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Old 05-12-2010, 09:09 AM   #21
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When my father died twenty years ago, I stated managing my mother's small retirement portfolio. I bought individual bonds because I hated the idea of a fund manager constantly trading bonds. Why add a casino aspect to the fixed income portion of your portfolio?

I managed to make that strategy work, but the experience convinced me that bond index funds are the way to go.

Here is why.

1. Enron. I never owned any Enron bonds, but only through sheer luck. They were exactly the kind of bonds that I was buying: AAA bonds of a well-known company.
2. Broker troubles. Everything from botched trades (long story, but the brokerage refused to make it right ) to constantly fending off whatever the brokerage was pushing that day. Bad experiences with two big, name-brand firms.
3. I hated reading prospectuses (prospecti?) for individual offerings.

At one point or another, we held bonds from GMAC, Ford, Chrysler, Citi, BofA, Fannie, Freddie, and Texaco. Only luck got us out without a scalping.

Since then I have read that when following our broker's advice, we did get taken in. Apparently, GMAC SmartNotes were specifically designed to market risky bonds at low-risk interest rates to naive investors like me. (Once again, the luck of the draw got us out of those turkeys before the blow-up).

And Audrey is right (as usual) about the NAV value of bonds fluctuating.
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Old 05-12-2010, 10:15 AM   #22
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Originally Posted by Gone4Good View Post
The exception, in my view, are government securities (especially TIPS) that can be bought at auction along side institutional investors and usually come at a slight discount to market. Individual TIPS make a lot more sense to me than a TIPS fund.

But other bonds I generally wouldn't buy individually for the reasons you cite, unless I was speculating on a turn-around story.
Yes, I agree that the exception is US government securities if you buy them directly from the government which the individual can do without commission.

And the single issue risk is the lowest for those securities.

Audrey
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Old 05-12-2010, 09:08 PM   #23
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I've watched a lot of "experienced investors" try to outsmart the market by getting out of an asset class that was "sure to go down soon".

They are usually way too early - by a year or two! It's just too easy to be wrong. And, IMO, early by a year or two is wrong.
Since retirement investing is long-term (generally), a year or two from the absolute peak or bottom of the market may not be such a big deal. Still, I'm trying to steer clear of debating the philosophy of passive vs. active portfolio management. Both have merit, depending on the investor's circumstances.

I can say, though, that in the past 18 months I was able to transfer funds into a simple broad stock index (VTI) when the Dow was at low levels, and that turned out to be one of the bright spots in my portfolio, even though it put me outside of my AA.

Rounding back to my original question of bonds vs. interest rates, my research has come up with something that is of interest to me, which is diversifying the bond portion of my portfolio. As of now, I'm tending to go with 50% of my bond allocation in the original CA IT muni fund I was considering (VCADX), then 25% in a TIPS fund (VIPSX), and 25% in a broad, high-quality bond index fund, like VBMFX. But of course, I will research this more and could change my mind... Any comments on this mix are welcome.
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Old 05-12-2010, 09:25 PM   #24
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Looks fine to me. The only question is where they will be? I'm assuming the munis will be in a taxable account. I'd avoid TIPS and Total Bond Index in a taxable account if at all possible.

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Old 05-12-2010, 10:12 PM   #25
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Looks fine to me. The only question is where they will be? I'm assuming the munis will be in a taxable account. I'd avoid TIPS and Total Bond Index in a taxable account if at all possible.

DD
Thanks, DD. The CA munis are tax-free as I'm a resident of CA.
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Old 05-13-2010, 09:48 AM   #26
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With interest rates so low and an economic recovery likely in the next year or two, it's a safe bet that interest rates (and inflation) will rise in the not-too-distant future. That means that bond prices will decline. True, the total yield will remain the same but, still, in a fund like this, the price is likely to drop, no?
Fixed-income analysis is more of an academic/mathematical discipline than equity analysis so you'll prob have to go to the bookstore finance section and do more thorough research if you plan to be so heavily weighted in bonds. Having said that, there are generally 4 ways that a bond portfolio can be changed in value and managed for better returns: 1) Interest rate risk (i.e. duration mgmt), 2) Yield curve risk (i.e. bullets, ladders, barbells, etc.), 3) Sector allocation (i.e. Govts, Mtges, Corps, etc.), and 4) Issue selection (i.e. specific bond u buy).

1 & 2 will be the largest contributors to a bond portfolio's return in normal times as the binary nature of receiving a fixed cash flow today vs where interest rates are tmrw will be better or worse for you if rates change - and rates always change. Duration is the simplest concept for most investors to grasp but the reality is that there are several methods and ways to calculate durations depending on how the analyst wishes to change the interest rate environment: Most retail investors are told how a bond portfolio's value will change if a parallel shift of 100bps in the yield curve occurs. While this basic duration risk gives a decent picture of overall interest rate risk, the reality is that rates rarely actually shift in a parallel manner. In today's environment, for example, inflation risk will violently move the long end of the curve (+10yrs out) while liquidity risk keeps the short end extremely low (until the day the mkt feels liquidity risk has subsided at which pt it will scream higher). A 5yr portfolio today can have much different return profiles going foward if it is a bullet portfolio (all in 5yr maturities) vs a laddered portfolio (an evenly distributed maturity profile to avg 5yrs) vs a barbelled portfolio (a combo of short and long-end bonds to avg 5yrs): Depending on the timing vs expectations of a global recovery, for example, there could be substantial return differences b/w all 3 portfolios.

3 & 4 are the part of bond mgmt that is more "equity" like in terms of analysis. As much as a stock portfolio can beat the mkt by being in the right sectors or the right individual stock, so too can a bond portfolio correctly overweight the best sector or choose the right individual bond issuer.

As for muni bonds, their analyses also includes - imo - political considerations in addition to the obvious tax environment considerations. I am also a Cal resident and have had a decent chunk in levered munis for the past 1-2yrs based on 1 & 2 analysis but have shifted to non-levered shorter portfolios recently due to 3 & 4 considerations.

Good luck.
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Old 05-13-2010, 11:04 AM   #27
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DD, I can understand your strategy, and of course the old adage about not timing the market.

In this case, though, I think that it's safe to time the market in the sense that sometime in the next year or so, it's a pretty safe bet that interest rates will rise. So, while I wouldn't try to time the market to find the ultimate low point of interest rates, knowing that we're at a historically low point makes sense.

As for bond funds, there is an opinion I received in the Boglehead forum, that the likely rise in interest rates is already built into the current price. Who knows...

I guess that looking at capital preservation bonds like treasuries and TIPs makes pretty good sense, but if someone is looking for a little more growth (as I am) the question is a little more complicated. But of course in the end, simple capital preservation is better than losing value in a bond fund.

BTW - would you recommend buying the treasuries and TIPS from Treasury Direct or through a broker?
Bond funds do recover from interest rate rises. If you are a long term investor then you just shouldn't worry about this. Treasuries and TIPs are just as vulnerable to interest rate rises as other bonds and will do no better to preserve capital. If you have an asset allocation, then the interest rate rise cycle gives you an opportunity to buy more bond shares when they are temporarily depressed.

Try to time it, IMO, and you are likely to do worse than if you just rebalance periodically. It may seem "obvious" but nothing is that simple or cut and dried. Best not to try to be too clever.

If you want an idea of how things behave in the real world, study how bond funds behaved during the previous rate rise cycle - late 2003-2006. It will probably be enlightening.

Audrey
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