Bond Funds v. Bonds

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ResNullius
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Bond Funds v. Bonds

Post by ResNullius » Tue Oct 13, 2009 2:52 pm

I know there have been many threads discussing the relative merits of bond funds versus holding individual bonds/ladders. My question is this: Is there an analysis of the total returns over 5, 10, 15, and 20 years that compare a lump sum invested in a bond fund with a lump sum invested in individual bonds (or a ladder constructed over say a year or two). With bond funds, the net asset value goes up and down, and the yield goes up and down as interest rates fluctuate. With individual bonds, the principal and interest rate stays constant, but the holder of the individual bonds loses out on the chance to sell and reinvest as the rate goes up. If the holder of the individual bonds sell, then there are loses that might compare to the losses in net asset value of the funds. Regardless, is there such an analysis? I think such an analysis would help show the true relative merit of owning bond funds versus individual bonds, assuming you hold both for relatively lenghy periods of time like 5, 10, 15 and 20 years. This might be a stupid question, but it's been nagging me for some time now.

mfen
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Post by mfen » Tue Oct 13, 2009 3:17 pm

With individual bonds, the principal and interest rate stays constant, but the holder of the individual bonds loses out on the chance to sell and reinvest as the rate goes up.


I can't answer your question about a study. However individual bond prices do fluctuate and you can sell them.
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ResNullius
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Post by ResNullius » Tue Oct 13, 2009 3:27 pm

mfen wrote:
With individual bonds, the principal and interest rate stays constant, but the holder of the individual bonds loses out on the chance to sell and reinvest as the rate goes up.


I can't answer your question about a study. However individual bond prices do fluctuate and you can sell them.


Yes, but when you sell a bond with a lower yield than currently issued bonds, you get less than the full principal amount of that bond. Wouldn't this mean that you then would have less to invest in the new higher rate bond?

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Post by mfen » Tue Oct 13, 2009 3:34 pm

Well, sure, but I wasn't proposing you sell it low. The bonds in the funds are being bought and sold that is they are not all held to maturity.

My simplistic understanding and the reason I do invest in bond funds is that it takes large sums of money and costs to construct a properly diversified bond portfolio. But I do dabble in the bond market and have realized gains with some of my bonds.
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Post by ResNullius » Tue Oct 13, 2009 3:43 pm

mfen wrote:Well, sure, but I wasn't proposing you sell it low. The bonds in the funds are being bought and sold that is they are not all held to maturity.

My simplistic understanding and the reason I do invest in bond funds is that it takes large sums of money and costs to construct a properly diversified bond portfolio. But I do dabble in the bond market and have realized gains with some of my bonds.


It's my simplistic understanding that has caused me to ask the original question. I use Vangaurd bond funds for my fixed asset allocation, but it seems that almost everyone on this forum (and elsewhere) is of the opinion that it's better to own individual bonds because they don't lose principal when interest rates go up (as bond funds do). I understand this point, but it seems to me that people who buy and hold individual bonds suffer a loss too. When rates go up and they don't sell their bonds so as to avoid incuring a loss of principal, they lose out on the potential to secure a higher yield resulting from increasing rates. I'm just wondering how this loss compare to the loss of net asset value in bond funds when interest rates go up. I might not be asking this the right way, but I hope readers at least know what I'm trying to get at.

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bonds

Post by hollowcave2 » Tue Oct 13, 2009 4:07 pm

I use Vangaurd bond funds for my fixed asset allocation, but it seems that almost everyone on this forum (and elsewhere) is of the opinion that it's better to own individual bonds because they don't lose principal when interest rates go up (as bond funds do).


I don't think this is a true statement. Most people here use bond funds for the diversification and liquidity.

Actually, slowly rising interest rates help the long term bond investor. As rates rise, you collect more income, and with time, this usually offsets and overcomes the drop in principal.

In order to choose the appropriate bond fund, look at duration. Ideally, choose a bond fund with a duration that matches your time horizon, or when you expect to pull the funds out. But always have a duration less than your time horizon. For less volatility, shorten the duration even more.

IMHO, the best bang for the buck in in intermediate bond funds with durations of 3 to 5 years.

By choosing the duration in this way, you'll maximize your chances of making money, even as interest rates climb.

And remember, slowly rising rates are good for long term investors in bond funds. You simply get more income, and that's a good thing.

JMHO

Steve

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Post by mfen » Tue Oct 13, 2009 4:27 pm

Back to your first question about studies. I doubt that study could be done with any certitude. But it may be helpful to look at performance of actively managed bond funds versus index bond funds. You maybe able to glean something from that.

I think most people here use the bond index and may buy individual bonds from the US Treasury. Treasury has no transaction cost and very small credit risk. I have also seen people group their CD's as bonds.

I would be curious how many bogleheads actually buy individual corporate, municipal or other bonds besides treasuries.

As an aside if inflation spikes as some gurus are predicting this time I am buying 10% treasuries. :wink:
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Post by raddle » Tue Oct 13, 2009 4:34 pm

ResNullius wrote:... it seems that almost everyone on this forum (and elsewhere) is of the opinion that it's better to own individual bonds because they don't lose principal when interest rates go up (as bond funds do).


The folks I have read here that advocate or own individual bonds say they do so to save on fees, not because of the reason you cited. Many also concede a good fund is almost or equally attractive.

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Post by ResNullius » Tue Oct 13, 2009 4:55 pm

raddle wrote:
ResNullius wrote:... it seems that almost everyone on this forum (and elsewhere) is of the opinion that it's better to own individual bonds because they don't lose principal when interest rates go up (as bond funds do).


The folks I have read here that advocate or own individual bonds say they do so to save on fees, not because of the reason you cited. Many also concede a good fund is almost or equally attractive.


I stand corrected, and happily corrected.

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Re: Bond Funds v. Bonds

Post by RobG » Tue Oct 13, 2009 5:01 pm

ResNullius wrote:I know there have been many threads discussing the relative merits of bond funds versus holding individual bonds/ladders. My question is this: Is there an analysis of the total returns over 5, 10, 15, and 20 years that compare a lump sum invested in a bond fund with a lump sum invested in individual bonds (or a ladder constructed over say a year or two).


