Asset Allocation Critique

[unclemick]

Dumb question

Once you own more than one bond - at higher numbers don't you become "bond fund like" in behavior? I've seen curves on 1-xx no.'s of stocks periodically compared to the "market" - anybody seen anything on bonds?

 

[wzd]

No, I don't think that owning more than one bond causes ones portfolio to become 'bond fund like'. The primary difference as I understand it is that with bonds you have the option of holding them to maturity or selling the individual bonds. With a fund, the fund has taken that option from you and it is controlled partially by the actions (withdrawals) of other investors, and by the fund management.

Also a bond fund keeps invested by rolling over bonds and usually has a target maturity. So a bond fund never matures like individual bonds do. With a bond you get the principal back at maturity, barring default. With a bond fund there is no such guarentee.

At least that is my understanding of the difference. I have heard many comments steering people away from bond funds, so it might be slightly biased.

Wayne

 

[Ted]

It is true that bond funds (other than short term ones) do not hold bonds to maturity, so that they can maintain the average maturity (or duration) that they is required by their bylaws.  So the value of a longer term bond fund could collapse if interest rates rose, and there would theoretically be no assurance that it would recover.  In practice, however, the "new" bonds being purchased by the fund would be paying a higher yield.  Ironically, a person reinvesting their interest payments would end up with more money in the long run -- despite the initial loss in market value.  In fact, over any extended period of time the returns on a bond fund will be pretty close to those of the market for bonds of that maturity (minus fund expenses -- which is why Vanguard's bond funds with their low expenses have consistently outperformed most others).

For a person who may need to liquidate bonds for cash, the potential risk is increased inflation whether they are holding individual long term bonds or longer term bond funds.  The strategies for reducing the inflation risk are (1) to hold assets in cash or short term bonds to cover spending needs in the foreseeable future, and (2) to hold TIPs (or a TIPs fund) to guarantee a modest real rate of return for the longer run, as Bob Smith said on 11/22.

For a person reinvesting their bond interest, even though an increase in interest rates will eventually put more dollars in their account, they will still lose purchasing power if inflation is the cause of the increase in interest rates (as is usually the case) because their dollars will buy less.  Inflation helps debtors at the expense of creditors (investors), and most retirees are in the latter category.

 

[Ted]

Dumb question

Once you own more than one bond - at higher numbers don't you become "bond fund like" in behavior? I've seen curves on 1-xx no.'s of stocks periodically compared to the "market" - anybody seen anything on bonds?

As with stocks, market risk (or "default risk" in the case of bonds) is reduced by holding the bonds of numerous issuers. The exception is that U.S. government bonds are presumably not subject to default risk, so it is OK to hold them individually. But where corporate or municipal bonds are concerned -- especially if they are lower rated and thus "high yield" -- thge diversification provided by bond mutual funds is a big benefit. Unless a person has enough money to hold the bonds of, say, 10 or more coprporations or municipalities, they had better either stick to U.S. Treasuries (including TIPs) or bond mutual funds for their bond investments.

 

[JWR1945]

I thought that Prof. Shiller concerned himself with equity market behavior, not bonds. And to the best of my (limited) knowledge, he has never examined SWR.

Have I missed something?

Mikey

SWR studies use Professor Shiller's data on bond returns.

Those studies treat bonds strictly as a one-year trading vehicles. You get the first year's interest plus any price changes for that year. The bonds are then replaced (without incurring any transaction costs) with new bonds at the new interest rates.

Quite clearly, real investors act differently. Making a really good model for the fixed income component would be difficult. Some kind of simplification is needed to make modeling reasonable.

It is correct to state that the SWR studies are oriented towards equities.

Have fun.

John R.

 

[ats5g]

Doug,

From my earlier reply:

"Thus, duration has important applications as a measure of interest-rate risk. As with yield and average life calculations, both Macauley and modified duration are highly sensitive to the prepayment assumptions used to project cash flows. As a result, duration can significantly misestimate the actual price change of pass-throughs when interest rates decline. More importantly, a pass-through's duration changes as the expected prepayment rates used to calculate it change in response to changes in the general level of interest rates..."

