Author Topic: Bond index funds are scary?  (Read 8558 times)

rjack

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Bond index funds are scary?
« on: January 06, 2013, 11:36:30 AM »
I do my asset allocation into index funds. It seems like interest rates are about as low as they can go and are likely to go up in the next few years. If so, long-term bonds are a bad idea. I recently switched some of my bond allocation from Total Bond Market Index fund to Investment Grade Short Term Bond fund.

Here are my questions:
  • Is anybody else worried about future bond prices rapidly declining due to interest rate increases?
  • If so, what are you doing about it?
« Last Edit: January 06, 2013, 01:54:34 PM by rjack »

Another Reader

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Re: Bond index funds are scary?
« Reply #1 on: January 06, 2013, 11:53:00 AM »
I'm reducing bond holdings by a large percentage.  As the Fed eases off the gas, we will have a very large correction in bond prices.  I don't know when, but I'm pretty sure it's coming and I'm all about loss avoidance.  Bond funds in general are mis-priced for the real risk you are taking on.  Look at what some of those folks own for the lousy yield you get.  A lot of securitized stuff where it's hard to determine the value of the underlying paper and derivatives are held in these funds.  I will keep some TIPs and some short term bonds, but less than 10 percent of the paper portfolio overall.

I have pensions and a lot of real estate, and I took that into account in making my decision.  Equity volatility does not affect my net worth or income as it does someone's portfolio of pure paper assets.  I would reconsider if I depended solely on a paper portfolio for income. YMMV.

Honest Abe

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Re: Bond index funds are scary?
« Reply #2 on: January 06, 2013, 11:54:24 AM »
1. Yes

2. Minimizing my exposure to bonds and keeping the bond fund I'm in limited to short term. The only bond fund I invest in ther that SHY and TIP is the Pimco BOND ETF.

Will

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Re: Bond index funds are scary?
« Reply #3 on: January 06, 2013, 05:24:29 PM »
Do bond funds work the same as stock funds as far as when they are down you are buying them on sale?  Or is it different and you are just throwing good money after bad?

Jack

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Re: Bond index funds are scary?
« Reply #4 on: January 06, 2013, 08:00:51 PM »
Is there a way to more aggressively take advantage of the rise in interest rates? In other words, is it possible to "short sell" bonds or bond funds? (Or is it a lot simpler just to take on low-fixed-interest debt, such as a mortgage, directly?)

projekt

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Re: Bond index funds are scary?
« Reply #5 on: January 06, 2013, 09:03:31 PM »
First, don't plan on a rise in US interest rates any time soon. The Fed has committed to a zero-interest-rate policy for several years provided unemployment stays high. Google "invisible bond vigilantes" for information about the constant drumbeat of news that interest rates will be skyrocketing soon, which we have been hearing for 4 years. Even Bill Gross, chairman of PIMCO, allowed himself to be deluded by his political leanings on this one.

That said, don't plan that they'll necessarily stay low. The whole point about regularly buying index funds and avoiding market timing is that you are generally unable to predict the future.

That said, if you are a speculator (i.e. a gambler), you can buy any of these ETFs and your return should be the inverse of the bond market: http://www.bondetf.net/short-bond-etf.htm

I do not recommend playing around with short ETFs if you never knew they existed before this post.

smedleyb

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Re: Bond index funds are scary?
« Reply #6 on: January 06, 2013, 11:09:53 PM »
Interest rates on the 10 year are up over 40% since hitting a low in late July.

Here's what Art Cashin is looking for as a tell tale sign the bond rally is finished:

“Well, there are a couple of things to look at.  For example, we are beginning to see rates move up.  Some of that was based on the FOMC minutes.  The thing that I will watch for is mortgage applications.  If the public begins to believe that the trend in rates has turned, that rates are heading higher, I believe you may begin to see a stampede of people trying to lock up those low mortgage rates.

http://www.businessinsider.com/art-cashin-end-of-the-bond-bull-market-2013-1

rjack

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Re: Bond index funds are scary?
« Reply #7 on: January 07, 2013, 06:11:17 AM »
The whole point about regularly buying index funds and avoiding market timing is that you are generally unable to predict the future.

That is true, but since long-term bond rates are near a historic low:

http://www.multpl.com/interest-rate/

It seems unlikely that they are going to go lower.

