Good explanation of how bond funds don't get crushed in rising rate environment

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
pbjmachine
Posts: 4
Joined: Wed Oct 17, 2018 8:50 am

Good explanation of how bond funds don't get crushed in rising rate environment

Post by pbjmachine » Wed Nov 07, 2018 10:40 am

I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!

PFInterest
Posts: 2554
Joined: Sun Jan 08, 2017 12:25 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by PFInterest » Wed Nov 07, 2018 10:59 am

bonds vs mm vs total us past 18 years.

http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D
Last edited by PFInterest on Wed Nov 07, 2018 11:01 am, edited 2 times in total.

User avatar
Taylor Larimore
Advisory Board
Posts: 27508
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Taylor Larimore » Wed Nov 07, 2018 11:00 am

pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
pbjmachine:

Sometimes it is better to look at figures than a long explanation.

Vanguard Total Bond Market Index Fund was introduced by Mr. Bogle in 1986. It's worst annual decline was -2.7% in 1994 (it gained +16% in 1995).

Total Bond Market benchmark is the U.S. Aggregate Bond Index which goes back to 1976 and high inflation years. You should find these historical figures informative:

YEAR--INFLATION--BOND INDEX--S&P 500
1976-------4.9%--------15.6%--------23.8%
1977-------6.7-----------3.0---------(-7.0)
1978-------9.0-----------1.4-----------6.5
1979------13.3-----------1.9---------18.5
1980------12.5-----------2.7---------31.7
1981-------8.9-----------6.3---------(-4.7)
1982-------3.8----------32.6---------20.4
1983-------3.8-----------8.4---------22.3
1984-------3.9----------15.2----------6.1
1985-------3.8----------22.1---------31.2
1986-------1.1----------15.2---------18.5
1987-------4.4-----------2.8-----------5.8
1988-------4.4-----------7.9----------16.5
1989-------4.6----------14.5----------31.5
1990-------6.1-----------8.9----------(-3.1)
1991-------3.1----------16.0----------30.2
1992-------2.9-----------7.4------------7.5
1993-------2.7-----------9.7-----------10.0
1994-------2.7---------(-2.9)-----------1.3
1995-------2.5----------18.5----------37.2
1996-------3.3-----------3.6----------22.7
1997-------1.7-----------9.7----------33.1
1998-------1.6-----------8.7----------28.3
1999-------2.7---------(-0.8)---------20.9
2000-------3.4----------11.6---------(-9.0)
2001-------1.6-----------8.4--------(-11.5)
2002-------2.4----------10.3--------(-22.0)
2003-------1.9-----------4.1----------28.4
2004-------3.3-----------4.3----------10.7
2005-------3.4-----------2.4-----------4.8
2006-------2.5-----------4.3----------15.6
2007-------4.1-----------7.0-----------5.5
2008-------0.1-----------5.2--------(-36.6)
2009-------2.7-----------5.9----------25.9
2010-------1.5-----------6.5----------14.8
2011-------3.0-----------7.7-----------2.1
2012-------1.7-----------4.3----------16.0
2013-------1.5---------(-2.0)---------32.2
2014-------1.6-----------6.0----------13.5
2015-------0.7-----------0.5-----------1.4
2016-------2.1-----------2.6----------12.3
2017-------2.1-----------3.5----------21.8

Source: U.S. Department of Labor, Barclays, DowJones Indices and Seeking Alpha

Observations:

* Inflation increased from 4.9% in 1976 to 13.3% in 1979; nevertheless the Bond Index had positive returns during that entire period of high inflation.

* The Aggregate Bond Index had only three negative years (all small) reflecting very low risk.

Best wishes
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

petulant
Posts: 349
Joined: Thu Sep 22, 2016 1:09 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by petulant » Wed Nov 07, 2018 11:10 am

Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?

alex_686
Posts: 3935
Joined: Mon Feb 09, 2015 2:39 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by alex_686 » Wed Nov 07, 2018 11:37 am

As a counter argument, why would they get crushed in a rising rate environment?

Everybody knows that rates are rising. These expected rate increases are already baked into bond prices. It is straight forward to extracted market expectation and the distribution of those expectations. All you need is a little math. Bloomberg terminals come loaded with canned reports, so bond traders don't even need to know that.

And rates have been raising as expected - or maybe even a little slower. The only way that bonds will be crushed is if yields spike upwards unexpectedly.

User avatar
Taylor Larimore
Advisory Board
Posts: 27508
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Taylor Larimore » Wed Nov 07, 2018 11:40 am

petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
These are nominal returns. You can figure the real (after inflation) returns by subtracting inflation from the nominal returns. Taxes, which are different for everyone, are not included.

Best wishes.
Taylor
Last edited by Taylor Larimore on Wed Nov 07, 2018 11:48 am, edited 1 time in total.
"Simplicity is the master key to financial success." -- Jack Bogle

WonderingDope
Posts: 18
Joined: Tue Oct 30, 2018 4:02 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by WonderingDope » Wed Nov 07, 2018 11:41 am

petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
They are nominal returns. Inflation is listed right there so you can calculate the real return yourself. Also, why would you think they would include anything about taxes, or was that a rhetorical question?
Last edited by WonderingDope on Wed Nov 07, 2018 11:51 am, edited 1 time in total.

WonderingDope
Posts: 18
Joined: Tue Oct 30, 2018 4:02 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by WonderingDope » Wed Nov 07, 2018 11:51 am

pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
Bonds are priced based on expectations. If you expect bonds to get "crushed" because of rising rates, you need to to be more prescient than everyone else investing in the bond market in order for the expected "crushing" to actually happen.

That's it in a nutshell.

User avatar
nisiprius
Advisory Board
Posts: 36869
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by nisiprius » Wed Nov 07, 2018 11:54 am

petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
1) PortfolioVisualizer will chart real returns. 2) Why should they include any assumptions about taxes? Data presentations about stocks almost never do. The almost universal convention is to show investment results pre-tax.

Source

Real returns:

Image

Nominal returns:

Image
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
nisiprius
Advisory Board
Posts: 36869
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by nisiprius » Wed Nov 07, 2018 12:01 pm

My capsule explanation is: "Read something that a dividend enthusiast has written about dividend stocks. Then just remember that it all applies to bonds, only much more so."

The reason bond funds don't get crushed in a rising rate environment is that the bonds pay out flippin' coupon interest every six months. Rising rates affect the market price, the capital appreciation. They have no effect at all on coupon payments, which continue unchanged and generate steady upward loft on a total return growth chart. Rising rates create a headwind that slows the growth. You can't put any limit on how bad it could be, because in our imagination and simulations there's no limit on how fast or how much rates could rise--but historically during 1940-1980 it was on the rough order of 1/2% per year. That's enough to slow growth, but not to stop or reverse it. Similarly, the falling rates from 1980 until recently generated a tailwind, helped returns, but are not the only source of return.

