Predictor for returns in bonds: accurate?

[NameTaken2]

With rising rates leading many to seek alternatives to bonds, I’m trying to quantify the possible downside risk (reasonable range and worst-case) over the next 3-5 years for a new investment in Vanguard Total Bond Index VBMFX.

The following Morningstar article states "Bonds are very predictable. Over the next 3-5 years, returns are going to be close to the starting yield" and supports this with Exhibit 2.
http://news.morningstar.com/articlenet/ ... 00#cpage=3.

Using this predictor, Total Bond Market Index VBMFX should have an annual rate of return just below 3% over the next 3-5 years. (=10 year treasury rate)
As of 12/31/13 the VBMFX 1yr return was –2.26%, 3yr=3%, 5yr=4.3%.

This is very interesting -I won't pretend to understand this predictor, but if reliable then the -2.26% return requires positive returns the next 2-4yr to provide a 3% rate of return. I was under the impression that rising rates mean more negative returns for VBMFX the next 3-5 years, and therefore considering the strategy used by many of placing 50% of my bond allocation in a Stable Value fund with a 2.1% yld.

If this predictor can be trusted then this fear seems unwarranted, and maybe the SV fund isn't a slam-dunk strategy? A 3% annual return for VBMFX for the next 3-5yr isn't nearly as bad as I thought it could be. I must be missing something(?)

I’m a new retiree working on allocating a lump sum and 401k, and need an understanding of the potential downside risk for VBMFX over the next 3-5yr before implementing a strategy to avoid it. Nobody can predict the future but recommendations to seek alternatives to bonds must have some basis on an expected range for losses in total bond funds over the next 3-5years(?)

Thanks-
Surfin

 

[Louis2]

I am not an expert by any means but I don't think your logic on this predictor will work. A poor year last year doesn't indicate better performance this year. My impression is that bond funds such as this will continue to perform poorly, likely even slightly negative, if interest rates creep up over the next couple years.

I personally continue to put some money into bonds, typically municipal bonds, because I am willing to hold them 20 years at typically 5% even if their market value goes down in the near term.

Bond funds on the other hand look like a poor choice in the short term because they have to sell bonds to meet any demands for withdrawals.

I'm sure someone with more expertise can improve my answer.

Roger

 

[brewer12345]

Bond returns are composed of two pieces: the interest income and the change in the price of the bonds. If you are just looking at the yield, you are only looking at one part of the equation and the most trivially easy part to predict. The much more challenging piece to guess at is where the price of the bonds will go in a given timeframe. Total bond market funds typically have a duration (measure of interest rate risk) of close to 5 years. That means if interest rates rise 1%, the price of the bonds will drop about 5%. If you start out with a 3% yield, that means that if the rate rise happens in a year your total return will be 3% - 5% = -2%. Will rates rise or fall in the future? That is the $64,000 question. Since it is extremely hard to forecast interest rate moves, you are better off picking an allocation to bonds/fixed income that gives you the amount of risk you can stomach and fits with your overall asset allocation plan.

Note that you might find high duration to be preferable to low duration despite the fact that the volatility of long duration bond prices is much higher. If the rest of your portfolio has you well positioned to endure inflation, an allocation to long duration bonds may help you offset the risk that deflation beats you up.

 

[Lsbcal]

You could take the last time rates rose in a sustained fashion (2004 to 2006) and extrapolate from that. Since yields were maybe 2.5% higher back (the income return) then you might subtract 2.5% from the total return for those years. Here is Vanguard's table for VBMFX performance:

So looking at year 2005 that Total Return might go to zero and 2006 might go to 1.8%. Of course, we don't know how far and how fast the rates might go up.

BTW, I hold a fair amount of intermediate bonds but not Total Bond Mkt.

P.S. There have been many, many threads on rising rate worries. One might read a few of these and also on Bogleheads. I have to constantly remind myself of the realities of bonds over the long term.

 

[NameTaken2]

My impression is that bond funds such as this will continue to perform poorly, likely even slightly negative, if interest rates creep up over the next couple years....

