Increase stocks in AA?

[RunningBum]

I guess I don't see how a bond fund vs individual bonds could be that different from a stock fund vs. individual stocks. Sure, you lose some control. For a bond fund, that means the value can fluctuate--up, as well as down. For a stock fund, you might take unwanted CG distributions without actually selling any of your stake. In return you get diversity and simplicity. I see a bond fund as more or less a ladder, with many different bonds at different rates and maturity dates.

If selling a bond early was such a bad deal as OldShooter's made-up scenario, no bond fund manager would ever sell unless they absolutely had to if they had investors bailing, and they'd find ways around that by keeping a cash reserve and having maturing bonds replenish that reserve. I just don't believe it. His bond friends can look at me with disdain all they want, without some hard evidence I'll stay in bond funds.

 

[Kwirk]

I was at nearly 100% equities for years because I expected the market to go up and because I can tolerate a very substantial loss. I'll continue to have a high proportion of equities because I suspect that work best (no guarantee) over the many years before my children or grandchildren retire. However, I've recently backed off to 80% and may go to 70%. I'm not doing it for safety but I'd like to have some money set aside to buy more when the market inevitably has a substantial drop.

 

[TwoByFour]

If selling a bond early was such a bad deal as OldShooter's made-up scenario, no bond fund manager would ever sell unless they absolutely had to if they had investors bailing, and they'd find ways around that by keeping a cash reserve and having maturing bonds replenish that reserve. I just don't believe it. His bond friends can look at me with disdain all they want, without some hard evidence I'll stay in bond funds.

Hard evidence?
10-year US Treasury interest rate, and price of VFITX, Vanguard's intermediate treasury bond fund:
9/27/17 yield = 2.13%, VFITX price = $11.18
9/27/18 yield = 3.06%, VFITX price = $10.69

Interest rate goes up, price (value) goes down. Reason why is that all the bonds in the fund are going down in value.

BUT, an investor will recapture that lost value, and get more but ONLY if he/she sticks with the fund for several years. The number of years is approximately the average maturity of the fund. Rising interest rates are not a problem for a buy-and-hold investor. They are a huge problem with someone who trades bond funds a lot, or who needs liquidity. It really depends on why you own bonds and how they fit into your plan. For me, I need more liquidity than I can get with a bond fund.

 

[RunningBum]

Yes, I understand that if interest rates go up the bond fund value goes down. Yield will go up in return though. Rising interest rates are also a problem for the bond holder in that the rate they locked into is now below market rate. Getting all of your money back at maturity is only part of the picture.

And I can't help but notice that for nearly a 1% rise, the fund only dropped 4.4%, nowhere near the "just for grins" 30% loss number from OS.

 

[pb4uski]

Yeah... I can't ever recall seeing a duration of 30... even the 30 year treasury duration is only about 18.... but I think OS was just using that as an example.

 

[audreyh1]

I guess I don't see how a bond fund vs individual bonds could be that different from a stock fund vs. individual stocks. Sure, you lose some control. For a bond fund, that means the value can fluctuate--up, as well as down. For a stock fund, you might take unwanted CG distributions without actually selling any of your stake. In return you get diversity and simplicity. I see a bond fund as more or less a ladder, with many different bonds at different rates and maturity dates.

If selling a bond early was such a bad deal as OldShooter's made-up scenario, no bond fund manager would ever sell unless they absolutely had to if they had investors bailing, and they'd find ways around that by keeping a cash reserve and having maturing bonds replenish that reserve. I just don't believe it. His bond friends can look at me with disdain all they want, without some hard evidence I'll stay in bond funds.

Agreed.

I don’t want to deal with individual bonds or stocks which is why I use funds.

A bond fund is giving you a constant maturity product, which is what I want. I’m staying invested in bonds indefinitely, as there is not a specific known future point at which I will need the funds.

I also don’t see much difference between a bond ladder and a bond fund in terms of interest rate risk. A bond fund manager will typically sell a bond before it matures, and repurchase a longer term bond since a bond price rises as it approaches maturity, all other factors being equal. For a positive yield curve this benefits the bond fund total return. Bond fund managers take advantage of this.

Bond index funds are available for 0.025% expense ratio. This is very inexpensive.

 

[Dtail]

I don’t want to deal with individual bonds or stocks which is why I use funds.

A bond fund is giving you a constant maturity product, which is what I want. I’m staying invested in bonds indefinitely, so there is not a specific known future point at which I will need the funds.

I also don’t see much difference between a bond ladder and a bond fund in terms of interest rate risk. A bond fund manager will typically sell a bond before it matures, and repurchase a longer term bond. Depending on the yield curve this can benefit the return.

Bond index funds are available for 0.025% expense ratio. This is very inexpensive.

