, there is an illegitimate connection being made between prospective capital losses for bond holders when interest rates rise and various profits to bond holders. If you've accumulated interest payments in the past from your bonds, you can of course choose to use this excess to compensate yourself for your losses in bond values, but you could choose to use that excess in other ways, too, perhaps buying stocks with it, or buying a new car. There isn't any intrinsic connection between the money you made in the past from bond interest and the money you're now losing due to falling bond prices. Similarly, after bond prices fall, you may find compensation in interest payments you collect subsequently, or in the rise in value of your now discounted bonds as they approach maturity, but there is no true connection between the money you lost in bonds and the gains that you make after the loss. Others can buy bonds, after the fall, if they wish to collect interest payments or have capital gains as bonds mature, but for them, the profits won't compensate for previous losses.
If you hold a bond to maturity, what have you lost?

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Re: bond markets defy experts

Post by GregLee » Tue May 08, 2012 9:38 am

Tom_T wrote:If you hold a bond to maturity, what have you lost?
If you bought the bond at a discount, you haven't lost anything -- you've gained. I bought some discounted bonds back in the early 80s and held them to maturity. I made some money. The money I made was at the expense of the original bond holders, who bought the bonds at full price, before interest rates rose.
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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 9:57 am

grabiner wrote:
Leesbro63 wrote:So you buy today to get 1.9%, but risk losing 6 times that if rates jump to very realistic "prior era levels"?
Yes, but only if you sell after one year. If you buy a six-year municipal bond with a 2% yield and hold it to maturity, you will earn 2% over six years no matter what happens to interest rates in the interim. If you buy a fund which holds six-year municipal bonds with a duration of slightly under six years and hold it for six years, then any change to the interest rate this year will be made up in higher returns over six years; that's what "duration" means. In my example, suppose that rates rise to 5% next year and you lose 12.57% instead of the gain of 1.9% you were expecting. You will earn 3.1% more per year over the next five years, and that makes up the 14.67% shortfall in just under five years. (And this is the definition of duration; the fund has a duration of 5.2 years, so an increase in the middle of next year will take 5.2 years to make up for a total of 5.7.)
This reminds me of my hypothetical grandmother who bot 6 year CDs, heavily, in 1972. She got the 6% return and got her money back when the bonds matured in 1978...right. But it wasn't right.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 9:58 am

GregLee wrote:
Tom_T wrote:If you hold a bond to maturity, what have you lost?
If you bought the bond at a discount, you haven't lost anything -- you've gained. I bought some discounted bonds back in the early 80s and held them to maturity. I made some money. The money I made was at the expense of the original bond holders, who bought the bonds at full price, before interest rates rose.
Nope, there was no free lunch there. Because you COULD have bot bonds at par that had a much higher coupon. What you gained in discount appreciation you lost in coupon interest.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 10:04 am

GregLee wrote:In my opinion, there is an illegitimate connection being made between prospective capital losses for bond holders when interest rates rise and various profits to bond holders. If you've accumulated interest payments in the past from your bonds, you can of course choose to use this excess to compensate yourself for your losses in bond values, but you could choose to use that excess in other ways, too, perhaps buying stocks with it, or buying a new car. There isn't any intrinsic connection between the money you made in the past from bond interest and the money you're now losing due to falling bond prices. Similarly, after bond prices fall, you may find compensation in interest payments you collect subsequently, or in the rise in value of your now discounted bonds as they approach maturity, but there is no true connection between the money you lost in bonds and the gains that you make after the loss. Others can buy bonds, after the fall, if they wish to collect interest payments or have capital gains as bonds mature, but for them, the profits won't compensate for previous losses.
+1. Yes, I realize this is market timing. But it's exactly about buying something when there is little value and the odds are that value will return. Kinda like prepaying for gasoline at $4 per gallon (which we can't easily do, but you catch my drift). Sure, someday gas might actually finally go to $6 per gallon, but it's ALWAYS returned to it's inflation adjusted baseline, which right now is about $3.30 per gallon or so. Do you bet on the "THIS IS THE TIME IT'S DIFFERENT", or do you go with the strong odds?

