Bonds Are Riskier Than People Think

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hoops777
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Re: Bonds Are Riskier Than People Think

Post by hoops777 » Fri Dec 01, 2017 7:14 pm

avalpert wrote:
Fri Dec 01, 2017 6:57 pm
hoops777 wrote:
Fri Dec 01, 2017 6:45 pm
Because I was annoyed that the poster said it was not an investment when by any reasonable definition of what an investment is,it is an investment.Thats all,now go write your book :D
A reasonable definition of an investment is where you put capital at risk with the expectation of future return - does a CD meet that definition?
Yes it does to me.Does anyone put money into anything without expectation of future return?I noticed you did not say future return beyond inflation.Even if I put it into something short term I still have expectations.I am not doing it to lose money.
Treasuries are considered investments,no?Cd’s have been better than treasuries.Like I said,I guess it depends on the individuals objective.
K.I.S.S........so easy to say so difficult to do.

dbr
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Re: Bonds Are Riskier Than People Think

Post by dbr » Fri Dec 01, 2017 7:23 pm

hoops777 wrote:
Fri Dec 01, 2017 7:14 pm
avalpert wrote:
Fri Dec 01, 2017 6:57 pm
hoops777 wrote:
Fri Dec 01, 2017 6:45 pm
Because I was annoyed that the poster said it was not an investment when by any reasonable definition of what an investment is,it is an investment.Thats all,now go write your book :D
A reasonable definition of an investment is where you put capital at risk with the expectation of future return - does a CD meet that definition?
Yes it does to me.Does anyone put money into anything without expectation of future return?I noticed you did not say future return beyond inflation.Even if I put it into something short term I still have expectations.I am not doing it to lose money.
Treasuries are considered investments,no?Cd’s have been better than treasuries.Like I said,I guess it depends on the individuals objective.
This is fun. In this case the capital is not at risk. At least it is not at risk unless we consider negative real return to be putting the capital at risk. I think I am going to go with a CD is not an investment by that definition. Of course Treasuries are different because they are marketable and at a risk one cannot retrieve the purchase price if we sell. For completeness I am not sure where possible lack of liquidity (inability to redeem the CD before term or with a penalty) should allow us to say the CD is at risk. But I don't think so because those terms are known with certainty beforehand and risk has to have an element of uncertainty, as we have all been told many times.

sjwoo
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Re: Bonds Are Riskier Than People Think

Post by sjwoo » Fri Dec 01, 2017 9:54 pm

If your withdrawal rate is 2% and your five-year laddered CDs are producing 2.5%, then I think it's more than reasonable to categorize the CDs as a positive income producing instrument, no?

Of course, if inflation keeps rising and your CDs stay locked at 2.5%, you'll be in trouble, but don't CD rates of a five year or greater duration always outpace inflation? Seems like the only danger with CDs is a sudden, violent rise in inflation, but if that were to occur, I'd think there would be downstream issues for many classes of equities.

hoops777
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Re: Bonds Are Riskier Than People Think

Post by hoops777 » Fri Dec 01, 2017 10:09 pm

dbr wrote:
Fri Dec 01, 2017 7:23 pm
hoops777 wrote:
Fri Dec 01, 2017 7:14 pm
avalpert wrote:
Fri Dec 01, 2017 6:57 pm
hoops777 wrote:
Fri Dec 01, 2017 6:45 pm
Because I was annoyed that the poster said it was not an investment when by any reasonable definition of what an investment is,it is an investment.Thats all,now go write your book :D
A reasonable definition of an investment is where you put capital at risk with the expectation of future return - does a CD meet that definition?
Yes it does to me.Does anyone put money into anything without expectation of future return?I noticed you did not say future return beyond inflation.Even if I put it into something short term I still have expectations.I am not doing it to lose money.
Treasuries are considered investments,no?Cd’s have been better than treasuries.Like I said,I guess it depends on the individuals objective.
This is fun. In this case the capital is not at risk. At least it is not at risk unless we consider negative real return to be putting the capital at risk. I think I am going to go with a CD is not an investment by that definition. Of course Treasuries are different because they are marketable and at a risk one cannot retrieve the purchase price if we sell. For completeness I am not sure where possible lack of liquidity (inability to redeem the CD before term or with a penalty) should allow us to say the CD is at risk. But I don't think so because those terms are known with certainty beforehand and risk has to have an element of uncertainty, as we have all been told many times.
Ok.He snuck in putting capital at risk,which went right by me.I have seen 5 actual definitions,as in dictionaries.None say anything about putting money at risk.The definitions are more like the outlay of money for income or profit.So the common definition is not what avalpert presented.
You can get really cute with this and play games,but if a person buys a cd for income or profit,they are investing.There are a lot of very well respected bogleheads who have made posts about buying CDs over treasuries because of higher yields.Do not tell me they were not investing by buying the higher yielding cd but would have been if they bought the treasury.I recall Mr.Swedroe on numerous occasions recommending investing in CDs over lower yielding treasuries.
K.I.S.S........so easy to say so difficult to do.

Theoretical
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Re: Bonds Are Riskier Than People Think

Post by Theoretical » Fri Dec 01, 2017 11:43 pm

I think one distinction here is the difference between a bank CD (non-negotiable with a discretionary early withdrawal and penalty) vs a brokered CD (fully negotiable but instead of the penalty you get skewered by the bond spread - which can be your reward when buying odd lots in the secondary market). The former is still an investment but has some caveats attached to it that make it a bit shakier.