Bolded - Perhaps it is the psychology of temporarily losing monies in a rising interest rate environment for a bond fund vs. not losing in an individual bond held to maturity even though there is "opportunity income" lost for the individual bond holder.

 

[OldShooter]

... BUT, an investor will recapture that lost value, and get more but ONLY if he/she sticks with the fund for several years. The number of years is approximately the average maturity of the fund. Rising interest rates are not a problem for a buy-and-hold investor. ...

Correct. The only penalty the long term investor pays is the fees.

... And I can't help but notice that for nearly a 1% rise, the fund only dropped 4.4%, nowhere near the "just for grins" 30% loss number from OS.

Let's keep the apples with the apples. My 30% hypothetical was for a individual issue, not for a fund. It would be a pretty exciting fund to see a drop of 30%. Maybe a long single-maturity fund if such a thing exists.

This discussion is getting kind of interesting. I'm going to go to the Schwab bond page and try the numbers for some real world examples. I'll report back.

 

[pb4uski]

.... I'm going to go to the Schwab bond page and try the numbers for some real world examples. I'll report back.

Slow day, eh?

 

[Dtail]

Slow day, eh?

Hey he is retired after all.

 

[OldShooter]

Slow day, eh?

Hey he is retired after all.

Yup.

Medum busy, so only one example:

Spoiler: The scenario, using a couple of optimistic assumptions, is not as brutal as my made-up example but it is still a net loss for the investor to sell a lower-coupon bond prior to maturity in order to reinvest at a higher rate.

Lab rat: $10,000 Face John Deere Credit 2.8% 2027. A-rated. Ask price is 9,330, YTM 3.69.

First I make two somewhat unrealistic assumptions: (1) the seller will get the "Ask" price, which is the only price I have. He won't of course. (2) The seller can reinvest 100% of the proceeds at the YTM figure, which might be almost true for a very large position but for just a few bonds, not possible.

Total interest payments/10 years: Hold=$2800, Sell & Buy: 3,443 ($9,330 @ 3.69%). Difference $643

End payout: Hold=$10,000, Sell & Buy: $9,330. Difference $670

Net: Sell & Buy investor gains $643 on interest payments, loses $670 on principal return.

I am too lazy to do the NPV, but I think the optimistic assumptions are optimistic enough to say that in the real world an investor with this plan loses.

So I will continue to believe that this is A Bad Idea, but the penalty may be less than I thought. Others wanting to try it with different lab rats, I'll be interested to see what you find.

 

[tdv2]

A couple of things come to mind when thinking about making a large AA change in the context of moving to much higher risk portfolio i.e. close to all equities.



1. Recency bias--tendency to extrapolate the recent past into the future indefinitely.
2. Long bull markets always come to an end--typically a period of very low returns follow--i.e. the lost decade of the 2000-2010.

3. Stocks are risky assets--30% drops or more happen regularly.


Personally I have a 40% cushion in my withdrawal rate and don't want to introduce undue anxiety in my life if the stock market drops significantly and stays there for an extended period of time. I didn't sell anything during the financial crisis but I was employed at the time and adding to my growth portfolio at a heavy LBYM rate...My recollection is I was about 75% stocks back then.



Right now I don't think anyone can be disappointed where we are today if you have been long stocks for the past 10 years. WHEN the next bear market arrives, I stand ready to re-balance into the correction. That's what works for me, sort of on auto pilot, I have learned that my best thinking can get me into trouble. For context ---FIRE'd 6 months ago (40 year planning horizon)...my AA is 60-32-8. Stock -Bond - Cash. One more thing---portfolio is almost entirely index funds.

 

[TwoByFour]

Bond index funds are available for 0.025% expense ratio. This is very inexpensive.

I decided one day to go through the Vanguard Statement of Operations that comes with the annual report for one of their bond funds. The ER that is reported is a constant fraction that is deducted from the fund's cash flow, along with other expenses. The last statement is important because ER is not the total cost to any fund holder. A mutual fund, like VFITX, has internal costs related to buying and selling bonds, but the parent company, which in this case is Vanguard Marketing, charges the fund a fee, the ER, in order to provide additional services to the fund. That is what the ER means. The other expenses are low, just a few basis points as I recall, but they are there, somewhat hidden.

The whole reason I went through this exercise is I wondered how defaulted bonds are accounted for. One really annoying thing about bond funds is that they never say how many defaults they have had. This is only an issue for corporate and municipal funds. I wanted to know if defaults end up counting against the NAV or against the distributions. From what I could see, they count against the NAV but there is no line item in their statement of operations that says "defaulted bonds". I believe it is just carried on the books as a bond held, but with 0 value.

I am probably the only person who likes to pour over financial statements. Yeah, I'm a nerd.

