The dynamics of bond duration and rising rates

[Midpack]

This Vanguard article from last Nov might have been mentioned but I couldn't find it. Just short read on bonds for those who are concerned about the short term outlook (who's not?) but not ready to ditch bonds altogether. I'm about 50:50 short:intermediate in my bond funds, but still not looking forward to the near term. I have to remind myself I/we are mostly LONG term investors here with (very) long "investment horizons." The conclusion from the article might offer a little comfort. We are all conditioned to patiently ride out equity slides for an eventual recovery, much more than bonds.

https://investor.vanguard.com/inves...he-dynamics-of-bond-duration-and-rising-rates

After a decades-long bull market, bonds have come under pressure. Yields hit all-time lows during the COVID-19 recession, but rose as the economy rebounded, and some anticipate they may climb higher with the Federal Reserve reducing its bond-buying program and the prospect of further fiscal spending. Make no mistake, though—bonds still merit inclusion in a broadly diversified portfolio.

As we outlined in a recent commentary by Roger Aliaga-Díaz , Vanguard’s chief economist for the Americas and head of portfolio construction, investment-grade bonds can be a shock absorber when equities fall.

“In the current climate—featuring a rise in inflation, reduced bond buying by the Fed, and more fiscal spending on the way—rising rates can actually lead to higher total returns from bonds if your investment horizon is longer than your bond portfolio duration,” said Ian Kresnak, a Vanguard investment strategy analyst.

“Rising rates are not all doom and gloom for bond investors,” said Mr Kresnak. “They should find some solace in rising rates if their bond portfolio is at least reasonably calibrated to their investment horizon.”

Duration is key:

• For an investment horizon longer than the duration of a bond portfolio, a rise in rates will create short-term pain but long-term gain.
• For an investment horizon shorter than the duration of a bond portfolio, consider an adjustment to align the two more closely.

 

[Phroig]

I confess I wasn’t able to stay put. After watching my short-term fund leak daily, and my muni fund get pummeled, I decided to switch out. Some money went to money market, and some to equity funds. (I have an easier time staying put, or buying more, with equities, in a down market.) I continue to hold a fair amount in a floating rate fund, and have, of course, been buying I bonds.

 

[Magus]

Main problem with this analysis is time value of money. A 1% higher return today is worth more than a 1.1% higher return in 15 years. Even if I plan to hold a bond fund for 15, 25 years for a lot of various reasons I *may* not (better investment opportunity, healthcare needs, other financial need, etc). And the cause of rising rates today is largely inflation and inflation running hotter for longer, which is also not good for bonds. If it was just because of rising GDP and fighting for capital, that'd be a bit different argument.

Personally, besides I bonds, I'd only invest in short and intermediary bond funds if you really want to go that route but why not get a ~0.5% savings account with zero risk and 100% flexibility instead for slightly less income?

My last company on a take private last year was able to borrow 10x EBITDA at LIBOR + 225 bps! And a swap to fix LIBOR was dirt cheap, effectively locking in 2.75% fixed! The debt market is just massively overvalued at the moment - far more than anything else with inflation where it is.

 

[njhowie]

I confess I wasn’t able to stay put. After watching my short-term fund leak daily, and my muni fund get pummeled, I decided to switch out. Some money went to money market, and some to equity funds. (I have an easier time staying put, or buying more, with equities, in a down market.) I continue to hold a fair amount in a floating rate fund, and have, of course, been buying I bonds.

That's too bad. You need to let your portfolio and AA do what you constructed them to do. Bonds are providing a "service" even when they are going down. Instead of selling, you might have considered buying more - buying future income and cash flows at a discounted price (higher yield). Though you may have experienced a short-term decline in value, interest payments would soften the blow and likely overcome them relatively quickly.

I am buying. For so long, fixed income investors have been pounded by microscopic interest rates. Now that interest rates are finally moving higher, you'd think fixed income investors would begin to feel a bit of relief. However, it seems that just the opposite is happening.

