The dynamics of bond duration and rising rates

[Winemaker]

We drove past a KFC the other day. The marquee was advertising the “deal of the day”. 12 piece chicken dinner for $39.00. I remember when McDonalds used to advertise get change back from your buck.

We went out to lunch yesterday. Two salads and one, ONE, slice of cheese pizza with tip $27.

A few years back, one could go to The Outback and get Alice Springs chicken for $xx.99, consisting of a either 2 chicken breasts or one huge breast butterflied w/ bacon, cheese, broccoli, and a half rack of ribs and choice of 2 sides. Now for $xx.99, you get a chicken breast the size of a pigeon, and the half rack is an add on, as is a full rack.

While I do still own some bonds, a TIP fund, numerous preferreds, and a stable value fund, I just purchased some Altria. Off it's 5 year high, yielding 7.12%, it will be inflation protected. While it is a sin stock, even with a dividend cut, it would/does provide income if that is one's point of an fixed income portion of their portfolio.

 

[OldShooter]

We hold TIPS in our personal fixed income tranche. DW and I are on the investment committee for a small nonprofit and there have a fixed income tranche of maybe $3-4M (too lazy to look it up). We hold only individual bonds, BBB or better, and will hold them to maturity. Maybe 100 issues well diversified across US line-of-business sectors. So no angst about duration, etc. Neither of us would approve the advisor if he wanted to buy funds, particularly now.

 

[daylatedollarshort]

Neither of us would approve the advisor if he wanted to buy funds, particularly now.

What do you think of floating rate funds?

 

[daylatedollarshort]

I agree, and yet the main source of the stellar bond fund returns over the past decade has been price appreciation. I was just suggesting that the opportunity cost of avoiding bonds for the next few months is likely to be low.

+1. Rates are so low right now they'd have to go negative to see a lot more appreciation in the bond funds, and that seems unlikely.

 

[OldShooter]

What do you think of floating rate funds?

We held serious six figures in SAMBX from 2014 into 2019 and I think it was a good investment. The theory of them, sort of "senior junk bonds" was attractive. In late 2018/early 2019 both Janet Yellen and The Economist magazine voiced concern about increasing risk in that category and we moved on. Subsequently I think it hit a rocky patch but overall has not done badly . I see it is still on Schwab's select list.

No recommendation either way for anyone else.

 

[mrfeh]

What do you think of floating rate funds?

We held serious six figures in SAMBX from 2014 into 2019 and I think it was a good investment. The theory of them, sort of "senior junk bonds" was attractive. In late 2018/early 2019 both Janet Yellen and The Economist magazine voiced concern about increasing risk in that category and we moved on. Subsequently I think it hit a rocky patch but overall has not done badly . I see it is still on Schwab's select list.

No recommendation either way for anyone else.

We've also held SAMBX in the past, and hold some FFRHX now. This is a pretty small portion of our fixed income, though.

It's a nice alternative to total bond when interest rates are going up, but know that such funds take a dive if the economy does (they have a positive correlation to equities).

 

[Lsbcal]

Speaking of bond dynamics, some have said the current bond rates are the best prediction for the future rates. This chart shows what the current prediction the yield curve presents (green) and the latest BofA prediction (blue) of 7 rate hikes in 2022.

The yield curve predictions of recent months appear to have anticipated rising rates too early.

You can see the past yield curve predictions were not something to hang your hat on. The period of 2009 to 2016 saw a lot of anticipated sharp rises that did not happen.

 

[daylatedollarshort]

You can see the past yield curve predictions were not something to hang your hat on. The period of 2009 to 2016 saw a lot of anticipated sharp rises that did not happen.

Didn't inflation rates stay pretty low during that period, too? That isn't the case currently. We've had posts on this in other threads, but a contributor to inflation now, besides supply chain issues, is the increase in labor costs in part due to a reduced pool of workers caused by stock market rich early retirees and worker deaths / disabled long haulers due to Covid.

I don't have a crystal ball, but my best guess is that it will take some time to get the supply chain issues sorted out, and the labor shortage issues in the U.S. don't have a short term fix. In the U.S., it will probably take something big like a stock market plunge to bring retirees out from retirement or an increase in immigration levels to add more workers back into the labor force. Now there is a new Omicron variant 1.5 times more transmissible than the original omicron strain, too, so that means there is no quick end to the pandemic either.

 

[Lsbcal]

Yes inflation turned out to have stayed low in the 2009 to 2016 period. But that was not what some were predicting back then. There were economists who wanted to move to austerity like Germany did.

Now we have a different set of concerns but there are still those who are hawks and others who are doves. That green line says we will be at 2% in 2 years with a faster ascent this year. Hence the consensus is for 5 rate hikes of 0.25% this year.

 

[audreyh1]

Speaking of bond dynamics, some have said the current bond rates are the best prediction for the future rates. This chart shows what the current prediction the yield curve presents (green) and the latest BofA prediction (blue) of 7 rate hikes in 2022.

The yield curve predictions of recent months appear to have anticipated rising rates too early.