 

[OldShooter]

A couple of things come to mind when thinking about making a large AA change in the context of moving to much higher risk portfolio i.e. close to all equities. ...

Comment on "much higher risk:" I think Markowitz did investors a disservice when he equated volatility with risk.

A long-term investor's risk is to NOT be in equities, assuming the historical equity premium of a few percent continues to exist. Compounded over many years, the equity premium produces massively larger portfolios than does investing in "low risk" bonds. At the end of, say, 20 years and even if you sell on a zig rather than a zag, the strong odds are that you will win.

To me, Markowitz ignores more real risks: Enron, Sears Holdings, JC Penney, JDS Uniphase, Theranos, .... and the list goes on. Long term investors deal with this risk by diversifying.

Agreed that volatility is risk for short-term investors and people who are forced to sell regardless of market conditions. But long term investors deal with that via AA, buckets, etc.

So, @TwoByFour, you are certainly stating conventional wisdom here. But I, at least, have an unconventional view.

 

[street]

I like your thinking on increasing equity stock. I have posted and replied to many threads that are on this topic or have veered from the main topic to what you are asking.

I have a 75/25 and I should be more on the equity side. My portfolio I want to continue to grow and I believe if you don't feel if you ever need that money why not be more risky with it.

I plan at this time to maybe just leave it as is and it will increase in equity funds as time goes on.

 

[pb4uski]

.... I wondered how defaulted bonds are accounted for. One really annoying thing about bond funds is that they never say how many defaults they have had. This is only an issue for corporate and municipal funds. I wanted to know if defaults end up counting against the NAV or against the distributions. From what I could see, they count against the NAV but there is no line item in their statement of operations that says "defaulted bonds". I believe it is just carried on the books as a bond held, but with 0 value.

I am probably the only person who likes to pour over financial statements. Yeah, I'm a nerd.

Investments are carried at fair value in NAV... so for a bond, as the credit deteriorates and the market perception of potential default increases the fair value will go down and daily changes in that fair value will be reflected in NAV. If/when the bond eventually defaults and becomes worthless or some amount less than par is received in settlement, any unrealized loss from the reduction in fair value would become a realized loss... the NAV would be unaffected since presumably any dimunition in value would have already been reflected in the fair value.

if they have a defaulted bond it would be a realized loss, but realized losses would also include bonds sold th normal course of business at for less than amortized cost.

 

[audreyh1]

I decided one day to go through the Vanguard Statement of Operations that comes with the annual report for one of their bond funds. The ER that is reported is a constant fraction that is deducted from the fund's cash flow, along with other expenses. The last statement is important because ER is not the total cost to any fund holder. A mutual fund, like VFITX, has internal costs related to buying and selling bonds, but the parent company, which in this case is Vanguard Marketing, charges the fund a fee, the ER, in order to provide additional services to the fund. That is what the ER means. The other expenses are low, just a few basis points as I recall, but they are there, somewhat hidden.

AFAIK, the ER does not include trading costs of the fund buying and selling bonds. The individual bond buyer has trading costs too. We would expect that the bond fund manager has lower trading costs per bond than an individual due to volume/access.

 

[OldShooter]

... We would expect that the bond fund manager has lower trading costs per bond than an individual due to volume/access.

I wouldn't bet for or against that theory. I just don't know.

In stocks, the issue is that a fund manager has to buy or sell enough that he is taking or abandoning a meaningful position. Maybe a few $million for a smaller fund, lots more for a bigger fund. There are plenty of meat-based traders and computer traders watching for this type of activity and trying to front-run it. Inevitably the bid prices decline when a whale is selling and ask prices increase when a whale is buying. (It would be interesting to know how long it took and and what range the of prices was as Bufffet got rid of his IBM last year.)

Granted a reliable low- or medium-volume buyer can probably split the spread on bonds, but if the same whale front-running problem happens in bonds then trading costs will be higher, not lower, than for lower volume buyers.

 

[tdv2]

Comment on "much higher risk:" I think Markowitz did investors a disservice when he equated volatility with risk.

A long-term investor's risk is to NOT be in equities, assuming the historical equity premium of a few percent continues to exist. Compounded over many years, the equity premium produces massively larger portfolios than does investing in "low risk" bonds. At the end of, say, 20 years and even if you sell on a zig rather than a zag, the strong odds are that you will win.

To me, Markowitz ignores more real risks: Enron, Sears Holdings, JC Penney, JDS Uniphase, Theranos, .... and the list goes on. Long term investors deal with this risk by diversifying.

Agreed that volatility is risk for short-term investors and people who are forced to sell regardless of market conditions. But long term investors deal with that via AA, buckets, etc.

So, @TwoByFour, you are certainly stating conventional wisdom here. But I, at least, have an unconventional view.

Point well taken. Volatility and risk are different animals. Risk of losing principal is real without adequate diversification. Unfortunately you can't diversify away shorter term market risks.

