Bond Funds

[Mysto]

In keeping with my usual timing - I got my allocations started at Vanguard just in time to watch long term rates rise. I have most of my fixed investment in Vanguard Total Bond Index Fund which is (of course) going backwards.

So what is the feeling here - should I move the bonds to short term or just let it ride in the total fund?

 

[2B]

I avoid bond funds for the reason you're seeing your value decline. In a fund you will never get your principal back until interest rates fall back to the level they were when you bought in. If you buy individual bonds or CDs, they may drop in value on paper; but at the end of the term, you will get back your principal (assuming no bankrupcy).

Diversification can be an issue for an individual investor but I only buy bonds that are backed by the US government. My bond allocation is not in any way speculative.

 

[mathjak107]

I avoid bond funds for the reason you're seeing your value decline.  In a fund you will never get your principal back until interest rates fall back to the level they were when you bought in.  If you buy individual bonds or CDs, they may drop in value on paper; but at the end of the term, you will get back your principal (assuming no bankrupcy).

Diversification can be an issue for an individual investor but I only buy bonds that are backed by the US government.  My bond allocation is not in any way speculative.

not true...depends on the duration of the bond fund...no one has ever lost a penny in a bond fund from intrest rate changes if they hold for the funds duration...dont forget bond funds are selling bonds every day and replacing them with the higher rates avail on that day...eventually a funds portfolio turns over and the higher rates offest any principal decline..took me a while to realize this..as an example my short term bond fund is down about 3 cents a sgare and paying almost 5%...the 3 cents reprecents .003 % in todays interest rate so if its 4.99% im actually getting 4.96% even with the 3 cent principal decline.....the key is holding the fund long enough to let duration do its thing,it dosnt have toi come back to the same rate you bought in on

 

[JPatrick]

The key in making your decision is knowing when rates will stop rising. 
When you find out please PM me.
As far as switching, it's all in the numbers.  No doubt you'll get better yield on the short vs total, but are there fees associated with switching?

About those rates - -  I think we about are about one increase away from being done.  Anymore than that is just nutso in this economy.  All IMO of course.

 

[2B]

not true...depends on the duration of the bond fund...no one has ever lost a penny in a bond fund from intrest rate changes if they hold for the funds duration...dont forget bond funds are selling bonds every day and replacing them with the higher rates avail on that day...eventually a funds portfolio turns over and the higher rates offest any principal decline..took me a while to realize this..as an example my short term bond fund is down about 3 cents a sgare and paying almost 5%...the 3 cents reprecents .003 % in todays interest rate so if its 4.99% im actually getting 4.96% even with the 3 cent principal decline.....the key is holding the fund long enough to let duration do its thing,it dosnt have toi come back to the same rate you bought in on

Yes! The interest rate rises with your decline in principal so you've effectively "locked in" your initial rate. That does not change the fact that if you are in a 10 year bond fund for 10 years your principal will not be returned intact. You may be able to sell your fund for more or less than you paid for it. Return of principal is not guaranteed!

 

[mathjak107]

depends...if your re-investing your dividends too that shortens duration...you have to look at total return in a bond fund to determine if you lost money...thats principal plus interest.........watching just the principal is like watching a 5% dividend from say gm without watching where the price per share fell and saying dosnt matter where the price per share goes ,im making 5% a year      ..a bond fund normally isnt graded in maturity length like say a 10 year bond would be.its maturity varies every day by what was bought and sold.....most long term bond funds today that normally would buy 20-30  year bonds are hedging these bonds and shortning duration to 4-5 years effectively.......that means if you own shares today and you are down it would take 4-5 years in the fund to achieve todays current interest rate and no lose of principal        .......if anyone can explain bond fund duration better step in here as im a little fuzzy myself although i have a basic idea                                   

 

[mathjak107]

found a good explanation in john c bogles book:
since bond funds never mature they actually become an average of the bonds they hold..an intermediate bond fund might hold some longer term bonds,some intermediate term and some what were intermediate bonds once but are now short term bonds since they have reached maturity or are close to.
   duration is the average amount of change the fund would have gone up or down in nav based on a 1% change in rates...by the same token he says bond investors have to realize that while an increase in rates cause a drop in nav ,the yield on the fund increases over time.so if rates rise 1%, the time it would take to make up the loss and get the orig rate of interest you started with would be approx equal to the funds origional duration on the day you got in....

 

[2B]

Last try.......

Case 1: 10 year treasury at 5%

$1000 dollars for a bond. Every year $50 shows up as interest that can be reinvested, spent, etc. In 10 years the original $1000 shows up.

