Author Topic: The current case for bonds in asset allocation  (Read 17593 times)

Gonzo

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The current case for bonds in asset allocation
« on: January 19, 2016, 10:48:15 PM »
First post.  I hope my questions are OK.  :)

I am not a 100% stock investor, but most of what is typically considered "fixed income" I hold in a high yield savings account and laddered CDs.  I do not own any bonds or bond mutual funds.  I think most people would refer to this as a cash holding. 

I do not have the best understanding of bonds so I want to discuss my main questions about them.  In discussions about asset allocation, I'm generally left wondering why anyone would buy bond mutual funds TODAY.  That doesn't make it wrong to buy bond mutual funds, but I do not because I cannot justify it in this environment.

With the current incredibly low interest rates and they likelihood of future rate increases, and with competitive offerings for high yield savings accounts and online bank CDs, is there a good reason to buy bonds for fixed income?  Do those reasons offset the risk of lost principal?  Specifically which types of bond mutual funds do you think should be owned for fixed income? 


mcampbell

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Re: The current case for bonds in asset allocation
« Reply #1 on: January 20, 2016, 02:51:02 AM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

AdrianC

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Re: The current case for bonds in asset allocation
« Reply #2 on: January 20, 2016, 07:47:31 AM »
It's a great question.

Here's Warren Buffett's answer:

“You shouldn’t be 40% in bonds…I would have productive assets. I would favor those enormously over fixed dollar investments now, and I think it’s silly to have some ratio like 30 or 40 or 50% in bonds. They’re terrible investments now…” Warren Buffett on CNBC May 2013

http://video.cnbc.com/gallery/?video=3000166399

"If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I'd do it," he said. "But that's not my game, and it can't be done in the kind of quantity that would make sense for us," he said. "But I think that bonds are very overvalued. I'll put it that way." Warren Buffett on CNBC May 2015

http://www.cnbc.com/2015/05/04/buffett-stocks-vs-bonds-dividends-vs-buybacks.html

ac

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Re: The current case for bonds in asset allocation
« Reply #3 on: January 20, 2016, 07:55:41 AM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

+1

I keep hearing people talk about high yield savings accounts, and I don't know where these things are.

Where are they?  What are they?

Heckler

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Re: The current case for bonds in asset allocation
« Reply #4 on: January 20, 2016, 08:18:15 AM »
CCP has enough convincing articles about holding a portfolio calming number of bonds.  Read them.

http://canadiancouchpotato.com/category/bonds/

Enough to convince me to buy 12k worth on Monday in my RSP to bring me up to my 30% AA, even though my TSX index is also low.  Ill be using my TFSA to prop up the TSX allocation instead.

Heckler

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Re: The current case for bonds in asset allocation
« Reply #5 on: January 20, 2016, 08:19:33 AM »
I set my AA a year ago, so there is no "current" case for the decision.  I am my own Robo Advisor!

GGNoob

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Re: The current case for bonds in asset allocation
« Reply #6 on: January 20, 2016, 08:23:13 AM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

+1

I keep hearing people talk about high yield savings accounts, and I don't know where these things are.

Where are they?  What are they?

That's at least what the companies always call them.

My Schwab Bank "High Yield" Investor Checking Account earns just 0.06% APY...high yield my ass.

Heckler

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Re: The current case for bonds in asset allocation
« Reply #7 on: January 20, 2016, 08:26:37 AM »
HIS are for the most part also taxable accounts, with interest at marginsl tax rates.  Hows that going for your fixed income?

P0IS0N

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Re: The current case for bonds in asset allocation
« Reply #8 on: January 20, 2016, 10:16:43 AM »
Although short term analysis isn't that relevant for long-term investing, you can see the "current case" by comparing how bonds are doing since the beginning of the year, compared to S&P 500 or total stock indices.

ZiziPB

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Re: The current case for bonds in asset allocation
« Reply #9 on: January 20, 2016, 11:41:42 AM »
I set my AA a year ago, so there is no "current" case for the decision.  I am my own Robo Advisor!
+1

CorpRaider

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Re: The current case for bonds in asset allocation
« Reply #10 on: January 20, 2016, 01:12:06 PM »
Bogle says to own intermediate term treasuries for ballast.  Read his little common sense investing or whatever book, if you care to learn more.  I've read articles making the case that treasuries should have a negative coupon due to the inverse correlation with "the stock market."  I think they're up like 3% YTD and at least historically you don't lose much CAGR in a 60-40% portfolio versus a 100% equities or 90-10 or whatever (of course even small changes in the CAGR can make pretty big impacts over 30 years), assuming you rebalance at least annually.  Check out portfoliovisualizer dot com if you want to tinker with the historical data.

