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Use a barbell to lower interest rate risk?
Old 07-03-2013, 05:35 PM   #1
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Use a barbell to lower interest rate risk?

I've been seriously thinking of lowering the duration of our bond funds i.e. lower the interest rate sensitivity of the overall fixed income portfolio.

William Bernstein has advocated a barbell approach for the FI part of the portfolio, i.e. maybe 80% in Tbills and 20% in an intermediate bond fund. Here is a link that I think works for that WSJ article: Taking the Reins to Cut Down on Risk - Wall Street Journal - WSJ.com

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For example, someone who wanted a one-percentage-point rise in interest rates to cause their fixed-income portfolio to drop by only 1% would put 80% of their money allocated to bonds into Treasury bills or a similar cash-like product, if their 401(k) plan offers one, and 20% in a low-cost bond index fund.
Importantly I think he is referring to nearly or fully retired folks.

Here is another recent Bernstein article: Bill Bernstein: Make Peace With T-Bills
Quote:
Bernstein: Get over the low expected returns of fixed-income instruments, because you don’t have a choice. If you’ve saved up enough assets to retire on, you still want to put it into relatively riskless assets—T-bills, CDs, things like that that have relatively short maturities. If things mean-revert, you’ll be fine; you’ll be back up to the normal historical yields. The yields we’re looking at are obviously artificially low, and will inevitably reverse.
Another thought, one could lower the duration of the FI by going to a short term bond fund like VFSUX short term investment grade. But note that in past rate rise periods the spread narrowed between intermediate and short term bonds so one did not get the full effects of reduced duration. For instance, in May 2004 to Mar 2006 the 5yr Treasury went up 2.2% but the 2yr Treasury went up 3.4%.

Yes, I think moving to another FI portfolio is market timing and it is tricky indeed. I think one would have to be satisfied with lowering portfolio rate sensitivity and not necessarily beating the market unless one got lucky.

We are in a remarkable period where the Fed is trying to manage the overall yield curve, not just the short end. So to me it might be sensible to move to this posture for 1 to 3 years. Also should we have a sudden inflation spike, unanticipated by the market inflation, Tbills would be the place to be for awhile.

What do other people here think of this barbell idea?
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Old 07-05-2013, 12:26 PM   #2
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I guess there is nobody who likes this barbell idea, oh well. Not surprising as this involves a good dose of a currently zero yielding asset.

I did a detailed study of this with a model and some nice graphs for the 2004 to 2006 rate rise. I will post it if there are others who are interested but otherwise I'll just file it away.

FWIW, I'm probably going to just stick with my full dose of intermediate and short term funds after doing the study and studying those fund's behavior in the 2004 to 2006 rate rise period.
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Old 07-05-2013, 08:24 PM   #3
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Originally Posted by Lsbcal View Post

I did a detailed study of this with a model and some nice graphs for the 2004 to 2006 rate rise. I will post it if there are others who are interested but otherwise I'll just file it away.
I'd like to see this analysis if you don't mind posting it.
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Old 07-05-2013, 08:49 PM   #4
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I'd like to see this analysis if you don't mind posting it.
OK, here is the scenario I analyzed from Fed data where the Fed slowly raised rates (as shown by the Tbill curve):




and here is some barbell analysis for an 80/20 barbell of Tbills/5yr_treasury:





There is a market timing choice which in this analysis was set (to 100) so one was always in the barbell for the entire period shown. Since the yield curve flattened back then and cash was a good investment, timing wasn't needed. We cannot necessarily expect this in the future.
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Old 07-06-2013, 07:08 AM   #5
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I tend to prefer shorter maturities in all market phases. Yes, the longer maturities have higher coupon yields and rise more when interest rates fall, but they are also more volatile and drop more when rates rise. I've tended to look at bonds as the more "stable" part of my portfolio, so I've usually stayed away from funds with long duration as well as junk funds. But that's just me...
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Old 07-07-2013, 11:01 AM   #6
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When I saw the title "barbell" I thought one side would be long term treasuries (i.e. 10+years).

