Author Topic: Question about bonds during next recession...  (Read 2083 times)

spud1987

  • Bristles
  • ***
  • Posts: 356
  • Location: SF Bay Area
Question about bonds during next recession...
« on: August 18, 2017, 09:45:24 AM »
Typically bond prices go up (i.e., yield goes down) when stocks go down. This makes sense when bond prices are low, like during a normal market upswing. But what about when there isn't much room for bond yields to fall? The fed funds rate is around 1% now. The 10 yr Treasury yield is around 2.2%.

Should I be rethinking my strategy of holding 30% bonds? I guess there is no better option, but it is something I've been thinking about.

talltexan

  • Magnum Stache
  • ******
  • Posts: 4402
Re: Question about bonds during next recession...
« Reply #1 on: August 18, 2017, 12:39:08 PM »
From the "1987" in your username, I'm guessing you have such a large bond stake because you are getting really close to FIRE. Otherwise, it's probably too high, and the reason you give is part of it.

Typically moves in financial markets happen prior to recessions (think the stock market decline from Oct 2007 to Feb 2009), and the bond market can move in either direction: despite the remarkable tailwind of the Fed cutting interest rates during 2008, bond prices fell substantially then causing the yield curve to "flip".

If you expect to retire after 2022, I'd seriously consider putting all new money into stocks until your bond stake goes down to something like 15%-17%.

ChpBstrd

  • Magnum Stache
  • ******
  • Posts: 3133
Re: Question about bonds during next recession...
« Reply #2 on: August 18, 2017, 08:48:54 PM »
Bond pricing is not as obvious as stock pricing. Instead of fluctuating based on expected earnings, your bonds will fluctuate based on expected interest rates. E.g. no one would buy your bond paying a 2% coupon when they could just buy a new bond yielding 4%. The market price of your bond would have to fall until the yield hit 4% in that example.

Bond investors have not seen a period of rising interest rates in decades. When they do start rising, the negative impact on the price of current bonds will be greatest for the longer duration bonds. Most ameteur bond investors have no idea that it's possible their 10 year bonds could drop 25-30% just because interest rates go up by 2%. They think they're owning bonds just so such an event could never happen. Find an online bond calculator and see how the price of your bonds changes given small modifications to the risk-free rate.

The nightmare scenario for your bonds is a tiny blip in inflation and/or interest rates. If a "normal" recession occurs with deflationary instead of inflationary pressures, your bonds will either do fine or increase in value. However, note that the current administration seems to have studied economics at the Andrew Mellon school, so its appointees might oppose stimulatory actions such as lowering interest rates.

For these reasons, I see chasing 2-4% returns through 10-30 year bonds as more risky than selling put options against stock indexes a couple times a year. Yes, the world is that upside down.

Indexer

  • Handlebar Stache
  • *****
  • Posts: 1463
Re: Question about bonds during next recession...
« Reply #3 on: August 18, 2017, 10:53:37 PM »
I'm not worried about bonds. There is a saying, "a bad year for bonds is a bad day for stocks." When bonds have a bad year they are down in the 2-6% range. The worst year for bonds was -8%. Stocks on the other hand can drop 2-6% in a day and the worst year for stocks was -43%. You probably shouldn't decrease your bond allocation because you are worried about risk. The stocks are the risky part of the portfolio.

Quote from: ChpBstrd
Bond investors have not seen a period of rising interest rates in decades.

From 2003 to 2006, slightly over 10 years ago, the fed funds rate went from <1% to over 5%. That's more than a 4% increase in 3 years.

VBTLX, Vanguard Total Bond index & VBLTX, Vanguard Long term bond index had positive returns every year during that period.

Now, you are right, the market value of the bonds went down as interest rates went up. However, the drop was so minor and spread over so many years that the income off the bonds covered the difference. Since the income is less now it would be easier for the returns to be negative, but it isn't anything to panic about.

Quote from: ChpBstrd
Most ameteur bond investors have no idea that it's possible their 10 year bonds could drop 25-30% just because interest rates go up by 2%.

Just eyeballing duration these numbers don't appear possible. Yields are still positive, at least in the USA, so the duration on a 10 year bond mathematically has to be less than 10 years. That means if rates went up by 1% a 10 year bond would drop less than 10%, and if rates went up by 2% it would drop less than 20%.

