Author Topic: Basic bond question  (Read 3252 times)

ePalmtrees

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Basic bond question
« on: February 16, 2018, 01:44:46 PM »
So, I'd like to better understand why bond funds go down in price. I understand it's because no one wants to buy them when interest rates rise and better options become available. But the bond is still repaid at the same rate in the end, right?

So does it matter if the bond fund goes down in price, or does your actual investment remain the same? Aren't the yearly returns based on the bond repayments, like if it yielded 4%, the average of all the bonds was 4% and that's where the yield came from, the bond fund passing those distributions onto the investors?

I guess I don't understand exactly where the return is coming from and why it would change if the metrics of the actual bonds in the fund didn't change.

For instance this year, at the bottom of the page, you can see this fund is down almost 1.5% ytd.

https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0044&funds_disable_redirect=true#tab=1

I was interested in bonds because I was interested in getting a good enough interest rate and just holding them until completion. Is this fund doing something different?

Tyler

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Re: Basic bond question
« Reply #1 on: February 16, 2018, 02:37:28 PM »
I'll try to explain it as succinctly as possible.

Bonds pay a fixed coupon payment.  Buy a bond and hold it all the way to maturity, and you get every coupon payment along the way and your entire principal back.  But if you want to sell your bond before it matures you have to account for the fact that bonds with higher coupon rates are more valuable to investors than bonds with lower coupon rates. Since interest rates change all the time, the value of your bond varies on the open market.  If rates have risen since you first purchased your bond it will be worth proportionately less.  If rates have fallen your bond will be worth more.  The bond market is liquid enough that the going rate for every bond is automatically priced in based on simple calculations, so if you watch your brokerage you'll see the "trade-in" value of your bond rise and fall over time. 

ePalmtrees

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Re: Basic bond question
« Reply #2 on: February 16, 2018, 02:44:05 PM »
I basically understand that, but so are there no bond funds that simply hold the funds until maturity?

I'd like to do that, but invest in a bond fund so I'm diversifying risk instead of buying a few personally. But I just want the 4% or whatever a year.

But this fund seems like you getting the money in a different way if it's responding to the change in interest rates. I don't want that.

Does that make sense? I want to get paid just on the interest rate of the bonds, not on the fluctuating valuation?

Is there no fund that does that, and doesn't change in value?

ePalmtrees

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Re: Basic bond question
« Reply #3 on: February 16, 2018, 02:56:13 PM »
Perhaps I'm not understanding this fund.

https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0044&funds_disable_redirect=true#tab=4

It looks like it does give distributions. Is it saying 3 cents on every share ($11)? Why does it say that's over 3% in the end column?

Does anyone know how to decipher this?


Tyler

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Re: Basic bond question
« Reply #4 on: February 16, 2018, 03:03:47 PM »
I basically understand that, but so are there no bond funds that simply hold the funds until maturity?

Even if they did, no bond index fund I'm aware of will guarantee your principal back.  You're buying into the bond market as a whole and will receive the interest for the weighted average maturity of the fund at any point in time.  That interest will change, and so will the value of your bond index fund shares.  So you will make money on the regular interest payments and also make/lose money based on the market value of your shares.

But if holding bonds to maturity and ignoring market gyrations is what you want to do you can always purchase the bonds directly.  Some brokerages like Fidelity even have nice features to allow you to automatically build your own bond ladder and roll over expiring bonds into new issues.  You'll also have the benefit of not paying an expense ratio.  When you want money out, you then have the option of just waiting until the bonds mature and putting the principal back into cash instead of new bonds. 

« Last Edit: February 16, 2018, 03:20:56 PM by Tyler »

Mezzie

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Re: Basic bond question
« Reply #5 on: February 16, 2018, 05:01:06 PM »
Have you looked into buying Treasury Bonds from Treasury Direct? Then you can hold them to maturity.

Bateaux

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Re: Basic bond question
« Reply #6 on: February 16, 2018, 06:43:33 PM »
I've only been buying bonds for a few months now.  They certainly lost me money in VTBLX.  They lose less than equities in big downturns tbough.

