What is a “bond bubble”?

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peterinjapan
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What is a “bond bubble”?

Post by peterinjapan » Sun Oct 08, 2017 3:11 am

I’ve been hearing various people in the financial press talking about how there’s a bond bubble, naturally after I just made a large purchase of bonds to balance my portfolio out more. While I hold all my bonds in very broad index funds (BND and AGG plus a little LQD), I realized I had no idea what a bond bubble might be. Could anyone here explain it to me?

Obviously a bond bubble would be the prices of bonds being bid up above where they “shoudl” be because of...what? Too many buyers of bonds (ncluding countries still doing QE)? Is it about junk bonds? What would a “deflating” be like to those of us holding broad index funds including investment grade corporate bonds?

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Re: What is a “bond bubble”?

Post by Stormbringer » Sun Oct 08, 2017 4:04 am

Some would argue that there is no such thing as a bubble in bonds, because if held to maturity you know exactly what you are going to receive. A $1000 10-year bond at 2.5% pays exactly that, and you you get you $1000 back at the end, no more, no less. Ignoring defaults, as long as you aren't selling them before they mature, there can be no capital loss or gain. The worst case is you are stuck receiving a below-market interest rate for some time.

I am assuming (someone correct me if I am wrong) that a passive bond fund would generally hold all their bonds until maturity. If that is the case, then over time you should be made whole, even though your monthly statement may show paper losses in the short run if rates rise.
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Re: What is a “bond bubble”?

Post by livesoft » Sun Oct 08, 2017 4:25 am

A bond bubble is a kind of literary device used to generate readers and page views and thus income for writers of financial porn.

With bond funds dropping about 4% in the last 6 months of 2016 and dropping 1% in the past month, I'm not sure that writers are using this literary device correctly. However, since investors seem to fear losses more than they like gains, writers know that they will get more readers with gloom and doom themes, so they write where the money is because their livelihood depends on it.
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Re: What is a “bond bubble”?

Post by livesoft » Sun Oct 08, 2017 4:36 am

Stormbringer wrote:
Sun Oct 08, 2017 4:04 am
I am assuming (someone correct me if I am wrong) that a passive bond fund would generally hold all their bonds until maturity.
That is probably not true because a long-term bond fund will not hold its bonds to maturity. And an intermediate-term bond fund will probably sell some of its bonds to a short-term bond fund. You get the idea.
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Re: What is a “bond bubble”?

Post by Stormbringer » Sun Oct 08, 2017 5:37 am

livesoft wrote:
Sun Oct 08, 2017 4:36 am
That is probably not true because a long-term bond fund will not hold its bonds to maturity. And an intermediate-term bond fund will probably sell some of its bonds to a short-term bond fund. You get the idea.
Ah, you are right. I just checked and my bond bond (SCHZ) has a 112% turnover rate. I learn something new every day on BH.

That makes me think then that a ladder of individual bonds might be superior for capital preservation than a bond fund.
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Re: What is a “bond bubble”?

Post by z3r0c00l » Sun Oct 08, 2017 6:19 am

A horrible year for bonds: -8%
A horrible day for stocks: -20%

I don't want to confuse volatility with risk since Bonds have had worse 20 year+ runs than stocks, 1940 - 1980 was pretty miserable, but this is why "bond bubble" sounds so funny. A bubble is a mania where prices are driven to extremes and then there is a sudden collapse, bonds don't seem to work that way. The 40 year decline in bonds was so gradual one would have a hard time noticing it except once inflation really picked up.

Bonds could be primed for another bad 40 years, but that is not the same as a bubble and is also completely unknowable at this time. (Trying to predict future interest rates or inflation is more difficult than most things we attempt to predict. One would have better luck forecasting climate change on a supercomputer or even predicting earthquakes.)

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Re: What is a “bond bubble”?

Post by BigJohn » Sun Oct 08, 2017 6:47 am

Stormbringer wrote:
Sun Oct 08, 2017 5:37 am
That makes me think then that a ladder of individual bonds might be superior for capital preservation than a bond fund.
Not necessarily
https://www.bogleheads.org/wiki/Individ ... _bond_fund

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Re: What is a “bond bubble”?

Post by nisiprius » Sun Oct 08, 2017 7:36 am

I've been trying to figure this one out myself. Normally, the name bubble is applied to situations in which some financial asset is bid up to several times its proper value as a result of market mania; it's a bubble because there's nothing real there, just air; and it is usually called a bubble when it bursts and it becomes obvious that there is a bubble. Most of things that are called "bubbles," the South Sea bubble, the Florida real estate bubble of the 1920s, the tulip mania, the tech bubble of 2000 clearly involve a rise in price of more than threefold in just a few years, and then a rapid collapse back to close to the pre-bubble value.