 

[daylatedollarshort]

For fixed income these days I'm sticking mostly with floating rate, a TIPS ladder and stable value. We didn't have a lot in any longer term bonds but DH had some in a target fund plus we had a few other odds and ends in our 401K and I've been dumping those. I don't see longer term bond funds as having anywhere to go but down in the next year. It is simply math.

 

[njhowie]

I don't see longer term bond funds as having anywhere to go but down in the next year. It is simply math.

I've heard/read the same for the past 5+ years and the gurus making those proclamations were wrong time and again.

It is simply math if you know that interest rates are going significantly higher than what the market has already priced in. Do you know that?

My belief is that most folks are significantly overestimating how high interest rates will go.

 

[daylatedollarshort]

I've heard/read the same for the past 5+ years and the gurus making those proclamations were wrong time and again.

It is simply math if you know that interest rates are going significantly higher than what the market has already priced in. Do you know that?

My belief is that most folks are significantly overestimating how high interest rates will go.

I know what inflation is and what the Fed has said it will do in the next year. I get the idea of staying diversified when no one knows where stocks or interest rates will go in the coming year so you hedge your bets. But this time we know the interest rate part with a fair degree of certainty. At least enough for me to take a calculated risk to not be in any long term bond funds right now.

 

[njhowie]

I know what inflation is and what the Fed has said it will do in the next year. I get the idea of staying diversified when no one knows where stocks or interest rates will go in the coming year so you hedge your bets. But this time we know the interest rate part with a fair degree of certainty. At least enough for me to take a calculated risk to not be in any long term bond funds right now.

If it works for you, that's all that matters in the end.

In general, it's interesting how so many folks preach about not timing the market when it comes to stocks, and yet that is exactly what many are doing with bonds and interest sensitive securities at this time.

We'll see how true to its word the Fed stays. Beyond one or two 1/4 point hikes they will be in serious trouble pushing higher. Stocks will decline hard, the housing market will pull back, and the likelihood for a (global) recession dramatically increases. I've already heard a couple of economists voicing the same opinions and concerns.

We'll see how far the Fed goes to tame inflation as its actions begin to cause reactions that are harder to swallow.

 

[COcheesehead]

If it works for you, that's all that matters in the end.

In general, it's interesting how so many folks preach about not timing the market when it comes to stocks, and yet that is exactly what many are doing with bonds and interest sensitive securities at this time.

We'll see how true to its word the Fed stays. Beyond one or two 1/4 point hikes they will be in serious trouble pushing higher. Stocks will decline hard, the housing market will pull back, and the likelihood for a (global) recession dramatically increases. I've already heard a couple of economists voicing the same opinions and concerns.

We'll see how far the Fed goes to tame inflation as its actions begin to cause reactions that are harder to swallow.

Amen.

 

[audreyh1]

This Vanguard article from last Nov might have been mentioned but I couldn't find it. Just short read on bonds for those who are concerned about the short term outlook (who's not?) but not ready to ditch bonds altogether. I'm about 50:50 short:intermediate in my bond funds, but still not looking forward to the near term. I have to remind myself I/we are mostly LONG term investors here with (very) long "investment horizons." The conclusion from the article might offer a little comfort. We are all conditioned to patiently ride out equity slides for an eventual recovery, much more than bonds.

https://investor.vanguard.com/inves...he-dynamics-of-bond-duration-and-rising-rates

I just rebalance as warranted. Right now my equities are down more than my fixed income.

I use a combination of cash, short-term bond index and intermediate-term index funds, and my investment timeline is way longer than the durations. I’ve already held most of these bond funds for over 20 years, so I don’t mind trimming when interest rates drop, and adding when interest rates rise.

 

[Dtail]

Not a current bond fan, but have ~3% yields on Stable Value and CD's for the Fixed Income portion of our portfolio.