That said, if you are a speculator (i.e. a gambler), you can buy any of these ETFs and your return should be the inverse of the bond market: http://www.bondetf.net/short-bond-etf.htm

I do not recommend playing around with short ETFs if you never knew they existed before this post.

I'm not much of a gambler, but it is an interesting idea as a hedge.
« Last Edit: January 07, 2013, 06:19:50 AM by rjack »

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Re: Bond index funds are scary?
« Reply #8 on: January 07, 2013, 07:06:05 AM »
A lot of success in paper markets is avoiding large losses.  I can't predict when the cycle will turn, but I can pare down my holdings when all the signs are there it is turning and values start to weaken.   

When everyone starts talking about buying weak foreign govenments' paper to find value or income, that's a little scary.  That's the majority of the holdings of a lot of these now popular emerging market bond funds and ETF's.

Art Cashin would be right if everyone eligible to refinance hadn't already done so.  As a Wells Fargo loan officer with years of experience said to me recently, Wells Fargo is in the process of refinancing its entire portfolio down to these low rates.  Once that's done, there won't be nearly as much business. 

When folks on forums like this one start talking about getting out, the big investors have already decided what to do.  It's your call whether to reallocate, but at least evaluate what you own.  If you own bond funds and ETF's, look at what they own and decide if that's a good set of investments for you.

tooqk4u22

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Re: Bond index funds are scary?
« Reply #9 on: January 07, 2013, 11:21:07 AM »
US Treasuries are highly overpriced for two reasons - the fed's operation twist and the US as safe-haven status.  Operation twist will end and when they start selling, watch out.  Safe haven status will end when investment alternatives appear more attractive - the fiscal cliff pardon and coming debt ceiling will surely accelerate that but Europe is still a disaster so we will see. Not to mention the 10-year is losing to inflation right now so the returns are negative - this is only good if you think deflation is a real concern that is what this normally means but because of the operation twist and safe haven status the current rate is at least 1.50-2.00% low artificially.   

Keep in mind that common assumption is that China is the largest holder of US Treasuries but that would be wrong.  The largest holder is the US Fed and other US Governement agencies - so on hand the US is incented to keep rates as low as possible because really if rates go up materially we will be bankrupt (well more so than we are already) - although in reality we are paying this through devaluation of the dollar and inflation.

 

Will

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Re: Bond index funds are scary?
« Reply #10 on: January 07, 2013, 11:41:59 AM »
Do bond funds work the same as stock funds as far as when they are down you are buying them on sale?  Or is it different and you are just throwing good money after bad?

Did someone answer this? If so, I still don't get it.

Kriegsspiel

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Re: Bond index funds are scary?
« Reply #11 on: January 07, 2013, 05:19:36 PM »
Hmm, I'm no expert or anything.  I own individual treasuries through Vanguard, I'm not sure how it would work with a fund.  But anyways, say I buy a treasury now for $1000, and interest rates go up.  I can't sell that bond for the $1000, but it's still going to be paying me the interest off the $1000.  I would just buy new bonds to reallocate into my bonds %.

Of course you would say "well yea, but sell your bonds now, then buy the new ones" or whatever, but I don't think any of us can predict the future, or when the rates will rise 'enough' to get back into bonds, so I figure my strategy will work just as well as any.

tooqk4u22

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Re: Bond index funds are scary?
« Reply #12 on: January 07, 2013, 05:47:54 PM »
Hmm, I'm no expert or anything.  I own individual treasuries through Vanguard, I'm not sure how it would work with a fund.  But anyways, say I buy a treasury now for $1000, and interest rates go up.  I can't sell that bond for the $1000, but it's still going to be paying me the interest off the $1000.  I would just buy new bonds to reallocate into my bonds %.

Of course you would say "well yea, but sell your bonds now, then buy the new ones" or whatever, but I don't think any of us can predict the future, or when the rates will rise 'enough' to get back into bonds, so I figure my strategy will work just as well as any.

Bond funds and individual bonds are a different proposition - as you said if you buy an individual bond at 2% for $1000 (par value) and rates rise then your bond value will go down on paper (or actual if you sell) but if you hold to maturity you will get your $1000 back or said more correctly to ignore par value vs. not you will get your 2% return. 

