Author Topic: Trying to understand the risk of bonds  (Read 2005 times)

webguy

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Trying to understand the risk of bonds
« on: March 28, 2018, 11:24:22 AM »
Hey fellow Mustachios,

I'm considering whether to add some more bonds to my portfolio (BND - Vanguard Total US Bond) and had a question I thought you fine folks might be able to help me answer.

I understand that as interest rates rise, the price of bonds in the fund will likely decrease. But as rates rise, doesn't this then result in bonds becoming more appealing due to their increased yield and so more people moving from stocks to bonds over time, which causes the price to increase again?  Or am I not thinking about this correctly?

Also, wouldn't the expectation of interest rate increases already be priced into the bond market?

Thanks!

koshtra

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Re: Trying to understand the risk of bonds
« Reply #1 on: March 28, 2018, 11:53:57 AM »
The two risk factors for bonds are default (which you mitigate by having a diverse fund) and inflation (which can easily outstrip the rates and make bonds something that no one wants. We haven't seen bad inflation for a while, but we haven't seen an administration this financially reckless for a while, either.)

In general non-junk bonds are not very risky. But they're not very profitable, either.

cosine88

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Re: Trying to understand the risk of bonds
« Reply #2 on: March 28, 2018, 11:56:19 AM »
But if people believe the interest rates will continue to rise, the prices will continue to fall, and that isn't exactly peachy.

If no one wants to buy them, they have to give higher and higher yields.

There's been a 35 year bull market in bonds. The US treasury has to sell over $1T of bonds over the next 12 months; guess how they will get people to buy them? By giving higher yields.

When the interest rates rise across all the US debt, and we have $20T of it, there is likely to be a dollar crisis.

When it rains, it will pour.

Eric

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Re: Trying to understand the risk of bonds
« Reply #3 on: March 28, 2018, 12:50:02 PM »
Hey fellow Mustachios,

I'm considering whether to add some more bonds to my portfolio (BND - Vanguard Total US Bond) and had a question I thought you fine folks might be able to help me answer.

I understand that as interest rates rise, the price of bonds in the fund will likely decrease. But as rates rise, doesn't this then result in bonds becoming more appealing due to their increased yield and so more people moving from stocks to bonds over time, which causes the price to increase again?  Or am I not thinking about this correctly?

Also, wouldn't the expectation of interest rate increases already be priced into the bond market?

Thanks!

This is true in a vacuum.  However, investing doesn't happen in a vacuum.  Lots of other factors will affect the price of BND.  If the stock market starts tanking, it will go up based on demand.  If the economy slows, the planned rate hikes won't happen.  And even if the rates hike happen, BND can and likely will still have a positive return.  See my recent post here where you can compare rising interest rates to past performace, showing that even in rising rate environments, it can still do fine.  But no matter what happens, the reason for owning bonds is not to make a super high return.  It's to reduce volatility.  Even if interest rates rise, they will accomplish that. 




maizeman

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Re: Trying to understand the risk of bonds
« Reply #4 on: March 28, 2018, 01:57:53 PM »
I understand that as interest rates rise, the price of bonds in the fund will likely decrease. But as rates rise, doesn't this then result in bonds becoming more appealing due to their increased yield and so more people moving from stocks to bonds over time, which causes the price to increase again?  Or am I not thinking about this correctly?

No, because with rising interest rates mean that people can buy brand new bonds which produce a higher yield at face value, whereas bonds from before the interest rate rise are only able to pay that yield by selling for less than face value so the price of "old" bonds stays depressed until either interest rates fall again or the bond matures.

SK Joyous

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Re: Trying to understand the risk of bonds
« Reply #5 on: March 28, 2018, 04:17:08 PM »
Another question to the group then - does laddering help mitigate the risk of rising interest rates/falling bond price or other risks? I'm still accumulating, so I don't own any bonds in my personal investing (although I do stay in a more balanced 70/30 in my pension plan), but I had planned to do laddering (or better yet buy a laddered bond ETF) when I did start to acquire bonds. Any opinions on this?

DreamFIRE

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Re: Trying to understand the risk of bonds
« Reply #6 on: March 28, 2018, 04:26:36 PM »
Check out this recent thread discussing this same topic.  Some nice graphs included:

https://forum.mrmoneymustache.com/post-fire/what-do-you-invest-in-during-financial-independence/

nihilism122

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Re: Trying to understand the risk of bonds
« Reply #7 on: March 28, 2018, 05:21:58 PM »
Bonds are a relatively low risk way to stabilize volatility in your portfolio.  They will never suffer huge gains or losses like stocks do when the markets are going crazy, but you won't get rich off bonds either.  As previously mentioned, they may not even keep pace with inflation.  But that is still better than dropping 50% like stocks can do when they crash. 