Now this distinction doesn't hold for a high yield savings account vs a t-bill or money market fund, as both are eminently liquid as well as interest-bearing. And (interest-bearing) cash is an asset class that historically tracks inflation fairly steadily as interest rates rise to halt the flames.

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dm200
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Re: Bonds Are Riskier Than People Think

Post by dm200 » Sat Dec 02, 2017 12:31 pm

Theoretical wrote:
Fri Dec 01, 2017 11:43 pm
I think one distinction here is the difference between a bank CD (non-negotiable with a discretionary early withdrawal and penalty) vs a brokered CD (fully negotiable but instead of the penalty you get skewered by the bond spread - which can be your reward when buying odd lots in the secondary market). The former is still an investment but has some caveats attached to it that make it a bit shakier.
Now this distinction doesn't hold for a high yield savings account vs a t-bill or money market fund, as both are eminently liquid as well as interest-bearing. And (interest-bearing) cash is an asset class that historically tracks inflation fairly steadily as interest rates rise to halt the flames.
Yes. And I can think of a similar word than skewered

I do like brokered CDs a lot, and are fine -- as long as you fully understand the risks and disadvantages.

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nisiprius
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Re: Bonds Are Riskier Than People Think

Post by nisiprius » Sat Dec 02, 2017 1:43 pm

JBTX wrote:
Thu Nov 30, 2017 3:39 pm
...I wanted to look at this longer term, but obviously this fund didn't exist much before this. As a proxy I found this data on 10 year T bonds, which I would assume would be a bit more volatile than your typical bond market with higher duration, but nonetheless serves as a rough proxy.

http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

At first, I was surprised to find that the 10 years didn't get killed in the late 70's and early 80's as expected, although they had low returns. However, I assume these are nominal returns, and the real returns were significantly worse...
YES to both. You are exactly right. I never seem to be able to communicate this clearly because so many people want a simplistic "bonds are great" or "bonds suck" story.

The late 70's were one of the worst times for both bonds and stocks in real terms, due to high inflation. The two periods of high inflation following World War II and the Vietnam War each were bad for bonds; you can look it up for different bond flavors, but think 50% loss of real value over 1940-1980. Cue standard argument, "inflation risk in nominal bonds is serious/But TIPS exist/But I don't like TIPS."

What you've seen for yourself is that fear of a stock-market-like scale crash in dollar value, due to interest rises, seems to be grossly exaggerated (for ordinary investors in "core" bond mutual funds).

In nominal, number-of-dollars terms, the interest rise from 1940 to 1980 was gradual enough that a total return, growth chart for bonds generally shows headwinds (slower growth), not losses. That of course depends on the details of how fast the interest rate rises. The usual "rise x duration = %loss" basically assumes an instantaneous rise. It is often overlooked that (again, in total return with reinvested coupon interest) a gradual interest rate rise may not result in any actual losses at all, and the historic rise from 1% to 16% from 1940 to 1980, i.e. less than 0.5%/year average, is irregular but low enough so that it mostly didn't create losses.

And you can see this in a few real-world bond mutual funds. For example, FBNDX up to 1980. Not great, and there a 10% drop in 1974 and a 13% drop in 1979, but in terms of nominal dollars the "rising interest rate regime" was not enough to stop the fund from making money over 1971-1981. Surely lots of other investments did much better, but it isn't like 2008-2009 in stocks or 2000-2002 in the NASDAQ Composite.

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CWRadio
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Re: Bonds Are Riskier Than People Think

Post by CWRadio » Sat Dec 02, 2017 2:51 pm

I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul

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Re: Bonds Are Riskier Than People Think

Post by spdoublebass » Sat Dec 02, 2017 2:57 pm

CWRadio wrote:
Sat Dec 02, 2017 2:51 pm
I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul
I think the answer to the first part of your question of if you put $1000 into a 5 year CD yielding 2.5% a year you'd end up with $1133.

The answer to your second question I don't know. I've been following this thread to learn more about this stuff.
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Re: Bonds Are Riskier Than People Think

Post by JBTX » Sat Dec 02, 2017 4:59 pm

spdoublebass wrote:
Sat Dec 02, 2017 2:57 pm
CWRadio wrote:
Sat Dec 02, 2017 2:51 pm
I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul
I think the answer to the first part of your question of if you put $1000 into a 5 year CD yielding 2.5% a year you'd end up with $1133.
While the nominal dollar value will not vary, the economic / real inflation dollar amount of that 1133 will. If inflation shoots up to 5% that 1133 will be worth a lot less.

The answer to your second question I don't know. I've been following this thread to learn more about this stuff.

Depends on the note. Let’s say a five year treasury note. You will get the $1000 at the end of 5 years and you will get $18 of interest for 5 years. Those are known. What is not known is what the return will be on the $18 reinvested every year. It could be less than or greater than 1.8% depending which way interest rates move.

People seem to think CDs are more “safe” because they know exactly the nominal terminal value when it matures. But even though the nominal value of the treasury note will vary slightly, the economic/real
value of the tnote will like vary less than the CD.

