Author Topic: Developing bond exposure  (Read 2017 times)

testtest

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Developing bond exposure
« on: January 20, 2018, 09:19:11 AM »
Real quick note: I've been lurking for years on the site and forums along with DW. We aren't as frugal as some here, but we max two 401ks, two Roth IRAs, and make considered decisions with our money. We regularly facepunch ourselves, but in the big scheme of things we're totally rocking it, so the facepunches don't hurt that much. MMM was initially and continues to be a catalyst for changes that we've made to get us in as great a position as we feel we're in, and the forum participants have been inspirational - both on the success and on the catastrophic failure (ie some case studies...) sides. Our family owes this community a lot of gratitude. Thank you.

We have both our 401ks and our Roth IRAs 100% indexed to the S&P 500, so it's all in stocks. This is not an asset allocation that I am particularly comfortable with, and I would like some bond exposure. If you're inclined to recommend against bond exposure (because you think it would reduce overall portfolio performance, for example), I don't really need to hear from you. Let's just assume that I'd like to reduce portfolio volatility and hedge against an equity market downturn, which we all know is inevitable. I'm not timing the market, we just haven't yet set up our accounts to have lower risk diversification, so think of this exercise as originating asset allocation. The plan is to not change any of our current accounts, but just to start contributing to a taxable account that has bond exposure (either 100% bonds or a "balanced" fund) until we get to ~20% bonds.

We have our IRAs with Vanguard and would be inclined to open taxable bond index accounts there. Should we go with VBILX? VBTLX? VBIAX? Does it matter? I've read some articles about the diversification of the bond fund allocations within themselves and am a little inclined to stay away from corporate bonds because that seems to run similar risk to equities in terms of tracking with the market; that is, if the stock market took a downturn then I might expect corporate bonds to also sink. Do I want a lot of exposure to government bonds (despite total disgust with this government)?
 What logic are you applying? Please let me know what other information would be helpful in administration of your advice.

Also, if someone can explain the syntax of hyperlinking then I can update this post with links to the funds identified above.

pegleglolita

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Re: Developing bond exposure
« Reply #1 on: January 20, 2018, 09:35:39 AM »
PTF

Viking Thor

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Re: Developing bond exposure
« Reply #2 on: January 20, 2018, 10:32:39 AM »
I am no expert and am in fact doing very similar thing to you, so will be interested to hear the advice.

I was at 100% stock index funds in 401k for many years and a year ago decided to start adding some bonds. I got to around 4% bonds gradually with new 401k additions, then decided recently to actually sell some stock and convert it to bond (in 401k), and now around 8%. From here I am going back to a more gradual approach, putting 40% of new 401k purchases into bonds, with the thought of very gradually getting bonds into the ~20% of portfolio range.

Not sure what The best approach is, but worth thinking about how long you take. One school of thought is to immediately shift to The desired asset allocation (assuming no tax consequences), while another is to do it more gradually with only new 401k purchases, but that could take a long time of you have a large portfolio.

I am not an expert on what bond fund to buy, but my 401k has a total bond market index fund with primarily corporate bonds and some gov bonds. I think corp bonds have higher return typically than U.S. Government bonds but more risk. They don't correlate (at least not completely) with stocks, so they still provide some diversification.

testtest

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Re: Developing bond exposure
« Reply #3 on: January 20, 2018, 10:40:22 AM »
You make a good point about correlation; it makes sense that corporate bond exposure would track but not completely overlap equities. Still though, with the goal of diversifying into a hedge / volatility reduction, government bonds seem superior...but I'm asking that question because I don't know the answer.

Also, is it the case that seeing dividends inside a tax-advantaged account is a superior tax situation than seeing dividends outside that shelter? To that end, wouldn't it be better to hold only equities inside tax shelters and to hold all bonds in taxable accounts? I asked a similar question in the tax sub-forum. Now that I made a forum account, I guess I'm off to the races!

Thanks for your input, Viking.

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Padonak

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Re: Developing bond exposure
« Reply #4 on: January 20, 2018, 11:04:34 AM »
I currently have about 6-7% of my portfolio in bonds (VBTLX). They sit in the tax advantaged space - IRA and Roth IRA. I am still working, but when I RE I am planning to move some of the stocks and REITs to bonds and make my asset allocation 80% stocks/20% bonds, cash and cash equivalents.

The rationale behind it is that while I am working, i have a stable and predictable source of income as long as I have the job. If the stock market drops 50% tomorrow, I'll just keep working as long as the job is available or until I have replenished my portfolio. The megacorp is slow moving so it's not like they're going to lay me off immediately regardless of the economic and market environment. When I RE, i will be a lot more vulnerable to stock market swings so it make sense to increase my bond allocation in response to that.

