Bond fund appreciation over long term

[COcheesehead]

Maybe "bond like" in that they pay interest, but guaranteed not with "bond like" risk. TANSTAAFL.

I feel like I am over at Bogleheads. They chastised me once for owning individual bonds. That, according to them, was too risky.

 

[audreyh1]

First of all - expected long term total return (appreciation?) of a bond fund with reinvested dividends at any point in time will generally be the current SEC yield. For example, Vanguard Total Bond Market Index Fund VBTLX on 1/6/20 had an 30 day SEC yield of 2.25%. So it should do slightly better than inflation pre-tax. That's probably all that you can expect to earn on funds you invest today. If interest rates rise quite a bit and you add funds after the rise, you can expect the total return on those funds to be correspondingly higher.

In terms of composition:

Buying a US broad base index bond fund makes no sense at the present time, for instance the vanguard total bond fund holds 70% US Treasuries, which you could buy at zero cost versus the 0.15% annual cost of vanguard = to almost 9 percent of the total yield of the bond fund and 30% corporates of which 50% are BBB that trade at historic low yields.

VBTLX does not hold 70% US Treasuries. It holds 62.3% in US Government-backed debt, of which Treasury AND Agency combined is 43.7%.

And the ER is not 0.15%, it is 0.05%. Big difference.


I use the Fidelity US Bond Index fund FXNAX as my core intermediate bond fund.

It holds 70.71% in US Government debt of which 43.45% is US treasuries, and another 25.64% is in (Agency) mortgage-backed securities. The foreign government exposure in this fund is extremely small.

It holds 23.50% in investment grade corporate securities. It only holds 9.08% overall in BBB rated debt. And a tiny fraction (0.03% BB) below BBB.

The expense ratio is 0.025%. I am quite happy to pay 0.025% ER and not mess with individual bonds even the easy to buy US Treasuries. Plus I have exposure to US Govt mortgage-backed bonds and to investment grade corporate debt.

Agree.

And I think it makes more sense to actively manage bond investments, either yourself or using a fund or manager.

When I contrast FXNAX with DODIX and FTBFX - two popular actively managed core bond funds, FXNAX is far more conservative and holds far less BBB or lower rated debt as well as being far less expensive to own.

Dodge and Cox Income DODIX holds 32.79% in Agency mortgage-backed securities and 9.36% in US Government debt which would include treasuries. It holds 35.04% in corporate bonds. Of this a whopping 29.90% of the entire fund is BBB rated debt, and another 5.61% in below BBB rated debt (i.e. non investment grade). It has a higher foreign debt exposure. ER is 0.42%.

Fidelity Total Bond Fund FTBFX owns 52.08% in US government debt, of which 31.64% is US government including treasuries, and 19.38% is (Agency) mortgage-backed securities. It holds 37.07% in corporate debt which includes 18.43% in BBB rated debt and 13.02% in below BBB rated debt (non investment grade) for a total of 31.45% of the entire fund in BBB or lower rated debt. ER is 0.45%.

The FXNAX profile matches what I want in terms of diversification against my equity funds (Treasuries and US-Govt backed debt has far lower correlation to equities than corporate debt and high yield debt), so I have a large investment in this fund at extremely low cost.

And frankly I don't understand the criticism of index funds holding BBB debt when I suspect many active bond funds hold far more plus a good chunk of even lower rated debt.

 

[ncbill]

There are better alternatives in "bond like" assets that yield 2x-3x-4x what a "bond" will get you today.

But how correlated are they to equities?

You want your investment in fixed not to be.

Chasing yield normally gets you into investments increasingly correlated with your equity portfolio, which is exactly what you don't want.

 

[audreyh1]

Fixed income is the ballast in your asset allocation.

Risk taking should be on the equity side of that allocation, not fixed income.

But how correlated are they to equities?

You want your investment in fixed not to be.

Chasing yield normally gets you into investments increasingly correlated with your equity portfolio, which is exactly what you don't want.

Absolutely agree.

 

[BeachOrCity]

I feel like I am over at Bogleheads. They chastised me once for owning individual bonds. That, according to them, was too risky.

Could you share with us what it is that gets 2x-4X bond returns, so the rest of us can decide if that makes sense for our own portfolios risk wise?

 

[Running_Man]

And frankly I don't understand the criticism of index funds holding BBB debt when I suspect many active bond funds hold far more plus a good chunk of even lower rated debt.