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Re: Bonds Are Riskier Than People Think

Post by JBTX » Sat Dec 02, 2017 5:46 pm

nisiprius wrote:
Sat Dec 02, 2017 1:43 pm
JBTX wrote:
Thu Nov 30, 2017 3:39 pm
...I wanted to look at this longer term, but obviously this fund didn't exist much before this. As a proxy I found this data on 10 year T bonds, which I would assume would be a bit more volatile than your typical bond market with higher duration, but nonetheless serves as a rough proxy.

http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

At first, I was surprised to find that the 10 years didn't get killed in the late 70's and early 80's as expected, although they had low returns. However, I assume these are nominal returns, and the real returns were significantly worse...
YES to both. You are exactly right. I never seem to be able to communicate this clearly because so many people want a simplistic "bonds are great" or "bonds suck" story.
Thanks! Nice to know I occasionally get one right.

The late 70's were one of the worst times for both bonds and stocks in real terms, due to high inflation. The two periods of high inflation following World War II and the Vietnam War each were bad for bonds; you can look it up for different bond flavors, but think 50% loss of real value over 1940-1980. Cue standard argument, "inflation risk in nominal bonds is serious/But TIPS exist/But I don't like TIPS."
Lots to unpack here. First I’ll say that when people think of the benefits of bonds they tend to think of what happened in 2007 and other similar economic and/or speculative driven stock market drops. In those cases bonds actually have a brief negative correlation with stocks which helps cushion the stock market losses. I don’t think they are thinking about the long periods over many years where they may be losing substantial REAL inflation adj dollars. We haven’t had inflation for so long nobody really thinks about it. These real losses tend to be over many years and as you indicate may not even manifest themselves as nominal losses. But ultimately nominal dollars are irrelevant but that is what people focus on, just like people’s preference for CDs vs short term bonds even though short term bonds are likely less risky in real terms.

As to the “but I don’t like TIPS” I have seen that too but I really don’t get it. It is true that TIPS won’t give you the cushion like traditional bonds in a 2007 like scenario but Tips would have held up much better in a late 70s situation. Thus why I like having both TIPS and traditional bonds.

What you've seen for yourself is that fear of a stock-market-like scale crash in dollar value, due to interest rises, seems to be grossly exaggerated (for ordinary investors in "core" bond mutual funds).

In nominal, number-of-dollars terms, the interest rise from 1940 to 1980 was gradual enough that a total return, growth chart for bonds generally shows headwinds (slower growth), not losses. That of course depends on the details of how fast the interest rate rises. The usual "rise x duration = %loss" basically assumes an instantaneous rise. It is often overlooked that (again, in total return with reinvested coupon interest) a gradual interest rate rise may not result in any actual losses at all, and the historic rise from 1% to 16% from 1940 to 1980, i.e. less than 0.5%/year average, is irregular but low enough so that it mostly didn't create losses.

And you can see this in a few real-world bond mutual funds. For example, FBNDX up to 1980. Not great, and there a 10% drop in 1974 and a 13% drop in 1979, but in terms of nominal dollars the "rising interest rate regime" was not enough to stop the fund from making money over 1971-1981. Surely lots of other investments did much better, but it isn't like 2008-2009 in stocks or 2000-2002 in the NASDAQ Composite.

Source

Image
Sorry but not exactly sure what point you are trying to make here. I’m probably being dense. Not sure what you mean about the risk of stock market crash being exaggerated, and in terms of your graph I would largely look at it as irrelevant because the same graph in inflation adjusted dollars would have told a dramatically different story.

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Re: Bonds Are Riskier Than People Think

Post by Buddtholomew » Sat Dec 02, 2017 6:49 pm

Never bought into the argument that you are losing to inflation while having fixed income allocation in cash or CD’s. Look at your portfolio as a whole and if the rest is invested in cash and CD’s then MAYBE you have a point over an extended period of time.

Holding 25% in equities and the balance in cash or CD’s SHOULD be sufficient to outpace inflation.

TL;DR Look at your portfolio as a whole.
"The first principle is that you must not fool yourself and you are the easiest person to fool" --Feynman.

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Re: Bonds Are Riskier Than People Think

Post by CWRadio » Sat Dec 02, 2017 6:56 pm

JBTX wrote:
Sat Dec 02, 2017 4:59 pm
spdoublebass wrote:
Sat Dec 02, 2017 2:57 pm
CWRadio wrote:
Sat Dec 02, 2017 2:51 pm
I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul
I think the answer to the first part of your question of if you put $1000 into a 5 year CD yielding 2.5% a year you'd end up with $1133.
While the nominal dollar value will not vary, the economic / real inflation dollar amount of that 1133 will. If inflation shoots up to 5% that 1133 will be worth a lot less.

The answer to your second question I don't know. I've been following this thread to learn more about this stuff.

Depends on the note. Let’s say a five year treasury note. You will get the $1000 at the end of 5 years and you will get $18 of interest for 5 years. Those are known. What is not known is what the return will be on the $18 reinvested every year. It could be less than or greater than 1.8% depending which way interest rates move.