Case 2: Mutual fund with an average bond maturity of 10 years currently paying 5%

$1000 is invested. Interest rates go up, down, or wherever for 10 years but the $50 shows up with only slight variations up and down. This money can be reinvested or spent. What happens to that money is irrelevant. After 10 years there is a desire or need to get some money and the mutual fund is sold as all of our investments will eventually be sold. Unfortunately, the rates have gone up so much the original fund shares are only worth $500. Or, they could have gone down so much that the original shares are now worth $2000.

My whole point is that there is a greater element of interest rate speculation involved with the purchase of a bond mutual fund than with individual bonds.

 

[audreyh1]

2B - a lot of people buy bond funds for asset allocation, and therefore care about total return (dividends are reinvested), not getting back the original principal.

If you buy bonds so that you can get back the original principal, then you had better buy individual bonds, not bond funds.

"Interest rate speculation" has nothing to do with it when you buy bond funds as one of your asset classes in an asset allocation portfolio. You add to bond funds when they are down (interest rates rise) and you take capital gains when the funds are up (interest rates fall).

Audrey

 

[2B]

Eventually you or your heirs will sell. You can't avoid the interest rate speculation inherent in bond mutual funds. If you accept that, they are fine. I personally want to minimize the speculative aspects of the fixed income portion of my portfolio.

Getting more picky about bond mutual funds:

1. They have management fees.
2. They have transaction costs.
3. It's not possible to "ladder" mutual funds.

 

[Maximillion]

International Monetary Fund have issued a warning on the increase in the Inflationary Rate and the potential for increases in the Rates of Interest.

The US in particular was singled out for its' current economic situation, one that the IMF calls worrisome and predicts a further decline in the exchange value of the US$, a need for an increase in rates to maintain economic stablity, and the potential for a recession.

The Prudent Investor would be locking in LONG Mortgage and other Debt responsibilities,and staying very SHORT in Bonds or other Fixed Income Assets.

10 to 15% of Holdings should be in Non US Currency, possibly a Euro Bond Fund or an ETF from Australia or similar commodity based economy.

 

[mathjak107]

there is next to difference bewtween buying a bond or a bond fund....
you buy a bond fund with a duration of 5 years paying 5%...rates rise to 6%....your principal drops 5% but your collecting 6% interest instead of 5% for 5 years..the extra 1% per year compensates the 5% drop in principal yielding the same 5% return for 5 years at the origional principal amount....no difference from holding a 5 yr bond instead except the fund expenses

 

[ESRBob]

I think 2B is underestimating the value of that higher coupon (6% instead of 5%) over the intervening years -- that is what brings these things back into alignment.

You might also contemplate the opportunity cost in holding the regular bond -- when interest rates go up, you are stuck earning the same old coupon (although it will be a 6% yield to maturity on your now-lower bond value) and you don't have the chance, as the bond fund does, of buying new investments yielding 6%. Not sure if this matters much compared to just holding the now-6%-yielding bond, but it was always mentioned in my finance textbooks!

I have heard this argument played out in vivid detail in my house (my father-in-law only buys 'real bonds'), and have come to the conclusion that some people just really worry about principal risk and there is no point in trying to change their minds. It isn't making one wrong or another right -- it is just a way of looking at the world and feeling risk.

And some of 2B's other bond fund quibbles have merit -- for instance, there are fees, although Vanguard's bond fund fees seem pretty de minimus.

If you are in treasuries, 2B, you should be fine, but I also like the diversifcation of risk of owning lots of different bonds and multiple maturities in a bond fund, as opposed to being locked into an illiquid (spreads will nail you if you ever had to buy or sell a 'used bond') investment which might actually carry some credit risk that you can't avoid. The bond funds' multiple holdings spread that risk better, imho.

 

[2B]

I had told myself that I was done answering comments on this thread but ESRBob demands a reply.

The interest payment on the individually owned bond and a bond mutual fund will stay the same. The principals will both move up and down in approximately the same amounts as interest rates change. The only difference is that at some point in the future the principal of the bond will be repaid in full. Liquidating the the bond mutual fund will return what ever the market price of the bond fund is on the day of redemption.

Reinvesting the interest payments is not relevant. It should be treated as a new investment decision.

If the argument is used that you can't necessarily reinvest the interest payments in new individual bonds, then you probably do not have any reason to be buying bonds in the first place. I would consider $100,000 to be the minimum that anyone would have any reason to own bonds for the fixed income. Anything less than that isn't going to provide any benefit over a good old CD or money market account.

My only interest in bonds is as a way of creating pseudo annuities. BTW -- Real annuities are bad investments for 98% of those of us in the US. If someone wants to brag about the annuities they have, start a thread.