In the case of bonds, the people talking about "bond bubbles" make a case that there is a bubble-like market psychology going on and that people have bid up bonds to some amount that is insanely above its true value. This could be true, but what I don't understand is how the scale can be comparable to that of other asset bubbles. In the case of most bonds, there is a perfectly known limit to the actual total amount the bond can ever possibly pay out. A five-year Treasury with a 2% coupon is going to pay out exactly ten payments of $10 each, twice a year, and then is going to pay back $1,000 in principal, together with the last interest payment, at maturity. A grand total of $1,100. It can't possibly pay $1,200 or $1,300. Unlike stocks, this is completely known in advance. The question of what the bond is worth today is a matter of math based on predictions of what interest rates are going to be (i.e. how much you could have earned buying freshly-issued bonds instead of the that existing bond).

If a bond is going to pay out a known grand total of $1,100 in the next five years, and can't possibly pay more, it is hard to believe that any "sky's the limit," "next big thing" mania could get people so excited about it that they would be willing to pay $2,000 or $3,000 for it.

From the point of view of an investor in the Vanguard Total Bond Market Index Fund, or any other similar "core" bond fund--investment-grade bonds (no junk) and no more than intermediate term--I just don't see how any kind of "bond bubble" can involve an expansion measured in anything more than percentage points, and a decline also measured in percentage points.

For example, the price per share (i.e. ignoring bond interest paid out as dividends) for Total Bond looks like this:
Source
Image
So, it began life in 1986 at $10 a share, and now, about 31 years later, it is at $10.77, or 7.7%--not per year, but overall, cumulative. Even if you assume that it is all "bubble," perhaps starting around 2008, that's not eightfold or threefold, it's just 1.077-fold. It just doesn't seem like a big deal to me.

By comparison, again, cumulatively, since inception (go to "source" and change the chart to "growth"), reinvesting the dividends resulting from bond interest payments, $10,000 would have grown to $59,760--oh, call it $60,000 in the fund. So over its life the bond has added a cumulative total of about $50,000. Assuming that 8% of it is "bubble," that's means that there has been $46,000 of honest earned value and $4,000 of "bubble" which might deflate and be lost.

The only ways I can make sense of "bond bubble" talk is to assume either that
a) they are referring to bonds in the technical sense of long-term Treasuries (because the intermediate-term securities are "notes" rather than "bonds,") or

b) that they're crazy or want to grab headlines or are trying to mislead, or... perhaps most likely...

c) that because bonds so predictable, on Wall Street the world of bonds is not retirement savers, but people building incredibly complicated financial structures based on bonds being almost mathematically predictable and trying to squeeze juice out of the tiniest differences in valuation... and that a mob-psychology mania that distorts bond values by a few percent is hugely consequential to these professionals.
Last edited by nisiprius on Sun Oct 08, 2017 7:53 am, edited 1 time in total.
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Re: What is a “bond bubble”?

Post by nisiprius » Sun Oct 08, 2017 7:43 am

Exercise for the reader.

1) 1993 was described after the fact as a "bond bubble" and 1994 was described as a "bond massacre." How bad were the bond bubble and bond massacre for an investor in Vanguard Total Bond (or any run-of-the-mill "core bond fund?")

2) In August 2010, Jeremy Schwartz and Jeremy Siegel warned of a "Great American Bond Bubble" in Treasuries, and said that bad things would happen if "if over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield." In fact, it happened. What they warned about came to pass. Interest rates rose to 3.71% before spring of 2011. Not all the way to 4%, but well above 3.15%. How bad was this event for an investor in Vanguard Total Bond (or any run-of-the-mill "core bond fund?")
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Re: What is a “bond bubble”?

Post by docbrown » Sun Oct 08, 2017 7:44 am

Stormbringer wrote:
Sun Oct 08, 2017 5:37 am
That makes me think then that a ladder of individual bonds might be superior for capital preservation than a bond fund.
Why not just buy a bond fund and let someone else manage the ladder for you?
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Re: What is a “bond bubble”?

Post by petulant » Sun Oct 08, 2017 8:01 am

Looking for a link from bubble prices to individual investor returns won't reveal anything. A bubble requires effects that would first be felt at large, systemically important financial institutions. Can there be a bond bubble that affects them?

Yes. The last recession was, in part, a bond bubble that affected large, systemically important financial institutions. The bonds in question were mortgage-backed securities--bonds that paid returns to bondholders based on mortgage interest and principal repayment on underlying mortgage loans. The failure of those bonds caused massive disturbances in the credit markets when money market funds holding MBSs "broke the buck," investment banks declared bankruptcy or were acquired under unfavorable circumstances, or AIG's derivative portfolio nearly pulled it under.

