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What counts toward the bond allocation?
Old 02-02-2008, 04:23 PM   #1
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What counts toward the bond allocation?

I have been reviewing my bond allocation driven by what I learned here about the need to think of the total return on bonds and not to consider cash to be bonds.

I used to consider everything not a stock or a stock mutual fund to be in the bond allocation. Now I am wondering about some items.

Series I Savings Bonds - These almost seem like a tax-deferred CD. Should I consider these as bonds rather than cash?

6-month CD - I currently have this in the bond part of my spreadsheet, but I think it is really more like cash?

Bond Funds - Some seem to be holding a very large percentage in cash. Should I worry about this or just consider the whole fund as bonds?

Money Market Fund - obviously cash.

This gets me wondering what the defining feature of a bond is that makes it a bond rather than cash.

It seems to me that it is the time-frame and the ability to sell the bond to someone else before maturity if the interest rate drops and makes the bond more valuable.

However, it seems to me that if you held an individual bond to maturity there would be no "capital gain" value and total return would be only based on the dividends. It that case would there be any difference between a 5-year bond and a 5-year CD aside from the possibility that the bond might pay dividends while maturing but the CD might pay all at the end?

Two more quick questions.

If I buy some REIT should I consider that part of my 40% bond allocation? I realize that it is a different asset class, but I guess I am asking that if one of my classes needs to be reduced by 2% for the REIT does bond make more sense than equity?

I am trying to keep all of my bond funds in retirement accounts, but I do not have enough in them compared to my taxable account to hold the entire 40%. If I had to choose between bond fund or REIT, which should I keep in the taxable account? Or should I not be buying any REIT if there is no room in the tax-deferred account to hold it?

Thanks.
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Old 02-02-2008, 04:30 PM   #2
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If a fund maintains a $1 NAV (or otherwise fixed), then it is cash. A CD is cash. An IBond is cash.

If the NAV of a (non-equity) fund varies (usually due to interest rate changes or credit spread changes), then it is behaving like a bond.

REITs are equities, not bonds.

I never worry about how much cash a bond fund is holding. That introduces too much useless complexity IMO.

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Old 02-02-2008, 04:38 PM   #3
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Audrey - thanks for the quick reply.
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Old 02-02-2008, 05:05 PM   #4
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Audrey's definition is very good. Another thing to consider is why you are making the differentiation? Cash in an account where it can be withdrawn the next day is different from cash in a 5 year CD.

If you are thinking functionally, then it matters what function(s) you want the cash to be able to perform.

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Old 02-02-2008, 08:13 PM   #5
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REITs should be in tax-advantaged accounts because the dividends are taxed as ordinary income.

If you must put bonds in taxable, then consider if tax-exempt bonds will give you a higher after-tax return.
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Old 02-03-2008, 03:47 AM   #6
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i have an un-traded reit and they work best in taxable accounts. unlike publicly traded reits you get to take a real depreciation write off against the dividends. they call it a return of capital but it works out to only 85% of the 8.5% dividend being taxable


i look at say a 50/50 mix as being 50% stock and 50% everything else. the old 50 stock/50 bonds is obsolete. new asset classes like bonds, reits, commodities, currancys etc have expanded out the definition for most of us. within the frame work of all my asset classes i work out the time frame of my buckets of spending money and how long before i need it determines what investment goes in what bucket
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Old 02-03-2008, 08:40 AM   #7
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I lump cash and CDs together to create my 40% cash/bond allocation. I move the relative amounts around based on anticipated cash needs and a goal of maximizing interest income. I buy CDs because they are FDIC insured and yield well above government bonds and above most highly rated corporates. My intent in all fixed income is to hold on until redemption so changes in interest rates are not important. I don't buy bond funds because of the fluxuation in NAV.

CDs will fluxuate in value if you are interested in selling them. Because of the recent interest rate drop the CDs I bought last year are all sell above prime except the one callable one I have. I suspect it will be called at the next opportunity.

I agree that REITs are a separate asset class.

Also, corporate preferreds could be considered fixed income but the maturities (if at all) are usually way out. You are also subject to credit risk and interest rate fluxuations. I have some preferreds in closed end funds for higher yield but I limit the amount to 5% of portfolio value. I treat them as a separate asset class -- "almost fixed income."
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Old 02-03-2008, 09:03 AM   #8
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Audrey's reply makes sense except for the noted issue of liquidity until maturity. CDs, like bonds, can be marked to market and getting your money before maturity will make what you can get out (probably) different than what you put in. It is the same as holding individual bonds instead of a bond fund.

Fyi, when providing asset allocation info on your account, Vanguard counts CDs as bond.
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long (sorry) but hopefully helpful......
Old 02-03-2008, 11:40 AM   #9
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long (sorry) but hopefully helpful......

Here are some excerpts taken from the 1999 version of the Canadian Securities Course textbook, Chapter 5: Investment Products: Fixed Income Securities.

Overview:
Traditionally considered buy-and-hold investments, where interest is collected and reinvested until maturity, bonds have now become quite sophisticated in price action, features and trading strategies thanks to recent interest rate volatility, inflation and growth in market size.

