Author Topic: Bonds 101?  (Read 1706 times)

Baylor3217

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Bonds 101?
« on: April 12, 2014, 12:46:13 PM »
I have little to no money in bonds.  I do, however, have about 20% of my portfolio in accounts yielding about 1.5% which generate some cash flow and that I largely use for any individual stocks when buying opportunities arise as the quarters flip by.

As I look towards my next decade of investing, I realize that this distribution of funds may be a little aggressive.  I have read however that as interest rates eventually rise over the next year or two (mostly likely in this time frame as that's the end game for the government to somehow get this ridiculous amount of debt semi-under control after keep rates so artificially low for so long), bonds may be a terrible place to be as their value will go down significantly.

That said, I'm a bonds novice.  If the above scenario plays out (you can choose to agree or disagree with said scenario of course), would it be a bad idea to purchase a Vanguard bond index with a lump sum investment of the majority of my money market capital?  Or would it yield something better than the 1.5% that I'm earning now each month and I'm fundamentally misunderstanding how bonds work? 


makingcents

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Re: Bonds 101?
« Reply #1 on: April 13, 2014, 10:07:01 AM »
I would be satisfied with a 1.5% return for short-term savings right now.

But given your overall concern about a changing interest rate environment, you should consider a bond funds duration before committing your money market capital into bond funds.

Duration is a measure of a bond or bond fund's sensitivity to interest rates.  So for Vanguard Total Bond Index (VBTLX), the duration is 5.5.  This means that for every 1% rise in interest rates, the bond value will drop 5.5%, roughly.  So a 3% rise in interest rates will drop the fund ~16.5%. 

At the other extreme, the Vanguard Long-term Bond Index (VBLTX), has a duration of 14.2!  Almost 3 times as sensitive to interest rates as VBTLX.


Lastly, for more info on bond funds and how they behave in different interest rate environments, this book is great:

http://www.amazon.com/The-Bond-Book-Third-Edition/dp/007166470X/ref=sr_1_1?ie=UTF8&qid=1397400895&sr=8-1&keywords=bonds

KingCoin

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Re: Bonds 101?
« Reply #2 on: April 13, 2014, 10:07:37 AM »
This is sort of a complicated question, in large part because we don't really know where interest rates will go and in what time-frame.

If you believe interest rates will rise significantly in the short to medium term, you're better off in cash. In a rising rate environment, bond prices will fall and the rate you earn on cash/money market accounts will rise.

However, it could be years before rates rise meaningfully, in which case the extra yield you earn in bonds can significantly contribute to portfolio performance. Rates would have to rise pretty quickly for you to lose money on a break-even basis.

Bonds (at least government bonds) also act as a portfolio diversifier, rising as stocks fall. So you have to consider a bond allocation from a porfolio construction basis as well.

As usual, your best bet is to come up with an asset allocation plan and stick to it, rather than trying to time or predict the market. If the US turns out to be like Japan in the early 90's your portfolio would benefit tremendously from a bond allocation.
« Last Edit: April 13, 2014, 04:49:38 PM by KingCoin »