Wrestling with bond allocation... again!

[audreyh1]

I expect interest rates to increase, causing my bonds to drop in value. But I don't sweat it too much - here is why:

1. Bonds are in my portfolio for ballast, to reduce the volatility of the equities in the portfolio. This is their primary function.

2. If bonds have dropped, when I rebalance I will add more to the lower bonds.

3. If something drastic happens to equities, bonds usually rise in value. Interest rates usually drop during a recession that causes equities to be hit hard. If you have high quality bonds, they will rise in value during this period. And you can rebalance using some of your bonds to buy stocks.

I have had a large position in bond funds since I retired in 1999. There have been many interest rate up and downs since then. The average duration of my bond funds are around 5 years, so they gradually catch up with major interest rate changes, and in the meantime rebalancing is an opportunity to add when bonds are down, and trim from them when they are up.

BTW - my bond funds are still up about 5% YTD even though there has been a recent increase in interest rates causing almost 2% decline over the past month. The thing is we're just back to where interest rates (10 year treasury) started at the beginning of the year.

 

[Lsbcal]

Rates rose back in the 1950's. I did some calculations for the 5 year Treasury which experienced a rise from 1.9% in April 1954 to 4.9% in December 1965. They returned about 0.9% real for those 10+ years. The current 5 year Treasury is at 1.8%.

These calculations do not include some extra return generally captured by funds such as yield curve roll.

 

[audreyh1]

Rates rose back in the 1950's. I did some calculations for the 5 year Treasury which experienced a rise from 1.9% in April 1954 to 4.9% in December 1965. They returned about 0.9% real for those 10+ years. The current 5 year Treasury is at 1.8%.

These calculations do not include some extra return generally captured by funds such as yield curve roll.

My observations (both personal experience since 1999 and looking at historical data) is that during gradual interest rate rises, intermediate bond funds generally return positive returns, although obviously reduced somewhat by the interest rate rise.

If the interest rate rises suddenly, the bond funds may have a negative year, but they generally make up a chunk of that the following year. Reason? Because sharp rate increases tend to reverse. Not completely, but in large part. In the long run rate rises tend to smooth out. You can see this happen happen in the taper tantrum of 2013, and in the initial part of a multi-year rise in 2003.

In fact - sustained sharp increases in interest rates tend to cause recessions, which mean equities drop, and then bonds rise as investors "rush to quality" and in the meantime the Fed is lowering interest rates to combat the recession.

 

[Lsbcal]

...
If the interest rate rises suddenly, the bond funds may have a negative year, but they general make up a chunk of that the following year. Reason? Because sharp rate increases tend to reverse. Not completely, but in large part. In the long run rate rises tend to smooth out. ...

Another example of this, 1994 was a bad year for bonds. Total Bond Market returned -2.7%. But in 1995, it returned 18.2%.

 

[NW-Bound]

Another example of this, 1994 was a bad year for bonds. Total Bond Market returned -2.7%. But in 1995, it returned 18.2%.

Hence, I have been waiting for bonds to crash.

 

[audreyh1]

Hence, I have been waiting for bonds to crash.

-2.7% is a crash?

 

[gcgang]

Rates rose back in the 1950's. I did some calculations for the 5 year Treasury which experienced a rise from 1.9% in April 1954 to 4.9% in December 1965. They returned about 0.9% real for those 10+ years. The current 5 year Treasury is at 1.8%.

These calculations do not include some extra return generally captured by funds such as yield curve roll.

Rates rose in the 1950's and continued to rise for about 30 years, climaxing at about 15% yields on Treasuries. Almost the only thing bonds were good for was tax loss swaps, leading to their nickname, "certificates of confiscation".

We've been in a 30+ year secular bull market in bonds.

Is this the end or will the trend extend having rates go negative? Stay tuned.

 

[Montecfo]

I am a rebalance and clean up my portfolio/AA once a year guy, generally in Dec/Jan, however, I find myself questioning my strategy often during the year as I weigh in on economic/financial/political news and start applying my wizard-like skills in thinking I can build a better mouse trap than my boring 70/30 AA, particularly my bond holdings. I generally succumb and let "Boggle-ism" rule my decisions, but man it is hard hitting the buy button on bonds! However, I took a peak at my bond fund/ETF holdings (Intermediate) and low and behold they are returning 4 - 5% for the year! I have been screaming at myself for about 2 yrs to sell those bastards and sit in cash because they are going to get killed as interest rates rise... so says the Wizard! So yes, I would of have lost my 4 - 5% on my 30% holdings, BUT, here I go again... interest rates have got to start rising (and they have), so is it time to sell those bastards??!!!

