Your current view of Bond Funds

[molly]

We have done a 401k rollover to Vanguard. We have a substantial sum that we have earmarked for Bond Funds. Currently we have money sitting in VMMXX, VFIJX, and VSGDX. We are concerned about a rise in interest rates but.........longer term will need to strip some of the interest for living expenses. Current interest rates for these funds isn't too hot.

What is your outlook/philosophy going forward with regard to bond funds in a potentially rising interest environment? This could be a slow tedious climb to higher rates and in the meantime --- the return on short term funds could be pretty dismal.

I am interested on your thoughts.

 

[DblDoc]

My thoughts haven't changed. Invest in high quality (eg gov't backed) and avoid long duration. I split mine between short and intermediate Treasuries and TIPS. I do have some high quality corporates but that is because my HSA and new 403b allow access "only" to institutional shares of the Vanguard Total Bond Index fund. If you feel you cannot handle rapid changes in rates near term then DCA into the funds over some period of time.

For more then you probably ever want to know about bond s I suggest you read this: Amazon.com: The Only Guide to a Winning Bond Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today (9780312353636): Larry E. Swedroe, Joseph H. Hempen: Books.

Also consider posting this question over at the Bogleheads site: Bogleheads :: View Forum - Investing - Help with Personal Investments

DD

 

[brewer12345]

Eh, I think that you will see rates gradually move over time. I would not be eager to go out beyond the 4 to 7 year window ("intermediate term"), and nominal treasuries do not seem like much of a value to me. OTOH, corporates are still offering pretty attractive spreads for single A rating type credit risk (not much), so I like intermediate investment grade corporates best. Junk and convertibles are also still pretty attractive, but they are corelated with equities so you would have to bear that in mind. In the ultra safe bucket, I think TIPS are a better bet than nominal treasuries, although obviously you will not get rich holding either.

 

[Gone4Good]

Speculating on interest rates is about as fruitful as speculating on equity prices. I'd suggest diversifying your fixed income holdings using the same discipline you use for your equity investments. Earmark a % for longer duration, a % for international, a % for shorter duration, a % for inflation protected, etc.

let interest rates do whatever it is they will do and rebalance as necessary.

 

[brewer12345]

yrs, just curious as to why you would include the very long end of the curve into the mix? Seems like you do not get paid for the risk and I was always under the impression that the long end of the curve has disortions because of the liability driven buyers who are not as price sensitive (pension funds, insurers, etc.).

 

[Gone4Good]

yrs, just curious as to why you would include the very long end of the curve into the mix?

I don't have a particular opinion about the risk adjusted returns of long bonds. I am aware of studies suggesting they are not a good risk, but none of those studies include 2008 where they proved quite helpful.

I wouldn't necessarily allocate a % of my fixed income portfolio to long bonds but I also don't mind that my bond index fund has some in the portfolio.

 

[brewer12345]

Gotcha.

 

[lakehawk]

Bond Funds

Remember that you are able to transfer investments between bond and stock mutual funds (ETF's are great too and generally have lower fees). Bond funds are great to be in right now, but if there is a strong pullback in the stock market you may want to transfer some funds from bonds to an ETF such as SPY or a mutual fund that tracks the S&P 500 to take advantage of future market upturns (you can then return to bonds when you feel the market is too high). Just an opinion as this is what I am doing after the S&P 500 went over 1000....got into bonds and am now looking for a market pullback.

Al

 

[Lsbcal]

Right now I'm putting about half my fixed income money into short term investment grade bonds which came out of long term TIPS. I'll include this info I posted at the Bogleheads site (hope it helps someone and would be interested in any comments or contrary strategies):

This data helped me to make a recent decision on where to put some fixed income money:

It shows the yearly returns for some short term bond funds and Prime MM. Also the lower part shows the yearly starting yields. The spread is the yield difference between vfstx and vbisx. Looking at 2004 vfstx won out although rates went up a bit that year so you did not get the beginning of the year yield. Not a big win but every little bit helps.