I am in my late 30s and I only have about 6% bonds in my portfolio, but that is gradually going to start increasing.  It is all about diversification and better risk adjusted returns.  I lost almost 20k in the markets last week.  I know it will go back up and I am not the least bit concerned at this stage of my life, but it helps put the value of holding bonds into perspective. 
« Last Edit: March 28, 2018, 05:23:55 PM by nihilism122 »

GOFU

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Re: Trying to understand the risk of bonds
« Reply #8 on: March 28, 2018, 06:10:05 PM »
Bonds are a relatively low risk way to stabilize volatility in your portfolio.  They will never suffer huge gains or losses like stocks do when the markets are going crazy, but you won't get rich off bonds either.  As previously mentioned, they may not even keep pace with inflation.  But that is still better than dropping 50% like stocks can do when they crash. 

I am in my late 30s and I only have about 6% bonds in my portfolio, but that is gradually going to start increasing.  It is all about diversification and better risk adjusted returns.  I lost almost 20k in the markets last week.  I know it will go back up and I am not the least bit concerned at this stage of my life, but it helps put the value of holding bonds into perspective.
If you are in the accumulation phase and your time horizon is long, volatility does not hurt you because you are not selling. In fact volatility can be your friend as it allows you to acquire assets over time at a lower average cost.

To the OP: I know your question was limited to the effect of rising interest rates on the price of bonds or the price of a bond fund. Why are you considering increasing your bond holdings now? What is the objective you seek to achieve by doing so?

harvestbook

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Re: Trying to understand the risk of bonds
« Reply #9 on: March 28, 2018, 06:14:35 PM »
Another question to the group then - does laddering help mitigate the risk of rising interest rates/falling bond price or other risks?

The way I look at it, a total bond fund IS a ladder, since it's always buying and selling bonds of different maturity lengths. Seems relatively safe to me if you hold it long enough.

Stachless

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Re: Trying to understand the risk of bonds
« Reply #10 on: March 28, 2018, 06:37:28 PM »
Other than the previously mentioned Default Risk and Inflation Risk, you bear 'very little' Return Risk simply by holding to maturity.   I.e., when the PV of your bond's stream of payments declines in a rising rate environment, you won't 'lose' your principal or interest if you just hold till maturity.  What you will lose is the opportunity cost of buying a bond of similar credit quality and duration (so pretty much the same risk) that would have paid you more.

Good luck!!

DreamFIRE

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Re: Trying to understand the risk of bonds
« Reply #11 on: March 28, 2018, 07:22:12 PM »
OP is clearly talking about bond funds, not bonds.  He specifically mentioned the fund BND by name.

smallstache

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Re: Trying to understand the risk of bonds
« Reply #12 on: March 28, 2018, 08:49:33 PM »
Bonds are a relatively low risk way to stabilize volatility in your portfolio.  They will never suffer huge gains or losses like stocks do when the markets are going crazy, but you won't get rich off bonds either.  As previously mentioned, they may not even keep pace with inflation.  But that is still better than dropping 50% like stocks can do when they crash. 

I am in my late 30s and I only have about 6% bonds in my portfolio, but that is gradually going to start increasing.  It is all about diversification and better risk adjusted returns.  I lost almost 20k in the markets last week.  I know it will go back up and I am not the least bit concerned at this stage of my life, but it helps put the value of holding bonds into perspective.

Never say never.

webguy

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Re: Trying to understand the risk of bonds
« Reply #13 on: March 28, 2018, 11:16:46 PM »
To the OP: I know your question was limited to the effect of rising interest rates on the price of bonds or the price of a bond fund. Why are you considering increasing your bond holdings now? What is the objective you seek to achieve by doing so?

Iím trying to put some more cash to work without taking on much more risk. I currently have about $1.3m in stocks/REITs and Iím not comfortable putting any more of our money into that asset class right now. I have a high income at the moment but due to business risk that could change at any time so Iím concerned with wealth preservation more so than growth at the moment. Iím considering putting more cash into bonds as a way to put some money to work while not increasing our risk much further.  Itís possible we may need to live partially off our investments if our business were to fail.

NorCal

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Re: Trying to understand the risk of bonds
« Reply #14 on: March 28, 2018, 11:23:30 PM »
Bond yields do have an inverse relationship with their price.  This is a direct mathematical relationship.  I'll use a single bond as an example, and not a bond fund.  This example is also

As an example, say you have a bond that pays $10 in annual interest.  If you paid $100 for that bond, you'd get a 10% yield.  If prevailing interest rates increase to 12%, the price you could sell the bond for would be $83.33.  If you sold the bond, you would lose $16.67.