If/when the stock market drops after I retire, I'll start selling VBTLX and spending that money. The way I'm planning to do that is a little tricky because my bonds are in IRA and ROTH IRA. Please correct me if this approach is wrong. Let's say I want to sell bonds without additional taxes or penalties. Also, if I am already retired, my income starting from the first full calendar year of retirement will be low enough not not worry about capital gains tax in taxable accounts. So, if the stock prices drop, I will do the following. Sell stocks in taxable (e.g. VTSAX) and buy VBTLX in taxable for the same amount. Then sell VBTLX and buy VTSAX in IRA for the same amount. Then keep selling VBTLX from taxable to finance my expenses. With ROTH IRA, I can just sell VBTLX tax/penalty free up to the total contribution amount, so no need to swap investments between ROTH and taxable.

One potential issue with swapping index funds between taxable and IRA: if you sell Vanguard index funds (not ETFs), there is a one month cooling off period before you can buy the same fund with Vanguard. You can't swap VTSAX for VBTLX in taxable and then immediately swap VBTLX for VTSAX in IRA if you do it all with Vanguard (I think it's the same or similar with other brokers). In this case you'll have to buy VTI (the ETF version of VTSAX) in IRA.

Selling bonds when the stock prices drop is not necessarily market timing, just maintaining asset allocation. If stock prices drop 50% and I have 20% in bonds and cash, that portion will become 40% of my portfolio. In this case I'll just start selling bonds until my asset allocation goes back to 20%. Using the 4% rule, I'll have 25X annual expenses initially. 20% of that is fixed income, so 5 years of expenses in bonds and cash. It will take 2.5 years of selling bonds and spending that money to go back from 40 to 20% bond allocation and there is always an option to go lower than 20%, though that would be market timing. By the time I go back to 20% bond allocation, the stocks will probably recover from the dip at least partially, maybe even fully.

For those who are more risk averse, you can do the same thing with a higher bond allocation, e.g. 30 or 40%. In this case you can last much longer before you start selling stocks following a market crash. However, the gains you are missing out on by buying more bonds will be the mirror image of the losses you avoid if the stock prices fall. For example, if you have 50% in bonds and stocks go up 20% and bonds stay about the same, your portfolio goes up by 10% instead of 20% with 100% stocks asset allocation. If the market drops 20% your portfolio also drops by 10% instead of 20% hence the mirror image analogy.

This startegy is also based on the assumption that bond prices, specifically VBTLX, stay relatively constant or at least don't move in the same direction with stocks which may or may not be true. However, historical correlation between stock and bond prices is pretty low, so I think it's a reasonable assumption, again correct me if I'm wrong. If you want the fixed income part of your portfolio to stay constant you can use CDs instead of bonds and earn less than inflation. You'll also get FDIC insurance in this case.

When it comes to diversification, there is no free lunch. Assuming that your portfolio risk/return point is already on the efficient frontier curve and not in the area below it (use Personal Capital free investment analysis feature to check that), you'll have to miss out on potential gains in order to protect youreslf against potential losses.
« Last Edit: January 20, 2018, 11:52:49 AM by Padonak »

testtest

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Re: Developing bond exposure
« Reply #5 on: January 20, 2018, 11:51:14 AM »
As I've developed more understanding of all these personal finance tools and details, it's really been surprising to me how individual everyone's situation actually is. So much depends on income, expenditure, expected life span (and actual life span!), tastes for luxury and travel, familial details, risk appetite, etc. etc. etc.

The notion that since you're still working there's more flexibility in some of your investment decisions is reasonable (particularly if you don't hate your job!).

I'm not an expert but I think you should rethink this:

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The way I'm planning to do that is a little tricky because my bonds are in IRA and ROTH IRA. Please correct me if this approach is wrong.

It has always been my understanding that since you've already paid taxes on Roth contributions and do not have to pay taxes on the gains in your Roth, that it is most advantageous to consume funds in your Roth account(s) last. That is, consume taxable funds, 401k (since you still have to pay taxes on those distributions) before spending Roth money. As such, having bonds that you intend to spend first (spending bonds first post-retirement is reasonable as I understand things) inside a Roth is probably not the best decision, mathematically. You want to highest gains to be in your Roth because that account is on the longest time scale, and bonds obviously don't provide the greatest returns. Not to say that you shouldn't be carrying the bonds, and again, everyone's situation is different, but it seems to me that bonds aren't the right holding for inside a Roth (if not also inside any tax-advantaged account).

