Author Topic: Help me understand: why should I buy bonds?  (Read 11809 times)

cbgg

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Help me understand: why should I buy bonds?
« on: March 02, 2015, 08:41:19 PM »
I know that I'm supposed to have a portion of my portfolio in bonds…but what I don't understand is why I would buy bonds right now.  Here's what I have gleaned:
 - Bond income is generated in the form of interest.  Interest rates are currently at historic lows.
 - When interest rates are low, bond prices are high.  In general, you don't want to "buy high."

So…I don't get it.  What am I missing?  Why am I supposed to buy these things?  They seem like a bad deal, but if the entire industry says to buy bonds I know I must be misunderstanding! 

pbkmaine

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Re: Help me understand: why should I buy bonds?
« Reply #1 on: March 02, 2015, 09:11:28 PM »
http://www.aaii.com/journal/200601/images/portstrategies_figure1.gif
A small allocation to bonds lowers the volatility of your portfolio without greatly affecting return. See Modern Portfolio Theory or the chart above.

skyrefuge

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Re: Help me understand: why should I buy bonds?
« Reply #2 on: March 02, 2015, 09:11:54 PM »
Here's a recent thread that covers the answer pretty thoroughly. Of course I'm partial to my answer:

http://forum.mrmoneymustache.com/investor-alley/why-would-i-be-in-anything-other-than-100-stocks/

cbgg

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Re: Help me understand: why should I buy bonds?
« Reply #3 on: March 02, 2015, 10:19:27 PM »
Here's a recent thread that covers the answer pretty thoroughly. Of course I'm partial to my answer:

http://forum.mrmoneymustache.com/investor-alley/why-would-i-be-in-anything-other-than-100-stocks/

Thanks, I gave the thread a read.  So from your answer here's what I'm getting - avoiding buying bonds until interest rates go up is a reasonable choice.

Am I on the right track, or just seeing what I want to see?

(Also, I loved your answer to the Dividend/Index question about the three end games!  Really helped me wrap my mind around that!)

Dodge

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Re: Help me understand: why should I buy bonds?
« Reply #4 on: March 02, 2015, 10:48:07 PM »
I know that I'm supposed to have a portion of my portfolio in bonds…but what I don't understand is why I would buy bonds right now.  Here's what I have gleaned:
 - Bond income is generated in the form of interest.  Interest rates are currently at historic lows.
 - When interest rates are low, bond prices are high.  In general, you don't want to "buy high."

So…I don't get it.  What am I missing?  Why am I supposed to buy these things?  They seem like a bad deal, but if the entire industry says to buy bonds I know I must be misunderstanding!

http://forum.mrmoneymustache.com/investor-alley/asset-allocation-100-stocks-for-how-long/

http://forum.mrmoneymustache.com/investor-alley/the-case-against-100-stocks/

http://forum.mrmoneymustache.com/investor-alley/why-would-i-be-in-anything-other-than-100-stocks/

You might not see it, but this is market timing.  Ignore the noise, the news reports, and the doomsday articles.  You can't guess where the market will go next.  Let's review what happened to bonds the last time interest rates soared:



Interest rates spiked pretty high from 1975 through 1981 (the peak).  Let's see what happened to intermediate term bonds during this time (orange line):



A $10,000 deposit grew almost 60%!

This is why we say ignore the noise.


dmn

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Re: Help me understand: why should I buy bonds?
« Reply #5 on: March 03, 2015, 02:36:53 AM »
Interest rates spiked pretty high from 1975 through 1981 (the peak).  Let's see what happened to intermediate term bonds during this time [...]

A $10,000 deposit grew almost 60%!

This is why we say ignore the noise.

You gave an example why one does not need to worry about interest rate changes (i.e., changes in valuation), but the OP's issue is that the fundamental yield (interest) from bonds is at historic lows (negative real yields). This is an important difference. Even if interest rates changed, with high initial yields the income from interest was guaranteed to overcompensate for your capital losses if you hold to maturity - and your example had starting interest rates of over 5%. With current yields on bonds, returns would be very bad even without changes in valuation - holding to maturity will lose you money in real terms.
« Last Edit: March 03, 2015, 02:38:46 AM by dmn »

PathtoFIRE

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Re: Help me understand: why should I buy bonds?
« Reply #6 on: March 03, 2015, 07:49:29 AM »
I believe the basic underlying reason is this:

1. Stocks provide superior long-term returns, so this is your engine for growth
2. Given the (a)short-term volatility and the (b)possibility of short to medium term underperformance of stocks historically, you need at least a little bit of something else to smooth out (a) and to counteract (b) [this second part isn't as important during accumulation, but is very important in the draw-down phase]

This is the basic gist of the argument against 100% equities. Now bonds are usually the default for item 2 because they typically (although not always!) show weak and sometimes negative correlation with stocks, and they are highly liquid similar to stocks and in contrast to many other non-stock forms of investment. However, there are some that substitute something else for item 2, such as real estate, commodities, collectibles/art, what have you. For many of us, especially the more passive investors, these types of investments usually require a lot more knowledge about what to invest in as the markets are less efficient, less liquid, and less accessible. If you've got an edge or a real passion about one of these alternatives, then great, maybe you can forgo the slight drag that bonds can add to a stock portfolio while still providing less volatility. For me, I lack that ability, so I'll go with the more sure but slightly less spectacular of bonds while providing balance to my predominant stock portfolio. And I believe that Dodge has done an excellent job on these forums highlighting that much of the conventional wisdom regarding bonds is just plain wrong, so actually don't believe I'm really missing out on much by going 80% stocks and 20% bonds.