I don't think you would draw the proper conclusion from the study because the last 40 years have been a falling interest rate environment. A person would have done far better to hold a long duration fund than holding individual bonds to maturity. The answer to the question is that a bond fund is probably different than a portfolio designed to meet your needs so it will behave differently.

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Post by RobG » Tue Oct 13, 2009 5:13 pm

raddle wrote:
ResNullius wrote:... it seems that almost everyone on this forum (and elsewhere) is of the opinion that it's better to own individual bonds because they don't lose principal when interest rates go up (as bond funds do).


The folks I have read here that advocate or own individual bonds say they do so to save on fees, not because of the reason you cited. Many also concede a good fund is almost or equally attractive.


Actually there is a good portion of people who point out that you can lose principal as you shorten the duration (e.g. going from long to intermediate) during a rising rate environment. This won't happen if you buy the individual bonds since they shorten the duration automatically.

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Post by dbr » Tue Oct 13, 2009 5:14 pm

My analysis is that every investor on this board who might be content to admit to holding bond funds is met by three investors who have reasons, possibly good ones, why the good plan can be made perfect.

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Taylor Larimore
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Past bond performance (like stocks) is misleading

Post by Taylor Larimore » Tue Oct 13, 2009 6:03 pm

I deleted this post because Tramper Al correctly identified a large error.

Thanks Al.
Last edited by Taylor Larimore on Wed Oct 14, 2009 3:09 pm, edited 1 time in total.
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danbek
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Re: Bond Funds v. Bonds

Post by danbek » Tue Oct 13, 2009 6:12 pm

ResNullius wrote: ... compare a lump sum invested in a bond fund with a lump sum invested in individual bonds (or a ladder constructed over say a year or two) ...


I don't think you can even begin to discuss whether a particular bond strategy is better than a bond fund until you answer (at least) two questions:

1. What are you trying to accomplish with this investment? Saving for retirement 30 years from now? Downpayment on a house 5 years from now? Funding ongoing retirement? etc.

2. What strategy do you propose to use in place of the bond fund? Rolling ladder of the same duration? Shorter duration, longer duration? Buy a single bond due in X years? Buy a bond due in Y years, roll it over every Y years? Etc. etc. etc.

The reason that so many people use bond funds in retirement accounts is that if you are saving for retirement, a rolling ladder of bonds is pretty damn close to what you want, and a bond fund (which is entirely equivalent to a rolling ladder of individual bonds) is simpler than rolling your own ladder.

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Post by danbek » Tue Oct 13, 2009 6:25 pm

RobG wrote:Actually there is a good portion of people who point out that you can lose principal as you shorten the duration (e.g. going from long to intermediate) during a rising rate environment. This won't happen if you buy the individual bonds since they shorten the duration automatically.


Could you expand on this? It doesn't make sense to me:

1. In a rising rate environment, won't shortening the duration help you save principal, not lose principal?

2. "This won't happen if you buy the individual bonds since they shorten the duration automatically" ... I'm having a hard time understanding what is meant by this ... exactly what strategy is being comparing to what particular bond fund here? It's true that the duration of an individual bond falls over time, but this just means that each passing year of rising rates hurts a little less than the year before. It still hurts, and you don't make it back to even until well after the bond matures and you can reinvest at higher rates. And of course you will never catch up with the rolling ladder of shorter initial duration.

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Post by Fear and Loathing » Tue Oct 13, 2009 6:31 pm

Like stocks, bond investors can reduce risk by diversifying their portfolio. In the case of bonds, bond investors can reduce risk by investing in bonds from different issuers with different maturities. The way to achieve this diversity is to purchase many different bonds. But treasury securities are sold in $1,000 increments, and corporate bonds are similar. There is also the commission for the sale or purchase of the bond. So to have an effective diversified portfolio of bonds requires a significant initial amount. A rule-of-thumb would be ten different securities for a diversified portfolio or at least $10,000 initial investment. This is a serious impediment to a diversified portfolio, especially for initial investors.
Bonds funds like open ended, closed end, indexed or actively managed bond mutual funds, including exchange traded funds (ETF) and unit investment trusts (UIT) are an excellent way to achieve a diversified bond portfolio, without the large initial investment of purchasing individual bonds. However there are differences between a bond fund and individual bonds.
In a bond fund, like a stock fund, the investor buys shares in a portfolio of bonds that has been created to achieve specific goals. These goals could by income, tax-exempt income, total return, or to achieve the performance of a specific market index. The portfolio could be focused on short term treasuries, corporate bonds, or have a specific maturity. Typically, short term bonds are three years or less; intermediate term is three to ten years; and long-term is ten years or longer.
Most bond funds pay monthly or quarterly dividends, unlike regular bonds that may pay yearly or semiannually. In the case of foreign bonds, there may also be a currency fluctuation dividend. The market price is based on the Net Asset Value (NAV), which is the market value of the portfolio divided by the number of shares outstanding. The market value of the fund can also depend on the amount of cash coming into the fund, and cash going out of the fund.

There are several advantages that bond funds have over individual Bonds. Some of these advantages include:
• Diversity. The ability to have a large portfolio of bonds of differing maturity and type reduces the risk of the investment over hold a single individual bond.
• Size. Discounts are available to the “big-boys” that are not available to individual investors. These include volume pricing, and commission structures.
• Lower Investment Amounts. Typically, the minimum purchase price for an individual bond is $1,000, with some bonds being denominated in amounts of $10,000. Because of this, it takes a significant amount of money to achieve a fully diversified portfolio. The minimum investment in a bond index fund depends on the issuer, but can be as low as $500. The dividends can be reinvested monthly or quarterly to buy additional shares. In addition, monthly contributions of as low as $25 per month can be used to purchase additional shares.
• Regular Monthly Income. Individual bonds pay interest semiannually or yearly. Bond index funds pay at regular monthly or quarterly intervals. In addition, individual bonds can not reinvest the interest payments automatically.
• Lower Commissions. Individual bonds have much greater commissions and brokerage fees than do bond index funds. The commission for a bond of $1,000 can be as high as 5%, and the purchase may contain a considerable amount of hidden fees.

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Re: Bond Funds v. Bonds

Post by Doc » Tue Oct 13, 2009 6:58 pm

ResNullius wrote: Regardless, is there such an analysis? I think such an analysis would help show the true relative merit of owning bond funds versus individual bonds, assuming you hold both for relatively lenghy periods of time like 5, 10, 15 and 20 years. This might be a stupid question, but it's been nagging me for some time now.