The S&P 500 gets a meaningful amount of return from dividends. However, the lion's share of S&P 500 total return is from capital appreciation (rising market value per share). Dividend stocks are the opposite. They get a meaningful amount of return from capital appreciation, but most of their return from the dividends.

Bonds get all of their return from "dividends," i.e. coupon interest payments, and basically nothing from capital appreciation. A chart of the price of an investment-grade bond fund like Total Bond is almost flat. It begins life at $10/share and never gets very far away from $10/share. As I write this today, it is at $10.23, down from as high as $11/share a few years ago. So, how "crushed" do you think it will get? A reasonable idea might be that it will go all the way back to $10/share, having lost maybe 8% of its value from the peak, with 2% to go. Maybe a 10% loss is your idea of being "crushed," but I can take it philosophically. In fact, between $11.23/share on 7/31/2011 and $10.23/share today, in total return there wasn't a loss--the fund made money--it grew $10,000 to $11,202, a gain of 12% cumulatively over seven years. It didn't lose money at all, it just didn't make as much as it would have made if the price per share hadn't dropped.

A speculator can try to make hay out of the fluctuations in market value, but that's a specialized thing. As ordinary investors, we don't expect to make our money by shrewdly buying and selling bonds on the fluctuations, we expect to buy and hold, and get our growth by reinvesting the coupon interest payments (= the "dividends" from a bond fund).
Last edited by nisiprius on Wed Nov 07, 2018 12:10 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Walkure
Posts: 48
Joined: Tue Apr 11, 2017 9:59 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Walkure » Wed Nov 07, 2018 12:08 pm

They don't get crushed by rates that are rising just because the economy is running hot so long as inflation is tame. Any short term drag gets more than made up for by the higher future coupon payments. Nominal bonds do get crushed by very high inflation - those years in the late '70s work out to real returns around -10%, which I would certainly call crushing for a person who relies on fixed income in the drawdown phase.

22twain
Posts: 1554
Joined: Thu May 10, 2012 5:42 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by 22twain » Wed Nov 07, 2018 12:17 pm

What do "hammered" and "crushed" mean? Down 50%? 20%? 10%? 5%? 2% 1%?
My investing princiPLEs do not include absolutely preserving princiPAL.

pbjmachine
Posts: 4
Joined: Wed Oct 17, 2018 8:50 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by pbjmachine » Wed Nov 07, 2018 12:30 pm

Thanks for the helpful replies.

In terms of mitigating risk, does a bond index mitigate rising rates by having multiple durations? Just curious about the mechanics of a bond index more for my own knowledge.

alex_686
Posts: 3935
Joined: Mon Feb 09, 2015 2:39 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by alex_686 » Wed Nov 07, 2018 12:49 pm

pbjmachine wrote:
Wed Nov 07, 2018 12:30 pm
In terms of mitigating risk, does a bond index mitigate rising rates by having multiple durations? Just curious about the mechanics of a bond index more for my own knowledge.
No.

Bond funds tend to pick 1 of 3 different structures:
Level: Hold a equal amount of short, intermediate and long term bonds.
Bullet: Hold bonds of a single duration. In this example let us use intermediate.
Barbell: Hold short and long bonds, but no intermediate.

In the above example, the 3 different portfolios would all have the same duration value but different risks. Unfortunately, different market structures favor different strategies. It is like rock, paper, scissors.

icetrap
Posts: 74
Joined: Mon Nov 06, 2017 12:30 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by icetrap » Wed Nov 07, 2018 1:04 pm

Personnaly I juste love the explanation from the Canadian couch potato on the subject.

In short:
  • Bonds may get crushed if you invested in a single company bond and that company/government went bankrupt with little cash. :(
  • Bonds Fund gets down in value when their underlying issuer (company/government) rise their interest rate. Said otherwise, a new buyer will find better return by buying these new debt than buying the old one. Thus the price of the old one aka the bond funds drop.
  • Bonds however, always deliver their past interest (if they do not fail). Thus you much likely are going to find positive return as promise by their past interest.
The pundits only mentions that the Bonds funds are going to expect low returns, as the interest rate are currently low And that the rising rate will further reduce the fund value in the short term. If you stick till all the bonds coupon are paid (which never happen in a bond fund), you will not lose money (unless the bonds fail). That's however, just a story.

If you started investing in junk bonds, rising rate may indeed crush you. Safer bonds will have better rate of return which will put pressure on the junk bond owner if they ever need more cash. Thus a lender may prefer safe and with nice return bonds vs riskier bonds. If the junk bond owner are unable to get said funding they may get crushed and your bonds along with it. The junkier the worst. Look at the wikipage for bond default rate.

rkhusky
Posts: 5715
Joined: Thu Aug 18, 2011 8:09 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by rkhusky » Wed Nov 07, 2018 1:11 pm

As long as you plan to hold a bond fund past its duration, you should be ambivalent about where the NAV goes. You will still be collecting your dividends.
Last edited by rkhusky on Wed Nov 07, 2018 2:26 pm, edited 1 time in total.

User avatar
patrick013
Posts: 2406
Joined: Mon Jul 13, 2015 7:49 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by patrick013 » Wed Nov 07, 2018 1:34 pm

pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
Image

Based on somewhat reliable info, say 60% reliable, TRSY10
will peak at 4% YTM in several years. Bond funds in that
maturity range (10 year avg. maturity) could lose 6-7% of
their NAV due to that while gaining NAV due to higher interest
yield on reinvestments. So in a couple years the fund would
be back into positive value again, it's very math-wise.

The price is determined by the market YTM. Also, CD-5's,
Agency-10's, and Corp-AAA-10's should be yielding close to
5% YTM. We'll just have to wait and see about that. Not
likely rates will expand higher however.

The above is a chart that displays the forecast from the
Congressional Budget Office (CBO.gov).
age in bonds, buy-and-hold, 10 year business cycle

OnTrack
Posts: 348
Joined: Wed Jan 20, 2016 11:16 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by OnTrack » Wed Nov 07, 2018 1:36 pm

An observation based on my recent experience. I invested in SCHP (a TIPS ETF) mostly purchased in July - Sept this year. So far, it is down 2.93% (without counting dividends). I realize in time I will earn that back if I hold long enough. On the other hand I would have been better off buying the fund now. Of course, I couldn't predict what was going to happen between July and Nov.

