Switch AA 10-year to 2-year Treasuries?

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TNOA
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Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 6:18 am

I am not one who makes changes to AA. But one thing, I've been struggling with. Considering how low the yields have sunk, and how little the spread has become between the 10-year Treasuries and 2-year Treasuries... And simply thinking, the path for treasuries from these lows or even perhaps negative yields one day soon, is most likely up... after all, it is less likely to assume treasuries in the future will yield negative 5% than positive 5% especially when they are near zero today... so my question is, does this warrant to switch the 10-year Treasury exposure within the AA (asset allocation) to 2-year Treasuries? I know this may tick you guys off as it is not "stay the course" but i honestly couldn't do without asking.

thx1138
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Re: Switch AA 10-year to 2-year Treasuries?

Post by thx1138 » Tue Aug 13, 2019 6:25 am

Here’s a thread full of people worried about potentially permanent negative interest rates and discussing whether switching to 20-30 year treasuries is the right thing to do:

viewtopic.php?f=10&t=287897

Interest rates have “had nowhere to go but up” for almost a decade now.

That said there is one school of thought that says when the yield curve flattens indeed shorten duration. The idea being you should expect to get some compensation for taking the risk of extending maturity. Such investors have some sort of threshold - so many basis points of yield per year of maturity - to set their target duration.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Call_Me_Op » Tue Aug 13, 2019 7:07 am

You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Switch AA 10-year to 2-year Treasuries?

Post by carolinaman » Tue Aug 13, 2019 8:23 am

TNOA wrote:
Tue Aug 13, 2019 6:18 am
I am not one who makes changes to AA. But one thing, I've been struggling with. Considering how low the yields have sunk, and how little the spread has become between the 10-year Treasuries and 2-year Treasuries... And simply thinking, the path for treasuries from these lows or even perhaps negative yields one day soon, is most likely up... after all, it is less likely to assume treasuries in the future will yield negative 5% than positive 5% especially when they are near zero today... so my question is, does this warrant to switch the 10-year Treasury exposure within the AA (asset allocation) to 2-year Treasuries? I know this may tick you guys off as it is not "stay the course" but i honestly couldn't do without asking.
Given the flattened yield curve, it makes sense to reallocate some intermediate bond money to short or limited term. I do not know what interest rates will do (neither does anybody else) but it seems the risk and impact of rising interest rates is greater than declining rates.

robertmcd
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Re: Switch AA 10-year to 2-year Treasuries?

Post by robertmcd » Tue Aug 13, 2019 8:28 am

Most important issue here is what your stock allocation is. In isolation 2 yr treasuries may be a higher risk/return asset than the 10 yr right now, but what about when paired with 60% stocks? The most important thing for me is that US stocks and treasuries bonds have historically had a negative correlation, and so you are very well compensated for taking the extra risk in treasury bonds when you pair it with a medium to high stock allocation.

The exception to this is using leverage thru treasury futures to make the 2 yr treasury as volatile as the 10 yr, but this is a bit much for the average boglehead.

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catalina355
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Re: Switch AA 10-year to 2-year Treasuries?

Post by catalina355 » Tue Aug 13, 2019 8:36 am

robertmcd wrote:
Tue Aug 13, 2019 8:28 am
Most important issue here is what your stock allocation is. In isolation 2 yr treasuries may be a higher risk/return asset than the 10 yr right now, but what about when paired with 60% stocks? The most important thing for me is that US stocks and treasuries bonds have historically had a negative correlation, and so you are very well compensated for taking the extra risk in treasury bonds when you pair it with a medium to high stock allocation.

The exception to this is using leverage thru treasury futures to make the 2 yr treasury as volatile as the 10 yr, but this is a bit much for the average boglehead.
Why do you say treasury bonds have extra risk? Also why is the 2 year a higher risk than the 10 year?

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Re: Switch AA 10-year to 2-year Treasuries?

Post by robertmcd » Tue Aug 13, 2019 8:54 am

catalina355 wrote:
Tue Aug 13, 2019 8:36 am
robertmcd wrote:
Tue Aug 13, 2019 8:28 am
Most important issue here is what your stock allocation is. In isolation 2 yr treasuries may be a higher risk/return asset than the 10 yr right now, but what about when paired with 60% stocks? The most important thing for me is that US stocks and treasuries bonds have historically had a negative correlation, and so you are very well compensated for taking the extra risk in treasury bonds when you pair it with a medium to high stock allocation.

The exception to this is using leverage thru treasury futures to make the 2 yr treasury as volatile as the 10 yr, but this is a bit much for the average boglehead.
Why do you say treasury bonds have extra risk? Also why is the 2 year a higher risk than the 10 year?
Sorry I meant higher sharpe ratio on the 2 yr. And that you are compensated for taking higher risk in your bond allocation by extending duration in your treasury bonds.

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vineviz
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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Tue Aug 13, 2019 10:17 am

TNOA wrote:
Tue Aug 13, 2019 6:18 am
... so my question is, does this warrant to switch the 10-year Treasury exposure within the AA (asset allocation) to 2-year Treasuries? I know this may tick you guys off as it is not "stay the course" but i honestly couldn't do without asking.
It does not, in my opinion.

