Making a case for bond allocation

[DawgMan]

So, like many, I will do my once a year assessment of my investment returns first part of Jan, perhaps tinker some with the individual investments, and then rebalance and set sail for another 12 months! I ratcheted down my AA a couple of years ago to 60/40 due to the advice of many of you since I was fortunate enough to have effectively "won the game" even though I am about 2 years from choosing to launch. My struggle, as I am sure is the same for many, is making peace with my "40" being in bonds in a rising interest rate environment. In my case, I made the decision 12 months ago to break up my "40" as follows... 25 in Intermediate Bonds, 5 in Preferred Stock, 5 in High Yield Bond, and 5 in Foreign Bond. After looking at the last 12 months of performance and taking into account basically 4 Fed increases (including Dec 2016), to my pleasant surprise, I noticed the following performance (assumes reinvestment of dividends and approximate returns)...

Type Yield Total Return
Intermediate 2.3% 3%
Preferred Stock 5.5% 11%
High Yield Bond 5% 11%
Foreign Bond 5% 10%

So, my take away is that perhaps I should not be so concerned about these gradual interest rate increases after all and stay the course? Your thoughts on your bond allocation going forward in 2018?

 

[USGrant1962]

As long as there is a normal yield curve bond funds should be fine, Michael Kitces describes what is happening with bond funds as "rolling down the yield curve". https://www.kitces.com/blog/how-bon...ve-help-defend-against-rising-interest-rates/

The yield curve has been flattening, so I'm not really clear what that means going forward for bond funds in this context. Of course if the yield curve inverts, look out for a recession! But that is when a percent or two loss in your bond allocation is a good thing compared to losses in your stock allocation.

 

[DawgMan]

As long as there is a normal yield curve bond funds should be fine, Michael Kitces describes what is happening with bond funds as "rolling down the yield curve". https://www.kitces.com/blog/how-bon...ve-help-defend-against-rising-interest-rates/

The yield curve has been flattening, so I'm not really clear what that means going forward for bond funds in this context. Of course if the yield curve inverts, look out for a recession! But that is when a percent or two loss in your bond allocation is a good thing compared to losses in your stock allocation.

I suppose I am comparing my alternative options to bonds such as CDs or MMK accounts that might return lesser returns. For the moment, I am overweighed in MMK accounts returning 1%-ish until I rebalance.

 

[audreyh1]

I have been watching the yield curve with interest and am interested to see if it continues to flatten next year or starts steepening again in response to increased economic activity and/or hints of higher inflation.

I hold mostly intermediate core-type bond funds, with some short-term index bond funds. Although I do have a bit in multisector bond fund and muni bond fundsas well.

Since my overall duration is intermediate (on the shorter side of the range) I don’t worry about near term performance impacts of Fed rate raises on my bond allocation as they will smooth out in a few years plus I will be rebalancing into them. I own bonds and cash mainly to diversify against equities. As stocks climb, gains are trimmed and reinvested in bonds. When stocks crater, some of the bonds are sold to buy more stock.

 

[Huston55]

break up my "40" as follows... 25 in Intermediate Bonds, 5 in Preferred Stock, 5 in High Yield Bond, and 5 in Foreign Bond.

So, my take away is that perhaps I should not be so concerned about these gradual interest rate increases after all and stay the course? Your thoughts on your bond allocation going forward in 2018?

We’re also 60/40 (more accurately 60/35/5ish), and our “40” is similar to yours:
- 25% Intermediate Investment Grade
- 5% High Yield
- 5% Foreign
- 5% Cash (mostly CDs)

I think it also depends on where your fixed income allocation resides. One of the ways we ‘sleep well at night’ is by keeping a bit of cash-ish assets on hand in our taxable account. We keep that in CDs + a Muni Bond Fund.

Going forward, and also with the ‘already won the game’ mindset, we will maintain our 60/40 AA (also maintaining the chunk of cash). I think the market is frothy and also plan to fill up our Zero LTCG bucket this year so, will make AA adjustments in Dec 2017. We will do this by selling equities to provide for 2018 living expenses and to fill up CD ladder rungs. We will also continue to hold the Muni Bond fund (which is honestly a little ‘yield chasing’), and view it as the ‘last rung’ on our fixed-income ladder.

 

[pb4uski]

While I have been concerned about interest rate risk, it seems that the Fed is doing a pretty good job of increasing rate gradually... that, along with the flattening of the yield curve have alleviated my concerns somewhat... I have no reason to believe that will change under the new Fed chair.