User avatar
Kevin M
Posts: 10197
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Kevin M » Wed Nov 07, 2018 2:20 pm

I wouldn't use the words "hammered" or "crushed" in describing nominal returns, but that's totally subjective. Based on historical bond fund variances, if you are expecting to earn the current yield to maturity on an intermediate-term bond fund, say 3%, you might well end up earning 2% or 4% over the next five or ten years. So maybe you earn 2/3 of what you were expecting on the downside.

You can't really look at Vanguard bond returns to determine what would happen in an extended period of rising rates, because we haven't had that since these bond funds existed. You can look at simulated bond fund returns during the 1940s or 1950s using something like the Simba/siamond backtesting spreadsheet.

Bond returns in real (inflation-adjusted) terms were negative for many years during extended periods of rising rates and inflation. You can see this as well using the backtesting spreadsheet.

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)

User avatar
patrick013
Posts: 2406
Joined: Mon Jul 13, 2015 7:49 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by patrick013 » Wed Nov 07, 2018 3:37 pm

Well expected YTM will just have to do for expected prices.

Excess demand is keeping spreads low around 1% for TRSY10.
But volatility being what it is lately anything between 0% and
2% for spread is somewhat possible. That creates a buying or
selling sign but I don't really want to do that. Watching the
average YTM over the FFR is just as good as any regression,
at least so far. Some funds aren't ladders so expecting certain
returns is hard.

:sharebeer
age in bonds, buy-and-hold, 10 year business cycle

User avatar
Lauretta
Posts: 805
Joined: Wed Jul 05, 2017 6:27 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Lauretta » Wed Nov 07, 2018 3:55 pm

Taylor Larimore wrote:
Wed Nov 07, 2018 11:00 am
pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
pbjmachine:

Sometimes it is better to look at figures than a long explanation.

Vanguard Total Bond Market Index Fund was introduced by Mr. Bogle in 1986. It's worst annual decline was -2.7% in 1994 (it gained +16% in 1995).

Total Bond Market benchmark is the U.S. Aggregate Bond Index which goes back to 1976 and high inflation years. You should find these historical figures informative:

YEAR--INFLATION--BOND INDEX--S&P 500
1976-------4.9%--------15.6%--------23.8%
1977-------6.7-----------3.0---------(-7.0)
1978-------9.0-----------1.4-----------6.5
1979------13.3-----------1.9---------18.5
1980------12.5-----------2.7---------31.7
1981-------8.9-----------6.3---------(-4.7)
1982-------3.8----------32.6---------20.4
1983-------3.8-----------8.4---------22.3
1984-------3.9----------15.2----------6.1
1985-------3.8----------22.1---------31.2
1986-------1.1----------15.2---------18.5
1987-------4.4-----------2.8-----------5.8
1988-------4.4-----------7.9----------16.5
1989-------4.6----------14.5----------31.5
1990-------6.1-----------8.9----------(-3.1)
1991-------3.1----------16.0----------30.2
1992-------2.9-----------7.4------------7.5
1993-------2.7-----------9.7-----------10.0
1994-------2.7---------(-2.9)-----------1.3
1995-------2.5----------18.5----------37.2
1996-------3.3-----------3.6----------22.7
1997-------1.7-----------9.7----------33.1
1998-------1.6-----------8.7----------28.3
1999-------2.7---------(-0.8)---------20.9
2000-------3.4----------11.6---------(-9.0)
2001-------1.6-----------8.4--------(-11.5)
2002-------2.4----------10.3--------(-22.0)
2003-------1.9-----------4.1----------28.4
2004-------3.3-----------4.3----------10.7
2005-------3.4-----------2.4-----------4.8
2006-------2.5-----------4.3----------15.6
2007-------4.1-----------7.0-----------5.5
2008-------0.1-----------5.2--------(-36.6)
2009-------2.7-----------5.9----------25.9
2010-------1.5-----------6.5----------14.8
2011-------3.0-----------7.7-----------2.1
2012-------1.7-----------4.3----------16.0
2013-------1.5---------(-2.0)---------32.2
2014-------1.6-----------6.0----------13.5
2015-------0.7-----------0.5-----------1.4
2016-------2.1-----------2.6----------12.3
2017-------2.1-----------3.5----------21.8

Source: U.S. Department of Labor, Barclays, DowJones Indices and Seeking Alpha

Observations:

* Inflation increased from 4.9% in 1976 to 13.3% in 1979; nevertheless the Bond Index had positive returns during that entire period of high inflation.

* The Aggregate Bond Index had only three negative years (all small) reflecting very low risk.

Best wishes
Taylor
during that time 10 yr yields fell from 15% to ~2%. The OP is instead about a rising rates environment (making the value of bonds fall due to a simple mathematical relationship).
When everyone is thinking the same, no one is thinking at all

Stormbringer
Posts: 606
Joined: Sun Jun 14, 2015 7:07 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Stormbringer » Wed Nov 07, 2018 5:26 pm

nisiprius wrote:
Wed Nov 07, 2018 12:01 pm
Bonds get all of their return from "dividends," i.e. coupon interest payments, and basically nothing from capital appreciation.
I totally get that from the perspective of buying a bond and holding it to maturity.

But bonds funds don't seem to do that. They have turnover ratio's of > 50% per year, which seems to imply that they are buying a bond, holding it for a while, and then selling it to buy a replacement. I assume they do that to keep the duration of the bonds in the portfolio clustered around a target duration.

So if they buy a bond when rates are 2%, and then sell that bond two years later when rates are 4%, I would expect that bond is being sold at a non-trivial capital loss.

I've never really gotten my head around how all that washes out in the end with a bond fund given various rate scenarios.
"Compound interest is the most powerful force in the universe." - Albert Einstein

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Wed Nov 07, 2018 5:59 pm

Lauretta wrote:
Wed Nov 07, 2018 3:55 pm
Taylor Larimore wrote:
Wed Nov 07, 2018 11:00 am
pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
pbjmachine:

Sometimes it is better to look at figures than a long explanation.

Vanguard Total Bond Market Index Fund was introduced by Mr. Bogle in 1986. It's worst annual decline was -2.7% in 1994 (it gained +16% in 1995).

