How long before a bond fund will at least return principle?

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Dan Kohn
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How long before a bond fund will at least return principle?

Post by Dan Kohn » Mon Mar 09, 2009 7:25 am

I'd like to follow up on a point for sheople2 from this previous discussion. This comes from Suze Orman's (in my view, incorrect) statement that investors should only hold bonds, not bond funds.

I've suggested that sheople2 should hold the TIPS fund (VIPSX). He is extremely averse to losing principle. So, the question is, how long does he need to hold VIPSX to ensure that he at least gets his principle back?

I believe the answer is that he needs to hold it for at least its duration, which is currently 6.0 years. As long as he holds it for 6 or more years, he will have gotten his principle back, no matter what is happening in the general bond market.

Of course, this only applies to bond funds with no default risk, like TIPS, GNMA, and Treasuries. Corporate and municipal bonds could default, in which case you could lose principle.

Could you please confirm my understanding, and add a little theory.

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Re: How long before a bond fund will at least return princip

Post by ddb » Mon Mar 09, 2009 7:31 am

Dan Kohn wrote:I'd like to follow up on a point for sheople2 from this previous discussion. This comes from Suze Orman's (in my view, incorrect) statement that investors should only hold bonds, not bond funds.

I've suggested that sheople2 should hold the TIPS fund (VIPSX). He is extremely averse to losing principle. So, the question is, how long does he need to hold VIPSX to ensure that he at least gets his principle back?

I believe the answer is that he needs to hold it for at least its duration, which is currently 6.0 years. As long as he holds it for 6 or more years, he will have gotten his principle back, no matter what is happening in the general bond market.

Of course, this only applies to bond funds with no default risk, like TIPS, GNMA, and Treasuries. Corporate and municipal bonds could default, in which case you could lose principle.

Could you please confirm my understanding, and add a little theory.


There is no time period over which an investor in any bond fund is assured that s/he will get back at least his/her principal.

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Post by dbr » Mon Mar 09, 2009 10:00 am

Are we discussing a bond fund in which all distributions are reinvested or are the conditions something else?

Naturally a bond fund from which interest payments are taken can find itself with a NAV at any point in time less than the NAV at any other point in time. The question as to when the investor can assume his total return is not negative is a completely different question.

I speculate Dan Kohn is refering to the latter and ddb to the former.

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Post by ddb » Mon Mar 09, 2009 10:03 am

dbr wrote:Are we discussing a bond fund in which all distributions are reinvested or are the conditions something else?

Naturally a bond fund from which interest payments are taken can find itself with a NAV at any point in time less than the NAV at any other point in time. The question as to when the investor can assume his total return is not negative is a completely different question.

I speculate Dan Kohn is refering to the latter and ddb to the former.


Doesn't matter either way. There's no way to know that your principal will be in tact at any point in the future, and there's no way to know if principal + reinvested interest will be worth what you initially invested at any point in the future.
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Total Return

Post by Dan Kohn » Mon Mar 09, 2009 10:19 am

We're discussing Total Return of the bond fund. You have $10 K. You can buy $10 K in a ladder of individual TIPS or $10 K in VIPSX. With the individual TIPS, I know that on the maturity of the longest dated bond, I will have my principle returned to me. In fact, I'll get my principle, the interest, and the inflation adjustment.

What is the worst case scenario for a TIPS bond fund like VIPSX? Both theoretical and in reality. Since the individual TIPS bonds won't default, I'm unclear why (at the extreme) waiting for the longest one to mature won't return my principle. More practically, in the worst case, we'd assume that interest rates continue to rise throughout the holding period, causing the fund's NAV to continue to fall. But as the fund keeps buying new bonds over time, it will be generating higher and higher yield.

Isn't it the case that if I hold the fund longer than the duration, the higher yield will directly compensate for the lowered NAV?

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Re: Total Return

Post by ddb » Mon Mar 09, 2009 10:29 am

Dan Kohn wrote:We're discussing Total Return of the bond fund. You have $10 K. You can buy $10 K in a ladder of individual TIPS or $10 K in VIPSX. With the individual TIPS, I know that on the maturity of the longest dated bond, I will have my principle returned to me. In fact, I'll get my principle, the interest, and the inflation adjustment.


This isn't necessarily true in the case of TIPS. If you buy an existing bond on the secondary market which has an inflation factor of greater than 1, and there is deflation between today and the bond maturity, then you will receive back less than you paid for it, in addition to the interest payments along the way. What you say is true for newly-issued TIPS bonds, or for secondary-market bonds where then inflation factor is less than or equal to 1.