Terminology: Fixed income security
A regular fixed income security is one where the income stream is known, as is the maturity date and value; if it is purchased and held to maturity the rate of return is fairly certain. There are variations. Traditionally, a fixed income security was a bond which was purchased at face value and held to be repaid at face value at maturity, with interim interest payments being made on that face value. Today, fixed income securities comprise those bonds as well as a host of variations, where the security may be purchased at some amount other than face value, may be sold prior to maturity, and interest may not be paid at all. Thus fixed income securities now encompass many types of securities including bonds, debentures, money market instruments, mortgages, swaps and even preferred shares. Essentially, where a lump sum is invested, and either a regular series of cash flows is paid on that lump sum, or a regular series of cash flows is expected and accrued, that investment is a fixed income security.

A bond is secured by physical assets in a trust deed written into the bond contract. If the bond goes into default, the trust deed provisions allow certain specified physical assets to be seized by the bondholders and sold to recover their investment. As will be seen, these physical assets could be a building, a railway car, or something more exotic. By contrast, a debenture may be secured by various protective provisions, by a general claim on residual assets and by the issuer's credit rating, but usually not by any specific physical asset which can be seized and sold in the event of default on the issue. In this chapter, we will follow the industry practice of referring to both types as bonds, except in specific situations where the difference is important. For example, government bonds are never secured by physical assets, and so technically are really debentures, but in practice they are always referred to as bonds.
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Old 02-03-2008, 12:10 PM   #10
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I have more of a "fixed income" allocation than a pure "bond" allocation. My target is to split fixed income roughly evenly between treasury securities, preferred stocks, and "other." "Other includes CDs, GNMAs, the stable principal part of my 401K, etc. I hold some cash in a treasury money market fund.
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Old 02-03-2008, 12:20 PM   #11
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Originally Posted by 2B View Post
I lump cash and CDs together to create my 40% cash/bond allocation. I move the relative amounts around based on anticipated cash needs and a goal of maximizing interest income. I buy CDs because they are FDIC insured and yield well above government bonds and above most highly rated corporates. My intent in all fixed income is to hold on until redemption so changes in interest rates are not important. I don't buy bond funds because of the fluxuation in NAV.

CDs will fluxuate in value if you are interested in selling them. Because of the recent interest rate drop the CDs I bought last year are all sell above prime except the one callable one I have. I suspect it will be called at the next opportunity.

I agree that REITs are a separate asset class.

Also, corporate preferreds could be considered fixed income but the maturities (if at all) are usually way out. You are also subject to credit risk and interest rate fluxuations. I have some preferreds in closed end funds for higher yield but I limit the amount to 5% of portfolio value. I treat them as a separate asset class -- "almost fixed income."

my un-traded reit goes in my fixed income bucket, my traded reit icf goes in the stock bucket. man is that thing volatile moving as much as 10% in a day...... the un-traded reit pays 8-1/2% interest and the price holds fixed until sold in 7 years
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Old 02-03-2008, 02:00 PM   #12
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Why would an I Bond be considered cash?

It is an inflation indexed bond.
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Old 02-03-2008, 02:21 PM   #13
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Originally Posted by mathjak107 View Post
my un-traded reit goes in my fixed income bucket, my traded reit icf goes in the stock bucket. man is that thing volatile moving as much as 10% in a day...... the un-traded reit pays 8-1/2% interest and the price holds fixed until sold in 7 years
Your untraded REIT is probably just as volatile as your traded REIT. The difference being the untraded REIT can not be sold so there is no price quote published. You could get the same effect if you'd just stop looking at the traded REIT's price for the next 7 years.
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Old 02-03-2008, 03:08 PM   #14
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yes it could all be a means to the same out come when sold. its hard to compare. but id rather take a nice cruise in a cadillac on a nice paved road rather than the back trail in a jeep wrangler in a pot holed road with dips and climbs. the traded reits trade more on perception of whats down the road then the here and now of real brick and morter. while traded reits are down as much as 50% to 60% or better from their highs the properties if sold may bring 10% less or maybe even more than they were bought at depending where or what they are. . last unlisted reit i had was sold last year. all thru the 2000's i got a nice 7-1/2% dividend in a world of less than 1% money markets. it was sold last year at a 17% capital gain. sweet deal. no guarantee that will happpen again but there is no question the pricing by perception of the markets cause wild swings that have almost no basis on actual value at the moment. my public reit ICF had a 9% swing last week in one day. no way the property gained or lost 10% in one day . thats why many stocks sell for less than break up value. its just a different pricing structure. there certainly is a bit of comfort on those days of 600 point swings and reits moving 9% in a day (my icf) when you hold un-traded reits which hold the same cost value until sold.
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Old 02-03-2008, 03:37 PM   #15
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Quote:
Originally Posted by joesxm View Post
I have been reviewing my bond allocation...

I used to consider everything not a stock or a stock mutual fund to be in the bond allocation. Now I am wondering about some items.

Series I Savings Bonds - These almost seem like a tax-deferred CD. Should I consider these as bonds rather than cash?

6-month CD - I currently have this in the bond part of my spreadsheet, but I think it is really more like cash?

