recommended bond portfolio

[JohnEyles]

With stock more or less where I want it, I need to make a significant
movement from cash into bonds , perhaps somewhere in the $100K
neighborhood. I'm not talking about stuff like T-Bills (which I consider
a cash investment, being laddered for use as I need it, and risk-free).

The simple answer is Vanguard's Total Bond Market Index, but I've read
a lot of stuff that it makes sense to buy individual bonds as well as bond
funds, since bond funds can go down with rising interest rates, whereas
bonds don't lose money (except to inflation) if you hold them to maturity.
On the other hand, funds make more sense for high-risk bonds (i.e. high
yield funds for junk bonds). TIPS are of course very popular; I'm a little
perplexed as to how to acquire them, since everyone says they should
be in IRAs, so you don't pay tax on the "phantom" interest on inflated
principal. But I don't think Treasury Direct allows IRAs (I could be
wrong) and Schwab doesn't seem to sell them (they sell T-Bills, with
no commission - maybe the "bond desk" can handle other Treasuries).

Obviously I'm pretty clueless about bonds - I guess what I'm really
looking for is a suggested overall bond portfolio, for about 20% of
my overall portfolio (for Bucket 2, or if you don't like buckets, for
money I intend to spend in more than 5yrs but less than 12yrs,
from now).

Thanks.

 

[mathjak107]

I posted my bucket 2 holdings in the ray lucia topic here.

 

[Mysto]

This is not a suggestion but rather another model to use to develop yours.
My bond allocation:

50% - VIPSX
25% - VFITX
25% - VBISX

Tips inflation protection and according to my backtesting perhaps a better return - your milage may vary.

 

[Craig]

I don't have your answer, but if you don't mind, let me add two questions:

• People often comment that bond funds drop in value, while individual bonds do not, if held to maturity.  But isn't it much more accurate to say that bond funds are valued / repriced daily, and therefore reflect the current market value of the portfolio; and when individual bonds are purchased, the owners don't value / reprice the bonds daily ... yet if those individual bonds were sold, they would certainly have gone up or down in value?  Don't most bond funds hold their bonds to maturity?  If so, then the main premise of individual bonds versus funds may be false.
• Wouldn't it also be wise to hold either bonds, or invest in a bond fund that holds a mix of bonds denominated in various currencies?  Seems to me that hedging / diversifying against currency fluctuations is logical for what is in many ways an investment in a currency as well as a loan, with a (usually) fixed rate of return on that currency.

Best of luck in determining the right bond mix, JohnEyles.  Would also be a good idea to carefully consider the tax impacts, based upon your personal situation and state ... sometimes those local tax exempt bonds make sense.

 

[brewer12345]

Unless you really want to fiddle, I would stick with funds and treasuries. I take it you are at Schwab? If so, I would take 2/3 of the money and buy AGG (or possibly PPT if you want to play the game a bit), and use the rest to buy a 5 year TIPS at auction in a few weeks. Schwab will let you participate in treasury auctions for no cost/no fee.

 

[youbet]

But isn't it much more accurate to say that bond funds are valued / repriced daily, and therefore reflect the current market value of the portfolio; and when individual bonds are purchased, the owners don't value / reprice the bonds daily ... yet if those individual bonds were sold, they would certainly have gone up or down in value?

I'm not sure if all brokerage houses do this, but mine does reprice my bonds daily and the price is there in my online portfolio positions report right along with the equity prices. If your brokerage house isn't doing this for you, you might want to find out why or switch brokerages.

 

[brewer12345]

• People often comment that bond funds drop in value, while individual bonds do not, if held to maturity. But isn't it much more accurate to say that bond funds are valued / repriced daily, and therefore reflect the current market value of the portfolio; and when individual bonds are purchased, the owners don't value / reprice the bonds daily ... yet if those individual bonds were sold, they would certainly have gone up or down in value? Don't most bond funds hold their bonds to maturity? If so, then the main premise of individual bonds versus funds may be false.
• Wouldn't it also be wise to hold either bonds, or invest in a bond fund that holds a mix of bonds denominated in various currencies? Seems to me that hedging / diversifying against currency fluctuations is logical for what is in many ways an investment in a currency as well as a loan, with a (usually) fixed rate of return on that currency.

1. People who hold individual bonds and think they are safe from the effects of interest rate movements are fooling themselves. Whether you hold the bonds directly or through a fund, your total return is affected by rate movements.