People seem to think CDs are more “safe” because they know exactly the nominal terminal value when it matures. But even though the nominal value of the treasury note will vary slightly, the economic/real
value of the tnote will like vary less than the CD.
One additional point. If interest rates go up (inflation is 0%) I understand the NAV of the bond fund goes down. So how do you do this calculation if you sell the bond fund after 5 years? What would you get? Paul

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Re: Bonds Are Riskier Than People Think

Post by siamond » Sat Dec 02, 2017 7:37 pm

JBTX wrote:
Thu Nov 30, 2017 3:39 pm
I wanted to look at this longer term, but obviously this fund didn't exist much before this. As a proxy I found this data on 10 year T bonds, which I would assume would be a bit more volatile than your typical bond market with higher duration, but nonetheless serves as a rough proxy.

http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

At first, I was surprised to find that the 10 years didn't get killed in the late 70's and early 80's as expected, although they had low returns. However, I assume these are nominal returns, and the real returns were significantly worse.

In most of the cases where you had a one bad bond year (typically less than 10% loss) the next year it bounced back. The expection was 1977-1980 where you had 4 years of practically zero nominal returns at a time when inflation was well above average, and the CPI from 77-80 was probably around 50%. So I am guessing in real terms 10 year T bills lost 30-40% from 1977-1980.
The way Prof. Damodaran derived bond returns from historical interest rates is a bit simplistic, and doesn't represent the dynamics of a bond fund (same thing for the SBBI book, by the way). The synthetic model we used in the Simba spreadsheet seems closer to what would have happened to a bond fund, but... I am splitting hairs... as your guess is quite correct.

When I ran the math with Simba, I found a loss of 36% in real terms for IT treasuries between 1977 and 1980. Note that the loss continued in 1981 with -4%. So yes, a 40%-ish loss of purchasing power over a period of 5 years. If that doesn't make people understand that, yes, (regular) treasury bonds can be very risky, I don't know what would. And yet, there is an incredible amount of denial about this topic, with very knowledgeable posters on this forum only considering nominal returns, and totally ignoring that one's purchasing power is a REAL quantity. Why the denial when facts are so clear? Beats me.

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Re: Bonds Are Riskier Than People Think

Post by JBTX » Sat Dec 02, 2017 8:03 pm

CWRadio wrote:
Sat Dec 02, 2017 6:56 pm
JBTX wrote:
Sat Dec 02, 2017 4:59 pm
spdoublebass wrote:
Sat Dec 02, 2017 2:57 pm
CWRadio wrote:
Sat Dec 02, 2017 2:51 pm
I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul
I think the answer to the first part of your question of if you put $1000 into a 5 year CD yielding 2.5% a year you'd end up with $1133.
While the nominal dollar value will not vary, the economic / real inflation dollar amount of that 1133 will. If inflation shoots up to 5% that 1133 will be worth a lot less.

The answer to your second question I don't know. I've been following this thread to learn more about this stuff.

Depends on the note. Let’s say a five year treasury note. You will get the $1000 at the end of 5 years and you will get $18 of interest for 5 years. Those are known. What is not known is what the return will be on the $18 reinvested every year. It could be less than or greater than 1.8% depending which way interest rates move.

People seem to think CDs are more “safe” because they know exactly the nominal terminal value when it matures. But even though the nominal value of the treasury note will vary slightly, the economic/real
value of the tnote will like vary less than the CD.
One additional point. If interest rates go up (inflation is 0%) I understand the NAV of the bond fund goes down. So how do you do this calculation if you sell the bond fund after 5 years? What would you get? Paul
Not sure how to answer your question. A bond fund is a bit different, in that you have many securities maturing at many different times. But simplistically, if interest rates go up, the immediate value of the bond fund goes down. But then going forward the annual return will be higher

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Re: Bonds Are Riskier Than People Think

Post by JBTX » Sat Dec 02, 2017 8:07 pm

siamond wrote:
Sat Dec 02, 2017 7:37 pm
JBTX wrote:
Thu Nov 30, 2017 3:39 pm
I wanted to look at this longer term, but obviously this fund didn't exist much before this. As a proxy I found this data on 10 year T bonds, which I would assume would be a bit more volatile than your typical bond market with higher duration, but nonetheless serves as a rough proxy.

http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html

At first, I was surprised to find that the 10 years didn't get killed in the late 70's and early 80's as expected, although they had low returns. However, I assume these are nominal returns, and the real returns were significantly worse.

In most of the cases where you had a one bad bond year (typically less than 10% loss) the next year it bounced back. The expection was 1977-1980 where you had 4 years of practically zero nominal returns at a time when inflation was well above average, and the CPI from 77-80 was probably around 50%. So I am guessing in real terms 10 year T bills lost 30-40% from 1977-1980.
The way Prof. Damodaran derived bond returns from historical interest rates is a bit simplistic, and doesn't represent the dynamics of a bond fund (same thing for the SBBI book, by the way). The synthetic model we used in the Simba spreadsheet seems closer to what would have happened to a bond fund, but... I am splitting hairs... as your guess is quite correct.

When I ran the math with Simba, I found a loss of 36% in real terms for IT treasuries between 1977 and 1980. Note that the loss continued in 1981 with -4%. So yes, a 40%-ish loss of purchasing power over a period of 5 years. If that doesn't make people understand that, yes, (regular) treasury bonds can be very risky, I don't know what would. And yet, there is an incredible amount of denial about this topic, with very knowledgeable posters on this forum only considering nominal returns, and totally ignoring that one's purchasing power is a REAL quantity. Why the denial when facts are so clear? Beats me.
It is hard to get excited about bonds at 2.4% 10 year. It just seems like there is a lot more downside risk than upside potential, and the diversification potential is less at such low rates. But I have been saying the same thing for about 20 years and have been consistently been wrong. :oops: I still own them - with the caveat that a decent chunk is in TIPS.