Here is the analysis.

Bond fund = Bond ladder minus expenses

Of course you have to have a ladder with the same attributes like risk and duration. A bond fund after all is a ladder. There is no requirement in either a fund or a ladder to hold bonds to maturity.
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Post by dbr » Tue Oct 13, 2009 7:04 pm

Ah, so now we have three (or so) posters arguing on the side of bond funds.

This forum is amazing.

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Post by RobG » Tue Oct 13, 2009 7:07 pm

danbek wrote:
RobG wrote:Actually there is a good portion of people who point out that you can lose principal as you shorten the duration (e.g. going from long to intermediate) during a rising rate environment. This won't happen if you buy the individual bonds since they shorten the duration automatically.


Could you expand on this? It doesn't make sense to me:

1. In a rising rate environment, won't shortening the duration help you save principal, not lose principal?


You lose when you make the jump from the long to short fund. For example, say you are in the long term index with a duration of 12.1 years and you want to switch to intermediate (duration 6.3 years). If the interest rates jump 1% the LT fund will drop 12.1% and you will be buying into a fund that only dropped 6.3%. You just had 6% of your money vaporize as you were trying to shorten the duration - something that wouldn't have happened if you just owned a single bond matched to your need. You can gradually shift over but in a rising rate environment you will lose.

The duration numbers are from the vanguard current bond indexes. The risk with bond funds isn't that large, but it is still annoying when people say they are the same.

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Re: Bond Funds v. Bonds

Post by RobG » Tue Oct 13, 2009 7:09 pm

Doc wrote:
ResNullius wrote: Regardless, is there such an analysis? I think such an analysis would help show the true relative merit of owning bond funds versus individual bonds, assuming you hold both for relatively lenghy periods of time like 5, 10, 15 and 20 years. This might be a stupid question, but it's been nagging me for some time now.


Here is the analysis.

Bond fund = Bond ladder minus expenses

Of course you have to have a ladder with the same attributes like risk and duration. A bond fund after all is a ladder. There is no requirement in either a fund or a ladder to hold bonds to maturity.


Actually Vanguard bond fund are not ladders. They follow an index of bonds that mature at roughly the same time. A ladder has bonds across the maturity spectrum.

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Correction--bond fund maturities

Post by Taylor Larimore » Tue Oct 13, 2009 7:25 pm

Actually Vanguard bond fund are not ladders. They follow an index of bonds that mature at roughly the same time.


Sorry, the above quote is incorrect.

Vanguard Intermediate-Term Investment Grade Bond Fund has the following maturities:

Under 1 Year 6.0%
1 - 3 Years 9.2%
3 - 5 Years 21.7%
5 - 7 Years 17.8%
7 - 10 Years 44.0%
10 - 20 Years 1.0%

https://personal.vanguard.com/us/funds/snapshot?FundId=0071&FundIntExt=INT#hist=tab%3A2
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Re: Correction--bond fund maturities

Post by RobG » Tue Oct 13, 2009 7:47 pm

Taylor Larimore wrote:
Actually Vanguard bond fund are not ladders. They follow an index of bonds that mature at roughly the same time.


Sorry, the above quote is incorrect.

Vanguard Intermediate-Term Investment Grade Bond Fund has the following maturities:

Under 1 Year 6.0%
1 - 3 Years 9.2%
3 - 5 Years 21.7%
5 - 7 Years 17.8%
7 - 10 Years 44.0%
10 - 20 Years 1.0%

https://personal.vanguard.com/us/funds/snapshot?FundId=0071&FundIntExt=INT#hist=tab%3A2


Sorry, your quote is incorrect*. That is not a ladder - most of the funds are bunched at 7-10 years. Furthermore, it is not representative of the funds. e.g. the 97% of the bonds in the LT index are between 10 and 30 years.

*except of course the part of your quote that contains my quote. ;)

[edit: VG total bond fund seems like a reasonable approximation of a ladder, TIPs fund too]

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Post by linuxizer » Tue Oct 13, 2009 8:07 pm

RobG wrote:You lose when you make the jump from the long to short fund. For example, say you are in the long term index with a duration of 12.1 years and you want to switch to intermediate (duration 6.3 years). If the interest rates jump 1% the LT fund will drop 12.1% and you will be buying into a fund that only dropped 6.3%. You just had 6% of your money vaporize as you were trying to shorten the duration - something that wouldn't have happened if you just owned a single bond matched to your need. You can gradually shift over but in a rising rate environment you will lose.


If you gradually shift over so that your average duration always remains less than the time you need the funds, then your results will be almost exactly equal to managing a bond ladder yourself as you advocate. Your criticism of Mel's post uses a very narrow definition of the term ladder (are you saying, for instance, that people who extend the duration of their ladder slightly when the yield curve is steeper don't really have a ladder, because the maturities aren't perfectly regular?). If you shift from an intermediate-term fund to a short-term fund, at any point you hold both of them your total proportion in each maturity will be the weighted average of the two.

Vanguard Short-Term Investment Grade has the following maturities:
Under 1 Year 23.7%
1 - 3 Years 42.3%
3 - 5 Years 28.2%
5 - 7 Years 2.8%
7 - 10 Years 2.8%
10 - 20 Years 0.0%
20 - 30 Years 0.0%
Over 30 Years 0.2%

(As an aside, does anyone know why this fund holds bonds with maturities over 30 years?)

Therefore, in a 50/50 mix, the maturity should be:

Code: Select all

   VFSTX   VFICX   Combined
Under 1 Year   23.7   6   14.85%
1 - 3 Years   42.3   9.2   25.75%
3 – 5 Years   28.2   21.7   24.95%
5 – 7 Years   2.8   17.8   10.30%
7 – 10 Years   2.8   44   23.40%
10 – 20 Years   0   1   0.50%
Over 30 Years   0.2   0   0.10%


That looks reasonably regular to me. Moreover, your focus on the individual bonds held within a fund seems to ignore the wonderful summary properties of the duration. What does knowing what's in a fund tell you that knowing the duration doesn't?

