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Higher interest rates, how destructive? are you reacting?
Old 04-15-2010, 10:54 PM   #1
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Higher interest rates, how destructive? are you reacting?

Perhaps this subject has been debated elsewhere. If so please provide a link. I don't mean to beat it to death.

Seems I read almost daily about the impending ravages of higher interest rates. Should I be afraid? I'm 50% in bond funds.

How much impact will there be on long term rates if the Fed raises short term rates? Will bond funds drop like stock funds did in 2008? The guru's don't quantify their estimates so I don't know how scared to be.

Will stocks be ravaged as well? Should we be going to MM funds? Short term bond funds?
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Old 04-16-2010, 12:00 AM   #2
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It depends on the term of the bond funds, if short not much if long a good bit. Conversly if you have CD's the interest rates will tick up at the same time. There is a formula tied to to duration of bond funds that tells the impact.
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Old 04-16-2010, 06:53 AM   #3
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I just read a blurb by John Bogle -- he says he's 80% in bonds to match his age.
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Old 04-16-2010, 09:42 AM   #4
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I just read a blurb by John Bogle -- he says he's 80% in bonds to match his age.
Yes, but do keep in mind that he considers SS as part of the bond allocation.
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Old 04-16-2010, 09:43 AM   #5
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This question nags me too. The conventional wisdom is that if a bond fund has a duration of say, 5, then for every percentage point that corresponding interest rates rise, the fund will lose 5% of its value. At least, that is my understanding. If I am wrong, somebody please correct me.

Let's have a look. Here is the NAV of Vanguard's Total Bond Fund (VBMFX, in blue) and the 10 year treasury interest rate (in red) from 1990 to present.
vbmfx.gif
You can see that we have been in a declining rate environment, which has made bond funds look pretty good. However, note the time period from 1993 to 1995 when rates rose.

10 year treasury rates went from 5.33% in Oct 93 to 7.96 in Nov 94, a gain of 2.36 percentage points. At the same time, VBMFX went from 4.06 to 3.9, a loss of 4%. Ouch. That would have probably wiped out dividends for that year. However, the next year rates fell again and VBMFX had a very good year.

I don't know what VBMFX's duration was then, but now it is 4.5 years. If you assume that VBMFX's duration hasn't changed much since 93/94, then the fund fell much less than expected.

However, duration isn't everything. When the FED tries to squelch inflation, it raises short term rates. Long term rates are up to the market. If the market believes that the FED will succeed in controlling inflation, then long term rates might not rise, so a short term bond fund could actually lose more than a long term one.

Also, there is the flight-to-quality aspect. In the recent panic, treasury funds rose while corporate funds mostly fell.

10 year treasuries are currently yielding less than 4%. Looks like they will probably rise, but even that is not certain. When Japan had a similar crisis, interest rates stayed near zero for a decade.

Confusing isn't it. Makes my head hurt.
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Old 04-16-2010, 10:08 AM   #6
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Vanguard seems to think it is possible that rising interest rates may not affect various types of bonds precisely as expected:
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Bond investors worried about the prospect of rising interest rates, rising inflation, and an inability to generate sufficient income may be taking on more risk than they realize if they switch to inflation-protected bonds or corporate bond funds with shorter average maturities.

"In fact, those investors have moved into precisely the area where—if bond market expectations are correct—the poorest returns could occur" when the Fed begins boosting interest rates, said Vanguard chief economist Joseph H. Davis, Ph.D.

While these moves would have been perfectly reasonable in the past, 2010 may not be a textbook year.

The Federal Reserve is keeping short-term interest rates at record lows for now, but at some point rates will rise. Rising rates typically cause the biggest price declines among bonds with the longest maturities, but this year that may not hold true.

The bond market is pricing in expectations for a "bear flattening" that, given current conditions, would mean steep increases for rates at the short end of the yield curve. This would result in price declines and yield increases. The market also expects little change in yields of long-term bonds—leading to short- and long-term yields being about the same.