Can there be a bond bubble in United States treasury bonds? Yes. The way this happens is if bondholders lend large amounts to the government at excessively low interest rates such that the United States will be forced to roll over this money rather than repay. Because of the government's budget and the amount of its loan portfolio taken up by short-term and intermediate-term debt, it is almost certain that the government would be forced to roll over its debt rather than repay it, even at high interest rates. A bubble would "pop" when there are no longer any buyers of the debt at lower interest rates, leading to a sudden reversal in interest rates. The sudden reversal would drastically undermine secondary prices for existing government bonds, meaning that systemtically important institutions linked to them may face write-downs. That would include haircuts on sale and repurchase agreements--the same instrument that brought down Lehman Brothers when they added MBS-backed repos to their existing treasury-backed repo products. It could include write-downs at numerous United States corporations holding treasury bonds under mark-to-market rules. Banks could have capital ratio problems if they also have mark-to-market rules, restricting their ability to make new loans. Derivatives could trigger. And foreign governments and banks could face stress because of their treasury holdings. With corporate losses, tightening credit, uncertain foreign conditions, and potential stalling in the sale-and-repurchase market, you've got a recipe for another recession.

However, with the Federal Reserve monitoring the situation and having excellent measures for affecting short-term interest rates and government bonds, it is highly unlikely this scenario would ever occur. The Federal Reserve has the ability to buy government bonds rolling over to prevent chaotic scenarios from affecting the government. Further, I am unclear on banks' rules for government bonds. They may not be mark-to-market. And, the change in interest rates would have to be much larger than 25 or 30 basis points, I think. My point is only that it is possible to have a bubble.

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Re: What is a “bond bubble”?

Post by stlutz » Sun Oct 08, 2017 9:50 am

I don't know why we're speculating over whether there can be a bond bubble. We've all seen one in our lifetime: Mortgage-backed securities circa 2006. Investors wildly mis-priced the risk they were taking and brought down the global financial system by doing so. Obviously if you didn't own the bonds that defaulted you did fine. It's worth keeping in mind however that it wasn't necessarily the case that Total Bond sailed through 2008 just fine. What if the government had not nationalized Fannie and Freddie? In that case those firms may not have been able to back up their guarantees on the MBS and things may have worked out differently for the investors in Total Bond who owned these bonds.

With bonds the better place to look for bubbles is with with credit risk more so than with interest rate risk. For example, if I look at the extra interest I receive from buying a BBB Corporate Bond right now (https://fred.stlouisfed.org/series/BAMLC0A4CBBB), it's very much at the low end of the historical average. Same goes for junk bond spreads as well. Investors apparently believe that it is very unlikely that we will experience an economic downturn over the next 5 years or so. That's not credible with me. A "bubble"? Maybe not. But credit risk does seem overpriced nowadays.

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Re: What is a “bond bubble”?

Post by Sandtrap » Sun Oct 08, 2017 10:25 am

z3r0c00l wrote:
Sun Oct 08, 2017 6:19 am
A horrible year for bonds: -8%
A horrible day for stocks: -20%

I don't want to confuse volatility with risk since Bonds have had worse 20 year+ runs than stocks, 1940 - 1980 was pretty miserable, but this is why "bond bubble" sounds so funny. A bubble is a mania where prices are driven to extremes and then there is a sudden collapse, bonds don't seem to work that way. The 40 year decline in bonds was so gradual one would have a hard time noticing it except once inflation really picked up.

Bonds could be primed for another bad 40 years, but that is not the same as a bubble and is also completely unknowable at this time. (Trying to predict future interest rates or inflation is more difficult than most things we attempt to predict. One would have better luck forecasting climate change on a supercomputer or even predicting earthquakes.)
40 years :shock:
So why rebalance with more bond funds?

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Re: What is a “bond bubble”?

Post by peterinjapan » Sun Oct 08, 2017 11:44 am

livesoft wrote:
Sun Oct 08, 2017 4:36 am
That makes me think then that a ladder of individual bonds might be superior for capital preservation than a bond fund.
One thing I know about Bogleheads is that they strongly dislike buying bonds directly.

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Re: What is a “bond bubble”?

