Bond strategy question

[Van]

Much appreciations for everyone's input on my newbie questions. I have learned a lot here. Just wished I have discovered this forum a few year earlier. Would have save me a very EXPENSIVE lesson. Okay to further my education, this time regarding bond.

We know that a good balance portfolio need to have some bond. How much depends on the risk profile of the investor. So far, so good? I also know that bond moves in the opposite direction of interest rate with the interest rate having more effect on long bond than short term bond.

Now my question. In the period of rising interest rates, is it desirable to switch to short term bond and vice versa during a period of declining interest rates or is it better to stay put and rebalance? I realize that like stocks, we can not be totally certain of the direction of interest rate movement. But it seems to this novice investor that the direction of the interest rate is more predictable based on the Fed's policy than the stock market's movement. Any thoughts?

Van

[Maximillion]

Today's yield Curve is flat, you are not compensated for going long.

A bond Ladder, maybe 3 and 5 years out, as the bond matures ladder out to 5 years.

An alternative would be to buy a Bond ETF and let the pros do the worrying, plus their acquistion costs are a lot less than yours.

A Bond ladder should have increments of $10 to $15,000 to get any kind of break on the Bonds Costs.

IMO.

[Van]

Using a bond ETF is my plan, but which one? Long term bond or intermediate or short term? Do I switch based on climbing or declining interest rate or stay put ?

Van

[free4now]

I'm somewhat of a newbie on the subject of bonds myself, but here's my take.

I think it's best to have exposure to long, intermediate, and short, because that minimizes your overall volatility. And I'd say it's best not to switch between them based on what you think interest rates will do; that would be timing.

A common mistake (which I catch myself making every once in a while) is to think "I know that rates will be going up in the next few months, so it doesn't make sense to lock in a long term rate". What that thinking ignores is that the long term end of the yield curve is determined by people who have the exact same knowledge as you and I do that the short term rates are going up in the near term. The likelihood of the fed raising rates short term at the next meeting is already priced into the long term end of the yield curve.

Why would the long term end of the yield curve be about the same level as the short term end, when we are all fairly certain of at least one more short term rate increase in the near future? Because the investor sentiment that drives the yield curves is that the interest rates will go down in mid to long term, even after they go up in the short term.

[cute fuzzy bunny]

Bernsteins work seemed to show there was little benefit to going past the short term bonds. Intermediates and longs pay a little better, but rarely enough to compensate for the extra interest rate risk.

Especially right now, i'd stick with the ultra short to short stuff...or cash/cd's. Wait for it...

[Maximillion]

CFB is correct, you are not compensated for going out long, better to stay short at this juncture.

http://www.etfinvestor.com

[cute fuzzy bunny]

Originally Posted by Maximillion

CFB is correct

Shoot...the temperature in Hell just dropped 3000 degrees....

[Maximillion]

CFB , what happened, your wife come home??

Cute little girl.

[samclem]

Originally Posted by Maximillion

CFB , what happened, your wife come home??

Cute little girl.

Well, I guess nothing's changed.

[brewer12345]

Originally Posted by Van

Using a bond ETF is my plan, but which one?* Van

I think AGG is a reasonable choice.

[ats5g]

Hey Van,

Trying to predict interest rate movements is usually a fool's errand. Also, staying short "until interest rates level out" or "start going down" is also a very hard strategy to time correctly. Here are a couple of articles to help you out:

What's the Proper Bond Duration for Your Portfolio? [from Bernstein]

Now Is Always the Best Time to Buy Bonds

Bond Basics: Introduction

Advanced Bond Concepts: Introduction

I'd try and create a bond strategy that will work in all kinds of interest rate cycles. For example, many people use bonds as the anchor their portfolio, thus they use short term bonds, CD's, stable value funds, etc. I try and use intermediate term bonds, a stable value fund, and TIPS.

- Alec

[Van]

Alec,

Thank you for the links. I will digest the information and try to come up with an appropriate bond strategy.

Van

[perinova]

welcome to the forum

I have another take on this Van
don't worry about interest rate buy Vang Total Bond Ix.
If interest rate drop you ll get cap. gain
If it goes down you ll get higher dividends

it really doesn't matter with bonds if you hold the fund long enough. your cap gain/loss is of the dividend difference. just make sure you are not getting into junk bonds as what I just wrote doesn't hold true (so only rated BB or better!!!)
the yield curve is flat when when this changes if you you be ahead of the others when this will change.

In short the only important thing is to get an average maturity shorter than your own horizon. nothing else.
You need it for 7 year get a 7 year avg maturity etc

[Van]

Thank you Perinova. I am 45, so my horizon is fairly long. Does this means I should favor long bond? I read the article by Bernstein and understand that long bond carries a higher standard deviation but am I correct that this usually is countered by the equity portion? If this is truly the case then should I focus on the long term return which shows that long bond is the best?

[perinova]

IMHO yes you are right. with one possible caveat:
you need to make sure that you won't bail out before your intial horizon. If interest rate goes up do not bail out of the fund before you actually receive those higher dividends.

also ask yourself a question with that time horizon is a bond the best place to put your money? It might not be most of us think of bonds as a medium term solution for our portfolio. Are long bonds competitive with the stock market over a periods of 20 years? If the answer is yes you wouldnot buy any stock.

if you buy Vang Total Bond Ix. (or similar) youwould hold long, medium and short bonds and have an automatic ladder with an average maturiy arount 6 years (I don't recall exactly if interested you can check the prospectus)

[mathjak107]

right now intermediate term bonds are an okay deal..they are slightly higher than the historical average of 5% and the best is its almost capital gain time on them....with the rates coming towards the end of the rises the markets will start to price these bonds on perception of rates stopping and even dropping allowing you to make a little capital gain sweetner if you sell em...even if rates pause remember the longer end is all priced by investor perception not actual events most of the time..since once we pause the perception maybe rates may drop in the future making these bonds more valuable

[brewer12345]

Originally Posted by perinova

if you buy Vang Total Bond Ix. (or similar) youwould hold long, medium and short bonds and have an automatic ladder with an average maturiy arount 6 years (I don't recall exactly if interested you can check the prospectus)

The total bond market index follws the Lehman Agg index (just like AGG). Duration is 4 and change, which means that a 1% increase in all rates across the curve would result in about a 4% drop in NAV (before coupons). This is reasonably conservative.

[ats5g]

Originally Posted by Van

Thank you Perinova. I am 45, so my horizon is fairly long. Does this means I should favor long bond? I read the article by Bernstein and understand that long bond carries a higher standard deviation but am I correct that this usually is countered by the equity portion? If this is truly the case then should I focus on the long term return which shows that long bond is the best?

Hi Van,

Q: Who buys long term bonds?
A: Insurance companies.

Why?: Because insurance companies have long term liabilities, and long term bonds are much better long term investments with which to match their long term liabilities, than stocks or short term bonds.

Now, insurance companies usually have long term nominal liabilities, so they buy long term nominal bonds. You and I, on the other hand, have long term real liabilities, so a very good long term conservative investment for us are long term inflation-protected bonds. While short term bonds, like Tbills, are riskless in the short term, they are riskier than long term inflation-protected bonds in the long term.

For more on inflation-protected bonds, see Understanding and Using Inflation Bonds, and TIPS as an Asset Class. Also see, “Who Should Buy Long-Term Bonds?”.

One problem with mean-variance optimization and efficient frontier analysis, like the Bernstein Link, is that this kind of analysis assumes that investors only care about the distribution of wealth one time period ahead, when what we really care about is the standard of living that our wealth can support over the long term. See Strategic Asset Allocation: Portfolio Choice for Long-Term Investors.

- Alec