Bonds: So Much More Dangerous Than You Think

[nun]

I've always ploughed the middle furough. My allocation is 50/50 and I'll stick with it. My bond funds are intermediate duration (5 years) and I don't plan to sell if interest rates go up. I'll rebalance and wait for the higher interest rates to propagate through my holdings. I'm not a market timer in stocks or bonds.

 

[Gatordoc50]

I've always ploughed the middle furough. My allocation is 50/50 and I'll stick with it. My bond funds are intermediate duration (5 years) and I don't plan to sell if interest rates go up. I'll rebalance and wait for the higher interest rates to propagate through my holdings. I'm not a market timer in stocks or bonds.

Rebalancing is plausible if Equities continue to rise. Or if one is still working they can add to their bond allocation if both go down . If interest rates go up 1%, then it will take you about 5 years to break even with a bond fund. What happens if they go up two or three percent or more over the next decade? Sounds like you are going to take a permanent hit on those funds. For this reason I like the laddering strategy using treasuries and agency bonds and CDs. It's the lesser of two evils. Once interest rates hit 5% or more, then bond funds will be a good option option IMO. Really, bond funds only make sense if you think interest rates are going to stay at present level or increase a max of 1% over the next decade.

 

[haha]

Seigel didn't say retirees, and he didn't say anything about tax rates. What tax rate would we assume: 50%? Some people do (and did), pay zero percent. And certainly dividends should be included, they are part of the total return. The quote from Siegel isn't "stock prices have never declined over a 20 year period."

Seigel's point is accurate: In the US there has not been a 20 year period when investors lost money with a broad investment in common stocks.

With the caveat that there is no practical significance to this statement, I guess you are correct. An interesting thing to me is that on these boards stocks are generally viewed as inflation fighters, and this was America's big fling with inflation, and valuations were not high by today's standards going into this period, and if one were paying no tax and having no expenses, which to me was likely a null set, then stocks barely eked out a gain over 20 years-nice that someone likes this, but I would not.

Ha

 

[Midpack]

There is really no place to hide. You just have to hope that most years at least some of your asset classes do well, and in years where most asset classes do poorly - well, you hope at least it doesn't last too long.

+1

• You have your folks who vigorously warn us about stocks, here and elsewhere.
• You have your folks who vigorously warn us about bonds, here and elsewhere.
• You have your folks who vigorously warn us about cash, here and elsewhere.
• ...gold, real estate, commodities, collectibles, derivatives, etc.

They're all right sooner or later (and that's when they are loudest), and they're all wrong sooner or later (and that's when they rationalize their POV or hide & wait). Asset allocation to a mix of asset classes has been proven itself superior to the market timing results most investors will actually achieve for the long term over, and over, and over...

YMMV

 

[Original Wally]

+1

• You have your folks who vigorously warn us about stocks, here and elsewhere.
• You have your folks who vigorously warn us about bonds, here and elsewhere.
• You have your folks who vigorously warn us about cash, here and elsewhere.
• ...gold, real estate, commodities, collectibles, derivatives, etc.

They're all right sooner or later (and that's when they are loudest), and they're all wrong sooner or later (and that's when they hedge or hide & wait). Asset allocation to a mix of asset classes has been proven itself superior to the market timing results most investors will actually achieve for the long term over, and over, and over...

YMMV

+1+1+1+1

 

[Original Wally]

(and that's when they rationalize their POV or hide & wait).

hahahaha... just a random thought - would that apply to asteroid strikes as well?

 

[nun]

Rebalancing is plausible if Equities continue to rise. Or if one is still working they can add to their bond allocation if both go down . If interest rates go up 1%, then it will take you about 5 years to break even with a bond fund. What happens if they go up two or three percent or more over the next decade? Sounds like you are going to take a permanent hit on those funds. For this reason I like the laddering strategy using treasuries and agency bonds and CDs. It's the lesser of two evils. Once interest rates hit 5% or more, then bond funds will be a good option option IMO. Really, bond funds only make sense if you think interest rates are going to stay at present level or increase a max of 1% over the next decade.

Lots of "if"s in there, which is why I'm 50/50. I don't know where the markets will go. I do as much as I can to reduce the impact of them on my retirement; I have no debt, own my home and a rental property, have a small annuity, a small pension and will get 2 x SS checks (one UK the other UK) and have ways to reduce my expenses in hard time. I don't know what the next 10 years will bring so I'll stay 50/50 with intermediate duration bonds. Vanguard sees it much as I see it.

https://personal.vanguard.com/us/insights/video/2426-RetExc2-01222013

 

[Texas Proud]

First, you have absolutely no reason to be so rude. That is inexcusable. Second, you are flat wrong. If you truly cannot see the difference between growth at even 1% and the loss of principle then the bullcrap is in your world.

