Bonds: So Much More Dangerous Than You Think

[nun]

Quote:

Originally Posted by Gatordoc50 It would be nice if bond funds existed in 1950 thru 1980 so we could see how they performed coming off zero interest rates. All the data, including calculators like firecalc, use 5 or ten year treasuries (individual bonds) in calculating returns. That is why I put my return expectations in myself when using firecalc. 7 percent for stocks which is what Bogle and Bernstein and Buffet predict. And 2% for bonds because that is what the ten year is paying.

I use 3% inflation and a 4% return (so 1% real return) from my portfolio in my planning, but it works with 0% return if needed.

Right now my bonds are a drag on my portfolio, but the recent years of 9% returns are way more than I need for retirement and I'm happy with the risk in my portfolio so I see no reason to change. If the economy heats up and interest rates rise, bonds will slide, but it won't be a disaster as I'm in intermediate bonds and eventually I'll see the benefit of higher interest rates. In fact I'll be happy when rates kick up so my bonds can start producing some reasonable income. If I knew when that would happen I'd be all about market timing, but I don't so I'll stick with my "on the fence" AA.

[Texas Proud]

Quote:

Originally Posted by AWeinel TP - first, believe me I do not have rose colored glasses. Not at all. And I did portfolio management for a living for a number of years. And, because it was a public entity (public money) it was 100% fixed income! From short term C.P. (A1/P1 only), to agencies, treasurites, corporate bonds (BBB or better), we did repos, reverse repos, BA's CD's - oh my ... I have forgotten all the produce we bought... Callable, Noncallable.... step adjustabels. The primary model we used was the SLY model - Safety, Liquidity, Yield. FIrst, do not lose the public's money. Then, can you get the money liquid if a need comes up, LASTLY, yield. Very conservative. I am not discounting the effects of inflation, just that "lost opportunity" is significantly differtent than lost principle.

I wasn't even trying to address lost opportunity... others have done a good job with that....

Since you were doing portfolio management, then you know that conserving principal is important... but if you bought a 5 year bond and rates went up, you lost principal... at least your statements should relect the current value of those investments to your investors. Sure, you did not sell them because they were still a part of your investment strategy, but the loss was real. Not realized, but real.

When I was doing my trust work, investing conservatively meant not going out more than one week.... I think I had only one trust that allowed me to invest more than 30 days for the free cash... now, the trust that allowed an investment in a pool of loans was another thing... the principal account was invested in longer maturing loans... and we had to price them daily to see what was happening with the total principal...

[rbmrtn]

Quote:

Originally Posted by Gatordoc50 It would be nice if bond funds existed in 1950 thru 1980 so we could see how they performed coming off zero interest rates.

That is an issue when looking at past performance. But there were a few

FPNIX
FBNDX
PRCIX
VWESX

But most of these only go back as far as the 70s

[Original Wally]

Quote:

Originally Posted by pb4uski To begin with, it's principal, not principle. But the key question is, is a loss of buying power bad as well? I would suggest that a loss of buying power is bad and a loss of principal is even worse. The thing is, if you are managing a fixed income portfolio and have a loss of principal it is really noticeable - a loss of buying power (by earning less than inflation) is less noticeable but still bad.

My apologies on the grammar - I know better.

I agree with you... loss of PP is not as critical. Bad, but not as bad. That was the whole point. Hold to maturity is a different risk and needs to be viewed differently from the original point that ipso facto you will get hammered if you hold bonds in a rising interest environment. The PP question is growth vs. inflation, which, while certainly influenced by the loss of Princ., is a different animal.

[gcgang]

Bonds are for getting out of jail.

[fritz]

Quote:

Originally Posted by nun I use 3% inflation and a 4% return (so 1% real return) from my portfolio in my planning, but it works with 0% return if needed. Right now my bonds are a drag on my portfolio, but the recent years of 9% returns are way more than I need for retirement and I'm happy with the risk in my portfolio so I see no reason to change. If the economy heats up and interest rates rise, bonds will slide, but it won't be a disaster as I'm in intermediate bonds and eventually I'll see the benefit of higher interest rates. In fact I'll be happy when rates kick up so my bonds can start producing some reasonable income. If I knew when that would happen I'd be all about market timing, but I don't so I'll stick with my "on the fence" AA.

Agree with your posts here, but did you ever have the feeling you were standing in the wrong line?

[Original Wally]

Back in the day when we issued real intaglio printed bonds we used to call them Naked Lady Bonds - they always seemed to have a "Columbia" type of woman holding a torch or something and she was nearly always topless. Go Figger. Good old Bearer Bonds w/ Coupons!