Bob W

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Re: Help me understand: why should I buy bonds?
« Reply #7 on: March 03, 2015, 08:40:42 AM »
It would be wrong to dump money into bonds at this point in the cycle.   But it would be prudent to ladder bond purchases over a 5-10 year window.    I like 10 year bonds.  If you do a 10 year ladder then you will always be receiving the 10 year average of bond interest and will be unswayed by their resale value. 
Also important to focus on a insured bonds.   You can always just do the bond funds.   I assume most of them are laddered but I also assume they would go down in value as rates go up.   

At this point the likelihood that bond rates will go up (and thus bond value down) over the next 5  years is very high.   It could happen that they won't, but the Fed has all but said they will start the rate cycle increase.

Of course I could always be wrong. 

In a perfect world you would wait for bond rates to go up and buy the shit out of them and then wait for rates to go down and sell the shit out of them. 

cbgg

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Re: Help me understand: why should I buy bonds?
« Reply #8 on: March 03, 2015, 08:57:21 AM »

In a perfect world you would wait for bond rates to go up and buy the shit out of them and then wait for rates to go down and sell the shit out of them.

That's what I'm thinking.  I cannot see any upside of holding them at this point.  Plus I'm only 30 so being in 100% equity is not a crazy choice for me for the next few years. 

My retirement portfolio has always included a small portion of bonds but I think I'm going to avoid them for now in my taxable portfolio.  It just seems like any way you slice it this is a bad bond market with no upside.

JackieTreehorn

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Re: Help me understand: why should I buy bonds?
« Reply #9 on: March 03, 2015, 09:43:23 AM »
Quote
You gave an example why one does not need to worry about interest rate changes (i.e., changes in valuation), but the OP's issue is that the fundamental yield (interest) from bonds is at historic lows (negative real yields).

Real yields are not negative.  One of the reasons interest rates are so low on bonds is because inflation is extremely low and maybe even negative, depending on what numbers you want to look at. 

http://www.advisorperspectives.com/dshort/updates/CPI-Headline-and-Core.php

The bond market is pricing in the possibility of deflation.  If this occurs, bonds will do very well, equities probably not so much.  I'm not saying this will happen, but there is a real possibility it could, as it has likely set in in Europe already.  A 2% yield on bonds with 0% inflation is just as good as (slightly better, in fact) than a 5% yield with 3% inflation.

If interest rates rise, bonds will not do well, but I wouldn't take that as a given.  People have been predicting interest rates would rise for about 5 years now, and all they've done is go down.  Bonds also add diversification, as several posters have already pointed out.

retireatbirth

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Re: Help me understand: why should I buy bonds?
« Reply #10 on: March 03, 2015, 04:44:26 PM »
I'm early 30s and not holding any bonds either. I think bonds are important as you near FIRE or when your portfolio is sufficiently large but not before that.

My reasoning is that although my portfolio is 100% stocks, I actually am only about 85% stocks counting expected discretionary income over the next 6 months. So if stocks fall, I have plenty of income to buy more stocks cheaper.

My short term future income is my safety net instead of bonds.

Note that this doesn't work without a high savings rate...another benefit of frugality :)

« Last Edit: March 03, 2015, 04:50:10 PM by retireatbirth »

Indexer

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Re: Help me understand: why should I buy bonds?
« Reply #11 on: March 03, 2015, 05:49:32 PM »
I know that I'm supposed to have a portion of my portfolio in bonds…but what I don't understand is why I would buy bonds right now.  Here's what I have gleaned:
 - Bond income is generated in the form of interest.  Interest rates are currently at historic lows.
 - When interest rates are low, bond prices are high.  In general, you don't want to "buy high."

So…I don't get it.  What am I missing?  Why am I supposed to buy these things?  They seem like a bad deal, but if the entire industry says to buy bonds I know I must be misunderstanding!

There are two main reasons to own bonds.
1.  Income:  If you are retired you probably care about income.  If you are still accumulating you probably don't which brings us to...

2.  Lowering your risk.  A 100% stock portfolio can average 10% growth over longs periods of time, but you can encounter drops of 40-50%.  On the other hand a portfolio that is 60% stocks and 40% bonds can average 7-8% growth over long periods of time, but you can encounter drops of 25-30%.   Getting 2% more average growth means adding a tremendous amount of volatility. 

