Bond Funds? Question about Rational Investing

[brewer12345]

Nice explaination. I even understand it. BTW Brewer, have you noticed the nice move BULK has made lately?

 

[Patrick]

But if you don't sell the bond then you'll collect interest until it matures, and you'll get your inflation-eroded principal back as well.

Isn't the inflation-erosion factor at work on money kept in a bond fund, also?

If interest rates rise higher than your bond's interest rate, you'll have a huge opportunity loss by not being able to invest the money in another higher-returning asset.

If the money were in a fund instead, and I sold it, wouldn't I have paid the opportunity cost also at that point?

 

[Patrick]

That's supposedly the beauty. Whether CPI is 5% or 50%, you supposedly make your 2.5% either way.

-CC

So why not use TIPS in the Rational Investing Portfolio instead of Bond Funds and get the guaranteed return without the possibility of a loss?

 

[brewer12345]

So why not use TIPS in the Rational Investing Portfolio instead of Bond Funds and get the guaranteed return without the possibility of a loss?

Fixed bonds and TIPS do well in different scenarios. In an environment where inflation is high and/or keeps accelerating, TIPS protect you from big losses because they automatically cover inflation. This is also when fixed bonds get killed.

In an environment where the economy is pitching into recession, the bottom is falling out of everything, and inflation is heading for zero or below, high grade fixed rate bonds do very well.

Having some of both means you have something that does well regardless of what happens.

 

[FinanceDude]

Oy! One last time on TIPS: the yield is a real yield. That means you get paid wahtever the yield is plus inflation as measured by the CPI. So if CPI=3.5% and yield=2.5%, total (nominal) yield is 3.5+2.5 = 6%.

What is the base CPI now

 

[magellan_nh]

In an environment where the economy is pitching into recession, the bottom is falling out of everything, and inflation is heading for zero or below, high grade fixed rate bonds do very well.

This makes perfect sense.

I'm trying to come up with the scenario where fixed rate bonds do well while TIPS get killed. Any takers?

I think it would happen when inflation is much-much lower than expected while the economy is booming and real interest rates are rising because of high investment demand (but not rising enough to offset the gain from the lower than expected inflation).

Does that sound right or is there a better scenario to show this?

 

[Nords]

Isn't the inflation-erosion factor at work on money kept in a bond fund, also?
If the money were in a fund instead, and I sold it, wouldn't I have paid the opportunity cost also at that point?

The questions like these (and their answers) are why we don't invest in bonds. If you want to make money then there are plenty of alternatives to bonds & bond funds.

I think that for most investors the purpose of bonds is just to reduce volatility, and we sidestep that with a couple years' expenses in cash.

 

[bosco]

If the money were in a fund instead, and I sold it, wouldn't I have paid the opportunity cost also at that point?

in theory, a good bond fund manager is replacing bonds reaching maturity with new ones, turning over issues etc. So, at least in the bond universe, you aren't losing nearly as much opportunity cost in a fund as you would be with individual bonds.

 

[theronware]

An individual buyer of bonds can also buy with differing maturities and so achieve the same as a bond fund manager. This is what I have done.

FYI, I have 25% of my portfolio in CA muni bonds. This year, I have a 5.53% capital return to date with an average 3.25% dividend on top of that. So my total return to date is 8.78% (tax free).

Yes, muni bonds reduce volatility but their return has been far from shabby over the last 3 years (Last year my muni bonds returned 9% total -- and, again, that's tax-free).

theronware

 

[CCdaCE]

http://www.bls.gov/cpi/home.htm#overview

Says +2.1% over the last year. Minus food and energy, it's +2.9%. I guess I'm not sure which one TIPS uses without researching it more.

-CC

 

[brewer12345]

http://www.bls.gov/cpi/home.htm#overview

Says +2.1% over the last year. Minus food and energy, it's +2.9%. I guess I'm not sure which one TIPS uses without researching it more.

-CC

TIPS uses full CPI without anything taken away, but IIRC it uses a 6 month average.

 

[wabmester]

I'm trying to come up with the scenario where fixed rate bonds do well while TIPS get killed. Any takers?

I think it would happen when inflation is much-much lower than expected while the economy is booming and real interest rates are rising because of high investment demand (but not rising enough to offset the gain from the lower than expected inflation).

Right. Nominal bonds have a built-in guestimate of inflation over the life of the bond. TIPS will give you a better return than nominals when that market guestimate is low, and they'll give you a worse return when the inflation guestimate is too high. The current embedded inflation guestimate over the next 5 years is about 2.1%/year (4.75 nominal - 2.65 real).

The bottom-line for me is that TIPS remove the need to guess what inflation is going to do over the next 5- 10- or 20-years. I know I'll get 2.5% (or so) above whatever CPI-U prints.

Historically, nominal bonds have returned right around 2.5% above inflation, so you can lock in that average return by buying TIPS today. When (if) the TIPS real yield goes over 3% or so, then back up the truck and load her up!

 

[Patrick]

And if we're buying them to make money, well, there are many more investments that make more money with not much more volatility-- especially when the yield curve is as flat as it is today!

Nords, can you list what those investments are? Thanks.

 

[Gone4Good]

This makes perfect sense.

I'm trying to come up with the scenario where fixed rate bonds do well while TIPS get killed. Any takers?

Deflation. The principal balance of TIPS are adjusted upward and downward for changes in CPI.

