bond convexity

[kenmoremmm]

i'm a complete noob with bonds. i understand some of the general concept. came across tyler's post about convexity:
https://portfoliocharts.com/2019/05/27/high-profits-at-low-rates-the-benefits-of-bond-convexity/

it seems, if i understand it correctly, that there is room for significant performance in bonds, even with our current low interest rates, due to appreciation. i had naively thought that holding bonds in today's bond market seemed foolish, but now am more intrigued.

to take advantage of convexity, assuming rates continue to trend down, even negative, can one just be invested in a bond fund (short, medium, long term?) or is it better to hold actual coupons? if in a bond mutual fund, would this be a rare case where it'd make more sense for active management to take advantage of short term drops?

[chasesfish]

I've been doing this for six months.  Most of my (30%) bond allocation is in long term treasuries. 

The most appreciation with declining rates comes from long term, zero coupon bonds.

Next are just the straight 30 year treasuries with coupon payments.

Then the ETFs like VGLT and TLT.

I've bought them all, pros and cons to all.   The zeros appreciate the most, but the bid/ask spread is a little wider with my brokerage (Fidelity).

This was a great post:  https://www.physicianonfire.com/zero-coupon-treasury-bonds/

[Radagast]

it seems, if i understand it correctly, that there is room for significant performance in bonds, even with our current low interest rates, due to appreciation.

Yes, but it goes both ways. There is also room for significant harm. I look at it as 1/3 chance long term rates will go up, 1/3 chance down, and 1/3 chance vaguely flat for any given time. Of course, in the long term there is a lot of "deep risk."

to take advantage of convexity, assuming rates continue to trend down, even negative, can one just be invested in a bond fund (short, medium, long term?) or is it better to hold actual coupons? if in a bond mutual fund, would this be a rare case where it'd make more sense for active management to take advantage of short term drops?

• Tyler's chart shows that longer term bonds get more of the effect. So yes.
• I vote a fund is better. You do no benefit if bonds mature naturally, you need to sell them early to get the max capital gain. Selling bonds regularly is a lot of work, and some places may charge commissions. Also you can only buy bonds in increments of $1,000 which is a lot for average people, while bond funds have smaller increments.
• Government bond funds might include GOVT,VGIT,VGLT,EDV,ZROZ depending on the type and strength of the effect you are after, from approximately least to most risky.
• No to active management. I have not seen any sign anybody can predict the bond market. In fact it seems far more difficult than the stock market.

[chasesfish]

I'll add a second endorsement for "no" to active management in the bond funds.  There's not enough margin in regular US government or corporate debt to justify paying active management.

Distressed debt and foriegn debt?  Yes, but the best folks in that space have their own closed-end investment shops and aren't.

As for the potential for loss?  Yes and no.  If you buy an individual zero coupon treasury today that is due in 2049, it costs around $53 to be guaranteed a return of $100 in 2049.   The $53 is based on the market interest rate and time to maturity.   It price will change, but it will eventually still climb to $100 by 2049.  Not a bad deal since some other developed countries have a near zero percent yield.  I see more upside in those than downside if worldwide rates continue on their trend.

If they don't, then my 60%+ stock allocation offsets the low performance in my bond side and I'm still retired early

[ChpBstrd]

Before buying long term bonds, do a quick calculation in Excel (PV formula) or an online calculator to observe how much the price would fall if interest rates went up, say, 2% or 3%.

This potential loss probably more than offsets the potential for gains if the US goes into zero interest policy. The risk is both positive and negative.

[chasesfish]

Before buying long term bonds, do a quick calculation in Excel (PV formula) or an online calculator to observe how much the price would fall if interest rates went up, say, 2% or 3%.

This potential loss probably more than offsets the potential for gains if the US goes into zero interest policy. The risk is both positive and negative.

This is true.  Its a hedge for me since I'm already nicely past my FI number.  One benefit of FatFIRE is keeping our risk lower than the market and getting assets with uncorrelated returns.

One lesson I learned from lots of researching on this topic is buying the individual bond carries less risk than buying the ETFs.  The ETFs can result in a permanent loss of capital because they're churning bonds.  You eventually get your money back with the actual bonds