If this scenario plays out, longer-term bonds would hold up relatively well because the Fed will have calmed fears of higher long-term inflation by raising short-term rates, Mr. Davis said.
(emphasis mine)
https://personal.vanguard.com/us/ins...prise-04012010

Since I am a Bogle'ish buy-and-holder with my own long term interests in mind, and since my asset allocation includes 55% fixed, and since I was reluctant to join the stampede to invest in TIPS or short term bond funds for some reason and had invested more in VBMFX (Total Bond Index Fund) as specified by my plan, I found this article to be reassuring. Vanguard sent me a link to it a few days ago.

A month ago I got tired of waiting for bond funds to fall, and went ahead and invested significantly more cash in VBMFX at that time since my financial plan calls for it, and since I wasn't getting much interest in MM. If the share price of VBMFX falls, then so be it but at least I will be getting some dividends. My bonds are mostly in VBMFX, the TSP "G Fund", and the bond fraction of Wellesley.
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Old 04-16-2010, 10:13 AM   #7
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One wild card -- though duration is a key factor -- is that rates don't always rise the same amount at all points on the yield curve. The yield curve is pretty sharply sloped now, and if interest rate hikes "flatten" it a bit, then short rates are rising more than long rates. Until and unless inflation kicks in hard, I don't see much of a driver to take long rates a lot higher.
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Old 04-16-2010, 02:55 PM   #8
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In a rising rate environment, I thought that mortgage securities (and the funds which invested in them) did well. This is because variable rate mortgages would pay more interest.

I thought I read that prior to last bubble, but feel free to correct this misinformation...
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Old 04-16-2010, 04:15 PM   #9
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Originally Posted by IndependentlyPoor View Post
Let's have a look. Here is the NAV of Vanguard's Total Bond Fund (VBMFX, in blue) and the 10 year treasury interest rate (in red) from 1990 to present.
That looks like a total return chart for VBMFX, not a NAV chart. Here's what I think the NAV has done . . .

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Old 04-16-2010, 04:22 PM   #10
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I don't think rate increases will be all that bad. 300bp on the short end over the next couple of years and maybe 100bp in the 10 year. A 100bp move in the 10-year means you pretty much break even for a year (capital loss offsets income) or lose a couple percent, which isn't the end of the world. The short end will likely suffer a bit more.

It looks to me like inflation is on its back and rates are going to stay lower than people think for longer than people think.
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Old 04-16-2010, 04:33 PM   #11
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For my regular investment portfolio, I am taking no action. I have owned the bond funds for over a decade and have already been through a couple interest rate cycles.

The nice thing about the AA approach, is that when bond fund NAVs are hit due to interest rate increases, when you rebalance, you buy more bond fund shares at the lower values.

Eventually bond funds recover from any hit to NAV due to an interest rate increase. Sometimes this happens very quickly!

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Old 04-16-2010, 04:51 PM   #12
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Originally Posted by Gone4Good View Post
That looks like a total return chart for VBMFX, not a NAV chart. Here's what I think the NAV has done . . .
doh.gif
Of course you are right. My VBMFX chart looks completely wrong, but as neither one of my neurons were firing this morning, I didn't notice.
Here is what the chart should look like.
vbmfx.gif
While the 10 year treasury went from 5.33% to 7.96% from Oct 93 to Nov 94, VBMFX went from 10.32 to 9.15, an 11% drop. Right in line with its 4.5 year duration. Whew! That is better. Thanks.
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Old 04-16-2010, 04:55 PM   #13
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One thing to remember is that as bonds mature, their value approaches $100. What this means, no matter how the price swings, you've locked in the yield to maturity/call at the time of purchase, if you hold to maturity/call. What you forgo by not selling as rates increase is a higher yield that, in a perfect world, is offset by the loss on the sale. Bond funds are a little different in that they do sell bonds, realizing a gain/loss.