Total Bond Market benchmark is the U.S. Aggregate Bond Index which goes back to 1976 and high inflation years. You should find these historical figures informative:

YEAR--INFLATION--BOND INDEX--S&P 500
1976-------4.9%--------15.6%--------23.8%
1977-------6.7-----------3.0---------(-7.0)
1978-------9.0-----------1.4-----------6.5
1979------13.3-----------1.9---------18.5
1980------12.5-----------2.7---------31.7
1981-------8.9-----------6.3---------(-4.7)
1982-------3.8----------32.6---------20.4
1983-------3.8-----------8.4---------22.3
1984-------3.9----------15.2----------6.1
1985-------3.8----------22.1---------31.2
1986-------1.1----------15.2---------18.5
1987-------4.4-----------2.8-----------5.8
1988-------4.4-----------7.9----------16.5
1989-------4.6----------14.5----------31.5
1990-------6.1-----------8.9----------(-3.1)
1991-------3.1----------16.0----------30.2
1992-------2.9-----------7.4------------7.5
1993-------2.7-----------9.7-----------10.0
1994-------2.7---------(-2.9)-----------1.3
1995-------2.5----------18.5----------37.2
1996-------3.3-----------3.6----------22.7
1997-------1.7-----------9.7----------33.1
1998-------1.6-----------8.7----------28.3
1999-------2.7---------(-0.8)---------20.9
2000-------3.4----------11.6---------(-9.0)
2001-------1.6-----------8.4--------(-11.5)
2002-------2.4----------10.3--------(-22.0)
2003-------1.9-----------4.1----------28.4
2004-------3.3-----------4.3----------10.7
2005-------3.4-----------2.4-----------4.8
2006-------2.5-----------4.3----------15.6
2007-------4.1-----------7.0-----------5.5
2008-------0.1-----------5.2--------(-36.6)
2009-------2.7-----------5.9----------25.9
2010-------1.5-----------6.5----------14.8
2011-------3.0-----------7.7-----------2.1
2012-------1.7-----------4.3----------16.0
2013-------1.5---------(-2.0)---------32.2
2014-------1.6-----------6.0----------13.5
2015-------0.7-----------0.5-----------1.4
2016-------2.1-----------2.6----------12.3
2017-------2.1-----------3.5----------21.8

Source: U.S. Department of Labor, Barclays, DowJones Indices and Seeking Alpha

Observations:

* Inflation increased from 4.9% in 1976 to 13.3% in 1979; nevertheless the Bond Index had positive returns during that entire period of high inflation.

* The Aggregate Bond Index had only three negative years (all small) reflecting very low risk.

Best wishes
Taylor
during that time 10 yr yields fell from 15% to ~2%. The OP is instead about a rising rates environment (making the value of bonds fall due to a simple mathematical relationship).
Let's look.

Here are historical U.S. Bonds returns and U.S. inflation extracted from the VPW backtesting spreadsheet for the period 1966 to 1975, inclusively:

Code: Select all

 Year   Bonds   Inflation 
  1966   5,08 %     3,46 %
  1967   0,79 %     3,65 %
  1968   2,75 %     4,40 %
  1969  -1,20 %     6,18 %
  1970  16,50 %     5,29 %
  1971   7,69 %     3,27 %
  1972   5,49 %     3,41 %
  1973   3,19 %     8,71 %
  1974   6,79 %    12,34 %
  1975   8,08 %     6,94 %
For those who are more visual, here's a chart showing the growth of bonds and inflation over that period:
Image

Here are the underlying data sources for bonds returns and inflation: Comments

Over that period, bonds had positive returns every year except for one year (1969, -1.2%) and mostly tracked inflation; the cumulative 10-year growth trailed inflation by only 2.9% (cumulative), despite a spike of two consecutive high-inflation years near the end of the period -- 8.7% and 12.3% in 1973 and 1974, respectively.

In other words, bonds did just fine, especially when one considers that U.S. stocks lost -40.6% (cumulative) in 1973 and 1974 (meanwhile, bonds had positive returns).
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
Kevin M
Posts: 10197
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Kevin M » Wed Nov 07, 2018 7:34 pm

It depends what model you use. The Simba/siamond backtest spreadsheet uses longinvest's 10-4 ladder to simulate Vanguard intermediate-term Treasury fund (ITT = Intermediate Term Treasuries) for 1966-1975, and it shows a cumulative real return of -10.4% for this 10-year period. I don't know that I'd call a 10-year loss in spending power of 10% "fine". It's true that US stocks did even worse for that particular 10-year period.

However, that wasn't the worst 10-year period for bonds. The worst for ITT since 1940 was 1972-1981, with a cumulative real return of -34%. During this particular 10-year period, stocks also had negative real returns, but lost about half as much spending power as bonds.

It's looking at longer time periods that nominal bonds start to look somewhat scary compared to US stocks (I'm not saying that stocks are less risky over longer periods, just that that's what happened in the past in the US). The worst 30-year period for ITT was 1940-1969, with a cumulative real return of -27%. The worst 30-year period for US stocks was 1965-1994 with a cumulative real return of +229% (there may have been some changes to the stock data since I copied the data from the backtest spreadsheet).

Now we have TIPS, so there's no need to take the unexpected inflation risk of nominal bonds if you don't want to.

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)

petulant
Posts: 349
Joined: Thu Sep 22, 2016 1:09 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by petulant » Wed Nov 07, 2018 8:36 pm

Taylor Larimore wrote:
Wed Nov 07, 2018 11:40 am
petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
These are nominal returns. You can figure the real (after inflation) returns by subtracting inflation from the nominal returns. Taxes, which are different for everyone, are not included.

Best wishes.
Taylor
Thanks.
WonderingDope wrote:
Wed Nov 07, 2018 11:41 am
petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
They are nominal returns. Inflation is listed right there so you can calculate the real return yourself. Also, why would you think they would include anything about taxes, or was that a rhetorical question?
Taxes affect high interest rates differently from low interest rates. The government calculates tax rates on nominal interest and capital gains, not real interest or capital gains. Bonds are more exposed to this factor since interest is taxed each year it is earned, while capital gains taxes are deferred until the sale of the asset. Bonds are therefore more affected both by taxes and higher inflation/nominal rates.
nisiprius wrote:
Wed Nov 07, 2018 11:54 am
petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
1) PortfolioVisualizer will chart real returns. 2) Why should they include any assumptions about taxes? Data presentations about stocks almost never do. The almost universal convention is to show investment results pre-tax.
As above, the government calculates tax rates on nominal interest returns each year, not real returns. The largest returns on stocks are typically deferred until sale as capital gains, while dividends are taxed at a lower rate than interests. Higher rates and taxes thus affect returns for bonds differently than stocks.

For all of the above, the upshot is that the statistics Taylor shared might not tell the whole story. If a rising rate environment is correlated with higher inflation, investors may face negative consequences beyond the nominal returns shared in the table. More variables should be reviewed and discussed.

