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.
User avatar
vineviz
Posts: 5391
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 6:53 am

grabiner wrote:
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,
That’s all true (except the very last part), but I think the important point is that many individual investors have little to no inflation risk. For these investors, which are probably the vast majority of investors under the age of 50, long-term nominal bonds can be entirely appropriate.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

rkhusky
Posts: 7607
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 » Fri Nov 09, 2018 7:05 am

bikechuck wrote:
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
Really? When I go to Vanguard's Total Bond Fund page and look up distributions, it says "Dividend". And my 1099 lists "Total ordinary dividends".

longinvest
Posts: 3983
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 7:39 am

vineviz wrote:
Fri Nov 09, 2018 6:53 am
grabiner wrote:
Fri Nov 09, 2018 12:33 am
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,
That’s all true (except the very last part), but I think the important point is that many individual investors have little to no inflation risk. For these investors, which are probably the vast majority of investors under the age of 50, long-term nominal bonds can be entirely appropriate.
Investors, young and old, take risks. The Bogleheads investment philosophy tells us to never take too much or too little of it. Those who decide to concentrate their bond investments into longer maturities shouldn't do so blindly. Let's put aside the inflation risk of nominal bonds and consider other risks. For one thing, long-term bonds (both nominal and inflation indexed) are volatile. For another, long-term bonds can take a long time to recover from increasing yields.

Here's a chart I've built comparing the growth of an investment into long-term bonds relative to an investment into 3-months Treasury bills in the early 1970's (in Canada, local currency). It took 20 years, from the start of 1973 to the end of 1992, for $10,000 invested into long-term bonds to match the growth of an investment into 3-months Treasury bills on a total-return basis!

Source data: The Stingy Investor Asset Mixer
Image

WARNING: The end points of the comparison period were carefully chosen to show a particular risk of long-term bonds. This isn't a prediction of future returns.

Long-term Treasury Inflation-Protected Securities (long-term TIPS) share a similar underperformance risk versus Series I Savings Bonds (I Bonds).

Let's not try to minimize the risks of long-term bonds. It's a mistake to claim that long-term nominal bonds aren't risky for investor below the age of 50. It's also a mistake to claim that a 30-year TIPS isn't risky for a young investor. Risk can take many forms, this includes personal risk. We don't know that investor's future. He could get a terminal illness diagnosis changing his plans just after a significant rise in nominal or real long-term yields has devastated the value of his investment.
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

longinvest
Posts: 3983
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 8:09 am

To get back to the main topic of this thread, which was about nominal bonds in general (e.g. something like a total bond market index fund), let's distinguish two cases:

a) Rates (yields) increase but inflation stays stable: in such a case, the bond fund will temporarily lose a little value but will recover it's purchase power over time. In the long term, the higher yields will lead to higher long-term returns.

b) Rates (yields) increase due to an increase in inflation: in such a case, the bond fund will experience a modest sticky loss of purchase power. Modest might mean 5% or even 10%. This isn't 0%, but it's quite smaller than the 50% that stocks could easily lose in a very short period of time.

In other words, interest rate risk and inflation risk are two distinct risks of nominal bonds. A bond fund of intermediate duration has a moderate amount of both risks.

Referring to my earlier posts in this thread, it's also important to always be aware at all times of the difference between current yields and recent inflation. Leaving money invested into securities that yield less than inflation will cause a permanent loss of purchase power.
Last edited by longinvest on Sun Nov 11, 2018 10:58 am, edited 2 times in total.
Bogleheads investment philosophy | One-ETF global balanced index portfolio | VPW

User avatar
nisiprius
Advisory Board
Posts: 39476
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 » Fri Nov 09, 2018 8:09 am

bikechuck wrote:
Thu Nov 08, 2018 10:42 pm
Bond funds do not pay dividends
Bond funds pay dividends. Why don't you think so? It is true that bonds pay "interest," not "dividends." A mutual fund is a kind of "investment company." Although we aren't usually aware of it, they are a fairly special kind of company. The money that the mutual fund earns from its transactions in the stocks or bond it holds, are paid out to fund shareholders as the fund's dividends.

By the way, a very important and special detail in the law, one that's not an obvious feature, is that investment companies are exempt from paying corporate income tax on the money they make, and are allowed to pass their dividends on to you without taxation.

Anyway, here are the dividends paid out by a bond fund. Each little icon at the bottom, four per year, indicates a dividend payment, and we can mouse over them to see them, $0.02/share on 3/29/2018 and so forth.
Image

It is puzzling to me that there is so much propaganda and publicity about the important of dividends from stock funds... and yet people believe that "bond funds do not pay dividends."
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
vineviz
Posts: 5391
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 8:17 am

longinvest wrote:
Fri Nov 09, 2018 7:39 am

Let's not try to minimize the risks of long-term bonds. It's a mistake to claim that long-term nominal bonds aren't risky for investor below the age of 50.
I agree with much of what you write, but I also think an important point which often gets missed is this: different investors face different risks in the same asset.

By this I mean that the amount of rate risk, for example, an investor faces is not a function of the bond duration per se but rather the MISMATCH between duration and investment horizon. A long term investor faces MORE interest rate risk with bonds of short duration than long.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

bikechuck
Posts: 565
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 » Fri Nov 09, 2018 9:53 am

nisiprius wrote:
Fri Nov 09, 2018 8:09 am
bikechuck wrote:
Thu Nov 08, 2018 10:42 pm
Bond funds do not pay dividends
Bond funds pay dividends. Why don't you think so? It is true that bonds pay "interest," not "dividends." A mutual fund is a kind of "investment company." Although we aren't usually aware of it, they are a fairly special kind of company. The money that the mutual fund earns from its transactions in the stocks or bond it holds, are paid out to fund shareholders as the fund's dividends.