My portfolio has been very short with lots of cash/i-bonds/ST bonds and only a little IT. However, I think if I had just put everything into an intermediate bond fund (like vanguard total bond) when I started investing I'd be ahead.
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Old 07-07-2013, 11:32 AM   #7
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This barbell data above used the 5yr Treasury constant maturity because the yield data was easily available. However, I would have implemented the long end with an intermediate bond fund such as total bond index (or PTTRX, or DODIX, etc.).

Yes, I think the intermediate term bond funds (that is, don't use a barbell) make a lot of sense for the long term. The barbell would have been really great if done a few months ago. But if one used it too early like a few years ago, probably the intermediate fund will work out to have been better but that depends on the future rate changes. So it's really a timing issue and we all know how difficult that is. IMO it's very tough to get timing right in the bond market, harder even then stocks.
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Old 07-07-2013, 01:50 PM   #8
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I'm glad you posted the charts. I always look forwards to reading your posts here and at BH because you have a lot to offer, I love to see that blue bunny!

You replied to one of my posts in another thread about this thread but I had no idea where it was and didn't find it until now. I have been considering putting some tax deferred (which is about 90% of what I have) into a short term bond fund to complement the intermediate term fund. I'll read the Bernstein article and see what he says.

I have 36% of the total portfolio in my Stable Value fund in a 40/60 equity/fixed income allocation. I have come to realize that since I don't have any need for distributions from investments (at least so far 6 years into retirement) I would prefer to grow the portfolio for my sister's benefit (principal heir). For this reason I want to get to a 50/50 allocation. I can exchange funds out of the Vg TIPS fund into the Short Term Investment Grade fund to complement the current holding in the Intermediate Term Investment Grade fund with the balance going into equity funds.
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Old 07-07-2013, 03:37 PM   #9
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Hi Veremchuka, thanks for the compliment ... you've made my day. I just have to say this again, I'm no expert (are there really any out there?) and these thoughts are just my way of coping with a scary financial environment with all sorts of conflicting advice.

I have some short term bond funds as a place to hold stuff that is going to be spent over the next few years. Since this is constantly refreshed by selling equity or intermediate bonds, it is really a long term strategy to get a little extra yield over many years. Over a few years cash may do better.

Over a few years who knows about where short rates are headed. Looking at the graph above the short rates rose more (2yr Treasury rose more then the 5 year Treasury back then). So that reduced the advantage of the shorter duration in a rising rate market. I'm not sure that just reducing duration will side-step a rate rise and this is an easy one for market players to respond to and arbitrage the strategy away.
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Old 07-07-2013, 06:09 PM   #10
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I could not read the WSJ article, because I'm too cheap to pay Rupert. However, I agree with the other "Get Over It" article. As far as I'm concerned, cash/bonds should be short-term all the time to dampen a larger equity allocation. For example it has been painful buying 5-year TIPS at action with a NEGATIVE real yield to maintain my ladder, but I've had to "Get Over It" to stick with my allocation.

As a general rule, I think you are rewarded for increasing duration beyond money market funds, but should not go very far beyond money market funds even in this abnormal environment.