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Post by RobG » Tue Oct 13, 2009 8:20 pm

linuxizer wrote:
RobG wrote:You lose when you make the jump from the long to short fund. For example, say you are in the long term index with a duration of 12.1 years and you want to switch to intermediate (duration 6.3 years). If the interest rates jump 1% the LT fund will drop 12.1% and you will be buying into a fund that only dropped 6.3%. You just had 6% of your money vaporize as you were trying to shorten the duration - something that wouldn't have happened if you just owned a single bond matched to your need. You can gradually shift over but in a rising rate environment you will lose.


If you gradually shift over so that your average duration always remains less than the time you need the funds, then your results will be almost exactly equal to managing a bond ladder yourself as you advocate. Your criticism of Mel's post uses a very narrow definition of the term ladder (are you saying, for instance, that people who extend the duration of their ladder slightly when the yield curve is steeper don't really have a ladder, because the maturities aren't perfectly regular?). If you shift from an intermediate-term fund to a short-term fund, at any point you hold both of them your total proportion in each maturity will be the weighted average of the two.

Vanguard Short-Term Investment Grade has the following maturities:
Under 1 Year 23.7%
1 - 3 Years 42.3%
3 - 5 Years 28.2%
5 - 7 Years 2.8%
7 - 10 Years 2.8%
10 - 20 Years 0.0%
20 - 30 Years 0.0%
Over 30 Years 0.2%

(As an aside, does anyone know why this fund holds bonds with maturities over 30 years?)

Therefore, in a 50/50 mix, the maturity should be:

Code: Select all

   VFSTX   VFICX   Combined
Under 1 Year   23.7   6   14.85%
1 - 3 Years   42.3   9.2   25.75%
3 – 5 Years   28.2   21.7   24.95%
5 – 7 Years   2.8   17.8   10.30%
7 – 10 Years   2.8   44   23.40%
10 – 20 Years   0   1   0.50%
Over 30 Years   0.2   0   0.10%


That looks reasonably regular to me. Moreover, your focus on the individual bonds held within a fund seems to ignore the wonderful summary properties of the duration. What does knowing what's in a fund tell you that knowing the duration doesn't?


Assuming we throw out the principle of investing in bond funds because it is simpler, I expect that you can come up with a scheme that will mimic a ladder - but that is a long ways from saying a (single) bond fund is a ladder. And it is a long ways from saying a bond fund (or even a group of bond funds) is no different than owning individual bonds.

Mimicking a particular duration with a mix of funds may or may not work - funds on either side of a maturity are not equal to that maturity because interest rates do not rise uniformly across the ranges.

The difference may be relatively small, but that argument is not the one that is being made.

[edit, I've been sucked in... my basic belief is that one should not blindly hold a ladder, but buy bonds that mature when you need them -- or just buy a fund. But funds aren't individual bonds].
Last edited by RobG on Tue Oct 13, 2009 8:30 pm, edited 1 time in total.

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Post by linuxizer » Tue Oct 13, 2009 8:25 pm

RobG wrote:Assuming we throw out the principle of investing in bond funds because it is simpler, I expect that you can come up with a scheme that will mimic a ladder - but that is a long ways from saying a (single) bond fund is a ladder. And it is a long ways from saying a bond fund (or even a group of bond funds) is no different than owning individual bonds.

Mimicking a particular duration with a mix of funds may or may not work - funds on either side of a maturity are not equal to that maturity because interest rates do not rise uniformly across the ranges.

The difference may be relatively small, but that argument is not the one that is being made.


The argument that has been made, by me and by others far more knowledgeable than I, is that a rolling bond ladder is equivalent to a bond fund. This inevitably leads to someone making an inappropriate comparison between a non-rolling ladder and a bond fund, which then leads someone to point out the inappropriate comparison, on and on and on. A bond fund holds bonds, just like an individual does when they construct a ladder. The major disadvantage of a bond fund is that you don't have control over the exact properties of this ladder. If you calculate a duration and price of your bond ladder, you will see that they respond identically to market conditions. I assume given the literally dozen or more heated threads on this topic in the last several months, that if a proponent of bond funds being WMDs were seriously inclined to check the math and prove their point that the Wiki would have been updated by now. It has not. The math is sound, and intuitively, things that hold bonds must react like collections of bonds.

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Post by RobG » Tue Oct 13, 2009 8:33 pm

linuxizer wrote:
RobG wrote:Assuming we throw out the principle of investing in bond funds because it is simpler, I expect that you can come up with a scheme that will mimic a ladder - but that is a long ways from saying a (single) bond fund is a ladder. And it is a long ways from saying a bond fund (or even a group of bond funds) is no different than owning individual bonds.

Mimicking a particular duration with a mix of funds may or may not work - funds on either side of a maturity are not equal to that maturity because interest rates do not rise uniformly across the ranges.

The difference may be relatively small, but that argument is not the one that is being made.


The argument that has been made, by me and by others far more knowledgeable than I, is that a rolling bond ladder is equivalent to a bond fund. This inevitably leads to someone making an inappropriate comparison between a non-rolling ladder and a bond fund, which then leads someone to point out the inappropriate comparison, on and on and on. A bond fund holds bonds, just like an individual does when they construct a ladder. The major disadvantage of a bond fund is that you don't have control over the exact properties of this ladder. If you calculate a duration and price of your bond ladder, you will see that they respond identically to market conditions. I assume given the literally dozen or more heated threads on this topic in the last several months, that if a proponent of bond funds being WMDs were seriously inclined to check the math and prove their point that the Wiki would have been updated by now. It has not. The math is sound, and intuitively, things that hold bonds must react like collections of bonds.


If I was to fix the wiki it would take far too much time on my part, and would likely be overruled anyway.

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Post by Jack » Tue Oct 13, 2009 8:36 pm

ResNullius wrote:it seems to me that people who buy and hold individual bonds suffer a loss too. When rates go up and they don't sell their bonds so as to avoid incuring a loss of principal, they lose out on the potential to secure a higher yield resulting from increasing rates. I'm just wondering how this loss compare to the loss of net asset value in bond funds when interest rates go up. I might not be asking this the right way, but I hope readers at least know what I'm trying to get at.