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Wed Nov 07, 2018 8:44 pm

Kevin M wrote:
Wed Nov 07, 2018 7:34 pm
It's looking at longer time periods that nominal bonds start to look somewhat scary compared to US stocks (I'm not saying that stocks are less risky over longer periods, just that that's what happened in the past in the US). The worst 30-year period for ITT was 1940-1969, with a cumulative real return of -27%.
The losses to inflation were due to government not allowing the bond market to discount the price of bonds in high-inflation years during the 1940s and early 1950s. I've written about this in other threads. Investors knew about it and could sell their bonds at inflated prices... The problem was to decide where else to put the money! Cash had lower yields than bonds, gold possession was outlawed, and investors had just been severely burned by stocks in two consecutive bear markets (including the great depression).

It's easy to verify my assertion. Just start an inflation-indexed chart in 1952 and you won't see the severe losses.

I'm not trying to minimize the risk of leaving money in low-yield nominal bonds in high-inflation years; I'm just putting the risk in context and clarifying that a bond investor can act when the market doesn't discount bonds appropriately.
Kevin M wrote:
Wed Nov 07, 2018 7:34 pm
Now we have TIPS, so there's no need to take the unexpected inflation risk of nominal bonds if you don't want to.
Let me insist that it's lower yields than inflation that really hurt bonds, not inflation itself. The 1970s are an example of how higher yields did let nominal bonds recover from high inflation.

TIPS are safer. They're directly indexed to inflation. But, they're bonds; they still fluctuate in value.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
grabiner
Advisory Board
Posts: 22900
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by grabiner » Wed Nov 07, 2018 10:49 pm

Stormbringer wrote:
Wed Nov 07, 2018 5:26 pm
nisiprius wrote:
Wed Nov 07, 2018 12:01 pm
Bonds get all of their return from "dividends," i.e. coupon interest payments, and basically nothing from capital appreciation.
I totally get that from the perspective of buying a bond and holding it to maturity.

But bonds funds don't seem to do that. They have turnover ratio's of > 50% per year, which seems to imply that they are buying a bond, holding it for a while, and then selling it to buy a replacement. I assume they do that to keep the duration of the bonds in the portfolio clustered around a target duration.

So if they buy a bond when rates are 2%, and then sell that bond two years later when rates are 4%, I would expect that bond is being sold at a non-trivial capital loss.

I've never really gotten my head around how all that washes out in the end with a bond fund given various rate scenarios.
Bond funds will have capital gains and losses when they sell bonds, but not much (except for defaults); the long-term return still comes from interest.

The reason it still washes out is that the bond fund sold the bond for a capital loss, and bought a new bond with a higher yield. If the fund bought a new bond of the same duration as the old bond, the new bond would yield 4%, and would exactly recover the difference at maturity. More likely, the fund will buy a new bond of a longer duration, so that it will only break even by the old bond's maturity date if rates don't change, but it has no inherent expectation of gaining or losing. (Actually, it is likely to have a slight gain, since longer-term bonds usually have higher yields.)
Wiki David Grabiner

jalbert
Posts: 3815
Joined: Fri Apr 10, 2015 12:29 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by jalbert » Thu Nov 08, 2018 3:56 am

But bonds funds don't seem to do that. They have turnover ratio's of > 50% per year, which seems to imply that they are buying a bond, holding it for a while, and then selling it to buy a replacement.
I think maturing bonds that are replaced also contribute to the turnover data.
Risk is not a guarantor of return.

MikeG62
Posts: 1171
Joined: Tue Nov 15, 2016 3:20 pm
Location: New Jersey

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by MikeG62 » Thu Nov 08, 2018 8:20 am

pbjmachine wrote:
Wed Nov 07, 2018 10:40 am
I've yet to read through a quality explanation of why bond funds don't get hammered in a rising rate environment? The lazy analysis you hear a lot is that bonds are a terrible place to be in such an environment. Can someone provide a thorough explanation of how bond funds that many of you invest in for retirement aren't going to get hammered, or point me to some indepth resources on the subject? Thanks a bunch!
OP, this might provide some of what you are looking for.

https://www.kitces.com/blog/how-bond-fu ... est-rates/
Real Knowledge Comes Only From Experience

WonderingDope
Posts: 18
Joined: Tue Oct 30, 2018 4:02 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by WonderingDope » Thu Nov 08, 2018 9:55 am

petulant wrote:
Wed Nov 07, 2018 8:36 pm
WonderingDope wrote:
Wed Nov 07, 2018 11:41 am
petulant wrote:
Wed Nov 07, 2018 11:10 am
Taylor—are those real returns or nominal returns? And do they include any assumptions about taxes on interest coupons?
They are nominal returns. Inflation is listed right there so you can calculate the real return yourself. Also, why would you think they would include anything about taxes, or was that a rhetorical question?
Taxes affect high interest rates differently from low interest rates. The government calculates tax rates on nominal interest and capital gains, not real interest or capital gains. Bonds are more exposed to this factor since interest is taxed each year it is earned, while capital gains taxes are deferred until the sale of the asset. Bonds are therefore more affected both by taxes and higher inflation/nominal rates.
I know all that. The point is, you knew that those were nominal numbers with no tax adjustments, so why did you ask? There is no way to do a single tax adjustment because it would be different for everybody. Just like capital gains tax will be different for everybody. And if your bonds are in tax advantaged accounts the point is moot anyway.

feh
Posts: 1271
Joined: Sat Dec 15, 2012 11:39 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by feh » Thu Nov 08, 2018 11:44 am

I own 2 "total bond" funds, both currently down about 2.5% for the year (nominal).

Looks like this is gonna be one of those rare years...

Dottie57
Posts: 4648
Joined: Thu May 19, 2016 5:43 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Dottie57 » Thu Nov 08, 2018 12:04 pm

feh wrote:
Thu Nov 08, 2018 11:44 am
I own 2 "total bond" funds, both currently down about 2.5% for the year (nominal).

Looks like this is gonna be one of those rare years...
Yes bonds are down, but is not “crushing” to me.

Whakamole
Posts: 776
Joined: Wed Jan 13, 2016 9:59 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Whakamole » Thu Nov 08, 2018 1:58 pm

Current YTD returns for some Vanguard bond funds (and a money market fund thrown in for good measure), as of 11/7:

VMFXX (Federal MM): 1.60%
VSBSX (Short-Term Treasury Admiral): 0.19%
VBTLX (Total Bond Admiral): -2.55%

That's a spread of 4.15% between money market and Total Bond.