 

[AlmostDone]

I don't know how to copy a quote from someone else, but I'm referring to Nord's statement above. It seems that it does not make much sense for us to have a 50/50 split of our portfolio, with bonds making so little. But I am concerned about volatility, as we are 60 and 57 years old. I am also interested in hearing what other investments you would recommend with not much more volatility than bond funds.

 

[Nords]

Nords, can you list what those investments are? Thanks.

I am also interested in hearing what other investments you would recommend with not much more volatility than bond funds.

Keep in mind that my idea of volatility involves at least two digits, and at the worst of the 2001-2003 period our portfolio was down 40%. This is probably too volatile for most people, and my govt pension could be considered the equivalent of Treasuries.

Our asset allocation has changed since then, but today we have:
30% Berkshire Hathaway
20% Powershares International Dividend ETF (PID)
15% S&P600 Small-cap Value ETF (IJS)
10% Tweedy, Browne Global Value (TBGVX), which is being replaced by PID
10% DOW Dividends ETF (DVY)
10% individual stocks
5% cash.

The least volatile component of that portfolio is the cash, a combination of a three-year CD at 6% and a money market (Fidelity Cash Reserves, FDRXX) at about 4.9%.

The next-least volatile funds are probably DVY & TBGVX. If the market got hammered tomorrow then we'd cash in the rest of the TBGVX for PID. (Lots of cap gains on shares that we've held for 10 years.) Then we'd consider selling some Berkshire (oooh, that hurts) and the individual stocks to buy more DVY & IJS. I think a portfolio of 50% DVY and 50% TBGVX (or PID) would have greater returns than the bond portfolio at within 10-15% of the volatility.

I'll make two more points:
1. Don't do anything that keeps you from sleeping at night. If bonds make you feel better, great! But don't complain that they're losing money when their main purpose is to reduce volatility.
2. Volatility doesn't matter if you don't have to sell the stocks. That's what the cash is designed to do-- ride out the volatile down markets and replenish the stash during the volatile up markets. Our cash will handle our expenses for two years, maybe three if we cut spending.

 

[wabmester]

Our cash will handle our expenses for two years, maybe three if we cut spending.

Does that mean you're only withdrawing 2.5% of your portfolio each year? Live it up a bit, Nords. Go buy that Prius you've been drooling over.

 

[Nords]

Does that mean you're only withdrawing 2.5% of your portfolio each year? Live it up a bit, Nords. Go buy that Prius you've been drooling over.

Yeah, I know. Becoming frugal is one thing, but realizing your cap gains is quite another.

Berkshire's been on a bit of a tear since we bought it...

 

[haha]

I am also interested in hearing what other investments you would recommend with not much more volatility than bond funds.

Pork bellies.

No, don't do it, just kidding.

Sp far this thread reads like something out of Mad Magazine.

Ha

 

[mathjak107]

The problem with tips is they follow not the cpi index but another index called the cpi-urban index. these indexes are easily manipulated and calculated by changing componenents and since this is the same index cola pension adjustments and social security is linked to you can be sure its massaged or will be to keep it as low as they can.

you may get an ocassional spike and get a nice return but im not so sure if it stuck around adjustments to the index wouldnt be in the cards to reduce it.

the penalty in interest you give up in economic climates like now for the inflation insurance is toooooo high too.

 

[brewer12345]

I don't know how to copy a quote from someone else, but I'm referring to Nord's statement above. It seems that it does not make much sense for us to have a 50/50 split of our portfolio, with bonds making so little. But I am concerned about volatility, as we are 60 and 57 years old. I am also interested in hearing what other investments you would recommend with not much more volatility than bond funds.

Bear in mind that Nords' views on this are a little, um, unorthodox and more than a little colored by his sizable gummint pension. For the rest of us, an all-equity portfolio is almost certainly a bad idea.

 

[Mysto]

It seems that it does not make much sense for us to have a 50/50 split of our portfolio, with bonds making so little. But I am concerned about volatility, as we are 60 and 57 years old.

Your allocation, as brewer and nords pointed out, is dependent on your risk tolerance. Try www.easyallocator.com and take a look at historical 1 year losses for different portfolios. You need to set your allocation so that you can sit and watch your portfolio lose money during a bad year without touching it. Where ever that is - that is the right allocation. I am in your age group and I have a 40/60 bond/stocks but that is based on my risk tolerance.

Another way to help determine this is to go to one of the major broker sites. Many have risk tolerance tests that will help you to better think about your best allocation.

BTW I am not suggestiong that you use the portfolio examples from these site or invest with them - just use the data to help you better understand your volatility risk tolerance.

 

[Mysto]

The problem with tips is they follow not the cpi index but another index called the cpi-urban index. these indexes are easily manipulated and calculated by changing componenents and since this is the same index cola pension adjustments and social security is linked to you can be sure its massaged or will be to keep it as low as they can.

All of that may be true mathjak but for us fund buyers the Vanguard TIPS fund has beat the Vanguard Bond Fund 7 out of the last 10 years and that is why (aside from the inflation protection) that it is part of my bond portfolio.

 

[Mr._johngalt]

Another way to help determine this is to go to one of the major broker sites. Many have risk tolerance tests that will help you to better think about your best allocation.

When I get my monthly statement (from my main broker) they always
show my chart indicating my risk tolerance is "high", even though
I am 100% bonds and have been for a decade. Of course, folks here
think some of my bonds are "risky". I probably just screwed up the test.


JG

 

[retire@40]

When I get my monthly statement (from my main broker) they always
show my chart indicating my risk tolerance is "high", even though
I am 100% bonds and have been for a decade...

That's because some bonds ARE high risk. Why would you think being 100% in bonds can't be high risk?