Bond Index Fund Alternative

[Chuckanut]

Here is an interesting interview with Burton Malkiel who wrote A Random Walk Down Wall Street.

BURTON MALKIEL WROTE “A RANDOM WALK DOWN WALL STREET” IN ‘73. HAVE HIS VIEWS CHANGED? : WealthTrack

At about 18 minutes he starts discussing Bond Index Funds. He believes that the US Total Bond Index funds are not that good since they are dominated by US Govt bonds (about 2/3 of the fund's holding). Also, he is not happy with the way interest rates have been kept 'artificially' low by the central banks.

He recommends alternatives to bond index funds. He recommends bond substitutes such as high dividend stocks (ATT for example yielding about 4.5% and worth the extra risk, in his opinion) and preferred stocks (increased risk but the dividend is paid before the regular stock holders). He also likes some ETFs for Emerging Market bonds as a substitute for the Total Bond Index funds.

Your thoughts?

 

[Which Roger]

All of the substitutes are riskier than bonds. So he's recommending taking on more risk with the hope of getting more return? I'll pass.

 

[gcgang]

Thanks for the link.

As he was a pioneer in broad based index investing, and adamant about minimizing expenses, I'll take heed of his warning on indexed bonds, and attempt to find more diversification in my income related investments.

While each bond alternative sector he mentions, preferred, foreign, Hi yield stock, reits, may have more risk than gov bonds, a combination of them all may allow for higher returns with less risk.

 

[Lsbcal]

I have stayed away from Total Bond Market partly for the well known reason stated, too much Treasury exposure. But my substitutes are still in the US bond market. Bonds are for safety of principle and one tries to get a modest real return.

So instead of using ATT or EM bonds, I'd first up my equities by some modest amount (maybe go to a 55/45 instead of a 50/50) and then seek out better US bond fund alternatives.

FWIW, my bond funds are currently VFIDX (VG intermediate investment grade) and VFSUX (VG short term investment grade).

 

[OldShooter]

Yes, thanks for the link.

I am a confirmed equity indexer, holding primarily total US and total International funds. But I favor individual bonds over bond funds, so it is interesting to hear his views.

Re risk & reward, he's not recommending anything. He just said what he is doing and commented that the risk/reward equation was, in his opinion, favorable. Making risk/reward decisions is the essence of investing. No news here, folks, just move along ...

 

[Fedup]

That reminds me, I used to buy individual bonds from Vanguard. I should look into it now. I think I bought Ford bonds yielding 5% back in 2006-2007 time frame.

 

[akck]

I went with high dividend yield funds several years ago because of the future impact of low coupon rates. I figured the 4-5% dividend yield outweighed the added equity risk. Currently, the yield on new purchases is <4%, so I feel comfortable with my past decision. As bond fund yields increase, I'll likely keep the dividend funds and sell individual equities that I still own, to buy bond funds.

 

[Scuba]

Yes, thanks for the link.

I am a confirmed equity indexer, holding primarily total US and total International funds. But I favor individual bonds over bond funds, so it is interesting to hear his views.

Re risk & reward, he's not recommending anything. He just said what he is doing and commented that the risk/reward equation was, in his opinion, favorable. Making risk/reward decisions is the essence of investing. No news here, folks, just move along ...

+1
I also prefer buying & holding individual US bonds. However, we do have an emerging markets bond fund to get exposure to that sector without having to research individual issues.

 

[haha]

I don't know how meaningful this is, but one very successful oldtimer with a long public record, Bob Rodriguez, has come to distrust anything beyond t-bills. This is his position, not mine, so I can't really defend it. But he is nobodies fool. Only extremely wealthy retirees or this with good public pensions could likely do this, but that is a separate question from would this be a desired action if one could afford it.

I am convinced that we are likely cruising for a bruising, not something sanely described with that stealth term " a correction".

What to do is not obvious, at least to me. I think if it were not for highly negative tax consequences I would do as Rodriguez, and go 100% cash and t-bills. After all we do not need a high return in every condition, just an adequate return over time.

Ha

 

[Happyras]

I hold bonds within a fund because of the management, and low cost due to bond price spread I might otherwise pay. I still believe it is better managed this way, but I accept the risk of a run on the fund to liquidate shares. However, since it is not solely a bond fund, but balanced (VWIAX, VWENX etc.) the risk of a run on the fund due to bond prices is offset by their value stocks which could turn to favor in rising rates. I have backed out of pure bond funds or individual bonds in favor of these types of balanced funds which historically have proven themselves through rising rate periods to perform.