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Re: Bonds Are Riskier Than People Think

Post by columbia » Sun Dec 03, 2017 10:07 am

I've seen the phrase bond bubble here many times, in relation to decades of declining interest rates.

Pretend that I don't know anything (and that's not too much of a leap): what is the math behind rising interest rates leading to a lower total return?

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Re: Bonds Are Riskier Than People Think

Post by dbr » Sun Dec 03, 2017 10:20 am

columbia wrote:
Sun Dec 03, 2017 10:07 am
I've seen the phrase bond bubble here many times, in relation to decades of declining interest rates.

Pretend that I don't know anything (and that's not too much of a leap): what is the math behind rising interest rates leading to a lower total return?
See "Duration" in this article: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration

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Re: Bonds Are Riskier Than People Think

Post by columbia » Sun Dec 03, 2017 10:31 am

dbr wrote:
Sun Dec 03, 2017 10:20 am
columbia wrote:
Sun Dec 03, 2017 10:07 am
I've seen the phrase bond bubble here many times, in relation to decades of declining interest rates.

Pretend that I don't know anything (and that's not too much of a leap): what is the math behind rising interest rates leading to a lower total return?
See "Duration" in this article: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration
I could reasonably live another 40 years. In the long run, it seems that bond price and interest movements should be a zero sum situation (excepting inflation effects) for total returns.

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Re: Bonds Are Riskier Than People Think

Post by nisiprius » Sun Dec 03, 2017 10:56 am

columbia wrote:
Sun Dec 03, 2017 10:07 am
I've seen the phrase bond bubble here many times, in relation to decades of declining interest rates.

Pretend that I don't know anything (and that's not too much of a leap): what is the math behind rising interest rates leading to a lower total return?
They don't lead to a lower total return in dollars. A bond is a contract to pay specific numbers of dollars on specific dates (well, many bonds are) and a change in the market rate doesn't change the contract. Assume in ideal bond (Treasuries are close) which won't default and doesn't have any call provisions or anything like that in it.

If a 10-year 2% coupon Treasury note is scheduled to make nineteen payments of $9.95 each on every January 15th and July 15th, then $1,009.95 on January 15th, 2028. Suppose interest rates rise instantly to 4% the day after you buy the bond. Your Treasury note still pays the same numbers of dollars on the same dates, and the rate of return on the bond (if held to maturity) is still 2%. Nothing changes in absolute terms.

What changes is the market value, which in turn is based on math--the calculation of the present value of that stream of payments at the current interest rate. Your bond, which pays $9.95, $9.95, $9.95, ..... $9.95, $1009.95 is now competing in the market against a newly-bought bond which pays $19.80, $19.80, $19.80, ... $19.80, $1019.80. Your bond is going to pay out a grand total of $1,199.00 over its lifetime. A new bond is going to pay $1,396 over its lifetime.

If the interest rate had remained at 2%, your bond would have a stable market value of $1,000 and you could sell it on the market at that price any time you liked.

But if try to sell your bond on the market to someone who knows they can buy a new bond that is going to pay out $1,396, they are certainly not going to pay you $1,000 for your bond, which will only pay out $1,199.00. In a rough conceptual way you might guess that your bond is only worth $1,199/$1,396 or 86% as much as the new 4% bond, and therefore the market value would be $860 instead of $1,000. The actual bond math is more sophisticated and takes compounding into account, and the actual value is $838.57.

1) For many purposes, what is important to you as an investor is to track the bond's market value now. You can get into interesting Zen questions about the value of a bond if you plan to hold it until maturity and never sell it on the market, which get debated endlessly and inconclusively.

2) To a rough first approximation, notice that in our example--using the value $838.57 the interest rate increased by 2%, and the market value = present value of the bond fell by 16.2%. A rate is a rate per year. If we do our math with units the way we do in high school physics, and divide 16.2% by 2% per year, the result is 8.1 years. This number is called the "duration" and it has several interesting aspects, but the basic fact is that the duration tells us the interest rate sensitivity of a bond or bond portfolio. If there is a small instantaneous overnight rise in the interest rate, the market value of the bond temporarily falls by an amount equal to the change in rate times the duration.

Notice that it is not a permanent loss in value, because the bond still makes all of its payments. On the day before it makes its final payment of $1,009.95, its market value will be close to $1,009.95, so the value of the bond must rise from $838.57 to $1,009.95.

3) If the reason for the increase in interest rates in inflation, then regardless of the bond's paying its contractual amounts, it will of course suffer a permanent decrease in real (inflation-adjusted) value, in all ways--the interest payments will be worth less in real value, the final payback of principal will be worth less in real value, and the present value calculation of the bond's market value will be worth less in real value than the number of dollars would indicate.
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Re: Bonds Are Riskier Than People Think

Post by dbr » Sun Dec 03, 2017 11:00 am

columbia wrote:
Sun Dec 03, 2017 10:31 am
dbr wrote:
Sun Dec 03, 2017 10:20 am
columbia wrote:
Sun Dec 03, 2017 10:07 am
I've seen the phrase bond bubble here many times, in relation to decades of declining interest rates.