The issue to me is that BBB rated debt has only a 3.1% interest rate versus 4.7% just one year ago and you can move into the A category and get 2.65% with a much better credit profile as a whole for a minimal long term impact on a portfolio.
If there ever is another downturn in the economy, BBB will be more strongly impacted by downgrades than any other rating. Total Market Bond Index funds make no distinction between BBB and A rated bonds and treat them the same. This has allowed the BBB to mushroom both in percentage terms of total impact to the market and to the dollars of BBB bonds outstanding. While not downgrading anybody the actual credit quality of the BBB category is far worse than it was in 2008, reaching a historic high of debt to assets, usually something a creditor should be concerned about, but since debt is freely available, not considered an issue today.

 

[pb4uski]

....The issue to me is that BBB rated debt has only a 3.1% interest rate versus 4.7% just one year ago and you can move into the A category and get 2.65% with a much better credit profile as a whole for a minimal long term impact on a portfolio.
If there ever is another downturn in the economy, BBB will be more strongly impacted by downgrades than any other rating. ....[/QUOTE]

But at least historically, BBB default rates have been much lower than the 0.45% spread. Weighted long term average is 0.17%, median is 0.06% and 2008 default rate was 0.49%... so it seems to me that BBB investors are being adequately compensated for the additional credit risk.

 

[OldShooter]

Could you share with us what it is that gets 2x-4X bond returns, so the rest of us can decide if that makes sense for our own portfolios risk wise?

Partial information: Here is a chart I was given in an investment review meeting last fall. My guess is that even if interest rates have moved since the chart was done, the fact that it talks to spreads and default rates means that a more current one will have not changed much. Read the footnote, though.

​

 

[audreyh1]

Total Market Bond Index funds make no distinction between BBB and A rated bonds and treat them the same. This has allowed the BBB to mushroom both in percentage terms of total impact to the market and to the dollars of BBB bonds outstanding. While not downgrading anybody the actual credit quality of the BBB category is far worse than it was in 2008, reaching a historic high of debt to assets, usually something a creditor should be concerned about, but since debt is freely available, not considered an issue today.

But actively managed core bond funds are holding even more BBB rated debt compared to index funds, in some cases substantially more, as well as junk (high yield) and emerging market debt. So moving from an index fund to an actively managed bond fund is not protecting you from a large exposure to lower credit quality debt.

 

[BeachOrCity]

This thread brings me back to all the issues the ratings agencies had in 2007-2010. There really was not much reform after that. Do people still trust them? I don't.

So my bonds / cash is almost all govt secured, or is in a stable value fund. I just don't trust their ratings of commercial debt so I largely stay away from it.

 

[COcheesehead]

But how correlated are they to equities?

You want your investment in fixed not to be.

Chasing yield normally gets you into investments increasingly correlated with your equity portfolio, which is exactly what you don't want.

They are in their own universe. But let's not discuss these. They are too "risky".

 

[COcheesehead]

Could you share with us what it is that gets 2x-4X bond returns, so the rest of us can decide if that makes sense for our own portfolios risk wise?

They are all available for anyone to find and research through any brokerage. Use the screener tools.

I encourage everyone to seek their own information through sites like Seeking Alpha on alternative fixed income products.

I hesitate to share because it brings out the belt and suspenders crowd who criticize anything with a percent of risk.

 

[Running_Man]

But actively managed core bond funds are holding even more BBB rated debt compared to index funds, in some cases substantially more, as well as junk (high yield) and emerging market debt. So moving from an index fund to an actively managed bond fund is not protecting you from a large exposure to lower credit quality debt.

Very true and I would not recommend those either. There is an Ishares A - AAA bond fund for corporates SEC yields 2.61 currently and US treasury funds at varying maturities available. If one feels a fund is essential those would be better credit risks. The difference in performance on the upside on a 60/40 portfolio would only be about .2% annually and the downside protection is far greater than what models show.

 

[audreyh1]

I’m comfortable with the current 9% exposure of FXNAX to BBB rated debt, but I definitely will keep an eye on it. I certainly appreciate you bringing my attention to the issue of the explosion of BBB debt and it was a good time to review fund composition. Although I have always paid careful attention to overall credit quality which actually made me move away from actively managed bond funds and towards index funds.

 

[ncbill]

This thread brings me back to all the issues the ratings agencies had in 2007-2010. There really was not much reform after that. Do people still trust them? I don't.

So my bonds / cash is almost all govt secured, or is in a stable value fund. I just don't trust their ratings of commercial debt so I largely stay away from it.

Yep, the next recession will reveal how much of that current "BBB" rated debt will turn out to be junk instead.

 

[OldShooter]

... I hesitate to share because it brings out the belt and suspenders crowd who criticize anything with a percent of risk.

