Bond Risk question

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Sum-day
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Bond Risk question

Post by Sum-day » Sun Dec 03, 2017 2:49 pm

Hello Bogleheads,
I'm looking for advice regarding individual bonds. In preparation for retirement I am reducing equity exposure and increasing bond exposure in our portfolio. Since the value of bond funds typically go down when interest rates rise am I better to ladder individual (high quality, short term) bonds to minimize loss?

Barring default, individual bonds held to maturity provide a known return. If I liquidate a bond fund at the wrong time (during a rate increase) I may not do as well. I realize individual bonds have a higher potential for default compared to a fund of bonds. Is there a way to quantitatively compare risk of an individual bond with a specific rating to a bond fund?

It seems like knowing the value a bond brings at maturity could put a retiree in a better position if they desire more certainty, less down-side risk or volatility. Am I missing something?

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SimpleGift
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Re: Bond Risk question

Post by SimpleGift » Sun Dec 03, 2017 3:04 pm

Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Since the value of bond funds typically go down when interest rates rise, am I better to ladder individual (high quality, short term) bonds to minimize loss?
Michael Kitces wrote a good article a few years ago, in which he analyzed in depth the very question you are asking:
Michael Kitces wrote:Yet the reality is that in an upward-sloping yield curve environment, rolling bonds to maintain a constant maturity is actually an enhancement to total return… enough that even if rates do rise, funds that roll bonds down the yield curve may still outperform the hold-to-maturity bond investor! And the steeper the yield curve becomes, the greater the benefit to sticking with bond funds after all.

Of course, the reality is that if rates spike “enough”, there is still risk that funds rolling their bonds will underperform just holding individual bonds until maturity. But on the other hand, trying to avoid rising rates by buying individual bonds is still at best a risk-return trade-off, as investors give up a “known” potential to roll down the yield curve for greater returns against just the potential that interest rates may, eventually, rise far enough and fast enough to offset the benefit!
Cordially, Todd

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Doc
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Re: Bond Risk question

Post by Doc » Sun Dec 03, 2017 3:26 pm

SimpleGift wrote:
Sun Dec 03, 2017 3:04 pm
Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Since the value of bond funds typically go down when interest rates rise, am I better to ladder individual (high quality, short term) bonds to minimize loss?
Michael Kitces wrote a good article a few years ago, in which he analyzed in depth the very question you are asking:
Michael Kitces wrote:Yet the reality is that in an upward-sloping yield curve environment, rolling bonds to maintain a constant maturity is actually an enhancement to total return… enough that even if rates do rise, funds that roll bonds down the yield curve may still outperform the hold-to-maturity bond investor! And the steeper the yield curve becomes, the greater the benefit to sticking with bond funds after all.

Of course, the reality is that if rates spike “enough”, there is still risk that funds rolling their bonds will underperform just holding individual bonds until maturity. But on the other hand, trying to avoid rising rates by buying individual bonds is still at best a risk-return trade-off, as investors give up a “known” potential to roll down the yield curve for greater returns against just the potential that interest rates may, eventually, rise far enough and fast enough to offset the benefit!
But there is no reason that the individual investor has to hold to maturity either. And the individual investor has the choice to sell or not sell when the remaining maturity reaches the low end of the the funds mandate if conditions are favorable.

That said the bookkeeping with "rolling your own" in a taxable account is a PITA. And if you put your ladder in tax advantaged you give up the ability to at times convert ordinary income into LTCG by selling before maturity.

Sorry SimpleGift, for the deep in the weeds response.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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SimpleGift
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Re: Bond Risk question

Post by SimpleGift » Sun Dec 03, 2017 3:55 pm

Doc wrote:
Sun Dec 03, 2017 3:26 pm
Sorry SimpleGift, for the deep in the weeds response.
No worries, Doc. The practical considerations of owning and buying/selling individual bonds are an important aspect of the decision faced by the OP. To which we can add higher bond transaction costs (bid/ask spreads, plus dealer markups) for individual investors who venture beyond just government bonds.