Now I'm actually the person who isn't going to tell you to buy bonds.  If you don't need income, and you are ok with taking on a lot more volatility to get a little more return than you might not need bonds.  I am 20/80 or 60/40 in my accounts where I might need the money in 1-5 years, but in my long retirement accounts I'm 100% stock.  I'm ok with the volatility.  Whether you are ok with that level of volatility is a question you need to really reflect on.  If the news was reporting "crisis, ahhhhh, run around like a chicken with its head cut off, stock brokers are jumping out windows, ahhh!!!, the dow is down a bajillion points, ahhh!!!!" can you look at your portfolio down 40% and still keep a cool head? 

Bob W

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Re: Help me understand: why should I buy bonds?
« Reply #12 on: March 03, 2015, 07:13:58 PM »
Of course the simple solution is to buy collectible stamps.  Queen Elizabeth does.   They average 10% a year and never go down in value.   It is the best of all worlds.   You can Google on how to do this.   You don't actually hold the stamps.    They ain't making anymore of them and collectors grow each year.  Or you could just go for numismatic coins.    Which beat the crap out of the S and P.     

Indexer

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Re: Help me understand: why should I buy bonds?
« Reply #13 on: March 03, 2015, 07:45:38 PM »
Of course the simple solution is to buy collectible stamps.  Queen Elizabeth does.   They average 10% a year and never go down in value.   It is the best of all worlds.   You can Google on how to do this.   You don't actually hold the stamps.    They ain't making anymore of them and collectors grow each year.  Or you could just go for numismatic coins.    Which beat the crap out of the S and P.     

[joke]Oh yeah.  I heard about this.  Good old Charles Ponzi made a ton of money in postage stamps.  He had this crazy strategy that was always profitable and never went down in value.  He also never actually held the stamps.[/joke]

Sorry, I couldn't resist.

 

And something I left out of my earlier post.  Even when rates do rise it only hits the long term bonds a lot.  Short term bonds rarely move at all when interest rates rise, and intermediate bonds rarely move much.  Remember when bonds have a bad year they move about as much as stocks can move in a single bad day.  Lowering your bonds to increase stocks is never a way to lower volatility, just to increase it.  Which again I'm fine with being 100% stocks as long as you understand what you are doing and you are ok with the risk.
« Last Edit: March 03, 2015, 07:49:12 PM by Indexer »

Wolf359

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Re: Help me understand: why should I buy bonds?
« Reply #14 on: March 04, 2015, 09:15:04 AM »
I know that I'm supposed to have a portion of my portfolio in bonds…but what I don't understand is why I would buy bonds right now.  Here's what I have gleaned:
 - Bond income is generated in the form of interest.  Interest rates are currently at historic lows.
 - When interest rates are low, bond prices are high.  In general, you don't want to "buy high."

So…I don't get it.  What am I missing?  Why am I supposed to buy these things?  They seem like a bad deal, but if the entire industry says to buy bonds I know I must be misunderstanding!

There are two main reasons to own bonds.
1.  Income:  If you are retired you probably care about income.  If you are still accumulating you probably don't which brings us to...

2.  Lowering your risk.  A 100% stock portfolio can average 10% growth over longs periods of time, but you can encounter drops of 40-50%.  On the other hand a portfolio that is 60% stocks and 40% bonds can average 7-8% growth over long periods of time, but you can encounter drops of 25-30%.   Getting 2% more average growth means adding a tremendous amount of volatility. 

Now I'm actually the person who isn't going to tell you to buy bonds.  If you don't need income, and you are ok with taking on a lot more volatility to get a little more return than you might not need bonds.  I am 20/80 or 60/40 in my accounts where I might need the money in 1-5 years, but in my long retirement accounts I'm 100% stock.  I'm ok with the volatility.  Whether you are ok with that level of volatility is a question you need to really reflect on.  If the news was reporting "crisis, ahhhhh, run around like a chicken with its head cut off, stock brokers are jumping out windows, ahhh!!!, the dow is down a bajillion points, ahhh!!!!" can you look at your portfolio down 40% and still keep a cool head?

If you want the most complete explanation, read "The Intelligent Asset Allocator" by Bernstein.  It's not really math-heavy, but it's beyond most people who have not taken statistics or don't have a decent understanding of math.

If you want what he calls "the liberal arts major" explanation, read "The Four Pillars of Investing," by Bernstein.

The bonds are not there to give you a long-term return.  They're there for diversification, to even out your ride.  And they're not necessarily there just so you don't panic and sell out at the bottom.  They provide the valuable function of capital preservation in a long-term buy-and-hold strategy.

You can use bonds in a portfolio aggressively.  Slide your stock/bond mix to 70/30 or 60/40 right now.  Yes, your performance will drag, but you'll still have capital appreciation and mostly participate in the bull market.  The current bull market is getting long in the tooth.  Who knows how long it will continue, but it won't last forever.  When it eventually crashes, you have a significant proportion of reserves in that bond fund that didn't drop with everything else.  You can then reduce your stock/bond mix to 80/20 (lowest Bogle recommends) or 100/0 (where many people seem to be now). 