Almost all non-govvie bonds have risk to one degree or another. When you say that there are products with 2x-4x yield I think it is very important that the OP understand that to the extent such options are available they have higher risk than govvies and high-grade corporates. To make that observation is not a criticism, it is simply stating a fact that you omitted.

We spent several years with serious six figures in SAMBX, a "floating rate" fund that gave us very nice yields, but we understood the risk we were accepting. From the OP's question, I would say that SAMBX and similar "2x-4x" options are probably not a good place for him/her to start.

 

[COcheesehead]

It depends why the OP is interested in bonds. Some investors might be looking for ballast or capital preservation in their bonds. Other investors are looking for a paycheck or income. Appreciation isn't generally why someone seeks bond or bond like investments.
I personally hold bond and bond like investments for both reasons. I seek safety with a part of my portfolio and I seek to maximize income knowing there could be some volatility for other parts of my portfolio.
I have 6 figures worth of annual cash flow with a combination of these two and I sleep well at night. I am also be no means a high risk investor. I am pretty moderate.

 

[Montecfo]

First of all - expected long term total return (appreciation?) of a bond fund with reinvested dividends at any point in time will generally be the current SEC yield. For example, Vanguard Total Bond Market Index Fund VBTLX on 1/6/20 had an 30 day SEC yield of 2.25%. So it should do slightly better than inflation pre-tax. That's probably all that you can expect to earn on funds you invest today. If interest rates rise quite a bit and you add funds after the rise, you can expect the total return on those funds to be correspondingly higher.

In terms of composition:


VBTLX does not hold 70% US Treasuries. It holds 62.3% in US Government-backed debt, of which Treasury AND Agency combined is 43.7%.

And the ER is not 0.15%, it is 0.05%. Big difference.


I use the Fidelity US Bond Index fund FXNAX as my core intermediate bond fund.

It holds 70.71% in US Government debt of which 43.45% is US treasuries, and another 25.64% is in (Agency) mortgage-backed securities. The foreign government exposure in this fund is extremely small.

It holds 23.50% in investment grade corporate securities. It only holds 9.08% overall in BBB rated debt. And a tiny fraction (0.03% BB) below BBB.

The expense ratio is 0.025%. I am quite happy to pay 0.025% ER and not mess with individual bonds even the easy to buy US Treasuries. Plus I have exposure to US Govt mortgage-backed bonds and to investment grade corporate debt.


When I contrast FXNAX with DODIX and FTBFX - two popular actively managed core bond funds, FXNAX is far more conservative and holds far less BBB or lower rated debt as well as being far less expensive to own.

Dodge and Cox Income DODIX holds 32.79% in Agency mortgage-backed securities and 9.36% in US Government debt which would include treasuries. It holds 35.04% in corporate bonds. Of this a whopping 29.90% of the entire fund is BBB rated debt, and another 5.61% in below BBB rated debt (i.e. non investment grade). It has a higher foreign debt exposure. ER is 0.42%.

Fidelity Total Bond Fund FTBFX owns 52.08% in US government debt, of which 31.64% is US government including treasuries, and 19.38% is (Agency) mortgage-backed securities. It holds 37.07% in corporate debt which includes 18.43% in BBB rated debt and 13.02% in below BBB rated debt (non investment grade) for a total of 31.45% of the entire fund in BBB or lower rated debt. ER is 0.45%.

The FXNAX profile matches what I want in terms of diversification against my equity funds (Treasuries and US-Govt backed debt has far lower correlation to equities than corporate debt and high yield debt), so I have a large investment in this fund at extremely low cost.

And frankly I don't understand the criticism of index funds holding BBB debt when I suspect many active bond funds hold far more plus a good chunk of even lower rated debt.

I do not really disagree with any of the stats you laid out. I will say that folks that believe indexing is the way to go with equity investments may also believe the same should be true of debt. For a number of reasons I don't find that to be the case as debt is a different animal.

1. Indexes tied to the Agg will be more heavily weighted to government securities. No credit risk but higher rate risk than most active managers of core or core plus bond funds would select.

2. Indexers buy the largest capitalization issuers in the largest quantities. But being a large cap equity (like MSFT or AAPL) is very different than being a large cap debt issuer, like AT&T.

3. Active managers do their own analysis of each issue, and buy the issues reflecting the greatest return for the risks assumed. Indexers do no such analysis. It is folly to assume the rating agencies have done their homework well, yet indexers rely on them exclusively

4. Active managers can tweak duration and debt composition based upon their view of the market. Indexers do not.

The best active managers have done very well over time compared to the Agg. You cited Dodge And Cox Income, it is certainly one of them.