Bond funds on the other hand look like a poor choice in the short term because they have to sell bonds to meet any demands for withdrawals.

Roger, thanks for your reply.

I see a 50:50 bond:SV strategy as allowing me to move the 50% in SV to VBMFX in 3-5 years after the expected trend in rising rates and downside in bonds may have run its course. I'm no expert, but assume many investors would re-allocate to bonds then also.

No clue as far as the potential downside risk in VBMFX price (10%? 20%?) that I may avoid by waiting 3-5 years to invest 50% of bond allocation.

Hoping for discussion/education on probability-risk regarding potential gain/loss range for a new investment in VBMFX vs the 50:50 strategy.

NT2

 

[brewer12345]

Roger, thanks for your reply.

I see a 50:50 bond:SV strategy as allowing me to move the 50% in SV to VBMFX in 3-5 years after the expected trend in rising rates and downside in bonds may have run its course. I'm no expert, but assume many investors would re-allocate to bonds then also.

No clue as far as the potential downside risk in VBMFX price (10%? 20%?) that I may avoid by waiting 3-5 years to invest 50% of bond allocation.

Hoping for discussion/education on probability-risk regarding potential gain/loss range for a new investment in VBMFX vs the 50:50 strategy.

NT2

Like I said, interest rate moves are tough to guess at. The historical return data offered above may give you some sense of things.

Much of this hinges on risk-reward. Over the very long term, bond returns usually do not vary much from the yield at which you buy them. As such, you have to choose a trade-off between the potentially higher yield you might get from a bond fund vs. other alternatives and the risk of loss that a bond fund will have but a stable value fund/CD will not. Given where interest rates are on bond funds vs. other alternatives, I personally have called down my exposure to bond funds significantly in favor of CDs, I bonds and other vehicles that are not interest rate sensitive. I am giving up little or no yield and reducing my risk of loss from bonds (while also giving up a chunk of the chance for capital gains). You might well make different choices that I, so its hard to give advice with any degree of certainty.

 

[NameTaken2]

lsbcal and brewer12345, thanks for your replies.

I understand the duration/rate rise calculation to project the change in bond price. Interested to know if there's any consensus regarding an estimate for how much rates will rise?

The 2004-06 VBMFX chart helps. I know that long term, rising rates counter lower price. I'm looking from the short-term perspective others apparently are applying. If it's reasonable to project VBMFX price will be down 10% or more in 3 years, then placing 50% of bond allocation in the SV fund seems like a good hedge. If a better estimate is 5% or less, this doesn't seem like a much of a concern to me.

Many investors are seeking alternatives to bonds, therefore looking for what the potential downside risk is that they think they are avoiding?

NT2

 

[Lsbcal]

I posted this history on another thread. Maybe it will help shine some light?

Shows returns for 2 intermediate bond funds (VBTLX is Total Bond Mkt), a short term bond fund VFSUX, and mentions returns for cash. Last year we had a big shift in the Treasury spread. I would not expect that to happen twice.

 

[Spanky]

Below is just a guess of what might happen for intermediate bond return if interest rises 1% and 0.5% per year.

 

[NameTaken2]

Thanks lsbcal-
The chart left me confused after comparing it to total annual returns for 03-06 in your previous post that range from 2.4% to 4.3%.
For example, how can 2006 have a 4.3% total return with monthly cumulative returns negative into August and the highest 2006 monthly cumulative return below 3%?

Sorry, this may fly over my head.
NT2

 

[NameTaken2]

Spanky, thanks for your reply -very helpful.
Investors seeking alternatives must see the 20% downside risk by returning to the 6.25% historical average for intermediate bond rates?
And they must bet that short-term, a rise of 1% or more annually is probable?
I understand that it's just an illustration and it may take longer than 4 or 8 years to return to the 6.25% historical avg.

