Bonds/CD question

[GoCubsGo]

Possibly a dumb "can't see the forest through the trees" question:

Bond prices go down as interest rates go up. We are currently in a low interest rate environment which should be good for bonds.  Conversely, interest rates for CD's have been pretty low the past 10 years.

Bonds are a significant placeholder in most all retirement scenarios. The real risk of increasing rates at some point by the Fed should have a large detrimental effect on bond prices (correct?).

That said, I remember buying CD's 15 years ago in the 5% range for 2 year terms.  If bonds prices do eventually crater due to rising interest rates, is it safe to assume interest rates on CD's will go back up to the 5-6% range? If so, can these be used as placeholder for bonds?

How much of an impact would that have on a FIRE calculation?  I guess what I'm wanting to know is what is "historical" rate of growth used in retirement calculators for bonds?  I'm anywhere from 5-8 years out and the thought of a crash in bonds just as I start heavier allocation to them has me a bit spooked.  The basic "40% in bonds" has me thinking of a sequence of return risk.

Any thought of people who studied these cycles or have personally been through them would be appreciated.

[Rob_bob]

Interest rate changes effect long term bonds more than short term bonds.  So use short term bonds in a rising rate environment.

As interest rates rise so will the rates on CD's.  Ally Bank just lowered the rate on my online account but I have money in their CD's as well, don't know what the rates will be when the CD's mature but my guess will be lower.

[FIRE@50]

If you are buying and holding bonds until maturity, the fluctuations in value over the life of that bond has no affect on your investment. Your rate of return will not change and you will get paid the par value of the bond at maturity.

I hope that answers the question that I think you are asking. :)

Now, as for the idea that bonds and CD's are going to suddenly jump to 5 or 6% again? I wouldn't hold my breath for that. The government has become addicted to living in a low rate environment.

I wouldn't calculate any historic rate of growth in my bond portfolio. You return will be the rate that you bought the bonds at. Assuming there are no defaults of course.

[Indexer]

Recent history:
2013 the Fed announced the end of their QE program. Markets were sure interest rates would rise. As a result, bonds took a hit. Some long term bond funds were down 10%, but a diversified bond fund like VBTLX was only down about 2%.

2014 turns out everyone was wrong, rates went down and bonds did amazing!

2018  The Fed raised interest rates several times and everyone was sure they would keep going up. As a result, bonds took a hit. VBTLX was basically flat in 2018.

2019 turns out everyone was wrong, rates went down and bonds did amazing.


I see 2 conclusions from this.

1. Predicting the bond market is about as reliable as predicting the stock market.

2. Even when bonds have a bad year it's really really boring. Down 2%, over a year?  Stocks can drop more than that in a few hours.


Why own bonds? Bonds tend to give better performance than cash over time, and more importantly, bonds tend to go up when stocks go down. In a vacuum you can compare bonds and cash, but as a compliment to stocks bonds are the clear winner.

[chasesfish]

A few comments:

1) I think the long-term trend in rates is down.  Bond and bond funds are generally better than CDs because of this.

2) If you're buying 10 year or shorter bond/bond funds, the price movement concern is overblown.  I bought some VGIT when the 10-year treasury bond was at 1.85%.  It went down to 1.55% and my bond fund when up a whopping 1%.  You have to get further out on the yield curve and even consider playing with zero coupon treasury bonds if you're interested in seeing big price movements. 

3) Bonds and CDs are both liabilities issued to fund businesses.  Bonds are issued by the US Government and non-banking companies to fund operations.  CDs are liabilities issued by banks which they turn around and fund loans with, they just happen to be US Government backed up to $250,000.   Your CD usually carries a penalty to redeem early, so it technically loses value the day you buy it if you were pricing it daily like a bond.


Corporate Bonds are also often correlated with the stock market since defaults rise when the economy gets bad. Municipalities can default too. You have to specifically buy treasury bonds or a treasury fund if you are trying to own an asset that doesn't go down when stocks go down.  They return less because they are lower rate.

[Andy R]

If you are buying and holding bonds until maturity, the fluctuations in value over the life of that bond has no affect on your investment. Your rate of return will not change and you will get paid the par value of the bond at maturity.

I hope that answers the question that I think you are asking. :)

Also need to point out that for bond funds (as opposed to individual bonds), which continually renew their holdings, if your bond fund's effective maturity is say 6 years duration, then to recoup all your money, you need to hold it for 6 years after any rate increase. So each time rates increase, the period is reset.