What is the worst case scenario for a TIPS bond fund like VIPSX? Both theoretical and in reality. Since the individual TIPS bonds won't default, I'm unclear why (at the extreme) waiting for the longest one to mature won't return my principle. More practically, in the worst case, we'd assume that interest rates continue to rise throughout the holding period, causing the fund's NAV to continue to fall. But as the fund keeps buying new bonds over time, it will be generating higher and higher yield.


Theoretical worst-case scenario for a TIPS fund is that the value of the fund drops to zero the day after you purchase it, because the US Government announces that it won't be paying back its debt.

Realistic worst-case scenario for a TIPS fund is that you lose a few percent per year for a relatively long period of time due to a rise in real interest rates between your purchase date and your sale date.

I understand what you are saying about how if you hold until the longest-bond matures, you'll get your principal back, but it isn't accurate. Consider a very simple bond fund, which you buy today. The fund holds two bonds in equal amounts, one which matures in 2014 and one which matures in 2019 (average maturity of 5 years, average duration of probably somewhere around 3-4). According to your logic, you are assured that you can't lose principal if you hold the fund for either the duration period (3-4 years) or the longest-maturity bond (10 years). The former is clearly wrong, as no bonds are maturing between now and the duration period. The latter is wrong, because when bond 1 matures in 5 years, the fund will take the proceeds and buy a new bond that matures in 2024. You have no idea what that 2024 bond will be worth in 2019, and therefore have no assurance about future principal value.

Isn't it the case that if I hold the fund longer than the duration, the higher yield will directly compensate for the lowered NAV?


Not necessarily.

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DDB

Post by Dan Kohn » Mon Mar 09, 2009 10:34 am

DDB, could you please give some probabilities to your "realistic" worst case scenario. Do you recommend that unsophisticated investors hold individual TIPS rather than a TIPS fund in order to avoid the possibility of a decline in value?

Note that we're not talking about a date-certain liability (in which case an individual bond might make more sense). The assumption is that you're buying the bond or fund today (as part of a new asset allocation) and then slowly withdrawing the money in the future.

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Re: DDB

Post by ddb » Mon Mar 09, 2009 10:50 am

Dan Kohn wrote:DDB, could you please give some probabilities to your "realistic" worst case scenario. Do you recommend that unsophisticated investors hold individual TIPS rather than a TIPS fund in order to avoid the possibility of a decline in value?


Steadily losing value in a TIPS portfolio would happen if real interest rates rise. Right now, it looks like the TIPS yield curve is around 1.5% for 5-year and around 2.5% for 20-year. If yields are higher when you sell any portion of the TIPS portfolio, then you will have lost money. Higher yields could happen for a number of reasons: lower inflation expectations, higher interest rate environments, decreasing credit quality of the US Gov't (unlikely), or just a general drop in demand for TIPS (like we saw late last year, when the market preferred the nominal treasuries much more than the TIPS, perhaps for liquidity or availability reasons).

I think that the decision to go with a fund vs. individual TIPS boils down to the size of the TIPS investment and the amount of complexity that the investor desires. Obviously if you have $20K to devote to TIPS, you probably won't ladder them. Or, if you don't like to spend any time working on your portfolio, you'll definitely go the fund route.

Going with a TIPS ladder may involve some projections about future cash flow needs, and also requires you to shop the TIPS market whenever an existing bond matures. You also have to figure out what to do with the coupon payments (not different from a TIPS fund where you don't reinvest interest payments). I think if I had to develop a rule of thumb, I'd probably say that $50-$200K is the gray area where either strategy could make sense. Below that, go with the fund, and above that, go with the invididual bonds.

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Re: Total Return

Post by tfb » Mon Mar 09, 2009 10:52 am

Dan Kohn wrote:Isn't it the case that if I hold the fund longer than the duration, the higher yield will directly compensate for the lowered NAV?

No. Imagine if you buy a fund when the interest rate is 4%. The fund's duration is 5 years. The interest rate stays stable for 4.9 years. One month before you want to withdraw, it jumps to 16%. You will not be able compensate for the NAV loss in one month.

Will a ladder protect you? Not if the ladder has the same bonds as in the fund. Say you invest in bonds maturing in 1-10 years with the intention of selling everything at year 5. You will lose money with the same kind of interest rate changes.