Post by Kevin M » Sun Oct 08, 2017 1:16 pm

nisiprius wrote:
Sun Oct 08, 2017 7:43 am
<snip>
2) In August 2010, Jeremy Schwartz and Jeremy Siegel warned of a "Great American Bond Bubble" in Treasuries, and said that bad things would happen if "if over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield." <snip>
This is just bond math. A very quick increase of the yield on a 10-year bond from 2.8% to 3.15% would result in a capital loss of 2.96% ( =-PV(4%,10,2.8%,1)-1 ), which is indeed a little more than the yield of 2.8%. Similarly, a very quick increase from 2.8% to 4% would result in a capital loss of 9.73%, which is almost 3.5 times the yield of 2.8%.
In fact, it happened. What they warned about came to pass. Interest rates rose to 3.71% before spring of 2011. Not all the way to 4%, but well above 3.15%.

The 10-year yield on 8/10/2010 was 2.79%, and on 2/8/2011 it was 3.75%: https://fred.stlouisfed.org/graph/?g=fld2. If this change had been very quick instead of taking six months, the capital loss on a 10-year Treasury purchased at par would have been 7.88%. Given that the remaining term to maturity was about 9.5 years when the high yield was hit, the actual loss would have been slightly less, at 7.56%.
How bad was this event for an investor in Vanguard Total Bond (or any run-of-the-mill "core bond fund?")
M* shows the total return for VBMFX (total bond) at -1.42% for this period. So clearly a bond fund, which is more like a bond ladder than a single bond, with a duration between 5 and 6 years had a much lower loss than a single 10-year bond with a duration closer to 9 years. Of course a bond fund with a longer duration would have had a larger loss. The Vanguard long-term Treasury fund, VUSTX, had a total return of -8.36% during this period, so more in the ballpark of the numbers discussed above, but the duration of VUSTX, currently at about 17 years, is even longer than that of a 10-year bond.

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Re: What is a “bond bubble”?

Post by Kevin M » Sun Oct 08, 2017 1:26 pm

In posting the above, I had missed the "if over the next year" part of the "Great American Bond Bubble" quote. So changing the remaining maturity from 10 years to 9 years in the calculation gives a loss of 2.71% for the 2.8%->3.15% scenario (0.97 times the initial yield), and a loss of 8.92% for the 2.8% to 4% scenario (3.19 times initial yield).

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Re: What is a “bond bubble”?

Post by Kevin M » Sun Oct 08, 2017 2:35 pm

peterinjapan wrote:
Sun Oct 08, 2017 3:11 am
What would a “deflating” be like to those of us holding broad index funds including investment grade corporate bonds?
One way to get a sense of this is to look at the worst drawdowns for the bond fund of interest. We can do this with Portfolio Visualizer for monthly returns. The worst drawdown for VBMFX (total bond) was -5.86% from Mar 1987 through Sep 1987: Backtest Portfolio Asset Allocation (click on the Drawdowns tab for drawdown details).

To see how this corresponded to yield changes at the time, perhaps the 7-year Treasury would be relevant, since the duration is in the same ballpark as VBMFX.

The 7-year yield on 2/27/1987 was 7.00%, and on 9/30/1987 it was 9.50%: https://fred.stlouisfed.org/graph/?g=flfS. That would have resulted in a capital return of about -11.8% and an income return of about 4.1%, for a total return of about -7.7%.

I think it's worth noting that since yields are much lower than they were in 1987, the income component of the return would have a smaller positive contribution to the total return. Also, with a much lower coupon rate, the duration of a 7-year bond is longer than it was in 1987, so the negative capital return component would be larger.

The 7-year yield is 2.20%: Daily Treasury Yield Curve Rates. A yield increase of 2.5 percentage points to 4.7% over seven months would result in a capital return of -13.7% and an income return of about 1.3%, for a total return of about -12.4%.

So we have to be a little bit careful about applying historical bond fund results when yields were higher to today's much lower yield environment.

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Re: What is a “bond bubble”?

Post by Doc » Sun Oct 08, 2017 3:50 pm

docbrown wrote:
Sun Oct 08, 2017 7:44 am
Why not just buy a bond fund and let someone else manage the ladder for you?
Because an index fund/ETF is not a ladder. A ladder has an equal distribution of maturity dates but an index fund does not because it is based on market value.

Bond maturity distribution of index funds/ETFs and a ladder:

Code: Select all

ETF->		SCHO	IEI	ITE	SCHR	Ladder
Index->		1-3	3-7	1-10	3-10	1-10
					
1 to 3 Years	100 	0 	36 	0 	22
					
3 to 5 Years	0 	59 	34 	48 	22
					
5 to 7 Years	0 	37 	17 	30 	22
					
7 to 10 Years	0 	4 	13 	21 	33

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Re: What is a “bond bubble”?