Well, the answer is that they are exactly the same. If you work through the numbers, you will find that selling a bond at a loss today and reinvesting the proceeds in an equivalent higher yielding bond today you end up with exactly the same return at the end as the person who kept the old bond to maturity. The extra yield of the new bond exactly replaces the loss that you took when you sold the old bond. That has to be the case because the bond market is very efficient. If you sell one bond with a lower yield to buy another bond on the same day with a higher yield, they must have exactly the same value when you get done because the market is trading one for the other. The different yields and different principal amounts balance out.

So it turns out that there is no difference between holding a bond versus selling a bond and reinvesting at the new rate. The only way you lose is if you sell for a loss but don't reinvest the proceeds. But if you do reinvest, a bond fund is the same as a bond ladder.

In this thread Magellan gives a nice numerical example that explains this:
I can't count the number of times I've had to explain to my finance students that individual bonds are not somehow superior to funds with respect to the "feature" that you don't lose any money if you don't sell the bond. There are plenty of other things to consider about the pros and cons of bonds vs bond funds, but this one "feature" shouldn't go into the calculation.

Many students (and perhaps Ms. Orman as well) don't seem to understand that whether you sell the bond immediately or hold it to maturity, your overall financial well-being is no different. If rates go up, the value of the bond, as defined as the present value of all future payments, goes down.

I've had to explain this many times and I'm not sure I've gotten any better at it over the years, but here goes...

Consider this hypothetical case...

Last year, Fred bought a 10 yr bond for $1000 with a 4% coupon payment. Over the past year, market interest rates have risen to 5%. If Fred tries to sell his bond today, he'll only be able to get $928.92
(to verify this in excel use =PV(.05, 9, 40, 1000) )

Some will argue that Fred is better off as long as he doesn't sell his bond, since he can still get $1000 for the bond when it matures. The problem with that logic is that it only accounts for one of the future cash flows that the bond will generate in the next 9 years (the last cash flow). It doesn't take into account that Fred is only getting a 4% coupon rate, while other bond buyers in the market today with $1000 will get a 5% coupon rate.

Now let's consider two scenarios of what Fred could do with his bond...

1) Fred keeps his bond.

He continues to get his $40 annual coupon payment for the next 9 years and at maturity he gets his $1000 back.


2) Fred sells his bond for $928.92 and buys another bond at the market price.

Assume he can buy a 9 yr bond with a face value of $928.92 that pays a coupon of 5% (this is the current market rate). This bond will be worth only $928.92 when it matures, but in the meantime he'll get annual payments of $46.45 instead of annual payments of $40 because the market rate is now 5% instead of 4%.
(in excel $928.92*.05 = $46.446).

Assume that every year, Fred spends the first $40 of the coupon payment just as he would have with the original bond. In addition, he takes the extra $6.446 he's getting in extra coupon payments each year and invests it at 5% (the prevailing interest rate) in a savings account.

At the end of 9 years, his savings account will be worth $71.08 ( in excel use =FV(.05, 9, -6.446, 0) )

So for scenario 2, he gets his $40 in coupon payments each year, just like in scenario 1, and he gets $928.92 when the bond matures, and he also gets the $71.08 from the savings account (928.92+71.08 = $1000).

So you can see that he is exactly as well off under scenario 2 (selling the bond) as he is with scenario 1 (keeping the bond to maturity).

Maybe this just makes things muddier, but hopefully it helps to erase this "non difference" between individual bonds and bond funds.

Jim

(note: transaction costs and minor differences in taxes between the two scenarios are ignored for simplicity).

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Post by RobG » Tue Oct 13, 2009 8:52 pm

RobG wrote:If I was to fix the wiki it would take far too much time on my part, and would likely be overruled anyway.


Here is alternative: Overwrite the exiting "real" wiki at http://en.wikipedia.org/wiki/Bond_fund with the Bogle wiki. I doubt it will last long as the Bogle wiki is far too concerned with advocating bond funds rather than objectively educating the reader on the differences.

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Post by linuxizer » Tue Oct 13, 2009 9:00 pm

RobG wrote:
RobG wrote:If I was to fix the wiki it would take far too much time on my part, and would likely be overruled anyway.


Here is alternative: Overwrite the exiting "real" wiki at http://en.wikipedia.org/wiki/Bond_fund with the Bogle wiki. I doubt it will last long as the Bogle wiki is far too concerned with advocating bond funds rather than objectively educating the reader on the differences.


There's plenty of time spent advocating the anti-fund position in these threads.

The Wikipedia article you linked to has a section called "Advantages over individual bonds," but no corresponding disadvantages section. Hardly seems like the objective education one would want.

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Post by RobG » Tue Oct 13, 2009 9:27 pm

linuxizer wrote:There's plenty of time spent advocating the anti-fund position in these threads.

Yes, but the wiki is always referenced as if is was a definitive source.

linuxizer wrote:
RobG wrote:
RobG wrote:If I was to fix the wiki it would take far too much time on my part, and would likely be overruled anyway.


Here is alternative: Overwrite the exiting "real" wiki at http://en.wikipedia.org/wiki/Bond_fund with the Bogle wiki. I doubt it will last long as the Bogle wiki is far too concerned with advocating bond funds rather than objectively educating the reader on the differences.


There's plenty of time spent advocating the anti-fund position in these threads.

The Wikipedia article you linked to has a section called "Advantages over individual bonds," but no corresponding disadvantages section. Hardly seems like the objective education one would want.


I agree it is inadequate so fix it by putting the Bogle wiki up there. That will likely annoy someone with enough time on their hands to do a better job and we will all benefit.

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Post by linuxizer » Tue Oct 13, 2009 9:30 pm

RobG wrote:I agree it is inadequate so fix it by putting the Bogle wiki up there. That will likely annoy someone with enough time on their hands to do a better job and we will all benefit.


Ah, I misread what you said.

Still, if it really bothers you, the solution is obvious. Claiming that there's this mysterious knowledge out there without showing calculations on a thread or on the wiki helps no one.

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Post by RobG » Tue Oct 13, 2009 10:10 pm

linuxizer wrote:
RobG wrote:I agree it is inadequate so fix it by putting the Bogle wiki up there. That will likely annoy someone with enough time on their hands to do a better job and we will all benefit.


Ah, I misread what you said.

Still, if it really bothers you, the solution is obvious. Claiming that there's this mysterious knowledge out there without showing calculations on a thread or on the wiki helps no one.


