Bond Funds or Bonds?

[simple girl]

Tons of very helpful info/food for thought in this response - thank you so much!!!

As far as time to recover, it depends on the funds holdings. If you notice, bond funds have a stated "duration" which is not just measured by the maturity date of bonds, it is a formula that calculates when the investment will be paid back, incorporating the coupon and other events also. It is thus said that the time to recover from a 1 percent increase in rates is equal to the duration of the fund. But look what we have, rates went up 4-5%.

So, Morningstar x-ray analysis of my port shows within my bond allocation (which is around 31% of my total port) is:

~ 51% medium quality, moderate term (3.5-6 yrs)
~ 19% "not classified" (a chunk of change I have in Ibonds & CD's)
~ 15% low quality, limited term (<3.5 yrs)
~ 10% high quality, moderate term (3.5-6 yrs)
~ 5% high quality, extensive term (>6 yrs)

Since the majority (~60%) of my bond funds have a moderate term of 3.5 to 6 years, if it's accurate that the time to recover is the duration of the fund * each % rate increase, I'd be looking at 14 years (3.5 yrs * 4%) best case scenario to 30 years (6 yrs * 5%) worst case scenario for the funds to recover. Good times! lol

It's hard to imagine it could be that bad but it's one possible scenario.

I'm glad we have many tiers to our FIRE plan (including a future pension which covers ~ 20% of our expenses, future SS, and a very low withdrawal rate). That helps me not get overly anxious about this drop, but I still want to be more on top of this part of our portfolio than I have been.

So what to do? depends on what you hold and why.

Indeed!

If you are in a taxable account, you may want to reposition to recognize losses and choose new funds that reflect your current understanding of funds, your goals and risk tolerance.

The only portion of our bond holdings that are in taxable accounts are our ibonds & CD's.

Everything else is either in IRA's or 401K's. In fact, I need to rollover two 401K's soon, one of which has our largest bond fund holding. Sooooo...trying to decide if I should just stay in the same fund or make some moves during that rollover...

Many people who do their equity investing via indexes want bond funds or indexes so they can rebalance easily.

Yep, that's me.

If you want to try individual securities you can go with US treasuries which have no credit risk, or agencies which have little. That can be a good way to get your feet wet and these also behave best in times of market turmoil, generally speaking.

I've been thinking about treasuries and am definitely investigating further. Tx!

Cd's can also be in the mix. If you regularly rebalance you want to have a plan for how you will do so with individual bonds or CD's. Perhaps harvest the shortest maturities.

For sure!

Be aware also that some of the investors most bullish on individual bonds here do not own equities at all (so no rebalance) and rely on bonds to provide income for living expenses. You may have different strategies. It is good to understand that as it provides context.

And by all means, Stay Fully Invested.

Yes, we have a different strategy, total return not living off of bonds for income. Definitely staying fully invested, no worries there!

 

[GravitySucks]

I think I now have a fairly good understanding of the advantages/disadvantages of bond funds vs bonds. The question is - if you were in bond funds, but didn't notice the carnage until afterwards why would you do anything now? It seems like you'd be locking in your losses. Is that what people (who are regular bond proponents) are suggesting here? Classic advice is to ride it out, not to sell when things are at their lowest. I did read on one of these threads that it could take decades for bond funds to recover, possibly. It seems like there is no easy answer for those who did not take action last year. I'm sitting in analysis paralysis.

I locked in a small loss in the brokerage account as I needed the money to live on last year and this. MM yield was good enough so I didn’t buy an individual bond with that money.
Yesterday sold a 12/23 bullet shares type etf and rolled it to a higher yielding treasury. I don’t see rates coming down by years end. Considering selling the 12/24 bullet fund for the same reason.
Holding my main bond fund as I won’t need to touch that until we’ll after the duration period, but I’m not adding to it either.
I’ve been buying 1 to 3 year bonds, CDs, and MYGAs since 2018 and now am almost half bonds and half bond funds.

So I locked in small loses by necessity and a bit to cut what I’m pretty sure would have been a larger loss.

 

[Fotodog]

I think I now have a fairly good understanding of the advantages/disadvantages of bond funds vs bonds. The question is - if you were in bond funds, but didn't notice the carnage until afterwards why would you do anything now? It seems like you'd be locking in your losses. Is that what people (who are regular bond proponents) are suggesting here? Classic advice is to ride it out, not to sell when things are at their lowest. I did read on one of these threads that it could take decades for bond funds to recover, possibly. It seems like there is no easy answer for those who did not take action last year. I'm sitting in analysis paralysis.