2. I think holding some non-US bonds is a good idea, but OP was clearly asking about something longer than cash, so I figured we were on the topic of domestic bonds. I would definately suggest that one at least consider some non-USD exposure.

 

[boutros]

The bond market is not as efficient or transparent as the stock market. Unless you are buying a very widely traded bond you are going to have a wide bid ask spread. Institutional investors have pricing power buying individual bonds but retail investors do not. Unlike the stock market you can expect a better price the larger the position you are looking to move. At my company (an investment management firm) when we buy a bond we might buy it in a lot of 50m to 750m, standard position sizes for individuals are usually 25m. With 100m into bonds you are looking at buying 4 issues. I would recommend funds for high yield and corp and CDs as a stand in for treasury notes. Right now credit spreads are at historic lows so if you want to be a dirty market timer you may want to stay in higher quality credit for the majority of your investment. As to the comment about bonds not losing money, just because you don't realize a loss doesn't mean it doesn't exist (I think that was a triple negative, good thing I am not paid to write).

 

[magellan_nh]

I've gone both routes in my portfolio and in general I agree with the other posters that a low cost bond fund is probably the best bet.

One exception to this rule is if you're looking for a custom portfolio of bonds that isn't readily available or that would cost too much as a fund. When I was working, I wanted to construct a portfolio of municiple bonds in a state that didn't have any good in-state bond fund options. In addition, I didn't want/need any income so I preferred zero coupon bonds over interest paying bonds.

As boutros pointed out, trading costs are much higher with smaller quantitiies (especially under 20 bonds), so the portfolio size can be a deciding factor all by itself. It seems to me that 100k is right on the edge of a minimum portfolio size.

In any case, if you're interested in individual bonds, check out www.investinginbonds.com

This site is the official Bond Market Association site and it shows a listing of recent trades for any given issue. It's a great way for individual investors to get at least some visibility into what's happening in this rather opaque market.

Even if you're not building a portfolio of individual bonds, the price tracking at the investing in bonds site is facinating to look at as a study into bond market efficiency. The trade data tells whether a transaction was an inter-dealer trade, or a buy or sell from a customer. In most cases, everything seems on the up and up, but occasionally, you can see a customer getting badly ripped off (to the tune of 5-10%) just by watching a block of bonds for a particular issue move through the system and watching the pricing.

Jim

 

[brewer12345]

FWIW, I buy individual corporate bonds and preferreds from time to time. When I do so, I am generally buying the obligations of a name I know or have done a very thorough analysis of, and I treat the position as analogous to owning an individual stock, especially if we are talking about a junk or distressed name. If you aren't prepared to do the work, stick to very high grade stuff or, better yet, funds.

 

[FinanceDude]

FWIW, I buy individual corporate bonds and preferreds from time to time. When I do so, I am generally buying the obligations of a name I know or have done a very thorough analysis of, and I treat the position as analogous to owning an individual stock, especially if we are talking about a junk or distressed name. If you aren't prepared to do the work, stick to very high grade stuff or, better yet, funds.

I used to buy indivdual issues, but it takes a lot of work to keep on top of them. The past 7 years, I have used only funds, and keeping the duration shorter in times of rate movement has helped me and my clients..............

 

[brewer12345]

keeping the duration shorter in times of rate movement has helped me and my clients..............

Depends on the direction of the rate movement as to whether staying short helps or hurts. The good thing about junk/distressed stuff is that it is not especially sensitive to rate movements.

 

[FinanceDude]

Depends on the direction of the rate movement as to whether staying short helps or hurts. The good thing about junk/distressed stuff is that it is not especially sensitive to rate movements.

Agreed, I usualy keep some shorter and some longer, and shift the percentages when I see trends............

Don't use a lot of junk stuff...............although I have several clients use GM and F bonds as a value play when they were going into freefall..........and so far they have made some money...............

 

[modlair]

Anyone want to offer up some comments of compare/contrast of . . . say . . . a 1 yr CD vs a 1 yr bond?

 

[Nords]

With stock more or less where I want it, I need to make a significant movement from cash into bonds , perhaps somewhere in the $100K neighborhood. I'm not talking about stuff like T-Bills (which I consider a cash investment, being laddered for use as I need it, and risk-free).

