Treasuries vs. Corporate Bonds vs. Money Market

[free4now]

During the recent economic crisis I had most of my bond allocation in short term investment-grade corporate bonds (VFSUX), and learned a tough lesson about credit quality risk, as the value dropped way below treasuries and other "safe" bonds, due to investors getting worried about defaults. See the graph below for a comparison of how much they fell compared with safer bonds.

Now that many timers are fleeing treasuries for junkier bonds, it seems like I'm nearly back on par with treasuries, so it's a good time for me to move into all treasuries (VFIRX), where I should have been all along.

Looking at long term total return performance charts, I tend to wonder what I was thinking chasing the small fraction of a percent yield advantages of corporate bonds over treasuries.

I've seen some folks on this board advocating VBISX, the vanguard short term bond index fund, which is about half treasuries and half corporate bonds. That certainly performed better than VFSUX, but why not just go all the way to full treasuries?

The only thing holding me back from treasuries now is the knowledge that interest rates pretty much can't go any lower, so I'm concerned that when the fed finally gets the balls to start raising interest rates in a year or two the bond NAV will drop. The evil market timer in me says to put everything in money market to avoid that principal loss.

But my understanding is that this treasury interest rate risk of NAV drop shouldn't be very much, as it's only going to fall by approximately the amount of interest rate increase over the duration. Presumably everyone else in the market knows that interest rates will rise, so this is already somewhat priced into the treasury bond fund NAV. So am I crazy for getting into a t-bond fund knowing its NAV is likely to drop in the near future?

I'm generally a buy and holder, intending to hold these for many years, buying or selling only to adjust my asset allocation and take living expense income. I'm just wondering if the current zero percent interest rates are one of those rare market anomalies where timing by investing in MM rather than bonds makes sense.

 

[Dennis]

Well..
1. I moved 75% INTO Treas in 07' & 08' per what my Bal. Funds were doing
2. Then I moved out of them for 09' and Into Corp and ST Bond Funds, same as My Bal. Funds did..
3. I just follow-their-lead ever since 99' and they have not steered my wrong..
4. Other Income /Yld Bond funds in my Core Port? VIPSX, PTTDX, TGBAX & FNMIX since 99' with a little touch of Irish Gold..USAGX..
5. and so far? PIMCO, nor My Bal. Funds are showing no move back into Treas. Yet. and they have ave over 9% apy for past 10 yrs now..
6. At the Least? Go with VBMFX and VFIIX instead..and stay out of Treas. for awhile. or find a Good top ranked Bal. Bond Fund and follow-their-lead..

Has really helped me since moving mostly into these funds since 99'..and it kept me from making alot of serious mistakes..proving itself right away in 00-02.

Hope that helps with some ideas to look into for you..

 

[audreyh1]

I've seen some folks on this board advocating VBISX, the vanguard short term bond index fund, which is about half treasuries and half corporate bonds. That certainly performed better than VFSUX, but why not just go all the way to full treasuries?

That's a really good question, as from your graph you they don't diverge that much, and the treasury fund is less correlated with equities - going up a bit when equities were creamed, and then staying more or less flat while the equities recovered. Even the 10 YR graph from M* which I know includes all dividends shows the same result - they end up very close to each other.

That said, I just can't bring myself to own only one asset class in my core bond fund. Especially as treasuries are still kind of an "overvalued" asset class right now.

There is definitely a conflict between my "instinct" and logic in this. Logic dictates to use the least correlated asset class with equities and that would be treasuries. I guess that means I am not a purist AA.

And most studies do use treasuries as the bond asset class to balance against equities in a portfolio, so using treasuries is definitely going by the book.

Frank Armstrong recommended using short-term very high quality bond fund for the bond portion, and VBISX definitely meets that definition.

Audrey

 

[audreyh1]

The only thing holding me back from treasuries now is the knowledge that interest rates pretty much can't go any lower, so I'm concerned that when the fed finally gets the balls to start raising interest rates in a year or two the bond NAV will drop. The evil market timer in me says to put everything in money market to avoid that principal loss.