I comment here to get educated, so please share your opinion on this.

 

[W2R]

All of the substitutes are riskier than bonds. So he's recommending taking on more risk with the hope of getting more return? I'll pass.

+1

Some individual investors do not understand the connection between risk and reward, and do not understand that comparing investments with non-equal risk is essentially comparing apples and oranges. IMO, those who do understand risk can invest more wisely than those who simply don't "get it".

 

[samclem]

I hold bonds within a fund because of the management, and low cost due to bond price spread I might otherwise pay. I still believe it is better managed this way, but I accept the risk of a run on the fund to liquidate shares.

"A run on the fund" . . . are you invested in a balanced closed-end fund (CEF)? A CEF can experience a drop in price if there's a "run" to sell off the CEF shares. OTOH, a typical open end fund doesn't experience a direct loss in value when people sell off shares in the fund, they only experience a change in share value when there's a decrease in the value of the assets the fund holds (e.g the stocks or bonds that make up the fund), which decreases the net asset value (NV) of the shares.
Even a really big mutual fund typically only owns a small %age of the shares of any particular company within the portfolio.

 

[Happyras]

"A run on the fund" . . .

NO, not what I meant. Most articles describe the risk of bond funds as a case where rates rise and folks sell shares forcing the fund manager to sell lower valued bonds to cover cash. Only those bonds considered by the market as higher grade, might be sold due to the market demand. It seems all other risks of funds versus individual bonds seem to be similar. Only funds are forced to sell to the market on demand the day of to cover a "run", otherwise cash holdings can cover day to day movements in selling fund shares. If you hold a bond you can choose to continue or sell at market price. Under normal conditions a fund carries the same type of bond market valuation risk. Its the nature of demand liquidation that could impact bond funds more due to sell pressures.

With that said, my friends with 8 figure $ hold individual bonds with a little in S&P index funds, they have no need to fund the trusts higher for any risk.

 

[audreyh1]

All of the substitutes are riskier than bonds. So he's recommending taking on more risk with the hope of getting more return? I'll pass.

+1

I want high quality bonds to diversify my stocks. US government is always going to be a large part of that.

Corporate and high yield and foreign bonds are always more vulnerable in a hard market downturn.

 

[OldShooter]

I hold bonds within a fund ... I comment here to get educated, so please share your opinion on this.

I don't like bond funds, except very short term governments.

When I buy a new issue individual bond, at maturity I get my money back and along the way I have gotten the coupon yield. If I buy a bond from a dealer, it's the same. I get my YTM and my money back at the end; the calculation is a little more complicated but the result is the same. I get everything I was promised, subject of course to credit risk.

With a bond fund that is not the case. If I buy a bond fund planning to cash out in, say, 10 years, my return along the way will vary as the fund buys and sells bonds and my value at the end is unknown. So I might make money and I might lose money. It is a sort of interest rate speculation. This "fixed income" thing is really not fixed at all.

So, assuming I can buy an individual bond portfolio that is adequately diversified (say, $500K), I prefer certainty.

Since you asked, that's my opinion.

Edit: Actually I have read that $100K is enough to purchase an adequately-diversified portfolio of individual bonds.

 

[Happyras]

With a bond fund that is not the case. If I buy a bond fund planning to cash out in, say, 10 years, my return along the way will vary as the fund buys and sells bonds and my value at the end is unknown. So I might make money and I might lose money. It is a sort of interest rate speculation. This "fixed income" thing is really not fixed at all.

.

I value your opinion, but the following is a quote from one article disclaiming the perceived benefit of holding a bond versus a fund...what is the error in this logic? http://awealthofcommonsense.com/2015/10/misconceptions-about-individual-bonds-vs-bond-funds/

"Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity and “get your money back” (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value just like the bond fund. By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less.

But getting your dollars back at maturity isn’t even the real issue. Individual bond prices are published in the same newspapers that publish bond fund prices, although many don’t seem to know that. If you own the bond fund that fell in value, you can sell it right after the fall and still buy the portfolio of individual bonds some say you should have owned to begin with (which, again, also fell in value!). Then, if you really want, you can still hold these individual bonds to maturity and get your irrelevant nominal dollars back. It’s just the same thing."

 

[OldShooter]

I value your opinion, but the following is a quote from one article disclaiming the perceived benefit of holding a bond versus a fund...what is the error in this logic? ...

Thanks. As a relative newbie here I have found that I value the point/counterpoint in many of these discussions.