A much better yield and higher credit rating over real annuities can be achieved by laddering bonds based on when the "guaranteed" money will be needed. My key goals are creating a pseudo social security payment before I actually begin my withdrawls and providing cash for living expenses for a nominal 5 year period so I can weather a market downturn without raiding a depressed stock funds. Laddered bonds and CDs work great for this.

I only have government backed or FDIC insured fixed income. The premium for high quality corporates just isn't there to justify the risk. Enron, Worldcom, GM, Ford, United and many others all had AAA credit ratings at one point. The government may have its problems but they still print the money.

Again, I don't buy bonds to speculate in interest rates. I buy bonds to make sure I have a certain amount of cash on a certain future date. I can't do that with a bond mutual fund!

 

[mathjak107]

good idea..i have some thoughts on immeadiate annuities ive been toying with..ill start new subject in a bit

 

[scrinch]

I appreciate this discussion, as I have had the same argument with myself for years. I have finally (okay, the argument probably isn't completely over) come to the conclusion that the diversity of a bond fund probably outweighs the issues of fees and principal risk. I finally realized that in a rising interest rate environment, just like I would, the fund will hold the bonds to maturity and realize a 100% return of principal also. So if I am willing to hold the bond for 10 years, then I should be willing to hold the bond fund for 10 years, and the fund would get its principal back despite the temporary paper loss of value in the intervening years.

there is next to (no) difference between buying a bond or a bond fund....
you buy a bond fund with a duration of 5 years paying 5%...rates rise to 6%....your principal drops 5% but your collecting 6% interest instead of 5% for 5 years..the extra 1% per year compensates the 5% drop in principal yielding the same 5% return for 5 years at the origional principal amount....no difference from holding a 5 yr bond instead except the fund expenses

There is no difference (except fees) between me holding a bond to maturity and a bond fund holding a bond to maturity. The difference between the the two is in the "getting out." With a series of individual bonds you are assured of getting 100% of your capital back (barring default) because you can get out of them precisely when they mature. If you hold a fund instead of individual bonds, you will not be able to realize par value when you ultimately get out of the investment because all of the bonds that the fund holds don't mature when you sell. You will essentially be forced to sell the bonds before maturity and their value will be impacted by how interest rates have changed since you originally bought into the fund. If that was 2 years ago, then it might have a big impact on your overall return. If it was 40 years ago, then the impact on your overall return will likely be small (unless rates have changed very radically).

 

[Nords]

You might also contemplate the opportunity cost in holding the regular bond -- when interest rates go up, you are stuck earning the same old coupon (although it will be a 6% yield to maturity on your now-lower bond value) and you don't have the chance, as the bond fund does, of buying new investments yielding 6%.  Not sure if this matters much compared to just holding the now-6%-yielding  bond, but it was always mentioned in my finance textbooks!
I have heard this argument played out in vivid detail in my house (my father-in-law only buys 'real bonds'), and have come to the conclusion that some people just really worry about principal risk and there is no point in trying to change their minds.  It isn't making one wrong or another right -- it is just a way of looking at the world and feeling risk.
And some of 2B's other bond fund quibbles have merit -- for instance, there are fees, although Vanguard's bond fund fees seem pretty de minimus.

I'm no bond expert, but this smells like the mutual-funds-vs-ETFs debate.

If you're DCA'ing with small monthly payments, then index mutual funds or DRIPs (or something rock-bottom cheap like Sharebuilder) are generally the cheapest way to maintain the DCA discipline. A mutual fund portfolio also allows great flexibility in adjusting asset allocations, especially in something like a targeted AA fund. This is also true of a bond fund.

If you're investing lump sums, however, then ETFs or actual stocks are cheaper. Not much cheaper than Vanguard's TSM index, true, but still cheaper when held for decades. This would also be true for individual bonds held to maturity, despite the bid/ask spread, and especially so for govt bonds.

The trick with the ETF/stock approach is maintaining diversification. And the trick with buying "real bonds" is not only diversification but laddering in order to spread out that interest-rate risk. Of course it takes some time & effort to build a ladder out of 30-year bonds.

Timing never hurts either. Waaaaay back in 2000 Mel Lindauer over at the Vanguard Diehards pointed out that I bonds had a base rate of 3%. I think he's one of the few retail investors who actually had the Treasury stop him at the $60K/SSN I-bond limit. He was pretty much regarded as an overconservative idiot bear back when the S&P500 was going to the moon, but of course for the last few months his I bonds have been earning a tax-free 9.73%.

 

[ESRBob]

The interest payment on the individually owned bond and a bond mutual fund will stay the same.

Reinvesting the interest payments is not relevant. It should be treated as a new investment decision.

If the argument is used that you can't necessarily reinvest the interest payments in new individual bonds, then you probably do not have any reason to be buying bonds in the first place.

My only interest in bonds is as a way of creating pseudo annuities.