If you absolutely, positively have to withdraw everything at a set point of time, buy bonds/CDs maturing at that time.

Is a bond ladder better if you hold everything to maturity? Suppose in the same example you buy bonds maturing in 1 to 10 years. Interest rates are 1% - 3% on your bonds. Right after you bought, interest rate immediately jump to 15% and stay there for the next 10 years. You withdraw from your ladder and spend the money as each bond matures. Do you not lose money because you got everything back when your bonds mature? It depends on your mental accounting. You can say you didn't lose money but you would have to agree buying those bonds when interest rates were low wasn't a good idea.

In another thread, I proposed this math exercise.

After you create your TIPS ladder, call this ladder "My TIPS Fund." Create some imaginary shares and calculate the NAV for your fund. When one bond matures, for which you receive the full guaranteed value and real yield, you take the cash, divide by the NAV at that time, and reduce the number of shares you still own in My TIPS Fund. Now, it's as if you just sold some shares from My TIPS Fund at the current NAV. Let's say the NAV is lower than the initial NAV. Did you just suffer a loss? Or did you receive the full guaranteed value and real yield from the matured bond? You see it's just a matter of framing. The substance remains exactly the same.
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Re: Total Return

Post by ddb » Mon Mar 09, 2009 11:12 am

tfb wrote:After you create your TIPS ladder, call this ladder "My TIPS Fund." Create some imaginary shares and calculate the NAV for your fund. When one bond matures, for which you receive the full guaranteed value and real yield, you take the cash, divide by the NAV at that time, and reduce the number of shares you still own in My TIPS Fund. Now, it's as if you just sold some shares from My TIPS Fund at the current NAV. Let's say the NAV is lower than the initial NAV. Did you just suffer a loss? Or did you receive the full guaranteed value and real yield from the matured bond? You see it's just a matter of framing. The substance remains exactly the same.


Thanks for pointing this out in an easy-to-understand way. I've always struggled to explain to people why it really doesn't matter why you buy a fund or if you buy individual bonds, even though I could explain it to myself in my own mind!

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Re: Total Return

Post by mudfud » Mon Mar 09, 2009 11:13 am

tfb wrote:After you create your TIPS ladder, call this ladder "My TIPS Fund." Create some imaginary shares and calculate the NAV for your fund. When one bond matures, for which you receive the full guaranteed value and real yield, you take the cash, divide by the NAV at that time, and reduce the number of shares you still own in My TIPS Fund. Now, it's as if you just sold some shares from My TIPS Fund at the current NAV. Let's say the NAV is lower than the initial NAV. Did you just suffer a loss? Or did you receive the full guaranteed value and real yield from the matured bond? You see it's just a matter of framing. The substance remains exactly the same.


I completely agree with tfb's reasoning. Suze Orman's advice is misguided. FWIW I invest in the TIPS fund. In addition to all the points made already, there may be an advantage to bond funds, in the form of better returns by "riding the yield curve". Now, this can also be replicated by buying individual bonds, but would be a pain to implement.
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Re: DDB

Post by Dan Kohn » Mon Mar 09, 2009 11:15 am

ddb wrote:If yields are higher when you sell any portion of the TIPS portfolio, then you will have lost money.

That's clearly an over-statement. In many cases, when yields increase, the dividends you receive will more than compensate for the decreased NAV.

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Real world

Post by Dan Kohn » Mon Mar 09, 2009 11:22 am

OK guys, I think you've convinced me that in theory, it is never as safe to hold a bond fund as your own ladder, because with a fund, you can't compensate for the risk that the rates skyrocket the day before you sell your fund, and you don't have enough time to have the higher dividend yield compensate for the lower NAV.

But could you please read the first couple posts of this thread, and see the practical question I'm trying to address. Which is whether an unsophisticated, risk-averse investor needs, as Suze Orman says, to own individual bonds rather than bond funds.

As long as the you're planning to hold the fund longer than the duration, and you plan to withdraw the money slowly thereafter, I believe a fund is a far superior choice than trying to set up your own ladder. With a ladder, you've only guaranteed you'll get your money back to a fixed day certain (say 5 years). At that point, you need to reinvest the money again. And the reinvestment of both dividends and principle takes real effort and a bit of sophistication.

The best solution for the original poster might be I-bonds, which are guaranteed never to go down. I thought it was worth recommending a TIPS fund to get the higher yield, but if he is really risk averse, he will probably be happier with I-bonds.