I have a good chunk in the PenFed 5-year 3% CDs offered a number of years ago. Other than that, I have not found any CDs as attractive and am a bit loathe to have so many IRA accounts as it would require to chase good bank CD rates. Similarly, I haven't found brokered CDs very attractive but probably need to take another look at them.

As a result, I have turned to maturity date bond funds to mitigate interest rate risk. These are essentially a pro-rata ownership in a diversified held to maturity bond portfolio. I get monthly interest distributions like a bond and a return of par in the maturity year. I prefer issues with about a 5 year term and have a ladder of them. Their return is similar to 5 year CDs. YMMV.

What I have found is the terminal year returns lag because bonds mature throughout the year and then a terminal distribution is done in late December.... I sidestep that issue by selling late in the year prior to the terminal year (or early in the terminal year).

 

[audreyh1]

Going forward, and also with the ‘already won the game’ We will also continue to hold the Muni Bond fund (which is honestly a little ‘yield chasing’), and view it as the ‘last rung’ on our fixed-income ladder.

I ended up holding Muni bond funds as one of our fixed income asset classes because they seems to behave quite differently from other fixed income assets classes yet generally hold their value well when stocks tank.

 

[audreyh1]

I notice that interest rates tend to creep up towards the end of the year and they are again this year. I rebalance in Jan - usually buying bonds, so this trend is my friend.

Many years interest rates run up at the end of the year, and then drop to lows in the middle of the year. It will be interesting to see what happens in 2018. If economic growth accelerates and/or inflation seems to get past the current lag, interest rates will probably rise during the year. We can hope it is gradual.

The Fed only controls the very short-end of the curve. The bond market economic and inflation outlook controls the rest of it. Even if the Fed raises rates gradually, the bond market could get spooked if they decide the Fed is “behind the curve”. Or they could do as they have done for the past year and decide the Fed is more aggressive than is warranted by economic conditions and keep long term rates low.

 

[Huston55]

As a result, I have turned to maturity date bond funds to mitigate interest rate risk. These are essentially a pro-rata ownership in a diversified held to maturity bond portfolio. I get monthly interest distributions like a bond and a return of par in the maturity year. I prefer issues with about a 5 year term and have a ladder of them. Their return is similar to 5 year CDs. YMMV.

Pls tell me more about these funds.

 

[FiveDriver]

I confess to being confused about Bond Funds.

As part of my 70/30 AA, I took a small position in FSITX, Fido's US Bond Index Fund. I bought an even $10K on July 29 2016, just to track performance. The Buy Price was $12.01 and I bought 832.6 shares.

In the past 18 months -- it's gone nowhere. Last night's closing price was $11.54 and the original investment is now valued at $9,924.

Where's the 2.5% SEC yield ?? They added about 30 shares at some point in the past year, but that doesn't sound like 2.5% to me.

Are Index Funds the wrong type of Bond Funds ??

I have a nice CD Ladder, and a High Yield MM at Capital One for stability.
Is there a good High Yield Bond Fund I should be looking at ??

 

[Midpack]

As a result, I have turned to maturity date bond funds to mitigate interest rate risk. These are essentially a pro-rata ownership in a diversified held to maturity bond portfolio. I get monthly interest distributions like a bond and a return of par in the maturity year. I prefer issues with about a 5 year term and have a ladder of them. Their return is similar to 5 year CDs. YMMV.

You mentioned this a while ago and it sounded great to me, but I didn't pull the trigger after thinking it over. I am not disputing your choice, I am asking to better understand. And I am not saying it's an inferior choice to a traditional bond fund of similar average duration.

Isn't the big issue with holding traditional bond funds not so much interest rate risk, it's NAV loss in a rising interest rate environment? Are maturity date bond funds not exposed to NAV loss, such that it all comes out in the wash by the time you sell? Again, I am trying to better understand.

I'm still 35% in bond funds (14% short term, 17% total bonds, 4% muni) and overweighted for my AA with cash at 7%. I reconsider alternatives to bond funds periodically, and haven't found an obvious better choice. My bond funds have done reasonably well despite those who've warned us to sell bonds for about 8 years so far.

 

[Montecfo]

I ended up holding Muni bond funds as one of our fixed income asset classes because they seems to behave quite differently from other fixed income assets classes yet generally hold their value well when stocks tank.