By the way, a very important and special detail in the law, one that's not an obvious feature, is that investment companies are exempt from paying corporate income tax on the money they make, and are allowed to pass their dividends on to you without taxation.

Anyway, here are the dividends paid out by a bond fund. Each little icon at the bottom, four per year, indicates a dividend payment, and we can mouse over them to see them, $0.02/share on 3/29/2018 and so forth.
Image

It is puzzling to me that there is so much propaganda and publicity about the important of dividends from stock funds... and yet people believe that "bond funds do not pay dividends."
Thanks Nisprius, I had always thought of returns from my bond funds as interest rather than dividends. However I learned something from you today. If you hold your bonds in a fund rather than as individual bonds the returns are appropriately characterized as dividends.

User avatar
nisiprius
Advisory Board
Posts: 39476
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 » Fri Nov 09, 2018 10:20 am

bikechuck wrote:
Fri Nov 09, 2018 9:53 am
...Thanks Nisiprius, I had always thought of returns from my bond funds as interest rather than dividends. However I learned something from you today. If you hold your bonds in a fund rather than as individual bonds the returns are appropriately characterized as dividends.
So, if we're just talking about terminology and technicalities, it's no big deal. I was concerned because I've seen posters who believed that bond funds had earned practically nothing because they looked at a long-term chart that showed price per share and didn't include bond interest = fund dividends.
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
House Blend
Posts: 4625
Joined: Fri May 04, 2007 1:02 pm

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

Post by House Blend » Fri Nov 09, 2018 10:21 am

bikechuck wrote:
Fri Nov 09, 2018 9:53 am
Thanks Nisprius, I had always thought of returns from my bond funds as interest rather than dividends. However I learned something from you today. If you hold your bonds in a fund rather than as individual bonds the returns are appropriately characterized as dividends.
Sorry for continuing this OT discussion, but let me add that this distinction can actually matter for tax purposes.

For example, states may choose to tax bond fund dividends even if the interest produced by the underlying securities would be state tax-free if held individually. (Most states do not do this.)

It's also why there isn't a broad array of balanced or target date funds that use munis.

The Feds do not allow any partial exemption for the taxation of fund dividends unless at least 50% of the underlying assets produce interest that would be tax-exempt if the securities were held individually.

User avatar
MossySF
Posts: 2361
Joined: Thu Apr 19, 2007 9:51 pm
Contact:

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

Post by MossySF » Fri Nov 09, 2018 10:58 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?
What's your definition of hammered?

Will bonds do worse when interest rates go up versus when they are flat or go down?

Of course.

Do you consider say a 2% drop for Total Bond Market hammered?

harmoniousmonk
Posts: 65
Joined: Sat Jun 09, 2018 1:35 pm

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

Post by harmoniousmonk » Fri Nov 09, 2018 3:36 pm

Noob question.

All else being equal. If you are hoping to make money in an intermediate term bond fund, are you hoping for the price to go up or the yield to go up?

User avatar
vineviz
Posts: 5391
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 3:40 pm

harmoniousmonk wrote:
Fri Nov 09, 2018 3:36 pm
Noob question.

All else being equal. If you are hoping to make money in an intermediate term bond fund, are you hoping for the price to go up or the yield to go up?
It depends entirely on your time horizon. If you are thinking short-term, the price increase is better for you. If you are thinking long-term, the yield increase is better for you.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

alex_686
Posts: 5097
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 » Fri Nov 09, 2018 4:55 pm

harmoniousmonk wrote:
Fri Nov 09, 2018 3:36 pm
All else being equal. If you are hoping to make money in an intermediate term bond fund, are you hoping for the price to go up or the yield to go up?
2 points. Risk and return are linked. Bonds have 2 primary forms of risk, principle risk and interest rate risk. If you squeeze on one side the risk will just pop up on the other.

I currently favor intermediate bonds because I think that they have the best risk / return ratio, and that risk is nicely split between principle and interest rate risk.

What one hopes in the current environment is that interest rates do the slow steady clime upwards that is expected of them. I stress expected here. It is the unexpected stuff that will cause losses.

User avatar
grabiner
Advisory Board
Posts: 25429
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 11:50 pm

harmoniousmonk wrote:
Fri Nov 09, 2018 3:36 pm
Noob question.

All else being equal. If you are hoping to make money in an intermediate term bond fund, are you hoping for the price to go up or the yield to go up?
The yield. If you gain from the price going up, this implies that you intend to hold the fund for less than its duration, which you shouldn't be doing because of the risk.
Wiki David Grabiner

petulant
Posts: 757
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 » Sat Nov 10, 2018 6:53 am

WonderingDope wrote:
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.
I asked a set of questions to make sure I understood the data correctly before complaining about how a bigger discussion of inflation and taxes is important to the usefulness of the data.

feh
Posts: 1331
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 » Wed Jan 02, 2019 8:47 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...
Hard to believe, but by the end of the year both of the funds I mentioned above are in the black for 2018. Not by a lot, but positive.

Shocking what happened to the 10 year yield the last 2 months.

Post Reply