MustacheAndaHalf

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Re: Basic bond question
« Reply #7 on: February 16, 2018, 09:57:39 PM »
The earlier descriptions are accurate, so I don't have much to add to the math.

A bond that is about to mature isn't impacted much by interest rates: you're about to get the principal back.  But the longer you have to wait, the longer you get paid a lower interest rate.  Even if you hold just one fixed bond, you are passing up the opportunity to own a higher paying bond.  That's why bond funds drop in value when yields increase - the opportunity cost.

The bond market is efficient.  Don't try to find a way you are guaranteed not to lose any money, as that's not available.  Instead, learn what impacts bond prices, like the quality of the bonds and the length of time until maturity.  If you opt for a short-term US treasury bond fund, the impact will be far smaller than if you buy into a long-term "high yield" (junk bond) fund.  You have some control over the losses by selecting higher quality bonds and a shorter term.  So take a look at those rather than trying to avoid all possible losses.

DreamFIRE

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Re: Basic bond question
« Reply #8 on: February 16, 2018, 10:01:46 PM »
I basically understand that, but so are there no bond funds that simply hold the funds until maturity?

I'd like to do that, but invest in a bond fund so I'm diversifying risk instead of buying a few personally.

What you are asking about is exactly what "defined maturity bond funds" are, also called "target maturity bond funds".

Here are some links to information that explain them in detail:

https://www.schwab.com/active-trader/insights/content/target-maturity-bond-etfs-diversified-baskets-single-year-maturity
http://www.etf.com/publications/journalofindexes/joi-articles/21296-target-maturity-bond-funds-as-retirement-income-tools.html
https://www.aaii.com/journal/article/defined-maturity-funds-a-bond-alternative-with-compromises.touch
https://personal.vanguard.com/pdf/ICRDMB.pdf
https://www.guggenheiminvestments.com/bulletshares

Radagast

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Re: Basic bond question
« Reply #9 on: February 17, 2018, 12:05:31 AM »
If you are holding the bond fund for a long time there is no downside to it, a rise in rates will eventually pay you back and then some. You may as well stick with a traditional bond fund. If you are say saving for a house payment in 6 years or something like that then a "defined maturity" bond fund can make sense.
Previous poster had some good links. Fidelity also has target maturity municipal funds for example
https://fundresearch.fidelity.com/mutual-funds/summary/31635V109
Or the aforementioned corporate funds
https://www.guggenheiminvestments.com/etf/resources/etf-bond-ladder

A popular choice is to use US government backed bonds, because you can buy a single one with no default risk and at many places no commission. Use bank CD's out to 5 or 7 years, then zero coupon treasury bonds (STRIPS) beyond that. At 20 years EE saving bonds are the best choice, but also basically certain to underperform other investments. I saving bonds are also guaranteed to not lose money.

I don't think a rolling ladder makes much sense, because an intermediate term bond fund will give you similar to better results over the years. The exception is CD's, which provide better than market returns relative to their risk thanks to FDIC insurance.
« Last Edit: February 17, 2018, 12:12:48 AM by Radagast »

ePalmtrees

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Re: Basic bond question
« Reply #10 on: February 17, 2018, 11:01:04 AM »
Thank you for all of these responses, all are very helpful.

MustacheAndaHalf

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Re: Basic bond question
« Reply #11 on: February 18, 2018, 11:33:37 PM »
One problem with how people are thinking about duration: they are thinking of a static one-time change.  If bond yields go up once, after waiting years equal to the bond fund's duration, you break even and start to be ahead.  But that assumes only one interest rate increase, which has not been true even for last year. 

Take Vanguard Total Bond Market  for example, with a duration of 6 years.  Does anyone believe there will be just 1 interest rate increase for 6 years?  Last year the Fed raised rates repeatedly, which tends to flow into bond yields.  But set aside multiple increases in one year, and consider one increase every 2 years.