I suspect you have analyzed and we'll understand what you own. I have no problem with that. I only suggest you not own it just for low costs alone but because it meets your performance expectations.

 

[OldShooter]

... I will say that folks that believe indexing is the way to go with equity investments may also believe the same should be true of debt. ...

Yes. I have studied the data that supports a passive approach to equities and it is 100% convincing to me. I have never, though, seen much to support the idea of bond indexing. Certainly there are tens of thousands of bonds out there, coming and maturing. What could an index really mean? And to some extent bonds are fungible; one AAA corporate is pretty much like any other. So how does that affect the concept of "index?" DW and I are, fortunately, not interested in bond funds, so I really don't have to understand.

Different subject: BBB bonds. I really don't understand the wailing and renting of garments where a BBB might get a downgrade. The risk of default is still small, so for an investor holding it to maturity, the downgrade may well be a don't care. Yeah, a bond fund's value would take a hit, but that's one of the reasons we don't buy funds.

 

[audreyh1]

IThe best active managers have done very well over time compared to the Agg. You cited Dodge And Cox Income, it is certainly one of them.

I suspect you have analyzed and we'll understand what you own. I have no problem with that. I only suggest you not own it just for low costs alone but because it meets your performance expectations.

What I care about most is how my bond funds behave during periods of market stress and liquidity crises. Higher credit quality does much better during these periods. I have equities to boost total return and I don’t look for that from my fixed income allocation.

I had a large position in DODIX during 2008, and it absolutely cratered. Just was horrible. It eventually recovered but that was a huge wake up call for me and I started repositioning my fixed income to be much higher credit quality. This in fact led me towards using the index funds instead.

I don’t worry too much about interest rate risk as I manage that by duration. I hold short to intermediate term duration. And I’m holding these funds essentially forever. Plus I rebalance more or less annually, so whenever bond funds lag I buy more.

When you say the actively managed funds have “done well” I think you mean they have had higher long term total return. But they have also taken on more credit risk to accomplish that, so I don’t consider their risk-adjusted total return to necessarily be better. I care about lower correlation with equities and having a good ballast during tough times.

And even though active bond fund managers can add value to a fund in many ways such as rolling down the curve, IMO they are no better at predicting interest rate moves and spread changes than anybody else, plus they tend to take on far more credit risk to boost returns.

 

[Montecfo]

What I care about most is how my bond funds behave during periods of market stress and liquidity crises. Higher credit quality does much better during these periods. I have equities to boost total return and I don’t look for that from my fixed income allocation.

I am fine with that. My fixed income portfolio reflects a range of risk levels, as does my equity portfolio. If I wanted the greatest ballast, I would be 100% in treasuries since that would be best in times of market stress.

I had a large position in DODIX during 2008, and it absolutely cratered. Just was horrible. It eventually recovered but that was a huge wake up call for me and I started repositioning my fixed income to be much higher credit quality. This in fact led me towards using the index funds instead.

It is only an issue if you wish to rebalance out of those funds and the performance is different than your expectations. But I agree with the idea of improving quality especially after a long bill run. That is wise in my view.

I don’t worry too much about interest rate risk as I manage that by duration. I hold short to intermediate term duration. And I’m holding these funds essentially forever. Plus I rebalance more or less annually, so whenever bond funds lag I buy more.

If you hold index funds how do you manage duration ?

When you say the actively managed funds have “done well” I think you mean they have had higher long term total return. But they have also taken on more credit risk to accomplish that, so I don’t consider their risk-adjusted total return to necessarily be better. I care about lower correlation with equities and having a good ballast during tough times.

I respect your judgement there. But obviously you are taking more risk than you have to in your debt portfolio, since it is not all treasuries. I think what you are saying is you are comfortabe with risks inherent in Agg indexed funds but not actively managed funds. These are choices we all have to make.

And even though active bond fund managers can add value to a fund in many ways such as rolling down the curve, IMO they are no better at predicting interest rate moves and spread changes than anybody else, plus they tend to take on far more credit risk to boost returns.

Could be. You are managing interest rate risk yourself and are fine with your own predictions (as reflected in the durations you choose). Within the funds I choose I pay a manager with a consistent track record of success doing so.

As Sly Stone said, different strokes.

 

[audreyh1]

I am fine with that. My fixed income portfolio reflects a range of risk levels, as does my equity portfolio. If I wanted the greatest ballast, I would be 100% in treasuries since that would be best in times of market stress.