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Originally Posted by Lsbcal View Post
Another thought, one could lower the duration of the FI by going to a short term bond fund like VFSUX short term investment grade.
During the great recession, I discovered that even short-term "investment grade" is not the place to be during a crash. My Vanguard short-term investment grade fund declined much more than I expected. No where near as much as stocks or junk bonds, but way more than government based funds. So while my powder did not get wet, it certainly was damp as I tried to re-balance. I rode the fund down and back up again. If you just compare the investment grade fund's total return against a government fund of the same duration, I was fine. However, when you realize that being in the investment grade fund limited my ability to buy stocks on sale, you understand why I eliminated that fund from my portfolio.
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Old 07-07-2013, 06:40 PM   #11
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...
During the great recession, I discovered that even short-term "investment grade" is not the place to be during a crash. My Vanguard short-term investment grade fund declined much more than I expected. No where near as much as stocks or junk bonds, but way more than government based funds. So while my powder did not get wet, it certainly was damp as I tried to re-balance. I rode the fund down and back up again. If you just compare the investment grade fund's total return against a government fund of the same duration, I was fine. However, when you realize that being in the investment grade fund limited my ability to buy stocks on sale, you understand why I eliminated that fund from my portfolio.
That is why I've got a plan in place to shift to short term Treasury should the trend run against short term IG. It's just to save my sanity or at least lessen my anxieties.
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Old 07-07-2013, 08:30 PM   #12
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Thanks for bringing this up Lsbcal. In 2006 when we created our bond section of the portfolio, we decided on Vanguard's 50% TIPS and 50% Intermediate Treasuries - with the nice secure feeling that we were set on auto pilot.

Now, I feel like a deer in the headlights. In 2011 we contributed TSM and FTSE all World ex US Small Cap funds into our Roth accounts. Then, for 2012, we simply put our Roth distributions into CD's. We may just stick with laddered CD's going forward.

I hesitate to sell the TIPS fund and Intermediate Treasury fund - because I hate to sell at the bottom. But, as much as I am a Stay-the-Courser, I would hate to see those funds take a dive. I just have to consider how long those funds will stay in our Roth accounts; we do want to leave an inheritance. If we have enough to live on going forward, then we shouldn't worry - should we?
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Old 07-07-2013, 08:37 PM   #13
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That is why I've got a plan in place to shift to short term Treasury should the trend run against short term IG. It's just to save my sanity or at least lessen my anxieties.
How would that work? My wife wants me to take my money out of the stock market when the stock market is going to go down. I have not figured out how to do that either.
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Old 07-07-2013, 09:02 PM   #14
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How would that work? My wife wants me to take my money out of the stock market when the stock market is going to go down. I have not figured out how to do that either.
I think it is best to just consider what one would put in a short term IG fund and then maintain that allocation. The additional potential reward is not worth it for switching. I could mention an algorithm that has worked in the past but the additional return is pretty minor.

Stocks are another beast. I have my own carefully researched thoughts there but probably buy-hold is best for most investors. Unfortunately nobody can get a guarantee in these things.
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Old 07-08-2013, 09:02 AM   #15
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....I hesitate to sell the TIPS fund and Intermediate Treasury fund - because I hate to sell at the bottom. ....
This is not a good reason not to sell. The past is irrelevant.

What is relevant is whether the reasons that you bought these investments to begin with still exist, what the future prospects for these investments are and how these positions jive with your AA.
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Old 07-13-2013, 06:07 PM   #16
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This is not a good reason not to sell. The past is irrelevant.

What is relevant is whether the reasons that you bought these investments to begin with still exist, what the future prospects for these investments are and how these positions jive with your AA.

I sold TIPS in Feb and midMay because I found a negative yield troubling, particularly under the sense that inflation was not going anywhere anytime soon. Placed money in floating funds, munis, and emerging market/foreign bonds (the latter got hammered, so whether it was worth the trouble is interesting). I intend to ladder into some Ibonds until TIPS seem like a little better of a bargain. Gains over 4 years were about 32% so I'm not complaining about the TIP fund, just I thought it was extremely overvalued (maybe irrationally overvalued) even before I sold. I pondered it for almost a year before selling--wasn't an easy decision, since floating funds are really stock-like in a recession or crisis.

BTW, in most times, I think the Intermediate approach is the right one--I used them exclusively as my bond component before the crisis. But I've been gradually moving shorter and shorter duration although I still have a slug of PIMCO total since it's the best bond option in my wife's 401. I put some of mine into Doubline and the rest in the other options mentioned above when I rebalanced in February. I had begun rebalancing beginning in 2011 into cash and shorter duration alternatives keeping PIMCO steady. I like to take a 1-2 year approach to big allocation changes, since my timing is almost always early.
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