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Re: bond markets defy experts

Post by hsv_climber » Tue May 08, 2012 10:30 am

Leesbro63 wrote: +1. Yes, I realize this is market timing. But it's exactly about buying something when there is little value and the odds are that value will return. Kinda like prepaying for gasoline at $4 per gallon (which we can't easily do, but you catch my drift). Sure, someday gas might actually finally go to $6 per gallon, but it's ALWAYS returned to it's inflation adjusted baseline, which right now is about $3.30 per gallon or so. Do you bet on the "THIS IS THE TIME IT'S DIFFERENT", or do you go with the strong odds?
US stocks have ALWAYS returned 8% real in the past. Why don't you invest 100% in to stocks?

Interest rates might or might not return to their historic values. Better yet, the longer the interest rates are near 0, the lower the value of the historic values become :wink: . Great Depression has lasted for 10+ years. Japan is not yet out of its Lost Decade. US economy might start growing again @4+% and then interest rates will go up. Or it might not.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 10:34 am

hsv_climber wrote: US stocks have ALWAYS returned 8% real in the past. Why don't you invest 100% in to stocks?
Because the sequence of returns cannot be predicted.

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Re: bond markets defy experts

Post by hsv_climber » Tue May 08, 2012 11:02 am

Leesbro63 wrote:
hsv_climber wrote: US stocks have ALWAYS returned 8% real in the past. Why don't you invest 100% in to stocks?
Because the sequence of returns cannot be predicted.
Please tell me how to predict the sequence of returns of US 10-year Treasury given the historic data:

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 12:19 pm

You can't. But unlike stocks, you CAN know exactly what your 10 year Treasury will pay over the 10 year period and what it will be worth at the end. Although you cannot be sure of that in REAL terms, unless you buy TIPS in a ROTH IRA.

I'm just saying I can't see the value in locking up money for 10 years for 2% taxable. I know I'll get my (nominal) money back in 10 years however.

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Re: bond markets defy experts

Post by GregLee » Tue May 08, 2012 1:11 pm

Leesbro63 wrote:Because you COULD have bot bonds at par that had a much higher coupon.
That's not so. It's been a while, and I can't recall the exact figures, but I got very good rates. However, the point of the steep discount, for me, was not really the capital appreciation, since I had to wait over ten years to collect that, but rather call protection, so I could continue to collect the great interest.

Edit: Well, what you say about the coupon is correct, but beside the point, since the effective interest rate of a discounted bond is the coupon adjusted by the discounted price.
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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 1:59 pm

I agree that discounted bonds are better protected from calls. But isn't that priced into your purchase?

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 2:04 pm

GregLee wrote:Edit: Well, what you say about the coupon is correct, but beside the point, since the effective interest rate of a discounted bond is the coupon adjusted by the discounted price.
How is that beside the point? i believe that IS the point. If I can buy a new bond at 4% coupon, or a 3% bond (of similar quality and duration) at a discount to yield 4%, it's the same. And if the 3% bond is less likely to be called, the very efficient bond market is going to bid that bond to yield a bit less to reflect that benefit.

Again I ask, where is the free lunch that you are claiming?

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Re: bond markets defy experts

Post by GregLee » Tue May 08, 2012 4:12 pm

Leesbro63 wrote:And if the 3% bond is less likely to be called, the very efficient bond market is going to bid that bond to yield a bit less to reflect that benefit.
Is this a fact? Or is it a religious conviction of yours? Above, you said "Because you COULD have bot bonds at par that had a much higher coupon," and I'm telling you that it is factually incorrect that I could have gotten much higher effective interest by buying at par. I admitted that my memory is foggy about the precise details, but I bought long term bonds about 12-15 years from maturity at discounted prices of around $600-$700 dollars with effective rates of around 12%-16%. I didn't say it was a "free lunch", but I do think it was a great investment.
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Re: bond markets defy experts

Post by Lbill » Tue May 08, 2012 4:53 pm

As I pointed out in this thread only 2% of the experts at the 2012 Bespoke Roundtable were bullish on bonds, while 81% were bearish. So, I promptly went out and bought me a buncha treasury bonds. Nothing like an expert consensus to inform you what to invest in (whatever they were bearish on). Of course, 2012 isn't over yet. Maybe they'll be right yet....
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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 5:11 pm

GregLee wrote:
Leesbro63 wrote:And if the 3% bond is less likely to be called, the very efficient bond market is going to bid that bond to yield a bit less to reflect that benefit.
Is this a fact? Or is it a religious conviction of yours? Above, you said "Because you COULD have bot bonds at par that had a much higher coupon," and I'm telling you that it is factually incorrect that I could have gotten much higher effective interest by buying at par. I admitted that my memory is foggy about the precise details, but I bought long term bonds about 12-15 years from maturity at discounted prices of around $600-$700 dollars with effective rates of around 12%-16%. I didn't say it was a "free lunch", but I do think it was a great investment.
I think it's pretty much an established fact. Does anyone else here find it hard to imagine that buying bonds at a discount, compared to similar bonds at par, would provide such a big difference?
Last edited by Leesbro63 on Tue May 08, 2012 5:13 pm, edited 1 time in total.