User avatar
Kevin M
Posts: 10197
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Kevin M » Thu Nov 08, 2018 7:43 pm

longinvest wrote:
Wed Nov 07, 2018 8:44 pm
Let me insist that it's lower yields than inflation that really hurt bonds, not inflation itself. The 1970s are an example of how higher yields did let nominal bonds recover from high inflation.
The backtest spreadsheet shows intermediate-term Treasuries (ITT) experiencing a cumulative real return of -34% for the 10-year period 1972-1981 (inclusive). I wouldn't consider losing more than 1/3 of my purchasing power in 10 years as recovering from inflation.

In extended periods of high unexpected inflation and increasing interest rates, shorter-term nominal bonds typically do better than longer-term nominal bonds, as one can roll into the higher yields more quickly. An exception was in the 1940s, as short-term rates were not allowed to increase with inflation, so one could not roll their shorter-term bonds into the higher rates as they matured.

For the 1972-1981 period, the shorter the term, the less the loss in real terms. Here are the cumulative real backtest values for that period:

-46% : LTT
-34% : ITT
-18% : STT
-07% : T-Bills

Stocks didn't do great either, with a cumulative real return of -14%, but better than ITT or even STT.

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Thu Nov 08, 2018 8:24 pm

Kevin M wrote:
Thu Nov 08, 2018 7:43 pm
longinvest wrote:
Wed Nov 07, 2018 8:44 pm
Let me insist that it's lower yields than inflation that really hurt bonds, not inflation itself. The 1970s are an example of how higher yields did let nominal bonds recover from high inflation.
The backtest spreadsheet shows intermediate-term Treasuries (ITT) experiencing a cumulative real return of -34% for the 10-year period 1972-1981 (inclusive). I wouldn't consider losing more than 1/3 of my purchasing power in 10 years as recovering from inflation.
It depends what one means by hurting. In my case, I see hurting as permanent irrecoverable losses to inflation. Let me explain.

Maybe it's simplest to explain this with a hypothetical perpetual bond, a consol.

I buy a consol with a $2 annual coupon in a 2% inflation environment; it costs me $100. If nothing changes, e.g. the yield remain 2% and inflation 2%, and I reinvest interest into consols, my investment will grow at the same speed as inflation. If inflation goes up to 3% and the consol's yield goes up to 3%, the price of a consol will drop to $66.67 (so that the annual $2 coupon becomes 3% of the price). That's a 33% drop. As long as things stay stable, inflation at 3% and consol yield at 3%, my investment will continue to track inflation but will be worth $66.67 in inflation-adjusted terms, 33% less than my initial investment in the 2% environment. If, eventually, inflation comes back down to 2%, and consol yields drop back to 2%, the consol's price will get back to $100, experiencing a 50% gain. Then it will continue to track inflation. The inflation-adjusted value of my investment will remain $100, equal to my initial investment.

The consol is an extreme example. It's a bond with no maturity. But, the basic principle explained in the previous paragraph applies to all bonds (and also to cash). If yields were always equal to inflation, losses and gains relative to initial investment value would be caused solely by the difference between the yield when the investment was bought and the yield when it was sold, assuming interest is reinvested all along.

What happened in the 1970s was something similar to the above. Inflation went up, and yields went up along with it. Bonds registered losses. The longer the bond, the deeper the loss. But, after the loss, bonds continued to grow faster than inflation, due to yields higher than inflation. When inflation came back down, yields got back down with it and bonds experienced gains, recovering from the earlier loss, then they continued to grow faster than inflation due to yields higher than inflation.

The scary thing isn't the 1970s. It's the 1940s, when yields didn't go up with inflation. This is a very scary situation best seen with the consol's example. Let's get back to consol with a 2$ coupon bought at $100 in a 2% inflation environment. Imagine that inflation goes up to 20% for 10 years, but the consol's price doesn't drop, remaining $100. Maybe some consol investors would be happy in the short term, but they better sell they consols, not keep them, because for the next 10 year, their investment will grow at 2% in a 20% environment, losing 15% per year to inflation. After a decade, inflation gets back to 2% and the consol nominal price remains $100. But, unfortunately, the total investment is now worth $20 in inflation-adjusted term, having lost 80% of its value with no anticipation of ever recovering the loss. That's really, really scary! A similar situation has happened in the 1940s.
Last edited by longinvest on Sun Nov 11, 2018 11:19 am, edited 1 time in total.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
Kevin M
Posts: 10197
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by Kevin M » Thu Nov 08, 2018 9:25 pm

Yes, the 1940s were worse, because staying short-term didn't help due to the government cap on all rates, including short-term rates. There was nowhere to hide in the 1940s in terms of fixed income. At least staying short-term in the 1970s helped.

At any rate, OP is asking for explanations about how bond funds do OK even in rising-rate environments. A minority of us (or is it just me?) are pointing out that they (nominal bond funds) don't necessarily do OK if you define "OK" as at least maintaining your purchasing power, if not achieving a return equal to your initial yield over a period equal to duration or two times duration or whatever (which also is not necessarily the case).

Yes, ITT did OK in real terms starting in 1972 if you extended your holding period long enough. At 20 years, the cumulative real return was 56%, but that wasn't during a period of generally rising rates. The second half of the period was a time of generally falling rates (and inflation). So this doesn't address the OP's question.

However, for the 20-year period 1962-1981, during which there were no government-imposed caps on rates, and for which rates were much higher toward the end of the period than at the beginning, here are the cumulative real returns:

-51% : LTT
-29% : ITT
-05% : STT
+05% : T-bills

Again, the best place to be in terms of fixed income was the shortest-term fixed income, T-bills. The risk-takers did better with stocks:

+25% : US stocks

It's interesting to note that the 5-year Treasury yield (a decent proxy for ITT) was above year over year inflation for much of this 20-year period, and the 5-year yield was relatively flat for much of this period.

Image

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Thu Nov 08, 2018 9:34 pm

Continuing my previous post.

Bonds investors obviously want higher yields when inflation goes up. This can only happen with bonds experiencing an immediate loss. An immediate loss is a good thing for bonds; we definitely don't want a repeat of the 1940s scenario! This loss will be proportional to the average duration of the bond portfolio (a 1% increase in yields causes an approximate immediate loss of duration%). Those who don't want to experience much loss in their bond allocation are best to invest in short-term bonds or a CD ladder (permanently, not as a market timing move, as we don't know if future yields will be higher or lower).

The typical Boglehead bond investment is a total bond market index fund, which contains bonds of all maturities, but with a significant weighting of short-term bonds, giving it an average intermediate-term duration. It offers an interesting balance between yield and risk of loss. The mix of various maturities gives it a remarkable smoothness because yields don't move similarly across maturities.