I had this same question last year as I watched my bond fund with a 7 year duration keep dropping, with distributions less than half of what I could earn with individual bonds. I read everything I could find on bond funds vs bonds. The most helpful information was the Golden Age thread on this site, with lots of great information provided by Freedom76 and CoCheesehead among others.

The key question for me was how long it would take my fund to recover. It might be the fund’s duration, but I have seen calculations (on the BH site I think) where in some interest rate scenarios it could take up to 2x the duration minus one year to recover.

I met with my Schwab rep for his perspective, and he thought my plan was reasonable. So, I decided to make the leap, selling my fund and investing in individual bonds. I view this as a lateral move in the fixed income portion of my IRA. Although it will take some time to make up the difference, it will happen and I will have more control over my fixed income.

Just know that it takes some “work” to build a bond portfolio. For me it’s fun, almost like a treasure hunt to find good deals and put the pieces together. As others have pointed out, you don’t have to rush since your brokerage MM fund is yielding over 4.5% now, likely to go higher.

Bottom line, financial decisions are very personal, and you have to do what feels right and lets you sleep well at night.

 

[latexman]

Since the majority (~60%) of my bond funds have a moderate term of 3.5 to 6 years, if it's accurate that the time to recover is the duration of the fund * each % rate increase, I'd be looking at 14 years (3.5 yrs * 4%) best case scenario to 30 years (6 yrs * 5%) worst case scenario for the funds to recover. Good times! lol

It's hard to imagine it could be that bad but it's one possible scenario.

I was an equity index fund/bond fund rebalancer for many years. I am kicking myself for not knowing that "bond funds are not bonds". I am thoroughly impressed that some folks here knew this, saw this coming, and got out of bond funds, or were into bonds, before bond funds crashed and burned.

Despite some folks here trying to warn us "the sky is falling", I held onto my bond funds until early-2023. At that time, as I read and learned more about how long it may take them to recover (too many years), AND the recent news that inflation isn't coming down as the market hoped, I locked in my 17.5% loses (at that time; it was a 22.8% lose peak-to-trough) and sold them. I put the proceeds into MM funds. The MM fund in my 401k is currently paying 4.46% , and the MM fund in my tIRA is currently paying 4.22%. That's what I did fearing bond funds would keep declining as the Fed raises rates even higher. I do not have a solid plan going forward yet. I may buy bonds in my tIRA. When inflation is tamed and rates start dropping, I may buy bond funds in my 401k; bonds are not a choice there. I'm thinking of MM funds as a safe haven while I figure out my next move, if any. It feels to me that it is almost certain that MM fund rates will be increasing in 2023, and, if not, my principal is protected.

So, the story is not over yet, but that's where I am. To summarize, MM funds are currently my fixed income safe haven.

I will continue to read and learn from others. This is a wonderful place. Knowledge is power!

 

[daylatedollarshort]

One option for fellow bond fund refugees to consider going forward is a TIPS ladder - The 4% Rule Just Became a Whole Lot Easier - "I built a 4.36% real (inflation-adjusted) systematic withdrawal portfolio using a 30-Year TIPS ladder....For the strategy to work, one would have to build it with individual TIPS maturing each year to be assured of a certain real amount.", https://www.advisorperspectives.com/articles/2022/10/24/the-4-rule-just-became-a-whole-lot-easier

Also, getting out of bond funds now doesn't mean you can't go back if we ever get clear signals that rates are going to drop or at least stabilize, and the distribution yields start to improve. It is not like a bad marriage where you have to stick things out hoping for an eventual recovery. You can sell your funds now when the distribution yields are low and interest rates look like they will continue to climb, and then get back in at a later date. This Kiplinger article recommends this strategy - "When the Federal Reserve cut interest rates to near 0% overnight two years ago to offset the impact of the COVID-19 crisis, we advocated investing in bond funds and decreased our investment in individual bonds where it made sense. We did this because the bonds in those funds were already providing higher yields than if we had purchased individual bonds. Now, as rates have started to rise, the reverse could make sense. " Bonds Are Having a Rough Year. Here Are 3 Actions That Can Help, https://www.kiplinger.com/investing...a-rough-year-here-are-3-actions-that-can-help

 

[dmpi]

I'm in the process of bailing out of my bond funds. I know the buy low sell high philosophy but I don't think it's possible to 'miss the boat' buying back into the bond fund when things turn around. I think it's only possible if the Fed suddenly cuts the rates which I think can only happen if & when we're in a recession which I don't think can happen overnight. In the meantime I think it's just better to use my money to try to generate some income which isn't all that hard these days with MM getting 4.5% rather than waiting for this elusive bond rebound.