0 years: rates +1%, BND loses -6% value but has +1% yield
2 years: BND has gained +2% over past 2 years, but -4% of loss remains
2 years: another +1% rates, same impact (-6% value, +1% yield)
2 years: now BND has -10% value, but has +2% yield
4 years: BND has gained +6% over 4 years, but -6% of the loss remains
4 years: another +1% rates, same impact (-6% value, +1% yield)
4 years: now BND has -12% value, and +3% yield
6 years: so far bond is still -6% down, and will have +2% yield going forward
6 years: another +1% rates, same impact (-6% value, +1% yield)
6 years: all told, BND is -12% with +3% yield

The key thing to note is although you waited 6 years after the original increase in yields, at no point did the bond fund break even.  Layers of increases keep the fund's value below your original purchase price.  While seeing exactly +1% yield increases exactly every 2 years is unlikely, it demonstrates the impact of repeated yield increases on a bond fund.

Last year rates were raised repeatedly.  In January the stock market took a hit when investors realized the Fed will probably be raising rates more than expected this year.  So while I agree duration is the break even point, in the case of the Total Bond Market fund it's unlikely that rates will only go up once in 6 years.

Heckler

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Re: Basic bond question
« Reply #12 on: February 19, 2018, 12:04:51 AM »

DreamFIRE

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Re: Basic bond question
« Reply #13 on: February 19, 2018, 05:36:08 PM »
6 years: all told, BND is -12% with +3% yield

Now figure in 6 years of inflation losing 3% of the value per year.  Doh!

Radagast

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Re: Basic bond question
« Reply #14 on: February 19, 2018, 11:29:57 PM »
One problem with how people are thinking about duration: they are thinking of a static one-time change.  If bond yields go up once, after waiting years equal to the bond fund's duration, you break even and start to be ahead.  But that assumes only one interest rate increase, which has not been true even for last year. 

Take Vanguard Total Bond Market  for example, with a duration of 6 years.  Does anyone believe there will be just 1 interest rate increase for 6 years?  Last year the Fed raised rates repeatedly, which tends to flow into bond yields.  But set aside multiple increases in one year, and consider one increase every 2 years.

0 years: rates +1%, BND loses -6% value but has +1% yield
2 years: BND has gained +2% over past 2 years, but -4% of loss remains
2 years: another +1% rates, same impact (-6% value, +1% yield)
2 years: now BND has -10% value, but has +2% yield
4 years: BND has gained +6% over 4 years, but -6% of the loss remains
4 years: another +1% rates, same impact (-6% value, +1% yield)
4 years: now BND has -12% value, and +3% yield
6 years: so far bond is still -6% down, and will have +2% yield going forward
6 years: another +1% rates, same impact (-6% value, +1% yield)
6 years: all told, BND is -12% with +3% yield

The key thing to note is although you waited 6 years after the original increase in yields, at no point did the bond fund break even.  Layers of increases keep the fund's value below your original purchase price.  While seeing exactly +1% yield increases exactly every 2 years is unlikely, it demonstrates the impact of repeated yield increases on a bond fund.

Last year rates were raised repeatedly.  In January the stock market took a hit when investors realized the Fed will probably be raising rates more than expected this year.  So while I agree duration is the break even point, in the case of the Total Bond Market fund it's unlikely that rates will only go up once in 6 years.
I have a few issues with this. First, there is a gigantic gap between The Fed raising rates and BND rates also going up. Over the past 25 years Fed rate increases have affected mostly short term rates, with a negligible effect on total bond market funds.