I think that you are looking at things in the light that a lot of people look at things... as an individual with rose colored glasses... which if you deal with finance you can not do....

Let me give an example... you buy a house... the houses all around you go down in value... but you hang on to yours... 20 years later your house has returned to the value it had when you bought... did you lose 'principal' at any time during that 20 years Your answer would be no... you would say 'I did not sell my house, so I never lost anything'... my answer would be yes.... why? Because the value of your house dropped during the time you held it... IF you had sold, you would have lost principal... it does not matter if you did not sell it, you lost principal.... you decided not to sell, which is perfectly fine, but that just means you did not realize your loss...

People say this all the time with stock.... 'yes, it has gone down in price but I have not lost anything because I have not sold it'.... that is basically what you are saying.... because you have not sold your bond you have not lost... but you really have a loss.... now, a bond is different in that your lost principal will come back over time as long as whoever is paying it does not go BK....

 

[Original Wally]

I think that you are looking at things in the light that a lot of people look at things... as an individual with rose colored glasses... which if you deal with finance you can not do.....

TP - first, believe me I do not have rose colored glasses. Not at all. And I did portfolio management for a living for a number of years. And, because it was a public entity (public money) it was 100% fixed income! From short term C.P. (A1/P1 only), to agencies, treasurites, corporate bonds (BBB or better), we did repos, reverse repos, BA's CD's - oh my ... I have forgotten all the produce we bought... Callable, Noncallable.... step adjustabels.

The primary model we used was the SLY model - Safety, Liquidity, Yield. FIrst, do not lose the public's money. Then, can you get the money liquid if a need comes up, LASTLY, yield. Very conservative.

I am not discounting the effects of inflation, just that "lost opportunity" is significantly differtent than lost principle.

 

[Gatordoc50]

Lots of "if"s in there, which is why I'm 50/50. I don't know where the markets will go. I do as much as I can to reduce the impact of them on my retirement; I have no debt, own my home and a rental property, have a small annuity, a small pension and will get 2 x SS checks (one UK the other UK) and have ways to reduce my expenses in hard time. I don't know what the next 10 years will bring so I'll stay 50/50 with intermediate duration bonds. Vanguard sees it much as I see it.

https://personal.vanguard.com/us/insights/video/2426-RetExc2-01222013

It would be nice if bond funds existed in 1950 thru 1980 so we could see how they performed coming off zero interest rates. All the data, including calculators like firecalc, use 5 or ten year treasuries (individual bonds) in calculating returns. That is why I put my return expectations in myself when using firecalc. 7 percent for stocks which is what Bogle and Bernstein and Buffet predict. And 2% for bonds because that is what the ten year is paying.

 

[pb4uski]

.....I am not discounting the effects of inflation, just that "lost opportunity" is significantly differtent than lost principle.

To begin with, it's principal, not principle.

But the key question is, is a loss of buying power bad as well? I would suggest that a loss of buying power is bad and a loss of principal is even worse.

The thing is, if you are managing a fixed income portfolio and have a loss of principal it is really noticeable - a loss of buying power (by earning less than inflation) is less noticeable but still bad.

 

[youbet]

"lost opportunity" is significantly differtent than lost principle.

Yes, lost opportunity is "different" than lost principal. But, in FIRE portfolios, lost opportunity can be just as problematic over time.

 

[Stanley]

+1

[*]You have your folks who vigorously warn us about stocks, here and elsewhere.
[*]You have your folks who vigorously warn us about bonds, here and elsewhere.
[*]You have your folks who vigorously warn us about cash, here and elsewhere.
[*]...gold, real estate, commodities, collectibles, derivatives, etc.


YMMV

I have one word to say on all stocks versus all bonds: Diversification

How many times do people have to rediscover the wheel?

 

[ziggy29]

It's a false distinction when applied in this way. But Ol' Jeremy is also flogging untruth about his darling stocks.

Look at this chart of inflation adjusted returns on S&P 500. Clearly there were 20 year periods that showed a loss- page down a bit and look at 1965-1985.

Ha

S&P 500: Total and Inflation-Adjusted Historical Returns

1965-85 was a lousy 20-year period, and even worse if you throw out 1983-85.

But it looks to me that while the level of the index was lower in 1985 than in 1965 when adjusted for inflation, it eked out a gain, albeit a small one, in "total return" (with dividends reinvested). Or am I reading it wrong?

 

[haha]

1965-85 was a lousy 20-year period, and even worse if you throw out 1983-85.

But it looks to me that while the level of the index was lower in 1985 than in 1965 when adjusted for inflation, it eked out a gain, albeit a small one, in "total return" (with dividends reinvested). Or am I reading it wrong?

No, you are correct. I was trying to allow for expenses and perhaps taxes on dividends. It seems that even with 1%/year for expenses, which would have been fairly cheap even for institutions at that time, and no tax on dividends, there would have been a real loss.