At the end of the day there is a pretty good range of stock / bond mixtures that historically would keep you ahead of inflation and provide some growth. I guess and all comes back to sleeping well.

 

[Oz investor]

i would be researching interest-bearing investments , with a view to ADDING ( NOT swapping existing investments ) but not at break-neck speed ( slowly and thoroughly )

interest rates are slowly rising , currently the risk. reward balance must be getting close

i am currently something like 97% stocks 2% bonds and 1% cash ( ignoring property assets ) this is mainly because my interest-bearing assets have mostly redeemed or matured and no suitable replacement found ( although 'stocks includes 'bond proxies but NOT 'bond ETFs ' )

please remember if the economy tanks , interest rates COULD be in for another cut ( more QE )

 

[RunningBum]

Correct. The only penalty the long term investor pays is the fees.

And getting stuck with the lower interest rate.

Let's keep the apples with the apples. My 30% hypothetical was for a individual issue, not for a fund. It would be a pretty exciting fund to see a drop of 30%. Maybe a long single-maturity fund if such a thing exists.

This discussion is getting kind of interesting. I'm going to go to the Schwab bond page and try the numbers for some real world examples. I'll report back.

You are right, that wasn't a valid comparison. I realized it after I shut down this morning and have been sightseeing/traveling all day.

 

[RunningBum]

Yup.

Medum busy, so only one example:

Spoiler: The scenario, using a couple of optimistic assumptions, is not as brutal as my made-up example but it is still a net loss for the investor to sell a lower-coupon bond prior to maturity in order to reinvest at a higher rate.

Lab rat: $10,000 Face John Deere Credit 2.8% 2027. A-rated. Ask price is 9,330, YTM 3.69.

First I make two somewhat unrealistic assumptions: (1) the seller will get the "Ask" price, which is the only price I have. He won't of course. (2) The seller can reinvest 100% of the proceeds at the YTM figure, which might be almost true for a very large position but for just a few bonds, not possible.

Total interest payments/10 years: Hold=$2800, Sell & Buy: 3,443 ($9,330 @ 3.69%). Difference $643

End payout: Hold=$10,000, Sell & Buy: $9,330. Difference $670

Net: Sell & Buy investor gains $643 on interest payments, loses $670 on principal return.

I am too lazy to do the NPV, but I think the optimistic assumptions are optimistic enough to say that in the real world an investor with this plan loses.

So I will continue to believe that this is A Bad Idea, but the penalty may be less than I thought. Others wanting to try it with different lab rats, I'll be interested to see what you find.

According to bankrate.com, if I invest $16/quarter ($64/yr) @ 3.69% compounded quarterly for 10 years, deposited at the end of the quarter, I wind up with $793, before taxes. I keep my bonds in my IRA, so no taxes on the dividends. Compared to $670 if I held to the end.

 

[Oz investor]

students of investing might look at Greece and Cyprus for recent examples of what can go wrong with interest-bearing securities

( apart from the fact 'bonds ' rarely increase much over face-value , despite inflation )

high interest rates ( on your investment ) carries it's own risks ( like early redemption , as has happened to me several times )
yes i got my cash back in 12 months rather than 5 years , but a quick investment wasn't what i was chasing when i invested ... i invest in shares for stuff like that

 

[OldShooter]

According to bankrate.com, if I invest $16/quarter ($64/yr) @ 3.69% compounded quarterly for 10 years, deposited at the end of the quarter, I wind up with $793, before taxes. I keep my bonds in my IRA, so no taxes on the dividends. Compared to $670 if I held to the end.

Sounds reasonable. What is it if you are getting more like the 2% you would be able to get if corporates are at 3.69% YTM? And if we want to get to fine details then we need to know how much below the "Ask" price the holder got when he sold his low coupon bond.

Basically, evaluating this scenario involves a reinvestment risk question. When a lower-coupon bond is sold at a discount (at the "Bid" price), the likelihood of being able to reinvest 100% of the funds at the original bond's YTM is near zero because the funds are less than what a single higher-coupon bond costs. The likelihood of being able to reinvest the small difference in interest payments at the YTM is zero unless rates continue to rise. In which case the game begins all over again.

(Reinvestment is easier if you're working with a larger sum, like 10 or more bonds of a single issue. But it is still a consideration. Thinking more, in the end if you're selling a discounted 3.69% YTM bond in order to buy a non-discounted 3.69% coupon bond with the proceeds, the best you can achieve is a wash less transaction costs.)

Kind of a fun discussion but I suppose we're boring some people.

 

[Oz investor]

Kind of a fun discussion but I suppose we're boring some people.

but hopefully not everyone

one helped person is still one person helped .

and the scenarios can be adapted for other usage