Budget_Ninja

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Re: Bond index funds are scary?
« Reply #13 on: January 07, 2013, 07:04:46 PM »
I do my asset allocation into index funds. It seems like interest rates are about as low as they can go and are likely to go up in the next few years. If so, long-term bonds are a bad idea. I recently switched some of my bond allocation from Total Bond Market Index fund to Investment Grade Short Term Bond fund.

Here are my questions:
  • Is anybody else worried about future bond prices rapidly declining due to interest rate increases?
  • If so, what are you doing about it?

1) Not worried, just expectant.  I don't think it happening tomorrow but my crystal ball is foggy.
2) Keeping my bond portfolio in a short duration (5 years or less)

Budget_Ninja

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Re: Bond index funds are scary?
« Reply #14 on: January 07, 2013, 07:17:36 PM »
Do bond funds work the same as stock funds as far as when they are down you are buying them on sale?  Or is it different and you are just throwing good money after bad?

Hi Will!

Bond funds hold a portfolio of bonds.  When interest rates go up the price of the bond fund will go down.  This doesn't mean they are on sale, it means that people value those bonds less because they can get better rates by buying new bonds at a better rate.  The only reason any one would by the old bonds is if you discounted them enough so that you would make the same money you would on the new bonds.  By selling them at a discount, the person buying them will expect to get the equivalent value from them as they would purchasing a bond with the higher rate.  There's a little more to bond pricing than that but until you get deeper into credit risk this is the main driver of the value of bonds and thus bond funds.

Your not throwing good money after bad, but if your expectation is that of rising interest rates you may be better off buying short term bond funds or buying short term bonds.  In this way your not invested for long periods at the 'bad' rate.

Kriegsspiel

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Re: Bond index funds are scary?
« Reply #15 on: January 07, 2013, 08:10:15 PM »
Correct me if I'm wrong, but the treasuries secondary market, at least on Vanguard, is a "fairly" priced market, correct?  IE, the bid/ask is pretty tight, and the yields are priced "efficiently," so you aren't really throwing good money after the bad on there, even if you are buying older treasuries, since they'll be priced accordingly.

Budget_Ninja

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Re: Bond index funds are scary?
« Reply #16 on: January 07, 2013, 08:24:49 PM »
Correct me if I'm wrong, but the treasuries secondary market, at least on Vanguard, is a "fairly" priced market, correct?  IE, the bid/ask is pretty tight, and the yields are priced "efficiently," so you aren't really throwing good money after the bad on there, even if you are buying older treasuries, since they'll be priced accordingly.

I'm no expert, but I agree the underlying bonds would be priced accordingly.  The issue becomes holding on to those bonds or buying into them in a low interest rate environment when your expecting rates to increase.  As the interest rates climes the bonds held by the fund will loose value and so will the bond fund.  In a short term bond fund, the bonds with the lower rate are redeemed at there par value and reinvested into bonds with a better rate so short term bonds and short term bond funds are better suited to investors who are sensitive to interest rate risk.  This is the basic idea behind a bond ladder.

I don't suggest not holding bonds in a portfolio or even varying the percent allocation.  I would just ensure that the duration of the bonds in my portfolio was short term.

tooqk4u22

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Re: Bond index funds are scary?
« Reply #17 on: January 08, 2013, 07:43:29 AM »
Correct me if I'm wrong, but the treasuries secondary market, at least on Vanguard, is a "fairly" priced market, correct?  IE, the bid/ask is pretty tight, and the yields are priced "efficiently," so you aren't really throwing good money after the bad on there, even if you are buying older treasuries, since they'll be priced accordingly.

Yes - they are priced fairly and efficiently.  No - you are not throwing good money after bad, you are simply accepting a yield to maturity (YTM is what matters).

Simplistic Example -  Let's say  10 year bond was issued with a 5% rate and a $1000 value and then interest rates immediately decline to 4.5% the next day.  You would have to buy that bond at $1,111. You would get paid $5000 a year in interest and at maturity you get $1000. 

Lagom

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Re: Bond index funds are scary?
« Reply #18 on: January 08, 2013, 08:05:58 AM »
I worry a little about this but "fortunately" I have about 50k in student loans @ ~6% (for a degree I don't even use professionally, alas). While I facepunch myself daily for the existance of that loan, I also have the option of accelerating payments in the amount I might otherwise put into bonds, which guarantees a pretty good rate of return to boot. Right now I allocate my savings at about 80% stocks and 20% extra student loan payments, although I am pondering moving more towards the loan, as I am sick of being in debt.