Bond fund questions

[timwalsh300]

I'm new to investing in bond funds. Tell me if I'm missing something here...

It is my understanding that a bond fund's NAV falls by 1% for every year of the fund's duration when interest rates rise by 1%.

For example, the yield on VFITX (intermediate-term Treasuries) is 2.2% and the duration is 5.1 years. So if rates go up by 1% it will take ~28 months to get back to even in that fund. Similarly VFISX (short-term Treasuries) has a yield of 0.74% and a duration of 2.1 years, so it would ~34 months to get back to even. VUSTX is even worse, requiring ~37 months.

But then there is VFIIX. The yield is 3% and the duration is 2 years. So even if the Fed raises rates by 1% over the next 12 months, VFIIX still returns 1%?

So is VFIIX a free lunch? Or is this just indicative of US Treasuries being tremendously overbought relative to everything else right now? Why? Aren't GNMA's just as safe?

Tim

 

[DblDoc]

I found the bond thing very confusing until I read this: Individual Bonds vs a Bond Fund - Bogleheads

DD

 

[LOL!]

Here's the deal on the GNMA fund: Bogleheads :: View topic - Vanguard GNMA

I own it.

 

[FIREd]

GNMAs are a special kind of bonds because they exhibit what's called "negative convexity" (see here: Bonds: Advanced Topics - Bogleheads). GNMA's prepayment risk means that they tend to have low durations when interest rates are low but that duration could rise when interest rates start going up.

 

[timwalsh300]

I see. I was missing the part about negative convexity, and forgetting that after a rate increase a fund can buy new bonds at higher yields.

So my assumption was correct - that VFIIX should still produce a positive return even if the Fed raised rates by 1% - but afterwards the yield on VFIIX would increase more slowly than the non-MBS funds?

And would I be correct in assuming that Treasury funds are subject to less call-risk (thus have higher convexity) than MBS or corporate bond funds?

Anyway, it sounds like my best option is just buying VBMFX (total bond market) and forgetting about it. All I'm trying to do is decide where to invest the portion of my portfolio, given my target asset allocation, that won't be in equities.

Tim

 

[audreyh1]

Also, just because short term rates rise, it doesn't mean mid-term and long-term rates rise - or rise as much. Sometimes short-term bond funds get hurt more than the longer durations.

If inflation goes up, then the longer term bond funds are usually hurt more. BUT if the Fed is raising short-term rates to stave off inflation sometimes that helps the longer term bond funds.

It's not that simple!

Personally, I think buying a well diversified bond fund and forgetting about it is a good move.

OR you can own a short term, very-high-quality bond fund like VBISX which might not be a great buy now (the short-term bonds are crowded at present and short-term rates artificially low), but over the long run is less correlated to equities than other durations and mixes and so good for rebalancing.

Audrey

 

[FinanceDude]

I believe the yield curve discussion is always interesting when you start talking about "the tail wagging the dog"..........

Hopfully, we don't see a movement to an inverted yield curve like a few years ago.........

 

[mathjak107]

normally treasuries which have no credit risk and no early repayment risk hold true to the formulas that predict if rates rise this amount the bond fund will fall this amount.

all other types of bond funds vary.. the more credit risk and the more they trade on fear greed and perception like stocks the more they vary from being effected by interest rates only.

 

[donheff]

Thanks for the Boglehead link. I too have had a problem understanding bond funds vs ladders. The Boglehead article does a good job of explaining why the effect as an investment is equivalent. But I still don't quite understand the ibest way to withdrawal from a fund. If you want to periodically pull money from a bond fund to cover expenses (or to replenish a cash bucket) is it important to time your withdrawals (i.e. wait until NAV is up) or if you are pulling a small amount of the fund is that equivalent to selling component bonds that have already matured in a ladder?

Or would it make more sense to pull $X and invest in zeros with a maturity matching the fund's maturity with the intent of rolling those zero's into the cash bucket? Whew - that last sounds like a PITA.

 

[brewer12345]

Thanks for the Boglehead link. I too have had a problem understanding bond funds vs ladders. The Boglehead article does a good job of explaining why the effect as an investment is equivalent. But I still don't quite understand the ibest way to withdrawal from a fund. If you want to periodically pull money from a bond fund to cover expenses (or to replenish a cash bucket) is it important to time your withdrawals (i.e. wait until NAV is up) or if you are pulling a small amount of the fund is that equivalent to selling component bonds that have already matured in a ladder?

Or would it make more sense to pull $X and invest in zeros with a maturity matching the fund's maturity with the intent of rolling those zero's into the cash bucket? Whew - that last sounds like a PITA.

Zeros would be a real pita.

I think you choose bond funds vs. individual bonds for different reasons. If you want cash flow certainty at a particular time (e.g. $50k a year for 5 years for living expenses), then buy a ladder of bonds/CDs. If you want the same economics but care more about flexibility and efficiency than cash flow certainty (e.g. this is part of my bond allocation in a long term portfolio), then buy a fund.

I think keeping maturities to intermediate term would be wise now. I like corporate credit over treasuries, but once rates rise I intend to buy back into the treasury market. Too rich now, especially with an economic recovery (and higher rates) clearly on the horizon.

 

[timwalsh300]

I think keeping maturities to intermediate term would be wise now. I like corporate credit over treasuries, but once rates rise I intend to buy back into the treasury market. Too rich now, especially with an economic recovery (and higher rates) clearly on the horizon.

I know you are the bond guru around here... What do you think of municipal bonds right now?

I currently have Vanguard's Intermediate-Term Tax-Exempt (VWITX) in taxable accounts and Total Bond Market (VBMFX) in IRA's.

Tim

 

[brewer12345]

Not sure I would call myself a guru.