From the way I see it, the rule is is very narrowly defined in order to show a tiny gain, which IMO would have been a loss in the real world.

Ha

 

[nun]

It would be nice if bond funds existed in 1950 thru 1980 so we could see how they performed coming off zero interest rates. All the data, including calculators like firecalc, use 5 or ten year treasuries (individual bonds) in calculating returns. That is why I put my return expectations in myself when using firecalc. 7 percent for stocks which is what Bogle and Bernstein and Buffet predict. And 2% for bonds because that is what the ten year is paying.

I use 3% inflation and a 4% return (so 1% real return) from my portfolio in my planning, but it works with 0% return if needed.

Right now my bonds are a drag on my portfolio, but the recent years of 9% returns are way more than I need for retirement and I'm happy with the risk in my portfolio so I see no reason to change. If the economy heats up and interest rates rise, bonds will slide, but it won't be a disaster as I'm in intermediate bonds and eventually I'll see the benefit of higher interest rates. In fact I'll be happy when rates kick up so my bonds can start producing some reasonable income. If I knew when that would happen I'd be all about market timing, but I don't so I'll stick with my "on the fence" AA.

 

[Texas Proud]

TP - first, believe me I do not have rose colored glasses. Not at all. And I did portfolio management for a living for a number of years. And, because it was a public entity (public money) it was 100% fixed income! From short term C.P. (A1/P1 only), to agencies, treasurites, corporate bonds (BBB or better), we did repos, reverse repos, BA's CD's - oh my ... I have forgotten all the produce we bought... Callable, Noncallable.... step adjustabels.

The primary model we used was the SLY model - Safety, Liquidity, Yield. FIrst, do not lose the public's money. Then, can you get the money liquid if a need comes up, LASTLY, yield. Very conservative.

I am not discounting the effects of inflation, just that "lost opportunity" is significantly differtent than lost principle.

I wasn't even trying to address lost opportunity... others have done a good job with that....

Since you were doing portfolio management, then you know that conserving principal is important... but if you bought a 5 year bond and rates went up, you lost principal... at least your statements should relect the current value of those investments to your investors. Sure, you did not sell them because they were still a part of your investment strategy, but the loss was real. Not realized, but real.

When I was doing my trust work, investing conservatively meant not going out more than one week.... I think I had only one trust that allowed me to invest more than 30 days for the free cash... now, the trust that allowed an investment in a pool of loans was another thing... the principal account was invested in longer maturing loans... and we had to price them daily to see what was happening with the total principal...

 

[rbmrtn]

It would be nice if bond funds existed in 1950 thru 1980 so we could see how they performed coming off zero interest rates.

That is an issue when looking at past performance. But there were a few

FPNIX
FBNDX
PRCIX
VWESX

But most of these only go back as far as the 70s

 

[Original Wally]

To begin with, it's principal, not principle.

But the key question is, is a loss of buying power bad as well? I would suggest that a loss of buying power is bad and a loss of principal is even worse.

The thing is, if you are managing a fixed income portfolio and have a loss of principal it is really noticeable - a loss of buying power (by earning less than inflation) is less noticeable but still bad.

My apologies on the grammar - I know better.

I agree with you... loss of PP is not as critical. Bad, but not as bad. That was the whole point. Hold to maturity is a different risk and needs to be viewed differently from the original point that ipso facto you will get hammered if you hold bonds in a rising interest environment. The PP question is growth vs. inflation, which, while certainly influenced by the loss of Princ., is a different animal.

 

[gcgang]

Bonds are for getting out of jail.

 

[fritz]

I use 3% inflation and a 4% return (so 1% real return) from my portfolio in my planning, but it works with 0% return if needed.

Right now my bonds are a drag on my portfolio, but the recent years of 9% returns are way more than I need for retirement and I'm happy with the risk in my portfolio so I see no reason to change. If the economy heats up and interest rates rise, bonds will slide, but it won't be a disaster as I'm in intermediate bonds and eventually I'll see the benefit of higher interest rates. In fact I'll be happy when rates kick up so my bonds can start producing some reasonable income. If I knew when that would happen I'd be all about market timing, but I don't so I'll stick with my "on the fence" AA.

Agree with your posts here, but did you ever have the feeling you were standing in the wrong line?

 

[Original Wally]

Back in the day when we issued real intaglio printed bonds we used to call them Naked Lady Bonds - they always seemed to have a "Columbia" type of woman holding a torch or something and she was nearly always topless. Go Figger. Good old Bearer Bonds w/ Coupons!