But my understanding is that this treasury interest rate risk of NAV drop shouldn't be very much, as it's only going to fall by approximately the amount of interest rate increase over the duration. Presumably everyone else in the market knows that interest rates will rise, so this is already somewhat priced into the treasury bond fund NAV. So am I crazy for getting into a t-bond fund knowing its NAV is likely to drop in the near future?

MM funds are paying NOTHING right now. Not that that matters in an overall AA as you don't have to worry about NAV loss either. But if you hold in MMs, waiting for the inevitable interest rate rise, you miss out on all the interest payments paid up until that point which may or may not exceed whatever NAV hit you take. AND it is really hard to guess how much the NAV will drop, PLUS there is usually some catch up after the fact as the interest rate payments increase.

Some people are staying in intermediate funds until short-term rates move back into a more "traditional" range. That worked last time as short-term funds were hurt worse than intermediate/long in the 2003-2004 interest rate hikes. Who knows if it will work this time.

I am gradually moving from DODIX to VBISX for the same reasons as you of better inverse correlation to equities, and I also had to wait for DODIX to recover which it has spectacularly. But instead of waiting in MMs, I am just taking my sweet time to make the transition, and they will be staged over time anyway - not all at once.

DODIX has significantly outperformed all your short-term bond funds over most of the past 10 years including YTD. FGOVX which hold all types of US govt debt - intermediate - compared to DODIX over 5 years looks very similar to your above graph. Both intermediate funds outperformed short-term funds over the past 5 and 10 year periods. Who knows what will happen going forward.

Actually, short-term bond funds seem particularly pessimistic about the future as opposed to the stock market. To me this indicates that short-term bond funds have not really priced in interest rate increases. Plus I have read that banks are holding a lot more short-term treasuries due to new capital requirements thus keeping short-term treasury interest rates down. This latter might indicate something that is a permanent change for this asset class.

Audrey

 

[free4now]

Good commentary Audrey. I keep coming back to the idea that medium term funds are more of a gamble than an investment. It seems to me that the only reason that their current ability to pay more interest than short term is balanced by the higher amounts their NAV will drop when interest rates rise. The way to play the game is to hold them until the fed's rate rise is imminent and then drop them, but I don't like to play those kind of timing games.

Dennis, you're right that the active managers are not excited about treasuries right now, but the contrarian in me says that's a sign I can get in at a reasonable price.

Thanks to both of you for the recomendations on other bond funds. I share the concern over having all my fixed income in one asset class (treasuries), but shucks there's just nothing else to diversify into that has the same solidity.

 

[FIREd]

Dennis, you're right that the active managers are not excited about treasuries right now

Except for Bill Gross, the "bond guru", who has been stocking up on long term treasuries lately...

 

[audreyh1]

I'm happy to discuss this, because I've spent more time thinking about this particular issue than any of the other investment issues this year.

I keep coming back to the idea that medium term funds are more of a gamble than an investment. It seems to me that the only reason that their current ability to pay more interest than short term is balanced by the higher amounts their NAV will drop when interest rates rise. The way to play the game is to hold them until the fed's rate rise is imminent and then drop them, but I don't like to play those kind of timing games.

Well, the intermediate term funds did survive the previous interest rate hikes much better than the short-term funds did, and that was another time that short-term rates were brought super, super low. In this scenario, the short term rates climb quickly, while the longer term rates stay the same or even drop slightly.

AND you could say that intermediate term funds help out more than short-term in a deflationary environment as well. So I don't really see them as a gamble at the shorter end of the "intermediate" curve - the 5 year duration.

I have some concerns that the short-end (3 yrs and less) of the curve is just being too heavily manipulated at this time, whereas the intermediate-term are less manipulated. The Fed keeping interest rates so low is one source. And the banks seem to have increased demand for this paper due to new structural requirements. And then there are all the folks running from cash into something that pays more. It's getting really crowded at the short end of the curve.