With that strategy, you're maximizing your stock buying after a market crash.  That's also called "buying low." 

As for an indicator of how frothy things are getting, look at the number of people advocating going 100% stock, like it isn't risky.  Increased speculation is a contrarian indicator.  Eventually, there will be a correction.  Bonds will preserve some of your portfolio so you're not falling behind.

Now, this sliding strategy is very aggressive.  A more rational approach is to select a stock/bond mix and stick with it.  The normal portfolio diversification approach reduces losses, so you don't have to recover so much ground. 

If you want to see this in action, go to Vanguard's fund performance comparison, and compare VTSAX (US Total Stock Market), VGTSX (International Total Stock Market), and VFIUX (Intermediate-term US Treasuries). Compare hypothetical growth of $10,000 over 10 years.  Obviously, the two stock indexes initially outperform treasuries until a market peak in 07 (VTSAX $13,723;  VGTSX $17,613; VFIUX $11,282).  The market slides throughout 2008 and crashes, reaching a bottom in early 2009 (VTSAX $7,309; VGTSX $6,795; VFIUX $12,896).  Treasuries stay ahead until 2013, when VTSAX finally recovers enough to overcome its losses.  VFIUX doesn't get ahead of Treasuries until 2014.  In other words, boring, low-interest rate treasuries actually were beating the two stock indexes for about half of the last ten year time period.  And that's assuming 3 separate $10,000 investments. 

If you combine all three portfolios, sometimes International stock outperforms, sometimes US stock outperforms, and sometimes Treasuries outperform.  When the market tanks, funds are rebalanced from the treasuries to the stock side of the portfolio and the overall portfolio will outperform a non-diversified portfolio over the long term. 

But what if you simply bought VTSAX and held it by itself?  Doesn't that beat all the others?  Yes, it beats the others in hindsight.  But you can't predict which of these three will be the best choice 10 years from now.  Even VTSAX lagged the other two funds for 8 out of the last 10 years. 

The balanced portfolio with US, International, and highest quality bonds outperforms a non-diversified portfolio over the long term.  Any one of the component assets will outperform the diversified portfolio at any given time, but you can't predict in advance which one. 

Right now, many people want to hold VTSAX only, because International Total Stock Market performance stinks.  Yes, it does, for the moment.  But will Asia be in recession forever?  Will Europe always be in crisis?  Is it reasonable to project that the rest of the world economy will just collapse and never recover?  The reason buying an asset low is so hard is that that's when nobody wants it.  If everybody wanted it, the price wouldn't be low.

I think the saying is that if you don't like one of the assets in your diversified portfolio, you're not doing it right.

Sorry I'm only referring to a chart and describing it rather than inserting one.  I haven't figured that out yet.

lovesasa

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Re: Help me understand: why should I buy bonds?
« Reply #15 on: March 05, 2015, 11:14:42 PM »
You can use bonds in a portfolio aggressively.  Slide your stock/bond mix to 70/30 or 60/40 right now.  Yes, your performance will drag, but you'll still have capital appreciation and mostly participate in the bull market.  The current bull market is getting long in the tooth.  Who knows how long it will continue, but it won't last forever.  When it eventually crashes, you have a significant proportion of reserves in that bond fund that didn't drop with everything else.  You can then reduce your stock/bond mix to 80/20 (lowest Bogle recommends) or 100/0 (where many people seem to be now). 

With that strategy, you're maximizing your stock buying after a market crash.  That's also called "buying low." 
...

If you want to see this in action, go to Vanguard's fund performance comparison, and compare VTSAX (US Total Stock Market), VGTSX (International Total Stock Market), and VFIUX (Intermediate-term US Treasuries). Compare hypothetical growth of $10,000 over 10 years.  Obviously, the two stock indexes initially outperform treasuries until a market peak in 07 (VTSAX $13,723;  VGTSX $17,613; VFIUX $11,282).  The market slides throughout 2008 and crashes, reaching a bottom in early 2009 (VTSAX $7,309; VGTSX $6,795; VFIUX $12,896).  Treasuries stay ahead until 2013, when VTSAX finally recovers enough to overcome its losses.  VFIUX doesn't get ahead of Treasuries until 2014.  In other words, boring, low-interest rate treasuries actually were beating the two stock indexes for about half of the last ten year time period.  And that's assuming 3 separate $10,000 investments. 

If you combine all three portfolios, sometimes International stock outperforms, sometimes US stock outperforms, and sometimes Treasuries outperform.  When the market tanks, funds are rebalanced from the treasuries to the stock side of the portfolio and the overall portfolio will outperform a non-diversified portfolio over the long term. 
...
The balanced portfolio with US, International, and highest quality bonds outperforms a non-diversified portfolio over the long term.  Any one of the component assets will outperform the diversified portfolio at any given time, but you can't predict in advance which one. 