I've seen some recent posts, in other threads, discussing concentrating one's investment into of long-term nominal bonds or even extended-duration zero coupon bonds(!). I would caution against being fooled by the higher historical returns of long-term bonds without, first, considering their significant risk of loss due to a potential increase of yields and inflation. Long-term bonds command long-term patience. Extended duration zero-coupon bonds can't be described other than speculation, given the typical longevity of an investor and his need for the money.
Last edited by longinvest on Thu Nov 08, 2018 9:52 pm, edited 1 time in total.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Thu Nov 08, 2018 9:45 pm

Kevin M wrote:
Thu Nov 08, 2018 9:25 pm
At any rate, OP is asking for explanations about how bond funds do OK even in rising-rate environments. A minority of us (or is it just me?) are pointing out that they (nominal bond funds) don't necessarily do OK if you define "OK" as at least maintaining your purchasing power, if not achieving a return equal to your initial yield over a period equal to duration or two times duration or whatever (which also is not necessarily the case).
You're not alone. Bonds are not cash. When yields go up, they lose value. In the case of nominal bonds, if yields go up due to inflation going up, the loss of purchase power will be sticky, or maybe slowly get erased with time if yields are higher than inflation, but that can be a long time. What I've been explaining is that, as long as this loss happens, the bond investment will track inflation or even beat it, after the loss, if yields are high enough.

Those who don't want to experience such a loss have no choice but to invest in either inflation-indexed securities (TIPS and I Bonds) or high-interest cash. Even a CD ladder will accumulate an inflation-indexed loss in case of higher inflation, as it will take 5 years before all rungs are replaced with new ones carrying higher interest to fight inflation.

Note that there's a distinction to make between rising yields in a constant inflation environment, in which case waiting for double duration would make the investor whole (given some strict assumptions), and rising yields in a rising inflation environment, where bonds would experience a sticky loss of purchase power.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

jalbert
Posts: 3815
Joined: Fri Apr 10, 2015 12:29 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by jalbert » Thu Nov 08, 2018 10:06 pm

Suppose you invest $1,000 in a treasury mutual fund with a 5-year duration and a yield of 3%. Suppose rates rise one percentage point over the first year, and suppose the entire rise occurs on the day after you invest.

With a 5-year duration, the fund value drops 5% and you now have $950 earning 4%. At the end of the year, you will have about 950 * 1.04 = $988.

So after a robust rise in interest rates you are down 1.2%. That’s hardly getting crushed. If the same thing happens each year for several years, similar losses will accrue, and it will only take about one year of relatively flat interest rates to be whole again at the then higher yield after the rate rise. For instance if rates rise one percentage point a year again the 2nd year, you are starting at a 4% yield, so the loss is less. The same is true the 3rd year. As rates rise, you earn more interest at a higher yield to dampen the effect of the rate increase.

Years of robust inflation can lead to poor real returns in a nominal bond fund. But the current interest rate environment is pretty tame. That’s not to say you can’t outperform by holding cash instead, but if rates turn the other way, you may be glad you have some term exposure if the portfolio is intended to provide ballast to an equity portfolio.
Risk is not a guarantor of return.

bikechuck
Posts: 369
Joined: Sun Aug 16, 2015 9:22 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by bikechuck » Thu Nov 08, 2018 10:42 pm

rkhusky wrote:
Wed Nov 07, 2018 1:11 pm
As long as you plan to hold a bond fund past its duration, you should be ambivalent about where the NAV goes. You will still be collecting your dividends.
Bond funds do not pay dividends

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Thu Nov 08, 2018 10:51 pm

Kevin M wrote:
Thu Nov 08, 2018 9:25 pm
Yes, ITT did OK in real terms starting in 1972 if you extended your holding period long enough. At 20 years, the cumulative real return was 56%, but that wasn't during a period of generally rising rates. The second half of the period was a time of generally falling rates (and inflation). So this doesn't address the OP's question.
This statement seems to imply that either rising rates or high rates of inflation might tend to lead to short-term bonds outperforming intermediate- or long-term bonds, but that's not the case.

The rate structure and yield curve that existed from 1966 to 1981 don't lead themselves to a simplistic analysis, in part because it is easy to draw an incorrect inference.

The Fed's stop and go attack on inflation and unemployment was surpassing long-term bond returns in a manner independent of the direction of rates and independent of the level of inflation. In normal circumstances the yield curve inverts not necessarily when inflation is HIGH but when it is expected to DROP.

And in even in rising interest rate environments, long-term bonds will typically produce higher total returns than short-term bonds if the bonds are held for a period that exceeds duration.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Thu Nov 08, 2018 10:56 pm

longinvest wrote:
Thu Nov 08, 2018 9:34 pm
I've seen some recent posts, in other threads, discussing concentrating one's investment into of long-term nominal bonds or even extended-duration zero coupon bonds(!). I would caution against being fooled by the higher historical returns of long-term bonds without, first, considering their significant risk of loss due to a potential increase of yields and inflation.
Interest-rate risk is minimized when the bond duration matches the investment horizon. Long-term investors, therefore, REDUCE their interest rate risk by choosing long-term bonds over short-term bonds.

Nominal bonds do potentially leave the investor exposed to inflation risk, but that doesn't mean long-term nominal bonds aren't appropriate investments for some investors. Other investors might be better served by shorter durations and/or inflation-adjusted bonds, but one size does not fit all.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Thu Nov 08, 2018 11:06 pm

vineviz wrote:
Thu Nov 08, 2018 10:56 pm
longinvest wrote:
Thu Nov 08, 2018 9:34 pm
I've seen some recent posts, in other threads, discussing concentrating one's investment into of long-term nominal bonds or even extended-duration zero coupon bonds(!). I would caution against being fooled by the higher historical returns of long-term bonds without, first, considering their significant risk of loss due to a potential increase of yields and inflation.
Interest-rate risk is minimized when the bond duration matches the investment horizon. Long-term investors, therefore, REDUCE their interest rate risk by choosing long-term bonds over short-term bonds.

Nominal bonds do potentially leave the investor exposed to inflation risk, but that doesn't mean long-term nominal bonds aren't appropriate investments for some investors. Other investors might be better served by shorter durations and/or inflation-adjusted bonds, but one size does not fit all.
I was discussing the loss of purchase power of long-term nominal bonds in case of an increase in yields due to higher inflation. The loss of purchase power will be sticky and could last for much longer than duration (even longer than twice duration) if inflation doesn't get back down.