Post by z3r0c00l » Mon Oct 09, 2017 6:27 am

Sandtrap wrote:
Sun Oct 08, 2017 10:25 am
z3r0c00l wrote:
Sun Oct 08, 2017 6:19 am
A horrible year for bonds: -8%
A horrible day for stocks: -20%

I don't want to confuse volatility with risk since Bonds have had worse 20 year+ runs than stocks, 1940 - 1980 was pretty miserable, but this is why "bond bubble" sounds so funny. A bubble is a mania where prices are driven to extremes and then there is a sudden collapse, bonds don't seem to work that way. The 40 year decline in bonds was so gradual one would have a hard time noticing it except once inflation really picked up.

Bonds could be primed for another bad 40 years, but that is not the same as a bubble and is also completely unknowable at this time. (Trying to predict future interest rates or inflation is more difficult than most things we attempt to predict. One would have better luck forecasting climate change on a supercomputer or even predicting earthquakes.)
40 years :shock:
So why rebalance with more bond funds?
Because bonds might match inflation, after taxes, with minimal volatility, and that is all many of us expect of them.

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Re: What is a “bond bubble”?

Post by z3r0c00l » Mon Oct 09, 2017 6:49 am

Kevin M wrote:
Sun Oct 08, 2017 2:35 pm
peterinjapan wrote:
Sun Oct 08, 2017 3:11 am
What would a “deflating” be like to those of us holding broad index funds including investment grade corporate bonds?
The 7-year yield on 2/27/1987 was 7.00%, and on 9/30/1987 it was 9.50%: https://fred.stlouisfed.org/graph/?g=flfS. That would have resulted in a capital return of about -11.8% and an income return of about 4.1%, for a total return of about -7.7%.

I think it's worth noting that since yields are much lower than they were in 1987, the income component of the return would have a smaller positive contribution to the total return. Also, with a much lower coupon rate, the duration of a 7-year bond is longer than it was in 1987, so the negative capital return component would be larger.

The 7-year yield is 2.20%: Daily Treasury Yield Curve Rates. A yield increase of 2.5 percentage points to 4.7% over seven months would result in a capital return of -13.7% and an income return of about 1.3%, for a total return of about -12.4%.

So we have to be a little bit careful about applying historical bond fund results when yields were higher to today's much lower yield environment.

Kevin
However none of this even approaches bubble territory as the term is normally used. If bonds lost 90% of their value in a year, that would approximate what it means to burst a bubble. A hypothetical -12% for the year, a record bad year for bonds, would still be a better year than several in living memory for stocks.

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Re: What is a “bond bubble”?

Post by Greg in Idaho » Mon Oct 09, 2017 8:46 am

in discussing a bond fund...if something shakes investors psychology and they decide to all get out of VBTLX, can't we have share prices decoupled from the value of the underlying bonds? And if we add in the opposite prior to this...with prices being bid up, then followed by a drop, couldn't that be bubble-like? :confused

How likely this is to occur, or whether anything like it is on the horizon now, seems to be another story...

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Re: What is a “bond bubble”?

Post by longinvest » Mon Oct 09, 2017 8:57 am

Greg in Idaho wrote:
Mon Oct 09, 2017 8:46 am
in discussing a bond fund...if something shakes investors psychology and they decide to all get out of VBTLX, can't we have share prices decoupled from the value of the underlying bonds? And if we add in the opposite prior to this...with prices being bid up, then followed by a drop, couldn't that be bubble-like? :confused

How likely this is to occur, or whether anything like it is on the horizon now, seems to be another story...
Just for fun, let's say that the NAV a total-market investment-grade bond fund with the following averages (3% coupon, 2% yield to maturity, and 10 years maturity) dropped 90%. This would mean that the yield to maturity has gone up to 39.5%.

Don't you think that some investors might buy in before the yield is up to 39%? Can you imagine an annual 39% return on your money for 10 years?!
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Re: What is a “bond bubble”?

Post by njboater74 » Mon Oct 09, 2017 10:00 am

peterinjapan wrote:
Sun Oct 08, 2017 11:44 am
livesoft wrote:
Sun Oct 08, 2017 4:36 am
That makes me think then that a ladder of individual bonds might be superior for capital preservation than a bond fund.
One thing I know about Bogleheads is that they strongly dislike buying bonds directly.
It depends on the type of bond. For Treasuries and CDs, where there is no diversification benefit from a fund, many prefer to buy directly.
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Re: What is a “bond bubble”?