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Re: bond markets defy experts

Post by Leesbro63 » Tue May 08, 2012 5:12 pm

Lbill wrote:As I pointed out in this thread only 2% of the experts at the 2012 Bespoke Roundtable were bullish on bonds, while 81% were bearish. So, I promptly went out and bought me a buncha treasury bonds. Nothing like an expert consensus to inform you what to invest in (whatever they were bearish on). Of course, 2012 isn't over yet. Maybe they'll be right yet....
While I agree that the masses and even the experts often get it wrong, just because that is a fact doesn't mean that a bubble might not be a bubble. Experts predicted a NASDAQ crash for a few years as it continued to confound them. Then it didn't.

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Re: bond markets defy experts

Post by Lbill » Tue May 08, 2012 7:08 pm

I rationalized my dive into Treasuries by purchasing STRIPS that will mature (as best I could figure) roundabout when I plan to start spending the money. The worst that can happen if rates go up, I reasoned, is that I missed the opportunity to purchase Treasuries with a higher yield down the road. I'll get my money back plus the interest minus whatever the dollar is actually worth when this thing matures. Somehow that seemed "safer" to me than buying a treasury bond fund or ETF, but it's probably just an illusion.
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Re: bond markets defy experts

Post by larryswedroe » Tue May 08, 2012 7:16 pm

Lbill
not an illusion and perfectly logical. Of course that would be true if you bought nominal bonds and the expenses you need to meet are nominal or bought TIPS and the expenses were real in nature.
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Re: bond markets defy experts

Post by protagonist » Wed May 09, 2012 5:35 pm

larryswedroe wrote:http://www.cbsnews.com/8301-505123_162- ... forecasts/?

Bond market has rallied 7 weeks in row, defying all those that said rates just had to go higher

Hope this is helpful

Larry
Yes, but NASDAQ rallied for years to its high around 5000, defying all that called a tech bubble and said stocks just had to go lower. :happy

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Re: bond markets defy experts

Post by larryswedroe » Wed May 09, 2012 5:39 pm

protagonist
Yes but there is a huge difference. NASDAQ at that level was clearly a bubble with valuations that could not be justified by any logical economic forecast, let alone the fact that the E/P ratio was about half the TIPS yield, There is no way to know if there is a bond bubble or not. The market may accurately be predicting both very low real growth and very low inflation and thus rates could be logical.
Best wishes
Larry

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Re: bond markets defy experts

Post by Leesbro63 » Wed May 09, 2012 6:10 pm

larryswedroe wrote:protagonist
Yes but there is a huge difference. NASDAQ at that level was clearly a bubble with valuations that could not be justified by any logical economic forecast, let alone the fact that the E/P ratio was about half the TIPS yield, There is no way to know if there is a bond bubble or not. The market may accurately be predicting both very low real growth and very low inflation and thus rates could be logical.
Best wishes
Larry
I seem to recall the "logical economic forecast" to be that bricks and mortar were dying and everything was gonna be bought on the internet...we were in a huge transition that and you had better get on board the "new economy" before the train left the station. I was skeptical too, but it really wasn't clear that it was honestly a "bubble" until after the fact. And even for those of us who were skeptical, I remember thinking that perhaps the bubble wouldn't burst, but just flatten out until earnings caught up...as they would "no doubt" do since everyone was quitting the local store and buying online.

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Re: bond markets defy experts

Post by Bongleur » Wed May 09, 2012 10:02 pm

Help me understand the potential benefits of buying bonds below par. Are these correct:

1) if you buy a bond discounted from par, eventually when it matures you will pay cap gains tax on the amount of the discount.

2) you can buy a greater quantity for the same amount of money vs a bond at par.

3) for the same credit risk, you should be getting the same interest rate as a par bond of the same maturity, otherwise the bond market would not be efficient. I think ???

4) the discounted bond has better call protection, so you are more likely to be able to hold to maturity, so benefits you if that is your intention. There is probably a slight cost for this.