The reason why the Michael Kitces article stuck in my mind was that I always assumed individual bonds held to maturity were preferable to bond funds in a rising rate environment — but as Kitces points out, this is not necessarily always the case.
Cordially, Todd

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Re: Bond Risk question

Post by JoinToday » Sun Dec 03, 2017 4:17 pm

Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Am I missing something?
The way I look at it is this: A bond fund is a collection of bonds. A bond ladder is a collection of bonds. There is no reason why they should behave differently (this is simplified, and not 100% true -- but for most people holding bonds long term, this is close to being accurate).

I hold bond funds for the reasons mentioned by Doc. It is a PITA to do the book keeping in a taxable acct, and I am smart enough to know that I don't know enough about bonds to pick bond issues intelligently. In addition, Vanguard trades probably $2B per week in bonds. Even if you were trading $1M per year (assuming a 10 year ladder with $10M in bonds), Vanguard will be getting a better bid/ask spread than you or I will be getting.
I wish I had learned about index funds 25 years ago

Sum-day
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Re: Bond Risk question

Post by Sum-day » Sun Dec 03, 2017 4:18 pm

Thanks for the replies. I read the Kitces article some time back. Part of my concern is, if rates were to spike, there could be a sell-off of bond fund shares by the people who depend on the income. I don't think Kitces addresses the potential for a panic sell-off in his article but, will reread again.

My consideration to go with an individual bond ladder would utilize Municipal bonds in a taxable account as this approach nets a higher after tax return than the CD ladder I've been setting up.

Tax deferred accounts current bond portion is invested in Vanguard Total Bond fund and one other. I don't intend any change to the tax deferred bond funds. They will remain in place.

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Doc
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Re: Bond Risk question

Post by Doc » Sun Dec 03, 2017 5:48 pm

JoinToday wrote:
Sun Dec 03, 2017 4:17 pm
The way I look at it is this: A bond fund is a collection of bonds. A bond ladder is a collection of bonds. There is no reason why they should behave differently (this is simplified, and not 100% true -- but for most people holding bonds long term, this is close to being accurate)
A bond ladder and an index mutual fund are not always the same. Sometimes not even close.

1) Most people think of a ladder as buying a bond and holding to maturity. The result is that you have a linear distributions of maturities.

2) An index fund rarely holds bonds to maturity. Rarely do they hold bonds with maturities less than one year and sometimes other minimums. And the maturities whatever the range are distributed by market weight so you are going to have more of the shorter maturities. For example you will have both a new three and a seven year old ten in the "three" range but only one in the "ten" range.

3) You also have the fact that the yield curve is usually curved so your yields differ depending on the distribution of the "steps" even if the duration is the same.

How close the two are depends ....

If you change your "most" to "many" you would be on a firmer step of your ladder.

(Pun intended.)
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Bond Risk question

Post by JoinToday » Tue Dec 05, 2017 1:50 am

Doc wrote:
Sun Dec 03, 2017 5:48 pm
JoinToday wrote:
Sun Dec 03, 2017 4:17 pm
The way I look at it is this: A bond fund is a collection of bonds. A bond ladder is a collection of bonds. There is no reason why they should behave differently (this is simplified, and not 100% true -- but for most people holding bonds long term, this is close to being accurate)
A bond ladder and an index mutual fund are not always the same. Sometimes not even close.

1) Most people think of a ladder as buying a bond and holding to maturity. The result is that you have a linear distributions of maturities.

2) An index fund rarely holds bonds to maturity. Rarely do they hold bonds with maturities less than one year and sometimes other minimums. And the maturities whatever the range are distributed by market weight so you are going to have more of the shorter maturities. For example you will have both a new three and a seven year old ten in the "three" range but only one in the "ten" range.

3) You also have the fact that the yield curve is usually curved so your yields differ depending on the distribution of the "steps" even if the duration is the same.

How close the two are depends ....

If you change your "most" to "many" you would be on a firmer step of your ladder.

(Pun intended.)
I agree with everything you wrote.

The bone I have to pick when I have this argument/discussion with my friends is that they really don't know the very basics of bonds vs bond funds, and have no business buying individual (corporate) bonds (in my opinion). I hear simplistic arguments that with individual bonds, you know how much it is worth at maturity (which is true), but they are unaware that the same forces that cause my bond funds to vary in value also affect their bond ladders, but they never see their bonds vary in value. I am pretty sure most of my friends don't understand duration and yield curve, and my not have even heard of the terms.