 

[simple girl]

I’ll round the numbers for simplicity, but they are based on reality. BND yields 2.5%. A ultra safe treasury yields 5%. For every $10,000 you have invested, you’ll make $250 more a year. Apply that to your loss and figure it out, knowing that you won’t lose anymore along the way.

That will make the number crunching fairly easy - thank you!

 

[audreyh1]

Rebalancing doesn’t give you better returns. It keeps your risk profile/asset allocation inline.

Yes, that’s precisely what I use it for. I also like the mechanical no predictions nature of it - just do it, no thinking required.

 

[pb4uski]

I think I now have a fairly good understanding of the advantages/disadvantages of bond funds vs bonds. The question is - if you were in bond funds, but didn't notice the carnage until afterwards why would you do anything now? It seems like you'd be locking in your losses. Is that what people (who are regular bond proponents) are suggesting here? Classic advice is to ride it out, not to sell when things are at their lowest. I did read on one of these threads that it could take decades for bond funds to recover, possibly. It seems like there is no easy answer for those who did not take action last year. I'm sitting in analysis paralysis.

Bonds are different from equities. What happened last year is done. What is most relevant is what will happen from here forward.

There are only two ways for bond fund/ETF holders to recover last years losses. One is for interest rates to decline which would push bond prices up. The other, absent any changes in rates, is to wait for the duration of the fund for the better yields to bring you back to zero.

So let's take BND, a large and popular bond ETF. It portfolio coupon is 2.8% and it has a 0.03% ER, suggesting a distribution of 2.77%. The most recent distribution was $0.164216/share on Mar 2... annualized that is $1.97/share and BND is trading at $72.07 is a 2.73% distribution yield.

So if interest rates don't change at all, then you'll get $1.97 of dividend distributions in the next year and the share value might creep up a little because the 4.3% portfolio YTM exceeds the 2.8% portfolio coupon.

The portfolio average maturity is 8.9 years. While that is longer than I would invest in at this point, let's say that the investor is fine with an 8.9 year average maturity. Today, you can invest in a 10 year UST ladder that will yield about 4.75%... might be a little less if you had a longer ladder... say 4.5% for a 20 year UST ladder.

So with BND you will get less than 3% and with a UST bond ladder you will yield 4.25% to 4.75% depending on how long your ladder is.

Would you prefer 4.25%-4.75% with more control over your holdings or 3% with no control over your holdings?

 

[simple girl]

So, the story is not over yet, but that's where I am. To summarize, MM funds are currently my fixed income safe haven.

I will continue to read and learn from others. This is a wonderful place. Knowledge is power!

Thanks latexman! I recall us talking about this briefly at our meet-up and sharing our bond woes. Last year about this time I had way too much personal stuff going on to keep up with what was going on in the market. So I didn't make any big moves. This year, I'm in a better place so I have time to think and ponder. Will I make a big change? I don't know. Either way, at least now I have time and less stress so I can actually research it and see what I think makes sense for our situation.

Since we are soon going to be able to rollover DH's 401K (which has a big portion of our bond allocation...and limited choices), I will now have the ability to choose whether I want to continue with funds, do a bond/CD ladder, or a mixture of both, perhaps. I will also need to decide where to roll it over - likely either Fidelity or Vanguard.

 

[simple girl]

Bonds are different from equities. What happened last year is done. What is most relevant is what will happen from here forward.

There are only two ways for bond fund/ETF holders to recover last years losses. One is for interest rates to decline which would push bond prices up. The other, absent any changes in rates, is to wait for the duration of the fund for the better yields to bring you back to zero.

So let's take BND, a large and popular bond ETF. It portfolio coupon is 2.8% and it has a 0.03% ER, suggesting a distribution of 2.77%. The most recent distribution was $0.164216/share on Mar 2... annualized that is $1.97/share and BND is trading at $72.07 is a 2.73% distribution yield.

