Author Topic: Rising interest rate and bond fund?  (Read 7002 times)

Rein1987

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Rising interest rate and bond fund?
« on: March 31, 2015, 05:33:03 PM »
I personally believe the interest rate will go up in the next few years. And, it seems people believe bond price will drop when interest rate go up. Is it wise to invest in bond fund at this point of time? (More specifically I'm looking at tax exempt CA muni bond fund)

I do not feel very comfortable to have a 100% stock portfolio. Also, I do not like to hold too much cash. That's why I'm still looking at bond fund. However, my DH keeps telling it is definitely not wise to invest in bond fund at this point that we'd better keep cash. We do not need money in short term, but I wish I can have enough money to pay off my mortgage in 7-10 years when our ARM expires.

So consider the possible rising interest rate, which one sounds better in the taxable account?
- stock/bond mixed portfolio (what we did before)
- 100% stock + emergency cash
- stock/cash mixed portfolio.

Dodge

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Re: Rising interest rate and bond fund?
« Reply #1 on: March 31, 2015, 06:01:57 PM »
Everyone knows (well almost everyone) not to market time the stock market.  The bond market is no different.  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%!

Now let's look at another point on the chart, the two decades from 1950-1970, where interest rates tripled from their record low.  What happens to bonds then?



Unfortunately Morningstar's Intermediate bonds graph doesn't start until 1955, so I added "High Yield Bonds", a category which should be more negatively impacted by a rise in interest rates.  Looking at the chart, we see:
  • High Yield Bonds more than tripled during this time.  With a $10,000 deposit growing to $31,775.33
  • Intermediate Bonds more than doubled during this time, despite not starting until about 1955.  A $10,000 deposit grew to $23,435.50

This is why we say ignore the noise.

forummm

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Re: Rising interest rate and bond fund?
« Reply #2 on: March 31, 2015, 06:06:05 PM »
I would be shocked if interest rates did not rise this year. Intermediate and long term bond prices always drop in the short term when interest rates go up (unless some other unusual event is happening) relative to newly issued bonds. But the rate increases should be pretty slow this year, so it's not likely to be very significant in terms of your portfolio return, especially if you hold the fund long enough for the bonds in it to mature. But what you should be doing is to have your asset allocation strategy and just stick with it. Don't try to time the market. If you don't want to be 100% stocks, then you shouldn't be. Interest rates could go up and the market could go down at the same time (which is somewhat likely actually).

Rein1987

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Re: Rising interest rate and bond fund?
« Reply #3 on: March 31, 2015, 06:54:43 PM »
Thanks for the reply. This makes perfect sense to me.

seattlecyclone

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Re: Rising interest rate and bond fund?
« Reply #4 on: March 31, 2015, 07:00:23 PM »
I've been hearing people say "interest rates will definitely go up this year" since at least when I took out my mortgage five years ago. It hasn't happened yet.

The rates could go up tomorrow, or they could stay flat for another five years. I happen to believe that the odds of a rate increase happening soon have already been adequately priced into the market. Unless you have strong evidence to the contrary, take no drastic action. Pick an asset allocation that works for you and implement it. If bond prices do go down, you'll have a great opportunity to buy more on sale when you next rebalance.

scottish

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Re: Rising interest rate and bond fund?
« Reply #5 on: March 31, 2015, 08:52:28 PM »
You could always buy bonds directly and hold them to maturity.   Then it doesn't matter what happens to the price, the face value is unchanged.  I agree with the other posters, don't try and time the market.

Actually what do people think of this approach?

neil

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Re: Rising interest rate and bond fund?
« Reply #6 on: March 31, 2015, 09:35:13 PM »
I found this book very good on the subject (it's free to borrow with an Amazon Prime sub):

http://www.amazon.com/Why-Bother-Bonds-All-Weather-Independence/dp/0985800402/ref=sr_1_1?ie=UTF8&qid=1427845472&sr=8-1&keywords=why+bother+with+bonds

The concept of duration is fairly easy to understand (and simulate via spreadsheet) and Morningstar lists duration for funds (though I am not sure how accurate it is).  The concept that really sold me was that rising interest rates would always lead to larger absolute returns over time if holding longer than the listed duration.  (The question of real return can not really be answered since inflation is a significant unknown.)  As always, if you are looking for a short term store of value, bonds do not fit.  Cash only fits that need safely.

