Bond fund bubble approaching?

[sailfish]

Almost everyday there is another article in the media (newspaper,internet, etc) about a bond and bond fund bubble happening. I have about 1/2 of our retirement assets in bond funds of all different types. Treasuries,corporate, TIPS, Hi yield , Ginnie Mae etc.
If rates do go up and the value of the funds decrease, how low can these funds really go?
We are both 64 and retired recently , and hope to use the interest for our income. Most of the funds are short to intermediate term except the Ginnie Mae and Hi Yield (both Vanguard).
Bottom line is, that all this talk is scaring me into selling most of it and holding cash. I don't want to be a market timer . How are you bond holders out there assesing what's going on?
Thanks, Joe

 

[ziggy29]

While I think interest rates and inflation are likely to put pressure on the NAV of bond funds in the next few years, I don't think it's going to be a grotesque popping of a bubble. For one thing that would probably require more economic growth than I expect to see; second of all, in the absence of a really strong economy and in the presence of a lot of fear I think a lot of yield-starved people would start moving in as the yields increased, say, 1-2%.

The key, if one is concerned about interest rate risk in bond funds, is keep maturities short -- say, to a maximum average maturity as 5 years or so. A 5-year bond won't lose nearly as much in a rising interest rate environment as a 20- or 30-year bond.

 

[Alan]

Almost everyday there is another article in the media (newspaper,internet, etc) about a bond and bond fund bubble happening. I have about 1/2 of our retirement assets in bond funds of all different types. Treasuries,corporate, TIPS, Hi yield , Ginnie Mae etc.
If rates do go up and the value of the funds decrease, how low can these funds really go?
We are both 64 and retired recently , and hope to use the interest for our income. Most of the funds are short to intermediate term except the Ginnie Mae and Hi Yield (both Vanguard).
Bottom line is, that all this talk is scaring me into selling most of it and holding cash. I don't want to be a market timer . How are you bond holders out there assesing what's going on?
Thanks, Joe

I am in a similar position with 50% in bonds and like you don't intend to sell any for income but take out the interest. For bond funds the NAV will go down for a while but then come back up as the older bonds in the fund mature and are replaced by newer, higher interest bonds.

I figure that since I don't need to sell bond funds or individual bonds before maturity for regular income then I don't need worry.

 

[Gone4Good]

If rates do go up and the value of the funds decrease, how low can these funds really go?

Pretty low, depending on how extreme an interest rate spike you think is reasonable. But there is a quick and dirty way you can calculate this for your self. Look at each fund's "duration". Duration is a measure of interest rate sensitivity. And for each "year" of duration, the fund will increase or decrease about 1% for every 100bp (1 percentage point) of interest rate moves. So if you have a fund with a duration of 5, and interest rates increase by 1 percentage point, you should expect your fund to decline about 5%. With big interest rate moves, and with long duration funds, you can have some pretty big NAV swings.

As with equity funds, I'd pick a reasonable mix of bond funds and just leave it. Nobody is any better at picking the direction of interest rates than they are at picking the direction of stock market moves. A mix of cash, short-term, and medium term normal bonds and TIPS will be about the best you can do, IMHO.

 

[sailfish]

Thanks for the quick response, I feel a little better now. Many people seem to be in similar positions with the low CD's out there.

 

[Gone4Good]

The other thing that can make a lot of sense now are 5-yr CDs. Pick ones with low break fees. That way if interest rates shoot up, you can reset your CD interest rate at a nominal cost. If rates stay flat, or decline, you benefit from a "good" coupon.

 

[freebird5825]

57% bonds (all via mutual funds, well diversified stableful of types and durations)

Most of what I've read is that the "bond bubble" already happened when investors [-]panicked[/-] scrambled to safety in 4Q08 and 1Q09. Not sure what is going on currently.
Any newer article links would be appreciated.

 

[roger r]

I am less heavily invested in bond funds, thanks to my 401K stable value fund where I've parked much of my fixed income investment. I don't see anything that concerns me in the next several months, but I may take a look at intermediate or longer term funds with a realtively high percent of treasuries (ie basic index funds) as we get near the end of the year. I've been terrible about predicting interest rates over the years, but at least this time I don't think they are going to go down. So half the guess work is eliminated.

 

[IndependentlyPoor]

Most of what I've read is that the "bond bubble" already happened when investors [-]panicked[/-] scrambled to safety in 4Q08 and 1Q09. Not sure what is going on currently.

The flight to quality was mainly for Treasuries. Look at the difference between Vanguard's Intermediate Treasury Fund (VFITX) and their Intermediate Investment Grade Fund (VFICX) during the recent unpleasantness.

The point about duration is important. For example, the Total Bond Market Fund's SEC yield is currently 3.16% and its duration is 4.5 years. If rates go up a percent, the NAV will go down about 4.5% (at least that is my understanding).
If the market believes that the Fed will be successful in preventing inflation, then long and medium term yields might not go up much. If the market loses faith in the Fed, then we could see much higher rates, and painful drops in NAV.
Me... I'm holding steady at about 45/45/10.