Also one should note that crisis like Sept 11, the Persian Gulf War, and LTCM did not really affect the investment grade fund. It seems to be more sensitive to broad business conditions and rolls off slowly enough that a simple moving average could be followed to move between short term Treasury and Investment Grade -- not critical for longer term investors though but if you are just going in it's something to keep in mind.

Anyway, something to chew on over your weekend .

 

[FIREd]

I am still putting most of my money in intermediate term bond funds. The yield curve for the bonds I am buying is still steep and shows no sign of flattening yet. So that's where I will keep putting my money until short term rates start rising. I think the yield curve is telling us that it's not going to happen any time soon.

 

[Lsbcal]

I am still putting most of my money in intermediate term bond funds. The yield curve for the bonds I am buying is still steep and shows no sign of flattening yet. So that's where I will keep putting my money until short term rates start rising. I think the yield curve is telling us that it's not going to happen any time soon.

I guess you're right that the yield curve is somewhat steep. That is indeed the case if one uses the rule to "extend out for each year you can get 25 basis points/year" and we see in Treasurys:

2yr 0.9%
3yr 1.4%
5yr 2.3%

I just get a little doubtful though when short and intermediate real rates (TIPS) are so low on a historical basis as are also the absolute values of those Treasury nominal returns I listed above. Any further thoughts?

 

[DblDoc]

Remember that you are able to transfer investments between bond and stock mutual funds (ETF's are great too and generally have lower fees). Bond funds are great to be in right now, but if there is a strong pullback in the stock market you may want to transfer some funds from bonds to an ETF such as SPY or a mutual fund that tracks the S&P 500 to take advantage of future market upturns (you can then return to bonds when you feel the market is too high). Just an opinion as this is what I am doing after the S&P 500 went over 1000....got into bonds and am now looking for a market pullback.

Al

And what if it doesn't pull back?

DD

 

[Independent]

We are concerned about a rise in interest rates but.........longer term will need to strip some of the interest for living expenses. Current interest rates for these funds isn't too hot.

I think the conventional wisdom is that you don't "need" either interest or dividends for living -- most people seem to be total return oriented even after retirement. I'm in that camp, though I know we have some members who aren't.

 

[Lsbcal]

I think the conventional wisdom is that you don't "need" either interest or dividends for living -- most people seem to be total return oriented even after retirement. I'm in that camp, though I know we have some members who aren't.

Good point. Also when thinking about bonds, one should only be concerned with inflation adjusted returns.

 

[audreyh1]

Definitely don't get sucked into the idea that your investments have to generate some type of interest income. Total return is the way to go IMO. Occasionally harvesting some capital gains for annual income is far more tax efficient that trying to maximize interest income.

IMO the role of bonds is to lower the volatility of a portfolio and to provide an asset class that is poorly correlated with equities for the purposes of rebalancing. For this reason it's best to lean toward bond mixes that are not too sensitive to equities (for example, high yield bonds closely track equities).

I don't sweat the rising interest rates issue too much. My thinking is this - interest rates going up is usually due to increased economic activity. If that is the case, then equities should out-perform bonds, which will eventually lead to rebalancing. In rebalancing, I will be trimming some equities to add to my bond funds. If the NAVs of the bond funds have dropped due to higher interest rates - no problem, I am buying them "cheaper". In the long run, if we go through another market crisis or the eventual economic slowdown bonds should outperform again (provided you have the right bond mix).

In the long run it evens out. If you get too hung up on short term effects of rising interest rates, you will try to time entry into bonds and that is difficult to do. In the past cycle, interest rates took longer to rise than anyone expected and then it was actually the short end that was hurt rather than the intermediate and long end because long term rates really didn't rise much. So trying to game the interest rate rise by staying in cash or playing with duration is not easy. Every cycle is different.