This is a good way of putting the the risk / reward battle (with typo correction):

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you'll have to miss out on potential gains in order to protect yourself against potential losses.

Ultimately, what I think I need a little more of is sleep at night, and diversifying into lower volatility will help with that. At our stage in accumulation, I'm less concerned with absolutely maximizing gains at any cost.

Does anyone have specific advice regarding which bond fund to buy?

Padonak

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Re: Developing bond exposure
« Reply #6 on: January 20, 2018, 12:46:45 PM »

It has always been my understanding that since you've already paid taxes on Roth contributions and do not have to pay taxes on the gains in your Roth, that it is most advantageous to consume funds in your Roth account(s) last. That is, consume taxable funds, 401k (since you still have to pay taxes on those distributions) before spending Roth money. As such, having bonds that you intend to spend first (spending bonds first post-retirement is reasonable as I understand things) inside a Roth is probably not the best decision, mathematically. You want to highest gains to be in your Roth because that account is on the longest time scale, and bonds obviously don't provide the greatest returns. Not to say that you shouldn't be carrying the bonds, and again, everyone's situation is different, but it seems to me that bonds aren't the right holding for inside a Roth (if not also inside any tax-advantaged account).


I agree and thank you for pointing this out. The reason I put bonds in tax advantaged accounts is to avoid paying taxes on interest. This is based on the Bogleheads wiki article about tax efficient fund placement. However, even according to that article (quote below) low yield bonds should be placed in taxable and higher yield bonds in tax advantaged accounts. My understanding is that VBTLX includes mostly lower yield bonds so it make sense to put it in taxable.

https://www.bogleheads.org/wiki/Tax-efficient_fund_placement
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Approximate Tax Efficiency Ranking for Major Asset Classes

Most Tax Efficient
Place Anywhere

Low-yield money market, cash, short-term bond funds
Tax-managed stock funds
Large-cap and total-market stock index funds
Balanced index funds
Small-cap or mid-cap index funds
Value index funds
Moderately inefficient

Moderate-yield money market, bond funds
Total-market bond funds
Active stock funds
Very inefficient

Real estate or REIT funds
High-turnover active funds
High-yield corporate bonds
 
Least Tax Efficient
Place in Tax-Free
or Tax-Deferred

I will reconsider my approach and just buy more bonds in taxable accounts. That way I won't have to swap assets between accounts when I need to sell bonds. I also agree about ROTH IRA. I should use it for the least tax efficient investments such as REITs and high dividend yield ETFs instead of low interest bonds. I don't currently invest in high risk/high yield bonds or active funds, but if I will, I should do it in ROTH as well.

Regarding VBTLX, according to Vanguard, "..the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues". Regarding my bond allocation, I considered investing in international and/or higher yield domestic bonds as well but chose VBTLX for simplicity. Based on the description, it seems like those who are still working should place it either in taxable or 401K/IRA and those who are retired, particularly in low/zero tax brackets, should place it in taxable.
https://personal.vanguard.com/us/funds/snapshot?FundId=0584&FundIntExt=INT&ps_disable_redirect=true
« Last Edit: January 20, 2018, 12:58:28 PM by Padonak »

harvestbook

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Re: Developing bond exposure
« Reply #7 on: January 20, 2018, 04:31:30 PM »
I use intermediate municipal bond funds in my taxable accounts. Part of it is a back-up emergency fund, hopefully keeping pace with inflation and no tax hit if I need to draw on them. I'm 90/10 overall. I am not crazy about loading up on bonds with what looks like rising interest rates, but I generally view them as a security blanket more than anything else. I just want enough of them to last a couple of years if things get hairy, but I am at least 10 years away from tapping anything anyway. I'd probably want to own more bonds around that time, maybe 60/40 to reduce sequence of return risk for a few years before I ramp back up.

Viking Thor

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Re: Developing bond exposure
« Reply #8 on: January 20, 2018, 09:52:36 PM »
That's a great point in terms of a backup emergency fund.

I have started doing this with government ibonds, they adjust to track inflation and are tax efficient since you don't have to pay taxes until you cash them out.

Of course you are not building wealth just tracking inflation, but it's an option if you want a small piece in government bonds for diversification. You can withdraw after 1 year with a 3 months of interest penalty, and after 5 years withdraw with no penalty.

