Am I crazy? 100% of portfolio in Vanguard high yield corporate

[REWahoo]

Question: "Am I crazy?"

Answer: "I'm not sure, but you do exhibit a number of interesting symptoms".

 

[Nords]

Can someone tell me why it is 100% certain that the dividend will decline with time. ... I will be the first to admit I don't have "the answer" but this seemed as plausible as many others out there

It isn't.
People are looking at odds.
Who is more at risk of loosing everything, the investor with one stock (or bond) or the investor with 100?
What you are doing very well may work out great for you. But you also have a much better chance of getting hit harder than you would if you were diversified.
In short, you are not investing, you are gambling.

It's not 100% certain that the dividend will decline with time.

But the longer you persist with an undiversified portfolio, the higher the probability that the dividend will decline with time.

It is 100% certain that you're not protected against that probability.

So in summary then...nobody really knows do they. I certainly am not ignorant, and I am not trolling here either. I simply wanted to get the pluses and minuses. I think most people have been taught some basic tenants about equities and buy and hold etc. and have chosen to stick with that.

We don't know the future, but we know what's worked in the past. Not your blink-of-the-eye fads of the last 20 years, but the last century or so. Past may not be prologue but some defensive techniques have worked well in all market conditions. One of those defensive techniques has been diversification. Another defensive technique has been annuitizing a portion of your income. A third defensive technique has been educating yourself, and a fourth has been staying open to constructive criticism.

Well then...I guess I should bow to all of the experts and take my leave

Good luck with that... feel free to come on back after you've done some reading.

 

[Texas Proud]

snip...

I see no reason for never drawing down the principal. The key is just to have enough money so that you won't outlive your savings. Why die with tons of money in the bank just because it is technically one's principal? I think you have to do a 50+ year spreadsheet under different inflation scenarios and coupon rates to see what I mean. Under high inflation the principal balance becomes huge.

True... you can draw down from principal... and you can calculate out how much that would be each year with and end date based on a bunch of options... but then you are into an inflation adjusted annuity.. but with TIPS you have an end date.. with an annuity you can not outlive it...

Also, remember your inflation probably will be different than the one used for TIPS.. it might not be enough to worry about, but I doubt it will be the same..

You still did not address the fact that you would have to save more to get the starting income you want.. that could be more than a decade of savings (maybe two)... not someone who wants to RE...

 

[unclemick]

Pssst - oh nevermind. I just wanted folks to know I read some of the posts on this thread.

heh heh heh - 1974 50/50 ala Ben Graham's Defensive Investor, 1980 60/40 da policy or traditional pension porfolio, 2006 Target Retirement 2015. Retired at 49 1993 and yes I did own a small % of high yield corporate for a while to boost cash income while nursing my IRA past age 59 1/2.

Diversify or slice and dice - that is the question, whether it is nobler in the mind ------

 

[teejayevans]

Yes, this is a crazy plan. Here's why.

1) Part of the current yield on a high yield bond goes to compensate for their very high default rate. You can probably expect to lose a couple of percentage points per year averaged over the course of a business cycle in a HY bond fund to defaults. If you're spending the cash flow, you're essentially consuming the portion of your principal lost to defaults. You can see this pretty clearly in a long-term price chart of VWEHX. The fund started at an NAV of $10 in 1979 and is now down to $5.48 (a loss of nearly 2% per year compounded). So in 30 years the principal balance has shrunk by 45%. You can expect something similar over the next 30 years. And assuming a constant yield over the next 30 years, your cash flow will decline along with your principal.

I don't think you can equate NAV price with default rates on the held bonds.
Just like you can't equate the price of gold with the amount gold available.
More likely it has to do with the interest rates at the time being in the
stratosphere (prime rate was around 20%).
TJ

 

[Maurice]

The chart shows the Nav OVER THE LAST 20 YEARS to vary between 6 and 8 dollars a share.