Of course, the bond market is BIG.  Much bigger than the stock market.  And there are different things that drive bond prices.  There are many days where prices on some bonds will go up and prices on others will go down. 

Some general rules of thumb:
-Bonds with long maturities are much more volatile than shorter term bonds.  They also carry higher yields.
-Bonds with higher default risk are also more volatile, and will carry higher yields.  However, these bonds sometimes move the opposite direction as the rest of the market, as default risk can fall faster than underlying rates can rise.
-Higher expected inflation will cause rates to rise and prices to fall.

Radagast

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Re: Trying to understand the risk of bonds
« Reply #15 on: March 29, 2018, 11:08:19 AM »
I understand that as interest rates rise, the price of bonds in the fund will likely decrease. But as rates rise, doesn't this then result in bonds becoming more appealing due to their increased yield and so more people moving from stocks to bonds over time, which causes the price to increase again?  Or am I not thinking about this correctly?

Also, wouldn't the expectation of interest rate increases already be priced into the bond market?

Thanks!
You are correct for both. Rising real interest rates make bonds more attractive, and the bond market is highly efficient (by all accounts much more so than the stock market) so that all the best guesses of future rates and events are fully accounted for. Also keep in mind that rising Federal Reserve rates are not necessarily the same as rising interest rates on longer term bonds: https://forum.mrmoneymustache.com/investor-alley/basic-bond-question/msg1909220/#msg1909220.

The greatest risks to bonds are unexpected inflation over a period of many years, and hyper inflation which tends to happen with really bad government or after losing a major war. Also a big risk is that bond returns will simply be too low to meet your objectives over many decades.

Another question to the group then - does laddering help mitigate the risk of rising interest rates/falling bond price or other risks? I'm still accumulating, so I don't own any bonds in my personal investing (although I do stay in a more balanced 70/30 in my pension plan), but I had planned to do laddering (or better yet buy a laddered bond ETF) when I did start to acquire bonds. Any opinions on this?
I generally only recommend laddering CD's, not individual bonds because individual bonds are either too risky or too low yielding. Exceptions might be Treasury STRIPS or TIPS for longer term goals, but the circumstances where these would be ideal are pretty limited, especially for the general audience of this forum.

A laddered bond ETF is pointless and detrimental. Its price fluctuates just like a normal bond fund, it doesn't get the capital gains that normal bond funds usually do by buying low and selling high, and it will probably have a higher expense ratio. If you are too lazy to make a CD ladder, then don't bother and just use a normal bond fund. Like harvestbook said, BND is pretty close to a 1 through 30 year ladder (except it sells 1 year before maturity, so you'd need to keep a small amount of cash to psychologically complete the ladder).



maizeman

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Re: Trying to understand the risk of bonds
« Reply #16 on: March 29, 2018, 11:25:09 AM »
The greatest risks to bonds are unexpected inflation over a period of many years, and hyper inflation which tends to happen with really bad government or after losing a major war. Also a big risk is that bond returns will simply be too low to meet your objectives over many decades.

A good summary of the risks. I'd add that if you're investing in non-government bonds, there is also a nontrivial risk of default during economic recession, depending on who actually issued the bonds. That's why corporate bonds, especially from riskier issuers tend to show more correlation with the stock market during recessions/depressions.

Governments can also default on their debts (for example Argentina), but usually at that point you'll have much more urgent problems to worry about. The more common approach if a government finds it cannot service its debt to to print new money, resulting in higher inflation rather than default. If the government doesn't control its own currency, default is more likely. That's what you are starting to see in parts of the municipal bond market, in Puerto Rico, and in foreign countries which are part of currency unions like Greece.

Radagast

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Re: Trying to understand the risk of bonds
« Reply #17 on: March 29, 2018, 01:34:23 PM »
A good summary of the risks. I'd add that if you're investing in non-government bonds, there is also a nontrivial risk of default during economic recession, depending on who actually issued the bonds. That's why corporate bonds, especially from riskier issuers tend to show more correlation with the stock market during recessions/depressions.
It's kinda hilarious that I didn't mention default as a major risk to bonds :). For investment grade bonds default rates have historically been very low, and it would take a much worse situation than 2008 for that to change much. https://en.wikipedia.org/wiki/Bond_credit_rating for historic default rates by credit rating. But, in a crisis a high grade bond will be progressively lowered in rating so the default rates of high grade bonds is a little misleading, a percentage of bonds which ever default at any subsequent rating would be more revealing. Corporate bonds are only about a third of a total bond index fund, so defaults should generally have a minimal impact on returns. Of course it's not the actual default rate that sets the price at any time, it's the feared default rate, which is why many gurus recommend sticking to government-backed investments.