The strategy I have seen used often is to have a "longer" bond fund for money you won't need for a while and consider this your long term investment (up to you how long you use, whether intermediate or long term bonds), and have either a ladder of individual bonds or else a short term bond fund (say 2-3 years) which will be less effected for money you may need in the next say 5 years.

[ChpBstrd]

Yes, if interest rates rise, say 3%, the resale value of bonds you buy today will go down. E.g. You buy a 10 year treasury with a 2% yield. Five years from now, you’d like to sell it but now investors are buying 5 year bonds for prices that give them a 5% yield. No one will bite on your bond with a 2% coupon when they could buy someone else’s bond and get a 5% coupon. So to sell your bond you must lower the price until the NPV of the cash flows from your bond equals the NPV of competitors’ bonds.

You can use the PV formula in Excel to calculate the price of your bond at a new rate. Instructions here: https://www.extendoffice.com/documents/excel/5088-excel-calculate-bond-price.html Or use an online calculator.

In a nutshell, if rates rise, bond investors will lose quite a bit of market value. The impact would be greater than the financial crisis of 2008, because the overall bond market is many times larger than the mortgage market, and because bond portfolios are so often used as collateral. If I thought rates were going to rise 3%, I would RUN from the markets.

The confusing thing to wrap your mind around is that you lose money whether you sell your bond or not. In the example above, by holding your bond with a 2% coupon, you forego the opportunity to invest those funds at 5%. The losses you think you avoided by not selling equal the losses experienced by missing out on the higher interest rate. The markets are absolutely mathematically efficient on this point. Had interest rates fallen, you would be sitting on capital gains.

When you invest in a bond fund, that fund is constantly trading to maintain their targeted duration or sensitivity to changes in interest rates, and meanwhile the market is pricing the fund based on the value of its holdings. So the value of the fund changes just like any of its holdings.

You can keep your interest rate risk low by maintaining short durations. However this risk reduction comes at the risk of losing the opportunity to lock in today’s rates, when rates might be even lower in the future!

[GoCubsGo]

Thanks all, definitely helps.  I guess in effect I'm worried about a bond bubble. My current 22% bond allocation of my portfolio is as follows:

40%-BNDX- Vanguard International -  Medium to long term bonds, Majority Investment Grade- Up 8.25% YTD
40%-BOND- PIMCO Active Bond- Longer term, riskier bonds - Up 8.09%
10%- FLTB- Fidelity Limited Term Bond- Actively Managed- Short term, Majority is Investment Grade- Up 5.43%
10%- mixed in with other mutual funds (look to be below investment grade)

When running an analysis of all my bond holdings it looks like I skew medium term with more non-investment grade bonds than compared to AGG.  I should probably dial back the risk some in bond allocation.

I know people have been calling for the bond bubble to burst for a while now and seeing close to 8% total returns on bonds seems unlikely going forward.  I'm 5 years out from FIRE so I worry about my current bond allocation exacerbating SORR rather than acting as a hedge.  I was just wondering if anyone else had these fears or if over a 40 year retirement bonds will even out and do what they are supposed to and I shouldn't even consider Cash.

[ChpBstrd]

You're not the only one. You might have seen articles like this:

https://www.barrons.com/articles/as-bonds-go-batty-its-time-to-rethink-your-60-40-allocation-51571219101?refsec=bonds

...or graphics like this:



...or you might just have reasoned that there's a helluva lot of downside for a 2% yielding 30 year bond, and not a lot of the upside that would in theory protect your portfolio during a downturn. Most people have no clue that "safe" government bonds could conceivably drop 30-40% - not due to some kind of default or crisis, but by mere reversion to the mean in interest rates. For these same reasons, my own AA relies less on bonds as it does on protective options positions.   

FWIW, my baseline scenario for the next decade is a Japanese-style disinflationary stagnation where stocks just oscillate and interest rates stay low for decades. The alternative - a reversion to the interest rate mean - would involve a depression IMO. If mortgage defaults rising to a few percent in 2008* caused the near-collapse of the world financial system, what would a rise in the ten year treasury rate to 5% do? My options protect me a lot better in either scenario than bonds would, and if I'm wrong I still get rich!