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.

A second factor is that 10-year bonds virtually always yield more than 2-year bonds, and even small differences will compound over time.

A third factor is that the longer bonds are better diversifiers for equities, so much so that even starting at a point when 2-year bonds yielded MORE than 10-year bonds, portfolios with the longer bonds have historically had higher returns and lower volatility.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Topic Author
TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 11:53 am

catalina355 wrote:
Tue Aug 13, 2019 8:36 am
robertmcd wrote:
Tue Aug 13, 2019 8:28 am
Most important issue here is what your stock allocation is. In isolation 2 yr treasuries may be a higher risk/return asset than the 10 yr right now, but what about when paired with 60% stocks? The most important thing for me is that US stocks and treasuries bonds have historically had a negative correlation, and so you are very well compensated for taking the extra risk in treasury bonds when you pair it with a medium to high stock allocation.

The exception to this is using leverage thru treasury futures to make the 2 yr treasury as volatile as the 10 yr, but this is a bit much for the average boglehead.
Why do you say treasury bonds have extra risk? Also why is the 2 year a higher risk than the 10 year?
Bonds haver extra risk because yield to maturity for both become almost equal and bond maturity is higher (higher risk if rates go up) than notes maturity. On your other question, I am not saying 2 year is higher risk. I am saying 10 year treasury bonds are higher risk.

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TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 11:55 am

vineviz wrote:
Tue Aug 13, 2019 10:17 am
TNOA wrote:
Tue Aug 13, 2019 6:18 am
... so my question is, does this warrant to switch the 10-year Treasury exposure within the AA (asset allocation) to 2-year Treasuries? I know this may tick you guys off as it is not "stay the course" but i honestly couldn't do without asking.
It does not, in my opinion.

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.

A second factor is that 10-year bonds virtually always yield more than 2-year bonds, and even small differences will compound over time.

A third factor is that the longer bonds are better diversifiers for equities, so much so that even starting at a point when 2-year bonds yielded MORE than 10-year bonds, portfolios with the longer bonds have historically had higher returns and lower volatility.
I could answer this and prolong the debate, but I will appear as though I am trading, and that's one thing I would hate. So, thank you, yes, I understand and have to agree with you on this. Thanks again.

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TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 11:57 am

Call_Me_Op wrote:
Tue Aug 13, 2019 7:07 am
You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
Sorry but who or what exactly is Pascal's Wager? Apologize for my ignorance.

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TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 11:57 am

thx1138 wrote:
Tue Aug 13, 2019 6:25 am
Here’s a thread full of people worried about potentially permanent negative interest rates and discussing whether switching to 20-30 year treasuries is the right thing to do:

viewtopic.php?f=10&t=287897

Interest rates have “had nowhere to go but up” for almost a decade now.

That said there is one school of thought that says when the yield curve flattens indeed shorten duration. The idea being you should expect to get some compensation for taking the risk of extending maturity. Such investors have some sort of threshold - so many basis points of yield per year of maturity - to set their target duration.
thank you for responding thoughtfully, I will review the link and I believe, I am getting the point you are trying to make even without clicking on the link you've provided -:).

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catalina355
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Re: Switch AA 10-year to 2-year Treasuries?

Post by catalina355 » Tue Aug 13, 2019 12:01 pm

TNOA wrote:
Tue Aug 13, 2019 11:57 am
Call_Me_Op wrote:
Tue Aug 13, 2019 7:07 am
You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
Sorry but who or what exactly is Pascal's Wager? Apologize for my ignorance.
Google will lead you here...

https://en.wikipedia.org/wiki/Pascal%27s_wager

mikemikemike
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Re: Switch AA 10-year to 2-year Treasuries?

Post by mikemikemike » Tue Aug 13, 2019 12:02 pm

TNOA wrote:
Tue Aug 13, 2019 11:57 am
Call_Me_Op wrote:
Tue Aug 13, 2019 7:07 am
You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
Sorry but who or what exactly is Pascal's Wager? Apologize for my ignorance.
https://lmgtfy.com/?q=Pascal%27s+wager

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Re: Switch AA 10-year to 2-year Treasuries?

Post by garlandwhizzer » Tue Aug 13, 2019 12:18 pm

VINEVIZ wrote:

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.
The following quote is from an article in Investopedia on interest rate risk:
What is interest rate risk?
The interest rate risk, or market risk, refers to the chance that investments in bonds – also known as fixed-income securities – will suffer as the result of unexpected interest rate changes. However, investors can somewhat mitigate interest rate risks by diversifying portfolios to include a multitude of different bonds that have varying maturation schedules
Investopedia apparently believes that interest rate risk is not minimized by moving to bonds of duration matched to your investment horizon, but rather by "diversifying portfolios to include a multitude of different bonds that have varying maturity dates."

I agree with that view. Greater duration in long term bonds dramatically increases principal losses in a rising rate environment. In a falling rate environment the opposite happens. The last 37 years have witnessed a general trend for falling rates which is why this long duration approach is suggested by the academic literature derived from backtesting. Backtesting often arrives at flawed conclusions which are period dependent and also it assumes the future will be a replay of the past. That assumption may work if this ever lower inflation trend continues unabated forever. Or it may not if at some point in the future before "your investment horizon," inflation rises from its grave. Increasing average bond duration increases potential interest rate risk. Whether that plays out positively or negatively for investor returns depends on inflation which over long time frames is not predictable beforehand.

