Bonds: So Much More Dangerous Than You Think

[Original Wally]

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.

Agree that this is not the time to be either heavy (AA) into bonds and to the extent you are in bonds, the shorter the better. No long bonds today.

 

[haha]

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.

You are certainly right that the damage is yield dependent, but yield figures into the calculation of duration. It is not really an independent factor.

Ha

 

[Gatordoc50]

You are certainly right that the damage is yield dependent, but yield figures into the calculation of duration. It is not really an independent factor.

Ha

Thanks. Time to do some studying up on duration.

 

[ShortInSeattle]

OK. So break the implications of this down for a newbie. Would you suggest that folks should toss their Asset Allocations out and go to all stocks until bonds become more favorable? What is the bottom line of this viewpoint?

Curiously,
SIS

 

[mathjak107]

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.

don't confuse the moves in the feds fund rate which is controlled by the fed with moves in the bond market which is controlled by the investors.

they may not move together at all. the famous inverted yield curve is a prime example. in fact history shows little movement in bonds when the fed funds rate was raised more then 90% of the time.

the problem is bonds have been in a bull run for around 30 years.

we have never experienced a real bear bond market since then .

we don't know the full damage we will see in bonds at this point if bond rates rise but i can tell you comparing the rise in the fed funds rate to the action in the intermediate and long term bond markets is worthless . historically there is little response from rises in the fed funds rate.

in fact more ofton then not it is taken as a good thing by the bond market as it curbs inflation.

you are not comparing apples with apples.

http://www.cbsnews.com/8301-505123_162-57518811/how-to-invest-with-interest-rates-so-low/

 

[audreyh1]

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.

Well, I don't know where to get that specific information [actually, you should be able to find the 10-year treasury yield history easily], but I do know that one thing that happened during the 2004-2006 jump in interest rates was that intermediate duration rates didn't go up much, long came down a bit, and it was short-term rates that took the biggest hit. In other words the yield curve flattened as long-term inflation expectations came down with the rise in the Fed Funds rate. So the short-term bond funds got hit the hardest at first, but even those recovered in a fairly short period of time with reinvested dividends.

And it is also a good warning about trying to hide in short-term bond funds. Sometimes, it's the shortest durations that are most "overvalued" (because a lot of people have piled into short-term funds in anticipation of rising interest rates) and take the biggest hit when the Fed starts raising interest rates. You just never know.

 

[audreyh1]

How to invest with interest rates so low - CBS News

Nice reference!

Only in 1994 did the federal funds rate rise by more than 1 percent and intermediate bonds lose money. In fact, over the last 36 years, we have seen a dramatic cyclical decline in interest rates. Yet, there were almost as many years when the federal funds rate increased (17) as there were years of decline. Yet, we only had one year (from 1973 through 2011) when the intermediate bond index produced negative returns.

 

[imoldernu]

Several comment have been prefixed with... "not simple", or "more complicated than... "
Understatements... Just when ya thought you understood risk and interest rates, and charting, and allocations and history... along comes an article like this... not directly relating to bonds, but will affect them, no matter what the Fed does...

Fears at Fed of rate payouts to banks - FT.com

Excerpt:

All banks hold reserves at the Fed. The central bank has boosted its balance sheet to more than $3tn as it buys assets to drive down long-term interest rates through its programme of quantitative easing.
It pays for the assets by creating bank reserves, which now amount to more than $1.6tn. The Fed could add another $1tn if it keeps buying assets for another year.
At the moment it only pays 0.25 per cent interest on those reserves. But according to its exit strategy, published in June 2011, the Fed plans to raise interest rates before it sells assets. Interest of 2 per cent on $2.5tn of reserves would run to $50bn a year.
That interest should not turn into profits for the banks. They will have to pass the revenues on by paying more interest to their depositors. But it could still add to a populist backlash in recent years against the Fed and the big banks.

 

[obgyn65]

Since I do not own any stock, I guess I am going to have to work a bit longer .

What do you think?

 

[mathjak107]

Nice reference!

Thanks, as you can see comparing the fed funds rate moves to how investors looked at bonds really does not have much of a link.

We do not know at this point what to expect when bond investors sour on future perception. It has not happened in more then 30 years.

 

[brewer12345]

Thanks. Time to do some studying up on duration.

To save you a lot of work and head scratching, it is pretty simple:

If you have two bonds with identical maturity dates but one has much higher coupons than the other, the high coupon bond will have lower duration. Duration can be loosely thought of as the weighted average maturity of all the bond's cashflows (both principal and interest). Bigger coupons mean you get more cash sooner, so the weighted average maturity of the cashflows is lower, hence higher coupon equals lower duration.

 

[brewer12345]

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.