[audreyh1]

Quote:

Originally Posted by Gatordoc50 Rebalancing is plausible if Equities continue to rise. Or if one is still working they can add to their bond allocation if both go down . If interest rates go up 1%, then it will take you about 5 years to break even with a bond fund. What happens if they go up two or three percent or more over the next decade? Sounds like you are going to take a permanent hit on those funds. For this reason I like the laddering strategy using treasuries and agency bonds and CDs. It's the lesser of two evils. Once interest rates hit 5% or more, then bond funds will be a good option option IMO. Really, bond funds only make sense if you think interest rates are going to stay at present level or increase a max of 1% over the next decade.

Hi Gatordoc.

I don't think things are nearly as simple as you lay out. We went through a sharp Fed Fund rate rise from 1% to 5.25% in a pretty brief period, from 6/04 to 6/06, yet intermediate bond funds did not suffer nearly as drastically as one might expect from simple formulas. The fact is that short-term, intermediate-term, long-term react differently in each rising rate environment, and differently again among the different bond types.

Here is a good view of three rising rate environments that occurred since 1993 and the effect on different types of bonds:
Investing in a Rising Rate Environment - How Rising Interest Rates Affect Bond Portfolios
http://www.rwbaird.com/bolimages/Med...nvironment.pdf

I expect that before long, I'll be adding to my bond funds because they will have dropped somewhat in value, giving back some of the tremendous capital gain I have already enjoyed since 2000. But that's just the name of the game in rebalancing and doesn't overly concern me. And it won't likely be a single direction move either - but rather a bumpy ride, going back and forth as economic and market conditions change this way and that.

And if there is a sudden jump in interest rates that hurt bonds badly, that is just as likely to be very hard on equities, so we're back to a nowhere to hide situation. You just have to keep rebalancing as things zig and zag to minimize the volatility.

And I haven't written off the possible Japan scenario of interest rates staying low for a considerable amount of time either. You just never know.

[Running_Man]

Quote:

Originally Posted by pb4uski To begin with, it's principal, not principle. But the key question is, is a loss of buying power bad as well? I would suggest that a loss of buying power is bad and a loss of principal is even worse. The thing is, if you are managing a fixed income portfolio and have a loss of principal it is really noticeable - a loss of buying power (by earning less than inflation) is less noticeable but still bad.

What I disagree with on the comparision is the fact that bonds when held to maturity is viewed as not meaningful because you have real losses along the way, but stocks are only held up to the goal of not losing any money over 20 years, losses along the way are ok and somehow the loss to inflation is not relevant for stocks, only the bond portion. I think that thought is even borne out by Siegel when he says stocks have never lost money over 20 years but bonds can lose 50%. I doubt any investor holding long term bonds over 20 years would have less money than he started with in actual value.

Whether or not 10 year bonds at 2 percent is a good deal or not would depend on if deflation would rear it's head over the next 10 years. That is certainly what the bond market is implying, though the government intrusion is probably more responsible for the mispricing than potential deflation.

But a 10 year ladder of US treasuries initiated over 10 years is not a very risky investiment. Had you apportioned an equal percentage each year for 10 years and maintained the significant losses did not arrive until well after the 2% average rate rate had been achieved in 1952, the threat of losses with a properly constructed bond portfolio is not nearly as dangerous as implyed. I attached a table The first column shows what the 10 year rate would be and the second column the blended rate a ladder of 10 year US treasuries would be. It was not for 22 years from the 1952 average 10 year blended rate of 2.41 percent that this portfolio of bonds would have been even 1 percent under inflation, certainly safe enough for any retiree. The mid-seventies certainly were devasting but they began with a much higher rate than we have presently.

[Gatordoc50]

Quote:

Originally Posted by audreyh1 Hi Gatordoc. I don't think things are nearly as simple as you lay out. We went through a sharp Fed Fund rate rise from 1% to 5.25% in a pretty brief period, from 6/04 to 6/06, yet intermediate bond funds did not suffer nearly as drastically as one might expect from simple formulas. The fact is that short-term, intermediate-term, long-term react differently in each rising rate environment, and differently again among the different bond types. Here is a good view of three rising rate environments that occurred since 1993 and the effect on different types of bonds: http://www.rwbaird.com/bolimages/Med...nvironment.pdf I expect that before long, I'll be adding to my bond funds because they will have dropped somewhat in value, giving back some of the tremendous capital gain I have already enjoyed since 2000. But that's just the name of the game in rebalancing and doesn't overly concern me. And it won't likely be a single direction move either - but rather a bumpy ride, going back and forth as economic and market conditions change this way and that. And if there is a sudden jump in interest rates that hurt bonds badly, that is just as likely to be very hard on equities, so we're back to a nowhere to hide situation. You just have to keep rebalancing as things zig and zag to minimize the volatility. And I haven't written off the possible Japan scenario of interest rates staying low for a considerable amount of time either. You just never know.

Thank you for the information. It is very complicated and it's nice to see that funds didn't get wiped out during rising rates. However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.

[Original Wally]

Quote:

Originally Posted by Gatordoc50 Thank you for the information. It is very complicated and it's nice to see that funds didn't get wiped out during rising rates. However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.