Garland Whizzer

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vineviz
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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Tue Aug 13, 2019 5:19 pm

garlandwhizzer wrote:
Tue Aug 13, 2019 12:18 pm
VINEVIZ wrote:

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.
The following quote is from an article in Investopedia on interest rate risk:
What is interest rate risk?
The interest rate risk, or market risk, refers to the chance that investments in bonds – also known as fixed-income securities – will suffer as the result of unexpected interest rate changes. However, investors can somewhat mitigate interest rate risks by diversifying portfolios to include a multitude of different bonds that have varying maturation schedules
Investopedia apparently believes that interest rate risk is not minimized by moving to bonds of duration matched to your investment horizon, but rather by "diversifying portfolios to include a multitude of different bonds that have varying maturity dates."
Investopedia is sometimes (frequently) wrong, or at least so imprecise as to be effectively wrong.

This is one of those times.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Tue Aug 13, 2019 7:06 pm

vineviz wrote:
Tue Aug 13, 2019 5:19 pm
garlandwhizzer wrote:
Tue Aug 13, 2019 12:18 pm
VINEVIZ wrote:

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.
The following quote is from an article in Investopedia on interest rate risk:
What is interest rate risk?
The interest rate risk, or market risk, refers to the chance that investments in bonds – also known as fixed-income securities – will suffer as the result of unexpected interest rate changes. However, investors can somewhat mitigate interest rate risks by diversifying portfolios to include a multitude of different bonds that have varying maturation schedules
Investopedia apparently believes that interest rate risk is not minimized by moving to bonds of duration matched to your investment horizon, but rather by "diversifying portfolios to include a multitude of different bonds that have varying maturity dates."
Investopedia is sometimes (frequently) wrong, or at least so imprecise as to be effectively wrong.

This is one of those times.
I don't understand what your definition of risk is then.

If rates for the bond in question (they're all correlated, but not in lockstep) change, the bond fund with the shorter duration will experience the least change in underlying value. It's like a lever. At the short end of the lever are short bond. On the long end of the lever are the long bonds.

It is usually this risk of bond fund value changing that is referred to as interest rate risk. The change in the value of the bond fund if interest rates change.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by columbia » Tue Aug 13, 2019 7:10 pm

Call_Me_Op wrote:
Tue Aug 13, 2019 7:07 am
You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
This is a good post: the least bad outcome - in terms of bonds - will usually track with short term treasuries.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Tue Aug 13, 2019 7:13 pm

columbia wrote:
Tue Aug 13, 2019 7:10 pm
Call_Me_Op wrote:
Tue Aug 13, 2019 7:07 am
You could certainly invoke Pascal's Wager to justify 2 year notes instead of the 10 year bonds. In other words the risk going with 2 year is re-investment risk if rates fall further - while the risk with the 10 year is inflation risk if there is a sharp rise in inflation - arguably more threatening.
This is a good post: the least bad outcome - in terms of bonds - will usually track with short term treasuries.
The flip side is that they'll do barely better than a money market account.

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Leif
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Re: Switch AA 10-year to 2-year Treasuries?

Post by Leif » Tue Aug 13, 2019 7:30 pm

I switched some of my ST bond fund to IT (5 year) bond fund when 10 Yr. Treasuries were around 2.2%. Of course it would have been better to do it when it was 3+%. So in the short term I now have a higher return now and a larger gain than if I'd kept the ST bonds. I think I'll keep the bonds allocation where they are now. The reason for my adjustment was not to market time, but to have an allocation to ST/IT that makes more sense for me. I have no plans to change my allocation regardless of interest rates going up, down, or staying the same

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TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Tue Aug 13, 2019 9:35 pm

Leif wrote:
Tue Aug 13, 2019 7:30 pm
I switched some of my ST bond fund to IT (5 year) bond fund when 10 Yr. Treasuries were around 2.2%. Of course it would have been better to do it when it was 3+%. So in the short term I now have a higher return now and a larger gain than if I'd kept the ST bonds. I think I'll keep the bonds allocation where they are now. The reason for my adjustment was not to market time, but to have an allocation to ST/IT that makes more sense for me. I have no plans to change my allocation regardless of interest rates going up, down, or staying the same
Again, what made you change your allocation then? And if this wasn't a market timing transaction, what compelled you to change your allocation, that we can all qualify as "- this wasn't market timing, but was ... !"

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vineviz
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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Tue Aug 13, 2019 11:56 pm

Lee_WSP wrote:
Tue Aug 13, 2019 7:06 pm
If rates for the bond in question (they're all correlated, but not in lockstep) change, the bond fund with the shorter duration will experience the least change in underlying value.
What you’re describing is half of interest rate risk: the portion usually referred to as “price risk”.

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.

When the investment horizon equals bond duration, the two components of interest rate risk perfectly offset each other.