 

[Midpack]

I've heard/read the same for the past 5+ years and the gurus making those proclamations were wrong time and again.

It is simply math if you know that interest rates are going significantly higher than what the market has already priced in. Do you know that?

My belief is that most folks are significantly overestimating how high interest rates will go.

I agree, and I’ve held a huge chunk of VBTLX since 2005. But the data (and Fed stance) is more compelling now than it has been.

 

[VanWinkle]

The current situation and the future is always scary compared to the known past. I don't base my decisions on the past, current situation, or the future(unknown). I made a plan and I'm sticking to it. 50/50, re-balance at 5% bands and let time handle the compounding. I don't know more than anyone else, but I am dedicated to my Investment Statement. I will make what the indexes make less a very small expense fee.

VW

 

[Lsbcal]

I hope that Janet Yellen was right when she recently said that by the end of 2022 she expected inflation rates to be around 2%.

I had about 50% bonds in short term investment grade (VFSUX). The rest is in inflation indexed bonds with high fixed rates that one cannot buy at present. Three weeks ago I opted to move the VFSUX into 3 month Tbills which I'll roll over as the rates move up. So basically I have zero interest rate risk at present. Will probably buy back into VFSUX when I feel that the reward justifies the (moderate) risk.

Now all I have to do is root for my equity holdings.

 

[Magus]

I hope that Janet Yellen was right when she recently said that by the end of 2022 she expected inflation rates to be around 2%.

If you want to think about something really scary with inflation, simply move the velocity of money multiplier back to where it was pre-pandemic. Adding a zero to the end of that 2% # wouldn't be enough. Plus, the ridiculous OER will eventually catch up with reality of what rents really are now, which alone will add about 1.5-2% to the official inflation rate. Virtually every company has announced price increases recently and wages are skyrocketing. I'll bet another repeat of the late 70s here is far more likely than returning to 2% in less than a year from now.

Personally, I think we'll be lucky if inflation is running below 5% by the end of the year. 7% is my base case for 2022. For the Fed Reserve to really put the breaks on inflation, they'd need to raise rates probably 300+ basis points this year and pull out a large chunk of the multiple trillion added to the system in the last two years. Neither of those are likely, much less both. I think they raise 50 basis points this year at the most and at best stop adding to the additional money.

 

[Dash man]

I sold bonds for tax loss harvesting purposes. Won’t buy any back in a taxable account. We increased DW’s position in her 401k’s stable value fund to offset the change in our asset allocation. The cash from the sale will go to the IRS for Roth conversions.

 

[njhowie]

If you want to think about something really scary with inflation, simply move the velocity of money multiplier back to where it was pre-pandemic. Adding a zero to the end of that 2% # wouldn't be enough. Plus, the ridiculous OER will eventually catch up with reality of what rents really are now, which alone will add about 1.5-2% to the official inflation rate. Virtually every company has announced price increases recently and wages are skyrocketing. I'll bet another repeat of the late 70s here is far more likely than returning to 2% in less than a year from now.

Personally, I think we'll be lucky if inflation is running below 5% by the end of the year. 7% is my base case for 2022. For the Fed Reserve to really put the breaks on inflation, they'd need to raise rates probably 300+ basis points this year and pull out a large chunk of the multiple trillion added to the system in the last two years. Neither of those are likely, much less both. I think they raise 50 basis points this year at the most and at best stop adding to the additional money.

Good points.

Price increases and higher wages are likely to stick. When was the last time we've seen food prices go lower? The $15+ wages for entry level no experience required jobs is also likely to stick. As a result, prices are likely not going to come back down...meaning, even should the inflation rate come back down to 2%, it's going to be on top of current price levels going forward.

 

[COcheesehead]

We drove past a KFC the other day. The marquee was advertising the “deal of the day”. 12 piece chicken dinner for $39.00. I remember when McDonalds used to advertise get change back from your buck.

