Bond Funds and Interest Rate Question

[CaseInPoint]

I'm considering buying a decent amount (at least in my terms) of Vanguard's California Intermediate-Term Muni fund - VCADX - for tax purposes, and to stick with my AA, which is crying out for more bonds. (I am a resident of CA).

With interest rates so low and an economic recovery likely in the next year or two, it's a safe bet that interest rates (and inflation) will rise in the not-too-distant future. That means that bond prices will decline. True, the total yield will remain the same but, still, in a fund like this, the price is likely to drop, no?

The same considerations must hold true for anyone considering bond funds these day. Or so I think...

Setting aside the issues of California in particular, do you think it's a good idea to invest in bond funds these days, considering the likelihood that interest rates will rise?

 

[haha]

I'm considering buying a decent amount (at least in my terms) of Vanguard's California Intermediate-Term Muni fund - VCADX - for tax purposes, and to stick with my AA, which is crying out for more bonds. (I am a resident of CA).

With interest rates so low and an economic recovery likely in the next year or two, it's a safe bet that interest rates (and inflation) will rise in the not-too-distant future. That means that bond prices will decline. True, the total yield will remain the same but, still, in a fund like this, the price is likely to drop, no?

The same considerations must hold true for anyone considering bond funds these day. Or so I think...

Setting aside the issues of California in particular, do you think it's a good idea to invest in bond funds these days, considering the likelihood that interest rates will rise?

Didn't you just answer this?

 

[CaseInPoint]

Didn't you just answer this?

Well, I may have, but it doesn't mean it's the correct answer...

 

[walkinwood]

A 1% change in interest rate will have an inverse effect approximately equal to the "duration" of the bond.

Bond duration - Wikipedia, the free encyclopedia

I think this applies to bond funds too.

 

[CaseInPoint]

A 1% change in interest rate will have an inverse effect approximately equal to the "duration" of the bond.

Bond duration - Wikipedia, the free encyclopedia

I think this applies to bond funds too.

Right. So, why would anyone stick to their AA and continue to add bond funds under the circumstances?

 

[DblDoc]

Right. So, why would anyone stick to their AA and continue to add bond funds under the circumstances?

Because timing the bond market is probably harder then timing the stock market. Here is a recent article published at Vanguard regarding bonds and anticipated rising rates: https://personal.vanguard.com/us/insights/article/bear-flattening-bond-surprise-04012010

"Judging whether or not one specific segment of the bond market will outperform another segment over a certain time period is difficult because it involves being able to forecast the direction, magnitude, and timing of interest rate changes," he said. "That's why it's important to remain well diversified."

I continue to buy short and intermediate term treasuries as well as TIPs' per my AA. If the market continues to fall your (and my) need to balance into bonds may disappear .

DD

 

[CaseInPoint]

Because timing the bond market is probably harder then timing the stock market. Here is a recent article published at Vanguard regarding bonds and anticipated rising rates: https://personal.vanguard.com/us/insights/article/bear-flattening-bond-surprise-04012010

I continue to buy short and intermediate term treasuries as well as TIPs' per my AA. If the market continues to fall your (and my) need to balance into bonds may disappear .

DD

DD, I can understand your strategy, and of course the old adage about not timing the market.

In this case, though, I think that it's safe to time the market in the sense that sometime in the next year or so, it's a pretty safe bet that interest rates will rise. So, while I wouldn't try to time the market to find the ultimate low point of interest rates, knowing that we're at a historically low point makes sense.

As for bond funds, there is an opinion I received in the Boglehead forum, that the likely rise in interest rates is already built into the current price. Who knows...

I guess that looking at capital preservation bonds like treasuries and TIPs makes pretty good sense, but if someone is looking for a little more growth (as I am) the question is a little more complicated. But of course in the end, simple capital preservation is better than losing value in a bond fund.

BTW - would you recommend buying the treasuries and TIPS from Treasury Direct or through a broker?

 

[IndependentlyPoor]

DD, I can understand your strategy, and of course the old adage about not timing the market.

In this case, though, I think that it's safe to time the market in the sense that sometime in the next year or so, it's a pretty safe bet that interest rates will rise. So, while I wouldn't try to time the market to find the ultimate low point of interest rates, knowing that we're at a historically low point makes sense.

I tend to agree that rates are likely to go up next year. But there is always the possibility that we retrace Japan's footsteps and see near zero interest rates for a decade.

 

[wolf]

OP:

I think you answered your own question.

I do agree interest rates are so low.

My plan, which I am doing, is to buy Vanguard GNMA's. Current yield 3.35%

I know when rates rise, my NAV will fall. My plan is when the fed's start to talk about raising rates, which they will do in 1/4 increments, I will immediately sell all of my Vanguard GNMA's.