Anyone want to offer up some comments of compare/contrast of . . . say . . . a 1 yr CD vs a 1 yr bond?

Yeah, no kidding.

John, I can understand investing in bonds for an asset allocation that reduces your portfolio volatility. If that's why you're investing in bonds then I get it.

What I have trouble understanding is why anyone would invest in a bond fund for the income when long-term CDs are paying 5.5%.

 

[brewer12345]

Yeah, no kidding.

John, I can understand investing in bonds for an asset allocation that reduces your portfolio volatility. If that's why you're investing in bonds then I get it.

What I have trouble understanding is why anyone would invest in a bond fund for the income when long-term CDs are paying 5.5%.

For 8 millionth time: CDs = yield only, bonds & bond funds = total return.

 

[FinanceDude]

Yeah, no kidding.

John, I can understand investing in bonds for an asset allocation that reduces your portfolio volatility. If that's why you're investing in bonds then I get it.

What I have trouble understanding is why anyone would invest in a bond fund for the income when long-term CDs are paying 5.5%.

Because you can access the principle without a penalty, and over time bonds will give you an interest premium above the average yield on your CD.................

You can also get capital appreciation in bonds, because when rates are cut they become more valuable............I had some high quality bond funds make better than 9% in 2000 and 2001............couldn't do that in CD's................

 

[Nords]

For 8 millionth time: CDs = yield only, bonds & bond funds = total return.

Because you can access the principle without a penalty, and over time bonds will give you an interest premium above the average yield on your CD.................
You can also get capital appreciation in bonds, because when rates are cut they become more valuable............I had some high quality bond funds make better than 9% in 2000 and 2001............couldn't do that in CD's................

C'mon, guys, I heard you the first 7,999,999 times.

If the types of bond funds that JohnEyles is contemplating will cough up that type of total return then that's what he should do. I just have a hard time throwing money at a flat (or inverted) yield curve and then trusting expecting a manager to generate the alpha. And if he's trading his own individual bonds then we probably wouldn't have to worry about the alpha.

But I guess this is why we stick to stocks.

 

[FinanceDude]

C'mon, guys, I heard you the first 7,999,999 times.

If the types of bond funds that JohnEyles is contemplating will cough up that type of total return then that's what he should do. I just have a hard time throwing money at a flat (or inverted) yield curve and then trusting expecting a manager to generate the alpha. And if he's trading his own individual bonds then we probably wouldn't have to worry about the alpha.

But I guess this is why we stick to stocks.

There's always dividend paying stocks..............

 

[magellan_nh]

Because you can access the principle without a penalty, and over time bonds will give you an interest premium above the average yield on your CD.................
You can also get capital appreciation in bonds, because when rates are cut they become more valuable............I had some high quality bond funds make better than 9% in 2000 and 2001............couldn't do that in CD's................

It's definitely true that most bond funds give you access to principle without penalty Although with bonds, the penalty is the trading cost which can be steep with short term trades. I'm not sure about the interest premium once you adjust for credit quality. I've actually noticed some price inefficiency in CD's, especially if you go with the highest rate from bankrate.com on an FDIC insured issue.

Also, I think the original comment was about short term CDs, so I take that to mean 1-3 years max. The total return potential in this space is much more limited. Also, if you're not market timing and you compare total returns from a bond fund with a 3 yr avg duration vs. a 3 yr CD, on average and over time, your total return is likely to be similar for each.

When considered in a portfolio, the bond component of the allocation does reduce volatility to the extent that bond price movements aren't correlated with other holdings. That reduction in volatility could help (more for longer term bonds) in a more meaningful way in increasing overall results even though average (total) returns may not be better than with using CDs. The key for this to work is that you MUST do regular rebalancing. (To be fair you could get this same effect with CDs if they're laddered and you faithfully rebalance).

Jim

 

[brewer12345]

C'mon, guys, I heard you the first 7,999,999 times.

If the types of bond funds that JohnEyles is contemplating will cough up that type of total return then that's what he should do. I just have a hard time throwing money at a flat (or inverted) yield curve and then trusting expecting a manager to generate the alpha. And if he's trading his own individual bonds then we probably wouldn't have to worry about the alpha.

But I guess this is why we stick to stocks.