Pretend that I don't know anything (and that's not too much of a leap): what is the math behind rising interest rates leading to a lower total return?
See "Duration" in this article: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration
I could reasonably live another 40 years. In the long run, it seems that bond price and interest movements should be a zero sum situation (excepting inflation effects) for total returns.
That is exactly right, which is why most of the hysteria over rising interest rates, etc., etc., makes no sense. It is possible to configure a personal situation where one should pay attention, and it is reasonable to understand that bond duration is related to bond volatility.

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Re: Bonds Are Riskier Than People Think

Post by columbia » Sun Dec 03, 2017 11:03 am

Thanks to you both.

I'll continue to not worry about my intermediate term bond fund holdings (outside of inflation). :)

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Re: Bonds Are Riskier Than People Think

Post by nisiprius » Sun Dec 03, 2017 11:09 am

columbia wrote:
Sun Dec 03, 2017 10:31 am
I could reasonably live another 40 years. In the long run, it seems that bond price and interest movements should be a zero sum situation (excepting inflation effects) for total returns.
I agree with you. (I phrase it that way because I expect arguments.) Obviously, "excepting inflation effects" is a big exception.

Note that there is a technical issue--Treasury securities with terms of two to ten years are "notes," not "bonds," and therefore quite a lot of what is written about "bonds" refers to the 20- and 30-year securities, which have much longer durations and much higher interest rate risk.

Note that Vanguard sort of agrees with you, too. Vanguard puts Total Bond, which has a duration of 6.1 years, at "risk level 2" which, they say, "In general, such funds may be appropriate for investors with medium-term investment horizons (four to ten years)."

My summary of the current consensus conventional wisdom--which has been influenced by books such as Jeremy Siegel's "Stocks for the Long Run"--is that a 20-30 year holding period makes stocks a reasonably prudent and safe investment. My personal belief is that funds like Total Bond are likely to be reasonably prudent and safe over holding periods like Vanguard's "four to ten years."
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Re: Bonds Are Riskier Than People Think

Post by UncleLongHair » Sun Dec 03, 2017 11:15 am

I am late to this thread, but I started a similar one not long ago.

viewtopic.php?f=10&t=232550

I agree that the next 10-20 years are likely not going to be good for bonds of anything but short duration. Mid to long term bonds are likely to lose value and the coupons paid today are not sufficient to offset inflation or the decrease in value.

However I'm sure there are bond funds out there with short durations or a different mix of bonds. Depending on the fund it might start to look more like a money market fund (which is really a collection of short bonds). So when people say "bonds" or "bond fund" it really matters which one you're talking about and it's hard to generalize.

The Vanguard Total Bond Fund is often mentioned. This fund is down 4% over the past 5 years and currently yields 2.4%. Many people are happy with this performance and consider it "safe". The only way that this is "safe" to me is if you have so much money that it doesn't actually matter how your investments perform (and if you do, kudos). I honestly don't see how anyone can be comfortable with their money here which is losing value both before and after inflation, without comparing it to equities or other investments. If a 2-3% yield is what you're after, why not buy a S&P 500 index fund which pays that coupon and, statistically, will be higher in 5-10 years?

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Re: Bonds Are Riskier Than People Think

Post by columbia » Sun Dec 03, 2017 11:22 am

The majority of my non-equity holdings are in TIAA traditional RC, which is paying 4.25% these days. That holding addresses (for me and for that portion of my money) the concerns expressed directly above.

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Re: Bonds Are Riskier Than People Think

Post by rbaldini » Sun Dec 03, 2017 11:35 am

UncleLongHair wrote:
Sun Dec 03, 2017 11:15 am
The Vanguard Total Bond Fund is often mentioned. This fund is down 4% over the past 5 years and currently yields 2.4%. Many people are happy with this performance and consider it "safe". The only way that this is "safe" to me is if you have so much money that it doesn't actually matter how your investments perform (and if you do, kudos). I honestly don't see how anyone can be comfortable with their money here which is losing value both before and after inflation, without comparing it to equities or other investments. If a 2-3% yield is what you're after, why not buy a S&P 500 index fund which pays that coupon and, statistically, will be higher in 5-10 years?
I'm confused. Yes, Vanguard Total Bond is 4% cheaper than it was 5 years ago. But the total return during that time was 9.6%, or about 1.8% annual. That's not good, historically speaking, but in total return it's not losing money.

More generally, why the separation of the fund price and the yield? Isn't it total return that matters? I don't get it.

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Re: Bonds Are Riskier Than People Think

Post by willthrill81 » Sun Dec 03, 2017 11:44 am

columbia wrote:
Sun Dec 03, 2017 11:22 am
The majority of my non-equity holdings are in TIAA traditional RC, which is paying 4.25% these days. That holding addresses (for me and for that portion of my money) the concerns expressed directly above.
+1

I think that those with access to such stable value funds (I do as well) are generally very well served by using them in lieu of bonds for the FI portion of their portfolio. Even if it involved sacrificing some return (which is highly unlikely to be the case in the case of TIAA Traditional for a while at least), the predictability and stability of returns is a big plus, particularly for those in the withdrawals phase. Personally, I would currently be more attracted to the TIAA Traditional supplemental account which currently pays 3.25% but offers full liquidity.
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Re: Bonds Are Riskier Than People Think

Post by saltycaper » Mon Dec 04, 2017 5:28 pm

avalpert wrote:
Fri Dec 01, 2017 6:57 pm

A reasonable definition of an investment is where you put capital at risk with the expectation of future return - does a CD meet that definition?
It may be reasonable--who's to say?--but it is not the definition. It is true that if you want to say an element is not part of a set, you can redefine what the set encompasses. That is much easier than trying to awkwardly extricate an element from a set to which it belongs.

