Intermediate, short bonds, cash ... reading tea leaves

[Lsbcal]

I keep reviewing my bond fund duration and questioning my choice. Maybe this analyses of the past rate rise history will help others. It will definitely help me to get the story straight.

The Fed forced short rates higher starting in early 2004 and lasting for about 2 years. You can see this here and the current situation in late Dec 2013:

You can see that the 3 month Treasury (green) was made to rise in a linear fashion and that at first the 5 year (blue) and 2 year Treasuries (red) rose together. But then the 2 year Treasury rose faster and the spread narrowed. Eventually the condition of yield curve flattening occurred. Historically this is not good for equities but that's another story.

So what happened to bond fund returns? The compound annual real returns (real CAGRs) during this 4 year period from Jan 2003 to Feb 2007 are shown here for some funds I track:

intermediate  VBTLX 0.7%  Vanguard Total Bond Market
intermediate  PTTRX 1.7%  Pimco Total Return
intermediate  DODIX 1.5%  Dodge & Cox Income
short term    VFSUX 0.7%  Vanguard Short Term Investment Grade
cash          VMMXX -0.3% Vanguard Prime Money Market

We see that intermediate bonds did better then short term bonds and much better then cash in the last rate rise. As it turns out the spread in Jan 2003 between the 5yr and 2yr Treasury was about the same as it is right now. This was not the case at the beginning of 2013. I think this is an important point.


My guesses after reading the tea leaves

So my guess is that going forward the Fed will raise rates maybe in 2015. Eventually the economy will cause the Fed and the markets to make the short rates move up faster as animal spirits take over.

The good news now is that the spreads are wide enough that it pays to be in intermediate bonds. Since we are starting at lower rates then in 2003, the real CAGR's for the next 3 or 4 years might be close to zero. Since intermediate bonds historically have yielded about 2.3% real returns, this will be disappointing. However, should real returns be low the intermediates will still keep one's purchasing power intact and fulfill the safety mission in one's portfolio.

My own bond portfolio is mostly intermediate bond funds with some short term bonds for spending in the next year.


Go ahead, gentle critiques welcomed.

 

[Ready]

In my mind, bonds (and especially bond funds) bear interest rate risk, which means their yields should be higher than an investment that does not have this inherent risk. Ever since PenFed began offering 3% CDs, I have been continuing to questions the value of short and intermediate term bond funds. I know of no such funds that pay 3% or greater, unless they invest in junk grade bonds, which then adds default risk to interest rate risk.

If a CD can offer 3% with FDIC insurance, and the only penalty for early withdrawal is forfeiture of one year of interest (less if you've been in less than a year since principal is always protected), it would seem to me that bond funds should offer greater than 3% to account for the added risk. Since they don't, they seem like a questionable investment choice for the FI portion of your portfolio.

That said, I haven not sold my bond funds, and I still maintain a 24% total allocation. However, I maintain 16% in CDs to reduce the volatility associated with interest rate risk. My gut tells me to get out completely and move the money to PenFed until rates begin to rise and NAVs fall, but I haven't taken the steps to do so yet.

 

[haha]

Bond funds do not exactly offer anything-they buy a selection of what is in the market, and sell fractional ownership of the total return and interest payments from this aggregation. So at a given duration and credit quality, what they are able to give to their buyers is only what they can find in the marketplace, less their costs and fees.

PenFed, otoh may have some fairly high yielding assets in their portfolio such as credit cards; so if they control costs they can offer a better rate. My bond funds are all in an IRA, and some taxable amounts already in Pernfed and other CDs with a year or more to run. I would probably benefit from changing to this current one, but I really did not want to take the trouble.

Also, if all my rmd requiring assets are at one competent broker, they will not let me slip up on required withdrawals, which takes one more detail off my plate.

Ha

 

[Lsbcal]

To do a PenFed CD, I would have to open an IRA at PenFed and move Vanguard IRA money to it. I'm not sure I want to go through this procedure. The 3% CD sounds kind of attractive if inflation stays around the 2% level.

 

[pb4uski]

I'm interested in this thread because I am in the middle of transitioning from Guggenheim target maturity bond funds to iShares. I have sold the Guggenheim and am currently sitting on a bunch of cash.

Over the past few months, the 2020 iShares product (IBDC) has traded at a premium, a discount and at ~NAV. Recently, it has traded at a substantial premium that is more than I am willing to pay so I am somewhat biding my time to get back in when pricing is closer to NAV.

 

[pb4uski]

To do a PenFed CD, I would have to open an IRA at PenFed and move Vanguard IRA money to it. I'm not sure I want to go through this procedure. The 3% CD sounds kind of attractive if inflation stays around the 2% level.

Just went through the process. It is relatively easy.

 

[Lsbcal]

Just went through the process. It is relatively easy.

What were the details of the mechanics like?

 

[pb4uski]

Going from memory.

"Joined" one of the charities to qualify me to join PenFed online. $15 tax-deductible donation IIRC.

Set up share account online and minimally funded it from my regular bank account. $10 IIRC.

Printed the IRA application to set up an IRA account and filled it out. Also printed a form to authorize a transfer of funds from my existing IRA to a PenFed IRA and filled it out. And then mailed (you can also fax but I don't have a fax).

They take it from there, I just monitored the progress of the transfer from my other IRA and PenFed investing it in the CDs.

Easy. YMMV.

 

[LOL!]

Another possibility is to play the "Broker Bonus" game and deposit money into a new brokerage account that pays a bonus. My spouse got $1,000 last year and invested in a Vanguard short-term bond fund ETF.

Maybe it is time to switch again?

 

[galeno]

We have it easy. We ALWAYS use intermediate term "bonds". We've boiled our choices down to two: our bond fund (PTTAX) or a new 5yrCD.

Our bond fund's SEC Yield = 1.40%. A new 5yrCD is yielding over 2%. If we had to chose today, the CD wins.