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #11 on: January 20, 2016, 05:34:35 PM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

About 1% is right.  I use Synchrony, 1.05%. It may be possible to do slightly better.  You can get 5 year CDs that pay 2.25%.

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #12 on: January 20, 2016, 05:35:57 PM »
It's a great question.

Here's Warren Buffett's answer:

“You shouldn’t be 40% in bonds…I would have productive assets. I would favor those enormously over fixed dollar investments now, and I think it’s silly to have some ratio like 30 or 40 or 50% in bonds. They’re terrible investments now…” Warren Buffett on CNBC May 2013

http://video.cnbc.com/gallery/?video=3000166399

"If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I'd do it," he said. "But that's not my game, and it can't be done in the kind of quantity that would make sense for us," he said. "But I think that bonds are very overvalued. I'll put it that way." Warren Buffett on CNBC May 2015

http://www.cnbc.com/2015/05/04/buffett-stocks-vs-bonds-dividends-vs-buybacks.html

Thanks. 

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #13 on: January 20, 2016, 05:37:09 PM »
HIS are for the most part also taxable accounts, with interest at marginsl tax rates.  Hows that going for your fixed income?

That's true, though CDs can easily be purchased in an IRA. 

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #14 on: January 20, 2016, 05:44:03 PM »
Although short term analysis isn't that relevant for long-term investing, you can see the "current case" by comparing how bonds are doing since the beginning of the year, compared to S&P 500 or total stock indices.

That's true, there is a slight capital appreciation for VBMFX and a decent yield. 

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #15 on: January 20, 2016, 05:51:22 PM »
Bogle says to own intermediate term treasuries for ballast.  Read his little common sense investing or whatever book, if you care to learn more.  I've read articles making the case that treasuries should have a negative coupon due to the inverse correlation with "the stock market."  I think they're up like 3% YTD and at least historically you don't lose much CAGR in a 60-40% portfolio versus a 100% equities or 90-10 or whatever (of course even small changes in the CAGR can make pretty big impacts over 30 years), assuming you rebalance at least annually.  Check out portfoliovisualizer dot com if you want to tinker with the historical data.

Thanks.  I may need to read his book.  Why would I want a negative correlation to the stock market in a long-term holding that I do not plan to access for many years?  I expect the stock market to go up long-term. 

thriftyc

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Re: The current case for bonds in asset allocation
« Reply #16 on: January 20, 2016, 09:20:21 PM »
As someone who just FIRED - I am in 40% short term bond Vanguard ETF's   Helps me sleep at night - especially during times like we are having recently. 
The additional benefits for me are: 
(1) Rebalancing when stocks are on sale
(2) When stocks are down - prevents me from selling shares of stock, instead I get income from the bonds and sell some shares of bonds while they are high.

Have to find a mix that works for YOU.
« Last Edit: January 20, 2016, 09:22:39 PM by thriftycanadian »

MustacheAndaHalf

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Re: The current case for bonds in asset allocation
« Reply #17 on: January 21, 2016, 12:15:44 AM »
I don't see an explanation of bonds, 0% rates or rising rates, so here goes.  The key thing is "duration", which is the impact to a bond fund when rates rise.  It's like measuring the time the bonds have left, making assumptions about key clauses, and reducing it to one number - the duration.  If rates rise 0.25% for all bonds, then a bond fund with duration 5.0 years winds up with a 5.0 x 0.25 = 1.25% impact, or loss.  But the bond is immediately earning +0.25% more per year, so after 5.0 years the 1.25% loss has been balanced out by the 5 years x 0.25% gains.  You can view "duration" as the time a change in interest rates takes to wash away (5 years in this example).

Are your CDs in a taxable account?  Earning 2.0% before taxes, for most people, equates to 1.5% after the median 25% Federal tax rate is applied.  A tax-exempt bond fund (typically holding municipal bonds) might be better, but it varies with your tax rate.