The affect of interest on principal is also a function of risk.  CA muni debt is not AAA.  (It is typically a mix of BBB/A/AA).  So it is important to understand interest rates do not affect all categories of debt equally.

Holding bonds to maturity does not reduce interest rate risk.  You still suffer opportunity cost and theoretically, selling your bond for one of equal maturity date at the higher interest rate ends up equivalent mathematically.  Holding to maturity also doesn't necessarily make sense if the maturity date has no meaning to your strategy.  If you are holding bonds to hold bonds, an intermediate bond fund will have a mix of intermediate term bonds and sell them as they become short term bonds (definition fluid, of course) to buy new intermediate bonds.  This keeps maturity consistent.  Holding to maturity results in holding a mix of short term, intermediate term and long term bonds, assuming you are laddering them.  If you are simply worried about an artificial short term loss of principal, you can take this approach, but it shouldn't improve or reduce your overall returns by doing so. 

Trying to time rate increases is no different than doing it with stocks.  If you decide to buy back in after one or two, there might be five more coming.  Bonds are guaranteed to drift back to par (unlike stock) so waiting is a serious enemy to total returns.  This number is controlled by a select few human beings and they set it for reasons that have little to do with returns of current bondholders.  SEC yield and bond duration is listed on every fund in Morningstar, you can find any calculator and see what the impact is for various scenarios.

We've been expecting this first increase for so long I am not even sure it isn't already baked into current valuations.  The market will usually start valuing the risk of a rate increase before it happens because obviously people are expecting it.

forummm

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Re: Rising interest rate and bond fund?
« Reply #7 on: April 01, 2015, 08:12:01 AM »
I found this book very good on the subject (it's free to borrow with an Amazon Prime sub):

http://www.amazon.com/Why-Bother-Bonds-All-Weather-Independence/dp/0985800402/ref=sr_1_1?ie=UTF8&qid=1427845472&sr=8-1&keywords=why+bother+with+bonds

I found this book to be overly simplistic. The theme seemed to be: "Buy bonds because if you're 100% stocks and the market goes down and then you sell your stocks and then the market goes up you'll have less money than if you'd had a balanced portfolio all along." But, if you aren't stupid, and you just don't deviate from your asset allocation strategy, you'd be better off anyway.

Dodge

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Re: Rising interest rate and bond fund?
« Reply #8 on: April 01, 2015, 09:51:20 AM »
I found this book very good on the subject (it's free to borrow with an Amazon Prime sub):

http://www.amazon.com/Why-Bother-Bonds-All-Weather-Independence/dp/0985800402/ref=sr_1_1?ie=UTF8&qid=1427845472&sr=8-1&keywords=why+bother+with+bonds

I found this book to be overly simplistic. The theme seemed to be: "Buy bonds because if you're 100% stocks and the market goes down and then you sell your stocks and then the market goes up you'll have less money than if you'd had a balanced portfolio all along." But, if you aren't stupid, and you just don't deviate from your asset allocation strategy, you'd be better off anyway.

Unless stocks stay down for 20 years, and you need the money.

forummm

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Re: Rising interest rate and bond fund?
« Reply #9 on: April 01, 2015, 11:14:56 AM »
I found this book very good on the subject (it's free to borrow with an Amazon Prime sub):

http://www.amazon.com/Why-Bother-Bonds-All-Weather-Independence/dp/0985800402/ref=sr_1_1?ie=UTF8&qid=1427845472&sr=8-1&keywords=why+bother+with+bonds

I found this book to be overly simplistic. The theme seemed to be: "Buy bonds because if you're 100% stocks and the market goes down and then you sell your stocks and then the market goes up you'll have less money than if you'd had a balanced portfolio all along." But, if you aren't stupid, and you just don't deviate from your asset allocation strategy, you'd be better off anyway.