With the crisis in Greece, and our high unemployment, and no inflation yet, I can't see the Fed's raising interest rates. yet........

again, just my 2 cents...

 

[brewer12345]

I would think that CA credit risk would be the bigger issue than interest rate risk in that fund.

 

[walkinwood]

You may find this discussion on bogle boards interesting. The paper linked to in the first post talks discusses your original question.
Bogleheads :: View topic - Interesting Vanguard Research on Bonds

 

[Livin Large in MT]

I would also be more inclined to keep my bond percentage in my portfolio appropriate to your risk tolerance and age rather than fussing over whether rates are headed up or down (though I agree with the posters here, rates will head up, but when: the europe events are suggesting that more deflation is coming at least in the short term).
The bonds themselves should be purchased based on if they are in a taxable account (so munis make sense there) and a certain percentage of TIP's is a good idea for any portfolio too.
Morningstar recently did a nice series of articles on TIPS...just google TIPs allocations in M.Star and the articles should come up.
The idea behind buying a bond fund is the fund buys funds based on their own projections of what is going on in the bond market. So PIMCO for my money seems to have good results. But Vanguard has excellent bond funds too.

 

[CaseInPoint]

You may find this discussion on bogle boards interesting. The paper linked to in the first post talks discusses your original question.
Bogleheads :: View topic - Interesting Vanguard Research on Bonds

Thanks for the link. It's right on target.

The VG analysis is complex in some ways, but the bottom line is that the expectation of rising interest rates is already built into the current NAV.

I would also be more inclined to keep my bond percentage in my portfolio appropriate to your risk tolerance and age rather than fussing over whether rates are headed up or down (though I agree with the posters here, rates will head up, but when: the europe events are suggesting that more deflation is coming at least in the short term).
The bonds themselves should be purchased based on if they are in a taxable account (so munis make sense there) and a certain percentage of TIP's is a good idea for any portfolio too.
Morningstar recently did a nice series of articles on TIPS...just google TIPs allocations in M.Star and the articles should come up.
The idea behind buying a bond fund is the fund buys funds based on their own projections of what is going on in the bond market. So PIMCO for my money seems to have good results. But Vanguard has excellent bond funds too.

Makes sense. Investing according to one's AA regardless of market conditions is a common strategy. Don't try to time the market. For most people, that's great advice, because their number-one challenge is just to keep on saving and investing rather than spend their money.

I wonder how strictly this advice should be followed, though, by someone who is an experienced investor seeing an asset class (in this case bonds) likely to drop in value.

You're correct that TIPs should be part of most portfolios. Curiosity - would you recommend buying them through a broker or through Treasury Direct?

 

[Gearhead Jim]

Someone recently posted to the effect that:

"People who need bonds, are sold bond funds instead."
The point being, I believe, that a fund never matures and is always subject to losing NAV.

Understanding the difficulties and dangers in buying individual bonds, at least you can build a ladder that should avoid the need to sell when values are significantly down. Even if you must sell a bond that matures next year, the NAV hit should be fairly small.

But I'd like to hear different opinions.

 

[MasterBlaster]

Someone recently posted to the effect that:

"People who need bonds, are sold bond funds instead."
The point being, I believe, that a fund never matures and is always subject to losing NAV.

Understanding the difficulties and dangers in buying individual bonds, at least you can build a ladder that should avoid the need to sell when values are significantly down. Even if you must sell a bond that matures next year, the NAV hit should be fairly small.

But I'd like to hear different opinions.

It's true, in a rising interest rate environment, you can indeed hold a bond until maturity and never lose any principal. However what you give up (ie forgo) is the better rate on newer issued bonds by giving up interest. In a perfect world the foregone interest would exactly equal the unlost principle value. In effect you do give up something.

Either way, as I see it, If you are holding bonds (or bond funds) in a rising interest rate environment - You lose. Bond ladders won't really help you if you look at your bond portfolio in a holistic manner.

 

[DblDoc]

The Boglehead Wiki has an excellent section addressing this issue Individual Bonds vs a Bond Fund - Bogleheads. There is a thread that is linked about "controversies" which is an enlightening read.

If what you are interested in is bonds for your retirement portfolio (ie no set date on which you need them) there is no advantage to using a ladder as MB pointed out above and there are certain advantages to using a fund as summarized here: Bonds vs. Bond Funds? An Easy Choice! - CBS MoneyWatch.com

DD

 

[audreyh1]

Makes sense. Investing according to one's AA regardless of market conditions is a common strategy. Don't try to time the market. For most people, that's great advice, because their number-one challenge is just to keep on saving and investing rather than spend their money.

I wonder how strictly this advice should be followed, though, by someone who is an experienced investor seeing an asset class (in this case bonds) likely to drop in value.

I've watched a lot of "experienced investors" try to outsmart the market by getting out of an asset class that was "sure to go down soon".