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Re: Real world

Post by dbr » Mon Mar 09, 2009 11:29 am

Dan Kohn wrote:OK guys, I think you've convinced me that in theory, it is never as safe to hold a bond fund as your own ladder, because with a fund, you can't compensate for the risk that the rates skyrocket the day before you sell your fund, and you don't have enough time to have the higher dividend yield compensate for the lower NAV.


It really gets tiresome to hear about the disaster that will befall if one has to sell one's bond fund the day after rates skyrocket. As Dan is saying and anyone would appreciate, one does not invest money all of which is needed at a specific point in time in bond funds with significant duration. The same problem would befall a long term ladder that is liquidated in its entirety with unmatured bonds and after a sudden interest rate skyrocket.

Regarding the safety of ladder, considering opportunity cost with regard to return and how badly one executes in purchasing bonds, I think a less than skilled investor is definitely in danger of costing himself significantly due to poor or even incompentent execution of the bond ladder.

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Re: Real world

Post by sewall » Mon Mar 09, 2009 11:49 am

dbr wrote:It really gets tiresome to hear about the disaster that will befall if one has to sell one's bond fund the day after rates skyrocket. As Dan is saying and anyone would appreciate, one does not invest money all of which is needed at a specific point in time in bond funds with significant duration. The same problem would befall a long term ladder that is liquidated in its entirety with unmatured bonds and after a sudden interest rate skyrocket.

Regarding the safety of ladder, considering opportunity cost with regard to return and how badly one executes in purchasing bonds, I think a less than skilled investor is definitely in danger of costing himself significantly due to poor or even incompentent execution of the bond ladder.


Tiresome indeed. My head is bloodied from banging against that wall. It is a shame that so much dust has been kicked up abound the risks of bond funds that it is hard to see the truth of the matter.
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rolling ladder

Post by Dan Kohn » Mon Mar 09, 2009 12:39 pm

sewall, I reviewed that thread, and I think I now see the crux of the disagreement. If you are budgeting for a specific future liability, nothing beats a bond ladder (or even just a single bond) for the guarantee that the money will be available when you need it.

But the apple-to-apples comparison here is between a bond fund and a rolling bond ladder. That is, we invest our $10 K today. If our goal is just to live off of the dividends (from the fund) or interest payments (from the ladder), than it never matters what happens to the NAV. Because with the rolling ladder, we will buy a new long-dated bond each time one of bonds comes due.

So, if we calculate NAV for our personal bond fund (the rolling ladder), and if duration is the same, the distributions and NAV movements should be identical to a real fund. In fact, if we want to slowly draw down the principle, we can do it by reinvesting less than 100% of each bond that comes due (for the ladder), or by selling off some of the fund at the end of each year, and the impact to the ladder/fund total value should still be extremely similar.

The main difference is the 0.20 expense ratio we pay for professional management of our fund, versus the management cost and risk we take doing it ourselves, and possible screwing it up (if we're not as competent as tfb).

Do you agree?

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Re: DDB

Post by ddb » Mon Mar 09, 2009 12:45 pm

Dan Kohn wrote:
ddb wrote:If yields are higher when you sell any portion of the TIPS portfolio, then you will have lost money.

That's clearly an over-statement. In many cases, when yields increase, the dividends you receive will more than compensate for the decreased NAV.


Sorry, I misspoke. If yields are higher when you sell any portion of the TIPS portfolio, then you will have lost principal.
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Re: rolling ladder

Post by dbr » Mon Mar 09, 2009 12:55 pm

Dan Kohn wrote:sewall, I reviewed that thread, and I think I now see the crux of the disagreement. If you are budgeting for a specific future liability, nothing beats a bond ladder (or even just a single bond) for the guarantee that the money will be available when you need it.

But the apple-to-apples comparison here is between a bond fund and a rolling bond ladder. That is, we invest our $10 K today. If our goal is just to live off of the dividends (from the fund) or interest payments (from the ladder), than it never matters what happens to the NAV. Because with the rolling ladder, we will buy a new long-dated bond each time one of bonds comes due.

So, if we calculate NAV for our personal bond fund (the rolling ladder), and if duration is the same, the distributions and NAV movements should be identical to a real fund. In fact, if we want to slowly draw down the principle, we can do it by reinvesting less than 100% of each bond that comes due (for the ladder), or by selling off some of the fund at the end of each year, and the impact to the ladder/fund total value should still be extremely similar.