Same. Wish I had bought more. Bond fund.

It seems to be the tax bill should tend to reduce rates by reducing supply. Will be interesting to see how this pans out.

 

[pb4uski]

....Isn't the big issue with holding traditional bond funds not so much interest rate risk, it's NAV loss in a rising interest rate environment? Are maturity date bond funds not exposed to NAV loss, such that it all comes out in the wash by the time you sell? Again, I am trying to better understand. ...

Interest rate risk and NAV loss in a rising interest rate environment are one and the same. It is true that when rates rise the NAV (and fair value) will decline... but, since I hold to maturity that decline eventually comes back to me. I only buy issues that are 5 years or less and intend to hold to maturity... from an interest rate risk perspective they are much like brokered CDs and I guess I just prefer the target maturity bond ETFs a bit more... IIRC they had a slightly more attractive yield when I bought them.

With these, any loss due to increases in interest rates get recovered over the remaining maturity... on average 2 1/2 years in my case since I have a ladder of 5 year instruments... if I invested in a bond fund it would take the duration for me to recover that loss.

 

[OldShooter]

... Isn't the big issue with holding traditional bond funds not so much interest rate risk, it's NAV loss in a rising interest rate environment?

Yes. But close behind that is fees.

Are maturity date bond funds not exposed to NAV loss, such that it all comes out in the wash by the time you sell?

Well, fees won't come out in the wash. They are permanent stains on your portfolio. But to your point, a maturity date fund (held to maturity) is safer than a vanilla bond fund and probably safer than individual bonds due to better diversification than you can do on your own. So is that diversification worth the fee you're paying?

Just for fun I will mention a paradox I wonder about: All of us split our AA between equities and fixed income because we want the stability and lower risk of fixed income investments. Makes sense, right?

But then why do we immediately run out and seek risk and volatility by buying junk bonds, emerging markets, and other excitement? These assets are highly correlated to equities anyway, so this is pretty much the same as moving some of the "safe" money back into equities. So why not just leave a few percent extra in equities and leave the "safe" side of the portfolio in safe investments like CDs, govvies, and highly rated corporates? Life would be simpler and I'm not at all sure it wouldn't be equally profitable with risk unchanged.

 

[USGrant1962]

Well, fees won't come out in the wash. They are permanent stains on your portfolio.

Great quote OldShooter

 

[pb4uski]

FWIW, the fees are 10 bps for the Blackrock corporate product and 24 bps for the Guggenheim corporate product... both are investment grade so negligible credit risk.

 

[Midpack]

Interest rate risk and NAV loss in a rising interest rate environment are one and the same. It is true that when rates rise the NAV (and fair value) will decline... but, since I hold to maturity that decline eventually comes back to me. I only buy issues that are 5 years or less and intend to hold to maturity... from an interest rate risk perspective they are much like brokered CDs and I guess I just prefer the target maturity bond ETFs a bit more... IIRC they had a slightly more attractive yield when I bought them.

With these, any loss due to increases in interest rates get recovered over the remaining maturity... on average 2 1/2 years in my case since I have a ladder of 5 year instruments... if I invested in a bond fund it would take the duration for me to recover that loss.

Yes. But close behind that is fees.

Well, fees won't come out in the wash. They are permanent stains on your portfolio. But to your point, a maturity date fund (held to maturity) is safer than a vanilla bond fund and probably safer than individual bonds due to better diversification than you can do on your own. So is that diversification worth the fee you're paying?

Thank you. I need to take another look.

 

[OldShooter]

FWIW, the fees are 10 bps for the Blackrock corporate product and 24 bps for the Guggenheim corporate product... both are investment grade so negligible credit risk.

I have a knee jerk abhorrence to fees, just like when the doc hits me with that little rubber hammer.

But to argue the other side, using some judgment and since broad diversification may allow safe buying of slightly higher yielding issues maybe the managers can cover their fees without increasing risk over what an individual bond buyer could do on their own. I don't know. I have never even petted one of these animals, much less owned one.

Edit: OTOH I think fees must be considered in the context of return. If the fund is returning 2.4%, then 24bps is a 10% fee. Is that OK? You decide. Where this view really sharpens one's thinking is in retirement, where a "1%" wrap fee is really a 25% fee on a 4% SWR.

