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Bond Allocation
Old 07-14-2004, 10:32 AM   #1
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Bond Allocation

I plan to RE in the next year at age 62. With my wife's retirement, plus my SS giving us 50% of what we need, I am thinking I don't need the standard 40 to 50% of my investments in bonds. I still would allocate the other assets. I still have a house payment, but it is low. Inputs?
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Re: Bond Allocation
Old 07-14-2004, 11:48 AM   #2
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Re: Bond Allocation

Hey Kenepp1,

I suggest that you review your asset allocation. If pensions/ss will provide you with a larger cash flow than you previously thought, perhaps you may wish to increase your equities position.

You mention the "standard" 40 or 50% bond allocation. I do not know of any standard allocation in either
stocks or bonds, as everyone has a different need and, if we are held to a standard, many of us would not be properly allocated.

Asset allocation is an issue for you alone to finally decide, depending on your situation.
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Re: Bond Allocation
Old 07-14-2004, 05:36 PM   #3
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Re: Bond Allocation

To reduce risk, i'd consider another option besides bonds right now, if it were me. *Right now, bonds arnt that attractive with interest rates as low as they are, and with them rising. *Interst rates really have only one way to go. *When the prime rate rises 1%, bonds drop 10%. *In this situation, your principal may decrease faster than you can earn interest.
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Re: Bond Allocation
Old 07-14-2004, 05:52 PM   #4
 
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Re: Bond Allocation

Quote:
To reduce risk, i'd consider another option besides bonds right now, if it were me. Right now, bonds arnt that attractive
Please tell us the other option
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Re: Bond Allocation
Old 07-14-2004, 05:58 PM   #5
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Re: Bond Allocation

Hey kenepp1,

IMHO, you should set a stock/bond mix that will give
you the return you need to cover your unfunded
expenses for the time period that you need, with a
withdrawal rate that gives you a high probability
of success. FIREcalc is a good tool to give you a
feel for the correct mix. If you are in the accumulation
phase, then 110- your age is a good place to start
your stock allocation.

If you have a low tolerance for stock market fluctuation,
and can cover your needs with a low stock allocation,
then by all means do what lets you sleep at night.

Personally, at age 70, I use a 60/40 stock/bond mix
because I need to take the risk and can handle the
volatility, thank God.

Cheers,

Charlie
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Re: Bond Allocation
Old 07-14-2004, 06:17 PM   #6
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Re: Bond Allocation

azanon,

I hate to be picky, but the amount a bond changes
depends on its maturity date. For example, a
bond fund with an average duration of 2 years will
change 2% for every 1% change in interest rates.
A fund with a duration of 5 years will change 5%, etc.

BTW, rising interest rates are not all that bad if you
reinvest your dividends. Eventually, the increase in
interest rate will offset the loss of NAV. Another way
to look at it is that a fund's duration is the length of
time it would take the fund to recover the initial loss
of NAV due to a rise in interest rates.

That having been said, IMHO at least a 1% rise in
interest rates has already been discounted by the
market. That's why you saw a recent rally in long
term bonds on fear that the economy may have
peaked.

Cheers,

Charlie
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Re: Bond Allocation
Old 07-14-2004, 07:20 PM   #7
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Re: Bond Allocation

Looking at the LBA Bond Index, bonds have eared 0.30% since the end of June for the last 12 months preceding (dont have July data on me). *Not so hot. *The rates were steady, then climbed during that period. *Conversely, the two years previous rates dropped quite a bit, and as one would suspect, bonds did quite well.

Correction noted; yes i should have said long-term bonds. *Still, since bonds essentially make money by the rate they pay, and from interest rate changes that sometimes work in their favor, i'd personally try to avoid them when a good portion of its change is almost certain to go south (due to the prime rate likely to climb again).

What would i pick? *Short-term US Treasuries. *Again, i see the main purpose here (in this environment) to preserve principle and offset the stock risk. *Seems it defeats that purpose if you're buying intermediate term or long-term bonds now.
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Re: Bond Allocation
Old 07-14-2004, 08:05 PM   #8
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Re: Bond Allocation

kenepp1,

Putting Charlie's response another way, I would determine how much I plan to draw from my portfolio annually, then keep some number of years of that amount in fixed income assets. I use 10 years. If you plan on a 4% draw, that works out to about a 60/40 split; 3% a 70/30 split. Of course, you can increase or decrease the number of years, depending on your sensitivity to the risk of selling equities in a down market. The interaction between the number of years and the withdrawal rate will drive the equity/fixed income split.