FWIW, I am not very knowledgeable with bond investing, but believe (1) risk and reward are highly correlated with bonds (no free lunch, especially with bonds), and (2) I know enough to know that I am better off letting Vanguard do all the buying and selling of bonds for me in the form of bond funds (except for short term bond funds vs CDs).
I wish I had learned about index funds 25 years ago

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Re: Bond Risk question

Post by AlohaJoe » Tue Dec 05, 2017 3:01 am

Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Since the value of bond funds typically go down when interest rates rise am I better to ladder individual (high quality, short term) bonds to minimize loss?
There have been rate spikes before. Go check how bond funds performed during those previous rate spikes then come back and tell us how much they lost.

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Doc
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Re: Bond Risk question

Post by Doc » Tue Dec 05, 2017 7:35 am

AlohaJoe wrote:
Tue Dec 05, 2017 3:01 am
Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Since the value of bond funds typically go down when interest rates rise am I better to ladder individual (high quality, short term) bonds to minimize loss?
There have been rate spikes before. Go check how bond funds performed during those previous rate spikes then come back and tell us how much they lost.
Rate spikes or price spikes? I'll bet you a Starbucks that you only get the latter and then due to something happening that has little to do with bonds themselves but with some non-bond spikey event that causes investers to run to quality.

Of course it depends on your definition of "spike".
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Re: Bond Risk question

Post by Sum-day » Tue Dec 05, 2017 8:36 am

Perhaps I a slight re-frame would help.
I would like to avoid the need to withdraw from the bond portion of my portfolio during periods when returns are negative. I am considering purchasing individual bonds structured in a ladder. Benefits to doing this appear to be:
1). For planning purposes (retirement income), I will know the maturity date and final value when each bond is purchased.
2). No yearly management fee (lower cost to own once purchased)
3). Will utilize municipal bonds in taxable account to lower tax burden and increase spendable funds
4). Will initially purchase short term maturities (1-2 yrs) to leverage upside (extend maturities) as rates increase. This should also limit downside exposure in the event I would need to sell prior to maturity for some unforeseen reason.

Am I missing something? Does the bond ladder approach make more sense than a bond fun?

Also, here is the performance on bonds according to Vanguard:
  • Historic risk/return (1926–2010)
    Average return 5.5%
    Best year 32.6% (1982)
    Worst year –8.1% (1969)
    Years with a loss 13 of 85 (15.3%)

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Re: Bond Risk question

Post by AlohaJoe » Tue Dec 05, 2017 9:07 am

Sum-day wrote:
Tue Dec 05, 2017 8:36 am
Also, here is the performance on bonds according to Vanguard:
  • Historic risk/return (1926–2010)
    Average return 5.5%
    Best year 32.6% (1982)
    Worst year –8.1% (1969)
    Years with a loss 13 of 85 (15.3%)
As Vanguard notes, those stats are based on corporate bonds. But you're not talking about a ladder of corporate bonds.

Since 1972 an intermediate US Treasury bond fund has had a loss in just 4 years. Those losses were:

-1% in 1972
-1% in 1994
-0.3% in 1999
-0.09% in 2013

That is...the worst loss is 1%. And that's only happened 2 times in 5 decades.

So the question is...you want to avoid withdrawing from a bond fund when it is "down". But the worst it has been down in the past 5 decades is 1%. I mean, I guess people can decide, yep, 1% one time in a single year is worth it to me. But that's the stakes we're talking about.

That said, I'm not totally against bond ladders. I think people just need to be realistic about them. As another poster suggested, what are the spreads you would be paying? Have you calculated them?