When bond duration is longer or shorter than the investment horizon, interest rate risk grows because one of the components is going to be stronger than the other.

Inexperienced investors often focus only on the price risk, overlooking the reinvestment risk.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Wed Aug 14, 2019 12:00 am

vineviz wrote:
Tue Aug 13, 2019 11:56 pm
The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
I am unclear why that is a consideration in terms of a bond fund. When rates change, all the bonds will now yield the new rate. New or old.

What exactly is the risk to purchasing a new bond today? You know exactly what the rate will be. The bond will yield exactly that rate. The only way future rate changes affect anything at all is if you go to sell it. But if you hold it until expiration, you got the yield you paid for initially.

As the bond fund replaces the sold or expired bonds, the new bonds will cost just as much as the old bonds because the old bonds rose in value.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by andrew99999 » Wed Aug 14, 2019 12:51 am

vineviz wrote:
Tue Aug 13, 2019 11:56 pm
What you’re describing is half of interest rate risk: the portion usually referred to as “price risk”.

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.

When the investment horizon equals bond duration, the two components of interest rate risk perfectly offset each other.

When bond duration is longer or shorter than the investment horizon, interest rate risk grows because one of the components is going to be stronger than the other.

Inexperienced investors often focus only on the price risk, overlooking the reinvestment risk.
Are these 2 risks affected by using a bond fund (which continually rolls onto new bonds of the fund's duration), vs individual bonds that you hold until maturity?
PassiveInvestingAustralia.com

me81
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Re: Switch AA 10-year to 2-year Treasuries?

Post by me81 » Wed Aug 14, 2019 3:34 am

Are these 2 risks affected by using a bond fund (which continually rolls onto new bonds of the fund's duration), vs individual bonds that you hold until maturity?
You're perfectly right andrew99999.

Individual bonds held to maturity do not suffer from interest rate risk, since price will go back to par at expiration. So a drop in price due to rising rates will be irrelevant if you hold to maturity..
Sure if you need to buy new bonds at expiration, you will still be hit by re-investment risk, hence the idea of having bonds matching your investment horizon..

They do suffer inflation risk however, since your coupon will not change (unless it's inflation-linked) and should inflation boom, your real return will feel the pinch.

Bond funds are indeed not the same as individual bonds for this very reason.. This is often overlooked in many forums in my opinion..

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Re: Switch AA 10-year to 2-year Treasuries?

Post by andrew99999 » Wed Aug 14, 2019 6:19 am

Thank you me81

While waiting for a response, I actually came across an explanation for this elsewhere saying something similar -
while the ETF price should fall in response to a rise in interest rates, the extra return from the higher interest rate bonds the ETF progressively acquires as old bonds mature will compensate you for that initial fall in bond price, but that compensation takes X years (where X is the bond fund duration); and if interest rates rise again during that time, it is again set back to X years.
So how would one work a bond fund into your portfolio?
Should it be that anything you don't need beyond that duration you put into the bond fund, and anything you may need earlier than that (eg if you wanted a min of 5 years of 'safe' expenses once retired) should be in a rolling 5 year ladder or something?
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Leif
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Re: Switch AA 10-year to 2-year Treasuries?

Post by Leif » Wed Aug 14, 2019 9:20 am

TNOA wrote:
Tue Aug 13, 2019 9:35 pm
Leif wrote:
Tue Aug 13, 2019 7:30 pm
I switched some of my ST bond fund to IT (5 year) bond fund when 10 Yr. Treasuries were around 2.2%. Of course it would have been better to do it when it was 3+%. So in the short term I now have a higher return now and a larger gain than if I'd kept the ST bonds. I think I'll keep the bonds allocation where they are now. The reason for my adjustment was not to market time, but to have an allocation to ST/IT that makes more sense for me. I have no plans to change my allocation regardless of interest rates going up, down, or staying the same
Again, what made you change your allocation then? And if this wasn't a market timing transaction, what compelled you to change your allocation, that we can all qualify as "- this wasn't market timing, but was ... !"
As I said:
to have an allocation to ST/IT that makes more sense for me.
Even today I have no idea if interest rates will go up, down, or stay the same. Then how can it be market timing? What prompted the change at this time was when I think how much I should have in short term, it was way too much for my needs. A bit off topic, but since you asked. Myself and my wife recently retired so I was looking forward to my RMD time and what I think I should have in short term, above and beyond the dividends and interest earnings, to make my RMDs.

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TNOA
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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Wed Aug 14, 2019 9:59 am