We went out to lunch yesterday. Two salads and one, ONE, slice of cheese pizza with tip $27.

 

[Montecfo]

A lot to unpack

It is said we should not time the market. Problem there is unlike equities, bonds have no upside. It's "fixed income".

And we have Fed funds at all-time low. And you have the Fed's balance sheet at all-time highs, $9T with plans announced to unwind that. So what other signal do you need that rates are going higher? And you have a catalyst: The Fed's announcements. Do we ignore those? So far, people who have "timed the market" by reducing duration have avoided some big losses relative to yields. And if you held variable rate securities you have recorded gains.

But if my time horizon exceeds the duration, I should be ok, right? It works for individual bonds. But for bond funds it is a different matter. Investors flee open-end bond fund (the kind most of us hold) in sloppy markets, which causes fund managers to have to sell bonds. This locks in losses, which are allocated to remaining shareholders. And duration risk remains.

But aren't higher rates already baked in? Well, that depends on what qualifies as higher rates.

Bond funds with duration risk have suffered losses since fall of 2020. I think the 10 year hit a low of about .6 percent that June/July. It is at 1.78 percent now. Post the 2008 financial crisis, rates were in the 2-3% range. 2000-08 rates were 3.75-6%. The only rate that is baked into the 10 year is 1.78% So we have a good ways to go to have normalized rates baked in.

But will the Fed ever normalize rates? Some say no. If they are right, then all of our portfolios are fine, stocks and bonds. And that view could be right. But how do you make QE to infinity your base case? And if you believe that, bonds are a distraction, you should be selling them to buy long-term growth equities which have been battered over the past three months or so.

The Fed usually overshoots and spooks the market. I expect that to happen this cycle, because of the balance sheet and because rates are so low. A quarter point is a larger hike from zero than it is from say 3% For those reason I expect rates to overshoot before settling into a new steady state.

I see no reason to take that risk when you get so little for extending duration, at least to this point. But our demographics suggest we will soon return to a slow growth economy, so I tend to think a 3% 10 year could be about it. But we are a long way from even that modest target.

 

[Lsbcal]

I don't have a model for inflation and many, many economists have been wrong about inflation forecasting over recent years.

So good luck with all those predictions.

 

[Phroig]

Two (sort of related) problems with trying to time equities are not knowing when to get back in, and missing out on the few days when the market shoots up. (I believe a significant portion of annual equity performance is concentrated in a few trading days.) Neither of these seems like it would be especially costly with bonds. Especially now, given the meager yields and low likelihood of price appreciation.

 

[COcheesehead]

I would never buy bonds expecting appreciation. Its not their primary intent. They are income instruments.

 

[Phroig]

I would never buy bonds expecting appreciation. Its not their primary intent. They are income instruments.

I agree, and yet the main source of the stellar bond fund returns over the past decade has been price appreciation. I was just suggesting that the opportunity cost of avoiding bonds for the next few months is likely to be low.

 

[COcheesehead]

I agree, and yet the main source of the stellar bond fund returns over the past decade has been price appreciation. I was just suggesting that the opportunity cost of avoiding bonds for the next few months is likely to be low.

It really depends. I still use a bond ladder to fund, really over fund, all my income needs. I wasn’t replacing the maturing rungs in the last year or so, but now I have begun to nibble on replacements. I am seeing muni’s back in the range of where they make sense again, both short and intermediate. I expect that to improve for a bit, and then, who knows.

I am glad I have a ladder, especially now. Everybody has their own goals. I don’t have a pension, so avoiding bonds for me would put me more at risk for SORR since I am early in my retirement and making withdrawals.

 

[Lsbcal]

I agree, and yet the main source of the stellar bond fund returns over the past decade has been price appreciation. I was just suggesting that the opportunity cost of avoiding bonds for the next few months is likely to be low.

Historically they have had a positive real return.
Example: for the 5 year Treasury from 1926-2010 the real return was 2.3%