I haven't had time to make my own demonstrations, but for example here is a post form poster nisiprius on Bogleheads.
Quote
  • The bond portfolio grows slowly and steadily from $1,000 to $1,231 until the interest rate rises hits.
  • While the interest rate is rising, the portfolio continuously loses value and reaches a minimum $1,138, i.e. a -8% loss.
  • When the interest rate levels off, the portfolio starts to gain again.
  • It makes back the lost ground in about two more years.
  • By about year #18, i.e. 8 years after the start of the interest rate increase, it is ahead of where it would have been if here had been no rate increase.
  • It is now growing faster than it did before the rate increase. If the investor had a time horizon of at least ten years, she is better off than if there had been no rate increase


I think bond funds will do perfectly well under a rise in rates from 2% to 6%, if they are intermediate-term investment-grade bonds and if your holding time is on the order of ten years or so. That isn't to say some other strategy might not do better.
You can google "bond returns rising rate site:bogleheads.org" and get lots of discussion. As I recall the Fed raised rates more than 20 times in 2004-2007, and VBMFX was barely impacted.

Rising rates are fine by me. The biggest threat to bonds is unexpected inflation.

Radagast

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Re: Basic bond question
« Reply #15 on: February 19, 2018, 11:36:36 PM »
I basically understand that, but so are there no bond funds that simply hold the funds until maturity?

I'd like to do that, but invest in a bond fund so I'm diversifying risk instead of buying a few personally.

What you are asking about is exactly what "defined maturity bond funds" are, also called "target maturity bond funds".

Here are some links to information that explain them in detail:

https://www.schwab.com/active-trader/insights/content/target-maturity-bond-etfs-diversified-baskets-single-year-maturity
http://www.etf.com/publications/journalofindexes/joi-articles/21296-target-maturity-bond-funds-as-retirement-income-tools.html
https://www.aaii.com/journal/article/defined-maturity-funds-a-bond-alternative-with-compromises.touch
https://personal.vanguard.com/pdf/ICRDMB.pdf
https://www.guggenheiminvestments.com/bulletshares
I had a chance to look through, and that is a pretty good list of resources on these things. I knew they existed, but I hadn't ever seen articles about them.

That said, by the time you account for fees, spreads, premiums, and default risk, they don't seem much if any better than a CD. Certainly a rolling ladder of these over the years would come out behind a generic bond fund of similar type. I only see them being used for non-rolling uses, such as lower sequence of returns risk around a FIRE date or to save up for an expense in a certain year/years.

DreamFIRE

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Re: Basic bond question
« Reply #16 on: February 20, 2018, 10:11:19 PM »
I basically understand that, but so are there no bond funds that simply hold the funds until maturity?

I'd like to do that, but invest in a bond fund so I'm diversifying risk instead of buying a few personally.

What you are asking about is exactly what "defined maturity bond funds" are, also called "target maturity bond funds".

Here are some links to information that explain them in detail:

https://www.schwab.com/active-trader/insights/content/target-maturity-bond-etfs-diversified-baskets-single-year-maturity
http://www.etf.com/publications/journalofindexes/joi-articles/21296-target-maturity-bond-funds-as-retirement-income-tools.html
https://www.aaii.com/journal/article/defined-maturity-funds-a-bond-alternative-with-compromises.touch
https://personal.vanguard.com/pdf/ICRDMB.pdf
https://www.guggenheiminvestments.com/bulletshares
I had a chance to look through, and that is a pretty good list of resources on these things. I knew they existed, but I hadn't ever seen articles about them.

That said, by the time you account for fees, spreads, premiums, and default risk, they don't seem much if any better than a CD. Certainly a rolling ladder of these over the years would come out behind a generic bond fund of similar type. I only see them being used for non-rolling uses, such as lower sequence of returns risk around a FIRE date or to save up for an expense in a certain year/years.
Right.  To get the potential better yield, you have to go with the Guggenheim junk bond fund.  I can get a 2 year CD with a 2.3% yield at Sallie Mae.   There are a couple banks out there offering a 3% yield on 5 year savings vehicles similar to CDs.  I'm not sure I want to go 5 years, but I do have some additional fixed assets I need to place, and I'm already nearly 80% in stocks with possible FIRE within the next couple years.
« Last Edit: February 21, 2018, 05:51:12 PM by DreamFIRE »