Anyone else struggling with this?

yes, to some extent. I have sold quite a bit in the way of equities over the past year or so with an eye toward increasing bond allocation when rates rose. Instead i found myself opportunistically nibbling at equities and having underutilized cash. But i plan to begin adding now that rates have moved some, and probably a bit more after Yellen et al increase rates (presumably) next month-intermediate bonds and perhaps more munis.

having said that, I expect to stay 70% equities or so, at least that is the plan as of now.

 

[NW-Bound]

-2.7% is a crash?

Not quite. In 2009, 10-yr T-Bond return was -11.1%. In 2013, it was -9.1%. Source: Federal Reserve.

PS. Lsbcal said that in 1994, total bond fund was down -2.7%. 10-year T-bond was down -8.25% that year.

 

[Lsbcal]

Not quite. In 2009, 10-yr T-Bond return was -11.1%. In 2013, it was -9.1%. Source: Federal Reserve.

PS. Lsbcal said that in 1994, total bond fund was down -2.7%. 10-year T-bond was down -8.25% that year.

Generally my bonds are intermediate. For the intermediate Treasury fund (VFITX) the 1994 return was -4.3% and in 1995 it was 20.4%.

The funds include some strategy returns not found in a single bond (like rolling down the yield curve). Previously I used to compute the return for say a 5 yr Treasury based on the constant maturity Treasury data. But that single bond return was always lower then the actual intermediate Treasury fund which holds a range of bond maturities.

 

[jazz4cash]

If you mean Andrews, those are 7 years, not 5.

Yes but with only 6 mo penalty it still pays 2.74 if you withdraw after 5 yrs. There is an early withdrawal calculator at the depositaccounts.com site. That's why I consider this to be a CD ladder all by itself. With this penalty the yield is higher than you can generally find for shorter maturities. I checked and they allow multiple partial withdrawals. I am using CDs in lieu of bonds for my 20% allocation.

 

[rodi]

I expect interest rates to increase, causing my bonds to drop in value. But I don't sweat it too much - here is why:

1. Bonds are in my portfolio for ballast, to reduce the volatility of the equities in the portfolio. This is their primary function.

2. If bonds have dropped, when I rebalance I will add more to the lower bonds.

3. If something drastic happens to equities, bonds usually rise in value. Interest rates usually drop during a recession that causes equities to be hit hard. If you have high quality bonds, they will rise in value during this period. And you can rebalance using some of your bonds to buy stocks.

+1.

 

[audreyh1]

Not quite. In 2009, 10-yr T-Bond return was -11.1%. In 2013, it was -9.1%. Source: Federal Reserve.

PS. Lsbcal said that in 1994, total bond fund was down -2.7%. 10-year T-bond was down -8.25% that year.

Well - since I don't invest in long bonds like the 10-year treasury either, I don't look at that metric specifically.

Total bond fund index (Vanguard VBMFX) was +5.93% in 2009
and -2.26% in 2013. Source: Morningstar.

 

[FreeBear]

I don't view bonds as helping performance of my portfolio - I view them as helping reduce the impact of stocks performing badly. It's also worth switching mindsets when you have enough to retire. Your bond allocation ensures you remain retired even during a harsh stock market. And then if you have enough to retire, the stocks help keep ahead of inflation and withdrawals.

Nicely said, reminiscent of Bogle.

I'm holding a 50/50 allocation, perhaps eventually creeping to 60/40. My goal in FIRE is to survive a terrible 2000's type decade in equities. Hopefully, bonds will take the edge off inflation while providing some stability to the overall portfolio. Their job is not to help me win, but to keep me from losing...

 

[audreyh1]

I don't view bonds as helping performance of my portfolio - I view them as helping reduce the impact of stocks performing badly. It's also worth switching mindsets when you have enough to retire. Your bond allocation ensures you remain retired even during a harsh stock market. And then if you have enough to retire, the stocks help keep ahead of inflation and withdrawals.

I agree with FreeBear, it's a great perspective well stated.

I don't worry about bonds or cash keeping up with inflation - that's why one should have enough in stocks.

 

[mathjak107]

equity's and cash instruments not bonds would have been the better choice since rates flipped 3 months ago .

there is nothing that says conventional bonds have to be the vehicle of choice just to avoid damage from stocks falling .

in fact there can be far better choices when rates rise than just sitting in a total bond fund since they are anything but total . they lack all the segments that would be at least better choices when rates on bonds and perception of inflation rises .