While duration can be a good measure of interest rate risk for regular bonds (and bond funds with plain old non-callable corporate and treasury bonds), it can be misleading for GNMA bonds/funds. Note the "expected repayment rates" in the previous paragraph. So, we don't really know beforehand how GNMA's will react to rising or falling interest rates.

You are certainly getting paid a premium for GNMA's in the form of higher yields. But, I don't think GNMA's are good for any sort of liability matching that could be used in retirement (like in a bond ladder). The duration of GNMA's could be lengthening (and fast) when you need to be selling bonds (when your stocks are doing badly).

As long as you understand the risks of GNMA's (negative convexity), there is certainly nothing wrong with using them.

- Alec

 

[Ted]

For a person who may need to liquidate bonds for cash, the potential risk is increased inflation whether they are holding individual long term bonds or longer term bond funds.  The strategies for reducing the inflation risk are (1) to hold assets in cash or short term bonds to cover spending needs in the foreseeable future, and (2) to hold TIPs (or a TIPs fund) to guarantee a modest real rate of return for the longer run, as Bob Smith said on 11/22.

While this is good investment advice, my terminology isn't entirely correct.

"Interest rate risk" applies to long term bonds, and is the risk that the market price will fall if interest rates rise.

Usually, a rise in long term interest rates is accompanied by a rise in inflation.  "Inflation risk," however, is different than interest rate risk.  It is the risk that financial assets will lose purchasing power.

Short term bonds are relatively immune from interest rate risk, but are particularly subject to inflation risk because short term yields barely compensate for inflation.

It is because of these risks and others that the best strategy is to diversify assets so that needs for money to spend can be met by liquidating assets that are not depressed in price.

 

[Bob_Smith]

It is because of these risks and others that the best strategy is to diversify assets so that needs for money to spend can be met by liquidating assets that are not depressed in price.

Ted, assume someone were to go with a portfolio of 100% 25 year TIPS at 2.5% for 40 years. They get a real return of 2.5%. But with a portfolio of 100% TIPS, they must liquidate as they go to cover the difference between the 2.5% coupon and their withdrawals (assume that needs to be 3.8%). Do you know how much of a worst case scenario downside impact those ongoing liquidations could have with TIPS? Certainly less than with regular long term bonds, correct? But how much less?

 

[JWR1945]

Bob_Smith

Ted, assume someone were to go with a portfolio of 100% 25 year TIPS at 2.5% for 40 years. They get a real return of 2.5%. But with a portfolio of 100% TIPS, they must liquidate as they go to cover the difference between the 2.5% coupon and their withdrawals (assume that needs to be 3.8%). Do you know how much of a worst case scenario downside impact those ongoing liquidations could have with TIPS? Certainly less than with regular long term bonds, correct? But how much less?

I am not Ted, but let me make an important point. When you look at those TIPS on the secondary market, they are being sold at a premium. Their coupon rates are much higher than 2.5%. IIRC, the coupons are around 3.5% (and even higher).

That means that the TIPS are self liquidating via their premiums. You do not have to sell them. Almost all of the difference between their 2.5% yield to maturity and that 3.8% that you have in mind will come from the smaller amount that you get back at maturity ($1000 plus inflation at maturity) as compared to the premium price that you have to pay.

You have fewer problems than you think.

Have fun.

John R.

 

[Bob_Smith]

Thanks JWR1945. That's even better than I expected it to be. If they get back to 2.5% I'm planning to start loading up on them.

 

[Ted]

Bob_Smith

That means that the TIPS are self liquidating via their premiums.  You do not have to sell them.  Almost all of the difference between their 2.5% yield to maturity and that 3.8% that you have in mind will come from the smaller amount that you get back at maturity ($1000 plus inflation at maturity) as compared to the premium price that you have to pay.

I don't agree with this.

As the TIPs mature, the market price (which is currently at a premium to the accrued principal) will converge with the accrued principal value.  Assuming continued inflation, the accrued principal value will continue to increase all the while.  So the market value will experience some fluctuations, but on the whole will probably continue to increase (at less than the inflation rate) until it coincides with the accrued principal value of the bonds when they mature.