Here is an article in case anyone is interested: https://www.forbes.com/sites/wadepfau/2017/02/14/what-every-retiree-should-know-about-i-bonds/#4053760157b9

MrSpendy

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Re: Developing bond exposure
« Reply #9 on: January 21, 2018, 08:21:07 AM »
There may be other threads similar to this one, but I remember this one because I participated in it.

https://forum.mrmoneymustache.com/investor-alley/bond-timing-school-me/msg1607690/#msg1607690

It's titled "bond market timing" but that's not really what it's about. It's about investing in the bond index versus using alternatives such as CD's, i-bonds, stable value funds, and HY savings accounts. I'm sure this as discussed ad nauseum at Bogleheads too.

I personally fall in the "CD's, i-bonds, some long term treasuries > bond index" camp and am happy to discuss why, but I think it's mostly outlined in that thread, as are the arguments for why the bond index is better than those.

retireatbirth

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Re: Developing bond exposure
« Reply #10 on: January 21, 2018, 12:39:29 PM »
I'm starting to develop some bond exposure myself, not necessarily due to the recent stock market returns, but more because of the size of my portfolio (now about $300k). It makes sense to start protecting your assets to some extent as your portfolio grows. Right now, all I've done is moved some of my cash emergency fund into muni bonds in the taxable account. Goal is to get about a year's worth expenses into muni bonds, which would put me at about 7% bonds. As my portfolio grows and interest rates rise, I hope to be able to buy a bond fund in my IRA and sustain something between 10-20% bonds overall growing as I get older. I don't look at this as market timing, but as adjusting to changing life circumstances. Suddenly moving from 100% equities to 70/30 because the market is looking scary would be market timing.

testtest

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Re: Developing bond exposure
« Reply #11 on: January 21, 2018, 01:49:03 PM »
Okay, everyone read the string that MrSpendy linked. If this thread is useful for you at all.

Hooooooooly shit, what an emotional roller coaster! So much detailed content in that string. It took me the better part of 24 hours to read, reread, digest, and interpret, and that's just for the stuff I could understand. Your input was really valuable to that string (and also therefore this one), MrSpendy. Thank you. Radagast and L.A.S also had some really great input.

Here's the really short answer, to whomever encounters this string, as far as I'm concerned: it doesn't really matter. If - for any of the good reasons that exist (not any of the bad ones!) - you want to diversify your portfolio to capture lower risk / lower volatility / lower return holdings, look around to find some good options, but don't look too hard because you're wasting your time. Getting good CD rates and laddering is viable, keeping a secondary EF in HY cash is fine, buying i-bonds isn't crazy, indexing to a sensible bond fund makes sense. Also long as these holdings don't represent a giant portion of your portfolio, it won't matter terribly, unless you're really cutting it close on the funds you need, about the return because there isn't a best option and the spread of returns is a pretty narrow band. Most mixes of these holdings will provide about the same return, basically. If you're pinching pennies so hard that this portion of your portfolio really matters, you probably just need to work a couple more years.

The juiciest stuff that had the most impact on me is here:

From L.A.S:
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Generally speaking bonds move inversely to the direction of prevailing interest rates.  So if the prevailing yield for a bond in the market moves up, then the price of the bonds will go down.  It is possible to loose money in investment grade bonds.

The rule of thumb for bond funds is that for rapid movements in market yield, the price of the fund will move in an amount of (-1) x rate change x (weighted average duration in years) of the bonds in the fund.  So if your bond fund has a duration of 7.2 years, and interest rates rise 2% over a short period of time -- say six months or so -- with respect to intermediate to long term bonds, then the investor will probably have suffered approximately a 14-15% capital loss in their holding.  If interest rates drop 2% then the investor would have a gain of 14-15% or so.  However, the exact amount would of course be set by the market.  This is interest rate sensitivity risk.

But, over long periods of time the volatility in bonds will be smoothed out just like with stocks.  In the case of drops, this is due to the fund having a higher yield as well as interest distributions being reinvested at that higher rate.

People have about as much luck predicting the direction of interest rates as they do predicting what the stock market is going to does next. 

One can protect themselves from interest rate sensitivity risk by buying shorter term bonds. 

MrSpendy gold:

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My opinion is that the bond market should be "timed" much more so than the equity market. one should weigh the potential risks versus potential rewards from investing in the bond market more so than the equity market. this is because the upward bound of return from an individual bonds (and to a lesser extent the bond market) is much more knowable and that bond market has competitors for your investment dollars (CD's and savings bonds) that are very legitimate alternatives to the Vanguard Total Bond market index.

