USAToday "Why are bonds outperforming stocks over long term?"

[traineeinvestor]

Right now I'm finding that I either have to go a long way out on the yield curve or compromise on credit quality to get a positive real return on fixed income investments. Unless I believe that interest rates will stay at these low levels for a very long time (which is what has happened in Japan and what some pundits are predicting given the impact of rising interest rates on government debt servicing costs), the only real reasons for holding fixed income would appear to be:

1. a place to park my 2-3 years of living expenses/buffer for when other investments are not performing well

2. a place to park money while waiting for other investment opportunities to present themselves

With many good quality companies offering dividend yields which are comparable to bond yields, as things stand today, I would expect equities to outerform bonds over the longer term.

[audreyh1]

Quote:

Originally Posted by ejman Yes same plan here, as part of my "ageing" plan I was thinking of slowly dropping my equities allocation to the 40-50% band (currently 54.5%, I like to keep a wide 10% band because I don't like rebalancing too often) but after due consideration I'm thinking I'm going to keep it at the 50-60% range until interest rates "normalize" if ever... I guess Japan has been waiting for 20+ years for that "normalization".

Exactly - which is why I don't abandon my plan for increasing bonds with age, but rather am considering making it a 50/50 bet. This stuff is impossible to predict - best to hedge one's bets.

[Gone4Good]

Quote:

Originally Posted by FIREd I remember reading a Vanguard article showing that, between 1976 and 1983, the increasing interest income from a diversified rolling bond ladder or bond fund more than compensated for the capital losses when reinvested.

I think that's true (and can be generally seen in this comment). A big difference between the 70's and today is thatyour starting yield was 7% or more, versus just 2% today. That means a 100bp increase in rates in the 70's still left you with a 2% total return versus a 3% loss today.

Besides, with CD's yielding nearly as much as the Total Bond Market Index we can get most of the coupon with none (or little) of the risk.

[audreyh1]

Quote:

Originally Posted by Gone4Good Besides, with CD's yielding nearly as much as the Total Bond Market Index we can get most of the coupon with none (or little) of the risk.

You bring up a good point about comparing CDs with something like the Total Bond Market Index.
Total bond Market Index is yielding 2.05% with a 5.2 duration.
The best deal on 5 year CDs right now is 1.81% - that's pretty close.

But Total Bond Market Index is yielding quite a bit lower than other diversified bond funds in it's duration. Reason? It has a huge amount in US Treasuries because that represents the total bond market right now. And that is what is pulling the rate way down. Also, many would argue that US Treasuries are way overpriced with respect to the rest of the bond market.

Contrast to DODIX which is yielding 3.85% with a lower average duration (3.9 years). This is more typical of diversified intermediate bonds right now.

Morningstar recently had an interesting article about core bond funds decoupling from their benchmark since 2008. http://news.morningstar.com/articlen...aspx?id=539744

Audrey

[Gone4Good]

Quote:

Originally Posted by audreyh1 But Total Bond Market Index is yielding quite a bit lower than other diversified bond funds in it's duration. Reason? It has a huge amount in US Treasuries because that represents the total bond market right now. And that is what is pulling the rate way down. Also, many would argue that US Treasuries are way overpriced with respect to the rest of the bond market. Contrast to DODIX which is yielding 3.85% with a lower average duration (3.9 years). This is more typical of diversified intermediate bonds right now.

True. We can always increase yield by taking more credit risk. According to Morningstar, DODIX has an average rating of BBB. Whereas CDs are basically treasury equivalents.

[pfleming]

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Originally Posted by Gone4Good One thing that is worth mentioning, and probably poorly understood, is the difference between capital gains in the bond market and other kinds of capital gains. Bond gains driven by declining market interest rates are not Mana from Heaven. They are an advance on future coupon payments. The only way we can pocket those gains is to leave the bond market. Consider a 5% 10-yr bond issued at par where the yield drops to 2% day one. The price of my bond increases from $100 to $127 . . . weeeeee! I've just made a 27% annual return on my 5% bond and feel terrific. But the bond only promised me a return of 5%. So what happens? Fast forward to the end of year 1. I get paid a $5 coupon, but a strange thing happens to the price of my bond. Even though market interest rates haven't changed, the market value of my now 9 year bond has dropped ~$3 to $124. Next year, I get another $5 coupon but my bond price drops another ~$3. That keeps happening until maturity, where I get back my original $100 face amount with no premium. So did I actually have a gain on these bonds? Only if I got out of the bond market. We can rejoice for the time being that our portfolios have been fattened by the lower interest rate fairy, but the truth is, if we continue to hold those bonds we'll eventually give back 100% those gains. We're only going to earn our stated yield, and not a penny more.

This is probably the best explanation I have read regarding why bonds behave the way they do inversely to the rate.

[audreyh1]

Quote:

Originally Posted by Gone4Good True. We can always increase yield by taking more credit risk. According to Morningstar, DODIX has an average rating of BBB. Whereas CDs are basically treasury equivalents.

This is not an issue for me as I have never limited my bond allocation to only US Treasuries and US Government backed bonds.

[FIREd]

Quote:

Originally Posted by audreyh1 This is not an issue for me as I have never limited my bond allocation to only US Treasuries and US Government backed bonds.

One of the take-home messages of the Vanguard article was that having a broadly diversified bond portfolio might be more important than ever.

I found a link to the said article:
https://personal.vanguard.com/pdf/icrdir.pdf

[audreyh1]

Thanks for the link! I'll read it soon.

Here is a link you might find interesting. In a recent Bogle interview he was critical of total bond indexing and I think the main issue was the current situation where US Treasuries are so much more highly valued than US corporate bonds and in his opinion the default rates don't justify it. This was related to how total bond indexes have such high US Govt debt exposure right now. Morninstar discussion of the interview The Bogle Interview (uncensored) - Morningstar

Audrey

[ejman]

Quote:

Originally Posted by FIREd One of the take-home messages of the Vanguard article was that having a broadly diversified bond portfolio might be more important than ever. I found a link to the said article: https://personal.vanguard.com/pdf/icrdir.pdf

Thank you very much for that link. Fascinating article. My take away is that when the urge comes to do something - anything drastic- regarding my portfolio I ought to lie down and contemplate navel until urge passes.