I think you may not have thought through all the implications of this for an early retiree with a long time horizon. If you have not already, go look at the hypothetical 1966-vintage retiree who withdrew 4% inflation adjusted from his starting portfolio. Not pretty, even if he held every bond in his portfolio to maturity.

 

[samclem]

OK. So break the implications of this down for a newbie. Would you suggest that folks should toss their Asset Allocations out and go to all stocks until bonds become more favorable? What is the bottom line of this viewpoint?

I have reduced my bond percentage and increased my cash percentage. The bonds I do hold are primarily short term. (In addition to some I-Bonds that I'll hold for a very long time).

 

[Original Wally]

I think you may not have thought through all the implications of this for an early retiree with a long time horizon. If you have not already, go look at the hypothetical 1966-vintage retiree who withdrew 4% inflation adjusted from his starting portfolio. Not pretty, even if he held every bond in his portfolio to maturity.

Who the dickens is advocating a huge bond AA. Mine is 13% and dropping.
I am 58 and strongly advocate equities. Sheesh.

 

[brewer12345]

Who the dickens is advocating a huge bond AA. Mine is 13% and dropping.
I am 58 and strongly advocate equities. Sheesh.

Every time someone [mod edit] spouts off [mod edit] that everything will be fine as long as you hold your 10/20/30 year bonds to maturity, dozens of impressionable wet-behind-the-ears investors reading it smile and think they don't have to worry about a spike in inflation or rates as long as they keep holding on.

 

[KMyer]

OK. So break the implications of this down for a newbie. Would you suggest that folks should toss their Asset Allocations out and go to all stocks until bonds become more favorable? What is the bottom line of this viewpoint?

Curiously,
SIS

Wow! I didn't realize that everyone would be so passionate about this subject when I posted the orginal article

I'm personally 100% invested in stocks right now but I think we are all in different situations. I don't advocate this approach for everyone. I'm willing to assume the extra short-term risk associated with this allocation because I'm 50 years old, still working, and I will be able to sell my closely-held business interests when I retire. I won't need to touch the investment money for a long time. I refuse to accept the current low yields from bonds. Bonds are currently more scary to me than equities. The article does a great job outlining the rationale I used to come to this decision.

 

[mathjak107]

the tide on bonds may have started to turn. most bond funds are now down the last 2 months.

i am getting ready to start to shed some of my all bond /income portfolio.

the fed may have comitted to keepuing rates low on the short end but i think investors at this point are seeing things differently on the bond ends.

there can be just as much of a disconnect as you saw in the charts above from short term moves and long term moves as the reverse.

 

[Gatordoc50]

To save you a lot of work and head scratching, it is pretty simple:

If you have two bonds with identical maturity dates but one has much higher coupons than the other, the high coupon bond will have lower duration. Duration can be loosely thought of as the weighted average maturity of all the bond's cashflows (both principal and interest). Bigger coupons mean you get more cash sooner, so the weighted average maturity of the cashflows is lower, hence higher coupon equals lower duration.

Thank you.

 

[audreyh1]

To save you a lot of work and head scratching, it is pretty simple:

If you have two bonds with identical maturity dates but one has much higher coupons than the other, the high coupon bond will have lower duration. Duration can be loosely thought of as the weighted average maturity of all the bond's cashflows (both principal and interest). Bigger coupons mean you get more cash sooner, so the weighted average maturity of the cashflows is lower, hence higher coupon equals lower duration.

Thank you.

Gatordoc50:

In your studies of bonds/bond funds, I suggest you also study some references on the yield curve, and what it means when a yield curve is steep (as it is now) versus flat, versus inverted.

It's fairly common, that when the economy seems to be doing better and the Fed is expected to start raising rates at some time, that the yield curve steepens, meaning that the intermediate and long-term bonds are already anticipating a rise to some extent. Then when the Fed actually starts raising rates, the yield curve starts to flatten, causing short-term bond rates to go up higher than intermediate bond rates - anticipating a slowing effect on the economy and inflation decrease in the longer term. It's very rare that all bond durations see the same % increase in interest rates.

The Swedroe reference discusses this yield curve behavior to some extent - How to invest with interest rates so low - CBS News and also gives a definition reference Yield Curve Definition | Investopedia

But I've seen better references on yield curve. Actually - here is a classic one from SmartMoney "The Living Yield Curve" which has an Applet that lets you graphically see the yield curve as you scroll through time: Living Yield Curve - Charting Interest Rates - SmartMoney.com

 

[HFWR]

Since I do not own any stock, I guess I am going to have to work a bit longer .

Everyone's entitled to [-]my opinion[/-] their own opinion, but what is it about "stock", i.e. partial ownership in a business, that deserves such a negative view? And I do mean "ownership", not day trading?