NT2

 

[brewer12345]

Investors seeking alternatives must see the 20% downside risk by returning to the 6.25% historical average for intermediate bond rates?
And they must bet that short-term, a rise of 1% or more annually is probable?
NT2

Not necessarily. In my case, it is simply that I do not know what the future path of rates will be, I fear that it may be upwardly biased, and the yields on bonds are currently about equal to my best zero risk alternatives (Pen Fed 5 year 3% CDs, etc.), so I choose not to take the risk. I will freely tell you that I can't forecast the path f rates with any degree of certainty.

 

[walkinwood]

I don't know lsbcal and spanky's careers, but brewer is a financial professional.

For someone like you, who isn't - I suggest you read some books on asset allocation, pick one that will allow you to stick to it in the face of a 50% stock market drop, and start there. Over time, as you learn more & can match wits with the likes of the previous posters, you can start trying to time your allocations.

The well thought out allocations (even simple ones like the couch potato portfolios) have done pretty well in just about any time period you look at. A lot of the SWR studies use very simple and fixed asset allocations.

I follow that advise myself.

 

[Lsbcal]

Thanks lsbcal-
The chart left me confused after comparing it to total annual returns for 03-06 in your previous post that range from 2.4% to 4.3%.
For example, how can 2006 have a 4.3% total return with monthly cumulative returns negative into August and the highest 2006 monthly cumulative return below 3%?

Sorry, this may fly over my head.
NT2

Good question and I was a bit worried at first when comparing the two (hadn't done that before). Notice that my graph shows cumulative real returns. Real returns are what really count in the bond world. So one might want to convert the Vanguard annual returns into real returns.

The graph shows something else. It might not be an easy ride. There will be ups and downs. Might be some gnashing of investor teeth and frequent fearful posts on this site, especially by people who want an all FI portfolio. That is why I want to have a balanced portfolio with a decent helping of stocks.

 

[NameTaken2]

walkinwood, thanks for your reply-
Yes, I'd be a fool to attempt matching wits with financial pros like brewer, and I apologize if that's your perception. I started this thread to take advantage of their knowledge and willingness to help me make a decision regarding my bond allocation. I have nothing but respect and appreciation for financial pros like brewer who are willing to share their wisdom.

You made me feel bad that I've made such a bad impression that you think I'm unfamiliar with the 3 Fund Portfolio! My allocation is based on that, plus international bond fund. I have a financial plan, understand asset allocation, and understand the market market can drop 50%. I'm no financial pro, but have those basics down

Once my retirement assets are allocated, I will "stay the course". I didn't sell anything in 2008.

My question is a reaction to the prevalent expectation for rising rates/downside risk in bonds leading to many seeking alternatives, and in this case I'm using the same short-term perspective they apparently are. If it's reasonable to project VBMFX price will be down 10% or more the next couple years, then placing 50% of bond allocation in the SV fund at a yield comparable to VBMFX seems like a good hedge. If down 5% or less is more likely, this doesn't seem like a such a concern.

Investors seeking alternatives to bonds must envision a potential short-term downside risk they think they're avoiding. I posted because I'm curious whether any who quantified the potential risk would share that.
NT2

 

[Lsbcal]

Not necessarily. In my case, it is simply that I do not know what the future path of rates will be, I fear that it may be upwardly biased, and the yields on bonds are currently about equal to my best zero risk alternatives (Pen Fed 5 year 3% CDs, etc.), so I choose not to take the risk. I will freely tell you that I can't forecast the path f rates with any degree of certainty.

I think CD's and other instruments (SV's maybe which I know nothing about) are probably good alternatives. Since my assets are at Vanguard in tax deferred accounts, I'm just not willing to do the paperwork to move stuff around. But others here may have easier access to these FI instruments.

 

[Lsbcal]

... If it's reasonable to project VBMFX price will be down 10% or more the next couple years, then placing 50% of bond allocation in the SV fund at a yield comparable to VBMFX seems like a good hedge. If down 5% or less is more likely, this doesn't seem like a such a concern.
...

The disaster scenario might be a huge inflation spike that causes the Fed to tighten (or the bond market to violently overreact). I don't think it likely nor does the bond market judging from TIPS and nominal rates. My money is on it not happening.