Leif wrote:
Wed Aug 14, 2019 9:20 am
TNOA wrote:
Tue Aug 13, 2019 9:35 pm
Leif wrote:
Tue Aug 13, 2019 7:30 pm
I switched some of my ST bond fund to IT (5 year) bond fund when 10 Yr. Treasuries were around 2.2%. Of course it would have been better to do it when it was 3+%. So in the short term I now have a higher return now and a larger gain than if I'd kept the ST bonds. I think I'll keep the bonds allocation where they are now. The reason for my adjustment was not to market time, but to have an allocation to ST/IT that makes more sense for me. I have no plans to change my allocation regardless of interest rates going up, down, or staying the same
Again, what made you change your allocation then? And if this wasn't a market timing transaction, what compelled you to change your allocation, that we can all qualify as "- this wasn't market timing, but was ... !"
As I said:
to have an allocation to ST/IT that makes more sense for me.
Even today I have no idea if interest rates will go up, down, or stay the same. Then how can it be market timing? What prompted the change at this time was when I think how much I should have in short term, it was way too much for my needs. A bit off topic, but since you asked. Myself and my wife recently retired so I was looking forward to my RMD time and what I think I should have in short term, above and beyond the dividends and interest earnings, to make my RMDs.
Thank you for clarifying... What is RMD (Retirement Monthly Distributions? No idea, just guessing sorry). So basically what you are saying, there comes a time, we need to make a wholesale AA revision. And that moment was this moment for you. If I understood you correctly.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by willthrill81 » Wed Aug 14, 2019 10:16 am

Many posters were saying the same thing a year ago. Yet from then until now, long-term bonds have far outperformed short-term bonds.

Historically, long-term bonds have reduced portfolio volatility more effectively than short-term bonds. However, long-term bonds themselves have been more volatile than short-term bonds. It's irrational to focus on a specific asset's volatility when portfolio volatility is what matters, but even so, some investors don't like seeing their 'safe money' gyrate around very much.

Unless you have a good personal reason to favor short-term bonds and want to permanently change your AA or IPS accordingly, I believe that you should stay put.
Last edited by willthrill81 on Wed Aug 14, 2019 10:48 am, edited 1 time in total.
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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Wed Aug 14, 2019 10:46 am

andrew99999 wrote:
Wed Aug 14, 2019 6:19 am
Thank you me81

While waiting for a response, I actually came across an explanation for this elsewhere saying something similar -
while the ETF price should fall in response to a rise in interest rates, the extra return from the higher interest rate bonds the ETF progressively acquires as old bonds mature will compensate you for that initial fall in bond price, but that compensation takes X years (where X is the bond fund duration); and if interest rates rise again during that time, it is again set back to X years.
So how would one work a bond fund into your portfolio?
Should it be that anything you don't need beyond that duration you put into the bond fund, and anything you may need earlier than that (eg if you wanted a min of 5 years of 'safe' expenses once retired) should be in a rolling 5 year ladder or something?
There are a couple of ways to mange this.

One way is to match each year’s expense (or at least the portion you want to cover with fixed income) with an individual bond. A little work to set up, but once setup it basically goes on autopilot.

The second way is to own a bond fund (or group of bonds) with a duration equal to the average time until the expenses. A little less precise, but easier to set up. Once you get closer to the expenses you’d need to reduce the average duration of the bonds, but this can be accomplished by simply rebalancing gradually from a long term fund to a shorter term fund.
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Re: Switch AA 10-year to 2-year Treasuries?

Post by Leif » Wed Aug 14, 2019 11:07 am

TNOA wrote:
Wed Aug 14, 2019 9:59 am
Thank you for clarifying... What is RMD (Retirement Monthly Distributions? No idea, just guessing sorry). So basically what you are saying, there comes a time, we need to make a wholesale AA revision. And that moment was this moment for you. If I understood you correctly.
Required Minimum Distributions. There is a requirement to remove a certain percentage of assets (depending on your age) from your traditional IRA accounts. I would not say a wholesale AA revision. I only changed my bonds after looking at a cash flow analysis. But I think some people make changes around retirement to better fit their needs in retirement.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by pascalwager » Wed Aug 14, 2019 2:24 pm

me81 wrote:
Wed Aug 14, 2019 3:34 am
Are these 2 risks affected by using a bond fund (which continually rolls onto new bonds of the fund's duration), vs individual bonds that you hold until maturity?
You're perfectly right andrew99999.

Individual bonds held to maturity do not suffer from interest rate risk, since price will go back to par at expiration. So a drop in price due to rising rates will be irrelevant if you hold to maturity..
Sure if you need to buy new bonds at expiration, you will still be hit by re-investment risk, hence the idea of having bonds matching your investment horizon..

They do suffer inflation risk however, since your coupon will not change (unless it's inflation-linked) and should inflation boom, your real return will feel the pinch.

Bond funds are indeed not the same as individual bonds for this very reason.. This is often overlooked in many forums in my opinion..
Bond funds and individual bonds are both subject to interest rate risk whether or not the individual bond is held to maturity.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by jdilla1107 » Wed Aug 14, 2019 3:04 pm

Going shorter duration because of the yield curve is completely silly. You could make an equally viable argument that you should go longer duration. (The yield curve is "telling you" that short term rates are going to drop.)

The correct answer is to not pay any attention to it and make no moves based on it.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Wed Aug 14, 2019 3:06 pm

pascalwager wrote:
Wed Aug 14, 2019 2:24 pm
me81 wrote:
Wed Aug 14, 2019 3:34 am
Are these 2 risks affected by using a bond fund (which continually rolls onto new bonds of the fund's duration), vs individual bonds that you hold until maturity?
You're perfectly right andrew99999.

Individual bonds held to maturity do not suffer from interest rate risk, since price will go back to par at expiration. So a drop in price due to rising rates will be irrelevant if you hold to maturity..
Sure if you need to buy new bonds at expiration, you will still be hit by re-investment risk, hence the idea of having bonds matching your investment horizon..