Radagast

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Re: Basic bond question
« Reply #17 on: February 22, 2018, 11:18:38 PM »
I compared 2023 muni, corporate, and junk funds from above with a 5 year CD. I took bid/ask spreads and premium to NAV from etf.com and SEC yields from morningstar. I looked up historical default rates per year for bond classes (0.1%, 4.12%, 0.02%) and optimistically assumed 50% recovery rates. Then I assumed 22% federal tax.
Ticker   Type   SEC Yd   B/A           P/D          Default   22% Tax   Total
BSCN   Corp   2.82%   -0.16%   -0.33%   -0.05%   -0.61%   1.67%
BSJN     Junk   4.84%   -0.10%   -0.20%   -2.06%   -0.61%   1.87%
FCHPX   Muni   1.75%   0.00%   0.00%   -0.01%   0.00%   1.74%
(CD)     FDIC   2.65%   0.00%   0.00%   0.00%   -0.58%   2.07%

Note junk bond default rates have generally gone over 10% in recessions. I am not sure I got all the details right (I excluded defaults from taxation for example), but CD's look like the obviously better choice here. As per usual, the muni fund would look better in ~30%+ tax brackets.

Radagast

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Re: Basic bond question
« Reply #18 on: February 22, 2018, 11:48:31 PM »
@MustacheAndaHalf
2003 Jun 25   1.00%
2004 Jun 30   1.25%
2004 Aug 10   1.5%
2004 Sep 21   1.75%
2004 Nov 10   2.0%
2004 Dec 14   2.25%
2005 Feb 2   2.5%   
2005 Mar 22   2.75%
2005 May 3   3.0%
2005 Jun 30   3.25%
2005 Aug 9   3.5%   
2005 Sep 20   3.75%   
2005 Nov 1   4.0%   
2005 Dec 13   4.25%
2006 Jan 31   4.5%   
2006 Mar 28   4.75%
2006 May 10   5.0%
2006 Jun 29   5.25%
Here is what happened to Total Bond Market the last time the Fed raised rates 17 times in 3 years, for a total increase of 4.25%. Not exactly a crash and burn; VBMFX gained over 5% (total) in that time. Maybe next time will be different.... sorry for big pic...

anisotropy

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Re: Basic bond question
« Reply #19 on: February 22, 2018, 11:52:10 PM »

Rising rates are fine by me. The biggest threat to bonds is unexpected inflation.

I second this. The calculation by M&half doesn't seem right. It is known that, eventually higher bond yields will be a positive for investors because expected returns will be higher; the graphs from Radagast look more reasonable.

Re: https://www.bloomberg.com/view/articles/2018-02-12/bond-bear-markets-aren-t-measured-in-losses-alone
"However, the real risk in bonds isnít nominal drawdowns or losses in the principal value. It is the loss of purchasing power over the long-term due to the effects of inflation."

Heckler

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Re: Basic bond question
« Reply #20 on: February 23, 2018, 08:07:13 AM »
@MustacheAndaHalf
2003 Jun 25   1.00%
2004 Jun 30   1.25%
2004 Aug 10   1.5%
2004 Sep 21   1.75%
2004 Nov 10   2.0%
2004 Dec 14   2.25%
2005 Feb 2   2.5%   
2005 Mar 22   2.75%
2005 May 3   3.0%
2005 Jun 30   3.25%
2005 Aug 9   3.5%   
2005 Sep 20   3.75%   
2005 Nov 1   4.0%   
2005 Dec 13   4.25%
2006 Jan 31   4.5%   
2006 Mar 28   4.75%
2006 May 10   5.0%
2006 Jun 29   5.25%
Here is what happened to Total Bond Market the last time the Fed raised rates 17 times in 3 years, for a total increase of 4.25%. Not exactly a crash and burn; VBMFX gained over 5% (total) in that time. Maybe next time will be different.... sorry for big pic...


And because your asset allocation had you buy more in early 2003, you did even better than this.

Tyler

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« Last Edit: February 23, 2018, 02:05:09 PM by Tyler »