Current expectations are that no changes to the Fed Funds rate will occur until the end of the year, so you have some time to decide what to do. I will say that's what was said last year at this time, but they might be right this time. I'm guessing that long-term rate will lag short-term rates, that is, short rates might go up 2-4% over a 9 month period while long rates go up 1-2%. This kind of supports the idea that bond funds won't be hurt unless it's a short-term bond fund.

It's probably not wise to invest in a short-term bond fund now or when rates go up (the value will be going down unless the manager timed it perfectly). Once it's bottomed out would be the time to get in as the value will return as the bonds reach maturity.
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Old 04-18-2010, 11:04 PM   #14
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...Bond funds are a little different in that they do sell bonds, realizing a gain/loss.

...This kind of supports the idea that bond funds won't be hurt unless it's a short-term bond fund.
So bonds (in a bond fund) are sold before they mature? Is this correct? Why would managers do that? Why not just let the bonds mature? That way there's no loss? Right? This gives me a whole different perspective on how bond funds work than I have had until now.

Right now a fair amount of my port is in short term bond funds. I've been thinking that short term funds are a defensive position against interest rate increases. That's what guru's have been saying for several years. So much for expert advice! Maybe I didn't understand what they said.

I thought that as bonds matured they were replaced by higher yielding bonds (in a rising rate environment). That way fund NAV would eventually move back up. Am I completely misunderstanding how bond funds work?

What determines when bonds are sold? I thought selling only occured if there was sudden demand by fund participants wanting to cash out.
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Old 04-19-2010, 09:17 AM   #15
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So bonds (in a bond fund) are sold before they mature? Is this correct? Why would managers do that? Why not just let the bonds mature? That way there's no loss? Right? This gives me a whole different perspective on how bond funds work than I have had until now.
Weird isn't it? One would think that buy-and-hold bond funds would be common... that they would perform well with respect to funds that trade all the time, and so they would do well in the market.
In fact, I don't know of any bond funds that follow a buy-and-hold strategy. (But that doesn't mean much. There are a lot of things I don't know.)
Even stalwarts like Vanguard's Total Bond Market Fund trades constantly. This from Googling VBMFX turnover rate:
Quote:
Vanguard Total Bond Market Index Fund (VBMFX) has an annual stock turnover rate of 80.00% vs Intermediate-Term Bond average of 201.62%. It is good that Vanguard Total Bond Market Index management does not trade extensively for its return.
http://www.fundmojo.com/mutualfund/f...tualfund/VBMFX
An 80% turnover means that they replace 80% of their portfolio each year.

For years I refused to buy bond funds for this very reason. Then Enron happened and I realized that the only reason that I didn't own Enron bonds was sheer luck. That was exactly the kind of blue-chip bond I would have purchased. So now I hold my nose and my bond funds and try not to worry about it.
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Old 04-19-2010, 09:30 AM   #16
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300bp on the short end over the next couple of years and maybe 100bp in the 10 year.
What you suggest seems reasonable given reasonable government behavior. However, One could imagine some irresponsible schemes where the borrowing gets out of hand. If the monetization games start all bets are off in terms of interest rates.

Therefore I must conclude that the interest rate outlook is unknowable at this time.
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Old 04-19-2010, 09:49 AM   #17
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So bonds (in a bond fund) are sold before they mature? Is this correct? Why would managers do that? Why not just let the bonds mature? That way there's no loss? Right? This gives me a whole different perspective on how bond funds work than I have had until now.
They can be. It depends on what the manager decides to do. Occasionally, a bond fund realizes a capital gain and you get a capital gain distribution.

It doesn't matter whether a bond is held to maturity. The bond fund NAV still fluctuates based on the current value of the bond. And the current value of the bond fluctuates with current interest rates.

And individual investor who owns a bond and holds it to maturity can choose to ignore this value fluctuation, but it is still there. The bond fund just makes it explicit. There is no difference.

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I thought that as bonds matured they were replaced by higher yielding bonds (in a rising rate environment). That way fund NAV would eventually move back up. Am I completely misunderstanding how bond funds work?