 

[Stevewc]

Sailfish/Joe,
One thing that came to my mind was: How long ago did you buy your bond funds and what is your average price per share. If you have bought over many years and your average price is reasonable, you may not see much of a drop at all.
Price does matter !!!
I hope to buy in as prices drop so I'm kind of on the other side of things.
When someone is selling there is usually someone hoping to buy at a fair price on the other side.
Just some thoughts to give possible balance,
Steve

 

[audreyh1]

But people flocking to short durations may regret it! Be very careful. The short end is VERY crowded (which is why yields are so low there).

In the 2004-2006 interest rate hikes, the short-term bonds got hit the worst. Here are two pictures of the yield curve during that time.

The yield curve in December of 2003, before the Fed started raising rates in June 2004:

The yield curve in March of 2007, after the Fed had finished raising rates in June 2006 (by June of 2006, the curve was essentially flat, and by end of 2006 it had inverted):

Note that the short term 0-5 years by far took the greatest hit. Not only that, but by the end of the period the ultra-short rates where higher than the long rates! Also, note that the 20 and 30 year rates actually dropped about 1% over that period!

You can play view the curve over the time period here. Click on the S&P chart to see the yield curve at each date: Dynamic Yield Curve - Charting Tools - StockCharts.com

So, the moral of the story is: Don't ignore the yield curve and how it changes over time. It is not a straight line and it changes shape!

I remember people flocking to super short durations in 2003. It looks like we're setting ourselves up for a repeat.

But another thing is worth note. Most of the bond funds took their hit early in 2004 - short-term much harder than long term. (Actually, there were also some temporary hits mid-2003 in anticipation of rates going up). But they all recovered well by 2005, and went on to appreciate nicely (with reinvested dividends). So if you are holding bond funds for the next several years, this should be a non-issue!

But if you are hiding in bond funds and trying to time things, this may be a problem.

Audrey

 

[freebird5825]

TY for that yield curve link. I actually followed what it was demonstrating. I have seen it before, and knew what it represented, but never in conjunction with historical chart of the S&P 500.

I just took an even closer look at the average durations of my 57% bond allocation (all in mutual funds) using M* portfolio tracker tools.

42% duration > 7 years but < 10 years
13% duration > 4 years but < 7 years
2% duration < 4 years

I am increasing the < 4 year duration percentage, but very slowly (DCA).

Comments are welcome.

 

[audreyh1]

TY for that yield curve link. I actually followed what it was demonstrating. I have seen it before, and knew what it represented, but never in conjunction with historical chart of the S&P 500.

I think one of the posters over at the Morningstar Forum created that Dynamic Yield Curve and made it generally available at StockCharts.com. So kudos to them!

Audrey

 

[MasterBlaster]

Fun with interest rates

here's a nifty little calculator that shows how bonds (and bond funds) change price as interest rates change.

put in the maturity date of your bond and then slide the interest rate botton to see how price is effected.

Bond Calculator at SmartMoney.com

As others have noticed short and medium term bonds don't change price so much with interest rates as do long bonds.

 

[Gone4Good]

In the 2004-2006 interest rate hikes, the short-term bonds got hit the worst. Here are two pictures of the yield curve during that time.

With the yield curve at an all-time steep, it is a pretty good bet we'll see something similar this time . . . unless the Fed lets inflation get away from it.

 

[Free To Canoe]

But people flocking to short durations may regret it! Be very careful. The short end is VERY crowded (which is why yields are so low there).

In the 2004-2006 interest rate hikes, the short-term bonds got hit the worst. Here are two pictures of the yield curve during that time.

The yield curve in December of 2003, before the Fed started raising rates in June 2004:

The yield curve in March of 2007, after the Fed had finished raising rates in June 2006 (by June of 2006, the curve was essentially flat, and by end of 2006 it had inverted):

Note that the short term 0-5 years by far took the greatest hit. Not only that, but by the end of the period the ultra-short rates where higher than the long rates! Also, note that the 10 and 30 year rates actually dropped about 1% over that period!

You can play view the curve over the time period here. Click on the S&P chart to see the yield curve at each date: Dynamic Yield Curve - Charting Tools - StockCharts.com

So, the moral of the story is: Don't ignore the yield curve and how it changes over time. It is not a straight line and it changes shape!

I remember people flocking to super short durations in 2003. It looks like we're setting ourselves up for a repeat.

But another thing is worth note. Most of the bond funds took their hit early in 2004 - short-term much harder than long term. (Actually, there were also some temporary hits mid-2003 in anticipation of rates going up). But they all recovered well by 2005, and went on to appreciate nicely (with reinvested dividends). So if you are holding bond funds for the next several years, this should be a non-issue!

But if you are hiding in bond funds and trying to time things, this may be a problem.

Audrey

I heard some talk about the medium and long term bonds doing better with interest rate rise. This seemed counter intuitive to me. Your explanation of the actual sequence of events from 2003 - 2007 is helpful in this regard.