Post by longinvest » Mon Oct 09, 2017 10:03 am

njboater74 wrote:
Mon Oct 09, 2017 10:00 am
It depends on the type of bond. For Treasuries and CDs, where there is no diversification benefit from a fund, many prefer to buy directly.
On the contrary, there's a lot of diversification benefit for a Treasuries fund over a single Treasury bond! While Treasuries have (practically) no credit risk, they have interest-rate risk. Diversifying across a wide range of issues and maturities is quite beneficial to dampen interest-rate risk.
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Re: What is a “bond bubble”?

Post by njboater74 » Mon Oct 09, 2017 10:08 am

longinvest wrote:
Mon Oct 09, 2017 10:03 am
njboater74 wrote:
Mon Oct 09, 2017 10:00 am
It depends on the type of bond. For Treasuries and CDs, where there is no diversification benefit from a fund, many prefer to buy directly.
On the contrary, there's a lot of diversification benefit for a Treasuries fund over a single Treasury bond! While Treasuries have (practically) no credit risk, they have interest-rate risk. Diversifying across a wide range of issues and maturities is quite beneficial to dampen interest-rate risk.
You are correct, I should have clarified that there is no diversification benefit from a credit perspective.
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Re: What is a “bond bubble”?

Post by patrick013 » Mon Oct 09, 2017 12:11 pm

One senior government analyst sees the 1% spread of TRSY 10 over
the FFR to continue indefinitely due to high demand. Doesn't matter
if the FFR is 1% or 3%. Due to high demand.

Treasury notes and bonds held by investors are expected to reach 100%
of GDP in just a few years. Other countries may have their government
bonds held by investors at 10% of their countries' GDP and may provide
better yield but at greater overall risk of course. Smaller economies
as well.
age in bonds, buy-and-hold, 10 year business cycle

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Re: What is a “bond bubble”?

Post by Doc » Mon Oct 09, 2017 12:26 pm

patrick013 wrote:
Mon Oct 09, 2017 12:11 pm
One senior government analyst sees the 1% spread of TRSY 10 over
the FFR to continue indefinitely due to high demand. Doesn't matter
if the FFR is 1% or 3%. Due to high demand.

Treasury notes and bonds held by investors are expected to reach 100%
of GDP in just a few years. Other countries may have their government
bonds held by investors at 10% of their countries' GDP and may provide
better yield but at greater overall risk of course. Smaller economies
as well.
Image
https://fred.stlouisfed.org/graph/?grap ... 48&rn=8795

"Ted spread is the price difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars having identical expiration months."

Read more: Ted Spread http://www.investopedia.com/terms/t/ted ... z4v25robLX
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Re: What is a “bond bubble”?

Post by Kevin M » Mon Oct 09, 2017 1:32 pm

Greg in Idaho wrote:
Mon Oct 09, 2017 8:46 am
in discussing a bond fund...if something shakes investors psychology and they decide to all get out of VBTLX, can't we have share prices decoupled from the value of the underlying bonds?
I don't see how, since the share price is the per share NAV, which is based on the prices of the bonds. Of course if lots of shareholders decide to sell their shares, that could contribute to downward pressure on prices, but that's not a decoupling of share price and underlying bond value.

For a bond ETF this can happen to some extent though, since ETF shares trade at a market price that can be different than the NAV (and usually is to some extent). A few years ago we saw this with some muni bond ETFs, and some of us took advantage of it by buying shares where the market price was abnormally below the NAV, and then selling the shares when the spread returned to more normal levels. It think that there's a limit on how far this can go though, due to the creation unit arbitrage mechanism.

Kevin
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Re: What is a “bond bubble”?

Post by Kevin M » Mon Oct 09, 2017 1:44 pm

z3r0c00l wrote:
Mon Oct 09, 2017 6:49 am
Kevin M wrote:
Sun Oct 08, 2017 2:35 pm
peterinjapan wrote:
Sun Oct 08, 2017 3:11 am
What would a “deflating” be like to those of us holding broad index funds including investment grade corporate bonds?
The 7-year yield on 2/27/1987 was 7.00%, and on 9/30/1987 it was 9.50%: https://fred.stlouisfed.org/graph/?g=flfS. That would have resulted in a capital return of about -11.8% and an income return of about 4.1%, for a total return of about -7.7%.

I think it's worth noting that since yields are much lower than they were in 1987, the income component of the return would have a smaller positive contribution to the total return. Also, with a much lower coupon rate, the duration of a 7-year bond is longer than it was in 1987, so the negative capital return component would be larger.

The 7-year yield is 2.20%: Daily Treasury Yield Curve Rates. A yield increase of 2.5 percentage points to 4.7% over seven months would result in a capital return of -13.7% and an income return of about 1.3%, for a total return of about -12.4%.

So we have to be a little bit careful about applying historical bond fund results when yields were higher to today's much lower yield environment.