They do suffer inflation risk however, since your coupon will not change (unless it's inflation-linked) and should inflation boom, your real return will feel the pinch.

Bond funds are indeed not the same as individual bonds for this very reason.. This is often overlooked in many forums in my opinion..
Bond funds and individual bonds are both subject to interest rate risk whether or not the individual bond is held to maturity.
Only hypothetically. In practicality, the holder gets exactly what he/she paid for at the beginning.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Hector » Wed Aug 14, 2019 4:54 pm

jdilla1107 wrote:
Wed Aug 14, 2019 3:04 pm
Going shorter duration because of the yield curve is completely silly. You could make an equally viable argument that you should go longer duration. (The yield curve is "telling you" that short term rates are going to drop.)

The correct answer is to not pay any attention to it and make no moves based on it.
It depends on investor’s goal. If the goal is capital preservation in nominal terms, it makes sense to buy treasury bills.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by jdilla1107 » Wed Aug 14, 2019 5:46 pm

Hector wrote:
Wed Aug 14, 2019 4:54 pm
jdilla1107 wrote:
Wed Aug 14, 2019 3:04 pm
Going shorter duration because of the yield curve is completely silly. You could make an equally viable argument that you should go longer duration. (The yield curve is "telling you" that short term rates are going to drop.)

The correct answer is to not pay any attention to it and make no moves based on it.
It depends on investor’s goal. If the goal is capital preservation in nominal terms, it makes sense to buy treasury bills.
That seems like i'ts always true. The difference between the 2 year and 10 year treasury has been like 10 to 20 basis points for all of 2019. To say that 20 basis points is substantially different than actually flat is silly. It's a psychological threshold.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by andrew99999 » Wed Aug 14, 2019 7:59 pm

vineviz wrote:
Wed Aug 14, 2019 10:46 am
andrew99999 wrote:
Wed Aug 14, 2019 6:19 am
Thank you me81

While waiting for a response, I actually came across an explanation for this elsewhere saying something similar -
while the ETF price should fall in response to a rise in interest rates, the extra return from the higher interest rate bonds the ETF progressively acquires as old bonds mature will compensate you for that initial fall in bond price, but that compensation takes X years (where X is the bond fund duration); and if interest rates rise again during that time, it is again set back to X years.
So how would one work a bond fund into your portfolio?
Should it be that anything you don't need beyond that duration you put into the bond fund, and anything you may need earlier than that (eg if you wanted a min of 5 years of 'safe' expenses once retired) should be in a rolling 5 year ladder or something?
There are a couple of ways to mange this.

One way is to match each year’s expense (or at least the portion you want to cover with fixed income) with an individual bond. A little work to set up, but once setup it basically goes on autopilot.

The second way is to own a bond fund (or group of bonds) with a duration equal to the average time until the expenses. A little less precise, but easier to set up. Once you get closer to the expenses you’d need to reduce the average duration of the bonds, but this can be accomplished by simply rebalancing gradually from a long term fund to a shorter term fund.
Thanks vineviz.

Are you saying that, say you wanted 5 years of money that will be potentially used and want to avoid bond risk, that you would use short term bonds (3 years approximate duration being average of 1,2,3,4,5 years) and the remaining "low risk" assets in an intermediate/long term bond fund which you can let ride, although I don't see how this removes the problem of taking risk on money you may need in the near future.

In the UK, they had a massive bond crash in '72 or '73 where UK gilts fell by 50% between 1972 and 1974, so I guess that is why a CD ladder (called a GICS ladder there) is mentioned on UK-based forums.

Is it right to say that -
Money you put in bonds, you need to be able to let it ride for at least the effective duration of the bond fund, and any money that you may need earlier, should either be in individual bonds or CDs of that duration, or else in MM?
PassiveInvestingAustralia.com

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Re: Switch AA 10-year to 2-year Treasuries?

Post by JBTX » Wed Aug 14, 2019 10:12 pm

Did not see every post in thread, but taking the counter argument, I am guessing that typically when short term rates are higher than long term rates, that signals weakness and rates go down across the board, which benefits long bonds much more than short and is also a better diversifier (or should I say hedge) as mentioned previously. The thing that is different this time is rates are so low. Usually long term and short term are both higher with yield curve inversions.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Wed Aug 14, 2019 10:33 pm

jdilla1107 wrote:
Wed Aug 14, 2019 5:46 pm
Hector wrote:
Wed Aug 14, 2019 4:54 pm
jdilla1107 wrote:
Wed Aug 14, 2019 3:04 pm
Going shorter duration because of the yield curve is completely silly. You could make an equally viable argument that you should go longer duration. (The yield curve is "telling you" that short term rates are going to drop.)