 

[audreyh1]

Rebalancing is plausible if Equities continue to rise. Or if one is still working they can add to their bond allocation if both go down . If interest rates go up 1%, then it will take you about 5 years to break even with a bond fund. What happens if they go up two or three percent or more over the next decade? Sounds like you are going to take a permanent hit on those funds. For this reason I like the laddering strategy using treasuries and agency bonds and CDs. It's the lesser of two evils. Once interest rates hit 5% or more, then bond funds will be a good option option IMO. Really, bond funds only make sense if you think interest rates are going to stay at present level or increase a max of 1% over the next decade.

Hi Gatordoc.

I don't think things are nearly as simple as you lay out. We went through a sharp Fed Fund rate rise from 1% to 5.25% in a pretty brief period, from 6/04 to 6/06, yet intermediate bond funds did not suffer nearly as drastically as one might expect from simple formulas. The fact is that short-term, intermediate-term, long-term react differently in each rising rate environment, and differently again among the different bond types.

Here is a good view of three rising rate environments that occurred since 1993 and the effect on different types of bonds:
Investing in a Rising Rate Environment - How Rising Interest Rates Affect Bond Portfolios
http://www.rwbaird.com/bolimages/Media/PDF/Whitepapers/investing-rising-rate-environment.pdf

I expect that before long, I'll be adding to my bond funds because they will have dropped somewhat in value, giving back some of the tremendous capital gain I have already enjoyed since 2000. But that's just the name of the game in rebalancing and doesn't overly concern me. And it won't likely be a single direction move either - but rather a bumpy ride, going back and forth as economic and market conditions change this way and that.

And if there is a sudden jump in interest rates that hurt bonds badly, that is just as likely to be very hard on equities, so we're back to a nowhere to hide situation. You just have to keep rebalancing as things zig and zag to minimize the volatility.

And I haven't written off the possible Japan scenario of interest rates staying low for a considerable amount of time either. You just never know.

 

[Running_Man]

To begin with, it's principal, not principle.

But the key question is, is a loss of buying power bad as well? I would suggest that a loss of buying power is bad and a loss of principal is even worse.

The thing is, if you are managing a fixed income portfolio and have a loss of principal it is really noticeable - a loss of buying power (by earning less than inflation) is less noticeable but still bad.

What I disagree with on the comparision is the fact that bonds when held to maturity is viewed as not meaningful because you have real losses along the way, but stocks are only held up to the goal of not losing any money over 20 years, losses along the way are ok and somehow the loss to inflation is not relevant for stocks, only the bond portion. I think that thought is even borne out by Siegel when he says stocks have never lost money over 20 years but bonds can lose 50%. I doubt any investor holding long term bonds over 20 years would have less money than he started with in actual value.

Whether or not 10 year bonds at 2 percent is a good deal or not would depend on if deflation would rear it's head over the next 10 years. That is certainly what the bond market is implying, though the government intrusion is probably more responsible for the mispricing than potential deflation.

But a 10 year ladder of US treasuries initiated over 10 years is not a very risky investiment. Had you apportioned an equal percentage each year for 10 years and maintained the significant losses did not arrive until well after the 2% average rate rate had been achieved in 1952, the threat of losses with a properly constructed bond portfolio is not nearly as dangerous as implyed. I attached a table The first column shows what the 10 year rate would be and the second column the blended rate a ladder of 10 year US treasuries would be. It was not for 22 years from the 1952 average 10 year blended rate of 2.41 percent that this portfolio of bonds would have been even 1 percent under inflation, certainly safe enough for any retiree. The mid-seventies certainly were devasting but they began with a much higher rate than we have presently.

 

[Gatordoc50]

Hi Gatordoc.

I don't think things are nearly as simple as you lay out. We went through a sharp Fed Fund rate rise from 1% to 5.25% in a pretty brief period, from 6/04 to 6/06, yet intermediate bond funds did not suffer nearly as drastically as one might expect from simple formulas. The fact is that short-term, intermediate-term, long-term react differently in each rising rate environment, and differently again among the different bond types.

Here is a good view of three rising rate environments that occurred since 1993 and the effect on different types of bonds: http://www.rwbaird.com/bolimages/Media/PDF/Whitepapers/investing-rising-rate-environment.pdf

I expect that before long, I'll be adding to my bond funds because they will have dropped somewhat in value, giving back some of the tremendous capital gain I have already enjoyed since 2000. But that's just the name of the game in rebalancing and doesn't overly concern me. And it won't likely be a single direction move either - but rather a bumpy ride, going back and forth as economic and market conditions change this way and that.

And if there is a sudden jump in interest rates that hurt bonds badly, that is just as likely to be very hard on equities, so we're back to a nowhere to hide situation. You just have to keep rebalancing as things zig and zag to minimize the volatility.

And I haven't written off the possible Japan scenario of interest rates staying low for a considerable amount of time either. You just never know.

Thank you for the information. It is very complicated and it's nice to see that funds didn't get wiped out during rising rates. However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.