So if interest rates don't change at all, then you'll get $1.97 of dividend distributions in the next year and the share value might creep up a little because the 4.3% portfolio YTM exceeds the 2.8% portfolio coupon.

The portfolio average maturity is 8.9 years. While that is longer than I would invest in at this point, let's say that the investor is fine with an 8.9 year average maturity. Today, you can invest in a 10 year UST ladder that will yield about 4.75%... might be a little less if you had a longer ladder... say 4.5% for a 20 year UST ladder.

So with BND you will get less than 3% and with a UST bond ladder you will yield 4.25% to 4.75% depending on how long your ladder is.

Would you prefer 4.25%-4.75% with more control over your holdings or 3% with no control over your holdings?

Hmmmm...what do you think pb? Mo money of course! lol

I really appreciate the detailed analysis and math. I need time to digest it all and analyze it with reference to our particular situation. Thanks much!

 

[latexman]

Thanks latexman! I recall us talking about this briefly at our meet-up and sharing our bond woes.

Yes, I remember me trying to verbally describe exactly when I had my epiphany and decided to sell my 401k bond funds and buy the one MM fund it offers. It was after listening to Freedom56, Montecfo, COcheesehead, pb4uski and others for quite some time, AND after I saw this graph of my 401k MM fund:



Everytime the Fed raises rates, it's rate is lock step along with them shortly thereafter. I'm sure this graphic communicates that better than my verbal description did.

Hindsight being 20/20, I should have done this early 2022, and I would have kept the balance of my fixed income portion up. And I should have definately done it Oct./Nov. 2022 when the returns of my bond funds were = to the returns of the MM fund. But, better late than never, I guess. Time will tell.

 

[Freedom56]

Those that are hanging onto longer duration bond funds should prepare themselves for a scenario where the 10 and 30 year treasury yields cross 5%. Investors will then be comparing a risk free 5% yield with 100% capital protection against a bond fund that yields 2.5-2.7% and zero capital protection. Don't be alarmed if you see another 20% drop in those funds. Duration and low coupons are a dangerous combination for both individual bonds and bond funds but most individual bond investors are wise enough not to lock in low coupons for long durations but the same cannot be said about bond funds.

 

[youbet]

An individual bond will not lose anymore if held to maturity.

Is it true that I can hold a bond that is currently valued below PAR to maturity and I get PAR. But I forego the additional interest I could receive by selling it and buying a newly issued, higher coupon bond?

For example, if my 2% coupon bond has a current NAV less than PAR because currently issued bonds are bearing a 4% coupon, I can just hold my 2% bond to maturity and receive full PAR value. Nice. But aren't I giving up the opportunity to sell at a capital loss and buy a new 4% bond. Wouldn't that be approximately a wash?

 

[COcheesehead]

Is it true that I can hold a bond that is currently valued below PAR to maturity and I get PAR. But I forego the additional interest I could receive by selling it and buying a newly issued, higher coupon bond?

For example, if my 2% coupon bond has a current NAV less than PAR because currently issued bonds are bearing a 4% coupon, I can just hold my 2% bond to maturity and receive full PAR value. Nice. But aren't I giving up the opportunity to sell at a capital loss and buy a new 4% bond. Wouldn't that be approximately a wash?

I think you are responding to my post about flipping out of a fund and going to an individual bond if the numbers work, but you only quoted a sentence. Are you responding to that or are you trying to make a point about flipping low for high yielders. Help me understand.

 

[youbet]

Yeah, that wasn't very clear was it!

I'm just noodling the fact that although holding a bond valued at less than PAR to maturity allows you to recoup your principal. But you still suffer the opportunity cost of the foregone interest from not selling and buying the higher coupon bond. Holding to maturity definitely gets you your PAR back. But it can't protect you from the opportunity cost of foregone higher interest rates. So, rising rates = "ouch" regardless.

 

[COcheesehead]

Yeah, that wasn't very clear was it!

I'm just noodling the fact that although holding a bond valued at less than PAR to maturity allows you to recoup your principal. But you still suffer the opportunity cost of the foregone interest from not selling and buying the higher coupon bond. Holding to maturity definitely gets you your PAR back. But it can't protect you from the opportunity cost of foregone higher interest rates. So, rising rates = "ouch" regardless.