Bond Funds - Some seem to be holding a very large percentage in cash. Should I worry about this or just consider the whole fund as bonds?

Money Market Fund - obviously cash.

This gets me wondering what the defining feature of a bond is that makes it a bond rather than cash....

However, it seems to me that if you held an individual bond to maturity there would be no "capital gain" value and total return would be only based on the dividends. It that case would there be any difference between a 5-year bond and a 5-year CD aside from the possibility that the bond might pay dividends while maturing but the CD might pay all at the end?

Two more quick questions.

If I buy some REIT should I consider that part of my 40% bond allocation?

Thanks.
I'm glad someone else is questioning this. I've posted on several boards asking essentially the same questions and have never gotten a satisfactory discussion going. This one seems to be a good discussion, nevertheless.

Here is how I have ultimately resolved things in my own mind, for better or worse
  • I don't think of my AA as "equities" vs. "bonds." I think of it as "equities" vs. "fixed income".
  • In the "fixed income" category I include individual Treasuries, bond mutual funds, longer-term CD's and "I" Bonds. (I own some of all of these.)
  • I exclude from "fixed income" anything in a Money Market fund or really short-term CD's. (I think of these as "cash reserves".)
  • I have so far been successful in buying "fixed income" instruments and not selling them before their maturity dates (at which time I generally buy another one.) Therefore, an individual bond and a CD are essentially the same. (If I wanted to get into the business of selling these instruments on the secondary market, I might go more with bonds, but I don't so they're pretty much the same to me.)
  • I avoid bond funds which hold too much cash by using Vanguard Total Bond fund which is always fully invested in bonds. That way I decide how much to hold in cash; not a fund manager.
  • I think of REITs as equities, not fixed income.

I'm not saying I have all the right answers, but what I described above makes sense to me and keeps me from obsessing about AA.
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Old 02-03-2008, 08:42 PM   #16
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This is pretty informative. Thanks to everyone who has replied so far.
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Old 02-04-2008, 09:09 AM   #17
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I guess my theory has been that if the security is not ownership [like stock], then it's probably some sort of loan I've made to someone/entity and am getting paid interest on that loan.

For example, I'd consider REITs equity because it's ownership, and I get my share of the profits/earnings through the REIT dividend. Just like I'd consider a share of GE equity because it's ownership, and I get my share of the profits/earnings through dividends, earnings growth, share appreciation, etc. Whether or not there's a secondary market for these stocks is immaterial to whether or not these stocks are "equity", IMHO. For years and years, SAIC was owned by its employees and not publicly traded, and it's shares were valued on a quarterly basis by an outside firm, but that didn't make the shares owned by the SAIC employees not equity.

But, I'd consider a MM [either bank or mutual fund], CD, I bond, Treasury Bill/note/bond, etc., fixed income because I'm making a loan to someone/some bank/some corporation. I don't think whether I have the ability to resell that fixed income asset to someone else makes it any different. For example, I'd consider a 5 yr CD to be a similar type of fixed income investment as a 5 yr Treasury note, or probably more precisely a 5 yr STRIP if the CD interest in reinvested zero-coupon esque. Just because the CD at Pen Fed, or I bond, is not marked-to-market and I can't resell it in the market doesn't make it "not a loan/IOU".

Obviously, a MM is very very very short term fixed income instrument, and a 30 yr T-bond is a very very very long fixed income instrument. So, you could certainly say that MM, 1-5 yr bonds/CD, ST bond fund are all short term fixed income, while the 30 yr T-bond/TIPS, IT term bond fund, LT bond fund, TIPS fund, are all longer term fixed income. But they're all fixed income IMO.

If I'm physically holding cash [ i.e. dollar bills] then that's cash, but if I deposit those dollars at a bank, I think that I've loaned the bank money. The terms of the loan like (1) the ability to immediately convert into dollars at any time or (2) agree to not to get paid back the principal for up to 5 yrs or (3) whether the interest paid is fixed or variable doesn't change the fact that I still just loaned the bank my dollars and am now a creditor of the bank.

Now, whether you hold a mix of very ST fixed income, IT and/or LT fixed income, or perhaps just ST fixed income, will depend on your own personal circumstances and liquidity needs. For example, someone far from retirement, or withdrawing money, may choose mostly LT fixed income, while someone closer or in retirement may choose to increase ST fixed income b/c of liquidity needs.

- Alec
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Old 02-04-2008, 09:18 AM   #18
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I am trying to keep all of my bond funds in retirement accounts, but I do not have enough in them compared to my taxable account to hold the entire 40%. If I had to choose between bond fund or REIT, which should I keep in the taxable account? Or should I not be buying any REIT if there is no room in the tax-deferred account to hold it?
That's a tough one to answer. You might want to check out Bernstein's A Limited Case for Variable Annuities.

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Old 02-04-2008, 02:55 PM   #19
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It would seem to me that CDs and iBonds are fixed income products because they represent a series of future cash flows and therefore carry interest rate risk. A series of cash flows doesn't have to be marketable to be valued.

Being very practical, though, I can see why someone might want to classify them as cash for the sake of an AA model. (espcially CDs)
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