Unless stocks stay down for 20 years, and you need the money.

That would have been a good point for the author to make.

Rein1987

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Re: Rising interest rate and bond fund?
« Reply #10 on: April 01, 2015, 11:21:55 AM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

seattlecyclone

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Re: Rising interest rate and bond fund?
« Reply #11 on: April 01, 2015, 11:30:08 AM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

forummm

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Re: Rising interest rate and bond fund?
« Reply #12 on: April 01, 2015, 11:47:13 AM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

If you DCA and are selling stock to buy bonds, then you'll be outside of your comfortable allocation zone longer (more risk). If you are using cash, then your cash will be sitting there deflating slowly instead of you getting the dividends.

Rein1987

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Re: Rising interest rate and bond fund?
« Reply #13 on: April 01, 2015, 12:21:41 PM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

But the problem here is to time the market. DCA is the way to avoid time the market, right?

Rein1987

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Re: Rising interest rate and bond fund?
« Reply #14 on: April 01, 2015, 12:22:31 PM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

If you DCA and are selling stock to buy bonds, then you'll be outside of your comfortable allocation zone longer (more risk). If you are using cash, then your cash will be sitting there deflating slowly instead of you getting the dividends.

I'm using cash..but cash might be possible later buy bonds at a lower price?

seattlecyclone

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Re: Rising interest rate and bond fund?
« Reply #15 on: April 01, 2015, 05:38:20 PM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

But the problem here is to time the market. DCA is the way to avoid time the market, right?

No, DCA is timing the market.

When you invest a lump sum now, you're saying "I know these investments usually go up in value, so I'm going to buy in now to maximize my expected return."

When you do DCA, you're saying "I know these investments usually go up, but I'm going to wait a while to buy them because I think this time is different and they're just as likely to go down soon as they are to go up."

Which statement sounds more like market timing?

scottish

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Re: Rising interest rate and bond fund?
« Reply #16 on: April 01, 2015, 05:55:14 PM »
DEFINITION of 'Dollar-Cost Averaging - DCA' The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.

DCA doesn't sound like market timing.

Indexer

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Re: Rising interest rate and bond fund?
« Reply #17 on: April 01, 2015, 06:17:45 PM »
DCA makes sense if it through normal contributions.  I DCA in my 401k.  This isn't market timing.  In this case letting the money build up to dump in all at once when I feel comfortable would be market timing.

If you have 100k just sitting around and decide to put 1k a month into the market... this is stupid.  You are leaving 99% in cash and putting 1% of the balance into the market.  The ONLY reason you would do this is that you are worried the market will drop in that time frame.  Its a form of market timing where you aren't completely screwing yourself if you are wrong.

If you have 100k already laying around you should invest it per your AA.  Any deviation from your AA based on what you think the market might do IS market timing.


Bonds:  So the guy who is 100% stock in his retirement accounts is now going to argue for bonds.  :) 

Whether you own bonds or not should be based on your asset allocation.  If you have the time horizon and risk tolerance for 100% stocks then go for it.  Far fewer people are actually ok with this than there are people who 'think' they are ok with it.  If you 'hope' for a market crash so everything goes on sale... you can handle 100% stock.  If you fear a market crash... even the slightest... you shouldn't be 100% stock. 

The amount of bonds in your portfolio should be based on your AA.  Nothing else.  They are the hedge to lower the volatility of stocks.  Given that... who cares what interest rates do?  And honesty you WANT rates to go up.  Bonds pay income... you want MORE income.  That gives you better returns.  Sure if rates rise existing bonds take a 'small' haircut, but then new bonds come out with better returns.   Higher rates = higher long term bond returns!
« Last Edit: April 01, 2015, 06:19:28 PM by Indexer »

forummm

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Re: Rising interest rate and bond fund?
« Reply #18 on: April 01, 2015, 06:19:33 PM »
One more additional question. The essential point I got from this thread is not to avoid investing in bond. Then, will it be better to DCA in this environment?