They are usually way too early - by a year or two! It's just too easy to be wrong. And, IMO, early by a year or two is wrong.

I've often been ahead just using the strict rebalance technique - with no attempt to do "dynamic AA" - i.e. changing my AA based on what I think a given asset class will do. I think you can get really burned that way.

IMO, in investing it's best not to try to be clever but rather keep it simple and stick to your plan.

Audrey

 

[audreyh1]

I have never believed that the (regular retail) individual investor gains a thing by owning bonds directly instead of bond funds. They are much more expensive to trade and you have much larger single issue risk than with a diversified bond fund.

The "don't lose value" part of owning bonds directly is an illusion. You are just kidding yourself IMO. Your individual bond is traded on the secondary market, it DOES have a NAV, and if you don't look at it as part of your net worth, you are just ignoring reality.

Audrey

 

[brewer12345]

I largely agree with Audrey's second post. I trade retail lots of bonds occasionsally and I can tell you that the costs are real. I pay multiples of equity commissions in direct fees when I trade bonds, and the bid-ask spread can often be 3% or even more (vs. A fraction of a percent for most equities).

 

[Gone4Good]

I have never believed that the (regular retail) individual investor gains a thing by owning bonds directly instead of bond funds.

The exception, in my view, are government securities (especially TIPS) that can be bought at auction along side institutional investors and usually come at a slight discount to market. Individual TIPS make a lot more sense to me than a TIPS fund.

But other bonds I generally wouldn't buy individually for the reasons you cite, unless I was speculating on a turn-around story.

 

[IndependentlyPoor]

When my father died twenty years ago, I stated managing my mother's small retirement portfolio. I bought individual bonds because I hated the idea of a fund manager constantly trading bonds. Why add a casino aspect to the fixed income portion of your portfolio?

I managed to make that strategy work, but the experience convinced me that bond index funds are the way to go.

Here is why.

1. Enron. I never owned any Enron bonds, but only through sheer luck. They were exactly the kind of bonds that I was buying: AAA bonds of a well-known company.
2. Broker troubles. Everything from botched trades (long story, but the brokerage refused to make it right ) to constantly fending off whatever the brokerage was pushing that day. Bad experiences with two big, name-brand firms.
3. I hated reading prospectuses (prospecti?) for individual offerings.

At one point or another, we held bonds from GMAC, Ford, Chrysler, Citi, BofA, Fannie, Freddie, and Texaco. Only luck got us out without a scalping.

Since then I have read that when following our broker's advice, we did get taken in. Apparently, GMAC SmartNotes were specifically designed to market risky bonds at low-risk interest rates to naive investors like me. (Once again, the luck of the draw got us out of those turkeys before the blow-up).

And Audrey is right (as usual) about the NAV value of bonds fluctuating.

 

[audreyh1]

The exception, in my view, are government securities (especially TIPS) that can be bought at auction along side institutional investors and usually come at a slight discount to market. Individual TIPS make a lot more sense to me than a TIPS fund.

But other bonds I generally wouldn't buy individually for the reasons you cite, unless I was speculating on a turn-around story.

Yes, I agree that the exception is US government securities if you buy them directly from the government which the individual can do without commission.

And the single issue risk is the lowest for those securities.

Audrey

 

[CaseInPoint]

I've watched a lot of "experienced investors" try to outsmart the market by getting out of an asset class that was "sure to go down soon".

They are usually way too early - by a year or two! It's just too easy to be wrong. And, IMO, early by a year or two is wrong.

Since retirement investing is long-term (generally), a year or two from the absolute peak or bottom of the market may not be such a big deal. Still, I'm trying to steer clear of debating the philosophy of passive vs. active portfolio management. Both have merit, depending on the investor's circumstances.

I can say, though, that in the past 18 months I was able to transfer funds into a simple broad stock index (VTI) when the Dow was at low levels, and that turned out to be one of the bright spots in my portfolio, even though it put me outside of my AA.

Rounding back to my original question of bonds vs. interest rates, my research has come up with something that is of interest to me, which is diversifying the bond portion of my portfolio. As of now, I'm tending to go with 50% of my bond allocation in the original CA IT muni fund I was considering (VCADX), then 25% in a TIPS fund (VIPSX), and 25% in a broad, high-quality bond index fund, like VBMFX. But of course, I will research this more and could change my mind... Any comments on this mix are welcome.

 

[DblDoc]

Looks fine to me. The only question is where they will be? I'm assuming the munis will be in a taxable account. I'd avoid TIPS and Total Bond Index in a taxable account if at all possible.

DD

 

[CaseInPoint]

Looks fine to me. The only question is where they will be? I'm assuming the munis will be in a taxable account. I'd avoid TIPS and Total Bond Index in a taxable account if at all possible.

DD

Thanks, DD. The CA munis are tax-free as I'm a resident of CA.