Bond Funds or Bonds?

[COcheesehead]

Anyone who says the unrealized losses are already reflected in the funds NAV have likely never sold a bond in the secondary market. In a rising rate environment, a bond does not sell for its mark to market price - which is the basis of a funds NAV.

 

[daylatedollarshort]

Anyone who says the unrealized losses are already reflected in the funds NAV have likely never sold a bond in the secondary market. In a rising rate environment, a bond does not sell for its mark to market price - which is the basis of a funds NAV.

But the bonds are also no longer on the books at the par value. If interest rates rise from 10% to 15%, that is going to cause a huge drop in the NAV price right there. In my example, the bonds book values drop from $100K to $75K when rates rose 5%. Then there may be another, secondary loss if the bond doesn't actually sell for the repriced value of $75K.


But is a 1% bond priced to yield 4% going to be priced to sell for an 8% yield when it is time to sell, assuming prevailing rates haven't changed? Or might it sell for 4.5% - 5%? The big loss would most likely occur when the bonds were repriced from 1% to 4%.

In a rising rate environment, the bonds are still getting repriced and the NAV prices updated daily.

 

[daylatedollarshort]

With the current government debt, I would bet that interest rates will find their way down in the near future. Down has been the direction for decades and it will persist IMO. Can you give me your logic for rates continuing to rise for the next 2 decades?

VW

That is the bet we all have to make. If you are right, the funds might be a better bet.

Many of us see CPI inflation still at 6.5%, and the Fed's inflation target at 2%, a persistently tight labor market, and don't see rates dropping for some time. But those out of bond funds aren't looking at 2 decades ahead. We're looking at the next year or two. There is no reason one can't switch in and out of bond funds as the probability of lower or higher market rates change. The changes in interest rates aren't as random and unpredictable as stocks. They've pretty much followed what the Fed members have told us they were going to do to the federal funds rates for over a year now.

 

[jldavid47]

Many of us see CPI inflation still at 6.5%, and the Fed's inflation target at 2%, a persistently tight labor market, and don't see rates dropping for some time.

Note that the Fed's 2% target is not based on the CPI but on the PCE deflator which tends to run lower than the CPI

 

[daylatedollarshort]

Note that the Fed's 2% target is not based on the CPI but on the PCE deflator which tends to run lower than the CPI

Good point, and the PCE is also indicating rate hikes - Fed’s Preferred Inflation Measure Supports Further Rate Hikes, https://www.forbes.com/sites/simonm...nflation-measure-supports-further-rate-hikes/

 

[jldavid47]

With the current government debt, I would bet that interest rates will find their way down in the near future. Down has been the direction for decades and it will persist IMO.

OK, that's your belief but it runs against economics. The current (and rising) government debt actually argues for interest rates rising as government bonds will have to pay more to compete with other assets in the absence of the Fed printing unlimited money.

Can you give me your logic for rates continuing to rise for the next 2 decades?

Sure. History. Once the trend in interest rates change the trend tends to persist for 2-4 decades. It will not be (and is never) a straight shot. There will be pullbacks (such as the one we saw from November through January) but the general trend upward should continue if history is any guide.

Here's a visual of the past 225 years or so of interest rates in the U.S:

https://advisor.visualcapitalist.com/us-interest-rates/

 

[pdxgal]

.Ultimately, you need to understand that a bond fund is not a bond. It is a mutual fund. And the 1940 Investment Company Act, which created mutual funds, defines these products as equities,

Wow. Super interesting and insightful. Greatly helps my understanding. Thanks for posting @daylatedollarshort !

 

[daylatedollarshort]

There was some discussion on another thread in the differences between TIPS and TIPS funds. This article seems well written and is a bit more succinct that I have been on the topic:

Pros and Cons of TIPS Mutual Funds: "Buying a TIPS mutual fund will not protect your money in the way a TIPS does. In the short term, TIPS funds may be more risky than TIPS. TIPS are priced daily, based on a view of future inflation rates. Changes in interest rates affect their value. If you own the TIPS outright, you will receive your adjusted principal upon maturity.", https://www.thebalancemoney.com/pros-and-cons-of-tips-mutual-funds-2466782

 

[Closet_Gamer]

There was some discussion on another thread in the differences between TIPS and TIPS funds. This article seems well written and is a bit more succinct that I have been on the topic:

Pros and Cons of TIPS Mutual Funds: "Buying a TIPS mutual fund will not protect your money in the way a TIPS does. In the short term, TIPS funds may be more risky than TIPS. TIPS are priced daily, based on a view of future inflation rates. Changes in interest rates affect their value. If you own the TIPS outright, you will receive your adjusted principal upon maturity.", https://www.thebalancemoney.com/pros-and-cons-of-tips-mutual-funds-2466782

That was probably me posting in the other thread. And, yes, that was an expensive little lesson...