So the benefit would be
A) the after-capital-gains difference between par & purchase price and
B) as above, for the extra quantity of bonds purchased
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Re: bond markets defy experts

Post by grabiner » Wed May 09, 2012 10:28 pm

Are these correct:

1) if you buy a bond discounted from par, eventually when it matures you will pay cap gains tax on the amount of the discount.
No. The discount will instead be treated as additional interest, prorated over the life of the bond. For example, if a bond pays $500 per year in interest on a $10,000 par, and you buy it for $9000 ten years before maturity, you report $600 in interest. (Conversely, if you bought such a bond for $11,000, you would report $400 in interest.)

If the IRS didn't do this, buying municipal bonds below par would be unattractive, as it would convert tax-free interest into taxable capital gains.
2) you can buy a greater quantity for the same amount of money vs a bond at par.
Yes, in total face value. If you have $90,000 to invest in bonds with a $10,000 par, you can buy ten of them if they are selling at a 10% discount, and you will get $100,000 at maturity (but lower interest payments, so this isn't really a benefit.)
3) for the same credit risk, you should be getting the same interest rate as a par bond of the same maturity, otherwise the bond market would not be efficient. I think ???
Almost correct; you should be getting the same interest rate as a par bond of the same duration (that is, interest-rate risk). If you have two bonds with the same current value but one is trading below par, the bond that is trading below par has less of its value in coupon payments and more in the final return of principal, since its principal payment will be more than the current value. Therefore, the one which is trading below par has a longer duration, and should usually have a slightly higher yield.
4) the discounted bond has better call protection, so you are more likely to be able to hold to maturity, so benefits you if that is your intention. There is probably a slight cost for this.
Duration calculations should adjust for the call provision; I believe Vanguard considers this in its published duration and maturity figures. For example, a bond with 21 years to maturity which is callable after 1 year has an effective maturity somewhere between 1 and 21 years, depending on how likely it is to be called.
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Re: bond markets defy experts

Post by linenfort » Wed May 09, 2012 10:47 pm

Great blog post, Larry. I've been holding mostly long-term treasuries in my 401(K), not because of any prescience but simply to fulfill the bond allocation of my portfolio. I'm sure I'll feel the pain when interest rates rise, but, it could be decades from now. No one knows.
Leesbro63 wrote:Something doesn't pass the smell test here, but I cannot put my finger on it.
With all those metaphors, you're liable to wind up with smelly fingers. :wink:
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Re: bond markets defy experts

Post by ziszew » Thu May 10, 2012 1:02 am

larryswedroe wrote:...It has always surprised me that most people don't get that--the yield curve already reflects the expectation of rising rates plus you get a risk premium for the unexpected! And the research shows that you get rewarded the most for extending when the curve is steep
Larry
Maybe I've taken most of the thread wrong, but is there a particular reason not to go long now if time your time horizon is 25 years+?

Comparing IT vs LT Inv Grade (Vanguard), LT has a significantly lower ratio between Div and SEC yields (it's DY is ~60% higher as well). With the flight to safety into ST and to some extent IT (of all types), how much of a price premium are they carrying over LT?

I realize it's an oversimplification, but what is the downside to LT over the others if you're looking at such a long horizon? With real rates for almost all ST and IT being near zero or negative, how sharp of a rise does there need to be for LT to suffer? My understanding is that sharp hurts worse than gradual for funds/ladders, although there is a very good chance I've gotten that wrong....

I apologize if this is Bonds 101, but every time I think I have a some conception of understanding something will trip me up. Or, to put it simply, understanding if the return/risk makes sense seems to be harder on the fixed side (for me)

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Re: bond markets defy experts