Thanks,
Free to canoe

 

[FIREd]

With the yield curve at an all-time steep, it is a pretty good bet we'll see something similar this time . . . unless the Fed lets inflation get away from it.

I agree. That's why I prefer to lower my fixed income portfolio's average duration using cash instead of short term bonds at the moment. As Audrey noted, the short end of the curve is very crowded because people have been using short term bonds as a place to park their "safe money" (since cash itself pays so little at the moment). People could pull their cash out very quickly if short term bonds get hit which could put further downward pressure on the short end of the curve.

 

[audreyh1]

As others have noticed short and medium term bonds don't change price so much with interest rates as do long bonds.

The Dynamic Yield Curve I posted showed just the opposite during the last cycle - Fed rate rises affected the short end way worse than the long. The straight duration model is far too simplistic and can lead people to the wrong conclusions. You can't assume interest rates will change the same % at each duration.

Audrey

 

[audreyh1]

I heard some talk about the medium and long term bonds doing better with interest rate rise. This seemed counter intuitive to me. Your explanation of the actual sequence of events from 2003 - 2007 is helpful in this regard.

Thanks,
Free to canoe

I think this has to do with market expectations of inflation. If the market thinks the Fed is keeping interest rates low for too long and worries about runaway inflation, then long bond rates start to rise in anticipation of future inflation.

However, when the Fed finally starts raising rates, the market may decide that hey - the Fed is finally taking steps to fight long term inflation, and long-term rates may actually come down some. That is what happened last time.

It's somewhat logical when you think about it!

But a lot of it has to do with how effective the bond markets think the Fed is and whether they are "doing the right thing".

Audrey

 

[ziggy29]

The Dynamic Yield Curve I posted showed just the opposite during the last cycle - Fed rate rises affected the short end way worse than the long. The straight duration model is far too simplistic and can lead people to the wrong conclusions. You can't assume interest rates will change the same % at each duration.

This is true, but just the same a 20-year bond will still lose a lot more with a 1% interest rate hike than a 1-year bond will lose with a 3% rate hike if the yield curve flattens.

 

[audreyh1]

This is true, but just the same a 20-year bond will still lose a lot more with a 1% interest rate hike than a 1-year bond will lose with a 3% rate hike if the yield curve flattens.

Yes, but if the the long-bond interest rates actually DROP, while then short-term interest rates climb (which is what happened last time), then the 20-year bond doesn't lose, but rather gains.

You just have to be really careful assuming stuff.

Audrey

 

[brewer12345]

Its hard to find great deals in the bond market. Treasuries look rich to me. Agency MBS (Fannies, Freddies, Ginnies) looks fairly priced at best. Investment grade corporates look fairly valued, while junk is at least fairly valued. Despite the obvious issues munis have, they seem to be bid up as well. Foreign bonds even look pretty fully priced (Greek bonds, anyone? Only yielding 6 or 7% for 10 years). So there is no obvious place to go for juice to one's portfolio.

Having said that, bonds are still worth holding. They balance things out, smooth things out and reduce volatility. All good stuff. I have been rejiggering my bond portfolio now that thebond market is fairly priced (as opposed to the huge distortions of a year ago). I have sold off all but two of my individual corporate bond positions, all of which were bought at distressed prices in the debacle. The last two I still hold are a packet of very illiquid 5 year bonds from a "crossover" name (one junk rating, one investment grade), and a slug of 4 year junk with a big coupon that I think is money good and will be called within 2 years. I have been buying more conservative stuff (intermediate bond funds) and dabbling in some FI CEFs trading at large discounts to NAV. Back to bonds being defensive in nature, in other words.

 

[IndependentlyPoor]

I don't mean to disagree with anything said so far, but another possibility is that we get stuck in a "liquidity trap" like Japan did. Their interest rate has been essentially zero for at least a decade, maybe longer. Long bonds would look mighty good in that scenario.

There is some reason to believe that this could happen. Our bank bailout resembled what Japan did during their crisis.

However, it does look like we are coming out of the recession, so maybe we dodged that bullet.

 

[Gone4Good]

I don't mean to disagree with anything said so far, but another possibility is that we get stuck in a "liquidity trap" like Japan did. Their interest rate has been essentially zero for at least a decade, maybe longer. Long bonds would look mighty good in that scenario.

There is some reason to believe that this could happen. Our bank bailout resembled what Japan did during their crisis.

However, it does look like we are coming out of the recession, so maybe we dodged that bullet.

Yup. So short bonds would be better than long bonds if a $2 Trillion Fed balance sheet and 0% funds rate sparks inflation. Long bonds "might" be better than short bonds if the Fed gets aggressive and inflation expectations collapse. But long bonds would definitely be better than most other asset classes if we get stuck in a deflationary deleveraging cycle.

Unless you have a strong view on one of these, or any of number of other possible scenarios, its best to stick with a diversified portfolio of bonds and stop worrying so much about things.

 

[FIREd]

Here is Vanguard's take on the possible dangers lurking on the short end of the yield curve:

https://personal.vanguard.com/us/insights/article/bear-flattening-bond-surprise-04012010