 

[NameTaken2]

Notice that my graph shows cumulative real returns.

The graph shows something else. It might not be an easy ride. There will be ups and downs. Might be some gnashing of investor teeth and frequent fearful posts on this site, especially by people who want an all FI portfolio. That is why I want to have a balanced portfolio with a decent helping of stocks.

aha! Thanks for your explanation lsbcal. I didn't look at your chart heading, just the label for the y axis.

Agree regarding a balanced portfolio for a rough ride -mine will be 60:40 stocks:bonds.
It's hard investing at market highs, but will DCA in and hope I can take advantage of the corrections that may be in store during the coming year.

Thanks again-
NT2

 

[walkinwood]

You made me feel bad that I've made such a bad impression that you think I'm unfamiliar with the 3 Fund Portfolio! My allocation is based on that, plus international bond fund. I have a financial plan, understand asset allocation, and understand the market market can drop 50%. I'm no financial pro, but have those basics down

My apologies, but that was not my impression of you. There is a wide range of expertise here & your low post count on this board led me to say what I did. All the best.

 

[NameTaken2]

I think CD's and other instruments (SV's maybe which I know nothing about) are probably good alternatives. Since my assets are at Vanguard in tax deferred accounts, I'm just not willing to do the paperwork to move stuff around. But others here may have easier access to these FI instruments.

I'm also at Vanguard, approx 2/3 tax-deferred. Not moving into CD's for the same reason, and because I've realized I'm fortunate to have the SV in my 401k to take advantage of.

NT2

 

[NameTaken2]

My apologies, but that was not my impression of you. There is a wide range of expertise here & your low post count on this board led me to say what I did. All the best.

No offense taken, and no apology required. All the best to you also!

 

[haha]

Investors seeking alternatives to bonds must envision a potential short-term downside risk they think they're avoiding. I posted because I'm curious whether any who quantified the potential risk would share that.
NT2

You can quantify (guess) the potential drop as well as anyone. All you need is your fund's duration and some estimate of the interest rate path of relevant rates going forward, and a range of changes and probabilities attached to each of these guesses.

No one can do this very well, as has been shown by studies of people trying. But anyone can throw his hat into the ring. In any case, the size of likely intermediate term losses in reasonable 3-6 year bond funds is tiny relative to equity volatility. No place for the rent money, but for anything with a 3 or so year horizon it is low risk. There are also good political reasons to think that all developed country central banks and governments will move mountains to avoid steep rate increases in their bonds, bills, and notes.

Ha

 

[Chuckanut]

There's a ton of good advice here along with personal information about how people have acted. I can only offer one other thought. Whatever you choose to do, make sure that if things go against you for a while, you can still sleep at night and avoid getting needlessly aggravated. Otherwise, you may panic and sell out at the bottom.

I add the above thoughts because of people I know who panicked in 2009, sold stocks at or near the bottom and then missed the recovery which would have made them whole or nearly so.

 

[Ready]

I see no upside to Vanguard Total Bond Market when PenFed is paying a guaranteed rate of 3% for 5 or 7 years and only charges a flat one year penalty for early withdrawal. TBM is only paying 2% right now, and for the rate to rise the NAV has to drop. So until it begins to pay at least 3% I would rather have my money in CDs. If rates rise, I can always cash in the CD and buy into the bond fund at a lower NAV and higher yield. It seems like a no brainer to me on this one. I've dumped all my TBM funds at this point. The only bond fund I still have is CA Municipal Bonds. At least they pay close to 3%, and both federal and state tax free. They still have interest rate risk, but at least there is a slight premium over the CD to justify the risk.

I would stay away from brokered CDs at this point though. If the PenFed deal goes away, we will all have to reevaluate. But brokered CDs have the same interest rate risk as bond funds, and their yield is not much higher (if any) than a bank CD.

 

[youbet]

That is why I want to have a balanced portfolio with a decent helping of stocks.

Interesting that you would go with a "decent helping." I've analyzed the situation and have chosen to go with a "significant dollup." We'll see who called it correctly in the years to come!