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

[pfleming]

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]

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]

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]

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.