fed funds rate effect bond funds?

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james7777
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fed funds rate effect bond funds?

Post by james7777 » Sat Jan 12, 2019 1:02 pm

Ive been hearing everywhere that if the fed raises rates say 1% then a 20 year bond fund (TLT in this case) should have its price go down 20%, and if rates go down 1% then TLT should go up 20%. from my research Ive found this is pure balony. the fed funds rate and interest rates have little to nothing to do with bond fund prices. here is proof:

from 2011 to the end of 2014 the fed finds rate was flat between .05 of 1% and .02 of 1% or 0.02 and 0.005. yet in 2011 TLT went up 33.96%!!, then in 2012 it went up 2.63%, then in 2013 it crashed 13%, then in 2014 it went up27% despite interest rates being flat those 4 years!. so why do I keep hearing this "you shouldnt invest in bonds especially long term bonds in this rising rate environment?"

am I right or am I missing something? WHY did TLT have these huge moves over 4 years of very low flat interest rates?

livesoft
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Re: fed funds rate effect bond funds?

Post by livesoft » Sat Jan 12, 2019 1:12 pm

I also agree the simplification is baloney. All one to do is look at a Morningstar.com "growth of" chart of your favorite bond fund over the time range(s) of FFR changes.
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Phineas J. Whoopee
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Re: fed funds rate effect bond funds?

Post by Phineas J. Whoopee » Sat Jan 12, 2019 1:21 pm

There are three problems, all due to oversimplifications.

The first is the Fed only sets the Federal Funds Rate, as you said, the target for overnight loans between creditworthy banks adjusting their bank reserves to conform with regulations.

Another is the Fed does not set bond yields at all. A free and open market does that. Yields are what the most recent seller and buyer agreed on. With respect to bonds the market mechanism is more complex than with stocks, but it's a good place to start. The Fed has influence, but not control.

The third is the idea bond prices move inversely to yields, a mathematical identity, is not a linear relationship. What you, OP, list, is a linear approximation of a very much curved function. For small differences in yield it's close enough. It isn't your fault, because so many people say it.

In addition, the linear model is based on a one-time yield change that applies evenly across the yield curve. They never do, and yields change constantly. The idea is a mental shortcut, which can be helpful but shouldn't be relied on for specific calculations.

Does that help?

PJW
Last edited by Phineas J. Whoopee on Sat Jan 12, 2019 1:24 pm, edited 1 time in total.

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abuss368
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Re: fed funds rate effect bond funds?

Post by abuss368 » Sat Jan 12, 2019 1:24 pm

james7777 wrote:
Sat Jan 12, 2019 1:02 pm
Ive been hearing everywhere that if the fed raises rates say 1% then a 20 year bond fund (TLT in this case) should have its price go down 20%, and if rates go down 1% then TLT should go up 20%. from my research Ive found this is pure balony. the fed funds rate and interest rates have little to nothing to do with bond fund prices. here is proof:

from 2011 to the end of 2014 the fed finds rate was flat between .05 of 1% and .02 of 1% or 0.02 and 0.005. yet in 2011 TLT went up 33.96%!!, then in 2012 it went up 2.63%, then in 2013 it crashed 13%, then in 2014 it went up27% despite interest rates being flat those 4 years!. so why do I keep hearing this "you shouldnt invest in bonds especially long term bonds in this rising rate environment?"

am I right or am I missing something? WHY did TLT have these huge moves over 4 years of very low flat interest rates?
Welcome to the Bogleheads!

What you are describing is interest rate risk to a bond fund. You should focus on the "duration" of a bond fund. This is usually available on the fund website. Essentially duration provides investors with a measure of sensitivity (perhaps volatility) of a fund as a result of an increase or decrease of 1.00% in interest rates in the markets. For example if a funds duration is 4 years and interest rates adjust up 1.00%, the fund price would decrease approximately 4.00%. As an alternative, if interest rates decrease 1.00%, the fund price would increase 4.00%

Remember, the Federal Reserve sets the Federal Funds Rate for their overnight lending between banks. They do not control the markets but rather influence them of course. The market adjusts and this is what impacts bonds traded in the markets.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + U.S. & International REITs

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Phineas J. Whoopee
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Re: fed funds rate effect bond funds?

Post by Phineas J. Whoopee » Sat Jan 12, 2019 1:25 pm

Thank you for clarifying my remarks.
PJW

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abuss368
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Re: fed funds rate effect bond funds?

Post by abuss368 » Sat Jan 12, 2019 1:26 pm

Phineas J. Whoopee wrote:
Sat Jan 12, 2019 1:21 pm
There are three problems, all due to oversimplifications.

