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Bond Funds and Interest Rate Question
Old 05-05-2010, 05:58 PM   #1
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Bond Funds and Interest Rate Question

I'm considering buying a decent amount (at least in my terms) of Vanguard's California Intermediate-Term Muni fund - VCADX - for tax purposes, and to stick with my AA, which is crying out for more bonds. (I am a resident of CA).

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?

The same considerations must hold true for anyone considering bond funds these day. Or so I think...

Setting aside the issues of California in particular, do you think it's a good idea to invest in bond funds these days, considering the likelihood that interest rates will rise?
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Old 05-05-2010, 06:26 PM   #2
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Originally Posted by CaseInPoint View Post
I'm considering buying a decent amount (at least in my terms) of Vanguard's California Intermediate-Term Muni fund - VCADX - for tax purposes, and to stick with my AA, which is crying out for more bonds. (I am a resident of CA).

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?

The same considerations must hold true for anyone considering bond funds these day. Or so I think...

Setting aside the issues of California in particular, do you think it's a good idea to invest in bond funds these days, considering the likelihood that interest rates will rise?
Didn't you just answer this?
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Old 05-05-2010, 06:35 PM   #3
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Didn't you just answer this?
Well, I may have, but it doesn't mean it's the correct answer...
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Old 05-05-2010, 07:53 PM   #4
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A 1% change in interest rate will have an inverse effect approximately equal to the "duration" of the bond.

Bond duration - Wikipedia, the free encyclopedia

I think this applies to bond funds too.
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Old 05-05-2010, 08:49 PM   #5
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A 1% change in interest rate will have an inverse effect approximately equal to the "duration" of the bond.

Bond duration - Wikipedia, the free encyclopedia

I think this applies to bond funds too.
Right. So, why would anyone stick to their AA and continue to add bond funds under the circumstances?
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Old 05-05-2010, 09:47 PM   #6
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Right. So, why would anyone stick to their AA and continue to add bond funds under the circumstances?
Because timing the bond market is probably harder then timing the stock market. Here is a recent article published at Vanguard regarding bonds and anticipated rising rates: https://personal.vanguard.com/us/ins...prise-04012010

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"Judging whether or not one specific segment of the bond market will outperform another segment over a certain time period is difficult because it involves being able to forecast the direction, magnitude, and timing of interest rate changes," he said. "That's why it's important to remain well diversified."
I continue to buy short and intermediate term treasuries as well as TIPs' per my AA. If the market continues to fall your (and my) need to balance into bonds may disappear .

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Old 05-05-2010, 10:19 PM   #7
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Because timing the bond market is probably harder then timing the stock market. Here is a recent article published at Vanguard regarding bonds and anticipated rising rates: https://personal.vanguard.com/us/ins...prise-04012010

I continue to buy short and intermediate term treasuries as well as TIPs' per my AA. If the market continues to fall your (and my) need to balance into bonds may disappear .

DD
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?
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Old 05-05-2010, 10:45 PM   #8
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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.
I tend to agree that rates are likely to go up next year. But there is always the possibility that we retrace Japan's footsteps and see near zero interest rates for a decade.
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Old 05-06-2010, 01:50 AM   #9
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OP:

I think you answered your own question.

I do agree interest rates are so low.

My plan, which I am doing, is to buy Vanguard GNMA's. Current yield 3.35%

I know when rates rise, my NAV will fall. My plan is when the fed's start to talk about raising rates, which they will do in 1/4 increments, I will immediately sell all of my Vanguard GNMA's.

With the crisis in Greece, and our high unemployment, and no inflation yet, I can't see the Fed's raising interest rates. yet........

again, just my 2 cents...
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Old 05-06-2010, 06:20 AM   #10
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I would think that CA credit risk would be the bigger issue than interest rate risk in that fund.
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Old 05-08-2010, 08:45 PM   #11
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You may find this discussion on bogle boards interesting. The paper linked to in the first post talks discusses your original question.
Bogleheads :: View topic - Interesting Vanguard Research on Bonds
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Old 05-09-2010, 12:37 PM   #12
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I would also be more inclined to keep my bond percentage in my portfolio appropriate to your risk tolerance and age rather than fussing over whether rates are headed up or down (though I agree with the posters here, rates will head up, but when: the europe events are suggesting that more deflation is coming at least in the short term).
The bonds themselves should be purchased based on if they are in a taxable account (so munis make sense there) and a certain percentage of TIP's is a good idea for any portfolio too.
Morningstar recently did a nice series of articles on TIPS...just google TIPs allocations in M.Star and the articles should come up.
The idea behind buying a bond fund is the fund buys funds based on their own projections of what is going on in the bond market. So PIMCO for my money seems to have good results. But Vanguard has excellent bond funds too.
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Old 05-10-2010, 06:54 PM   #13
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You may find this discussion on bogle boards interesting. The paper linked to in the first post talks discusses your original question.
Bogleheads :: View topic - Interesting Vanguard Research on Bonds
Thanks for the link. It's right on target.