The annual interest payments are determined by the fixed coupon rate times the accrued principal.  Thus, the interest payments will increase somewhat every year, but not enough to sustain an inflation-adjusted withdrawal rate of 3.8%.  In order to do that, it will be necessary to liquidate some TIPs each year to supplement the interest payments.  The maximum inflation-adjusted withdrawal rate that could be sustained without liquidating TIPs would be the current yield, which would be around 3% in this example.

Since the maximum term available with TIPs is about 30 years (on the secondary market) even they cannot guarantee a particular real rate of return for 40 years.  However, given the uncertainty inherent in any projections that far into the future, it is probably reasonable to assume that the real rate of return on TIPs will still be 2.5% in 30 years.

According to FIRECalc, withdrawing 3.8% per year from a portfolio of 100% TIPs paying 2.5% has a 79% chance of surviving 40 years (assuming zero expenses).  While I think that FIRECalc's means of creating "synthetic" returns for TIPs during the years before they existed have a bit of an optimistic bias, I'd say that that's about as good an estimate as one can get.  I would note, however, that adding stocks to the portfolio substantially increases its chances of success over that long a time period.

I hope that everyone's turkey dinner is easier to digest than this  

 

[JWR1945]

Ted, thanks for catching my mistake.

payments (or coupons) = interest + principal

In terms of the yield to maturity, the principal is negative since you must pay a premium. That premium decreases to zero since the bonds are redeemed at par. That is, you purchase each bond at $1000 + a premium and redeem them at $1000 each.

For Bob_Smith: If you were to purchase 25 year TIPS at 2.5% (real) interest (to maturity), selling some along the way and assuming no losses on those sales, and if you withdrew 3.8% of your initial balance (plus inflation) each year, you would be down to 55.6% of your initial balance at the end of 25 years.

You could continue making those 3.8% withdrawals for another 14.6 years assuming that your investments matched inflation (e.g., TIPS at zero percent interest). That gets you to 39.6 years.

FIRECalc results differ from these apparently because of the exact details of when the withdrawals and inflation adjustments are made. There is a very slight mismatch of less than one year. If everything lined up exactly the same, there would not be any spread in the survival times.

Have fun.

John R.

For those interested in the mathematics, an investment with a real interest rate r results in mortgage like payments (interest plus principal) of r / [1 - ( 1/ [1+r]^N ) ]. This causes the balance to equal zero after exactly N years. Multiply this number by the initial balance to determine the annual payment (of interest plus principal).

Others may use slightly different formulas, depending upon the exact details (such as whether the first payment is on day 1 instead of at the end of the first year). A mortgage calculator (or, for my generation, a mortgage payment book) does this for you.

To solve for the percentage balance that remains after N years (such as 25 years), break your initial balance into one part that will be paid down to zero (at the rate generated by the formula) and another part that remains unchanged at the rate r. The second part is your remaining balance. The two parts, when added together, equal your initial balance.

 

[Ted]

Unless a retired person has well over $1 million in financial assets or plans to live very modestly, they will need to liquidate some of their financial assets in order to meet their spending. The whole point of FIRECalc is to indicate the level of spending that could be sustained by a combination of interest/dividend payments and gradual liquidation of assets, assuming a scenario of asset returns duplicating their worst or nearly worst historical performance.

My point is that liquidating assets is pretty much of a "necessary evil" for most retirees. The important thing is to structure a portfolio in a way that it contains some high risk/high return assets (particularly, stocks) but makes it unlikely that it will be necessary to liquidate these assets when they are severely depressed in price.

Holding bonds to maturity allows them to be liquidated without any transaction cost, but transaction costs do not really detract substantially from asset returns as long as people avoid high "loads" on mutual funds and hold their assets for a number of years before selling them.

 

[John Galt]

Hello Ted! I am not anywhere close to a
million bucks, but can see that with a little luck I
could live 100% off the income (including SS) until
my demise.
Sooooooooooooooo, I guess we must conclude that
I am living pretty modestly. I suppose this is true as compared to a lot of my fellow Americans. I just got
back from a long road trip and noticed all of the new shiny cars, trucks and SUVs on the road. I bought my last new vehicle in 1993 and am quite sure that I
will never buy another.

John Galt