My consol example should be easy enough to understand. It makes the sticky loss obvious.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Thu Nov 08, 2018 11:13 pm

longinvest wrote:
Thu Nov 08, 2018 11:06 pm
I was discussing the loss of purchase power of long-term nominal bonds in case of an increase in yields due to higher inflation. The loss of purchase power will be sticky and could last for much longer than duration (even longer than twice duration) if inflation doesn't get back down.
This happens only in an example in which the increase in yields is somehow prevented from fully adjusting for inflation and/or there is a duration mismatch between the bonds and the investor's time horizon.

I suppose those are real possibilities, even if the probability of the former circumstance is tiny and the latter circumstance is easily avoided.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Thu Nov 08, 2018 11:27 pm

vineviz wrote:
Thu Nov 08, 2018 11:13 pm
longinvest wrote:
Thu Nov 08, 2018 11:06 pm
I was discussing the loss of purchase power of long-term nominal bonds in case of an increase in yields due to higher inflation. The loss of purchase power will be sticky and could last for much longer than duration (even longer than twice duration) if inflation doesn't get back down.
This happens only in an example in which the increase in yields is somehow prevented from fully adjusting for inflation and/or there is a duration mismatch between the bonds and the investor's time horizon.

I suppose those are real possibilities, even if the probability of the former circumstance is tiny and the latter circumstance is easily avoided.
You've removed an important part of my post, in your quote. Here's the full post:
longinvest wrote:
Thu Nov 08, 2018 11:06 pm
vineviz wrote:
Thu Nov 08, 2018 10:56 pm
longinvest wrote:
Thu Nov 08, 2018 9:34 pm
I've seen some recent posts, in other threads, discussing concentrating one's investment into of long-term nominal bonds or even extended-duration zero coupon bonds(!). I would caution against being fooled by the higher historical returns of long-term bonds without, first, considering their significant risk of loss due to a potential increase of yields and inflation.
Interest-rate risk is minimized when the bond duration matches the investment horizon. Long-term investors, therefore, REDUCE their interest rate risk by choosing long-term bonds over short-term bonds.

Nominal bonds do potentially leave the investor exposed to inflation risk, but that doesn't mean long-term nominal bonds aren't appropriate investments for some investors. Other investors might be better served by shorter durations and/or inflation-adjusted bonds, but one size does not fit all.
I was discussing the loss of purchase power of long-term nominal bonds in case of an increase in yields due to higher inflation. The loss of purchase power will be sticky and could last for much longer than duration (even longer than twice duration) if inflation doesn't get back down.

My consol example should be easy enough to understand. It makes the sticky loss obvious.
My example, where yields (across the curve) match current inflation at all times, shows that a bond fund (of any constant average maturity greater than zero) will exprience a sticky loss of purchase power. Duration won't mend this loss. Only inflation getting back down can fix it. This should be pretty obvious.

It seems that some investors confuse nominal properties of nominal bonds (e.g. duration and investment horizon) with inflation-related risks of nominal bonds.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Thu Nov 08, 2018 11:42 pm

longinvest wrote:
Thu Nov 08, 2018 11:27 pm
My example, where yields (across the curve) match current inflation at all times, shows that a bond fund (of any constant average maturity greater than zero) will exprience a sticky loss of purchase power. Duration won't mend this loss. Only inflation getting back down can fix it. This should be pretty obvious.
Your example seems custom-tailored to make the point you were trying to make.

Which is fine, but it's pretty far removed from the way that actual financial markets operate.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Thu Nov 08, 2018 11:44 pm

longinvest wrote:
Thu Nov 08, 2018 11:27 pm

It seems that some investors confuse nominal properties of nominal bonds (e.g. duration and investment horizon) with inflation-related risks of nominal bonds.
It also seems that some investors have an irrational fear of nominal bonds, based on scary stories more than real-world data.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

longinvest
Posts: 3027
Joined: Sat Aug 11, 2012 8:44 am

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by longinvest » Fri Nov 09, 2018 12:03 am

vineviz wrote:
Thu Nov 08, 2018 11:44 pm
longinvest wrote:
Thu Nov 08, 2018 11:27 pm

It seems that some investors confuse nominal properties of nominal bonds (e.g. duration and investment horizon) with inflation-related risks of nominal bonds.
It also seems that some investors have an irrational fear of nominal bonds, based on scary stories more than real-world data.
Did you look at my signature? You might even want to lookup the average duration of the Canadian nominal and inflation-indexed bond index ETFs I use.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

User avatar
vineviz
Posts: 2044
Joined: Tue May 15, 2018 1:55 pm

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by vineviz » Fri Nov 09, 2018 12:16 am

longinvest wrote:
Fri Nov 09, 2018 12:03 am
vineviz wrote:
Thu Nov 08, 2018 11:44 pm
longinvest wrote:
Thu Nov 08, 2018 11:27 pm

It seems that some investors confuse nominal properties of nominal bonds (e.g. duration and investment horizon) with inflation-related risks of nominal bonds.
It also seems that some investors have an irrational fear of nominal bonds, based on scary stories more than real-world data.
Did you look at my signature? You might even want to lookup the average duration of the Canadian nominal and inflation-indexed bond index ETFs I use.
What made you think I was speaking specifically about you?

You clearly weren't talking about me, since I'm not confused about anything we've discussed.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
grabiner
Advisory Board
Posts: 22900
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Good explanation of how bond funds don't get crushed in rising rate environment

Post by grabiner » Fri Nov 09, 2018 12:33 am

vineviz wrote:
Thu Nov 08, 2018 10:56 pm
Interest-rate risk is minimized when the bond duration matches the investment horizon. Long-term investors, therefore, REDUCE their interest rate risk by choosing long-term bonds over short-term bonds.

Nominal bonds do potentially leave the investor exposed to inflation risk, but that doesn't mean long-term nominal bonds aren't appropriate investments for some investors. Other investors might be better served by shorter durations and/or inflation-adjusted bonds, but one size does not fit all.
Long-term nominal bonds are appropriate investments for those investors who have long-term nominal liabilities, and thus are not sensitive to inflation risk. Those investors include pension funds, insurance companies, and investors who have 30-year mortgages which they do not intend to pay off early. Since pension funds and insurance companies demand a lot of these bonds, investors who are sensitive to inflation risk are not adequately compensated for taking the risk,

Conversely, long-term TIPS are the lowest-risk investment for individual investors with a long time horizon. If you are 35 and buy a 30-year TIPS, you know how much purchasing power you will have at 65. (If you do this through a TIPS fund, you will want to shorten your duration as your approach retirement; at age 60, you don't want to be holding a lot of 30-year TIPS because you expect to spend most of your portfolio before you turn 90.)
Wiki David Grabiner

Post Reply