 

[pb4uski]

As we've discussed before, I suspect that funds and ETFs get better bond pricing than retail bond investors that offsets the cost in whole or in part. If I have $400k invested in corporate investment-grade bonds that might mean 40 different issues to get decent credit risk diversification so 40 issues that I have to think about... why when I can get much better diversification and I think pricing with a few.

 

[audreyh1]

Folks should look at the Kitces reference linked above. It shows total return comparing a 5 yr treasury held to maturity versus a constant 5 year maturity treasury fund during various rising rate environments. The bond fund total return outperforms or comes close in some cases.

https://www.kitces.com/blog/how-bon...ve-help-defend-against-rising-interest-rates/

 

[OldShooter]

Folks should look at the Kitces reference linked above. It shows total return comparing a 5 yr treasury held to maturity versus a constant 5 year maturity treasury fund during various rising rate environments. The bond fund total return outperforms or comes close in some cases.

Normally I like to read that guy, but I think he was off his game that day.

For example: " [assume that] this yield curve will remain in place for the next 5 years." Right. From that point he goes into a long and tedious explanation of what a bond I am holding to maturity would be worth during the 5 years I hold it. In addition to being based on the false premise that the yield curve will not be changing it is also based on the false premise that I care what the bond is worth prior to maturity.

Also IIRC when I read that article more carefully than today, he also assumes a bond fund that charges no fees. A search for the word "fee" produces no hits this afternoon, anyway.

My head is hurting at this point but I think his final argument is that if bond yields rise no more than 25bps over five years, his fee-less bond fund will begin to win after the fourth year. Not exciting.

So I dunno. His argument seems quite strained. Maybe he has bond funds as sponsors.

 

[Cobra9777]

Regarding target maturity bond funds... I've looked at these a few times over the last several years. What spooks me every time is how incredibly small and thinly traded they are, leading to wide bid/ask spreads and liquidity concerns. Has this changed in recent years?

 

[Golden sunsets]

Interest rate risk and NAV loss in a rising interest rate environment are one and the same. It is true that when rates rise the NAV (and fair value) will decline... but, since I hold to maturity that decline eventually comes back to me. I only buy issues that are 5 years or less and intend to hold to maturity... from an interest rate risk perspective they are much like brokered CDs and I guess I just prefer the target maturity bond ETFs a bit more... IIRC they had a slightly more attractive yield when I bought them.

With these, any loss due to increases in interest rates get recovered over the remaining maturity... on average 2 1/2 years in my case since I have a ladder of 5 year instruments... if I invested in a bond fund it would take the duration for me to recover that loss.

PB; I have purchased a ladder of target date Guggenheim funds as you have. In my case the ladder mirrors RMD’s in my and DH’s IRA’s. The first of these purchases matures on 12/31 of this year. These funds will supply us with the cash for our 2018 RMD. We will invest these funds in a brokered CD or T bill for 11 months until late next year when we are ready to “take the RMD”. As you have pointed out the asset has lagged this year and is red versus cost, due to bonds maturing throughout the final year of maturity and cease to generate as much interest. But for the life of me I still don’t get how my total return of capital will occur (9 days from now). The difference in market value at the time of purchase vs now is not huge, but notable. I can’t quite see how I will be made whole in 9 days. For the remainder of our ladder we can sell early as you suggest, and reinvest in a brokered cd or tbill but I’m still perplexed, less than satisfied and wondering how this vehicle compares to a straight bond, which we also incorporated into our ladder. Does it boil down to the distribution rate versus the yield?

 

[pb4uski]

Boy, I dunno. Your post prompted me to take a hard look at mine and am disappointed as well. In both cases of BCSK (Guggenheim) and IBDC (BlackRock), the current value is higher than what I have invested... so that should be good. However, the inception to date returns have been disappointing... 1.5-2.0% range while at least by memory I was expecting 2.0-2.5% at purchase.

Luckily, not losses and not a huge part of the portfolio, but time to keep an eye on it and reassess. Makes me appreciate my 3% PenFed CDs.... that is for sure.

FWIW, I would think that the terminal value of your BSCH would be pretty close to the NAV of $22.63.... I can't see how it could be much different.

IIRC Brewer owns some of these so I PMed him to see if he has any insights.

 

[Midpack]

For those interested in more information on defined maturity bond funds.

https://personal.vanguard.com/pdf/ICRDMB.pdf

And an article

http://www.aaii.com/journal/article/defined-maturity-funds-a-bond-alternative-with-compromises.touch