 

[daylatedollarshort]

With the Fee in rate hiking mission, bonds are ALSO doomed to continue their money losing record.

Rising rates reduce the value of bonds, whether held in funds or directly.

It is just a fact.

Rising rates reduce the market value of bonds, but they don't change the principal on a bond held to maturity, since you aren't earning market rates on that bond. That is an opportunity cost, but it doesn't change the cost basis of the bond in your brokerage account. If you have a 2%, 2 year bought you bought at par and then rates rise to 4%, not selling it causes an opportunity cost, but there is no tax loss or cost basis change on your bond principal because you chose not to sell it and are still only earning 2%. Bond funds don't have maturity dates so that makes the bond values more volatile. The open ended bond funds price all their bonds at mark to market daily. You never know when you go to sell if you will get more or less than your original investment returned.

This is what Fidelity has to say, Bonds: "If you bought the bond when it was issued at its original issue price and hold it until maturity, you generally will not recognize a capital gain (or loss)." Bond Funds: "There are 2 ways investors could owe capital gains tax on a bond fund investment. First, there are the capital gains (and losses) generated by the fund manager, as he or she buys and sells securities...Secondly, when you sell shares of the fund itself, you'll incur a gain or a loss depending on your cost basis, the amount of your initial investment, and any reinvested dividends." From Tax implications of bonds and bond funds, https://www.fidelity.com/learning-c...ucts/mutual-funds/tax-implications-bond-funds

As noted in the Golden Period thread, if you held a 1.5% TIPS bond last year in a taxable account, your 1099s would show 1.5% in interest payments and a 6.5% inflation adjustment. Treasury Direct describes how this works - https://treasurydirect.gov/marketable-securities/tips/. You would would report 8% in earnings on your tax returns. Your brokerage statement would show 1.5% earned in interest income and a 6.5% increase in the cost basis of your bond principal amount.

If you want to say you have a loss on an individual TIPS bond because mark to market rates changed, that is your choice, but for tax purposes, cost basis in your brokerage account and Treasury Department interest calculations, last year they would all show around a 6.5% gain on your TIPS principal due to an increase in the CPI for 2022.

 

[pb4uski]

There is no doubt that one has an economic loss because of the decline in value of bonds caused by increases in interest rates... the fair value of your assets has declined... that is just fact.

At the same time, IF you intend to hold to maturity then that economic loss isn't particularly relevant because it will reverse between the measurement date and maturity... that is also a fact.

But to deny that an economic loss temorarily exists is particularly odd.

 

[daylatedollarshort]

There is no doubt that one has an economic loss because of the decline in value of bonds caused by increases in interest rates... the fair value of your assets has declined... that is just fact.

At the same time, IF you intend to hold to maturity then that economic loss isn't particularly relevant because it will reverse between the measurement date and maturity... that is also a fact.

But to deny that an economic loss temorarily exists is particularly odd.

In the Golden Period thread, after stating that individual TIPS had big losses last year, Montecfo also stated that, "This is part of the misinformation [DLDS] regularly repeat here. You really should stop...Bonds values fluctuate with interest rates as do bond fund NAVs...The principal value of ANY bond (other than I-bonds) or bond fund will fluctuate with interest rate changes, regardless of holding period. Even if you hold to maturity, it is not accurate to say the principal value did not change during that holding period."