Kevin
However none of this even approaches bubble territory as the term is normally used. If bonds lost 90% of their value in a year, that would approximate what it means to burst a bubble. A hypothetical -12% for the year, a record bad year for bonds, would still be a better year than several in living memory for stocks.
I was only trying to answer the question with actual numbers. I'm not too interested in participating in the subjective discussion about what a bond bubble is, but I don't think most people have stock-level declines in mind when they use the term with respect to high-quality, intermediate-term bonds.

Kevin
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Re: What is a “bond bubble”?

Post by Greg in Idaho » Tue Oct 10, 2017 4:40 pm

Kevin M wrote:
Mon Oct 09, 2017 1:32 pm
Greg in Idaho wrote:
Mon Oct 09, 2017 8:46 am
in discussing a bond fund...if something shakes investors psychology and they decide to all get out of VBTLX, can't we have share prices decoupled from the value of the underlying bonds?
I don't see how, since the share price is the per share NAV, which is based on the prices of the bonds. Of course if lots of shareholders decide to sell their shares, that could contribute to downward pressure on prices, but that's not a decoupling of share price and underlying bond value.

For a bond ETF this can happen to some extent though, since ETF shares trade at a market price that can be different than the NAV (and usually is to some extent). A few years ago we saw this with some muni bond ETFs, and some of us took advantage of it by buying shares where the market price was abnormally below the NAV, and then selling the shares when the spread returned to more normal levels. It think that there's a limit on how far this can go though, due to the creation unit arbitrage mechanism.

Kevin
thanks much for washing that window

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Re: What is a “bond bubble”?

Post by visualguy » Wed Oct 11, 2017 11:30 am

There's definitely a lot of concern about bonds:

https://www.cnbc.com/2017/10/06/wealth- ... etime.html

I mostly stay away from bond index funds. I don't want to take risk with the non-stock part of my portfolio. Stable value funds and CDs work as alternatives for me.

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Re: What is a “bond bubble”?

Post by longinvest » Wed Oct 11, 2017 11:55 am

visualguy wrote:
Wed Oct 11, 2017 11:30 am
There's definitely a lot of concern about bonds:

https://www.cnbc.com/2017/10/06/wealth- ... etime.html

I mostly stay away from bond index funds. I don't want to take risk with the non-stock part of my portfolio. Stable value funds and CDs work as alternatives for me.
I wouldn't listen to the CNBC noise. I would take time to learn about the mathematics of a bond fund, instead.

Here's an exercise I did a while back to convince myself that a total-market bond index fund is nothing like a total-market stock index fund. I simply simulated what would happen if historical interest rates from 1999 to 2016 were to play in reverse from 2017 to 2033. Here's what I got:
longinvest wrote:
Sun Oct 02, 2016 6:52 pm
Using our Bond Fund Simulator, I ran a simulation to see what would happen if historical yields from 1999 to 2016 (based on FRED data) were to play in reverse.

But, before I run the "reverse yield sequence" simulation, here's the result of a bond fund simulation using (normal sequence) historical yields compared to Vanguard's Total Bond Market index fund:
Image

I hope you'll agree that our simulator seems good enough to get a rough idea of what happens to bonds given a sequence of annual yields.

So, what would happen if in 2017, yields were identical to 2015, yields in 2018 identical to 2014, and so on? Here's the result of the simulation:
Image

In the reverse simulation, most annual returns were positive. The worst annual return was -3.46 in 2023 (2009), followed by another negative return of -3.20 in 2024 (2008), for a cumulative 2-year drawdown of -6.54%, which is recovered from in 2027 (2005). On the positive side, from 2025 (2007) to 2027 (2005), there was a three-year sequence of returns higher than +6%. There were various years with returns of +7.17%, +8.80%, and even +15.60%.

That's what a bear market could look like, in bonds.
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Re: What is a “bond bubble”?

Post by visualguy » Wed Oct 11, 2017 12:16 pm

longinvest wrote:
Wed Oct 11, 2017 11:55 am
I wouldn't listen to the CNBC noise. I would take time to learn about the mathematics of a bond fund, instead.

Here's an exercise I did a while back to convince myself that a total-market bond index fund is nothing like a total-market stock index fund. I simply simulated what would happen if historical interest rates from 1999 to 2016 were to play in reverse from 2017 to 2033. Here's what I got:
There's also something about waiting 2*d-1 years, where d is the duration of the bond fund (so over a decade of waiting for typical intermediate term funds). If you wait that long, you will get the original yield even if interest rates go up.

Anyway, I don't see the point with messing with all that... I find it very hard to understand and assess the future behavior of bond index funds. For example, any reason to believe you would do better than in a CD ladder of staggered 5-year CDs?