The main difference is the 0.20 expense ratio we pay for professional management of our fund, versus the management cost and risk we take doing it ourselves, and possible screwing it up (if we're not as competent as tfb).

Do you agree?


Not sewall, but speaking for myself, this is essentially my view.

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Post by zeugmite » Mon Mar 09, 2009 12:59 pm

The NAV issue with a bond fund is but a special case of the NAV issue with a single bond.

Suppose you buy a single one-year bond priced at $100 and at yield 3%. Then the next day the interest rate goes up to 5%. So the bond's price drops to around $98 with the corresponding yield now at the market's 5%. If you sell that bond now, did you lose $2 of your principal? Not really, because you can still get your principal back. One "obvious" way is just to "undo" selling that bond and hold to maturity. How do you undo it? You just buy another bond on the market that is yielding 5% with your $98. At the end of the year, you will get $98 back along with 5% in interest, or $103. But that's the same as your $100 principal back with the original 3% interest. There, you got your principal back, guaranteed.

You can do the same thing with a bond fund. If the NAV was $10, yield was 3%, duration was 1 year, and the interest rate went up to 5%, the NAV will go down to $9.8 while the yield goes to 5%. (The bond fund manager can implement this in a number of different ways, but that's beside the point.) If you sell 10 shares of this bond fund, you suffer a loss of "principal" of $2, but you can just as well go reinvest the $98 withdrawn in a 5% bond like previously. At the end of the year, you get your $103. There, you got your principal back again.

The point is, with a bond fund, you don't get to control the maturity date, because the maturity date is continuously rolling. Let's recognize that you do lose that flexibility. But, you can get your principal back if you are willing to reinvest what you took out of the bond fund into a fixed bond of the same maturity as the bond fund duration. However, if your investment horizon is "a long time" or infinity, then only the income stream matters and the principal isn't important.

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Post by sewall » Mon Mar 09, 2009 1:25 pm

What a breath of fresh air this thread is. Not much smog clouding the issues. Nice, clear posts...I agree with everything that has been posted, at least in the prior four posts or so.

So far we all seem to be on the same page about bonds, ladders, and funds. (I should really only speak for myself but it sounds too arrogant to say "everyone is on my page" or "I'm on all your pages" :lol: ).
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Getting principal back

Post by Dan Kohn » Mon Mar 09, 2009 1:37 pm

zeugmite wrote:But, you can get your principal back if you are willing to reinvest what you took out of the bond fund into a fixed bond of the same maturity as the bond fund duration.

zeugmite, I think you may have answered my original question. If the duration of VIPSX is 6 years, than the theoretical maximum time it would take to get back your principle is 2 x the duration, or 12 years.

That's because if interest rates rise, causing the NAV to fall, and I decide I want my principle back, I can just sell the fund and buy a (now high-yielding) individual bond with a maturity equal to the duration of the fund. This is equivalent to me deciding that I want to break my bond ladder. I the worst case, I would sell all of my bonds and buy a single new bond with a maturity equal to the duration of the ladder. This would then return my principle, and would do so faster than waiting for my longest dated bond to mature.

Do I have it correct? Can you comment on what the average time it would take to get my principle back (which I think equals the duration), and whether the distribution has narrow tails or not?

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Re: Getting principal back

Post by zeugmite » Mon Mar 09, 2009 1:48 pm

Dan Kohn wrote:
zeugmite wrote:But, you can get your principal back if you are willing to reinvest what you took out of the bond fund into a fixed bond of the same maturity as the bond fund duration.

zeugmite, I think you may have answered my original question. If the duration of VIPSX is 6 years, than the theoretical maximum time it would take to get back your principle is 2 x the duration, or 12 years.

...

Do I have it correct? Can you comment on what the average time it would take to get my principle back (which I think equals the duration), and whether the distribution has narrow tails or not?


Yes, more or less correct. Actually it wouldn't need to be 2x, since you don't need to wait the duration in the bond fund. You sell that any time you want, then you wait.

To be fair, I gave a very simple case as example. The actual time you'd have to wait would depend on the differences across the entire yield curve between the time you buy the fund and the time you sell the fund, since there are bonds in the fund across the yield curve. However, if nothing totally bizarre has been going on with the yields, the time you'd wait should be around the duration, but in all cases it shouldn't be longer than the longest dated bond in the bond fund -- after all, you can replicate the bond fund portfolio and hold to maturity. Does that make sense?