Post by Jerilynn » Thu May 10, 2012 2:26 am

Leesbro63 wrote:
grabiner wrote:
Leesbro63 wrote:So you buy today to get 1.9%, but risk losing 6 times that if rates jump to very realistic "prior era levels"?
Yes, but only if you sell after one year. If you buy a six-year municipal bond with a 2% yield and hold it to maturity, you will earn 2% over six years no matter what happens to interest rates in the interim. If you buy a fund which holds six-year municipal bonds with a duration of slightly under six years and hold it for six years, then any change to the interest rate this year will be made up in higher returns over six years; that's what "duration" means. In my example, suppose that rates rise to 5% next year and you lose 12.57% instead of the gain of 1.9% you were expecting. You will earn 3.1% more per year over the next five years, and that makes up the 14.67% shortfall in just under five years. (And this is the definition of duration; the fund has a duration of 5.2 years, so an increase in the middle of next year will take 5.2 years to make up for a total of 5.7.)
Something doesn't pass the smell test here, but I cannot put my finger on it. Perhaps it's the risk that rates will keep rising. I guess the whole thing seems like an assymetrical risk. Plus, while I am generally not a government conspiracist, I don't really understand what our (and other) central bank is doing. But my gut tells me that zero percent interest rates cannot be real enough to last. And finally I guess I don't like the fact that the current situation has turned the "safe" portion of a traditional portfolio into a risky proposition.
Let me ask a different question that is (I think) related to this stuff.
If I buy $50k of BND today and interest rates on 10-yr T-bills go up 1% every year for the next 5 years, how much will my initial $50k investment be worth at that point in time?
Cordially, Jeri . . . 100% all natural asset allocation. (no supernatural methods used)

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Re: bond markets defy experts

Post by Tom_T » Thu May 10, 2012 10:45 am

Jerilynn wrote: Let me ask a different question that is (I think) related to this stuff.
If I buy $50k of BND today and interest rates on 10-yr T-bills go up 1% every year for the next 5 years, how much will my initial $50k investment be worth at that point in time?
Someone can correct me if I am wrong, but I believe this is the math: you lose around 1% for each year of duration. If BND has an average duration of 5 years, then a 1% hike would result in a loss of 5%. You lose 5% the first year, you earn 3%, so your net loss is 2%. After five years of 1% hikes, if you reinvested your earnings, you would have around $49k or so (based on my rough Excel calculations.)

If rates continued to rise one percent a year, however, you would remain ahead, because at that point you'd be earning more than what a rate hike costs you:

Year 1: lose 5%, earn 3%
Year 2: lose 5%, earn 4%
Year 3: lose 5%, earn 5%
Year 4: lose 5%, earn 6%
Year 5: lose 5%, earn 7%
Year 6: lose 5%, earn 8%
Year 7: lose 5%, earn 9%

If rates rose 2% a year, all the way to 12%, you would have around $43k after five years. But at that point, another two years of earning 10% would put you at $53k.

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Re: bond markets defy experts

Post by garlandwhizzer » Thu May 10, 2012 12:01 pm

Tom_T wrote
If rates continued to rise one percent a year, however, you would remain ahead, because at that point you'd be earning more than what a rate hike costs you:

Year 1: lose 5%, earn 3%
Year 2: lose 5%, earn 4%
Year 3: lose 5%, earn 5%
Year 4: lose 5%, earn 6%
Year 5: lose 5%, earn 7%
Year 6: lose 5%, earn 8%
Year 7: lose 5%, earn 9%
This is true. A Vanguard research paper demonstrates that even in a rising rate environment, bonds catch up over a period of years in NOMINAL dollars. Unfortunately, we're spending REAL dollars, not nominal dollars. High and increasing interest rates are often associated with high and increasing inflation which gnaws away at those returns in real buying power.

Britain lowered interest rates to very low levels in WW2 and kept them there as long as possible in order to finance the cost deficits of the war, much as we have been and are currently doing to stimulate our weak economy. British bond investors who bought those bonds had negative returns in REAL dollars for more than a decade. This is not theory or model but fact.

Bonds serve a critical purpose in a portfolio and are necessary to balance the risk of equities. When they have a bad decade you lose in real dollars only a modest sum relative to the losses incurred in a bad decade in stocks. Bonds are a great anchor in an equity tornado of which we have had two in the last decade or so. On the other hand, if you have 60% or 70% of all your assets in bonds which may over a decade of increasing rates and inflation lose money in real dollars, meaning that the other 30% or 40% of your portfolio has to carry all the weight, I don't know how that qualifies as reducing risk. Perhaps our excessive risk aversion and over-reliance on the glorious past history of a 30 year bull market in bonds has distorted current market valuations in a way that may compromise their performance relative to stocks over the next decade or so. There is a reason why many experienced and knowledgeable financial people (Warren Buffet, Jeremy Siegel, Robert Shiller, Burton Malkiel, and Marc Faber among them) have expressed caution on bonds, especially US Treasuries, in the current interest rate environment.

Garland Whizzer

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Re: bond markets defy experts

Post by hsv_climber » Thu May 10, 2012 12:17 pm

If you are afraid of inflation then buy TIPS / I-bonds.