The Treasury web site says this about TIPS, "The principal (called par value or face value) of a TIPS goes up with inflation and down with deflation. When a TIPS matures, you get either the increased (inflation-adjusted) price or the original principal, whichever is greater. You never get less than the original principal.", How TIPS protects you against inflation, https://treasurydirect.gov/marketab...ow-tips-protects-you-against-inflation-327309. In their description of how the principal in TIPS is adjusted, there is no mention of mark to market values or changes in principal due to interest rates, just CPI changes. Interest rate changes are only a factor in the funds, which price their bonds at mark to market prices daily, or if you sell an individual bond prior to maturity, when you have to accept the mark to market price. That is one of the key differences between TIPS funds and TIPS, which even many financial writers confuse, and is an important distinction in what kinds of returns or possible losses investors in either asset type might expect.

Many posters in this forum and others didn't expect their TIPS funds to go down during a period of high inflation because they didn't understand this key difference.

 

[pb4uski]

 

[foxfirev5]

+1000

 

[simple girl]

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.

 

[audreyh1]

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.

When things go down I buy more. But I’m one of those crazy few who occasionally rebalances.

 

[VanWinkle]

When things go down I buy more. But I’m one of those crazy few who occasionally rebalances.

I'm with you audreyh1. I buy low and never sell........at least not until RMDs at 73.

VW

 

[COcheesehead]

Deciding to sell a bond fund is just a math equation. What is the distribution yield on the fund vs an individual bond or a ladder of bonds and how long will it take me to make up the loss.
An individual bond will not lose anymore if held to maturity. A fund can absolutely lose more as rates continue to rise.

 

[VanWinkle]

Deciding to sell a bond fund is just a math equation. What is the distribution yield on the fund vs an individual bond or a ladder of bonds and how long will it take me to make up the loss.
An individual bond will not lose anymore if held to maturity. A fund can absolutely lose more as rates continue to rise.

Or balance can rise as interest rates fall...... during the 5-6 years before I need to draw from my IRA.

VW

 

[COcheesehead]

Or balance can rise as interest rates fall...... during the 5-6 years before I need to draw from my IRA.

VW

Rise from what point though. I think ‘23 will be a repeat of ‘22 and funds will lose NAV. ‘24 is TBD.

 

[simple girl]

When things go down I buy more. But I’m one of those crazy few who occasionally rebalances.

I'm with you audreyh1. I buy low and never sell........at least not until RMDs at 73.

VW

Thanks, nice to hear from a few who are staying the course.

Deciding to sell a bond fund is just a math equation. What is the distribution yield on the fund vs an individual bond or a ladder of bonds and how long will it take me to make up the loss.
An individual bond will not lose anymore if held to maturity. A fund can absolutely lose more as rates continue to rise.

OK so can you give me a sample math equation please to help me visualize how long it could take to make up a loss? (make up any numbers you like) I would find that very helpful!

 

[Montecfo]

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.

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 the issue is less about bond funds than about the unprecedented rise in interest rates.

So what to do? depends on what you hold and why. My fund holdings are mostly floating rate. I jettisoned my mid-term bonds at the start of 2021 in favor of floaters, which have done very well. Otherwise it is individual bonds. So I am staying the course in the floaters for now, but may lighten if we get a hard recession, as these are riskier securities, though I love the diversification.

I have a bond ladder with bonds maturing over most of the next 8 years. Some roll off this month so I have a new chunk to reinvest.

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.

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

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. Corporates are higher yield but also a bit more complicated and you need to have more funds to invest to get adequate diversification in the view of many. But again, if you stick to high quality, shorter maturities and diversify that can be a good way to go also. 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.

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.

 

[COcheesehead]

OK so can you give me a sample math equation please to help me visualize how long it could take to make up a loss? (make up any numbers you like) I would find that very helpful!

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.

 

[audreyh1]

Thanks, nice to hear from a few who are staying the course.



OK so can you give me a sample math equation please to help me visualize how long it could take to make up a loss? (make up any numbers you like) I would find that very helpful!

I don’t care about distribution yield because I don’t use my bond funds for income. They are there for diversification against equities.

I never worry about “making up a loss” in any given fund or equity class - stocks or bonds. When they go down I buy more, when they go up I trim.

I’m just sticking to an asset allocation that matches my risk tolerance and long term goals.

Also I don’t sweat this year or that. The bulk of my investments were made decades ago (when coincidentally interest rates were still higher than now) and just been rebalancing all this time. I never compare against the most recent high as that’s always ephemeral and kinda silly IMO. 2020-2021 markets were crazy out of whack and serious corrections way overdue.

 

[COcheesehead]

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