I don't know how to time transitions either. I hate to do that. The only thing I know to do is to come up with some kind of "staging" schedule, and frankly, I have not come up with one yet. And my gut says stalling on this right now and continuing to mull over it is probably the right thing to do.

Audrey

 

[Gone4Good]

Well, the intermediate term funds did survive the previous interest rate hikes much better than the short-term funds did, and that was another time that short-term rates were brought super, super low. In this scenario, the short term rates climb quickly, while the longer term rates stay the same or even drop slightly.

I'd say that is the most likely scenario this time around too. The yield curve is very steep. The Fed could tighten 200bp before the 10-yr bond moves at all. And remember when the Fed starts tightening inflation expectations will come down possibly keeping a lid on longer-term rates. My guess is that short-duration bonds are more risky right now than intermediate bonds given the steepness of the curve.

 

[haha]

But my understanding is that this treasury interest rate risk of NAV drop shouldn't be very much, as it's only going to fall by approximately the amount of interest rate increase over the duration. Presumably everyone else in the market knows that interest rates will rise, so this is already somewhat priced into the treasury bond fund NAV. So am I crazy for getting into a t-bond fund knowing its NAV is likely to drop in the near future?

I am not qualified to comment on whether or not you are crazy. But be careful about assuming that the treasury bond market reflects what "everybody knows". A lot of demand is from dedicated buyers- foreign entities governmental and otherwise, and pensions and life insurance companies with matched mautrity liabilities.

ha

 

[FIREd]

I think that it is very dangerous to play either end of the curve right now. There are too many possible scenarios that could unfold. Gold seems to point to a high threat of inflation in the next few years while treasuries seem to point to a timid recovery with little or no inflation. Which is it? I have no idea. I think that intermediate bonds offer a good compromise at this time. I keep my average duration right around 5 years and don't worry about it.

 

[audreyh1]

I'd say that is the most likely scenario this time around too. The yield curve is very steep. The Fed could tighten 200bp before the 10-yr bond moves at all. And remember when the Fed starts tightening inflation expectations will come down possibly keeping a lid on longer-term rates. My guess is that short-duration bonds are more risky right now than intermediate bonds given the steepness of the curve.

Yes, I agree - I keep seeing it as very likely that the last scenario will repeat.

Audrey

 

[audreyh1]

I am not qualified to comment on whether or not you are crazy. But be careful about assuming that the treasury bond market reflects what "everybody knows". A lot of demand is from dedicated buyers- foreign entities governmental and otherwise, and pensions and life insurance companies with matched mautrity liabilities.

ha

I totally agree with this too, and it really concerns me.

For example, I just don't begin to understand how the 10-year treasury could get down to 3.2% yield as it did recently. This after much more positive economic news than early August when it was approaching 4%. That just makes me very nervous - like something just doesn't add up. There are considerable factors at play in the treasury market.

Whether these factors are going to be a constant or not - who knows.

Audrey

 

[free4now]

Some good points have been made here, making me reconsider whether intermediate term treasuries could possibly be better than short term for balancing out the swings in the equity portion of my portfolio.

Here's a graph comparing Intermediate, Short, and the S&P 500. The Intermediate term is clearly more volatile, and I'd hate to give up the nice smooth "almost always up" curve of the short term. But the Intermediate is clearly outperforming short, and perhaps more importantly the swings seem generally in the opposite direction of the stock market, which is a very good thing.

I dunno, maybe I'll go half intermediate and half short, just so I don't have to ever be totally wrong

 

[molly]

I can't think of any investing topic that has given us more "angst" than bonds. We are old enough to remember the Carter years and the high inflation. We were building a house at the time, bought a short term cd with our sale proceeds and earned a whopping 12% on a year cd. Later, my DH bought a bond that yielded 16% (TAX-FREE muni). Meanwhile, my FIL who had already retired and was in bonds --- took a HUGE hit. All of this seemed to occur overnight on the way up and subsided VERY slowly on the way down. There were some very smart people during this time that latched on to 30 yr. Treasuries paying 15%.

