Bond Funds? Question about Rational Investing

[Patrick]

I read ESRBob's book "Work Less, Live More," and noticed in his Rational Investing example on page 176 that the U.S. Bond Fund had lost money. Would it be better to just buy the bonds so that you are guaranteed a return, as Suze Orman says? If so, it seems like eliminating the downside would result in higher overall returns in the long run. Any advantage to owning the fund as opposed to the bonds?

Thanks.

 

[brewer12345]

as Suze Orman says?

It makes no difference whether you hold bonds directly or through a fund: if they go down in value you lose either way.

 

[FinanceDude]

Keep in mind that when Suze was a broker, she used to consult with CRYSTALS to give her guidance about where to invest her client's money..............

 

[Patrick]

It makes no difference whether you hold bonds directly or through a fund: if they go down in value you lose either way.

But only if you sell them, right? If you hold til maturity, you collect the interest, no?

 

[brewer12345]

But only if you sell them, right? If you hold til maturity, you collect the interest, no?

Wishful thinking, my friend. Bonds, like all investments, are about total return. Yes, you still collect interest either way (unless you own zeros), but the capital loss can offset or more than offset the interest you get.

 

[FinanceDude]

Wishful thinking, my friend. Bonds, like all investments, are about total return. Yes, you still collect interest either way (unless you own zeros), but the capital loss can offset or more than offset the interest you get.

Based on your premise, funds would be better than individual bonds, as long as the duration is correct for the interest cycle and the manager knows what the heck they're doing, right?

I used to do lots of bond ladders, but have pretty much stuck to bond funds the past 6 years................

 

[Patrick]

Wishful thinking, my friend. Bonds, like all investments, are about total return. Yes, you still collect interest either way (unless you own zeros), but the capital loss can offset or more than offset the interest you get.

But if you hold til maturity, you get your capital back, right?

 

[FinanceDude]

But if you hold til maturity, you get your capital back, right?

Yes, unless the company goes into default on the bonds. However, bondholders are first in line to get compensated, while common stock owners go to the end of the line..........

 

[brewer12345]

But if you hold til maturity, you get your capital back, right?

Question: If you buy a 10 year bond for $10k and inflation is 5% annually, what is your capital worth in inflation-adjusted dollars at maturity?


A: About $6,139.

 

[Patrick]

Question: If you buy a 10 year bond for $10k and inflation is 5% annually, what is your capital worth in inflation-adjusted dollars at maturity?


A: About $6,139.

And what is the comparable bond fund worth?

I'm trying to figure out why the Rational Investing model uses bond funds instead of actual bonds, and if there may be some advantage to using the actual bonds.

 

[FinanceDude]

Question: If you buy a 10 year bond for $10k and inflation is 5% annually, what is your capital worth in inflation-adjusted dollars at maturity?
A: About $6,139.

That should work for Treasuries and CD's too.............

When was the last time we had 5% inflation over a multi-year period??

 

[Nords]

Would it be better to just buy the bonds so that you are guaranteed a return, as Suze Orman says?

I wouldn't do anything upon Suze Orman's recommendation except run away fast.

Yes, if you go out and buy a bond (instead of a bond fund) then you will earn interest for as long as you hold the bond. Of course if you have to buy it on your own you may pay a much higher spread & commission than a bond fund, although you can buy Treasuries at a decent price.

If you have to sell the bond, you have the same spread/commission issues plus the possibility of a capital loss. But if you don't sell the bond then you'll collect interest until it matures, and you'll get your inflation-eroded principal back as well.

If interest rates rise higher than your bond's interest rate, you'll have a huge opportunity loss by not being able to invest the money in another higher-returning asset. This is why high inflation can quickly savage a bond portfolio-- except for TIPS & I bonds, which don't get savaged so quickly.

Any advantage to owning the fund as opposed to the bonds?

Yes, now you can pay experts to knife each other in the back buy the bonds for you. Hopefully your annual expense-ratio payments will cost you less than the expense of doing it on your own. Good luck with that.

Perhaps a more pertinent question would be "Any advantage to owning bonds?" If we're buying bonds to reduce portfolio volatility then instead of fretting about losing money we'd be rejoicing at the lower volatility of our money-losing portfolio. If we're buying bonds for their inverse correlation to stocks then we'd have to re-examine the last 20-30 years of data on that correlation or, again, rejoice at the improved portfolio performance (despite the losses of the bond portfolio). And if we're buying them to make money, well, there are many more investments that make more money with not much more volatility-- especially when the yield curve is as flat as it is today!

When was the last time we had 5% inflation over a multi-year period??

Funny you should mention that!

Dimson & Marsh ("Triumph of the Optimists") calculated that inflation averaged about 3% over the last century. However over the last 30 years it's averaged 5%. Yeah, yeah, 1970s bad, Volcker, Greenspan, never happen again, sure. We'll have to compare notes again in five or six decades.