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Re: What is a “bond bubble”?

Post by Doc » Wed Oct 11, 2017 1:20 pm

longinvest wrote:
Wed Oct 11, 2017 11:55 am
That's what a bear market could look like, in bonds.
You need to look at price not total returns to determine what a bear looks like.
What is a 'Bear Market'
A bear market is a condition in which securities prices fall and widespread pessimism causes the stock market's downward spiral to be self-sustaining. Investors anticipate losses as pessimism and selling increases.
Read more: Bear Market http://www.investopedia.com/terms/b/bea ... z4vDyj87Ma

FWIW in stocks it's usually a 20% downturn.

Here's a price chart that you can judge for yourself what a bond correction (10% drop) might look like. Go to the link and move the slider around to different periods to get a better feel for what might happen.


Image

http://quotes.morningstar.com/chart/fun ... 2%3A955%7D

Since we all :twisted: rebalance when the markets are in turmoil we are going to be buying or selling bonds in the short term and long term total return averages don't give us a good picture.
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Re: What is a “bond bubble”?

Post by longinvest » Wed Oct 11, 2017 1:32 pm

visualguy wrote:
Wed Oct 11, 2017 12:16 pm
longinvest wrote:
Wed Oct 11, 2017 11:55 am
I wouldn't listen to the CNBC noise. I would take time to learn about the mathematics of a bond fund, instead.

Here's an exercise I did a while back to convince myself that a total-market bond index fund is nothing like a total-market stock index fund. I simply simulated what would happen if historical interest rates from 1999 to 2016 were to play in reverse from 2017 to 2033. Here's what I got:
There's also something about waiting 2*d-1 years, where d is the duration of the bond fund (so over a decade of waiting for typical intermediate term funds). If you wait that long, you will get the original yield even if interest rates go up.

Anyway, I don't see the point with messing with all that... I find it very hard to understand and assess the future behavior of bond index funds. For example, any reason to believe you would do better than in a CD ladder of staggered 5-year CDs?
Where's the so-called waiting in the chart (reproduced below)? I don't see it. Let's not forget, too, that this was a purely hypothetical simulation which assumed that yields will perfectly play in reverse, illustrating a scenario feared by many investors.

Image

A 5-year CD ladder isn't comparable to a total-market bond fund; it's comparable to a short-term bond fund of similar duration* (approximately 2.5 years).

Also, it would be a mistake to compare the yield-to-maturity (YTM) of a short-term bond fund to the rate on a single 5-year CD. A better (yet imperfect) comparison would first calculate the average YTM of the CD ladder, taking into account current 1-year, 2-years, 3-years, 4-years, and 5-years CD rates, and then compare this CD ladder average YTM to the bond fund's YTM. But, even then, one would be comparing a fully liquid and convenient-to-trade fund to a somewhat-illiquid cash investment with many inconveniences (due to needing to move money from bank to bank, chasing the highest yield, when reinvesting maturing CDs).

There's nothing wrong with CDs and other cash investments. But, the fact that cash investments don't fluctuate in value doesn't make bonds a bad investment. Government and high-quality corporate bonds fluctuate in value, but their value necessarily matures at par. And, these bonds keep paying bi-annual coupons until maturity. So, even if every individual bond, in a bond fund, fluctuates in value, shorter bonds (which make up a significant portion of Vanguard's Total Bond Market Index Fund) significantly dampen the fluctuations of longer-maturity bonds. When coupons are taken into account, to calculate total returns, this results in most annual returns being positive, for this total-market bond index fund with an average maturity of only 8.3 years and average duration of 6.1 years. When negative annual returns happen, coupons significantly limit the losses. In its history, the worst ever annual return of Vanguard's Total Bond Market Index Fund was -2.66 in 1994 an event that some bond investors called a bond massacre. My stocks sometimes lose more in a single day (on a total-return basis).

* Duration can be defined as the average maturity of all individual payments, including coupons and principals, in a bond fund.
Last edited by longinvest on Wed Oct 11, 2017 2:06 pm, edited 1 time in total.
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Re: What is a “bond bubble”?

Post by Doc » Wed Oct 11, 2017 1:46 pm

longinvest wrote:
Wed Oct 11, 2017 1:32 pm
There's nothing wrong with CDs and other cash investments. But, the fact that cash investments don't fluctuate in value doesn't make bonds a bad investment.
Moreover the fact that (Treasury) bonds do fluctuate in value and that value often increases during a stock market bear may make them better than CDs if you consider your portfolio holistically and not at just at its individual parts in isolation.
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