The 1989 date probably exaggerates the performance of this asset class. Junk bonds blew up in the late 80s, which is not reflected in that 20 year span (remember Michael Milken and Drexel?). By 1989 (IIRC) they were considered pretty toxic so they would have been near all time lows.

 

[Gone4Good]

Can someone tell me why it is 100% certain that the dividend will decline with time. Silverton 39 motor yacht.

I did.

The reason is that the stated yield of a bond fund assumes that all of the bonds mature according to schedule at par. This is not true of a high yield fund. Bonds default and receive less than par recovery in bankruptcy. This gradually erodes your original principal.

But if the proof of the pudding is in the eating, then you are in for some very slim gruel. Here's what your income stream would have looked like had you invested $1MM in the Vanguard HY fund in 1981 and never sold a share . . . .

 

[Gone4Good]

I don't think you can equate NAV price with default rates on the held bonds.
Just like you can't equate the price of gold with the amount gold available.
More likely it has to do with the interest rates at the time being in the
stratosphere (prime rate was around 20%).
TJ

Yes there is going to be noise year to year but the overall trend for 30 years running is down. And it trends down for a very good reason. Assume you have a portfolio of 10 bonds each with $1,000 face value and an NAV of $10. If one of those bonds defaults and recovers 50 cents on the dollar your NAV goes down to $9.50. That process is going to happen repeatedly. Remember that most HY bonds are issued at par. Someone is buying those par bonds. And a meaningful fraction of those bonds will never pay par back, which means guaranteed principal loss for the market. That loss is presumably compensated for through coupon payments but if you spend all of your coupons, you'll slowly deplete your principal.

This is the price chart for VG HY bond fund. And as you point out, yields were declining during this entire time (which should cause bond prices to go up)

 

[haha]

I did.

The reason is that the stated yield of a bond fund assumes that all of the bonds mature according to schedule at par. This is not true of a high yield fund. Bonds default and receive less than par recovery in bankruptcy. This gradually erodes your original principal.

But if the proof of the pudding is in the eating, then you are in for some very slim gruel. Here's what your income stream would have looked like had you invested $1MM in the Vanguard HY fund in 1981 and never sold a share . . . .

You may have just ruined this guy's chance for getting a Darwin Award. Well, for now.

Ha

 

[smjsl]

Yes there is going to be noise year to year but the overall trend for 30 years running is down. And it trends down for a very good reason. Assume you have a portfolio of 10 bonds each with $1,000 face value and an NAV of $10. If one of those bonds defaults and recovers 50 cents on the dollar your NAV goes down to $9.50. That process is going to happen repeatedly. Remember that most HY bonds are issued at par. Someone is buying those par bonds. And a meaningful fraction of those bonds will never pay par back, which means guaranteed principal loss for the market. That loss is presumably compensated for through coupon payments but if you spend all of your coupons, you'll slowly deplete your principal.

This is the price chart for VG HY bond fund. And as you point out, yields were declining during this entire time (which should cause bond prices to go up)

Great response and great spreadsheet YrsToGo !

 

[FANOFJESUS]

I can't say too much bad about the OP his returns have beaten mine in the last 10 years.

 

[clifp]

Nestegg + one basket - bad event = shattered retirement.

I guess the good news is I think I may have found the person who wants to buy my Vanguard High Yield fund shares. I bought 100K worth back in Nov 2008, when VWHEX was yielding more than 10%. This was a less than 5% of my portfolio and having seen it raise in value and the yield drop to 7.3%, I am thinking it maybe a good time to sell. Especially after hearing that somebody that had devote 4 whole weeks to research wants create 100% high yield research portfolio. Ok that was a cheap shot but...

One important thing to understand is that accumulation phase while saving retirement is a lot different than the distribution phase after you are retired. Dollar cost averaging works great while saving for retirement, not so great while in retirement. In your case when you retire you will have X number of shares of High Yield and for the most part that will be a fixed number.

