Author Topic: Aren't bonds actually a better investment right now than people keep saying?  (Read 3306 times)

webguy

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This might be a stupid question, but I hear a lot of negativity related to investing in bonds right now as people say that interest rates will rise which means that the value of bonds go down. I get how that works, put isn't it also true that as interest rates rise and bond rates become more attractive then people will start buying more bonds, or rebalancing from stocks to bonds, which will cause them to increase in value and cancel the losses out? Or do I have that completely wrong?
« Last Edit: December 23, 2016, 04:03:27 PM by webguy »

mgarf

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People's buying pattern don't fundamentally have an effect on bond rates... these are (mostly) set by the government.

If you're scared of interest rate rises and want to buy bonds... buy short-term bonds.

Heckler

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They are a good investment as long as you will hold them past thier maturity timeframe.

http://canadiancouchpotato.com/2015/05/18/how-changing-interest-rates-affect-fixed-income/

phil22

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i think you're both right -- people are willing to take the hit to get out of their longer-term bonds since the rates look like they're going to be on the rise.  so those selling bonds outnumber those buying, for the time being, causing the bond funds to drop in value and all of this negativity.

then yes, as i understand it for the very long-term/FI outlook, over the next few years as bond sellers dry up, stocks have corrections, rates get higher, and potentially if rates are left alone for a while or are lowered again, bonds will recover.  so for the "buy and hold for your lifetime" bonds are ok despite the negativity.

ChpBstrd

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One of the hardest concepts for my Finance professor to get across is why the market price of a bond paying 5%, for example, would decrease when new bonds start being issued at 5.5%.

The class understood that they'd rather own the 5.5% bonds than the 5% bonds, and they understood that with either purchase held to maturity you get exactly the yield you paid for unless the bond defaults. The hard part was the idea that your bond yielding 5% would lose value in the resale market until its effective yield became 5.5%. E.g. depending on the duration, the 5% bond you bought for $1,000 might now be selling for $950.

So yes, the resale value of your bond will decrease as interest rates rise. But if you hold to maturity (or close) and the bond doesn't default, you get exactly what you planned to get when you bought the bond. If you sell after rates rise, you'll lose money on the trade.

The bigger concern for bond investors trying to earn a point or two above the current inflation rate (which tends to be really close to the 10y treasury bond yield) is what happens when inflation spikes a percent or two in a year and interest rates follow. If this happens and you're holding a 20-30 year bond, your bond might drop in value by 20-40%, even as it continues paying interest on schedule. Worse, your bond might be paying below the rate of inflation, meaning you're losing purchasing power every day, despite your investment.

These concerns seem salient with so many hundreds of billions of dollars plowing into bonds yielding 3%ish. If inflation hits 4 or 5% a year from now, a lot of institutions will have to mark down their assets big time - i.e. on the scale subprime mortgage portfolios were marked down in 2008.

The case could be made that an inflation surprise would terrify people out of bonds as they wait for a continuation of that inflation trend (e.g. the yield-inflation spread might widen). Who wants to catch a falling knife?

Regarding stocks, the CAPM equation (http://www.investopedia.com/terms/c/capm.asp) to price a stock investment build's the stocks value on top of a "risk-free" baseline alternative investment yield - usually thought of as the yield on US treasury bonds. When that risk free interest rate increases, you have less incentive to buy a stock that might earn slightly higher than that. That is, when your risk free rate is 2%, you'll pay more cash for a stock investment expected to yield 5%. If that risk-free rate rose to 5% though, your risky investment that might earn 5% is worth a lot less, because the people you would sell that investment to might as well just buy the risk-free option instead of your risky option.

So rising rates could cause both stocks and bonds to fall, just as falling rates contributed to both of them rising in the past.

marty998

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Snip

Hence the popularity of Inflation Linked Bonds (ILB's)

You may lose a fraction on yield, but you won't have issues with capital being eroded over decades.

Mighty-Dollar

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The primary role of bonds in your portfolio is to serve as a diversifier against sharp swings in the stock market.

When interest rates rise, yields go up but the price of bonds go down. Initially it's bad for bond prices, but in the long run you're getting that higher yield if you stay the course.

mathjak107

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the reality is if you are a long term investor bonds are a solution to a temporary problem that  permanently reduces long term gains .

the logic makes no sense . unless you are a good market timer bonds will just reduce long term gains while mitigating  a problem that is not a problem .

bonds are useful when you are dealing with time frames other than long term . they are good for refilling cash when you need more cash for living on .

the exception would be if you are going to an all weather portfolio which has assets like long term bonds which have enough ooomph to profit in down markets and make money in all parts of the cycle  .

having assets capable of the same volatility is different than holding assets like short and intermediate term bonds which really can't generate the same gains as stocks when called upon to do so .

that is why the portfolio's like the  gb stress test better than portfolio's with higher stock percentages but without opposing asset classes capable of some heavier lifting . .
« Last Edit: December 26, 2016, 06:03:52 AM by mathjak107 »

mathjak107

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holding a bond to maturity  and losing purchasing power or not getting a  market rate  is the same thing as a loss in a bond fund   . even at 2% inflation getting back 1k in 30 years is a 50% loss in what you can buy .

a bond fund will have it's interest rate it pays increasing in a rising rate environment . that offsets some of the nav drop over time . an individual bond does not drop in nav but it never sees a penny more in interest either .

in the end a bond fund is nothing more than a collection of bonds . some you sell ,some you buy ,some mature .  at the end of the day it is likely you will come out close .

a bond fund can have credit upgrades or down grades making things better or worse if they are not gov't bonds  as well as sell at a premium or discount to asset value .

unless rates stabilize eventually you will always be behind the curve even with the higher interest coming in .


but odds are you still will be pretty close between the bond fund and individual bonds  once the 1k is repaid down the road in purchasing power terms .
« Last Edit: December 26, 2016, 08:50:16 AM by mathjak107 »

ChpBstrd

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I see people note that it doesn't matter if you hold the bonds to maturity.  That seems to make sense, you can't actually lose money in a bond unless it defaults.  But trading bonds you can lose money - makes sense based on less desirable interest rate.

Can someone help me understand how it works with a bond fund like the vanguard total bond index?  When rates rise the fund value will go down, right?  But if I plan to hold the bond fund long term it will go back up? 

I'm a bit confused because people always say bonds act opposite to stocks generally.  Stocks go down, bonds go up and vice versa.  So if rates go up, bonds go down and stocks go up?  I must be missing something basic because this doesn't sound right.

A bond index fund will behave similarly to a bond portfolio in your account. Because it is a portfolio of existing bonds, its value will change based on changes in the interest rates available on new bonds. Look up the newsfeed for a bond fund and you'll see price fluctuations based on events that investors interpret as evidence for an interest rate change.

Of course, an index fund will also have some churn (buying and selling of underlying assets so as to maintain resemblance with the index), so the effect might not be as straightforward, but it's still there.