I don't understand. I did a calculation earlier. Everything is fine until you need to cash in the bond fund.

Here is another thought example: Buy a 10 year Tsy note for $1000 and spend the coupons. You will have $1000 at the end of ten years.

Invest $1000 in a bond fund and spend the coupons. You don't know how much you will have in ten years. Obviously the bond fund is more risky. You can't know the end point by mixing bond funds to synthesize a declining duration bond either.

(Investing the coupons doesn't reverse this - both will invest at the current rate).

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Post by linuxizer » Tue Oct 13, 2009 10:18 pm

RobG wrote:I don't understand. I did a calculation earlier. Everything is fine until you need to cash in the bond fund.

Here is another thought example: Buy a 10 year Tsy note for $1000 and spend the coupons. You will have $1000 at the end of ten years.

Invest $1000 in a bond fund and spend the coupons. You don't know how much you will have in ten years. Obviously the bond fund is more risky. (For extra credit derive a bond fund allocation scheme that allows one to know the value at 10 years - you can't do that either). (No, investing the coupons doesn't reverse this - both will invest at the current rate).


How exactly do you propose to invest the coupons of an individual bond?

These threads go nowhere because the comparisons are inappropriate. You should not invest in a bond fund of longer duration than you know you need the money in. Your example clearly violates that, starting the day after you buy the fund if the fund's duration is 10 years (because your need for the money is now in 9 years, 354 days).

An equally absurd example: Buy a 20-year Treasury for $1000 and sell it after ten years. How much will you get for it? See, it's risky!

Creating examples where rolling ladders are inappropriate does not add anything to the discussions. Now, if you want to argue that you can, at your discretion, convert a rolling bond ladder into a non-rolling ladder by failing to renew the ladder, that's a good point. Dan Kohn has pointed out a way to accomplish the same thing using with a bond fund, however, by selling the bond fund and purchasing a zero-coupon bond.

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Post by RobG » Wed Oct 14, 2009 1:05 am

linuxizer wrote:
RobG wrote:I don't understand. I did a calculation earlier. Everything is fine until you need to cash in the bond fund.

Here is another thought example: Buy a 10 year Tsy note for $1000 and spend the coupons. You will have $1000 at the end of ten years.

Invest $1000 in a bond fund and spend the coupons. You don't know how much you will have in ten years. Obviously the bond fund is more risky. (For extra credit derive a bond fund allocation scheme that allows one to know the value at 10 years - you can't do that either). (No, investing the coupons doesn't reverse this - both will invest at the current rate).


How exactly do you propose to invest the coupons of an individual bond?

These threads go nowhere because the comparisons are inappropriate. You should not invest in a bond fund of longer duration than you know you need the money in. Your example clearly violates that, starting the day after you buy the fund if the fund's duration is 10 years (because your need for the money is now in 9 years, 354 days).

An equally absurd example: Buy a 20-year Treasury for $1000 and sell it after ten years. How much will you get for it? See, it's risky!

Creating examples where rolling ladders are inappropriate does not add anything to the discussions. Now, if you want to argue that you can, at your discretion, convert a rolling bond ladder into a non-rolling ladder by failing to renew the ladder, that's a good point. Dan Kohn has pointed out a way to accomplish the same thing using with a bond fund, however, by selling the bond fund and purchasing a zero-coupon bond.


See we are miles apart. Those examples are not absurd, you just cannot see the point. The bond fund = indi bonds argument falls apart as soon as you need to start drawing principal. This is not a special case; it is what every portfolio is designed for!

Now if you want to say that a big kludge of bond funds updated daily to shorten the duration as you get older (zero coupons apparently help too) can be made to give the same performance as a individual bonds, I'm with you all the way. :wink:

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Post by spam » Wed Oct 14, 2009 4:46 am

linuxizer wrote:
(As an aside, does anyone know why this fund holds bonds with maturities over 30 years?)


While it is pretty difficult to know for sure, one possible explanation could be due to a SEC ruling. 80% of a bond funds assets must match the description in the name. In this case, it is short term. By adding 20% bonds with a longer maturity, you can reduce turnover and enjoy higher yields because this cabbage is "good to go" for a long time. The fact that the long-term number is small may say something about managements desire to reduce average duration.

The turnover rate for many bond funds can be higher than what you would expect. I think the turnover for VUSTX (LT Treasury) is typically around 80%. The SEC ruling can require funds to sell bonds when enough of them have maturities under 10 years (in this case).

It is theoretically true that if the fund grew at a great enough rate, that they would never be required to sell anything. The 80% turnover indicates that this goal could be difficult to reach.

So, the fund can be forced to sell bonds during a variety of interest rate movements, while the individual has the luxery of choosing when to sell.

I own both funds and individual issues. I just harvested bond fund gains (the NAV's have been at or above hitoric highs) and sold them to cash. I will be buying individual issues, CD's or Bonds, and most likely short term. I am tweeking my average duration a small amount ahead of time.

I suspect that the Fed could raise interest rates aggressively before inflation even begins to appear. It would be nice to have a few extra pork bellies in the IRA coffer during such an event. Even TIPs would get hammered in that environment.

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Post by linuxizer » Wed Oct 14, 2009 6:08 am

RobG wrote:See we are miles apart. Those examples are not absurd, you just cannot see the point. The bond fund = indi bonds argument falls apart as soon as you need to start drawing principal. This is not a special case; it is what every portfolio is designed for!

Now if you want to say that a big kludge of bond funds updated daily to shorten the duration as you get older (zero coupons apparently help too) can be made to give the same performance as a individual bonds, I'm with you all the way. :wink:


It is a heck of a lot easier to draw principal from a bond fund than from an individual bond if you desire increments smaller than the smallest bond. Shortening the duration by shifting your allocation between two funds is not complicated at all. In fact, it is exactly as difficult as shifting between stocks and bonds as you age--something nearly everyone does (I hope). By contrast, managing a bond fund with ten or more bonds requires more effort IMO, restricts you to certain asset classes (Treasuries vs. corporates), is difficult to manage in small increments (you could buy many small bonds instead of a few large ones, but then the complexity argument shifts even more in the fund's favor), and is far less liquid as a reserve to your emergency fund (because of the pounding individual investors take when entering the secondary bond market).