Lets consider 3 scenarios where your plan fails.
1. High inflation
2. Lower income due to defaults
3. Lower income due to reinvestment risk

There is a large number of smart people who think that the massive deficits will lead to intentional or unintentional high inflation. If inflation is 10% a year your 7.3% yield doesn't look so great. Three years of 10% inflation and your $72K income can only buy the equivalent of 48K.

The nightmare scenario for a junk bond owner, is high inflation couple with a weak economy (stagflation like we had in the late 70s). I am pretty sure that is zero political will to continue to bailout failing companies. So bond holder of shaky companies like Ford, or Citigroup, BofA, Quest, Charter Communication (My mom's cable/internet provider a horrible company IMO) will likely in be for a big haircut of these companies go under or are taken over by the FDIC. Oh BTW, these are the top holdings of VWHEX. If the bailout hadn't happen VWHEX would have lost a lot of money on bank bonds.

Finally, the most likely risk you face is reinvestment risk. This same situation people are finding today with CD ladders. The same 3-5 year CD that was earning 6 or even 7% a few years ago now has come do and the best you can find is 2.5-3%.

Lets take the case of the smart retiree who in Aug of 2008, decided to get out of the market and take his 1 million dollar portfolio and buy 100,000 shares Vanguard GNMA bond fund (Admiral VFIJX). Unlike your junk bond fund, the principal of GNMA bonds is backed by the full faith of the US government so it gets a AAA credit score.. Vanguard fund share price is very stable $10 +/- $.50 for most of the last twenty odd years. In short a much safer investment than a junk bond fund even a great one like Vanguards.

Back in Aug 2008, 100K share of VFIJX provided a monthly income of $4,467 probably enough to live on with a paid of house for many people in much of the country. Fast forward to today. The value of VFIJX shares has increased from $10.27 to $10.75, certainly a better than leaving the money in the stock market. What do you think the income is $5,000? $4,000?

Click on this link and check out Jan 2010 distribution of the GNMA fund. Then explain why this couldn't happen to the Vanguard junk bond fund. My betting is it will soon.

 

[Running_Man]

I did.

The reason is that the stated yield of a bond fund assumes that all of the bonds mature according to schedule at par. This is not true of a high yield fund. Bonds default and receive less than par recovery in bankruptcy. This gradually erodes your original principal.

But if the proof of the pudding is in the eating, then you are in for some very slim gruel. Here's what your income stream would have looked like had you invested $1MM in the Vanguard HY fund in 1981 and never sold a share . . . .

The method I have found that works quite well on a fixed income is to take only 45% of the yield as the starting basis of the income, to account for inflation. In the instance you printed with 1 million in investment one would take just 61,480 (6% of the total investment in this case) and reinvest the remainder in the fund.

Had that been done in the case you posted with the same inflation numbers and assuming reinvesting on 12/31 of the next year 2009 he would have ended with 668,365 shares and income of $274,030 with an inflation adjusted need of $142,936.

The interesting thing about this is the value of the portfolio in the end would be up 50% inflation adjusted and you would be nowhere near a failure and you would have supported a 6% withdrawl for 30+ years easily.

Now at present prices this means only pulling 3.37% of the total portfolio out each year. And a high yield fund certainly is very risky to do this with in my opinion, but not as risky with a 45% withdrawl as you may think.

 

[TooFrugal]

Also, remember your inflation probably will be different than the one used for TIPS.. it might not be enough to worry about, but I doubt it will be the same..

You still did not address the fact that you would have to save more to get the starting income you want.. that could be more than a decade of savings (maybe two)... not someone who wants to RE...

I think my personal inflation rate might be less than the TIPS inflation rate because initially I'd have a fixed rate mortgage and then a paid off house. So housing most likely wouldn't be a factor for me.

With a TIPS portfolio it does require saving more than most people tend to think about, especially at current rates. But I'm self employed, like my job and have no plans to retire any time soon. Plus we shouldn't need as much as 45K in addition to social security and a few modest pensions.