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Re: Bond Risk question

Post by AlohaJoe » Tue Dec 05, 2017 9:09 am

Doc wrote:
Tue Dec 05, 2017 7:35 am
AlohaJoe wrote:
Tue Dec 05, 2017 3:01 am
Sum-day wrote:
Sun Dec 03, 2017 2:49 pm
Since the value of bond funds typically go down when interest rates rise am I better to ladder individual (high quality, short term) bonds to minimize loss?
There have been rate spikes before. Go check how bond funds performed during those previous rate spikes then come back and tell us how much they lost.
Rate spikes or price spikes?
In these kinds of threads usually people mean "the Federal reserve jacks up the target rate for federal funds which leads to bond-ageddon".

There is data on bond funds going back to 1972 and there have been many instances of large Fed rate hikes over that period and exactly zero instances of bonds imploding. I mean, there was a huge rate hike in the early 2000s that everyone seems to have totally forgotten about (probably because it didn't lead to bond catastrophe and confuses the simple narrative they read on some blog somewhere)...

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Re: Bond Risk question

Post by pkcrafter » Tue Dec 05, 2017 9:53 am

You have to be careful about how you buy individual bonds.

http://money.cnn.com/pf/money-essential ... index.html

Buying new issue individual munis at no commission isn't so easy.

https://www.thebalance.com/how-to-buy-m ... tly-357929

Paul
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Re: Bond Risk question

Post by dbr » Tue Dec 05, 2017 10:14 am

Sum-day wrote:
Sun Dec 03, 2017 2:49 pm

It seems like knowing the value a bond brings at maturity could put a retiree in a better position if they desire more certainty, less down-side risk or volatility. Am I missing something?
The position of a retiree is dominated by withdrawal rate and the luck of when he retires. After that the stock/bond allocation plays a role. There is a weak effect on failure rate of the portfolio and a strong effect on how wealthy the investor will be when he dies. The effect of whether one ladders bonds or hold a bond fund is probably about number 11 on a list of 10 regarding how well off a retired investor is going to be.

Note there is a hazard in holding individual bonds. We had a relative who started out with about a half million in Treasuries all of which ended up in that person's checking account because they stopped renewing the holdings. The bank finally figured out who the relatives were and called us up to see what was going on. Of course, that was a bank where people used to know each other.

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Re: Bond Risk question

Post by Sum-day » Tue Dec 05, 2017 10:31 am

Lots of good feedback. Thank you to the group!

Okay, top concerns are:
1) Buying "right" and properly understanding how bonds work.
2) Since 1972 Treasuries worst annual loss was 1% so there is little to worry about.

Anything else?

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Re: Bond Risk question

Post by Doc » Tue Dec 05, 2017 12:27 pm

AlohaJoe wrote:
Tue Dec 05, 2017 9:09 am
In these kinds of threads usually people mean "the Federal reserve jacks up the target rate for federal funds which leads to bond-ageddon".
I think of "spike" as a short term, relatively large and mostly unexpected event. If the Fed did indeed "jack up" the target rate that might cause a spike but the Fed moves are usually not unexpected and are not that large. If the Fed moved the target rate by 100 bps that would probably cause a spike.
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Re: Bond Risk question

Post by AlohaJoe » Tue Dec 05, 2017 9:11 pm

Doc wrote:
Tue Dec 05, 2017 12:27 pm
[...]but the Fed moves are usually not unexpected and are not that large. If the Fed moved the target rate by 100 bps that would probably cause a spike.
I agree they usually are not. But it has happened multiple times, so we don't have to guess about the effects, we can look at the actual historical record. The Fed increased rates by 3.75% in a single meeting in 1973. By 4% in a single meeting in 1974. By 3.25% in a single meeting in 1978. By 5.5% in a single meeting in 1979. By 6% in March 1980. And another 8% in December of that same year. In 1988 they increased it by 3.25% in December. From 2004 to 2005 it went from 1% to 4.25%.

And there have been bond fund indexes around for all of those. I challenge people to show me the alleged terrible effects of those rate increases on the Bloomberg Barclays Aggregate Bond Index.

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Re: Bond Risk question

Post by Doc » Wed Dec 06, 2017 7:06 am

AlohaJoe wrote:
Tue Dec 05, 2017 9:11 pm
The Fed increased rates by 3.75% in a single meeting in 1973. By 4% in a single meeting in 1974. By 3.25% in a single meeting in 1978. By 5.5% in a single meeting in 1979.
That's spikes.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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