As for bonds, I'm likely to finally sell HYG soon, but not sure I'll up my equity position? Thinking...

 

[audreyh1]

the tide on bonds may have started to turn. most bond funds are now down the last 2 months.

i am getting ready to start to shed some of my all bond /income portfolio.

the fed may have comitted to keepuing rates low on the short end but i think investors at this point are seeing things differently on the bond ends.

there can be just as much of a disconnect as you saw in the charts above from short term moves and long term moves as the reverse.

Hi Mathjak107:

Of the 7 bond funds I own, only 4 are down YTD (not most), and of those, one is down only by 0.02% (so it could go positive any day), one by 0.08%, and two by 0.2%. These are hardly dire losses, and with the end of Feb interest payment, they will probably all return to positive YTD. To me these are closer to "flat" YTD.

In looking at the long term interest rate curve (10-year Treasury):

from http://www.multpl.com/interest-rate/

It looks like the troughs between interest rate peaks tend to be pretty shallow bowl-shaped. Which to me indicates that it's likely that we bump along a range bound area for a long while before rates head seriously higher. And as long as the US and global economies remain weak, I just don't see that much of a catalyst to push them higher. So in that context, I don't see that it matters whether the "tide has turned" - as if that's even detectable yet - as we're likely to drag along the bottom for years. From a 2% 10 year rate in 1941, we didn't cross 3% until after 1956.

But, if your portfolio is indeed 100% in bonds right now, it does seem prudent to diversify!

I guess you're going to ignore Bernstein's latest "quit when you've won the game" advice?*

Audrey

* P.S. I don't agree with Bernstein's latest philosophy for myself, as I rode out the 2008 crash just fine. Better for those who sold at the bottom.

 

[Running_Man]

Every time someone [mod edit] spouts off [mod edit] that everything will be fine as long as you hold your 10/20/30 year bonds to maturity, dozens of impressionable wet-behind-the-ears investors reading it smile and think they don't have to worry about a spike in inflation or rates as long as they keep holding on.

And this is quite correct if this is part of a well thought out reasoned approach. If you held 10 year treasury bonds in a ladder from 1966 to today, you would have periods when you would have done better than inflation, periods when you would have done worse than inflation but overall you would have averaged over that 46 year period 2.44 percent over the inflation rate by not worrying about what the value of the bonds are.

Now for some reason, this view is an acceptable point for owning stocks, but for bonds a loss during the holding period is considered horriffic and to be avoided at all costs by market timing via obvious interest rate forecasting.

100 thousand dollars invested in a 10 year treasury bond ladder if completed in 1966 would be worth 2.7 million dollars today, assuming you are holding this in your ROTH IRA. The inflation value of that 100K is 708K. The largest deficit to inflation on the holdings to inflation is 15% of the total portfolio value by the end of 1981. I did not figure out what stocks did versus inflation from 1966 to 1981, but I presume it was not pretty either.

The 10 year treasury bond ladder has outperformed inflation for the last 30 years straight so it would not surprise me if inflation outran bonds for a while. But losses in a ROTH IRA in a 10 year treasury bond ladder would be very hard pressed to approach 50 percent. But the ability to predict inflation or deflation rates as well as future interest rates is a very difficult chore.

The implication appears to be of course there must be inflation around the corner, however we live in a very deflationary enviroment. With the internet and the rapid deployment of information the need for people to assist with Social Security, the need to create books and all the fuel and movements involved in their financial trail, business travel for presentations all is being made rapidly obsolete. This decline in the need for goods can quite offset other inflationary pressures.

I do not pretend to understand how this will manifest itself in interest rates and what inflation will do, but I do believe if inflation becomes apparent bond yields will increase and for a time the bond ladder would lose to inflation, but predicting what stocks would do in that situation is equally fragile. What I do assume is that our financial leaders view potential deflation as a very serious threat and so they are the leading purchasers of this very type of financial instrument.

Holding long term bonds in some percentage, and noone on this thread has stated as you imply that all long term bonds in a ladder makes a long term early retirement possible, makes as much financial sense as holding stocks as part of a financial plan. What I do know is that in the past, when long term interest rates have been similar to what they are now, the 10 year treasury bond ladder will return more after inflation than will holding cash. And that the risk of this holding is relatively minor and the rewards certainly less, than owning stocks.

 

[audreyh1]

Thanks for sharing those observations, Running_Man. Very interesting!

 

[noone]

Holding long term bonds in some percentage, and noone on this thread has stated...

I've done no such thing. Please do not attempt to drag me into this discussion.

 

[audreyh1]

I've done no such thing. Please do not attempt to drag me into this discussion.

Oops! We're going to have to watch our spelling!