Incidentally, I do not have a copy of Avalpert's Dictionary. Is that the book you are writing? I will buy a copy for sure.

Semantics aside, one thing I am sure of: If a CD is not an investment, then there are some non-investments that are superior to investments in accomplishing the goals of investing.
Quod vitae sectabor iter?

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Re: Bonds Are Riskier Than People Think

Post by dbr » Mon Dec 04, 2017 5:30 pm

saltycaper wrote:
Mon Dec 04, 2017 5:28 pm

Semantics aside, one thing I am sure of: If a CD is not an investment, then there are some non-investments that are superior to investments in accomplishing the goals of investing.
Strangely enough that doesn't bother me in the slightest. Who cares what things are called?

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Re: Bonds Are Riskier Than People Think

Post by Phineas J. Whoopee » Mon Dec 04, 2017 5:57 pm

dbr wrote:
Mon Dec 04, 2017 5:30 pm
...
Strangely enough that doesn't bother me in the slightest. Who cares what things are called?
That which we call a nose, by any other name would still smell. *

PJW

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Re: Bonds Are Riskier Than People Think

Post by saltycaper » Mon Dec 04, 2017 6:07 pm

dbr wrote:
Mon Dec 04, 2017 5:30 pm

Who cares what things are called?
In the sense that words are sounds and also appear in written form, probably very few people care about the aesthetics of either, but in the sense that words convey meaning, and shifting meanings often signify cultural changes, the acquisition of power by a group of people, or any number of other humanistic transformations? Probably very few still.

:P
Quod vitae sectabor iter?

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Re: Bonds Are Riskier Than People Think

Post by Seasonal » Mon Dec 04, 2017 6:15 pm

visualguy wrote:
Thu Nov 30, 2017 4:55 pm
Seasonal wrote:
Thu Nov 30, 2017 4:33 pm
visualguy wrote:
Thu Nov 30, 2017 4:17 pm
Seasonal wrote:
Thu Nov 30, 2017 4:01 pm
When rates rise, principle value falls, but the additional interest more than makes up for the temporary dip after a bit.
It's not "a bit", it's many years. My understanding is that the number of years is 2 X d - 1 where d is the duration, so for something like BND, it can take 11 years to earn the interest you were expecting when you invested. Again, why even worry about this when you don't need to, and when there's no compensation for this risk.
If you're a long term investor, the dip is just a bit compared to your horizon. If not, your bond portfolio duration is too long and you should shorten it.

Duration is the break-even point, not twice duration.

What's the alternative investment?
Break-even means you don't lose principal. If you want to make the original interest over the time you hold the bond fund, you need close to double the duration.

Alternative investments include CD ladders and stable value funds.
You appear to disagree with the wiki. You might want to suggest an edit:
Duration has another useful summary property, which is that if the yield curve shifts in parallel[note 1], then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss. Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen.
https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration

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Re: Bonds Are Riskier Than People Think

Post by saltycaper » Mon Dec 04, 2017 6:45 pm

Seasonal wrote:
Mon Dec 04, 2017 6:15 pm

You appear to disagree with the wiki. You might want to suggest an edit:
Duration has another useful summary property, which is that if the yield curve shifts in parallel[note 1], then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss. Thus duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen.
https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration
That assumes a one-time rate increase. You may experience multiple rate increases over the time you hold the fund. The "two times duration" approximation accounts for that.
Quod vitae sectabor iter?

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Re: Bonds Are Riskier Than People Think

Post by Phineas J. Whoopee » Mon Dec 04, 2017 7:04 pm

The double-duration approximation is an answer to those who say: Oh yeah? What if bond yields keep going up for years and years and years? Everybody's sure to lose money! You're very clever, young man, but you don't fool me! It's turtles all the way down! *

Even if yields continue to rise, a lot, one still is likely to come out ahead prior to double the duration.

But yes, in terms of the basic explanation of duration, with reinvested interest (or technically dividends if we're talking about a mutual fund), given a one-time parallel increase in yields across the yield curve the average duration is the point of indifference, at which one's total reinvested bond assets are the same as they would have been if yields had not risen.

If anybody wants to have a rollicking good time, ask why I carefully use the term yields instead of interest rates.

PJW

* The final two sentences may have been said by, according to Stephen Hawking but possibly it was not original since the expression is known from centuries ago, an attendee at a public lecture, during the question and answer period, challenging Bertrand Russell.

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Re: Bonds Are Riskier Than People Think

Post by RAchip » Mon Dec 04, 2017 9:30 pm

Why in the world would anyone buy a 20 year bond yieldind about 3%? If you dont need your principal back for 20 years you can buy an s&p index fund, get a dividend of 2% (with a better tax rate than bond interest) and be virtually guaranteed that your original investment amount will have appreciated a lot when you need it back in 20 years (even without dividend reinvestment).

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Re: Bonds Are Riskier Than People Think

Post by Denny01 » Mon Dec 04, 2017 10:11 pm

Its interesting to compare comments from this thread "What have you learned from the lost decade" from 2011 and this thread from 2017 "Bonds are Riskier than People Think"
viewtopic.php?t=76356

From the thread in 2011, you see a lot of comments regarding the importance of being diversified, or that bonds sometimes outperform stocks, or sometimes you lose money in stocks over a long period of time.