Agree that this is not the time to be either heavy (AA) into bonds and to the extent you are in bonds, the shorter the better. No long bonds today.

[haha]

Quote:

Originally Posted by Gatordoc50 However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.

You are certainly right that the damage is yield dependent, but yield figures into the calculation of duration. It is not really an independent factor.

Ha

[Gatordoc50]

Quote:

Originally Posted by haha You are certainly right that the damage is yield dependent, but yield figures into the calculation of duration. It is not really an independent factor. Ha

Thanks. Time to do some studying up on duration.

[ShortInSeattle]

OK. So break the implications of this down for a newbie. Would you suggest that folks should toss their Asset Allocations out and go to all stocks until bonds become more favorable? What is the bottom line of this viewpoint?

Curiously,
SIS

[mathjak107]

Quote:

Originally Posted by Gatordoc50 Thank you for the information. It is very complicated and it's nice to see that funds didn't get wiped out during rising rates. However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.

don't confuse the moves in the feds fund rate which is controlled by the fed with moves in the bond market which is controlled by the investors.

they may not move together at all. the famous inverted yield curve is a prime example. in fact history shows little movement in bonds when the fed funds rate was raised more then 90% of the time.

the problem is bonds have been in a bull run for around 30 years.

we have never experienced a real bear bond market since then .

we don't know the full damage we will see in bonds at this point if bond rates rise but i can tell you comparing the rise in the fed funds rate to the action in the intermediate and long term bond markets is worthless . historically there is little response from rises in the fed funds rate.

in fact more ofton then not it is taken as a good thing by the bond market as it curbs inflation.

you are not comparing apples with apples.

http://www.cbsnews.com/8301-505123_1...-rates-so-low/

[audreyh1]

Quote:

Originally Posted by Gatordoc50 Thank you for the information. It is very complicated and it's nice to see that funds didn't get wiped out during rising rates. However, I think the damage is yield dependent. Is there a way to find the yields of various bond funds prior to the interest rate hikes. For example, a fund with a duration of 5 years would have had little damage if it was yielding 5 percent. Compare that to today with yields of 1.5 percent and a duration of five years. Seems like it would take 3 times as long to recover.

Well, I don't know where to get that specific information [actually, you should be able to find the 10-year treasury yield history easily], but I do know that one thing that happened during the 2004-2006 jump in interest rates was that intermediate duration rates didn't go up much, long came down a bit, and it was short-term rates that took the biggest hit. In other words the yield curve flattened as long-term inflation expectations came down with the rise in the Fed Funds rate. So the short-term bond funds got hit the hardest at first, but even those recovered in a fairly short period of time with reinvested dividends.

And it is also a good warning about trying to hide in short-term bond funds. Sometimes, it's the shortest durations that are most "overvalued" (because a lot of people have piled into short-term funds in anticipation of rising interest rates) and take the biggest hit when the Fed starts raising interest rates. You just never know.

[audreyh1]

Quote:

Originally Posted by mathjak107 How to invest with interest rates so low - CBS News

Nice reference!

Quote:

Only in 1994 did the federal funds rate rise by more than 1 percent and intermediate bonds lose money. In fact, over the last 36 years, we have seen a dramatic cyclical decline in interest rates. Yet, there were almost as many years when the federal funds rate increased (17) as there were years of decline. Yet, we only had one year (from 1973 through 2011) when the intermediate bond index produced negative returns.

[imoldernu]

Several comment have been prefixed with... "not simple", or "more complicated than... "
Understatements... Just when ya thought you understood risk and interest rates, and charting, and allocations and history... along comes an article like this... not directly relating to bonds, but will affect them, no matter what the Fed does...

Fears at Fed of rate payouts to banks - FT.com

Excerpt:

Quote:

All banks hold reserves at the Fed. The central bank has boosted its balance sheet to more than $3tn as it buys assets to drive down long-term interest rates through its programme of quantitative easing. It pays for the assets by creating bank reserves, which now amount to more than $1.6tn. The Fed could add another $1tn if it keeps buying assets for another year. At the moment it only pays 0.25 per cent interest on those reserves. But according to its exit strategy, published in June 2011, the Fed plans to raise interest rates before it sells assets. Interest of 2 per cent on $2.5tn of reserves would run to $50bn a year. That interest should not turn into profits for the banks. They will have to pass the revenues on by paying more interest to their depositors. But it could still add to a populist backlash in recent years against the Fed and the big banks.

[obgyn65]

Since I do not own any stock, I guess I am going to have to work a bit longer .

Quote:

Originally Posted by KMyer What do you think?

[mathjak107]

Quote:

Originally Posted by audreyh1 Nice reference!

Thanks, as you can see comparing the fed funds rate moves to how investors looked at bonds really does not have much of a link.

We do not know at this point what to expect when bond investors sour on future perception. It has not happened in more then 30 years.