Dollar-cost averaging is never optimal. If bonds go up in value over the next year, you're better off putting all your cash in now. If they go down in value over the next year, you're better off waiting until the bottom. Dollar-cost averaging will get you somewhere in the middle regardless of what happens. But since price increases are more likely than decreases, a lump sum investment right away is the better bet.

If you DCA and are selling stock to buy bonds, then you'll be outside of your comfortable allocation zone longer (more risk). If you are using cash, then your cash will be sitting there deflating slowly instead of you getting the dividends.

I'm using cash..but cash might be possible later buy bonds at a lower price?

Maybe. Maybe the price goes up. Maybe if the price does go down, it goes down by less than the dividends you would have gotten in the mean time. If you buy short or medium duration bonds, any interest rate changes will produce smaller changes in the bond prices. But the bond market has probably already priced in some anticipation that interest rates will rise. So it probably doesn't matter much. And the Fed will probably not raise rates very fast or very high. Things are still too slow, especially when the rest of the world is pursuing loose money.

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Re: Rising interest rate and bond fund?
« Reply #19 on: April 01, 2015, 06:31:16 PM »
I know I'm not explaining this right, but it's because of the interest rate changes that I prefer long term bonds. When the interest rates are high and bonds aren't as good, my stock portion should be doing good as well so I don't mind taking a hit on the bond portion. I buy long term bonds because the market crashes come in cycles and I'm hoping I have enough long term bonds to carry me through part/most of the crash while still paying out the higher rates from when it was a bad buy. Though I'm young enough (AKA I missed this last crash in 2008) to not be able to put this through a test yet.

If anyone has evidence of this strategy not working, please post so I can correct myself before I get too deep

forummm

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Re: Rising interest rate and bond fund?
« Reply #20 on: April 01, 2015, 06:52:37 PM »
I know I'm not explaining this right, but it's because of the interest rate changes that I prefer long term bonds. When the interest rates are high and bonds aren't as good, my stock portion should be doing good as well so I don't mind taking a hit on the bond portion. I buy long term bonds because the market crashes come in cycles and I'm hoping I have enough long term bonds to carry me through part/most of the crash while still paying out the higher rates from when it was a bad buy. Though I'm young enough (AKA I missed this last crash in 2008) to not be able to put this through a test yet.

If anyone has evidence of this strategy not working, please post so I can correct myself before I get too deep

Long term Treasury bonds are generally not correlated with stock returns. And during market crashes like 2008, they have historically increased in price quite a bit. However, Fed interest rates are currently 0%. And are widely expected to increase. If they go up 1%, the long term bond fund could easily lose 20% of it's value due to the interest rate shift. Double that for a 2% interest rate hike. It's a risk.

scottish

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Re: Rising interest rate and bond fund?
« Reply #21 on: April 01, 2015, 09:25:17 PM »
I'm going to have $12K to invest this year, $1K per month.  Because the markets always go up, I'm going to borrow $12K and invest it right now, and then pay it back $1k per month.  Market timing versus dollar cost averaging?  I'll go with dollar cost averaging thank you.   Especially since I've experienced the result of bad timing by going all in too quickly.   Indexer, you should go all in because this is what you're comfortable with.   If you're wrong you'll find out.  If you're right, you'll find that out too.

eyem you've got it.   Bonds mitigate the risk of a market downturn.  Stocks mitigate the risk of high inflation.


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Re: Rising interest rate and bond fund?
« Reply #22 on: April 01, 2015, 10:48:20 PM »
Long term Treasury bonds are generally not correlated with stock returns. And during market crashes like 2008, they have historically increased in price quite a bit. However, Fed interest rates are currently 0%. And are widely expected to increase. If they go up 1%, the long term bond fund could easily lose 20% of it's value due to the interest rate shift. Double that for a 2% interest rate hike. It's a risk.
Thats what i dont get when you say that. If interest rates went up and the bond lost half its value, wouldnt that make it a good buy? Then during the crash, i would enjoy the 2% interest rate vs the near 0% of shorter term bonds? With 20% of my portfolio being bonds, and if they lost half their value, i still only lose 10% of portfolio, but in a crash and i lost half my stocks, i would lose 40% of portfolio value. In that case, wouldnt i be happy i bought the higher paying bonds? In a longer recovery, wouldnt the longer bond contract be even better becuase the short term ones expire and you get lower interest bonds earlier when you rebuy bonds
« Last Edit: April 01, 2015, 10:53:08 PM by eyem »