Right now, many people want to hold VTSAX only, because International Total Stock Market performance stinks.  Yes, it does, for the moment.  But will Asia be in recession forever?  Will Europe always be in crisis?  Is it reasonable to project that the rest of the world economy will just collapse and never recover?  The reason buying an asset low is so hard is that that's when nobody wants it.  If everybody wanted it, the price wouldn't be low.

Not the original poster, but this was INCREDIBLY helpful! I just want to say thank you for posting this. Suddenly this all makes much more sense. I especially liked your point about people advocating 100% stocks being a sign of how "frothy" the market is. I was actually considering going all stocks with my first investment, but I think you've just convinced me otherwise.

Quote
I think the saying is that if you don't like one of the assets in your diversified portfolio, you're not doing it right.

I'm probably just being dense, but I don't understand this part.

CanuckExpat

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Re: Help me understand: why should I buy bonds?
« Reply #16 on: March 05, 2015, 11:42:13 PM »
If you want to see this in action, go to Vanguard's fund performance comparison, and compare VTSAX (US Total Stock Market), VGTSX (International Total Stock Market), and VFIUX (Intermediate-term US Treasuries). Compare hypothetical growth of $10,000 over 10 years.  Obviously, the two stock indexes initially outperform treasuries until a market peak in 07 (VTSAX $13,723;  VGTSX $17,613; VFIUX $11,282).  The market slides throughout 2008 and crashes, reaching a bottom in early 2009 (VTSAX $7,309; VGTSX $6,795; VFIUX $12,896).  Treasuries stay ahead until 2013, when VTSAX finally recovers enough to overcome its losses.  VFIUX doesn't get ahead of Treasuries until 2014.  In other words, boring, low-interest rate treasuries actually were beating the two stock indexes for about half of the last ten year time period.  And that's assuming 3 separate $10,000 investments. 
...
But what if you simply bought VTSAX and held it by itself?  Doesn't that beat all the others?  Yes, it beats the others in hindsight.  But you can't predict which of these three will be the best choice 10 years from now.  Even VTSAX lagged the other two funds for 8 out of the last 10 years. 

The balanced portfolio with US, International, and highest quality bonds outperforms a non-diversified portfolio over the long term.  Any one of the component assets will outperform the diversified portfolio at any given time, but you can't predict in advance which one. 

Right now, many people want to hold VTSAX only, because International Total Stock Market performance stinks.  Yes, it does, for the moment.  But will Asia be in recession forever?  Will Europe always be in crisis?  Is it reasonable to project that the rest of the world economy will just collapse and never recover?  The reason buying an asset low is so hard is that that's when nobody wants it.  If everybody wanted it, the price wouldn't be low.

I think the saying is that if you don't like one of the assets in your diversified portfolio, you're not doing it right.

Sorry I'm only referring to a chart and describing it rather than inserting one.  I haven't figured that out yet.
Here you go:

I had this handy because I posted it recently in another thread. It's one of my favourite charts to review for the same reasons listed above. Note this is from Morningstar, a total return chart, and I plotted Vanguard total Bond, not the US treasury fund. Link to interactive version

jlajr

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Re: Help me understand: why should I buy bonds?
« Reply #17 on: March 06, 2015, 04:59:38 AM »
I enjoyed reading this thread, and I'd like to add my own observations, and pose a few questions.

Price volatility is only one type of risk, but it does not necessarily reflect the level of "institutional" risk. (Is that the proper way to describe it?) I imagine the traditional rules regarding institutional risk remain relevant, correct? Those rules being, to my understanding: Government bonds carry the least amount of institutional risk (even though they can display significant price volatility, especially for longer-term bonds), corporate bonds carry more institutional risk than government bonds but less institutional risk than stocks, and stocks carry the most institutional risk.

Index-based funds/ETFs can mitigate price volatility to a certain extent, correct? But do they mitigate the institutional risk? I'm not sure. Does a fund/ETF that tracks a government bond index carry the same institutional risk as a government bond? No, correct? The fund/ETF carries more institutional risk because you're not buying the bond from the government. It is not the government's responsibility to pay you the interest and principal. Isn't that the exact institutional risk investors are trying to avoid by buying government bonds? So, a fund/ETF that tracks an index for a particular asset class is attaching itself to the (lack of) price volatility of that asset class, but it doesn't always carry the same level of institutional risk as that asset class, correct?

Thanks in advance.

Retire-Canada

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Re: Help me understand: why should I buy bonds?
« Reply #18 on: March 06, 2015, 07:19:45 AM »
Thanks for taking the time to comment I found this thread and the other bond related thread well worth reading. :)

I'm thinking of a post-FIRE allocation something like this:

- equities 85%
- bond funds 15%
- money market = 1 year's COL

I don't care about absolute best performance as much as flexibility and the ability to buy equities cheaply if there is a crash/correction.

