Low interest rates

[Whisper9999]

One of the things I found very powerful was the 4% and the body of research around it. If I understood it right, it was based on backtesting a portfolio of a majority of SnP indexed stocks and a minority of fixed interest instruments.

Now what is interesting to me is that I have the majority of people have "diverged" from that pattern during the time of low interest rates and are investing in REITS, foreign markets, junk bonds, etc. And that seems logical with int. rates at (I beleive) historic lows and dang near zero.

But I'm interested in the investing psychology of all of this. I'm wondering if everyone who has "diverged" is going to go back to the original mixtures (that adhere more to the 4% Rule studies) once intersest rates start to rise again to a respectable level?

Well, here again I don't expect anyone else to follow
me (different drummer) I intend to partially return to my old habits when (if?) interest rates come back up.
Having made the leap into various bonds from mostly CDs, I will not be coming all the way back. In fact, if my
market values fall too far or too fast, then I will just
stay put and "hold to maturity" on my "forever money".
If interest rates fail to rise much faster, I expect to have
some bonds called in the next 6 months. Thus, I will
have that old conundrum, where to put it?

John Galt

[brewer12345]

Quote:

Well, here again I don't expect anyone else to follow me (different drummer) *I intend to partially return to my old habits when (if?) interest rates come back up. Having made the leap into various bonds from mostly CDs, I will not be coming all the way back. *In fact, if my market values fall too far or too fast, then I will just stay put and "hold to maturity" on my "forever money". If interest rates fail to rise much faster, I expect to have some bonds called in the next 6 months. *Thus, I will have that old conundrum, where to put it? John Galt

Ugh. JG, I hate to pick on you, but you are a poster child for why retail investors shouldn't buy callables. Bonds don't get called when rates rise. They get called when rates drop.

[Jarhead*]

Quote:

Ugh. *JG, I hate to pick on you, but you are a poster child for why retail investors shouldn't buy callables. *Bonds don't get called when rates rise. *They get called when rates drop.

Brewer12345:

Exactly. If I remember right you are a bond analyst.
Also don't want to pick on JG, but will have to admit to twitching a little bit when he said that he had recently purchased a 20 year bond. (In current interest rate environment, a step on the dark side as far as I am concerned.
You would be doing old John a big favor if you could "splain" the way bonds work off line.
Regards, Jarhead

If it wasn't too much to ask an explanation of bond funds would benefit everyone. I know that I would be interested in the relationship between duration and risk. I am trying to keep my durations under 5 years due to the expected rate rise, but some feel that even 5 years is too much exposure.... Comments would be appreciated.


JP

[ats5g]

Hey JP,

From Vanguard:

Understanding bonds and interest rates

From Investopedia:

Bond Basics

Advanced Bond Concepts

- Alec

This is for Brewer. I misspoke. I do know the
difference. Honestly. It's a pretty simple concept
really.

BTW, I am not surprised at a few twitches when I talk
about buying 20 year bonds, Here is the deal.

I ask myself if I can afford to tie up the money and if
I can live with the income it generates no matter what
interest rates do and no matter what that does to market value. Right now I can get 4.5 % on a 5 year CD or potentially go way out and get 7% by adding a bit
of risk. I choose the 7% (Cut-Throat, I know what you are thinking). Honestly folks, we can debate this stuff all day. I am comfortable. Hopefully you are too.

John Galt

[brewer12345]

Quote:

If it wasn't too much to ask an explanation of bond funds would benefit everyone. I know that I would be interested in the relationship between duration and risk. I am trying to keep my durations under 5 years due to the expected rate rise, but some feel that even 5 years is too much exposure.... Comments would be appreciated. JP

Heheh, a "brief" discussion of the machanics of bond valuation and interest rates? I have at least half a dozen graduate level textbooks on the subject.

Having said that, I will try to give you the Cliff's Notes version:

- Duration: duration is a rough measure of a bond's sensitivity to interest rate changes. This is a gross simplification, but a straight risk free bullet (i.e. treasury bond with coupon payments and a single fixed maturity date with no call provision or other embedded derivatives) will change in value by duration times the change in interest rates in basis points. So a $100 bond with a duration of 5 would drop in value by $5 if there were an immediate upward shift of interest rates of 1% across the yield curve.