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Post by mfen » Wed Oct 14, 2009 7:12 am

Looking past a Treasury only portfolio I still maintain that constructing a diversified portfolio of bonds is difficult and expensive. GNMA's alone are $25K minimum (last time I checked) and then you take on all the risks associated with holding that single bond. Here is a detail of bond risks: http://www.investinginbonds.com/learnmo ... d=3&id=383

To construct your corporate portfolio you can certainly buy bonds in $1000 increments (commissions aren't horrible but they are not cheap either) but again how many are you going to buy. You also have to acknowledge that you may not be able to assess the default risk - it is exactly like stock picking.

I looked at the portfolio of VBMFX and constructed on paper a portfolio of individual securities. A few things jumped out: commissions, bond risks, also the time needed to purchase the bonds and the cash needed to invest in some categories of bonds. By buying the fund I am able to capture past markets and do not have to continuously gauge the market going forward. I also am able to hold a highly diversified corporate portfolio selected by qualified managers.

Treasuries are a bit different in that there is no commission, practically no credit risk and no call risk. There is interest rate risk. Having said that I do buy individual treasuries including I-bonds and when I need short term investing I buy 3-6 mos bills. In normal economic times I find treasury bills an acceptable replacement for savings accounts or CDs.
Maryanne

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Post by ResNullius » Wed Oct 14, 2009 7:48 am

Well, it's been a whole night since I last checked the responses. This is the exact type of discussion I was looking for. I don't understand the bond fund versus individual bonds/ladder story. I know there are plenty of folks who claim that owning bond funds is bad, just plain bad, that you come out much better over time with individual bonds of similar characteristics. I know bond funds are convenient, but what I would like to know is whether managing a portfolio of individual bonds is signficantly better than owning bond funds with similar characteristics...during rising interest rates over a period of years, falling interest rates over a period of years, or fluctuating interest rates over a period of years. In other words, is it worth the effort over time to manage a bond portfolio versus using bond funds. I don't know the answer, and it surprises me greatly that there hasn't be some quality research done on the issue. So, I asked the original question. And, I used "significant" difference because who really gives a hoot about a few cents here or there. On the other hand, if a person's fixed asset allocation is in the hundreds of thousands or even millions, it would be good to know what's being passed up in favor of convenience.

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Re: Past bond performance (like stocks) is misleading

Post by Tramper Al » Wed Oct 14, 2009 8:18 am

Taylor Larimore wrote:Suppose in 1981 you bought a Long-Term Treasury Bond yielding 14% (yes, 14%). You could have bought a Long-Term Treasury Bond Fund yielding about the same.

Today your individual Treasury Bond is still yielding 14%. However your Bond Fund is yielding only about 4%. The individual Bond was the better choice.

Is everyone going to just let this "still yielding 14%" tale go without comment? Seriously?

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Post by RobG » Wed Oct 14, 2009 9:39 am

linuxizer wrote:
RobG wrote:See we are miles apart. Those examples are not absurd, you just cannot see the point. The bond fund = indi bonds argument falls apart as soon as you need to start drawing principal. This is not a special case; it is what every portfolio is designed for!

Now if you want to say that a big kludge of bond funds updated daily to shorten the duration as you get older (zero coupons apparently help too) can be made to give the same performance as a individual bonds, I'm with you all the way. :wink:


It is a heck of a lot easier to draw principal from a bond fund than from an individual bond if you desire increments smaller than the smallest bond. Shortening the duration by shifting your allocation between two funds is not complicated at all. In fact, it is exactly as difficult as shifting between stocks and bonds as you age--something nearly everyone does (I hope). By contrast, managing a bond fund with ten or more bonds requires more effort IMO, restricts you to certain asset classes (Treasuries vs. corporates), is difficult to manage in small increments (you could buy many small bonds instead of a few large ones, but then the complexity argument shifts even more in the fund's favor), and is far less liquid as a reserve to your emergency fund (because of the pounding individual investors take when entering the secondary bond market).


I'm not sure why you are quoting me on those points. My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration.

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Post by Jacobkg » Wed Oct 14, 2009 10:00 am

"My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration."
--RobG

In that case, bond funds also have the potential to make more money than holding individual bonds for exactly the same reason. Which is more likely? Given the unpredictability of interest rates, I would say that it's a wash. Therefore, your argument speaks more to the potential for bond funds to be riskier than that they are worse performing. If you stick to intermediate duration bonds or lower, as many experts such as William Bernstein recommend, that would substantially reduce this risk as well.

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Post by RobG » Wed Oct 14, 2009 10:12 am

Jacobkg wrote:"My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration."
--RobG

In that case, bond funds also have the potential to make more money than holding individual bonds for exactly the same reason. Which is more likely? Given the unpredictability of interest rates, I would say that it's a wash. Therefore, your argument speaks more to the potential for bond funds to be riskier than that they are worse performing. If you stick to intermediate duration bonds or lower, as many experts such as William Bernstein recommend, that would substantially reduce this risk as well.


Not sure what your point is. This is just saying that bond funds have more risk, which was my point. You can't tell in advance if you will gain or lose.

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Post by ResNullius » Wed Oct 14, 2009 10:14 am

RobG wrote:I'm not sure why you are quoting me on those points. My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration.


I think this misses my question. When you hold a portfolio of indivdual bonds, then interest rates go up, you lose out on the ability to have your principal yield the higher interest rate unless you sell and replace with new bond at the higher rate. This means you would have to constantly sell/buy. If you buy and hold, then the amount you lose in investment potential would need to be considered when comparing a portfolio of individual bonds to a bond fund that lost net asset value due to the same rise in interest rates.

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Post by RobG » Wed Oct 14, 2009 10:37 am

ResNullius wrote:
RobG wrote:I'm not sure why you are quoting me on those points. My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration.


I think this misses my question. When you hold a portfolio of individual bonds, then interest rates go up, you lose out on the ability to have your principal yield the higher interest rate unless you sell and replace with new bond at the higher rate. This means you would have to constantly sell/buy. If you buy and hold, then the amount you lose in investment potential would need to be considered when comparing a portfolio of individual bonds to a bond fund that lost net asset value due to the same rise in interest rates.