Someone [Cathy?] mentioned using a line of credit instead of cash to get through a crash/correction. I'm going to give that some more thought. I'll probably establish a bigger line of credit than I have currently. Not sure I'll use it for this purpose, but it's good to have options.

Someone else mentioned that MMM style ER folks have many other options including lowering spending and part-time work. I see that as my primary response to low equity prices. Aside from giving me the ability to not draw down my investments it also means I have more money available to buy investments I think are discounted.

-- Vik

RaymondG

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Re: Help me understand: why should I buy bonds?
« Reply #19 on: March 06, 2015, 08:00:58 AM »
Here is an interest article about using adaptive allocations between stock market ETFs and Treasuries. I agree with the point inside but I use a simpler  way to adjust allocations between multiple less-correlated ETFs. I aims to have Domestic : International : Commodity/Gold : Bond/REIT at 50 : 15 : 10 : 25 at this moment.

http://seekingalpha.com/article/2714185-the-spy-tlt-universal-investment-strategy?page=1

Wolf359

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Re: Help me understand: why should I buy bonds?
« Reply #20 on: March 06, 2015, 11:01:37 AM »

Quote
I think the saying is that if you don't like one of the assets in your diversified portfolio, you're not doing it right.

I'm probably just being dense, but I don't understand this part.

You're not dense, I made a typo.  The phrase should have been "if you don't hate one of the assets in your diversified portfolio, you're not doing it right."  If you are properly diversified, one of your assets will look and feel like a loser.

A properly chosen diversified portfolio is made up of components that don't go up and down at the same time.  Let's say that my three assets were an S&P Health Care ETF, an S&P 500 index fund, and a Dividend fund.  I'd be very happy with all three assets right now, because they all performed well last year.  The problem is that they're correlated, that is, they all go up at the same time, and all go down at the same time.  In a down year, I'd be looking a massive losses.  They don't offset each other.

If the assets were not correlated, one asset may be up when one or both of the others is down. 

Again, having a portfolio like this is hard, because there are temptations to sell the losing asset and buy more of the winning one. 

It's also hard when the down assets are not the S&P 500.  In the US, people compare their portfolio performance to the S&P 500.  If the S&P 500 is up, a properly diversified portfolio will underperform (because you also have assets in bonds with low return, and foreign stocks, which are out of favor.)  It's hard to own a portfolio that does worse than everybody else you know. 

On the other hand, when the S&P is down, then you're doing better than everybody else you know.  But it's the periods of domestic outperformance (like now) that are harder.

Wolf359

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Re: Help me understand: why should I buy bonds?
« Reply #21 on: March 06, 2015, 11:38:21 AM »
I enjoyed reading this thread, and I'd like to add my own observations, and pose a few questions.

Price volatility is only one type of risk, but it does not necessarily reflect the level of "institutional" risk. (Is that the proper way to describe it?) I imagine the traditional rules regarding institutional risk remain relevant, correct? Those rules being, to my understanding: Government bonds carry the least amount of institutional risk (even though they can display significant price volatility, especially for longer-term bonds), corporate bonds carry more institutional risk than government bonds but less institutional risk than stocks, and stocks carry the most institutional risk.

Index-based funds/ETFs can mitigate price volatility to a certain extent, correct? But do they mitigate the institutional risk? I'm not sure. Does a fund/ETF that tracks a government bond index carry the same institutional risk as a government bond? No, correct? The fund/ETF carries more institutional risk because you're not buying the bond from the government. It is not the government's responsibility to pay you the interest and principal. Isn't that the exact institutional risk investors are trying to avoid by buying government bonds? So, a fund/ETF that tracks an index for a particular asset class is attaching itself to the (lack of) price volatility of that asset class, but it doesn't always carry the same level of institutional risk as that asset class, correct?

Thanks in advance.

The term you're looking for is "capital risk."

Capital risk is:  The risk an investor faces that he or she may lose all or part of the principal amount invested.

When you buy a bond and hold it to term, by contract you will get your money back, plus interest. When you buy a stock, hold it, and sell it, nobody guarantees how much you'll be able to sell it for.  If a company declares bankruptcy, bond holders are paid first.  There is usually little left for shareholders.

A bond therefore has lower capital risk than a stock.

While a corporation may go out of business, governments don't.  If necessary, the federal government may just print more money.  Therefore, a US government bond has less risk than a corporation.  Given its relative size and power in the world, a US treasury is considered the closest thing to risk-free available (in terms of low capital risk.)

There's also interest-rate risk.  If you buy a bond that pays 2% in 5 years, and they start selling bonds that pay 4% in 5 years, the current value of the 2% bonds will drop.  HOWEVER, if you wait 5 years, you'll still get all your original money back, plus the 2%.  You didn't lose your capital. 