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Re: bond markets defy experts

Post by hoops777 » Thu May 10, 2012 12:33 pm

The more I read the comments from so many very smart people,the more I realize that nobody really has any idea what is going to happen to the bond market or the stock market.Historical returns really mean nothing if the future is different from the past and this is a world unlike we have ever known.I believe we are in unchartered waters and this is a horrible time to make portfolio decisions for people close to or in retirement that are not wealthy and need a certain level of income to make ends meet.This is the most complicated world we have ever lived in with the new global economy,technologies,terrorism and our wonderful political climate.I and many people have zero confidence in investing in anything right now.If you are wealthy and can afford to lose 20 or 30 % of your money it is not so stressful,but for most people it is very stressful :(
K.I.S.S........so easy to say so difficult to do.

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Re: bond markets defy experts

Post by garlandwhizzer » Thu May 10, 2012 1:17 pm

by hsv_climber » Thu May 10, 2012 1:17 pm

If you are afraid of inflation then buy TIPS / I-bonds.
TIPS currently guarantee that your return will be LESS than inflation. The current yield on the Vanguard TIPS fund is -.82%, meaning that you lose almost one percent to whatever inflation turns out to be by the government measurements. TIPS, while offering some protection from unexpected inflation, offer no protection from rising bond rates and their principle value tends to decline as interest rates rise just like any bond. The greatest risk to TIPs is a possible but unlikely scenario in which inflation doesn't rise significantly but the bond market loses confidence in US govt. obligations due to our ongoing failure to create a realistic plan to deal with our deficits. In that case, like Greece, Spain, Portugal, Ireland, and Italy, the US will have to offer interest rates that reflect not only expected inflation but also fear in order to entice buyers. That would be a disaster for TIPS, rising rates, low inflation. It is not a likely outcome but as a wise man said about predictions, "The problem with predictions is the future."

There is no guaranteed positive real return anywhere in the bond market that is risk free. Having been through the tech bubble collapse of 2000 and the financial collapse of 2008, investors are all too aware of the risks of stocks. The greatest bull market in the history of bonds, 30 years of outsized returns, has lulled many into a perhaps overestimated confidence in the long term safety and stability of bond returns.

Garland Whizzer

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Re: bond markets defy experts

Post by Tom_T » Thu May 10, 2012 1:22 pm

Don't I-Bonds provide a guaranteed real rate of return before taxes?

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Re: bond markets defy experts

Post by thomasbayarea » Thu May 10, 2012 1:31 pm

Can someone explain to me what this means: "a laddered bond portfolio of about 10 years"?

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Re: bond markets defy experts

Post by Leesbro63 » Thu May 10, 2012 1:31 pm

hoops777 wrote:The more I read the comments from so many very smart people,the more I realize that nobody really has any idea what is going to happen to the bond market or the stock market.Historical returns really mean nothing if the future is different from the past and this is a world unlike we have ever known.I believe we are in unchartered waters and this is a horrible time to make portfolio decisions for people close to or in retirement that are not wealthy and need a certain level of income to make ends meet.This is the most complicated world we have ever lived in with the new global economy,technologies,terrorism and our wonderful political climate.I and many people have zero confidence in investing in anything right now.If you are wealthy and can afford to lose 20 or 30 % of your money it is not so stressful,but for most people it is very stressful :(
And yet you could have said that many many many times over the last 200 years.

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Re: bond markets defy experts

Post by Jerilynn » Thu May 10, 2012 1:40 pm

Tom_T wrote:
Jerilynn wrote: Let me ask a different question that is (I think) related to this stuff.
If I buy $50k of BND today and interest rates on 10-yr T-bills go up 1% every year for the next 5 years, how much will my initial $50k investment be worth at that point in time?
Someone can correct me if I am wrong, but I believe this is the math: you lose around 1% for each year of duration. If BND has an average duration of 5 years, then a 1% hike would result in a loss of 5%. You lose 5% the first year, you earn 3%, so your net loss is 2%. After five years of 1% hikes, if you reinvested your earnings, you would have around $49k or so (based on my rough Excel calculations.)