I ran the numbers to check. For reference I used the TVM equation. Maturity = 10 years, semi-annual payments. Yield =2.2%. Rate increase = 1%. The market value of the bond drops 8.5%. Now add back in the 2.2% for a total return of -6.3%.
2% increase = -16.19% return. Add back the 2.2% for a total return of -13.99%

For context we are using 10 year treasuries in these examples. A well diversified bond portfolio, like VBTLX, has a lower maturity and lower duration so it would fair better. We are also talking about an increase of 2% within 1 year. Currently markets aren't sure if we are going to even see another 0.25% by the end of the year.

Quote
But what about when there isn't much room for bond yields to fall?

Bond yields can still fall. When there is uncertainty people will gladly pay for safety. When the UK voted to leave the EU stocks in Europe dropped at the same time government bond yields in the EU dropped which pushed bond prices up. Bonds went up when stocks went down. Keep in mind that interest rates on many of those bonds were already negative. Investors were happy to pay Germany for the safety of their bonds in a world that had just become more uncertain. US bonds still have positive yields so we aren't even in that situation yet. Now, during the 08 crash there was a day when short term treasuries were selling with negative yields on the secondary market. Investors were panicking, they wanted something safe, and the money was moving so quick people probably didn't even realize the yield was negative. When panic sets in people want safety. Under normal circumstances that safety means you have a return that is lower than inflation, a negative real return. Now we have low inflation so the negative return is more obvious, but it was always there.

Conclusion: don't panic over bonds. They are a hedge against stocks that also given you some income along the way.
« Last Edit: August 18, 2017, 11:05:49 PM by Indexer »

Financial.Velociraptor

  • Handlebar Stache
  • *****
  • Posts: 1701
  • Age: 48
  • Location: Houston TX
  • Devour your prey raptors!
    • Financial Velociraptor
Re: Question about bonds during next recession...
« Reply #4 on: August 19, 2017, 05:11:03 PM »
I'm about 30% in bonds myself in FIRE (5 years in October).  I'm wanting MORE bonds, not less.

Personally, I think the threat of a large rising in US interest rates is small.  The Fed broke the market.  Now they've bought it.

Mr Mark

  • Handlebar Stache
  • *****
  • Posts: 1199
  • Location: Planet Earth
  • Achieved Financial Independence summer 2014. RE'18
Re: Question about bonds during next recession...
« Reply #5 on: August 20, 2017, 01:38:44 AM »
I get the inverse yield/bond price thing - when yields rise bond prices fall and visaversa. Longer term bonds see more sensitivity to rates. No problem.

But I struggle with these negative bond yields. Shouldn't my existing bond prices with a positive coupon go to infinity?

Indexer

  • Handlebar Stache
  • *****
  • Posts: 1463
Re: Question about bonds during next recession...
« Reply #6 on: August 20, 2017, 09:27:35 AM »
I get the inverse yield/bond price thing - when yields rise bond prices fall and visaversa. Longer term bonds see more sensitivity to rates. No problem.

But I struggle with these negative bond yields. Shouldn't my existing bond prices with a positive coupon go to infinity?

No, it wouldn't go to infinity, but it would make that bond a lot more appealing than newly issued bonds.

Let's use TVM to solve for the change in price.
Starting price = $1,000. Payment = $12(semiannual). Annual rate= 2.4%. Term= 20 payments(10 year bond). Par= $1000.

Keeping everything else the same we change the annual rate(I) and solve for price (PV).
I= 2%. PV= $1036.09   +3.6% 
I= 1% PV= $1132.91   +13.3%
I= 0% PV= $1240.00   +24%
I= -1% PV= $1358.52  +35.9%

Conclusion: If rates went to -1% the 10 year bond paying 2.4% would appreciate in value by 35.9%. That's before your income return of 2.4%, which gives us a total return of 38.3%. Not a bad return for a bond.

Going the other direction.
I= 2.9%. PV= $956.87 -4.3%
I= 3.4% PV= $915.83 -8.4%
I= 4.4% PV= $839.60 -16.04%
« Last Edit: August 20, 2017, 09:31:04 AM by Indexer »

Mr Mark

  • Handlebar Stache
  • *****
  • Posts: 1199
  • Location: Planet Earth
  • Achieved Financial Independence summer 2014. RE'18
Re: Question about bonds during next recession...
« Reply #7 on: August 20, 2017, 11:47:39 AM »
Gotcha. Makes sense now. Cheers indexer!