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Re: Bond Allocation
Old 07-14-2004, 08:23 PM   #9
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Re: Bond Allocation

Kenapp,
An alternative approach that I follow is to break away from the simple 'Stock/Bond' dichotomy to something that is "Stock/Bond/Other". In the Other category I put the following: (you may choose differently)
Private Equity, Commodities, Commercial Real Estate, Oil and Gas, Market Neutral Hedge Fund and possibly Precious Metals (I don't have precious metals but many do -- they reduce short term volatility but have poor long run returns).

If nothing else, this exercise will cure you of following simple Stock/Bond ratios which the investment community so loves us to stay stuck in. After all, every one of them involves a traded security (pretty much).

One thing you can do in your Other category is take on illiquid investments which pay well but don't let you bail out on short notice (e.g. owning a bit of a medical office building is my favorite), or owning directly in oil and gas wells (haven't had the guts for it myself, but lots of smart people do this). The beauty of these investments is that they will tend to correlate only loosely with the stock and bond markets, helping you reduce overall volatility in your portfolio. Gillette Edmunds makes a pretty persuasive case for this in his early retirement book.

Illiquid investments do involve more risk, but I feel that ERs with our long horizons and no need for ready cash can first carefully research for quality and then take on risks like this if we limit any single investment to no more than say 3% of our portfolio.

ESRBob
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Re: Bond Allocation
Old 07-14-2004, 10:21 PM   #10
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Re: Bond Allocation

Quote:
What would i pick? *Short-term US Treasuries.
In case it wasn't obvious, short-term treasuries are the same as t-bills, which are the stuff of money market accounts. So, you're basically saying that cash is king, which might be true if inflation weren't 2 points higher than T-bill rates.

A lot of people talk about what will happen "when interest rates rise." I can only guess that they're talking about the Federal funds rate. A common misconception appears to be that when the fed raises the funds rate, all bonds are hit according to their duration. Not so.

Duration is context sensitive. So, if a long-term muni bond fund has a duration of 10 years, that means it will drop 10% if the market rate for long-term munis goes up 1%. The federal fund rate is a driver of short-term rates, not long-term rates. So if the fed raises rates 1%, long-term munis (for example) may do absolutely nothing. As Charlie says, a lot of rate change expectations are already built in.

Ironically, the funds that will probably be the hardest hit by a fed funds rate increase will be short-term bond funds, at least initially.
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Re: Bond Allocation
Old 07-15-2004, 06:24 AM   #11
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Re: Bond Allocation

Quote:
In case it wasn't obvious, short-term treasuries are the same as t-bills, which are the stuff of money market accounts. * So, you're basically saying that cash is king, which might be true if inflation weren't 2 points higher than T-bill rates.
Money Market accounts can be composed of a variety of debt type instruments, T-bills being one of them. *Money Market mutual funds come in all kinds of varieties and flavors, and it is very ameteurish to equate them with T-bills.

However, I must assume since you're disagreeing with me, your default position is supporting bonds so lets compare the recent numbers shall we? * From June 03-June 04, the LBA Bond index earned 0.3% (which i stated above). *From June 03-04, T-bills paid a return of 4.29%. *Futher, bonds have far more future interest rate risk as well as the default risk whereas T-bill interest rate (change) risk is negligible and has no default risk.

BTW- *thinks for educating our audience; a short-term treasury is often referred to as a "T-Bill".

Quote:
So, if a long-term muni bond fund has a duration of 10 years, that means it will drop 10% if the market rate for long-term munis goes up 1%.
Who said anything about munis. *I thought we were talking corporate.

Quote:
Ironically, the funds that will probably be the hardest hit by a fed funds rate increase will be short-term bond funds, at least initially.
If you're comparing them to munis, maybe so. *but to long-term corporate bonds? *You're dreaming.
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Re: Bond Allocation
Old 07-15-2004, 09:10 AM   #12
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Re: Bond Allocation

azanon, munis were just an example of one of the many instances in which long-term rates will be and have been relatively uncorrelated to fed fund rate changes. * If you want to talk about corporate, look at high-yield corporate bonds for another class that won't be much affected by short-term rate changes.