2B
I think your approach (5 year, pseudo-annuity, high quality and insured bonds) is the best fit for your situation -- don't want to leave the impression I think otherwise or would want to convert you to bond funds!


One side point -- reinvesting coupons back into the market at prevailing interest rates isn't a no-brainer. You are right that It is a new investment decision, but there are some simple pragmatics of where and how to reinvest the relatively small amounts of the coupons in order to get paid prevailing interest rates for the maturity of the bond. One approach for bond-investors might be to re-invest coupons from the bonds back into a bond fund of similar maturity rather than a money market fund. (Generic advice -- I promised not to try to convince you to start investing in bond funds!

On a final note, though -- again, not an advantage of funds -- just an observation that although you are getting back your principal at maturity, due to inflation it is worth less in real terms than it was when you made the investment.

Nords,
I sure feel like a doofus -- I bought 30k of Ibond for everyone in my family in Fall 2000, self-limiting and assuming there was some sort of central repository of this info, and now find that everyone else was just buying away, and that I could have been loading up on them since no one was really looking? Ay Ay Ay! Those still rank as my all-time best bond purchases. (See 2B, I do buy bonds as well as funds!)

 

[Mysto]

Thanks for all of the replies.  Well, I think I will just hold the bond fund - it appears that I am in it for the right reason - portfolio diversity and it is intended to stay there for a long time.

2B - It may interest you to know that I also agree with many of your comments.  I am building a CD ladder that is seperate from my "investment" portfolio that I plan to use like an "annunity" so I can leave my investments alone for 6-8 years.  I am in short term right now and will go for longer durations as soon as the Fed "sounds" like they might cool it. (I don't know the future of interest rates but I would be willing to bet on at least one more hike)

 

[brewer12345]

Mysto, all of the jibber-jabber aside, you seem to have bought the bond fund as part of a portfolio allocation. So you did it to diversify and reduce volatility, which the bond index fund gives you. I think you got a bunch of responses trashing bond funds because many of the people who buy individual bonds are the ones who are terrified of losing principal. What they seem not to realize is that they earn total return on bonds just like you would in a bond fund.

You asked whether to switch to the short term fund instead. Assuming you chose the Lehman Agg fund as a conscious portfolio allocation, I would suggest that you really only should switch if you wish to speculate on what interest rates will do. The Lehman Agg fund you are in now has modest duration (around 4 IIRC), so it would take a pretty big rate increase for your total return to be negative, given the almost 5% coupon on the fund. I wouldn't get too excited about it and just stick to your allocation.

 

[scrinch]

Good discussion. What I've gotten out of it is that laddered Treasuries can create a very low risk cash flow instrument (2B), while bond funds look better when viewed as part of a total return, allocated asset portfolio. So if you are likely to need to use your principal in the short- to medium-term, buy short- to medium-term bonds to avoid interest rate risk. If you want to invest part of your nest egg in bonds for the long term you can get diversification and automatic reinvestment more conveniently in bond funds.

 

[2B]

I finally realized that in a rising interest rate environment, just like I would, the fund will hold the bonds to maturity and realize a 100% return of principal also.  So if I am willing to hold the bond for 10 years, then I should be willing to hold the bond fund for 10 years, and the fund would get its principal back despite the temporary paper loss of value in the intervening years.

That is not true. The classical bond mutual fund targets a specific maturity -- short term, medium or long. They buy bonds on the high side of their target and then sell them several years later on the low side. They don't hold bonds to maturity.

There are closed end bond funds that do hold their bonds to maturity. They are a whole nother thread.

 

[2B]

I think you got a bunch of responses trashing bond funds because many of the people who buy individual bonds are the ones who are terrified of losing principal.  What they seem not to realize is that they earn total return on bonds just like you would in a bond fund.

I would like to point out that I am the only one trashing bond mutual funds.

The only way the bond fund's total return will exceed that of an individual bond is in a falling interest rate environment. There the bond mutual fund will continue to pay the same interest payment indefinitely and a capital gain will be available at any time.

Of course, in a rising interest rate environment, the interest payment stays the same and a capital loss will be realized when the fund is sold.

 

[mathjak107]

Of course, in a rising interest rate environment, the interest payment stays the same and a capital loss will be realized when the fund is sold




no the intrest rate never stays the same in a bond fund ..its always variable along with the principal thats variable....they equal out to the origional purchase deal when duration is met

 

[2B]

I used the work "payment" and not "interest rate." In reality the payment will move a little but it will stay pretty close to the same dollar amount as when purchased. The interest rate of the bond mutual fund will vary with the market. That's where the principal changes come from. It's just about the same for an individual bond -- except at maturity you know how much the asset will be worth.