Advice on Bond Index Funds

[poorgeezer]

I retired in 2005 and am currently living on savings. I am 58 years old and will begin drawing on my retirement IRA with Vanguard at age 59 1/2. My concern is about my lack of understanding on how the Total Bond Index funds actually work. The concern being that if we get into a rising rate environment it seems that the bond fund would shrivel up similar to the way things went in the early 80's. Is this a valid concern or am I missing something and if that is the case what should I do? My AA is about 50/50 in index funds and I have enough cash on hand to coast approx. five years.

Thanks for your thoughts on this.

PG

 

[LOL!]

How much did total bond index funds shrivel up in the early 80s? Do you actually know?

See also: Wiki article link: Bond Basics

 

[bld999]

Here's a chart you can set per year and see actual price changes[treasuries] back to 1977.

Treasury Bonds Year Historical Prices Charts - Historical Commodity Futures Charts'

Find similar for libor or your favorite interest rate and compare.

 

[LOL!]

That chart does not show total bond index funds, so it really does not apply here.

 

[pfleming]

Bond basis moves inverse to the interest rate. If you are concerned with loss of basis perhaps individual bonds held to maturity using bond ladders might be a better? I may be blurring the IRA/Taxable account line...

 

[bld999]

Did total bond index funds exist in 1980?

 

[walkinwood]

If you are worried about interest rate risk, choose a short or intermediate term bond index fund. However, if rates go up, price of bonds go down - you can't get away from that.

 

[LOL!]

@bld99, If they did, then they had a different duration than 30-year Treasury bonds. Several Vanguard funds were around in the early 1980s. The Vanguard GNMA fund (VFIIX) was around and might be a decent proxy for other bond funds of that time. Hint: It did not shrivel up. See also VWESX.

1986 is when Total Bond Index was started.

 

[bld999]

@bld99, If they did, then they had a different duration than 30-year Treasury bonds. Several Vanguard funds were around in the early 1980s. The Vanguard GNMA fund (VFIIX) was around and might be a decent proxy for other bond funds of that time. Hint: It did not shrivel up. See also VWESX.

1986 is when Total Bond Index was started.

I see; I looked around and read someplace that average duration for total bond funds ~3.7 years, 30year treasuries ~ 16, so my chart is bunk as you say. I was looking for a proxy, maybe VFIIX works well enough.


Also: poorgeezer, there is a discussion of bonds going on right now at:
http://www.early-retirement.org/forums/f28/any-good-ideas-for-bond-funds-60670.html

 

[Gone4Good]

Here is a rough estimate of what a bond fund with a duration and average maturity similar to the Total Bond Market Index would have returned:

 

[poorgeezer]

Here is a rough estimate of what a bond fund with a duration and average maturity similar to the Total Bond Market Index would have returned:

This is helpful, for me, to see the yield/price fluctuations side by side.

If this is in fact the case then I am somewhat relieved.

Thanks, PG

 

[clifp]

This is helpful, for me, to see the yield/price fluctuations side by side.

If this is in fact the case then I am somewhat relieved.

Thanks, PG

Remember these are nominal returns pre tax. You really want to look at real after tax returns. Top Marginal tax rates back in the late 70s and early 80s (Pre Reagan Tax cut) were 70% and 50% was pretty common. If we assume a 50% marginal tax rate.

The real returns for the total bond market fund holder.

Year	Portfolio Yield	After Tax	Price Change	Inflation	Real Return
1978	7.23%	3.61%	-5.38%	7.62%	-9.4%
1979	7.64%	3.82%	-5.55%	11.22%	-12.95%
1980	8.3%	4.15%	-10.04%	13.58%	-19.47%
1981	9.2%	4.6%	-13.88%	10.35%	-19.63%

This means that the end of 1981 the purchasing power $10,000 investment with interest reinvested would be worth ~$5,160 every bit as painful as the 2008/9 crisis for equity investors.

Needless to say trying to withdraw 3% or 4% adjusted for inflation from bond heavy portfolio would make a 30 year retirement virtually impossible.

During this time 1978 to 1981 10 year T-bill went from 8% to 15%. I am not sure if the impact of rise of T-bill from 2% to 9% would be more or less devastating (although taxes hopefully would be lower) . My guess is more.

 

[Gone4Good]

During this time 1978 to 1981 10 year T-bill went from 8% to 15%. I am not sure if the impact of rise of T-bill from 2% to 9% would be more or less devastating (although taxes hopefully would be lower) . My guess is more.

The biggest difference today is that the starting portfolio is only earning 2%, versus 7% in 1970. That extra 500bp of yield is an extra 500bp of cushion to help absorb the volatility in principal. To get a sense of how a similar change in interest rates would impact today's Total Bond Index fund, subtract 500bp from each year of the total return column.

Also, lower coupon bonds have higher duration - so today's TBMF is more sensitive to interest rates than the same fund would have been in the 80's. For example, a 10yr bond yielding 8% has a duration of 7 whereas a 2% bond has a duration of 9. Although the calculation above assume a constant duration similar to the one of today's fund.

 

[audreyh1]

Remember these are nominal returns pre tax. You really want to look at real after tax returns. Top Marginal tax rates back in the late 70s and early 80s (Pre Reagan Tax cut) were 70% and 50% was pretty common. If we assume a 50% marginal tax rate.

If someone's portfolio is in a tax-deferred account, then the tax hit is not going to be there until money is withdrawn. I don't know if such accounts beyond pensions and annuities were available back then, but the point is moot since things have changed so much.

Great info though - thanks!

Audrey

 

[pb4uski]

When you say your AA is about 50/50 I presume that you mean 50 fixed and 50 equity?

You are right that when interest rates increase then the fair value of the bond fund will decline, but the nominal income the bond fund generates will take a long time to change dramatically as proceeds from maturing bonds will be reinvested in new bonds that have higher yields. The fund's historical trading range has been $9-11/share and it is currently towards the upper end of that range.

My thinking is that if interest rates increase it will likely be because the economy is doing better, so any loss in value of my Total Bond holdings are likely to be offset by increases in value of my equity holdings. That's the whole reason behind holding both fixed income and equities. As we saw in 2008, it doesn't always work that way.

I think it is important to look at the whole portfolio rather than just the fixed side.

YMMV

 

[nun]

Rising interest rates will probably indicate an improving economy, unless the US is about to default. If interest rates go up bond prices will fall, but yields will go up and your equity assets will probably be doing well (ingoring the default possibility). You are spreading your risk by owning the Total Bond Index so think of it in just the same way you think of a Total Stock Market Index. If you are doing this passive style it's all about AA and rebalancing, so don't try to guess what interest rates are going to do. You'll be tempted to do exactly that every time the Fed makes a statement, but unless you want to look at yield curves, slice and dice your fixed income and time the market just stay 50/50 with a bond index and maybe some cash and short term bonds to ride out down turns. Take income from winners and rebalance.......you won't maximize your returns, but you'll be well placed to do OK in most scenarios.

 

[Bdroc]

I suggest short term corporate instead of total bond market. Lower yields but less risk if rates increase.

 

[nun]

The OP is in index funds and has 5 years in cash. I'd first decide on an AA and general philosophy. If they are a passive investor I'd dollar cost average over a few years into Total Bond Index and maybe a more "sectorly" and or duration biased index as a nod to your active inclinations and to massage your ego that you can read the indicators. Once the AA is achieved take out gains and rebalance.