For example, I don't think it is hopeless market timing or a bad thing to say "the bond index yields 2.3% with duration of 6, I can buy a CD or saving bond with a similar yield and liquidity without credit or duration risk / reward, I'll do that instead". it is market timing in that you will miss out if rates go down and the bond market experiences capital appreciation. your return will vary from the "passive alternative".

if the role of bonds in the portfolio is stability and you can get more stability with the same hold to maturity type of return, why not?

there is a sophisticated retort to this line of reasoning involving bonds' correlation with stocks and the diversification benefits, but I'd counter that CD's / savings bonds correlation of 0 to everything but a collapse of the FDIC / government also works and that historical correlation of bonds / equities (particularly during the last crisis where bonds shot up when equities went down) may not repeat.

in short, I think it's okay to decide when to not take duration or credit risk for the safe part of the portfolio and to weight the risks versus the reward.

 it's not the same as saying "I think this company will outperform the stock market", it's saying making 2% isn't worth it if I can lose 7% if rates increase by 1% or 2.7% isn't worth it to me if I can lose 18% if rates go up by 1% (in the case of the 30 year treasury).

to answer the question about the long term bond fund. I would say that you should buy it if you want to make 3.5% yield + - the return from duration+a little credit risk. if that has a role in your portfolio, then buy it. if not, then don't buy it. I personally think you should have a very good reason for buying bonds with the most risk and reward in terms of duration. You don't appear to have one so I'd advise against it.

From Radagast:

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Yes, at your stage you should have bonds. When you are halfway/within 5 years of FIRE start gliding towards 10-25% bonds to minimize sequence of returns risk (up to 40% if you are scared of stocks or planning a reverse glide path). Move your cash to bonds ASAP, because cash is even less useful, unless you need it tomorrow.

VBTLX is fine. If you want to go yield chasing for CD's that is fine too. Don't over think it, because the rewards for successfully timing the bond market are very tiny.

VSBSX has a yield of 1.28%. Say inflation is 2%. You lost money. Good job. What where you trying to do again?

Rates rise, VSBSX loses 2% and pays back 2%, VBTLX loses 7% and pays back 3%. In 2.5 years VBLTX will come out ahead. In fact it will come out ahead after 3 years about 95% of the time (I made that up, not looked it up).

Say VBLTX lost 5% more than VSBSX did because of a 1% increase in yield, and bonds were 20% of your portfolio. Well, you suffered a huge 1% loss over the course of a year because of your choice of bond funds. Big whoop, your stock funds lost more than that several times this week. That is why timing the bond market is virtually pointless, and differences between bond funds are mostly not important. I see no reason to use VSBSX when the most likely result is having less money.

It is easy to get into the weeds thinking about bonds with virtually no meaningful difference in outcome.
"I use intermediate term bond index because I don't like the convexity of MBS" OK
"I only use 3-7 year treasury bonds because academic research shows term and credit risk don't pay" Fine (what is inflation?)
"I listen to Jack Bogle and add corporate bonds, because total bond doesn't have enough" whatever
"I use a barbell of short and long term treasury bonds" carry on
"I have 12 CD's from 7 online credit unions because that has given me an extra .5% return (we're talking about 10 bps per year on my portfolio people!!!) without the interest rate risk compared to bonds, plus the early withdrawal penalty is less than interest rate risk 12% of the time!" Ummm alright
"I divide my bond allocation among total bond, long duration zero coupon treasury bonds, high yield tax exempt bonds, series I savings bonds, hedged international bonds, TIPS, plus some CD's at various banks" Ok, wow

None of the above really matter on 10-20% of the total. If you start getting into long term bonds it can matter a little.

There was some stuff I didn't really understand, too.

Here's a question: If I'm willing to get 3.5% in highly secure returns to reduce volatility in our total holdings, are EE bonds reasonable? I'm thinking to execute on a mix of EE bonds, CDs, and HY savings where I want true liquidity. Let me also just point out that there are high income taxes for our bracket in our state and we're planning on staying here, so not paying the state taxes on EE bonds is also appealing. I assume that taxes are due in the state of residence at time of redemption.

For those not doing the math or not familiar with the product, you can buy a bond (EE Bond) that is currently guaranteed (by the US government) to double in value in 20 years. The intermediate returns are close to zero, but then they up the return at the 20 year mark so the bond has doubled in value. If you do the math on 10k (which is the max per person (by SSN) per year) turning into 20k over 20 years, that's a 3.5% compounded APY. Doing that while also being on the lookout for good CDs and laddering those seems at least as good as parking dough in a bond index. Also, if exclusively using CDs and EE bonds, there is no risk of those investments losing value (at my expected contribution levels, not hundreds of millions) other than opportunity cost.

Correct me where I'm wrong, please! And again, thanks for that link!

edited to comment on high state taxes and how great it would be to not pay them on EE bond redemption.
« Last Edit: January 21, 2018, 02:07:23 PM by testtest »