What determines when bonds are sold? I thought selling only occured if there was sudden demand by fund participants wanting to cash out.
Yes, as bonds mature they are replaced by higher yielding bonds, but that doesn't necessarily make the NAV go back up. From what I have observed, the NAV seems to be more related to the current interest rate.

The trick is not to be focused on the NAV. Look at the total return. Who cares is the NAV drops a little as long as the increasing interest paid more than makes up for it?

And yes, bonds can be sold if there are heavy fund redemptions. Probably not that common, but perhaps occurs more during rising rate periods than one would like.

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Old 04-19-2010, 10:29 AM   #18
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So bonds (in a bond fund) are sold before they mature? Is this correct? Why would managers do that? Why not just let the bonds mature? That way there's no loss? Right? This gives me a whole different perspective on how bond funds work than I have had until now.

Right now a fair amount of my port is in short term bond funds. I've been thinking that short term funds are a defensive position against interest rate increases. That's what guru's have been saying for several years. So much for expert advice! Maybe I didn't understand what they said.

I thought that as bonds matured they were replaced by higher yielding bonds (in a rising rate environment). That way fund NAV would eventually move back up. Am I completely misunderstanding how bond funds work?

What determines when bonds are sold? I thought selling only occured if there was sudden demand by fund participants wanting to cash out.

Let me try one flavor for answering this.

One mutual fund I own is Permanent Porfolio (PRPFX). I recently received the year end prospectus (maybe it was quarter end).

It holds about 30-40% of its assets in treasuries
It holds 20% gold and 5% silver (might be 25-5)
It holds about 30-40% of assets in equities.

Its stated goal is to maintain and improve the purchasing power of the shares purchased.

Most people which own this fund want a steady 6-10% type return. We hold this fund because we believe it can do this in most markets, regardless of what is up or down that year by savvy investing.

It appears the fund has a treasury ladder... I was reading the treasuries it held... when they were yielding 7% or more, the fund manager appeared to buy the treasuries in 100,000 bond lots
as yield lowered, it appears he is buying smaller lots (several 90k lots of treasuries yielding 2-3% were listed as well).
My guess is once treasuries yield north of 4-6%, the lot sizes will go back to 100k.

This is because if 30% of the fund (the treasuries) are giving portfolio a 6% return, the probability the whole portfolio loses money is minimal. If 30% of the fund is in treasuries yielding 2%, it is easier for the whole portfolio to lose money (the bonds are not going to shift or keep total return in positive territory).

So its in managers best interest to have a 5-6% return "locked in" for longer time periods to attempt to stabilize the portfolio's return (keep it positive). That means sell low yielding treasuries for higher yields.
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Old 04-19-2010, 07:00 PM   #19
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So bonds (in a bond fund) are sold before they mature? Is this correct? Why would managers do that? Why not just let the bonds mature? That way there's no loss? Right? This gives me a whole different perspective on how bond funds work than I have had until now.

Right now a fair amount of my port is in short term bond funds. I've been thinking that short term funds are a defensive position against interest rate increases. That's what guru's have been saying for several years. So much for expert advice! Maybe I didn't understand what they said.

I thought that as bonds matured they were replaced by higher yielding bonds (in a rising rate environment). That way fund NAV would eventually move back up. Am I completely misunderstanding how bond funds work?

What determines when bonds are sold? I thought selling only occured if there was sudden demand by fund participants wanting to cash out.
I think you got enough answers to your question. To clarify, turnover is due to maturities, called bonds and selling. As to why they sell, they're chasing performance. Every fund has a benchmark that they endeavor to beat. They all try to anticipate the market, selling to realize gains (which disappear if you hold to maturity), or selling at a small loss in order to get a better return in the future.

For example, you can sell a bond with a 3 year maturity and buy a bond with a 10 year maturity, picking up 1-3% in the coupon rate. The sale may have even made you a gain, depending on the coupon rate of the bond. This would be one of the tactics bond managers use to improve performance.
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