Yes, we got sidetracked from your original question. Your observation looks correct to me, but assuming you have the resources, there is no reason why you can't duplicate the performance of a bond fund (but not vice versa): just hold the same portfolio that they do. Sell/buy, just like they do. You would pay transaction fees, but save on expense ratio. I would think it would be a big pain in the butt with minimal savings to do this so you'd be better off with a bond fund that follows that active strategy if that is what you want. (Plus there would be a lag between your portfolio and the bond portfolio.)

I did answer your question about the study earlier. I don't think the results would be of predictive value since the interest rates have trended downward over the last 40 years.

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Post by RobG » Wed Oct 14, 2009 10:50 am

ResNullius wrote:
RobG wrote:I'm not sure why you are quoting me on those points. My point is that a bond fund has potential to lose more money than holding individual bonds. This occurs because you have to sell longer term funds to shorten your duration.


I think this misses my question. When you hold a portfolio of indivdual bonds, then interest rates go up, you lose out on the ability to have your principal yield the higher interest rate unless you sell and replace with new bond at the higher rate. This means you would have to constantly sell/buy. If you buy and hold, then the amount you lose in investment potential would need to be considered when comparing a portfolio of individual bonds to a bond fund that lost net asset value due to the same rise in interest rates.


I overlooked this. The bolded point is a red herring. If interest rates go up the value of the bond (or bond fund) goes down to that point that it is a wash. I.e. you will gain nothing by selling the lower interest bond and buying the higher interest bond. So yes, you lose out on that with indi bonds, but you also lose out with bond funds.

rg

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Post by danbek » Wed Oct 14, 2009 10:52 am

RobG wrote:You lose when you make the jump from the long to short fund. For example, say you are in the long term index with a duration of 12.1 years and you want to switch to intermediate (duration 6.3 years). If the interest rates jump 1% the LT fund will drop 12.1% and you will be buying into a fund that only dropped 6.3%. You just had 6% of your money vaporize as you were trying to shorten the duration


1. The scenario I had in mind was an environment in which rates rise gradually over a long period of time, not just a one-time rise; I should have made that clear. I believe that in this environment, going to shorter duration early on will better preserve your principal, because each subsequent rise in rates will hurt less. Am I incorrect about this?

2. I don't understand the comment about "locking in" a 6% loss. Switching to a shorter duration doesn't change the fact that you've suffered a 12% loss. The only way you "lock in" the loss is if rates go back down after you change duration. But that's not the scenario we are talking about.

3. In the usual situation where long term rates are higher than short term rates, you are better off staying in the long-term fund (if interest rates don't continue to rise). But even given this, I don't see where you get the lock-in of a 6% loss from switching. The amount by which you will end up worse off depends on the interest rates, right?

RobG wrote: - something that wouldn't have happened if you just owned a single bond matched to your need. You can gradually shift over but in a rising rate environment you will lose.


Whoa ... why are you suddenly talking about a date-specific need?

No one disagrees that if you have a date-specific need, then hold a bond fund exposes you to interest rate risk (to the extent that the duration of the bond is not much smaller than the time remaining until the date you need the money).

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Post by danbek » Wed Oct 14, 2009 10:54 am

Maybe a constructive way forward is to ask the "pro individual bond" people what set of individual bonds you would recommend for savings intended to be used in retirement, when retirement is a long time away (10+ years). This is a very common scenario, and most people have much more money saved for these types of needs than for date-specific needs like a house downpayment, college tuition, roof replacement, etc.

In retirement you do have a set of date-specific needs, but you don't know what all of the dates are, because you don't know when you will retire and you don't know how long you are going to live. So can't buy a set of bonds maturing on the "correct" dates. And of course some of those possible dates are so far in the future that you can't buy long enough bonds. And maybe you want to bequeath money to your heirs.

For a situation like this, I've always assumed that going with an intermediate bond fund might not be clearly the best ex-ante approach, but it's probably pretty close to the best ex-ante approach. Am I wrong about this? Is there some individual bond strategy that should be expected to do better? Can someone explain what it is?

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Post by Jack » Wed Oct 14, 2009 10:56 am

ResNullius wrote:I think this misses my question. When you hold a portfolio of indivdual bonds, then interest rates go up, you lose out on the ability to have your principal yield the higher interest rate unless you sell and replace with new bond at the higher rate.

Perhaps you missed it, but if you look above you will see that I explained why your belief is not true and gave a mathematical example that showed why. The person that holds the bond and the person that sells to buy a higher yielding bond have exactly the same return. A change in interest rate than lowers the price of the old bond, increases the yield of the new bond by a precisely compensating amount. Efficient bond markets make this mathematically correct.

ResNullius wrote:This might be a stupid question, but it's been nagging me for some time now.

It is not a stupid question, but it has been answered. You can put your mind at ease. There is no difference between holding a bond or selling to reinvest at a higher rate. They have the same return.
Last edited by Jack on Wed Oct 14, 2009 11:47 am, edited 1 time in total.

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Post by dbr » Wed Oct 14, 2009 11:02 am

Retirement investing is a continuation of accumulation investing. The rate and timing of disinvestment is slow and continuous over a long and indeterminate period of time. The only arithmetic difference is that the sign applied to the small increment of contribution is changed from positive to negative to indicate a small increment of withdrawal.

I agree that what is needed is a specification for exactly what structure of individual bonds should be engineered for this situation.

Note that not too long ago there was a flurry of posting on exactly this subject using TIPS ladders and these pages also address TIPS ladders in a withdrawal plan:

http://bobsfiles.home.att.net/SaferPlan2.html

http://bobsfiles.home.att.net/WithdrawingFromTIPS.html

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Post by RobG » Wed Oct 14, 2009 12:05 pm

danbek wrote:
RobG wrote: - something that wouldn't have happened if you just owned a single bond matched to your need. You can gradually shift over but in a rising rate environment you will lose.


Whoa ... why are you suddenly talking about a date-specific need?

No one disagrees that if you have a date-specific need, then hold a bond fund exposes you to interest rate risk (to the extent that the duration of the bond is not much smaller than the time remaining until the date you need the money).


Actually, most people seem to disagree. To quote linuxer: "You should not invest in a bond fund of longer duration than you know you need the money in." Most people say similar things regarding this point.

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