That’s why you ladder. It helps with interest rate risk. You’ll always have fresh funds to invest at a higher rate. It minimizes the “ouch”.

 

[pb4uski]

Yeah, that wasn't very clear was it!



I'm just noodling the fact that although holding a bond valued at less than PAR to maturity allows you to recoup your principal. But you still suffer the opportunity cost of the foregone interest from not selling and buying the higher coupon bond. Holding to maturity definitely gets you your PAR back. But it can't protect you from the opportunity cost of foregone higher interest rates. So, rising rates = "ouch" regardless.

It's a wash. IOW if you sell the 2% coupon bond that is now yielding 4% for a loss and then immediately buy it back then you'll yield 4%, the same 4% as if you hold to maturity.

And the result would be the same whether you repurchased the same bond that you sold or say another bond with a 4% coupon at par and the same maturity date as the bond that you sold.

If it's in a taxable account putting wash sale concerns aside you might come out ahead by a smidgen.

 

[youbet]

That’s why you ladder. It helps with interest rate risk. You’ll always have fresh funds to invest at a higher rate. It minimizes the “ouch”.

Yeah, I understand about laddering.......

I was just trying to point out that when you hold a bond to maturity in a rising rate market, you preserve principle. That's great. But the advantage of that is reduced by the fact you absorb the opportunity cost of holding a bond with a lower coupon.

 

[youbet]

It's a wash. IOW if you sell the 2% coupon bond that is now yielding 4% for a loss and then immediately buy it back then you'll yield 4%, the same 4% as if you hold to maturity.

And the result would be the same whether you repurchased the same bond that you sold or say another bond with a 4% coupon at par and the same maturity date as the bond that you sold.

If it's in a taxable account putting wash sale concerns aside you might come out ahead by a smidgen.

That 'splains it! Tnx!

 

[Montecfo]

Yeah, that wasn't very clear was it!



I'm just noodling the fact that although holding a bond valued at less than PAR to maturity allows you to recoup your principal. But you still suffer the opportunity cost of the foregone interest from not selling and buying the higher coupon bond. Holding to maturity definitely gets you your PAR back. But it can't protect you from the opportunity cost of foregone higher interest rates. So, rising rates = "ouch" regardless.

In fact, getting back to "par" should not be your goal. Getting the best risk adjusted total return going forward should be.

 

[Montecfo]

Yeah, I understand about laddering.......



I was just trying to point out that when you hold a bond to maturity in a rising rate market, you preserve principal. That's great. But the advantage of that is reduced by the fact you absorb the opportunity cost of holding a bond with a lower coupon.

Correct. And your last sentence is glossed over way too often by some of the bond holding posters.

Even if you hold the bond to maturity you must reinvest in the then-current market, unless you will be spending the funds at maturity.

This an advantage of of bond funds.

 

[Montecfo]

The big bogeyman of 2022 was not the question of Bond Funds or Bonds(?). It was duration of securities held.

Low duration bonds and bond funds did not get killed.

High duration bonds and bond funds did. Yes, including TIPS. They were actually hurt worse than comparable treasuries due you low coupons.

So the best strategy was to avoid duration. This kept any losses to an absolute minimum. No need to mitigate by holding to maturity or waiting to get back to par.

 

[COcheesehead]

Yeah, I understand about laddering.......

I was just trying to point out that when you hold a bond to maturity in a rising rate market, you preserve principal. That's great. But the advantage of that is reduced by the fact you absorb the opportunity cost of holding a bond with a lower coupon.

If you understand laddering then there really isn’t opportunity cost. You can always flip out of low yielder too.

 

[youbet]

If you understand laddering then there really isn’t opportunity cost. You can always flip out of low yielder too.

No, the opportunity cost is still there with laddering. When your ladder holds a bond yielding less than currently available yields and you hold it to avoid a loss of principle, you still miss the opportunity of the higher coupon bonds you could have switched to. As you say, "you can always flip out of a low yielder." If you do flip, you absorb the capital loss. If you don't flip, you absorb the opportunity cost of holding the lower coupon.

It just doesn't seem possible to avoid a bit of pain when you hold bonds or bond funds in a rising interest rate environment. You just try to minimize it. And certainly some holdings will suffer more than others. (Don't ask me how I know! )