You notice that the last two COLAs have been 3.3 & 4.1%? I don't think that 30-year 5% average is dropping as quickly as it was a few years ago...

 

[brewer12345]

I'm trying to figure out why the Rational Investing model uses bond funds instead of actual bonds, and if there may be some advantage to using the actual bonds.

Bond funds are suggested because:

- You get much better diversification, which is even more important with credit risk than it is with equities.
- You get access to bonds that the retail investor will never see and might not even be permitted to buy.
- You get much better liquidity. The dealer will skin you alive if you try liquidating/rebalancing a reatil bond position.

 

[FinanceDude]

Bond funds are suggested because:

- You get much better diversification, which is even more important with credit risk than it is with equities.
- You get access to bonds that the retail investor will never see and might not even be permitted to buy.
- You get much better liquidity. The dealer will skin you alive if you try liquidating/rebalancing a reatil bond position.

Come on, EVERYONE wants a marked up bond for their portoflio, even the "new issues" have a markup hiding in the yield............

Wonder if the manager running the $10 billion bond fund gets the "good maturities" or the client going through Schwab..........hmm...........

 

[JohnEyles]

Bond funds are suggested because:

- You get much better diversification, which is even more important with credit risk than it is with equities.
- You get access to bonds that the retail investor will never see and might not even be permitted to buy.
- You get much better liquidity. The dealer will skin you alive if you try liquidating/rebalancing a reatil bond position.

These things do not apply, or apply as much so, to Treasury bonds. Hence the
oft-repeated advice to buy corporate and muni bonds in funds, but to buy
Treasuries individually. Even Schwab will let you buy "Treasuries at auction"
with no commission.

Speaking of which, I'm seriously considering dumping a PILE of IRA money into
the re-opening of the 5-y TIPS which is occuring NOW (announced today and
auction Monday) and wondering if there is a way to estimate what the price
will be (dollars per $100 par value); I understand the coupon is the same as
for the initial offering in April.

 

[wabmester]

Speaking of which, I'm seriously considering dumping a PILE of IRA money into
the re-opening of the 5-y TIPS which is occuring NOW (announced today and
auction Monday) and wondering if there is a way to estimate what the price
will be (dollars per $100 par value); I understand the coupon is the same as
for the initial offering in April.

The coupon is 2.375, maturity is 4.5 years, current market yield is about 2.58 (as of yesterday). Iterating a couple of times on that YTM calculator I pointed you to in another thread suggests that the price should be around 99.

 

[brewer12345]

You can get a good idea of the yield by looking at current market quotes here: http://www.bloomberg.com/markets/rates/index.html

Looks like 5 year TIPS are yielding around 2.63%.

 

[Patrick]

So with a bond fund, are you basically gambling on which way interest rates are going to move?

And with a bond, you are investing at a fixed interest rate for a specific time?

 

[brewer12345]

So with a bond fund, are you basically gambling on which way interest rates are going to move?

And with a bond, you are investing at a fixed interest rate for a specific time?

You are gambling which way interest rates (and more importantly inflation) will move. IBonds in a fund/not in a fund behave the same way.

 

[JohnEyles]

The coupon is 2.375, maturity is 4.5 years, current market yield is about 2.58 (as of yesterday). Iterating a couple of times on that YTM calculator I pointed you to in another thread suggests that the price should be around 99.

Ah yes, the infamous "TIPS for Dummies" thread. I missed that pointer the
first time through - great stuff ! - thanks. I'll repeat it here for others:

http://www.moneychimp.com/articles/finworks/fmbondytm.htm

 

[Patrick]

Looks like 5 year TIPS are yielding around 2.63%.

Why would anyone want to buy these when you can get 5.5% in a checking account? Just curious.

 

[brewer12345]

Why would anyone want to buy these when you can get 5.5% in a checking account? Just curious.

Oy! One last time on TIPS: the yield is a real yield. That means you get paid wahtever the yield is plus inflation as measured by the CPI. So if CPI=3.5% and yield=2.5%, total (nominal) yield is 3.5+2.5 = 6%.

 

[Patrick]

Oy! One last time on TIPS: the yield is a real yield. That means you get paid wahtever the yield is plus inflation as measured by the CPI. So if CPI=3.5% and yield=2.5%, total (nominal) yield is 3.5+2.5 = 6%.

Thanks. So if the CPI is 2%, you get 4.5%? So you're gambling on how much inflation there will be, again?

 

[Dawg52]

Oy! One last time on TIPS: the yield is a real yield. That means you get paid wahtever the yield is plus inflation as measured by the CPI. So if CPI=3.5% and yield=2.5%, total (nominal) yield is 3.5+2.5 = 6%.

Nice explaination. I even understand it. BTW Brewer, have you noticed the nice move BULK has made lately?

 

[CCdaCE]

Thanks. So if the CPI is 2%, you get 4.5%? So you're gambling on how much inflation there will be, again?

That's supposedly the beauty. Whether CPI is 5% or 50%, you supposedly make your 2.5% either way.

-CC