- Convexity: convexity is the second order derivative of the change in a bond's value given a change in rates. For the bullet referenced above, convexity is always positive. What this means is that a bond with positive convexity doesn't drop in value as much as duration would suggest as rates rise, and it rises more than duration would suggest as rates drop. Callables and MBS typically have negative convexity, which is why I am not a fan. At the retail level, buyers of callables get slightly higher yield to compensate for the negative convexity, but they usually get less than the market demands (IOW, they sell the convexity too cheap).

- Credit spreads: My comments thus far are applied to treasury bonds only. Corporates also have credit risk (risk of default), for which the investor receives extra yield to compensate. This is known as the "credit spread" and the riskier the borrower, the higher the spread. Credit spreads change over time, sand lately they have been at historic lows. If credit spreads widen at the same time rates rise, investors in corporate bonds are likely to get a double-whammy.

- Duration and risk management: This is a tough one. If you are chiefly an investor in bonds because you wish to reduce portfolio volatility, then keeping durations low is wise. I personally will not go out more than 5 years at current rates, and I am not buying corporates because you don't get paid for the credit risk right now. If you are a bond investor because you want income, you would be well advised to set duration and credit risk bounds on your bonds and then go shopping. In this latter scenario, I probably would not go out further than 10 years and would probably limit duration to something like 7.

As I said, this is a gross simplification, but it is the basic thumbnail sketch. When I hear JG mention buying 20 year, callable corporates from barely investment grade borrowers, it is like hearing fingernails on a blackboard. Hopefully you have an inkling as to why after reading this post.

Hello Brewer12345. Okay, I get the message, but
someone is buying bazillions of dollars of 20 year
(or longer) corporates to get the yield. Are they all
idiots too, and if not, who are all of those other
folks buying up these offerings along with me?
As to the callable feature, I don't care. I get a good rate
(absent default) and worst case I need to find a home for 100% of my money if the bond is called. I could have
worse problems.

John Galt

[brewer12345]

Quote:

Hello Brewer12345. *Okay, I get the message, but someone is buying bazillions of dollars of 20 year (or longer) corporates to get the yield. *Are they all idiots too, and if not, who are all of those other folks buying up these offerings along with me? As to the callable feature, I don't care. *I get a good rate (absent default) and worst case I need to find a home for 100% of my money if the bond is called. *I could have worse problems. John Galt

Hey, what you do is up to you, but I would suggest that you are fooling yourself if you think you have taken a low risk approach.

The buyers of long-dated paper are either unsophisticated retail investors chasing yield or institutional players who have long-dated liabilities to hedge with long dated assets. Since the institutions can immunize themselves with appropriate assets, they don't have to care about fluctuations in the value of the bonds.

[haha]

Quote:

...or institutional players who have long-dated liabilities to hedge with long dated assets. *Since the institutions can immunize themselves with appropriate assets, they don't have to care about fluctuations in the value of the bonds.

You said a mouthful here. I doubt you will get very far trying to explain it to John Galt, because he doesn't lack confidence in his plan.

But I have had conversations with relatives, old friends, etc, where they take comfort that (due to efficient market) they can't be the only ones buying some long term bond at historically low interest rates.

They either don't know or have forgotten that not every bond buyer has real liabilites. Some have nominal, fixed liabilities; and their only career risk is screwing up the relatively simple task of matching those liabilities with low risk credits of similar duration.

M

Well, John Galt " doesn't lack confidence" in pretty
much all areas. But, I think I have analyzed the risks
pretty well. I am aware that what I am doing is perceived as "chasing yield", but so far (several years now) it's been working fine. Maybe I will opt out.
Maybe not. Maybe the NAV will drop so far that I can't move the money. But, if I don't have to sell and the bond doesn't default, I don't see much downside,
other than I might miss out on those 17% CDs from
20 years ago. What am I missing? Seriously.............
You all know I won't own stocks. Should I be sitting
at ING and getting 2%?

John Galt

[Nords]

Quote:

Okay, I get the message, but someone is buying bazillions of dollars of 20 year (or longer) corporates to get the yield. *Are they all idiots too, and if not, who are all of those other folks buying up these offerings along with me?John Galt

The answer to the first question is "yes."