First, the viewpoint of the author is that of a trader. While it is certainly true that my individual bonds go up and down in value every day, I have no interest in trading or marking to the market. So his concern about this is not of interest.

When he says " ... in an environment with higher interest rates and inflation, those same nominal dollars will be worth less." he is certainly correct. But it is equally correct to say " ... in an environment with lower interest rates and inflation, those same nominal dollars will be worth more." I don't know what either of those statements proves. Maybe: "Life is uncertain." ??

At best, I think he is arguing that bond funds are as good as individual bonds or the same as individual bonds. "It’s just the same thing." He doesn't seem to argue anywhere that they are better. And that's before discussing fees. So what's the point? If they are the same before fees then they are worse after fees. And beyond that, there is the risk of poor management. IMO for any active fund the tail on the left is fatter than the one on the right.

Fees are not the main reason I avoid bond funds, but why seek out something that is complicated and uncertain when I have available something that is simple and less uncertain?

I was quite amused to see that the author has written a book with the subtitle "Why Simplicity Trumps Complexity in Any Investment Plan." Maybe he has forgotten this.

 

[Lsbcal]

+1

I want high quality bonds to diversify my stocks. US government is always going to be a large part of that.

Corporate and high yield and foreign bonds are always more vulnerable in a hard market downturn.

Many of our intermediate holdings are in investment grade funds like VFIDX which holds a lot of "industrial" and "finance" category bonds. I would personally not hold high yield or foreign bonds. I agree all of these three broad types are more vulnerable to hard market downturns.

Specifically this would happen if entering a recession and historically this is fairly easy to trade in the case of decent quality investment grade funds i.e. go to Treasuries. I've convinced myself that at least the Vanguard investment grade funds are low enough volatility to sell only when some key recession conditions appear.

For me the key would be a near flat yield curve. This doesn't mean the recession will happen right away but there is little cost in moving to non-credit risk bonds except one gives up some yield for perhaps several months. Since our holdings are in retirement accounts, there are no tax consequences which is why I've studied this to death with detailed spreadsheets.

 

[Scuba]

I don't like bond funds, except very short term governments.

When I buy a new issue individual bond, at maturity I get my money back and along the way I have gotten the coupon yield. If I buy a bond from a dealer, it's the same. I get my YTM and my money back at the end; the calculation is a little more complicated but the result is the same. I get everything I was promised, subject of course to credit risk.

With a bond fund that is not the case. If I buy a bond fund planning to cash out in, say, 10 years, my return along the way will vary as the fund buys and sells bonds and my value at the end is unknown. So I might make money and I might lose money. It is a sort of interest rate speculation. This "fixed income" thing is really not fixed at all.

So, assuming I can buy an individual bond portfolio that is adequately diversified (say, $500K), I prefer certainty.

Since you asked, that's my opinion.

Edit: Actually I have read that $100K is enough to purchase an adequately-diversified portfolio of individual bonds.

Exactly how I feel

 

[audreyh1]

Many of our intermediate holdings are in investment grade funds like VFIDX which holds a lot of "industrial" and "finance" category bonds. I would personally not hold high yield or foreign bonds. I agree all of these three broad types are more vulnerable to hard market downturns.

Specifically this would happen if entering a recession and historically this is fairly easy to trade in the case of decent quality investment grade funds i.e. go to Treasuries. I've convinced myself that at least the Vanguard investment grade funds are low enough volatility to sell only when some key recession conditions appear.

For me the key would be a near flat yield curve. This doesn't mean the recession will happen right away but there is little cost in moving to non-credit risk bonds except one gives up some yield for perhaps several months. Since our holdings are in retirement accounts, there are no tax consequences which is why I've studied this to death with detailed spreadsheets.

If you think you can time, yes. I don't want to bother with timing subsets of my portfolio so I stick with mostly high quality short to intermediate bond funds, and rebalance as needed after major market moves.

 

[audreyh1]

I stick with bond funds because I am holding fixed income indefinitely, so I don't care about "maturity", and just like I avoid holding and managing individual stocks, I avoid having to deal with individual bonds.

 

[Gotadimple]

I stick with bond funds because I am holding fixed income indefinitely, so I don't care about "maturity", and just like I avoid holding and managing individual stocks, I avoid having to deal with individual bonds.

+1

Avoiding the research, waiting for maturity and the deposit of funds, and executing a new buy. Plus the fund/etf manager gets a break on the commission by buying in larger quantities.

- Rita