The most comparable bond to a certificate of deposit would probably be a US Treasury Bond.  Right now a 5-year treasury is only earning 1.4% according to the US Treasury website.  You pay Federal tax on a treasury, so with a 25% tax rate you're looking at 1.05% after tax.  Right now, CD rates seem better.
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

CorpRaider

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Re: The current case for bonds in asset allocation
« Reply #18 on: January 21, 2016, 12:39:51 PM »
Bogle says to own intermediate term treasuries for ballast.  Read his little common sense investing or whatever book, if you care to learn more.  I've read articles making the case that treasuries should have a negative coupon due to the inverse correlation with "the stock market."  I think they're up like 3% YTD and at least historically you don't lose much CAGR in a 60-40% portfolio versus a 100% equities or 90-10 or whatever (of course even small changes in the CAGR can make pretty big impacts over 30 years), assuming you rebalance at least annually.  Check out portfoliovisualizer dot com if you want to tinker with the historical data.

Thanks.  I may need to read his book.  Why would I want a negative correlation to the stock market in a long-term holding that I do not plan to access for many years?  I expect the stock market to go up long-term.

The negative correlation with lower volatility and up volatility adjusted returns.  If you know you can greet a 50% decline in the quoted value of your stocks with "equanimity" then yeah you probably don't need any, but if one is just a noob, bull market genius, who will panic after you are down a couple hundred thousand dollars the next time we get a 50% drawdown and "adjust" asset allocation, then you would probably be better off going in with a more balance asset allocation. 

Interest Compound

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Re: The current case for bonds in asset allocation
« Reply #19 on: January 21, 2016, 07:17:04 PM »
Kevin M. from over at Bogleheads has been promoting CDs over Bonds for years. It's definitely a viable alternative, it just takes a bit of work (not much really) settings things up. He recently wrote a 3 part series on his blog giving his review of the last 5 years he's been doing it:

http://www.kevinoninvesting.com/2015/10/cd-5-year-report-card-part-1.html





Risk vs Reward:

dungoofed

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Re: The current case for bonds in asset allocation
« Reply #20 on: January 22, 2016, 03:17:49 AM »
Two things I want to add to this thread:

1) Rising rates are not a given. If we were to enter a period of negative interest rates, say -1%, then the 3% offered on 30-year bond 912810RP5 auctioned a week ago would be very attractive. You've effectively got 4% more dry powder each year than anyone who had their money in cash. If the market doesn't recover for another 10 years and you kept buying into the market with this 4% yield then you would be at a massive advantage to people without bonds. Alternatively, you could sell the bonds for much more than you paid for them, and use this money to fund a massive stock purchase.

2) http://www.nytimes.com/2016/01/24/magazine/why-are-corporations-hoarding-trillions.html

I think this article is relevant.

"The notion that a corporation would hold on to so much of its profit seems economically absurd, especially now, when it is probably earning only about 2 percent interest by parking that money in United States Treasury bonds. These companies would be better off investing in anything — a product, a service, a corporate acquisition — that would make them more than 2 cents of profit on the dollar, a razor-thin margin by corporate standards. And yet they choose to keep the cash."

There are a bunch of reasons a company would keep their money in cash/treasuries. Buffet too, he's no stranger to keeping money as cash/treasuries. BRK has increased cash/treasury holdings from $25 billion to almost $70 billion since 2007 so he's not practicing what he preaches.

AdrianC

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Re: The current case for bonds in asset allocation
« Reply #21 on: January 22, 2016, 05:59:12 AM »
There are a bunch of reasons a company would keep their money in cash/treasuries. Buffet too, he's no stranger to keeping money as cash/treasuries. BRK has increased cash/treasury holdings from $25 billion to almost $70 billion since 2007 so he's not practicing what he preaches.

Buffett has cash or cash equivalents (short term treasuries) waiting for investment opportunities. He's always done this, and I'm happy he does (long time BRK shareholder). He has no significant holdings of 30 year treasury bonds.

dungoofed

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Re: The current case for bonds in asset allocation
« Reply #22 on: January 22, 2016, 07:14:07 AM »
Wait. This might be cultural.

"You shouldn’t be 40% in bonds…I would have productive assets. I would favor those enormously over fixed dollar investments now, and I think it’s silly to have some ratio like 30 or 40 or 50% in bonds. They’re terrible investments now…” Warren Buffett on CNBC May 2013

He's using "bonds" to refer to "bonds that are not short term treasury bonds"?