Audrey

 

[audreyh1]

I am still putting most of my money in intermediate term bond funds. The yield curve for the bonds I am buying is still steep and shows no sign of flattening yet. So that's where I will keep putting my money until short term rates start rising. I think the yield curve is telling us that it's not going to happen any time soon.

Why is a steep yield curve telling us that short term interest rates aren't going to start rising any time soon? I would have thought the implication is - steep yield curve = future increased economic activity = short term interest rates will rise sooner rather than later.

I don't actually believe short term interest rates will rise sooner, but that is because IMO the Fed will stick with easy money policy for a good while, not due to what the yield curve says.

Just curious.

Audrey

 

[Lsbcal]

...(snip)...
In the long run it evens out. If you get too hung up on short term effects of rising interest rates, you will try to time entry into bonds and that is difficult to do. In the past cycle, interest rates took longer to rise than anyone expected and then it was actually the short end that was hurt rather than the intermediate and long end because long term rates really didn't rise much. So trying to game the interest rate rise by staying in cash or playing with duration is not easy. Every cycle is different.

Interesting observations Audrey. I'm not in Treasury's because the absolute rates are extremely low by historical standards and the real short/intermediate term TIPS rates are also low by historical standards. The spread is still wide between short Treasury's and short investment grade (see above table).

I'd rather be in short Treasury's for the safety but have sort of convinced myself that short investment grade is the way to go for now. If right it might give me an extra percent or two but the real action is in equities.

 

[audreyh1]

Interesting observations Audrey. I'm not in Treasury's because the absolute rates are extremely low by historical standards and the real short/intermediate term TIPS rates are also low by historical standards. The spread is still wide between short Treasury's and short investment grade (see above table).

I'd rather be in short Treasury's for the safety but have sort of convinced myself that short investment grade is the way to go for now. If right it might give me an extra percent or two but the real action is in equities.

I agree that 100% short treasuries make no sense right now UNLESS you were already in them before the crisis started in which case stay put. They make no sense to switch into from something else because they are currently an overvalued asset class, not due to the low interest rate. If you are a total return investor you don't try to maximize the interest income from your bond funds.

I don't invest in TIPs. Some of my diversified bond funds do - but they move in and out based on perceived value. I never looked to TIPs for inflation protection - I don't believe they will provide such in the long run.

I prefer diversified bond funds to manage the bond allocation for me. I am currently building a position in VBISX (from DODIX), but it is very gradual and may take years because IMO I do need to average it out over a long cycle since it is a shift from one asset mix to another.

I don't like using a corporate only bond fund as my core bond fund. They are too closely correlated with equities IMO. My core bond fund DODIX surprised me by being quite a bit less diversified than I expected, going into the crisis heavily weighted in corporates and as a consequence suffered mightily. I notice that the Vanguard Intermediate Investment Grade did even worse and has only now not quite back up with VBISX since Jan 1 2008. The Vanguard intermediate-term index did much better over the period than the investment grade - it has almost caught up with DODIX (which has recovered big time so far this year).

I wanted a core bond fund that behaved well when equities swooned to increase the rebalancing benefit. The Vanguard intermediate-term bond index fund looks like a great mix and seems to behave pretty well over long periods, and it may be a great mix going forward even through an interest rate rising cycle. But it still had a pretty good dip during the crisis (as bad as DODIX although it recovered faster), and it is during these market swoons or economic slowdowns when I want to be able to rebalance. It's not fun rebalancing when your bond funds take a big hit too....

But then again, I don't switch around between bond funds in anticipation of changing market conditions. What makes me change is deciding that a certain fund is not meeting my long-term investment goals. After the recent crisis I did a careful review of bond funds and looked at what I needed and how things behaved in the long run, and I concluded that a short-term diversified index like VBISX was a much better match for my long term goals. Nevertheless, since we have just come out of a crisis where VBISX is "overvalued" relative to other bond funds, I have to make the transition gradual, otherwise I am just buying high and selling low.