*https://fred.stlouisfed.org/series/DRSFRMACBS

[GoCubsGo]

Yikes.  Thanks for the link to the Barrons article.  The potential lack of a negative correlation definitely concerns me. 

I was considering selling my 2 rental properties.  I'm starting to think I should hang on to them and maybe turn them over to a property manager when I retire.  Both did very well through the last recession and I feel I have more control and less downside risk than just blindly dumping 40% into bonds.  I may even look to purchase another if I can find one that works financially.

The article mentioned Munis as a potential option.  I think that could be worth looking into as a counter to corporate bonds.  I've actually been watching the Allen Ellman options tutorials.  Not sure options would be viable long term solution (just because of the active upkeep on it) but you would know better than I.

[chasesfish]

I saw the article.

My question is "What is your goal".

If the goal is to get a balanced return with some smoothness in the ride, the duration of a total bond market fund is short enough to not crush you if rates go up.  That fund *is* correlated with stocks though, when the economy hits a recession, credit risk of default on bonds increase, and the price investors are willing to pay for those bonds are less.

If your goal is to have a non-correlated asset with the market, long term treasuries fit that role.  Investors fly to safety when the market hits a selloff.  Long term bonds equal safety.  If the economy takes off and interest rates start going up because of other opportunities, then the gains in the stocks more than offset the loss in treasuries

[GoCubsGo]

@Chasefish

My goal would definitely be to smooth the ride and provide ballast in a prolonged downturn (hence the fear that AGG would correlate with equities in the next correction/recession).

If I could get my SWR low enough (shooting for 3.75%), that would allow me to replace some riskier correlated bonds with long term treasuries (maybe a 10% chunk early on to combat SORR).  My guess is that a fire calculation that replaces AGG with long term treasuries will backtest as lower performing.  The point about stock gains outpacing my losses in treasuries is a solid point. 

The more I think about it this really is a SORR issue.  I'm fine having a total bond fund over a 40 year retirement but the thought of a large equity drop combined with a large drop in AGG bothers me.  Keeping a rental as a source of income along with dividends and a lowly correlated holding in something else (treasuries, muni, other) might be the ticket.

[chasesfish]

How quickly are you planning on leaving your income?

I'm doing a 60/40 equity glidepath that slowly creeps up in early retirement.

The difference between me and most doing the glide path is I've been moving into more value stock vs. index investing.  I'm not afraid to go against the herd and I see more SORR in VTSAX trading at a 20+ PE with a 21% technology stock concentration than doing my own value investing. 

Most of my bond investing is held in long term treasuries, just because instead of getting around 2% on cash, I'd rather get 2%+ on a long term treasury and pickup some upside if yields keep going down.  If yields go up, I get hurt some on the treasuries but my equity allocation more than makes up for it.  Corporate bonds just don't pay enough right now for me to take the credit & correlation risk.  1/2% extra in yield just isn't enough for me.   
 
The lazy way to do what I do with individual stocks would be to just by VTV, the Vanguard Value Index ETF.   If you hold that plus treasuries, you get a 3.16% yield on VTV and are earning 2% on treasuries.    That leaves you with the need of 1.25% in appreciation to meet your SWR.  Not bad.

I think we're in a lower return for longer world, if I only get 5-6%/year over the next 10 years, I want to get it with as little volatility as possible.   I can live with getting 8% while others are getting 10% if I can get my 8% by taking less risk.  My goal is to not have to dig my suit out and go to work again, not to be the richest corpse to enter the graveyard.

[ChpBstrd]

@GoCubsGo your rental properties offer excellent diversification against SORR, provided they have positive cash flow and a good ROE. If they are mortgaged, they also may help hedge inflation risks. If they are in a LCOL area, you could sell them during a downturn and pivot into equities. If they are HCOL, there is some risk of depreciation during a downturn, so you might not have that option.

If yields go up, I get hurt some on the treasuries but my equity allocation more than makes up for it. 

@chasesfish are you saying your equities would appreciate, or at least not fall, in a rising interest rates environment?

[chasesfish]

@ChpBstrd - I am.  Demand for treasuries should go down when other asset classes are returning more.

The only time that really diverged was in the second half of the seventies.  The nifty-fifties were coming back to earth in valuation while inflation ran wild.  My read is the divergence really only happened because of how bubbly the top 50 stocks got (up to a 90 PE for low growth companies) at the same time inflation was held artificially low.  Corrections are a turd