AdrianC

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Re: The current case for bonds in asset allocation
« Reply #23 on: January 22, 2016, 10:35:24 AM »
He's using "bonds" to refer to "bonds that are not short term treasury bonds"?

My second Buffett quote:

"If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I'd do it," he said. "But that's not my game, and it can't be done in the kind of quantity that would make sense for us," he said. "But I think that bonds are very overvalued. I'll put it that way." Warren Buffett on CNBC May 2015

Short term treasuries are just cash equivalents. Long term bonds - treasuries or not - are what Buffett is referring to as overvalued.

He might be wrong - he tends to be optimistic about economic growth. He "bets on America".

CorpRaider

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Re: The current case for bonds in asset allocation
« Reply #24 on: January 22, 2016, 11:35:30 AM »
Yeah, he's been sort of totally wrong about that since then too, just saying.  Bogle likes intermediate term treasuries, he's not saying load up on duration.  I don't own any personally, I've got access to G fund and have never maxed out annual space for I bonds. 

StacheEngineer

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Re: The current case for bonds in asset allocation
« Reply #25 on: January 24, 2016, 06:24:47 PM »
It's not clear to me (or the market) that U.S. interest rates will return to say 4-5% in a short amount of time. Japan, EU and China are all printing as much money as they can and lowering interest rates due to their weak economies. While the U.S. doesn't depend on trade quite as much as China, it is exposed to the world economy and if the rest of the world enters an outright recession, the U.S. probably will too which implies the Fed will lower interest rates and/or start quantitative easing. Even if we expect U.S. rates to rise, the market is only pricing in two interest rate hikes for all of 2016 which will bring rates to ~0.75%. Two more years at that rate of raising will bring rates to only 1.25%. And that is assuming that even if the rest of the world doesn't bring the U.S. down, just the end of the business cycle (the U.S. hasn't had a recession in ~7 years now) will force the Fed to either stop or lower rates.

Psychstache

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Re: The current case for bonds in asset allocation
« Reply #26 on: January 24, 2016, 07:34:38 PM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

+1

I keep hearing people talk about high yield savings accounts, and I don't know where these things are.

Where are they?  What are they?

That's at least what the companies always call them.

My Schwab Bank "High Yield" Investor Checking Account earns just 0.06% APY...high yield my ass.
Off topic, but I would check your local credit union. I use a CU for my checking account and they pay 2.5% right now.

Sent from my SM-G900V using Tapatalk


Ursus Major

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Re: The current case for bonds in asset allocation
« Reply #27 on: January 24, 2016, 08:38:46 PM »
I'd also say pick short-term to intermediate bonds. I am leaning more to intermediate, because I believe that the raise in interest rates will be gradual. In my company's 401(k) (managed by Vanguard) I picked MWTIX (Metropolitan West Total Return Bond I), as it was the only intermediate bond fund available.

Another interesting possibility (though only in small quantities) are I-bonds from the treasury. You can buy up to $10k a year (plus some extra from your income tax refund IIRC) and after one year can sell them with only 3 months loss of interest and after 5 years with no loss of interest. They have a fixed interest rate, and additionally will adjust for inflation. You can read more about them here: https://www.treasurydirect.gov/indiv/products/prod_ibonds_glance.htm

I believe though that you have to keep them in a taxable account. However they are excluded from state income tax.

faramund

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Re: The current case for bonds in asset allocation
« Reply #28 on: January 24, 2016, 09:49:45 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

 

Ursus Major

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Re: The current case for bonds in asset allocation
« Reply #29 on: January 24, 2016, 10:46:28 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.

faramund

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Re: The current case for bonds in asset allocation
« Reply #30 on: January 24, 2016, 11:58:20 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.

I don't think I disagree with anything you've written, I was just pointing out the direction that value changes. Which is what's also in the vanguard site you show - if interest rates go up by 2%, values drop (and yes you're right, it drops more for long-term funds).

MustacheAndaHalf

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Re: The current case for bonds in asset allocation
« Reply #31 on: January 25, 2016, 01:58:54 AM »
In case OP is still following, think of your bond after rates change.  If your bond earns $50 while everyone else's earns $30, yours is better.  So a $1000 bond at 5% rises in value when rates fall to 3%.  Everyone wants the higher rate bond, and the price changes to reflect it.

Annoying thing about duration, you can't compare short-term and long-term rates without assuming that all bond prices change by the same amount.  When 2-year bonds fall 0.25%, it might not become a 0.25% drop for 10-year bonds.  Take a look at treasury yield curves, and note how they can change at different rates.