I have no idea what is going to happen to different bond funds during the next interest rate rise cycle. As long as the economy improves and we have no financial crisis, investment grade will likely outperform other bond funds, and a continued steep yield curve means intermediate pay out more. However, the role of bond funds in my portfolio is to be there as a cushion for future financial crisis, so I need to reposition my bond allocation to better meet that goal.

Audrey

 

[FIREd]

Why is a steep yield curve telling us that short term interest rates aren't going to start rising any time soon? I would have thought the implication is - steep yield curve = future increased economic activity = short term interest rates will rise sooner rather than later.

I don't actually believe short term interest rates will rise sooner, but that is because IMO the Fed will stick with easy money policy for a good while, not due to what the yield curve says.

Just curious.

Audrey

Well I look at the trend. Short term rates are still falling for the bonds I purchase and the slope of the yield curve has steepened slightly in the past few months because short term rates are falling faster than intermediate term rates. I don't see any sign of reversal yet, meaning that, as a whole, the market still expects that intermediate term bonds will give you the best bang for the buck for the foreseeable future. If you believe, as some do, that the yield curve gives you a glimpse into the near future, then it sounds like the market is signaling that the threat of higher short term interest rates is not immediate. I agree. Vanguard also believes that the Fed won't start raising interest rates until late 2010.

 

[audreyh1]

I don't believe that the Fed will start raising interest rates until some time 2nd half 2010 either. But I didn't deduce that from the yield curve.

Audrey

 

[IndependentlyPoor]

yrs, just curious as to why you would include the very long end of the curve into the mix?

Suppose we do a repeat of Japan: near zero interest rates and lethargic stock performance for a decade?

 

[brewer12345]

Suppose we do a repeat of Japan: near zero interest rates and lethargic stock performance for a decade?

I suppose, but that appears pretty sarned unlikely.

 

[Lsbcal]

Here is a nice view from Vanguard on a few bond funds over the last 10yrs:

I would like to be maybe 50% intermediate term Treasurys and 50% TIPS but only when real rates (TIPS) are closer to historic norms. Here is the data I've got on historic real rates for Treasurys:

1yr 1.7%
5yr 2.2%
10yr 2.6%
20yr 2.7%

I think keeping these rates in mind when looking at Treasury rates and TIPS is a good idea. For instance, today the 5yr Treasury is 2.35% and unless we have near zero inflation over the next 5yrs how are you going to get the historic average real rate of 2.2% ? We could get near zero inflation but no way am I going to bet on that.

P.S. I think the bond market is very efficient and way too complicated .

 

[Rich]

Forgive my ignorance, but I'm uncertain as to the advantage of bond funds over a MM. Please understand, my spouse and I have, among other investments, some Wellesley and Wellington (that's where we have our bonds) but we also have a good chunk of change in a couple of MM funds (over six figures – these are in both qualified and non-qualified spots).

What are we doing wrong?

Rich

 

[IndependentlyPoor]

Forgive my ignorance, but I'm uncertain as to the advantage of bond funds over a MM. Please understand, my spouse and I have, among other investments, some Wellesley and Wellington (that's where we have our bonds) but we also have a good chunk of change in a couple of MM funds (over six figures – these are in both qualified and non-qualified spots).

What are we doing wrong?

Rich

I don't know what you mean by qualified, so maybe I should just keep quiet but...

I wouldn't say you are doing anything wrong, but the funds do behave very differently. Here is a chart showing the growth of $10K in three popular funds over the last three years.

You can see that the bond funds end up with more money than the money market, but the price stability of the money market fund is a huge advantage.

You give up a lot for that price stability though. Here is a chart of the same three funds over ten years. The return of the bond funds is more than 30% better than the money market.


Here is a chart of Vanguard's Prime Money Market fund with Wellington and Wellesley. Today (and for most of the 10 years) the two balanced funds show a better return than the money market fund, but if we were having this conversation in back in March, the money market fund would be looking awfully good.