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Yes

Post by Dan Kohn » Mon Mar 09, 2009 1:58 pm

Yes, but I was hoping for more insight into what the distribution "wait time" looks like. Back to the OP's original question (and in contradiction to ddb's initial response), you're saying that you will never need to wait longer than the fund's bond with the longest dated maturity.

I'm assuming when you decide to push the eject button, you sell your fund immediately and then buy a single bond whose yield returns you 100% of your original principle. What would the yield curve have to look like for you to need to wait more than twice the duration? Has that ever happened? What is the likelihood that you need a bond dated longer than the duration?

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Re: Getting principal back

Post by ddb » Mon Mar 09, 2009 2:32 pm

Dan Kohn wrote:
zeugmite wrote:But, you can get your principal back if you are willing to reinvest what you took out of the bond fund into a fixed bond of the same maturity as the bond fund duration.

zeugmite, I think you may have answered my original question. If the duration of VIPSX is 6 years, than the theoretical maximum time it would take to get back your principle is 2 x the duration, or 12 years.


Right, but to be clear, his strategy involvs SELLING the fund (at a loss of principal), and reinvesting the proceeds into individual bonds. It is still true that there is no assurance of principal by keeping your money in the fund, because the ladder within the fund is continually rolling forward.

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Re: Getting principal back

Post by Dan Kohn » Mon Mar 09, 2009 2:54 pm

ddb wrote:Right, but to be clear, his strategy involvs SELLING the fund (at a loss of principal), and reinvesting the proceeds into individual bonds. It is still true that there is no assurance of principal by keeping your money in the fund, because the ladder within the fund is continually rolling forward.

Right. The whole question is a bit artificial. sheople2 asked me: "How long do you have to hold Vanguard TIPS fund in order to not lose money in the end?"

What he really wants to know is, how do I avoid losing 24% of my balance (the difference between high and low NAV last year)? And the real answer is that as long as you plan on mainly using distributions from the fund and just selling a small portion of principle each year, there is no meaningful difference between buying the fund and setting up a rolling ladder of bonds. In both cases, the mark-to-market value of your holdings may vary, but you will, in the vast majority of the cases, make money from the fund as long as you hold it for the duration. All the scenarios about selling the fund and buying a new bond are really just theoretical exercises to illustrate what it would take to get your principle back.

The key thought is that although bond funds do have volatility, they are exactly as volatile as a rolling bond ladder with the same duration. If you are really scared of volatility, take the lower return and zero volatility that I-bonds provide. But if you are planning to hold for longer than the duration, and particularly if you plan to slowly withdrawal your money over time, TIPS will almost certainly provide a better total return than I-Bonds. In fact, the only case where they wouldn't would be if interest rates went consistently up and up for most of the time you held the fund, until you had exhausted most of the principle. That is possible, but extremely unlikely.

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Re: rolling ladder

Post by Doc » Mon Mar 09, 2009 2:57 pm

Dan Kohn wrote: The main difference is the 0.20 expense ratio we pay for professional management of our fund, versus the management cost and risk we take doing it ourselves, and possible screwing it up (if we're not as competent as tfb).

You probably don't need to be as competent as tfb. An equal ladder is going to give you a bond distribution that is very similar to VIBSX - close enough in any case. As long as the fund doesn't consciously make large changes in their duration and I don't think they will get too far from the index, you should be OK. However unless you have a very large portfolio or have a lot of time on your hands 20 bp may not be worth the effort if the funds duration suits your needs.
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Re: Yes

Post by zeugmite » Mon Mar 09, 2009 3:19 pm

Dan Kohn wrote:I'm assuming when you decide to push the eject button, you sell your fund immediately and then buy a single bond whose yield returns you 100% of your original principle. What would the yield curve have to look like for you to need to wait more than twice the duration? Has that ever happened? What is the likelihood that you need a bond dated longer than the duration?


Right, the reported duration of bond mutual funds is just some simple average of the underlying bond maturities. That doesn't imply that a single bond at such an average duration has the same behavior as the portfolio of bonds in the mutual fund. However, the part of the behavior that affects the question of "getting the principal back" may be close enough between the two cases if the yields have risen uniformly across the maturities. But you should verify this with real data.

One trivial "weird" case I can think of is if the short and long yields all go up, but the "average duration" yield stays put. Then obviously you can't just get your principal back by reinvesting in the "average duration" bond. A more likely instance where you may have to wait longer than is implied by average duration is if the long yields go up more than the short yields (a steepening yield curve).[/b]

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Yield curves

Post by Dan Kohn » Mon Mar 09, 2009 3:23 pm

Yep, a deeply steepening yield curve could cause you to have to buy a very long dated bond to get your principal back. Unfortunately, I don't think any of us have the tools or historical data to be more specific.