The bottom line is that short-term rates currently have a negative real yield for the most part. * And fed fund rate changes will directly impact short-term rates. * Of course, the impact will be relatively short-lived as the short-term bonds mature and are replaced by new ones.

Long-term bonds have built-in expectations about *long-term* trends in inflation and real interest rates. * Bond traders are not stupid. * If they think interest rate changes are imminent, those changes will be priced in well before the changes occur. That's why the yield curve is so steep right now.
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Re: Bond Allocation
Old 07-15-2004, 01:29 PM   #13
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Re: Bond Allocation

Hot damn I love a spirited discussion. Sometimes
we need to be reminded of things like wab's comment that long term rates and short term rates are not
necessarily in lock-step.

Cheers,

Charlie
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Re: Bond Allocation
Old 07-15-2004, 06:02 PM   #14
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Re: Bond Allocation

Maybe this has something to do with my profession, but I tend to look at my asset portfolio as a way to hedge/offset my liabilities. Most of the short term stuff (mortgage, living expenses, etc.) I assume is satisfied by current wages. So my other liabilities are very long duration: paying for college for my 1 month old and her as of yet non-existant sibling(s), ER (to be paid out over ~40 years and doesn't start for 15 or 20 years), satisfyinf estate tax obligations, etc. When I look around for appropriate long duration assets to match these liabilities, I have a choice of everything from cash to long bonds to equities to other. Cash and short bonds are clearly inappropriate, except for necessary liquidity requirements (e.g. emergency fund). Most bonds are too short for my liabilities (treasuries don't go out more than 10 years and I am not confident of my ability to forecast a company's creditworthiness for the next 25 or 30 years). So what is left? Equities, mostly. Its not primarily to do so, but my significant mortgage is effectively a large short position on the bond market, with duration of roughtly -5 and significant positive convexity, which serves to lengthen my overall asset duration.

I will eventually start looking around at "other", but mot of these assets really require lots of specialized knowledge. As I get closer to payout and my liability duration starts to shorten, I will start rethinking shorter duration assets, but until then...
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Re: Bond Allocation
Old 07-15-2004, 06:08 PM   #15
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Re: Bond Allocation

*I* have significant positive convexity.
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Re: Bond Allocation
Old 07-15-2004, 06:15 PM   #16
 
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Re: Bond Allocation

Like TH, I admit I am a Bond Idiot. The more I learn, the dumber I feel about Bonds.

Does anyone know of a good book for the Bond side of the portfoilo. (e.g. Constructing ladders, I-bonds, Savings Bonds, TIPS etc.) Strategies etc.
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Re: Bond Allocation
Old 07-15-2004, 06:20 PM   #17
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Re: Bond Allocation

Its a darn moving target too. I was just warming up to the idea of lousy returns on ibonds and tips, and ran across an entire raft of experts who claimed both were awful ideas and they're buying EE bonds.

I'm just gonna stick with the short term corp, what the wellington peeps are buying in my wellesley fund, and if interest rates pick up, I'll have another look at ibonds, tips and the total bond market fund.

The 3.5% returns on the intermediate term california muni fund are starting to look good to me too.

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Re: Bond Allocation
Old 07-15-2004, 06:21 PM   #18
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Re: Bond Allocation

Also the book should cover convexivity - something else I vaguely remember I don't understand.
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Re: Bond Allocation
Old 07-15-2004, 06:34 PM   #19
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Re: Bond Allocation

On second thought - after using web crawler - I remember why I stick with bond funds. Convexity can lie in peace.
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Re: Bond Allocation
Old 07-15-2004, 07:19 PM   #20
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Re: Bond Allocation

Quote:
Most bonds are too short for my liabilities (treasuries don't go out more than 10 years and I am not confident of my ability to forecast a company's creditworthiness for the next 25 or 30 years).
Brewer, I don't understand. Since equities are the longest duration of all, and since all debt is senior to equity, how can you feel confident buying equity, if you don't feel that you can assess long term credit worthiness? If the concern isn't credit worthy, surely the equity must be even less predictable.

Mikey
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