The VG analysis is complex in some ways, but the bottom line is that the expectation of rising interest rates is already built into the current NAV.

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I would also be more inclined to keep my bond percentage in my portfolio appropriate to your risk tolerance and age rather than fussing over whether rates are headed up or down (though I agree with the posters here, rates will head up, but when: the europe events are suggesting that more deflation is coming at least in the short term).
The bonds themselves should be purchased based on if they are in a taxable account (so munis make sense there) and a certain percentage of TIP's is a good idea for any portfolio too.
Morningstar recently did a nice series of articles on TIPS...just google TIPs allocations in M.Star and the articles should come up.
The idea behind buying a bond fund is the fund buys funds based on their own projections of what is going on in the bond market. So PIMCO for my money seems to have good results. But Vanguard has excellent bond funds too.
Makes sense. Investing according to one's AA regardless of market conditions is a common strategy. Don't try to time the market. For most people, that's great advice, because their number-one challenge is just to keep on saving and investing rather than spend their money.

I wonder how strictly this advice should be followed, though, by someone who is an experienced investor seeing an asset class (in this case bonds) likely to drop in value.

You're correct that TIPs should be part of most portfolios. Curiosity - would you recommend buying them through a broker or through Treasury Direct?
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Old 05-11-2010, 04:53 PM   #14
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Someone recently posted to the effect that:

"People who need bonds, are sold bond funds instead."
The point being, I believe, that a fund never matures and is always subject to losing NAV.

Understanding the difficulties and dangers in buying individual bonds, at least you can build a ladder that should avoid the need to sell when values are significantly down. Even if you must sell a bond that matures next year, the NAV hit should be fairly small.

But I'd like to hear different opinions.
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Old 05-11-2010, 05:01 PM   #15
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Someone recently posted to the effect that:

"People who need bonds, are sold bond funds instead."
The point being, I believe, that a fund never matures and is always subject to losing NAV.

Understanding the difficulties and dangers in buying individual bonds, at least you can build a ladder that should avoid the need to sell when values are significantly down. Even if you must sell a bond that matures next year, the NAV hit should be fairly small.

But I'd like to hear different opinions.
It's true, in a rising interest rate environment, you can indeed hold a bond until maturity and never lose any principal. However what you give up (ie forgo) is the better rate on newer issued bonds by giving up interest. In a perfect world the foregone interest would exactly equal the unlost principle value. In effect you do give up something.

Either way, as I see it, If you are holding bonds (or bond funds) in a rising interest rate environment - You lose. Bond ladders won't really help you if you look at your bond portfolio in a holistic manner.
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Old 05-11-2010, 09:23 PM   #16
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The Boglehead Wiki has an excellent section addressing this issue Individual Bonds vs a Bond Fund - Bogleheads. There is a thread that is linked about "controversies" which is an enlightening read.

If what you are interested in is bonds for your retirement portfolio (ie no set date on which you need them) there is no advantage to using a ladder as MB pointed out above and there are certain advantages to using a fund as summarized here: Bonds vs. Bond Funds? An Easy Choice! - CBS MoneyWatch.com

DD
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Old 05-11-2010, 09:37 PM   #17
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Makes sense. Investing according to one's AA regardless of market conditions is a common strategy. Don't try to time the market. For most people, that's great advice, because their number-one challenge is just to keep on saving and investing rather than spend their money.

I wonder how strictly this advice should be followed, though, by someone who is an experienced investor seeing an asset class (in this case bonds) likely to drop in value.
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.

I've often been ahead just using the strict rebalance technique - with no attempt to do "dynamic AA" - i.e. changing my AA based on what I think a given asset class will do. I think you can get really burned that way.

IMO, in investing it's best not to try to be clever but rather keep it simple and stick to your plan.

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Old 05-11-2010, 09:45 PM   #18
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I have never believed that the (regular retail) individual investor gains a thing by owning bonds directly instead of bond funds. They are much more expensive to trade and you have much larger single issue risk than with a diversified bond fund.

The "don't lose value" part of owning bonds directly is an illusion. You are just kidding yourself IMO. Your individual bond is traded on the secondary market, it DOES have a NAV, and if you don't look at it as part of your net worth, you are just ignoring reality.

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Old 05-12-2010, 07:00 AM   #19
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I largely agree with Audrey's second post. I trade retail lots of bonds occasionsally and I can tell you that the costs are real. I pay multiples of equity commissions in direct fees when I trade bonds, and the bid-ask spread can often be 3% or even more (vs. A fraction of a percent for most equities).
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Old 05-12-2010, 08:06 AM   #20
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I have never believed that the (regular retail) individual investor gains a thing by owning bonds directly instead of bond funds.
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.
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