Can someone explain the "Bond Drama"

[ERD50]

Bond funds have no set maturity date, so when rates rise the price goes down.
Verses an actual bond that can go up and down but will return to par when maturing.

I think this was Suzie Orman's point.

but the bond funds interest rises over time and a fixed bond's doesn't . at the end of the day there is little difference .

It seems to me that mathjak's observation must be true (in the long term).

It would almost seem like magic if it were not - where did the money go? And if it wasn't true, wouldn't some computers be programmed to arbitrage this delta?

But I could be wrong - is there any good reference to back this up (from anyone, I'm not really directing this at mathjak)?

-ERD50

 

[utrecht]

mathjak107,

In this thread
http://www.early-retirement.org/forums/f28/bond-funds-for-income-57089.html

You posted this on July 26th, 2011

"bond funds have little place to go except down with the end of the 30 year bull market coming to an end.

income from the fund while your principal is dropping sucks!"

There are many more of your posts like this but I'm not going to spend any more time on this. Like I said, you've been talking about a bond rout for years. Almost 4 years in this case. You just now said you bet I couldn't find one post where you talked negatively about bonds until recently. Unless your definition of "recently" is 4 years, then you lose because there are dozens of them. My bond fund has returned 5.5% per year since you made that post. Pretty damned good I would say.

 

[OrcasIslandBound]

Obviously, bonds are actually a bit trickier to invest in and manage. Some of this is due to the really long cycles as has been pointed out in this thread. I personally decided that index bond fund etfs such as BND and BLV are good enough as assets that are inversely correlated with stocks. They both have a healthy chunk of us treasuries as well as corporate bonds. I use 1/3 BLV and roughly 2/3 BND.

Some of this strategy is a result of a personal belief that interest rates are, unfortunately, going to continue for several decades, at relatively low levels. They'll move up and down a bit, but I'd be surprised to see them ever hit even 5 or 6 percent for a very long time.

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[LOL!]

Aren't all those PBS fund-raising things repeats from 5 and 10 years ago? The Orman thing must be about an ancient bond drama.

I didn't see the fund drive, but a decade ago Orman didn't like bond funds but wanted everybody to buy individual bonds because she didn't know about "mark-to-market" and thought erroneously that individual bonds were different from bond funds.

 

[pb4uski]

....Since the Fed has signaled that it will increase interest rates when the economy is strong enough, the value of bonds will fall. ....

Maybe, maybe not. The market sets the price of bonds, so it's impossible to say. One could argue this is all priced in already....

The Fed reduced rates and the value of bonds rose... what makes you think that when rates rise that the value of bonds will not fall. It's just math and a higher interest rate being used to discount fixed contractual cash flows so a higher interest rate has to result in a lower price/present value. WADR, to think otherwise is either naive, or ignorant about how bonds are priced and how interest rates affect bond prices..

 

[REWahoo]

I've posted this previously but this is as good a time as any to trot it out again for a fresh look:

Must Bond Investors Fear Rising Interest Rates?

For the diversified bond fund, bond index or balanced fund investor, rising interest rates are simply not the looming catastrophe they have been made out to be.

 

[utrecht]

Notice the date of that article which is Jan, 2012. 3 1/2 yrs ago and "experts" were talking about the imminent bond massacre back then. I'll keep my AA the way it is and sleep just fine.

 

[Mulligan]

At least this thread is having disagreement amongst informed people. A friend of mine was commenting just today about how pleased he was with his returns on his bond funds the past few years in relation to money in his savings account. I could not get him to understand the difference between his "total return" and the "true yield" of his bonds. In his mind they are the same and I couldn't get him to understand the difference.


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[audreyh1]

I have a model based on the 5 year treasury rate reaching 2.75% 5 years from now, which is one of the current market predictions.

So 0.25% interest rate increase per year, over 5 years, for intermediate bonds. You can then apply this to your favorite intermediate bond fund by multiplying by the duration, and calculate the "drag" in performance that might occur each of those years due to gradually increasing rates.

The economy isn't the same as it was two decades ago. I don't think it's reasonable to expect a sudden return to the interest rates of the 90s or mid 2000s.

 

[utrecht]

I have a model based on the 5 year treasury rate reaching 2.75% 5 years from now, which is one of the current market predictions.

So 0.25% interest rate increase per year, over 5 years, for intermediate bonds. You can then apply this to your favorite intermediate bond fund by multiplying by the duration, and calculate the "drag" in performance that might occur each of those years due to gradually increasing rates.

The economy isn't the same as it was two decades ago. I don't think it's reasonable to expect a sudden return to the interest rates of the 90s or mid 2000s.

Based on your model, what would be the return over those 5 years for an intermediate bond fund with a duration of 4.1 years?