Buying an index fund does mitigate capital risk when compared to buying individual securities.  It is possible that any given company, even an S&P 500 firm) could suddenly and unexpectedly go out of business (see Enron).  But when you buy Total Stock Market, it is very unlikely that every publicly traded company in the US will go out of business simultaneously.  Corporate Bond index funds are similar -- their risk is mitigated by the bond fund buying many bonds.

A US Treasury fund doesn't actually diversify capital risk. All the bonds in a US Treasury fund are from one source.  You could actually buy treasury bonds directly yourself, to create your own "bond fund" with a 0% ER.  (Vanguard brokerage will actually buy treasuries from auction on your behalf with no commission.)  I still use a treasury bond fund for convenience.

jlajr

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Re: Help me understand: why should I buy bonds?
« Reply #22 on: March 06, 2015, 12:28:27 PM »
The term you're looking for is "capital risk."

Capital risk is:  The risk an investor faces that he or she may lose all or part of the principal amount invested.

When you buy a bond and hold it to term, by contract you will get your money back, plus interest. When you buy a stock, hold it, and sell it, nobody guarantees how much you'll be able to sell it for.  If a company declares bankruptcy, bond holders are paid first.  There is usually little left for shareholders.

A bond therefore has lower capital risk than a stock.

While a corporation may go out of business, governments don't.  If necessary, the federal government may just print more money.  Therefore, a US government bond has less risk than a corporation.  Given its relative size and power in the world, a US treasury is considered the closest thing to risk-free available (in terms of low capital risk.)

There's also interest-rate risk.  If you buy a bond that pays 2% in 5 years, and they start selling bonds that pay 4% in 5 years, the current value of the 2% bonds will drop.  HOWEVER, if you wait 5 years, you'll still get all your original money back, plus the 2%.  You didn't lose your capital. 

Buying an index fund does mitigate capital risk when compared to buying individual securities.  It is possible that any given company, even an S&P 500 firm) could suddenly and unexpectedly go out of business (see Enron).  But when you buy Total Stock Market, it is very unlikely that every publicly traded company in the US will go out of business simultaneously.  Corporate Bond index funds are similar -- their risk is mitigated by the bond fund buying many bonds.

A US Treasury fund doesn't actually diversify capital risk. All the bonds in a US Treasury fund are from one source.  You could actually buy treasury bonds directly yourself, to create your own "bond fund" with a 0% ER.  (Vanguard brokerage will actually buy treasuries from auction on your behalf with no commission.)  I still use a treasury bond fund for convenience.

Awesome explanation. Thank you so much.

About US Treasury bond funds, though, because the individual investor is not buying the bonds directly, the capital risk does not actually reflect the underlying asset class, that is, the US Treasury bonds, correct? It reflects the fund manager instead, correct? So, what kind of capital risk does that entail? Meaning, if the fund manager goes bankrupt, where do the fund's investors stand in the line of creditors?

The topic fascinates me, and likely confuses many beginners to investing - like myself.

rmendpara

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Re: Help me understand: why should I buy bonds?
« Reply #23 on: March 06, 2015, 12:53:56 PM »
Why buy bonds?

Let's boil it down to one line: Investing is about managing risk, not maximizing return.

Everyone's risk tolerance and investing goals are different, so it really depends on what you want. I am assuming that this is more for long term savings and perhaps retirement stuff? In that case, you should have a lower risk tolerance than 100% equity. Not necessarily in your first few years, since that amount of capital won't really make much of a difference, but just try to avoid "Wow, bonds sure do seem expensive now...", because your gut is wrong more often than not... unless you're David Einhorn.

Many people have already said something similar, but your overall portfolio return will decline very little for adding even a relatively small amount of fixed income, say 5-8%, but your overall portfolio risk will decrease much more.

Again, this all comes back to your investing goals and how much you can handle volatility. If you really don't need the money for many years, and have an investing horizon like Warren Buffett did in 1970, then yes, equity ownership is a more rewarding form of investing over long periods of time. However, it's unlikely you are investing on that long of a term and that you could handle that kind of risk.

CanuckExpat

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Re: Help me understand: why should I buy bonds?
« Reply #24 on: March 06, 2015, 12:56:48 PM »
About US Treasury bond funds, though, because the individual investor is not buying the bonds directly, the capital risk does not actually reflect the underlying asset class, that is, the US Treasury bonds, correct? It reflects the fund manager instead, correct? So, what kind of capital risk does that entail? Meaning, if the fund manager goes bankrupt, where do the fund's investors stand in the line of creditors?

The topic fascinates me, and likely confuses many beginners to investing - like myself.
Not exactly. Some of this will depend on the regulatory environment in your individual country, but usually the fund company is holding the assets with a custodian on your behalf. So the fund company going bankrupt shouldn't affect you (other than perhaps a delay getting access to your funds) unless there was shady/illegal accounting practices going on.
This is explained somewhere here: http://www.bogleheads.org/wiki/Vanguard_safety

jlajr

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Re: Help me understand: why should I buy bonds?
« Reply #25 on: March 06, 2015, 01:27:35 PM »
Not exactly. Some of this will depend on the regulatory environment in your individual country, but usually the fund company is holding the assets with a custodian on your behalf. So the fund company going bankrupt shouldn't affect you (other than perhaps a delay getting access to your funds) unless there was shady/illegal accounting practices going on.
This is explained somewhere here: http://www.bogleheads.org/wiki/Vanguard_safety

OK. Thank you.