I'm not sure I'm going to do the whole TIPS thing, it is just something I'm thinking about. But I like the idea of never losing any money on my investments and still keeping up with inflation.

 

[drb111]

The method I have found that works quite well on a fixed income is to take only 45% of the yield as the starting basis of the income, to account for inflation. In the instance you printed with 1 million in investment one would take just 61,480 (6% of the total investment in this case) and reinvest the remainder in the fund.

Had that been done in the case you posted with the same inflation numbers and assuming reinvesting on 12/31 of the next year 2009 he would have ended with 668,365 shares and income of $274,030 with an inflation adjusted need of $142,936.

The interesting thing about this is the value of the portfolio in the end would be up 50% inflation adjusted and you would be nowhere near a failure and you would have supported a 6% withdrawl for 30+ years easily.

Now at present prices this means only pulling 3.37% of the total portfolio out each year. And a high yield fund certainly is very risky to do this with in my opinion, but not as risky with a 45% withdrawl as you may think.

Floatingdoc.....come back!

 

[Gone4Good]

Now at present prices this means only pulling 3.37% of the total portfolio out each year.

Which gets you back to the same $2MM initial portfolio the OP was originally trying to avoid by putting everything in a HY fund. Interesting how that works.

 

[Running_Man]

I do not see where he ever states he was trying to avoid a 2MM portfolio, I read that he has a portfolio at present of about 1 million and will add everything he can for the next 7 years and just live off the interest. My calculations show if nothing changed on the fund, which is impossible, and only reinvested annual dividends of shares he holds now without any other additions his high yield portfolio will be 1.6M and he would still own the office building. It would depend on the interest payments at the time and if they were less than 45% of the total there would be a historical precendent that he could be successful.

 

[Gone4Good]

I do not see where he ever states he was trying to avoid a 2MM portfolio,

I read this comment as suggesting he could accomplish with one million what it would take $2MM to do with a diversified portfolio.

I imagine it is in efficient tax wise but what size portfolio is necessary to draw 72 k annually for 30 years...2.1M.

It turns out he needs at least $2MM either way.

 

[Bikerdude]

So in summary then...nobody really knows do they. I certainly am not ignorant, and I am not trolling here either. I simply wanted to get the pluses and minuses. I think most people have been taught some basic tenants about equities and buy and hold etc. and have chosen to stick with that.

Then of course there are the people who don't know they don't know.

 

[Texas Proud]

Great response and great spreadsheet YrsToGo !

I agree... someone took the time to show the results... and the fault of the original post... but he said he is gone anyhow, so he will find out in a few years....

 

[Nords]

I agree... someone took the time to show the results... and the fault of the original post... but he said he is gone anyhow, so he will find out in a few years....

JG used to put great store by his GM junk bonds. Wonder how that's working for him these days.
http://www.early-retirement.org/forums/f28/gm-bankruptcy-fears-18542.html#post345577

 

[floatingdoc]

No kids...I am here. I simply had to go to work, getting out of same the original intent of my plan. I had no intention of "trying to avoid saving 2 million". I still don't see how this post proves "fault" just risks I have already taken into account. I appreciate the responses made with thought and with genuine goodwill to help identify said risks.

 

[cantlogin]

I can't say too much bad about the OP his returns have beaten mine in the last 10 years.

Since I'm not equipped to add anything truly constructive to this technical analysis I will offer this often stated remark.

"Past Performance Is Not Indicative of Future Results."

 

[floatingdoc]

I have looked for the default rate for this fund but cannot seem to find it. Also, the fact that it holds "safer" junk should help longterm.

 

[John Galt]

Making concentrated bets can pay off (my portfolio's average rate of return has been 9.57% over the last 10 years and maybe half of those gains can be attributed to a single stock) but it can also end in disaster.

what stock?