Yes, I have chosen a overall credit quality that behaves well enough during rough times by historical measures where funds have remained relatively flat or appreciated somewhat.

It is only an issue if you wish to rebalance out of those funds and the performance is different than your expectations. But I agree with the idea of improving quality especially after a long bill run. That is wise in my view.

Well, yes, rebalancing during nasty market events is exactly what I have done and will continue to do.

If you hold index funds how do you manage duration ?

In general, generic bond index funds tend to stay intermediate in overall duration. However, I hold short-term bond index funds as well.

I respect your judgement there. But obviously you are taking more risk than you have to in your debt portfolio, since it is not all treasuries. I think what you are saying is you are comfortabe with risks inherent in Agg indexed funds but not actively managed funds. These are choices we all have to make.

Well perhaps as I age I will continue to improve credit quality and ultimately end up all US government. But yes, at the moment I’m comfortable with AA average credit quality and avoiding below investment grade debt.

Could be. You are managing interest rate risk yourself and are fine with your own predictions (as reflected in the durations you choose). Within the funds I choose I pay a manager with a consistent track record of success doing so.

I’m not predicting, I’m simply targeting a generally short to intermediate duration for my fixed income.

Unlike you I haven’t been particularly impressed with active bond fund managers and I’ve owned bond funds from several well respected fund shops including DODIX and MWTRX. From my experience over the past two decades they tend to become far more aggressive in terms of credit quality at the worst times.

 

[2177V]

Fixed income novice questions of the day:

• Should an investor holding a bond fund expect that it will, in all likelihood, appreciate in value over long (say, 20+ year) time periods? VBMFX has a 5.86% CAGR since its inception in 1987, for example.
• If it's reasonable to expect such appreciation in bond fund value, what drives this appreciation? Inflation? Something else?
• Should a prospective investor looking to buy into a particular bond fund be concerned with (or driven by) the current share price? Would it be best just to buy all at once without regard to current share price, or would some sort of DCA over say, 6-12 months, be worth considering?

Thanks in advance for helping me get smarter about these puzzling but important parts of our investment world.

IMO: Stay away from corporate bonds. My opinion is based on last year's Morgan Stanley Report which I cut and pasted below:
_____________________________________________________

Important Report from Morgan Stanley on Bond Risk

Below is the outcome of ultra-low interest rates and huge liquidity, both linked to the quantitative easing program post 2008 financial crisis.

There is a massive pile-up of risk in the corporate bond market.

"The investment-grade corporate-bond market has also grown massive; it is much larger than it was going into the prior credit crisis. A Morgan Stanleyresearch report suggests that, based on leverage ratios alone, 45% of investment-grade corporate bonds would be rated junk right now. The report further suggests that around 60% of corporate bonds currently rated BBB would be rated junk by the same leverage-ratio metric. That’s around $1 trillion of par value, or about 150% of the junk-bond market’s value."


Rublin, L., 2019. Forget trade wars and rate hikes: our experts see a good year for stocks. Barron’s, Jan. 12
____________________________________________

My own risk assessment: When a BBB bond is downgraded to High Yield Junk, then generally the value on the BBB Investment grade bond goes down.

If you recall from 2007, there was a financial crisis because mortgages were given to unqualified borrowers. The mortgages were sold on the secondary market as a financial derivative that the borrower had good credit or the mortages met standards. When the crash happened, the borrowers could not pay back the mortgages and many houses foreclosed while some investors lost money.

We may have a similar situation: We have BBB bonds being sold as investment grade bonds but they are really junk according to Morgan Stanley. This means there is a higher risk that the BBB company cannot pay back the bond holder their promised bond interest rate returns during hard times and the BBB company may even default...just like the unqualified mortgage borrower in 2007.

I recognize this as a higher risk so I sold my corporate bonds for US Treasury Bonds. The Bond market is stable as long as we do not have a crash. However, when the market becomes unstable then there may be a lot of investors who may get crushed because they depend on their corporate bonds to stabilize their portfolio during a recession. This is my opinion so other people should do their own research and risk assessment on this subject.

 

[SpinDoctorTX]

This speaks to my biggest concern about buying into a bond fund right now (which I'm actively contemplating due to AA rebalancing). I'd be buying at historic highs, resulting in far fewer shares than if I waited until bond funds come back down to earth. Market timing, I know, I know... but in this case, it seems prudent to wait since we know interest rates really have nowhere to go but up eventually. So now I'm thinking of just waiting it out in VMMXX and CDs for a while to see what happens.

Thanks for that... I've been on the fence regarding this topic for months now. I remain in a holding pattern as well.