Spe

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Re: Help me understand: why should I buy bonds?
« Reply #26 on: March 06, 2015, 05:16:14 PM »
In my case I own a apartment and I have some index funds. Out of the total I would say 80% of my portfolio is in the apartment and 20% are index funds. I own no bonds. Doesnt this sound good? I have no loans so if the shit hits the fan and i for some reason need liquidity for some time I can get a home equity loan.
What do you think?

I actually have some experience with the market crash of 2008-09. I had just bought stocks and funds for everything I owned and it was tough watching my portfolio drop 50% in value. I decided I would not sell anything with loss. So I kept them in there for some years until the value of the portfolio came back to where it was before the crash and then I sold everything and decided to not go into the stock market again.. but now I changed my mind and Im back and my portfolio is now more diversified by owning this apartment..

phillyvalue

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Re: Help me understand: why should I buy bonds?
« Reply #27 on: March 07, 2015, 09:04:18 AM »
One thing I will say with regards to allocation towards bonds is that, if you have a mortgage outstanding at X%, then paying off the mortgage is like buying a bond that pays an interest rate of X(1-T)%, where T is your marginal tax rate [assuming you can deduct the interest]. If you have a mortgage outstanding and are also investing in bonds, you are basically only cancelling out your fixed income exposure. Normally the key advantage to a mortgage note is that it is callable, you can pay it off and refinance if rates go lower; that option isn't very valuable these days, however. Depending on what after-tax rate you are paying on your mortgage versus what you are getting in a bond fund, you may be better off just paying off your mortgage. Financially it may end up being a wash, but it certainly makes the process simpler.

Retire-Canada

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Re: Help me understand: why should I buy bonds?
« Reply #28 on: March 07, 2015, 09:41:35 AM »
Im back and my portfolio is now more diversified by owning this apartment..

I would dispute this notion.

You own 1 apartment in 1 building in 1 block of 1 city. That's highly un-diversified. Something can happen very locally to impact the value of your real estate investment.

It would be the stock market equivalent of putting all your money into 1 company.

If the market crashes the value of your apartment will likely be impacted as well. Depending on the nature of the crash you may find lenders less keen on providing credit or the credit will be at high rates.

If you had that 80% in REITs owning real estate all over the country you would be more diversified.

The trouble I see with your asset allocation is the lost opportunity cost of the money in your apartment is a huge drag on your investments unless you live in a very select market where real estate is appreciating 8%+/yr and will continue to do so. Keeping your money out of the stock market eliminates the risk of a crash/correction, but it guarantees you'll miss out on the gains as well.

If you want to rely on a HELOC I'd get it now while things are good so you aren't asking for credit in the middle of an economic crisis.

-- Vik
« Last Edit: March 07, 2015, 09:48:48 AM by Vikb »

Spe

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Re: Help me understand: why should I buy bonds?
« Reply #29 on: March 07, 2015, 02:10:09 PM »
Yes its true what you say, but I own a place in Norway and there are a ton of tax-advantages for owning your own place compared to owning stocks. I will list the main ones:

If you have a 500.000 dollar property, you only pay fortune tax/wealth tax on 35% of the value of the property. If you own stocks the "tax value" is 100% of the real value. If you want to rent out a part of your property its tax free. If I need a loan I can get a home equity one. Without a home to act as security for the loan I would settle for a much higher interest rate. The building has property insurance.
If I ever deicde to sell this place then I will pay 0% tax from the rise in value of the place while I lived here. Where as when I sell stocks I have to pay 27% tax from all the gains I got.

There are much stricter national requirements for banks to give sub-prime mortages. Mortage takers has to have 15% of the money they want to borrow for a house in cash upfront before the bank is allowed to borrow them money. I also read that in the US its like if you have a loan of 95% of the property, and the value of the house drops so now you have 110% of the value of the house in loan then you can choose to forfeit the house and loan and it will be the banks problem, its not like this here.
Thats why its more safe to own here. Especially in the center of the 2nd largest city like I am.

When this is said I know that it has a higher yield for me to put money in stocks. However the risk/volatility for owning a apartment is much lower, and that is why i think bonds are not necessary for me. 
Not to mention that it is cheaper to live in my own house than to pay rent to someone who makes a profit of my living needs.

So thats why I think 80% in house 20% in stocks and as I get more money from work I will put them in stocks. And if I need money for some reason which I cant pay for from my small buffer then ill take up a home equity loan.

That being said I dont think I would use this strategy in the US, but its different tax laws so its a different game here.