The first is the Fed only sets the Federal Funds Rate, as you said, the target for overnight loans between creditworthy banks adjusting their bank reserves to conform with regulations.

Another is the Fed does not set bond yields at all. A free and open market does that. Yields are what the most recent seller and buyer agreed on. With respect to bonds the market mechanism is more complex than with stocks, but it's a good place to start. The Fed has influence, but not control.

The third is the idea bond prices move inversely to yields, a mathematical identity, is not a linear relationship. What you, OP, list, is a linear approximation of a very much curved function. For small differences in yield it's close enough. It isn't your fault, because so many people say it.

In addition, the linear model is based on a one-time yield change that applies evenly across the yield curve. They never do, and yields change constantly. The idea is a mental shortcut, which can be helpful but shouldn't be relied on for specific calculations.

Does that help?

PJW
Hi PJW -

Well said with excellent points. :beer

Best.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + U.S. & International REITs

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james7777
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Re: fed funds rate effect bond funds?

Post by james7777 » Sat Jan 12, 2019 1:45 pm

guys, I understand your points but my question remains, why did TLT make those wild moves in those 4 years? I believe it was news events and traders/bots trading TLT that caused these moves. where TLT and BND will go in the next year is anybodys guess, but for certain TLT will have wilder moves than BND as thats what the charts and data show. . just like last months 20% stock crash had nothing to do with earnings but with news events and high frequency bots trading various algorythems. . IMO interist rates are going down to staying flat in the next 10 years as the stock market crashes every time the fed hints at raising rates .25% as it was this very news that crashed stocks in december.

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jeffyscott
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Re: fed funds rate effect bond funds?

Post by jeffyscott » Sat Jan 12, 2019 3:05 pm

Phineas J. Whoopee wrote:
Sat Jan 12, 2019 1:21 pm
There are three problems, all due to oversimplifications.

The first is the Fed only sets the Federal Funds Rate, as you said, the target for overnight loans between creditworthy banks adjusting their bank reserves to conform with regulations.

Another is the Fed does not set bond yields at all. A free and open market does that. Yields are what the most recent seller and buyer agreed on. With respect to bonds the market mechanism is more complex than with stocks, but it's a good place to start. The Fed has influence, but not control.

The third is the idea bond prices move inversely to yields, a mathematical identity, is not a linear relationship. What you, OP, list, is a linear approximation of a very much curved function. For small differences in yield it's close enough. It isn't your fault, because so many people say it.

In addition, the linear model is based on a one-time yield change that applies evenly across the yield curve. They never do, and yields change constantly. The idea is a mental shortcut, which can be helpful but shouldn't be relied on for specific calculations.

Does that help?

PJW
There's a bonus problem related the third, it would be based on duration not yield. Duration of TLT is not 20, it's about 17 years.

So even the approximation is wrong. If long term interest rates were to rise by 1%, the approximation would be a 17% loss. Or to use a smaller increment, long term rates rising by 0.25% would mean about a 4.25% loss to TLT's NAV.
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patrick013
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Re: fed funds rate effect bond funds?

Post by patrick013 » Sat Jan 12, 2019 4:13 pm

james7777 wrote:
Sat Jan 12, 2019 1:45 pm
guys, I understand your points but my question remains, why did TLT make those wild moves in those 4 years? I believe it was news events and traders/bots trading TLT that caused these moves. where TLT and BND will go in the next year is anybodys guess, but for certain TLT will have wilder moves than BND as thats what the charts and data show. . just like last months 20% stock crash had nothing to do with earnings but with news events and high frequency bots trading various algorythems. . IMO interist rates are going down to staying flat in the next 10 years as the stock market crashes every time the fed hints at raising rates .25% as it was this very news that crashed stocks in december.

Normal volatility. To resolve that the FFR would have to stay static for many years, then AAA yields would have less volatility and more observations of higher yields at longer maturities. But all that volatility was within expected spreads.

Expected equations can be developed statistically but within normal or expected spreads. When the FFR rises spreads will lessen and when the FFR falls spreads will rise. What's one observation. Another is that spreads can deviate + or - 1% or more from their historical average spread just about anytime, and still capture statistical correlation within those upper and lower bounds.

Ideally, if the FFR was static, you would see + or - yields normally offering buy or sell opportunities. Right now we just have to wait and see what happens. If it rises I'd expect spreads to lower even if yields rise, if it falls spreads should rise even as yields fall. So it's not really crazy because volatility is limited and expected to be limited even if the yield jumps or falls 1 or 2%. It's just more recorded history, as usual.

Here it's shown in a chart. Obviously this was a period of low correlation of the bond to the FFR but some high spreads when the FFR was close to zero.

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

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