While nobody seems to think that this will happen again - if you look at the price of oil and its impact on interest rates and COLA, it does give one pause to consider. With the dollar not being considered such a stalwart currency at the moment, you have to wonder about the safety of your principal in bond funds right now. Fact is if interest rate patterns repeat the late 70’s and early 80’s, you could end up taking a hit that would take years of distributions to just get back to where you started.

In the meantime-where DO you put your money?

 

[audreyh1]

In the meantime-where DO you put your money?

Molly,

There was a pretty good discussion of that issue here:
http://www.early-retirement.org/for...t-the-coming-inflation-if-it-comes-46683.html

Audrey

 

[audreyh1]

I dunno, maybe I'll go half intermediate and half short, just so I don't have to ever be totally wrong

Well, basically, that is what I expect to end up doing.

When the short-term interest rates start to come into more historically "normal" ranges, and the 10-year Treasury gets back to the more "normal" 4 to 5% range, I may reconsider.

Audrey

 

[thefinancebuff]

Don't forget FDIC insured CDs. You often get a higher yield than Treasuries with no loss in credit quality. They are not as liquid as bond funds, but if you do a ladder, you can always spend part of the matured CD and roll forward the rest.

 

[Lsbcal]

Coming out of the last recession after 2003 we had ~2.5 yrs where short term funds showed negative 12mo real returns. Still my instinct is to stay short or be in TIPS and Ibonds (if you have the older ones). So that's what I've got: TIPS + Ibonds + VFSUX.

When rates move up to more "normal" levels (including TIPS rates) then I'd be more comfortable moving to an intermediate Treasury & intermediate TIPS combo. Maybe in a few years?

With big government spending and wars going on, few in government are currently talking about reduced spending. Recent inflation numbers are not that encouraging either with Jan-Sept inflation of +2.3% (although Sept-Sept it's -1.3%). When the fed starts to worry about inflation they could tighten in a hurry and I'd not want to be in longer duration bonds then.

Glad to see everyone else on this thread has it all figured out too .

 

[Gone4Good]

We are old enough to remember the Carter years and the high inflation.

They didn't have TIPs then. We have them now and IMHO it's foolish not to include them in a diversified bond portfolio. I know there are plenty of people who don't like them for various reasons but to my knowledge nobody has identified a better way of hedging inflation risk. TIPS aren't perfect. Just better than everything else.

Here's one possible allocation that should handle inflation pretty well . . .

1) 5% - Cash
2) 35% - Bond or CD ladder
3) 15% - Bond index
4) 15% - Foreign Bonds
5) 30% - TIPS

 

[audreyh1]

They didn't have TIPs then. We have them now and IMHO it's foolish not to include them in a diversified bond portfolio. I know there are plenty of people who don't like them for various reasons but to my knowledge nobody has identified a better way of hedging inflation risk. TIPS aren't perfect. Just better than everything else.

Well, I'm considering something like Fidelity Strategic Real Return FSRRX instead. That has an allocation: "using a neutral mix of approximately 30% inflation-protected debt securities, 25% floating-rate loans, 25% commodity-linked notes and related investments, and 20% REITs and other realestate related investments."

So presumably it does use TIPs, but it also uses exposure to commodities and real-estate. I prefer some commodity exposure as well to help hedge against inflation.

Audrey

 

[Gone4Good]

Well, I'm considering something like Fidelity Strategic Real Return FSRRX instead. That has an allocation: "using a neutral mix of approximately 30% inflation-protected debt securities, 25% floating-rate loans, 25% commodity-linked notes and related investments, and 20% REITs and other realestate related investments."

It's an option.

But with 70% of the fund linked to equities, commodities and high yield loans one may question the fund's suitability for their "fixed income" allocation.

Many people hold REITs in their equity buckets (I know I do), so they may not want to double dip here.