This is a gross simplification, but for the sake of argument the Lehman Agg/VG TBIF yields around 5% and has a duration of roughly 4. So if the economy craps out (housing-lead recession, anyone?) and the equity market goes to hell while the yield curve shifts dow 1% over the course of a year, the bond fund would return 5% (yield) plus 4% (appeciation). Meeanwhile the S&P500 has cause a round of pants-sihtting and Mr. CD has eked out 5% and chane in yield.

 

[FinanceDude]

This is a gross simplification, but for the sake of argument the Lehman Agg/VG TBIF yields around 5% and has a duration of roughly 4. So if the economy craps out (housing-lead recession, anyone?) and the equity market goes to hell while the yield curve shifts dow 1% over the course of a year, the bond fund would return 5% (yield) plus 4% (appeciation). Meeanwhile the S&P500 has cause a round of pants-sihtting and Mr. CD has eked out 5% and chane in yield.

Exactly..................I personally have never owned a CD.............

I guess because when I could have gotten a 15 year @ 13%, I had no money..............

 

[donheff]

This is a gross simplification, but for the sake of argument the Lehman Agg/VG TBIF yields around 5% and has a duration of roughly 4. So if the economy craps out (housing-lead recession, anyone?) and the equity market goes to hell while the yield curve shifts dow 1% over the course of a year, the bond fund would return 5% (yield) plus 4% (appeciation). Meeanwhile the S&P500 has cause a round of pants-sihtting and Mr. CD has eked out 5% and chane in yield.

I have to confess I am clueless about bonds. Like Nords, I have never bought any bonds or bond funds. So I need some education. As I understand a regular bond (T-bill, corporate, whatever) you buy a promiss that "guarantees" a certain yield over a certain period (e.g. 5% over 5 years). If you hold the bond to maturity you get back your original priciple plus the 5 years of interest (i.e. that is total return at maturity). During the time you held the bond, its "value" if sold was moving around depending on how good it looked relative to the current market so total return if sold could be more or less than if held to maturity.

As I understand bond funds, the managers buy the real thing and tend to hold them to maturity. You buy shares in the pot at a particular point and you are affected by the value of the overall fund porfolio relative to the current market. That value jumps around in a fashion similar to that of a single "real" bond except it reflects the value of the whole pile.

Since (if?) the managers hold the underlying bonds to maturity, shouldn't the fund over time simply return the overall yield of the underlying bonds plus original principal like regular bonds? In other words, wouldn't expected long term total return be about the same as bonds (less management fees)?

I am asking all of this to make sure my understanding is correct since my ultimate question goes back to Brewer's quote. If the real estate market leads a crash in equities, I would expect bonds to go up - thus the extra 4% appreciation. That is why volatility is lower. But five years later, when the equity market catches fire, the bond fund share value would depreciate roughly as much as it went up as the fund returned to the underlying pricipal plus yield long term return wouldn't it?

 

[brewer12345]

You got the part about direct ownership of bonds right.

With bond funds, I'll restrict my comments to index funds. The indexes are constantly changing, just like the equity indexes. One of the reasons they change a lot is that the indexes usually swap out bonds on a regular basis to maintain something like a consistent maturity. So the fund buys a 6 year treasury, and two years later they sel it and replace it with a new 6 year bond to move back out on the maturity curve (since the original bond is now a 4 year bond). In contrast, if you just bought the individual bond and held it, you would have a shorter and shorter maturity while the bond fund's average maturity stayed roughly stable.

Where you get a lot of mileage in owning bond funds in a downturn is by rebalancing. That's how you capture at least part of the cap gains. If you are a dirty market timer, maybe you try to capture all of the bond cap gains.

 

[JohnEyles]

For 8 millionth time: CDs = yield only, bonds & bond funds = total return.

Man, I'm clueless - help me understand. This AGG that Brewer (and many
articles I've read) recommends is yielding 4.5% and yet YTD rtn is only 1.7%.
What the heck does that mean ? That the share value has dropped by
4.5-1.7% ? I don't think so, looks like share price has fallen only about 1%
this year. YTD rtn of 1.7% sounds pretty lousy - seems like I'd be better
off with MM, T'Bill, CD, whatever. Should I even be considering bonds, or
am I misunderstanding this YTD rtn ?

To clarify my original query, I have no interest in getting into buying individual
bonds, other than Treasuries (some T'Bills in my cash positions, and maybe
some TIPS or longer term notes/bonds in my "bond" position).