The correct answer is to not pay any attention to it and make no moves based on it.
It depends on investor’s goal. If the goal is capital preservation in nominal terms, it makes sense to buy treasury bills.
That seems like i'ts always true. The difference between the 2 year and 10 year treasury has been like 10 to 20 basis points for all of 2019. To say that 20 basis points is substantially different than actually flat is silly. It's a psychological threshold.
I don't know 2019... but as of today, the difference is practically reduced to zero.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by TNOA » Wed Aug 14, 2019 10:36 pm

JBTX wrote:
Wed Aug 14, 2019 10:12 pm
Did not see every post in thread, but taking the counter argument, I am guessing that typically when short term rates are higher than long term rates, that signals weakness and rates go down across the board, which benefits long bonds much more than short and is also a better diversifier (or should I say hedge) as mentioned previously. The thing that is different this time is rates are so low. Usually long term and short term are both higher with yield curve inversions.
Good point re from one perspective, long bonds may be favored... Thank you for raising this reasoning

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Re: Switch AA 10-year to 2-year Treasuries?

Post by me81 » Wed Aug 14, 2019 11:24 pm

Bond funds and individual bonds are both subject to interest rate risk whether or not the individual bond is held to maturity.
pascalwager, interest rate risk is the drop in price of a bond if interest rates rise.. If you need to sell the bond, you might receive less than you paid for. However, if you buy the bond at par and hold it to maturity (which is what the question was), you will receive par back, therefore any drop in price during the holding period will only be a loss "on paper".

In fact, I could even argue that if you buy in the secondary market at a discount and hold to maturity, you will receive the YTM at the time of purchase, which will be more than if you bought at the time of issue (due to par being higher than what you paid for), regardless of the price fluctuations in between.

You might incur in opportunity risk, by not being able to take advantage of new, higher yielding bonds, but that is not interest rate risk, as I interpret it.

The FINRA website explains bond risks, note the "if you sell" part.. https://www.finra.org/investors/understanding-bond-risk

If you have any evidence or reasoning to support your statement, I'm all ears..

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Re: Switch AA 10-year to 2-year Treasuries?

Post by garlandwhizzer » Thu Aug 15, 2019 1:56 pm

vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising reinvestment of lower duration bonds that turn over more quickly take advantage of rising yields by reinvesting at ever higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them. Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected it in 1940 either after more than a decade of persistent deflation in the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer

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Re: Switch AA 10-year to 2-year Treasuries?

Post by catalina355 » Thu Aug 15, 2019 2:13 pm

garlandwhizzer wrote:
Thu Aug 15, 2019 1:56 pm
vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising reinvestment of lower duration bonds that turn over more quickly take advantage of rising yields by reinvesting at ever higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them. Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected it in 1940 either after more than a decade of persistent deflation in the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer
I agree. What kind of funds would you use to include multiple durations? Total Bond or a combination of short term bond funds as well as intermediate term bond funds. I am retired and trying to work out how to allocate the bond portfolio. Currently Total Bond in IRA and ST Treasury in taxable.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Thu Aug 15, 2019 2:34 pm

garlandwhizzer wrote:
Thu Aug 15, 2019 1:56 pm
vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising, reinvestment of lower duration bonds [sic] take advantage of rising yields by reinvesting at [sic] higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them.

Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. (ed. Note: you mean long term inflation & interest rate risk right?)

Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected [this to happen] in 1940 after more than a decade of persistent deflation [during] the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer
I edited this for easier reading.

I think we all agree that no one else agrees with Vineviz's definition of interest rate risk.

Inflation risk is a separate additional risk for holding bonds.

I am unaware of "duration risk" being a separate defined risk. But the way you put it, I think you are referring to how longer durations amplify the risks (and rewards). As you point out, the lower the duration, the faster the turnaround and the lower the risk.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Thu Aug 15, 2019 2:47 pm

Lee_WSP wrote:
Thu Aug 15, 2019 2:34 pm
garlandwhizzer wrote:
Thu Aug 15, 2019 1:56 pm
vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising, reinvestment of lower duration bonds [sic] take advantage of rising yields by reinvesting at [sic] higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them.

Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. (ed. Note: you mean long term inflation & interest rate risk right?)

Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected [this to happen] in 1940 after more than a decade of persistent deflation [during] the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer
I edited this for easier reading.

I think we all agree that no one else agrees with Vineviz's definition of interest rate risk.

Inflation risk is a separate additional risk for holding bonds.

I am unaware of "duration risk" being a separate defined risk. But the way you put it, I think you are referring to how longer durations amplify the risks (and rewards). As you point out, the lower the duration, the faster the turnaround and the lower the risk.
What I wrote earlier reflects the standard treatment of interest rate risk, as taught in every finance program and the CFA curriculum: a bond or bond fund’s duration reflects the point in time in which interest rate risk zeroes out because price risk and reinvestment risk are balanced.

This is one of the definitions of “duration”, in fact.
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Re: Switch AA 10-year to 2-year Treasuries?

Post by Lee_WSP » Thu Aug 15, 2019 3:07 pm

vineviz wrote:
Thu Aug 15, 2019 2:47 pm
Lee_WSP wrote:
Thu Aug 15, 2019 2:34 pm
garlandwhizzer wrote:
Thu Aug 15, 2019 1:56 pm
vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising, reinvestment of lower duration bonds [sic] take advantage of rising yields by reinvesting at [sic] higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them.

Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. (ed. Note: you mean long term inflation & interest rate risk right?)

Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected [this to happen] in 1940 after more than a decade of persistent deflation [during] the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer
I edited this for easier reading.

I think we all agree that no one else agrees with Vineviz's definition of interest rate risk.

Inflation risk is a separate additional risk for holding bonds.

I am unaware of "duration risk" being a separate defined risk. But the way you put it, I think you are referring to how longer durations amplify the risks (and rewards). As you point out, the lower the duration, the faster the turnaround and the lower the risk.
What I wrote earlier reflects the standard treatment of interest rate risk, as taught in every finance program and the CFA curriculum: a bond or bond fund’s duration reflects the point in time in which interest rate risk zeroes out because price risk and reinvestment risk are balanced.

This is one of the definitions of “duration”, in fact.
FINRA defines duration risk as "Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates."

They also define interest rate risk as: "when interest rates rise, bond prices fall, and vice versa. This is known as interest rate risk." (emphasis added)

https://www.finra.org/investors/alerts/ ... -portfolio

The google search "duration risk" CFA does not yield any results that support your position. Nor do any of the results disagree with the FINRA definition.

Other CFA documents appear to be behind paywalls.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by HawkeyePierce » Thu Aug 15, 2019 4:00 pm

catalina355 wrote:
Thu Aug 15, 2019 2:13 pm
garlandwhizzer wrote:
Thu Aug 15, 2019 1:56 pm
vineviz wrote:

The other half of interest rate risk is “reinvestment risk”, which is the risk that bond payments will be reinvested at a different (lower) rate if yields changed.
Interesting that this looks at only one side of reinvestment risk (lower rates). If rates are rising reinvestment of lower duration bonds that turn over more quickly take advantage of rising yields by reinvesting at ever higher interest rates while longer term bonds are stuck with the low rates that existed when you purchased them. Rates have historically gone both ways, not just lower over time. Personally I believe it's imprudent for anyone at this time to load up on 30 year Treasuries that are yielding 2%. That's locking in the lowest 30 year Treasury rate in history and being stuck with it for 3 decades. 2% nominal, essentially zero percent real at current inflation rates, is an absurdly small payment for taking on 3 decades of duration risk. Long term bonds got devastated from 1940 to 1980, losing about 70% of their real value over 4 decades. No one expects severe inflation like that period going forward now. On the other hand, no one expected it in 1940 either after more than a decade of persistent deflation in the Great Depression. No one knows the future of inflation/deflation with actionable certainty over the next 3 decades. It seems reasonable to me to admit that up front and select a bond portfolio that includes multiple durations, ready for whichever way the wind blows in the future.

Garland Whizzer
I agree. What kind of funds would you use to include multiple durations? Total Bond or a combination of short term bond funds as well as intermediate term bond funds. I am retired and trying to work out how to allocate the bond portfolio. Currently Total Bond in IRA and ST Treasury in taxable.
(I'm not invested in it) but GOVT is a fairly low cost ETF holding a broad range of durations of Treasuries from 1-30 years. However at an ER of 0.15% it would be cheaper to combine multiple Vanguard Treasury funds as they cost less than half as much.

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Re: Switch AA 10-year to 2-year Treasuries?

Post by Doc » Thu Aug 15, 2019 4:27 pm

vineviz wrote:
Tue Aug 13, 2019 10:17 am

For one thing, moving to bonds with a duration shorter than your investment horizon increases your interest rate risk.

...

A third factor is that the longer bonds are better diversifiers for equities, so much so that even starting at a point when 2-year bonds yielded MORE than 10-year bonds, portfolios with the longer bonds have historically had higher returns and lower volatility.
You have two reasons that are somewhat contradictory.

If you are basing your duration on your investment horizon you wouldn't be selling them to buy equities so the diversifiers effect is somewhat mute.
(OK you might sleep better if your total portfolio is less volatile but that's why we drink bourbon before going to bed. :sharebeer )
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Re: Switch AA 10-year to 2-year Treasuries?

Post by vineviz » Thu Aug 15, 2019 4:28 pm

Lee_WSP wrote:
Thu Aug 15, 2019 3:07 pm
Other CFA documents appear to be behind paywalls.
Interest rate risk, term risk, duration risk, etc. are all commonly used in the industry to refer to the same thing. “Interest rate risk” is probably the most accurate and commonly used, but they all have identical meaning.

Here’s a summary from the CFA curriculum learning standards:

https://www.cfainstitute.org/membership ... isk-return


Image

It’s a summary so it doesn’t go into full detail. There are a couple of ways to calculate duration, one of which marks the EXACT point at which price risk and reinvestment risk balance out.

Image

For most practical purposes, effective duration and modified duration are going to be interchangeable. If the difference mattered to you, you’d know which to use.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Switch AA 10-year to 2-year Treasuries?

Post by SandysDad » Thu Aug 15, 2019 9:33 pm

in my IPS I look at the term premium for my bond investments. Based on long term averages I keep my duration at or under 2 years if 2/10 year premium is <1%. I invest in a mix of duration if term premium is 1-2%. And if over 2%, then I tilt my investments to longer term.

There has not been a good term premium lately, so my investments right now are shorter term.

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