 

[audreyh1]

Based on your model, what would be the return over those 5 years for an intermediate bond fund with a duration of 4.1 years?

Subtract 0.25% x 4.1 or about 1% from whatever it is yielding each year for the guesstimate of total return each year. Yields will increase each year, but we don't know what they will be - depends on the fund.

If the fund is currently yielding say 2.5%, then maybe total return can be modeled as 1.5% each year, although it is more complex than that as yields will change over time.

Personally, I will be adding to bond funds whenever they underperform equities, just from rebalancing, so I don't worry too much about bond returns going forward. The function of bonds as part of the AA in my portfolio is to reduce volatility and to provide funds during stock market drops.

 

[Mulligan]

I have a model based on the 5 year treasury rate reaching 2.75% 5 years from now, which is one of the current market predictions.

So 0.25% interest rate increase per year, over 5 years, for intermediate bonds. You can then apply this to your favorite intermediate bond fund by multiplying by the duration, and calculate the "drag" in performance that might occur each of those years due to gradually increasing rates.

The economy isn't the same as it was two decades ago. I don't think it's reasonable to expect a sudden return to the interest rates of the 90s or mid 2000s.

I agree especially if the assumption is rates being tethered to expected inflation rates. Technology seems to greatly assist in keeping the lid on inflation where its in manufacturing processing or even energy exploration. I watched an interesting conversation on tv recently where a man was listing some near future breakthroughs on technology. According to him tech has its eyes squarely on two of the remaining inflation prone areas: education and medicine. They already have the means to eliminate anesthesiologists.
Up until now, it seems to me technology actually has increased medical costs. It would be nice to see it start to work the other way.


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[utrecht]

Subtract 0.25% x 4.1 or about 1% from whatever it is yielding each year for the guesstimate of total return each year. Yields will increase each year, but we don't know what they will be - depends on the fund.

If the fund is currently yielding say 2.5%, then maybe total return can be modeled as 1.5% each year, although it is more complex than that as yields will change over time.

Personally, I will be adding to bond funds whenever they underperform equities, just from rebalancing, so I don't worry too much about bond returns going forward. The function of bonds as part of the AA in my portfolio is to reduce volatility and to provide funds during stock market drops.

Thanks for the bond math lesson. The rest of your post about the reason you have bonds in your portfolio matches my thoughts exactly.

 

[Lsbcal]

In a recent thread I posted this analysis of an 11 year rise in Treasuries starting in 1954.

We do have some historical data for 5 year Treasuries (intermediate bonds). From April 1954 to Dec 1965 these bonds went from 1.9% up to 4.9% yield. The compounded annual return was 2.4% nominal and 0.9% real. I computed this from the Fed interest rate and inflation series assuming one held the Treasury each month at the current rate -- not too far from a Treasury bond fund (I think).

The current 5 year Treasury is at 1.6% so not too much lower then in 1954.

FWIW, I have a fair amount of our stash in intermediate bonds. With the current steeply sloped yield curve (30 bp/year), I would tilt towards intermediates over short term.

So we see that a rising rate environment is not necessarily awful for bond investors. One just doesn't get the juicy capital gains of a declining rate environment. I have more data for the 1970's inflationary period but it's not that relevant ... yet.

 

[karluk]

I have more data for the 1970's inflationary period but it's not that relevant ... yet.

We already have some data from the inflationary 1970s, namely the performance of PINCX, mentioned earlier in this thread. Depending on the start date and end of the analysis, it appears that PINCX produced a compounded annual return in the high 3% or low 4% range. It's likely that this represents a negative inflation adjusted return for at least part of the period, since the 1970s were the extreme outlier in American history for producing high inflation.

Still, looking at PINCX during a period of rapidly rising interest rates, as well as every other analysis of bond funds I've ever seen, bond funds do, indeed, deliver very close to their expected return (based on yield at the time of purchase), assuming one holds them for at least as long as the fund's average duration. The problem in the 1970s was the unexpectedly high inflation, not PINCX's low yield at the start of the period. PINCX was priced in the late 1960s to produce anemic but positive returns over the long haul, and that's exactly what it delivered.

 

[Chuckanut]

I've posted this previously but this is as good a time as any to trot it out again for a fresh look:

Must Bond Investors Fear Rising Interest Rates?

Here's the best advice from the article:

Avoid experimenting with untested products or strategies during rising rates.

I can already see the various 'new' products that promise to beat rising interest rates. No doubt the sellers of these things will make money, but "Where are the customer's yachts?"

 

[HFWR]

My bond allocation is ST and intermediate gubmint bond index funds. I assume that the fund will adjust to rising rates, perhaps not in lock step, but that as bonds in the fund mature, they will be replaced by lower cost but higher rate bonds, mitigating the yet unseen rising rate problem. Rolls dice...