I think munis are fairly priced, given the level of other rates. Certainly they are not the ridiculous bargains they were a year ago. The trick with munis is that what is often available is very long maturity. If we are in for a period of rising rates, stick to intermediate term paper or shorter.

 

[REWahoo]

brewer, my wife just inherited a small slug of NUV. Closed-end muni funds are completely foreign to me so I'm not sure if she should hang on to them or sell and invest in something we are more familiar with. Your thoughts?

 

[brewer12345]

brewer, my wife just inherited a small slug of NUV. Closed-end muni funds are completely foreign to me so I'm not sure if she should hang on to them or sell and invest in something we are more familiar with. Your thoughts?

This is actually a halfway decent CEF, since it is unleveraged and has (for CEFs) a reasonable .64% expense ratio. It is a pretty plain vanilla muni fund, basically. Not a lot of credit risk that I can see and Nuveen has a good reputation in munis.

There are three knocks against this fund, although none of them are earth-shattering:

- You could do a lot better than .64% ER at VG.
- It is currently selling at close to a 4% premium to NAV. Generally speaking, I like to buy CEFs at a fat discount and sell them at a premium. This is at a premium.
- The fund is kind of far out there on the maturity/duration scale. They have lots of 20+ year maturity paper and duration is a hefty 8 years. If the yield curve backs up in the far end, the fund would be hurting.

So its not a terrible fund, but I imagine you could do better. If there were no tax implications, I would consider liquidating. OTOH, if you want muni exposure and you would incur significant taxes by selling, I might be content to sit with it. But a lot depends on your objectives, overall goals/view of the world, and tax situation, so it is hard to give a specific suggestion as to buy, sell, or hold.

 

[yakers]

First let me say I take full responsibility for my financial decisions (including some mistakes like buying MGM Grand because I figured they had held up well in previous recessions) but based on Brewers advice I did buy some GIM last year and it is one of the bright spots in my portfolio. Not sure if I would buy it now but glad I did at the time and it still looks good if you intend to hold a long time and want a foreign bond asset in your portfolio.

 

[brewer12345]

Uhoh. Someone did something on my advice? Lucky it randomly turned out to be good...

Always do your own DD folks. Some yahoo on the interweb may spout something random off, but you have to live with the consequences.

 

[bosco]

Uhoh. Someone did something on my advice? Lucky it randomly turned out to be good...

Always do your own DD folks. Some yahoo on the interweb may spout something random off, but you have to live with the consequences.

Same story here--I bought some GIM after hearing about it from Brewer. I did do a fair bit of research before I pulled the trigger, however.

I dumped BEGBX for it, and it has definitely outperformed BEGBX.

 

[charlie]

Since Brew is paying attention on this thread, I would like to ask a question on municipals:

Since foreigners are not motivated to own them, would they tend to hold their value better in the event of run on the U.S. bank?

Cheers,

charlie

 

[brewer12345]

Run on the "US bank"? You mean the USD taking a beating?

 

[charlie]

Yes. Sorry about the attempt to be funny.

Cheers,

charlie

 

[brewer12345]

USD denominated bonds will follow the USD, whether treasuries, munis or corporates. And if teh feddle gummint has problems, its hard to imagine that the states will be that much better off.

 

[harley]

I'm looking at buying a muni bond fund (VWITX) as 1/3 of my bond holdings. The other 2/3 will be in non-taxable accounts. I need an income producer, but I'm trying to keep my tax bracket down for Roth conversion purposes. I'm not a bond guru by any stretch, and I keep reading that munis have had a big run up and that they are now expensive with low yields (partially due to the Buy America bond situation). My question is, if I'm going to put a certain dollar amount into munis (my allocated percentage of my assets), does is matter what the price is that much? If I buy in high and the price falls, doesn't the yield going up pretty much counter that from the POV of my cash flow? I suspect I'm missing something, but I'm not sure what.

 

[charlie]

If market interest rates go up, you will see about 1% drop in the NAV of your bond fund for every year of "duration". Your initial cash flow won't change at first, but as the lower yielding bonds are replaced with higher yielding bonds, your income will gradually rise until the extra income replaces the loss of NAV. For example, if the duration of your fund is 10 years, the initial NAV will drop 10% if interest rates rise 1% and it will take 10 years to recover the loss. The reverse is true if interest rates drop.

I hope I did not screw this up. Somebody please correct me if wrong.

Cheers,

charlie

 

[Alan]

If market interest rates go up, you will see about 1% drop in the NAV of your bond fund for every year of "duration". Your initial cash flow won't change at first, but as the lower yielding bonds are replaced with higher yielding bonds, your income will gradually rise until the extra income replaces the loss of NAV. For example, if the duration of your fund is 10 years, the initial NAV will drop 10% if interest rates rise 1% and it will take 10 years to recover the loss. The reverse is true if interest rates drop.

I hope I did not screw this up. Somebody please correct me if wrong.

Cheers,

charlie

Sounds right to me, and a quick look at VWITX has average duration at 5.5 years.

 

[audreyh1]

If market interest rates go up, you will see about 1% drop in the NAV of your bond fund for every year of "duration". Your initial cash flow won't change at first, but as the lower yielding bonds are replaced with higher yielding bonds, your income will gradually rise until the extra income replaces the loss of NAV. For example, if the duration of your fund is 10 years, the initial NAV will drop 10% if interest rates rise 1% and it will take 10 years to recover the loss. The reverse is true if interest rates drop.

I hope I did not screw this up. Somebody please correct me if wrong.

Cheers,

charlie

No, it's just not that simple - not all durations react the same way to Fed rate increases. Please see my reply #6 above:

http://www.early-retirement.org/forums/f28/bond-fund-questions-47566.html#post880616

You're formula may be a decent predictor for the reaction of different durations due to increasing inflation, but not due to Fed interest rate increases.

Audrey