Read all about it! *Start with "Extraordinary Popular Delusions And The Madness Of Crowds", then segue to "Serpent on the Rock" (Prudential-Bache selling LLPs in the 1980s), then try "When Genius Failed" (LTCM in the 90s), "Liar's Poker" or any other Michael Lewis book, and then anything by Frank Partnoy. *The list goes on & on.

Just because an investment is in high demand doesn't mean that it's a good investment. *Just because it has a good yield doesn't mean that we should buy it. *

But perhaps it's really truly different this time...

Well, I agree that just because everyone is buying or that a particular investment has a "good yield"
is (by itself) a poor reason to buy. I made all of these
decisions by myself and the " herd mentality" has never
influenced me much. Hell, I've been a maverick my entire
life, and specialized in financial work for over 30 years.
I am doing what a lot of other people are doing, but I am not doing it because they are. I can't speak for them.

John Galt

[brewer12345]

Quote:

Well, John Galt *" doesn't lack confidence" in pretty much all areas. *But, I think I have analyzed the risks pretty well. *I am aware that what I am doing is perceived as "chasing yield", but so far (several years now) it's been working fine. *Maybe I will opt out. Maybe not. *Maybe the NAV will drop so far that I can't move the money. *But, if I don't have to sell and the bond doesn't default, I don't see much downside, other than I might miss out on those 17% CDs from 20 years ago. *What am I missing? *Seriously............. You all know I won't own stocks. *Should I be sitting at ING and getting 2%? John Galt

What are you missing? Let me try to put it in a nutshell. You are thinking and investing in nominal dollars but you live on goods that are priced in real dollars. If rates spike, it is probably because inflation has done so as well. With your 20 year 7% bonds, you will be eaten alive by the ravages of inflation as time goes on. Holding to maturity is all fine and well, but the purchasing power of your coupons will be savaged in that time period. If you are OK with 7% now, 15 years of low 3% inflation cuts your purchasing power and the value of your principal in half in real terms.

I don't know how to make it any simpler. You will likely be fine over the next 5 to 10 years, but further than that you may be slowly finding cat food more and more appealing on your income.

[retire@40]

Not being a bond expert, I wonder why GMAC would even have a 7% bond in today's low interest rates and why it would be rated as junk or almost junk since GMAC is a multi-billion dollar company?

However, I did find this on Fidelity(http://fixedincome.fidelity.com/fi/F...play?name=GMAC):
As of October 12, 2004, General Motors Acceptance Corporation has been put on negative credit watch by Moody's. *

Is this something to worry about?

[haha]

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As of October 12, 2004, General Motors Acceptance Corporation has been put on negative credit watch by Moody's. * Is this something to worry about?

Nah, Moody's just does this to shake out the economic girly-men.

Mikey

[brewer12345]

Quote:

Not being a bond expert, I wonder why GMAC would even have a 7% bond in today's low interest rates and why it would be rated as junk or almost junk since GMAC is a multi-billion dollar company? However, I did find this on Fidelity(http://fixedincome.fidelity.com/fi/F...play?name=GMAC): As of October 12, 2004, General Motors Acceptance Corporation has been put on negative credit watch by Moody's. * Is this something to worry about?

Basically, it means that further downgrades are a possibility, but not a given. Not a positive.

Last year (2003) GMAC had a profit (a record I think)
of 2.3 Billion dollars. They must be doing something right. Re. "eaten alive by inflation", no chance!
I have COLA'd SS and 50% of my net worth in real estate. I am still waiting to hear SOMETHING
concrete to show me the error of my ways.
Bring it on!

John Galt

[brewer12345]

Quote:

Last year (2003) GMAC had a profit (a record I think) of 2.3 Billion dollars. *They must be doing something right. *Re. "eaten alive by inflation", no chance! I have COLA'd SS and 50% of my net worth in real estate. *I am still waiting to hear SOMETHING concrete to show me the error of my ways. * Bring it on! John Galt

JG, if you are happy with what you have done, then great. No biggie. I wouldn't touch those bonds with someone else's 10 foot stick, but a difference of opinions is what makes a market. I guess I would wonder why you would invest in the GMAC paper when you would probably have less risk and more reward with a conservative equity portfolio, but vive la difference.

Just make sure you really understand what you are getting into. The only times I have regretted an investment are when I didn't really understand what I was doing.