I do think loans have some merit, especially now, as short rates only have only one way to go and many companies are starting to refinance their leveraged loans (often times repaying at par loans that are trading at 80-90 cents). Fidelity also has a loan fund (FFRHX) that might be worth taking a look at. But if the OP thought recent volatility in VFSUX was too much, loan funds fared worse.

One other thought I had on loans. If inflation goes disco on us, and short rates go up dramatically, those highly leveraged companies may not be able to handle the increased cost of debt. So while your coupon goes up with inflation, so does your probability of default. They may not be a great hedge against very high inflation . . . but will probably do well as interest rates go up to mid single digits.

 

[audreyh1]

It's an option.

But with 70% of the fund linked to equities, commodities and high yield loans one may question the fund's suitability for their "fixed income" allocation.

Many people hold REITs in their equity buckets (I know I do), so they may not want to double dip here.

I do think loans have some merit, especially now, as short rates only have only one way to go and many companies are starting to refinance their leveraged loans (often times repaying at par loans that are trading at 80-90 cents). Fidelity also has a loan fund (FFRHX) that might be worth taking a look at. But if the OP thought recent volatility in VFSUX was too much, loan funds fared worse.

One other thought I had on loans. If inflation goes disco on us, and short rates go up dramatically, those highly leveraged companies may not be able to handle the increased cost of debt. So while your coupon goes up with inflation, so does your probability of default. They may not be a great hedge against very high inflation . . . but will probably do well as interest rates go up to mid single digits.

Well - I have been going round-and-round in my head about how to categorize something like this. I could switch my REIT position to this, or I could create a 4th category in my AA for this, and get rid of REITs as part of may equity allocation, or I could.........

That conversation has been going on in my head for several months now.

I just assumed he was using FFRHX for the floating rate loan portion - or, the same investments - same difference. I am very familiar with that fund.

I'm not concerned about how such a fund would handle all weathers - I just need it to help hedge some market conditions. I would really like some commodity exposure, but I think I might prefer it wrapped in this instead of stand alone. And then there is deflation - this fund would be killed by deflation. The more traditional bonds though would do well (usually).

I would use this fund as a "diversifier" against the more core bond positions in my AA - or even against the entire rest of my AA.

Audrey

 

[Lsbcal]

Hi Audrey, I was looking very seriously at PCRIX which is a PIMCO commodities fund that uses the collatoral to purchase TIPS. Swedroe recommended this on the Boglehead's site and there have been many CCF posts pro & con. Perhaps you have seen some of this. Also Swedroe covered CCF's versus other investments like gold and natural resource stocks in his recent Alternative Investments book. If I purchased CCF's it would be for protection in an extreme geopolitical event leading to something like an extreme oil supply disruption event.

Unfortunately, to purchase CCF's Swedroe is recommending this come from the equity side because they go down with demand shocks like equities do (as we saw in the last half of 2008).

 

[Gone4Good]

Well - I have been going round-and-round in my head about how to categorize something like this. I could switch my REIT position to this, or I could create a 4th category in my AA for this, and get rid of REITs as part of may equity allocation, or I could.........

This fund is pretty hard to classify, but I'd try to include it in my AA according to its components. What's clear to me is that 30% (TIPS) belongs in "fixed income" and 20% (REITs) belongs in "equity". The loan allocation probably belongs in "fixed income" (although junk bonds sometimes become equity, and often behave like equity). The commodity slice is a tougher one because it fits neither category. Maybe the correct approach is to ask yourself how comfortable you are with the current risk profile of your portfolio. If you're really comfortable, then allocate it to fixed income (because that will increase the risk of your portfolio) and if you're less comfortable use commodities to displace equities.

For me, I have TIPS and REITs. I even own a DJUBS index, even though I'm not completely sold on commodities as an asset class. So I've pretty much replicated this fund in my standard asset allocation. All I'd have to do to make it complete is add FFRHX, which may not be a bad idea.