 

[MichaelB]

Here's an interesting blog entry by financial analyst Ben Carlson, in his typical calm, down to earth style.
How Bad Could Bond Market Losses Get?

A sample of his conclusion.

I’m amazed at the number of people who are certain rates are going to see a sustained rise. It could happen, but you would think people would have learned their lesson about the difficulty of predicting interest rate movements over the past 5-10 years that has seen nearly everyone get it wrong.

A bad year in the high quality, intermediate maturity bonds is typically the same as a bad day or week in the stock market.

Some investors may choose to avoid bonds altogether and just hold cash and stocks in a barbell approach. The problem here is when do you get back into bonds? What if you’re wrong on rates?

 

[audreyh1]

equity's and cash instruments not bonds would have been the better choice since rates flipped 3 months ago .

there is nothing that says conventional bonds have to be the vehicle of choice just to avoid damage from stocks falling .

in fact there can be far better choices when rates rise than just sitting in a total bond fund since they are anything but total . they lack all the segments that would be at least better choices when rates on bonds and perception of inflation rises .

But to do that you have to be able to predict, each year or quarter what interest rates are going to do across the yield curve and adjust your fixed income investments accordingly. I don't know anyone who can do that, certainly not I. And I've heard way too many dead wrong pundit predictions on interest rates to think the "experts" can call it either.

 

[NW-Bound]

I understand all the arguments for holding bonds. But having little in bonds now, I see no urgency to buy right at this point. For the last 5 years, VBMFX (MF) and BND (ETF) have not gone anywhere, and any gain comes from the yield which is currently too low for me to consider (2.34% for VBMFX, and 2.49% for BND).

When the yield gets higher to compensate for the risk, I will get some. The annualized inflation in the past 5 years was very low at 1.4%. If it is going to go up, I want the yield to rise with it.

 

[jazz4cash]

I understand all the arguments for holding bonds. But having little in bonds now, I see no urgency to buy right at this point. For the last 5 years, VBMFX (MF) and BND (ETF) have not gone anywhere, and any gain comes from the yield which is currently too low for me to consider (2.34% for VBMFX, and 2.49% for BND).

This has been my thinking exactly but I was never comfortable being 100% equities so I stumbled into the CDs paying 3-5%. I had to go to longer maturities and they are still a bit less than the total return on bond funds available in my 401k but I feel very comfortable with this barbell strategy. I consider CDs>24 months to be bonds for allocation purposes.

 

[NW-Bound]

In the past, I have had higher stock AA than most people, up to 70-80% but never 100%.

There are more asset classes than just stocks and bonds. And within bonds, there are different kinds. I was just talking about the bond index, which does not look appealing.

 

[haha]

The market for treasuries and investment grade corporates is likely as efficient as any market. Why does an investor think he can outguess it?

Ha

 

[NW-Bound]

These markets are indeed efficient because of the number of players. It still does not mean that as an individual I have to participate. For example, the RE market in SF is very efficient and competitive, but I do not have to play either. The players may have some constraints that I do not have. And people may have reasons for not participating, the same as Bogle not liking foreign stocks.

Right now, I have about 9% in I-bonds that pay 1% above inflation, and about the same as the yield of the bond index. Unless I believe that inflation will be even lower than it is now, I see my I-bonds as a lot safer than Treasury which already pays lower, and even the total bond index that pays the same. Institutional investors cannot do the same that I can, but that is their problem.

 

[haha]

These markets are indeed efficient because of the number of players. It still does not mean that as an individual I have to participate. For example, the RE market in SF is very efficient and competitive, but I do not have to play either. The players may have some constraints that I do not have. And people may have reasons for not participating, the same as Bogle not liking foreign stocks.

Right now, I have about 9% in I-bonds that pay 1% above inflation, and about the same as the yield of the bond index. Unless I believe that inflation will be even lower than it is now, I see my I-bonds as a lot safer than Treasury which already pays lower, and even the total bond index that pays the same. Institutional investors cannot do the same that I can, but that is their problem.

Of course, but this does not appear to be the main thrust of this thread. The topic seems to be that rates will go up, how to react?

You have suggested what seems to me to be an excellent strategy. If one might buy treasuries now, wouldn't inflation indexed treasuries perhaps be a better bet?

Ha

 

[mathjak107]

only if inflation creeps up with rates . increasing short term rates can choke inflation . so increased rates with out much inflation and fear of inflation will not be a good bet .