If rates continued to rise one percent a year, however, you would remain ahead, because at that point you'd be earning more than what a rate hike costs you:

Year 1: lose 5%, earn 3%
Year 2: lose 5%, earn 4%
Year 3: lose 5%, earn 5%
Year 4: lose 5%, earn 6%
Year 5: lose 5%, earn 7%
Year 6: lose 5%, earn 8%
Year 7: lose 5%, earn 9%

If rates rose 2% a year, all the way to 12%, you would have around $43k after five years. But at that point, another two years of earning 10% would put you at $53k.
Makes sense, thanks. One question, where are you getting that initial 3%? BND has a current sec yield of 2.04%
Cordially, Jeri . . . 100% all natural asset allocation. (no supernatural methods used)

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Re: bond markets defy experts

Post by Tom_T » Thu May 10, 2012 1:43 pm

Jerilynn wrote: Makes sense, thanks. One question, where are you getting that initial 3%? BND has a current sec yield of 2.04%
Ah, it was just a question of when to apply the first interest rate increase. I assumed it would be right now. You get the idea.

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Re: bond markets defy experts

Post by Tom_T » Thu May 10, 2012 1:43 pm

thomasbayarea wrote:Can someone explain to me what this means: "a laddered bond portfolio of about 10 years"?
Wiki to the rescue.

http://www.bogleheads.org/wiki/Bond_Ladder

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Re: bond markets defy experts

Post by hsv_climber » Thu May 10, 2012 2:45 pm

garlandwhizzer wrote:
by hsv_climber » Thu May 10, 2012 1:17 pm
If you are afraid of inflation then buy TIPS / I-bonds.
TIPS currently guarantee that your return will be LESS than inflation. The current yield on the Vanguard TIPS fund is -.82%, meaning that you lose almost one percent to whatever inflation turns out to be by the government measurements.
So, don't buy fund, but buy 15+ year TIPS instead. They provide guaranteed POSITIVE REAL return if you hold them till maturity.

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Re: bond markets defy experts

Post by nisiprius » Thu May 10, 2012 3:45 pm

garlandwhizzer wrote:TIPS currently guarantee that your return will be LESS than inflation.
Nonsense. Don't just repeat stuff like that without even bothering to look. These aren't princely returns and they aren't enough to sustain 4%-then-COLAed withdrawals all by themselves, but they aren't negative. "Some TIPS currently guarantee that your return will be less than inflation" shouldn't be abbreviated to "TIPS currently guarantee that your return will be less than inflation." (Yes, these are real yields).

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Re: bond markets defy experts

Post by garlandwhizzer » Thu May 10, 2012 6:55 pm

The examples given do in fact show that if you're willing to by very long durations TIPS, 15+ years, your return equals inflation,your returns can in fact beat inflation by a fraction of 1%. But the amount of the return greater than inflation is so small, a little over 0.6% if you buy a 30 year TIPS bond, that it doesn't much appeal to me as an investor. Going out that far in duration in any bond is risky because although TIPS may protect you from inflation, it does not protect you from interest rate risk in the bond market, the degree of which is directly correlated to duration in a rising interest rate environment. In short, it is not risk free. There is a reason why the Vanguard TIPS fund has an average duration of 8.4 years and an average maturity of 9.2 years, rather than 15+ years which would carry more interest rate risk.

TIPS have had quite a run up in recent years as a result of pervasive risk aversion and inflation fears, the reason that intermediate term and short term TIPs bonds currently pay rates less than the inflation rate. Will this continue? I don't know, but I know that starting out with a long term instrument that over 30 years is going to beat inflation by less than 1% does not appeal to me as a favorable risk/reward trade. No one can be certain, certainly not me, what the next 15 or 30 years hold in store for us investors, but over that long a time period I'm betting on stocks vastly more than bonds, especially TIPS and Treasuries at current rates. Bonds have a role in portfolios to anchor portfolios from the volatility of equities which will always be the case, but in my view if you want to get somewhere, you don't put 60% of your assets in the anchor and 40% in the motor.

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Re: bond markets defy experts

Post by PaFromFL » Sat Mar 21, 2015 10:45 pm

I finally sat down and plotted the 1990-present Fed Funds rate along with the price history of VWALX, VWLUX, and Nuveen NPM and NIO to see the effect of Fed Funds rates and bond duration on the price of bond funds. Bond prices seemed poorly correlated with the Fed Funds rates. The duration (and Nuveen leveraging) seemed to produce a smaller than expected rate change amplification effect. What am I missing? Is it possible that the theory doesn't hold when interest rates are low because of yield-chasing? Is the problem that Fed Funds rates don't always reflect the actual interest rates?

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