Bond Funds and Interest Rate Question

[GusLevy]

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.

 

[audreyh1]

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