Thanks everyone for your help on this question. It's really improved my understanding of funds and ladders.
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Re: Getting principal back

Post by ddb » Mon Mar 09, 2009 3:30 pm

Dan Kohn wrote:The key thought is that although bond funds do have volatility, they are exactly as volatile as a rolling bond ladder with the same duration.


Yes! Perfect way to compress the main points of this thread into a single sentence.

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Post by Oicuryy » Mon Mar 09, 2009 4:27 pm

Dan Kohn wrote:sheople2 asked me: "How long do you have to hold Vanguard TIPS fund in order to not lose money in the end?"

What he really wants to know is, how do I avoid losing 24% of my balance (the difference between high and low NAV last year)?

Well, say he put $100 into the fund and it dropped 24% to $76 and stayed there. Say he then collected and spent $2 in dividends each year. It would take 12 years for the dividends to replace his lost principal.

Dan Kohn wrote:I believe the answer is that he needs to hold it for at least its duration, which is currently 6.0 years. As long as he holds it for 6 or more years, he will have gotten his principle back, no matter what is happening in the general bond market.

I don't think so. That might be true for an individual bond since a bond's market price moves towards its face value as it gets closer to maturity. But a fund (or a ladder) does not have a maturity to get closer to.

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Re: Getting principal back

Post by peter71 » Mon Mar 09, 2009 4:49 pm

ddb wrote:
Dan Kohn wrote:The key thought is that although bond funds do have volatility, they are exactly as volatile as a rolling bond ladder with the same duration.


Yes! Perfect way to compress the main points of this thread into a single sentence.

- DDB


I think the ultimate reason lots of non-Bogleheads recommend individual bonds is that they believe in simply "muddling through" when it comes to their fixed income / cash investments. Thus, rather than immediately "rolling" an individual bond when it comes due, they might look around for an attractive CD rate, an entirely different sort of bond, etc. So while I agree that there's not any real difference between the two "passive" options, I don't think it's any more surprising to hear Suze Orman et al. recommending individual bonds than, e.g., it is to hear people recommending home buyers either wait for or lock in a given mortgage rate.

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Re: Yes

Post by Doc » Mon Mar 09, 2009 5:09 pm

zeugmite wrote:
Dan Kohn wrote: Right, the reported duration of bond mutual funds is just some simple average of the underlying bond maturities. That doesn't imply that a single bond at such an average duration has the same behavior as the portfolio of bonds in the mutual fund. However, the part of the behavior that affects the question of "getting the principal back" may be close enough between the two cases if the yields have risen uniformly across the maturities. But you should verify this with real data.

Well it's not really that simple but anyway. For a zero coupon bond the duration and the maturity are the same. So if you could buy a zero coupon bond with a maturity equal to the funds duration. It would have the same behavior as the fund and "you would get your principle back" at the maturity/duration date. The problem is that the duration/maturity of that zero keeps decreasing with time but the duration of the fund does not because the manager keeps buying new bonds as the originals are sold or mature. So you would have to sell the bond and buy another one periodically to match the "behavior". Of course each time you trade you extend the maturity but it could be done.
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Post by Dan Kohn » Mon Mar 09, 2009 10:52 pm

Oicuryy wrote:
Dan Kohn wrote:sheople2 asked me: "How long do you have to hold Vanguard TIPS fund in order to not lose money in the end?"

What he really wants to know is, how do I avoid losing 24% of my balance (the difference between high and low NAV last year)?

Well, say he put $100 into the fund and it dropped 24% to $76 and stayed there. Say he then collected and spent $2 in dividends each year. It would take 12 years for the dividends to replace his lost principal.

Dan Kohn wrote:I believe the answer is that he needs to hold it for at least its duration, which is currently 6.0 years. As long as he holds it for 6 or more years, he will have gotten his principle back, no matter what is happening in the general bond market.

I don't think so. That might be true for an individual bond since a bond's market price moves towards its face value as it gets closer to maturity. But a fund (or a ladder) does not have a maturity to get closer to.