neil

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Re: Rising interest rate and bond fund?
« Reply #23 on: April 02, 2015, 08:48:05 AM »
You can easily use a bond calculator to estimate the impact of rate changes on prices.  Take the average maturity and sec yield as the base value and input a new rate.  Intermediate bonds fall far less because the time to maturity is much less and you can see that impact since it's basically simple math.

The real world problem is the fed controls the base rate.  Treasuries still float based on supply and demand.  If the rates go up 100 points and the market feels comfortable more are not coming, long term bonds may only move 50 points.  And with bond rates moving up, they become more attractive versus stocks - and this creates outflows from stocks and into bonds.  (It can easily go the other way as well.)

That's what makes bonds just as hard to predict as stocks.  Prices are still dictated more by investor supply and demand than fed decisions for the most part - unless they do something rash.
« Last Edit: April 02, 2015, 11:11:05 AM by neil »

forummm

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Re: Rising interest rate and bond fund?
« Reply #24 on: April 02, 2015, 10:30:30 AM »
Long term Treasury bonds are generally not correlated with stock returns. And during market crashes like 2008, they have historically increased in price quite a bit. However, Fed interest rates are currently 0%. And are widely expected to increase. If they go up 1%, the long term bond fund could easily lose 20% of it's value due to the interest rate shift. Double that for a 2% interest rate hike. It's a risk.
Thats what i dont get when you say that. If interest rates went up and the bond lost half its value, wouldnt that make it a good buy? Then during the crash, i would enjoy the 2% interest rate vs the near 0% of shorter term bonds? With 20% of my portfolio being bonds, and if they lost half their value, i still only lose 10% of portfolio, but in a crash and i lost half my stocks, i would lose 40% of portfolio value. In that case, wouldnt i be happy i bought the higher paying bonds? In a longer recovery, wouldnt the longer bond contract be even better becuase the short term ones expire and you get lower interest bonds earlier when you rebuy bonds

I don't think Treasuries have ever lost half their value. You'd have to have interest rates shoot up dramatically, and the Fed just doesn't do that in times like these.

It sounds like you could benefit from doing some more reading on the price of bonds and why they change. Why Bother With Bonds is one book that has that kind of information. But you can find that information online as well.

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Re: Rising interest rate and bond fund?
« Reply #25 on: April 02, 2015, 08:47:20 PM »
I meant that I just don't "care" what the face value of the bond is exactly. I'm getting bonds for the slow trickle of money. If I buy a bond for $1000 and it pays 3% interest, I'm buying that knowing that's what I bought. If interest rates goes up to 6%, sure it's nice to get more, but if I was happy with 3%, why would I not be happy with it still? If interest rates are high, then I'll buy more and be even happier? If interest rates go up, my stocks should too like I said above. When I rebalance and sell them to buy long term bonds. I'm getting the bonds locked in at a longer time period at the higher interest rate. In a market crash and interest rates drop, I'd have my 3% and 6% bonds paying instead of 0-1% bonds.

But yeah, I don't understand bonds well so my thinking on it is basic and possibly flawed. I wasn't saying the bonds would lose half their value, I'm just saying if it ever did, I'd only lose 10% of the portfolio if I only kept 20% bonds.

rocketpj

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Re: Rising interest rate and bond fund?
« Reply #26 on: April 02, 2015, 11:07:18 PM »
Hmm, DCA in practice for me is I buy as many of my index funds as I can whenever I put money into my tax sheltered accounts (every paycheque, as it happens).  Sometimes I have extra so I buy more, other times I am a bit short of my usual.  But my income fluctuates independently of the market so there is no point fiddling with it.

If I had a lump sum I'd invest it just as I always do with smaller sums - right away.  Buy and hold forever, no matter what (preretirement anyway).