For example (from 2011) one user wrote: "Why are people so determined not to see the Lost Decade as a lost decade? What's gained by not acknowledging the simple and obvious truth? Does it make it any better to call it a Really Really Bad Decade?
What I learned:
1) Yeah, stocks do that sometimes. You can have a bad decade or two. "


Contrast the above comment with comments on this thread from 2017 like this one: "If you dont need your principal back for 20 years you can buy an s&p index fund, get a dividend of 2% (with a better tax rate than bond interest) and be virtually guaranteed that your original investment amount will have appreciated a lot when you need it back in 20 years (even without dividend reinvestment)."

Frankly, I"m astonished in the difference in tone and sentiment between the two threads that are only separated by a few years.

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Re: Bonds Are Riskier Than People Think

Post by Money Market » Tue Dec 05, 2017 6:36 am

Denny01 wrote:
Mon Dec 04, 2017 10:11 pm
Its interesting to compare comments from this thread "What have you learned from the lost decade" from 2011 and this thread from 2017 "Bonds are Riskier than People Think"
viewtopic.php?t=76356

From the thread in 2011, you see a lot of comments regarding the importance of being diversified, or that bonds sometimes outperform stocks, or sometimes you lose money in stocks over a long period of time.

For example (from 2011) one user wrote: "Why are people so determined not to see the Lost Decade as a lost decade? What's gained by not acknowledging the simple and obvious truth? Does it make it any better to call it a Really Really Bad Decade?
What I learned:
1) Yeah, stocks do that sometimes. You can have a bad decade or two. "


Contrast the above comment with comments on this thread from 2017 like this one: "If you dont need your principal back for 20 years you can buy an s&p index fund, get a dividend of 2% (with a better tax rate than bond interest) and be virtually guaranteed that your original investment amount will have appreciated a lot when you need it back in 20 years (even without dividend reinvestment)."

Frankly, I"m astonished in the difference in tone and sentiment between the two threads that are only separated by a few years.
Haha, this is a great comment. I mentioned something similar except I compared people mentioning 100% stock allocations compared to 60/40 or permanent portfolios during the last bear market

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Re: Bonds Are Riskier Than People Think

Post by BlackStrat » Tue Dec 05, 2017 8:48 am

nisiprius wrote:
Sun Dec 03, 2017 10:56 am
They don't lead to a lower total return in dollars. A bond is a contract to pay specific numbers of dollars ..........
thank you nisiprius - this (entire) post was one of the best (pithy) explanations I've seen and should be a sticky somewhere

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Re: Bonds Are Riskier Than People Think

Post by Wakefield1 » Wed Jan 10, 2018 8:54 pm

As to whether the Bank CD puts anything at risk/is it an investment or just savings?
What if I buy ,say,a 2 year CD and one week later the interest rate goes UP!(on new ones): :annoyed Then I am faced with the possible decision to break it (if the bank will allow it which it doesn't have to do early) and immediately buy another one at the higher interest rate vs. keeping the original one and wishing I had the higher interest rate: so there must have been something at risk

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Re: Bonds Are Riskier Than People Think

Post by Alexa9 » Wed Jan 10, 2018 9:02 pm

Wakefield1 wrote:
Wed Jan 10, 2018 8:54 pm
As to whether the Bank CD puts anything at risk/is it an investment or just savings?
What if I buy ,say,a 2 year CD and one week later the interest rate goes UP!(on new ones): :annoyed Then I am faced with the possible decision to break it (if the bank will allow it which it doesn't have to do early) and immediately buy another one at the higher interest rate vs. keeping the original one and wishing I had the higher interest rate: so there must have been something at risk
Yes there is risk that interest rates will go up (they seem to be going up right now) and you could've gotten a better rate but it is FDIC insured unlike a bond fund. There are also no penalty CD's if you're worried as well as CD Ladders.

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Re: Bonds Are Riskier Than People Think

Post by NYCwriter » Thu Jan 11, 2018 3:30 pm

Consider that some money market rates are above 1.4% Doesn't this make even the best option of shorter-term laddered CDs less attractive with an eye to rising interest rates?

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Re: Bonds Are Riskier Than People Think

Post by jalbert » Thu Jan 11, 2018 4:19 pm

CWRadio wrote:
Sat Dec 02, 2017 2:51 pm
I trying to understand.
If I put $1000 on January 1 into a 5 year CD yielding 2.5% a year. What would I get at the end of the five years.
If I put the same $1000 in a short term government bond fund starting January 1 (yield 1.8%) and interest rates goes up 0.5% a year what would I get if I close the bond fund after 5 years? Thanks paul
If rates are 250 bp higher in 5 years, the CD will win. A treasury bond fund gives you daily liquidity and protects against reinvestment risk-- if the 5-year rate is at 1% in 5 years, the CD will turnover at "par" to 1% upon maturity. The bond fund likely will have appreciated and you will have a larger principal earning the lower yield in 5 years. You just have to decide which risks you prefer to take.
Index fund investor since 1987.

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Re: Bonds Are Riskier Than People Think

Post by itstoomuch » Thu Jan 11, 2018 4:35 pm

+1 @ jalbert :beer
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