If your goal is to regain your principal in the shortest time possible, then you should sell the fund and buy the shortest term zero-coupon bond with the face value of your original principal. But what sheople actually wants is to not lose money. And if the fund's NAV has dropped 24% and stayed there, then yields have skyrocketed and remain high, so he is still getting the dividend payments he was hoping for. The 2% yield he had at purchase has jumped to 5 or 6%.

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Post by smcgrath12 » Thu Apr 02, 2009 1:25 pm

What a superb thread along with the WIKI post at http://www.bogleheads.org/wiki/index.ph ... _Bond_Fund

I have learned more in these posts than with any other literature on bond durations/loss of NAV/yields. :D

EDIT: Grammer
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Yep

Post by Dan Kohn » Thu Apr 02, 2009 1:36 pm

Yep, I learned a huge amount from the contributors and was happy to write it up into the wiki.

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Post by smcgrath12 » Thu Apr 02, 2009 1:55 pm

Mods should consider making this thread a sticky. I hope this thread is not lost with the passage of time. This thread answers common questions on bonds/bond funds that every starting investor has.

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Wiki

Post by Dan Kohn » Thu Apr 02, 2009 3:07 pm

That's the purpose of the wiki. It's easy to add a link to the wiki in any conversation (where it's appropriate!).

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Post by haberd » Thu Apr 02, 2009 5:21 pm

The wiki is good but I have a problem with this statement:

"At any moment after buying a bond fund, you can always be assured of getting your principal back. Doing so requires selling the fund and buying a zero-coupon bond with the face value of your principal. Such a bond will always be available, because if the fund's NAV is down, yields will have gone up a commensurate amount. "

Nice theory, but only Treasury bonds have readily available zero coupon versions and they do not necessarily track other types of bonds.

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Zeroes

Post by Dan Kohn » Thu Apr 02, 2009 5:45 pm

It's not necessary for it to be a zero coupon bond to get your principle back. If the price of the TIPS funds falls dramatically, then the price of a long-dated individual TIPS bond should fall as well. The face value of the bond you can purchase with the proceeds of your fund, plus the payments you receive along the way, should be higher than the original value of your fund.

Using a zero coupon bond is just useful as an illustration, because the duration is equal to the maturity. With zeroes, it's more obvious that the maturity of the bond you need is much shorted (on average, half the length), than the maturity of the longest-dated bond in your fund.

Also note that with TIPS, it's easier to just think of all payments as being in real terms, which allows you to ignore the effect of inflation.

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Tips principal

Post by bitterroot » Thu Apr 02, 2009 8:45 pm

I am glad that this topic was addressed. I have been trying to decide whether to buy the TIP bonds or VISPX. I still dont know wha to do. I mainly want it to protect my purchasing power in retirement.

Also, is the statement that"it dosent matter if the NAV goes down if you just want the dividend" correct. If the value of your acct. goes down ,even though the yield rises, want there be less principle in your acct. to pay dividend on?

Buying TIP protection is something I really feel strongly about but done know which way to go.


IF I buy ETF is it the same problem as VISPX re losing principal. I suppose it is.

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Tips principal

Post by bitterroot » Thu Apr 02, 2009 8:45 pm

I am glad that this topic was addressed. I have been trying to decide whether to buy the TIP bonds or VISPX. I still dont know wha to do. I mainly want it to protect my purchasing power in retirement.

Also, is the statement that"it dosent matter if the NAV goes down if you just want the dividend" correct. If the value of your acct. goes down ,even though the yield rises, want there be less principle in your acct. to pay dividend on?

Buying TIP protection is something I really feel strongly about but done know which way to go.


IF I buy ETF is it the same problem as VISPX re losing principal. I suppose it is.

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Re: Tips principal

Post by Dan Kohn » Fri Apr 03, 2009 7:25 am

bitterroot wrote:it dosent matter if the NAV goes down if you just want the dividend

Correct. Imagine that you have a portfolio of TIPS. Interest rates jump up, and so the NAV plummets. However, that portfolio of bonds still produces the same dividends it did the day before. The only difference is that the yield has skyrocketed, because the same dividends are being paid on a smaller principle. (The denominator has shrunk while the numerator stays the same, so the yield is higher.)

Now, here's the key thing. The above scenario is true whether you constructed the portfolio of bonds yourself or whether you bought a bond fund. In both cases, the NAV is down, the yields are up, but the dividends stay the same.

So, if you are not an experienced investor who enjoys purchasing bonds at auction, I would hold the TIPS fund. I am an experienced investor, but I prefer the convenience and simplicity of the TIPS fund.

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