You can see the past yield curve predictions were not something to hang your hat on. The period of 2009 to 2016 saw a lot of anticipated sharp rises that did not happen.

I thought the current bond fund rates were the best prediction of future total returns, not of future rates.

 

[Lsbcal]

I thought the current bond fund rates were the best prediction of future total returns, not of future rates.

Maybe you have it right. But isn't the 1 year yield taking into account what might happen to the 2 year bond in 1 year? You buy the 2 year and roll it down the yield curve. If the curve stays static then you have a 1 year bond at a bargain rate. But clearly the 2 year must have some component of what the 1 year is thought to be at 1 year out.

I thought some part of these predictions came from looking at the current yield curve as the current bonds have to compete with what might happen to the yield curve in the future. But I really don't know how these predictions are arrived at.

One sees the Goldman predicts 5 rate rises, it was 4 rate rises before, and BofA is at 7 rate rises this year. Bonds are confusing.

 

[audreyh1]

Don't know about that part.

 

[daylatedollarshort]

Hence the consensus is for 5 rate hikes of 0.25% this year.

If that is true then what do you see as being the upside for being in most bond funds this year then? They can always be bought into again next year if it looks like inflation has cooled down and interest rate start coming down.

 

[Lsbcal]

If that is true then what do you see as being the upside for being in most bond funds this year then? They can always be bought into again next year if it looks like inflation has cooled down and interest rate start coming down.

I am not in bond funds at present. Some day I will be. See my previous post above.

 

[VanWinkle]

If that is true then what do you see as being the upside for being in most bond funds this year then? They can always be bought into again next year if it looks like inflation has cooled down and interest rate start coming down.

Timing the equity and bond markets is much harder than people think!!
Most that try to time the market are wrong and actually do worse than those that just stay invested.

VW

 

[OldShooter]

Timing the equity and bond markets is much harder than people think!! Most that try to time the market are wrong and actually do worse than those that just stay invested.

This.

My standard post on timing, always amusing reading: Taylor Larimore's market timing quotes https://www.bogleheads.org/wiki/Taylor_Larimore's_market_timing_quotes

 

[Lsbcal]

Give me a break. I am not advocating generalized timing just saying what I am doing. I assume we are all practicing adults here.

 

[daylatedollarshort]

Timing the equity and bond markets is much harder than people think!!
Most that try to time the market are wrong and actually do worse than those that just stay invested.

VW

But that wasn't my question. My question only involved bonds, and only the coming year. Because right now we know rates are coming off historic lows, there isn't that far they could drop. And the Fed has said they plan to raise rates. The opportunity cost of not being in long term bonds seems very low, while the potential for losses could be very high.

 

[Lsbcal]

But that wasn't my question. My question only involved bonds, and only the coming year. Because right now we know rates are coming off historic lows, there isn't that far they could drop. And the Fed has said they plan to raise rates. The opportunity cost of not being in long term bonds seems very low, while the potential for losses could be very high.

I agree.

Still we have to acknowledge that the bond market has priced some (or all?) of this in. The expected Fed tightening may not proceed as in the consensus guess. What if we have another variant that really clobbers the economy? What if we have a crisis in some other way that is seen to effect the economy (stocks down, bonds up)?

Currently my thought is to buy Tbills and maybe step back into intermediate (not long) term bonds or even short term bonds as the year progresses. If rates do not go up then maybe equities will do even better. Not much risk and I do have 50% in inflation protected bonds. Most of this is in tax protected accounts.

 

[VanWinkle]

But that wasn't my question. My question only involved bonds, and only the coming year. Because right now we know rates are coming off historic lows, there isn't that far they could drop. And the Fed has said they plan to raise rates. The opportunity cost of not being in long term bonds seems very low, while the potential for losses could be very high.

I thought you were asking about changing your bond allocation/duration based on the news of rising inflation and interest rates. What you do is your business, and what works in the real world is anyone's guess. I'm sorry if you feel I was off the original subject, but I read your post again and didn't change my mind.

Best to you,

VW

 

[daylatedollarshort]

I thought you were asking about changing your bond allocation/duration based on the news of rising inflation and interest rates

No, that isn't what I've been posting about. I'm not changing our allocation to fixed income, just long term bond funds.

"For fixed income these days I'm sticking mostly with floating rate, a TIPS ladder and stable value. We didn't have a lot in any longer term bonds but DH had some in a target fund plus we had a few other odds and ends in our 401K and I've been dumping those."

 

[Lsbcal]

No, that isn't what I've been posting about. I'm not changing our allocation to fixed income, just long term bond funds.

"For fixed income these days I'm sticking mostly with floating rate, a TIPS ladder and stable value. We didn't have a lot in any longer term bonds but DH had some in a target fund plus we had a few other odds and ends in our 401K and I've been dumping those."

So you are adjusting duration, right? Trying to reduce interest rate risk.

 

[daylatedollarshort]

So you are adjusting duration, right? Trying to reduce interest rate risk.

Not necessarily duration as we still have our ladders, just the funds with longer term bonds.