RedmondStash

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Re: The current case for bonds in asset allocation
« Reply #32 on: January 25, 2016, 09:24:54 AM »
I don't know about fixed income, but here's how I think about bonds and stocks generally.

Inflation means that if your money doesn't grow, it becomes worth less over time. Putting money in a mattress means you lose value. Putting money in a low-yield savings account means you still lose value if the rate of return is lower than inflation, which it often is.

The stock market has the highest long-term rate of return, but that's over decades. Over a span of a few years, it is highly volatile and unpredictable.

The bond market is sort of in between: higher return than your mattress, lower long-term return than the stock market, but also far less volatile in the short term.

I like the idea of investing in a bond fund (Vanguard's VBTLX, the total-market bond fund) as a protection for my stock investments over the short term. If stocks take a beating, like they did last year, you can draw from your bond investments to pay your bills and not have to sell your stocks and lose money on them. Over years and decades, I believe stocks will recover and gain in value. I don't want to have to sell them when they're down.

Not sure if that hits your question exactly, but I hope it helps.

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #33 on: January 25, 2016, 10:01:54 PM »
In case OP is still following, think of your bond after rates change.  If your bond earns $50 while everyone else's earns $30, yours is better.  So a $1000 bond at 5% rises in value when rates fall to 3%.  Everyone wants the higher rate bond, and the price changes to reflect it.

Annoying thing about duration, you can't compare short-term and long-term rates without assuming that all bond prices change by the same amount.  When 2-year bonds fall 0.25%, it might not become a 0.25% drop for 10-year bonds.  Take a look at treasury yield curves, and note how they can change at different rates.

I am still following.  Do you think there is opportunity for significant capital appreciation right now?  I think bond investors are more likely to see capital depreciation, though I can't know for sure. 

dungoofed

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Re: The current case for bonds in asset allocation
« Reply #34 on: January 26, 2016, 01:12:30 AM »
http://www.bloomberg.com/news/articles/2016-01-25/goldman-s-cohn-says-sell-treasuries-morgan-stanley-is-bullish

There's still no consensus as to which way bonds will go from even the biggest players in the game.

I think a better idea is just to stick with your asset allocation as per your IPS. If you buy BND and it goes down then you'll just buy more, while buying less gold/reits/stocks/whatever else is on a tear.

mrpercentage

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Re: The current case for bonds in asset allocation
« Reply #35 on: January 26, 2016, 01:15:40 AM »
High yield savings? I've not seen anything higher then 1%. Vanguard VBMFX total bond, is yielding 2.27% coupon plus in most years it has appreciated in value.

For now. Interest rates are supposed to be going up. Bonds don't lose value often but they can. They are not the same as cash and should never be treated like they are.

Scandium

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Re: The current case for bonds in asset allocation
« Reply #36 on: January 26, 2016, 07:04:35 AM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.
Just remember that if your holding period is longer than the funds duration you're better off when rates rise, as the increased yield compensate for the lowered price of the fund.

faramund

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Re: The current case for bonds in asset allocation
« Reply #37 on: January 26, 2016, 03:30:35 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.
Just remember that if your holding period is longer than the funds duration you're better off when rates rise, as the increased yield compensate for the lowered price of the fund.
Yes, but only for new bonds.

Say you buy bonds in 2015, and then in 2016 rates go up. Then your bonds from 2015 will lose money, but then if you buy new bonds after the rates go up - you will get a higher interest rates on those bonds.

If you buy $100 of bonds in 2015, and they pay 2% ($2). In 2016, if rates got up to 4%, then your bonds would drop in value, maybe to around $50.. so then that $2 would be 4%.. but its still just $2.

Scandium

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Re: The current case for bonds in asset allocation
« Reply #38 on: January 26, 2016, 05:14:45 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.
Just remember that if your holding period is longer than the funds duration you're better off when rates rise, as the increased yield compensate for the lowered price of the fund.
Yes, but only for new bonds.

Say you buy bonds in 2015, and then in 2016 rates go up. Then your bonds from 2015 will lose money, but then if you buy new bonds after the rates go up - you will get a higher interest rates on those bonds.

If you buy $100 of bonds in 2015, and they pay 2% ($2). In 2016, if rates got up to 4%, then your bonds would drop in value, maybe to around $50.. so then that $2 would be 4%.. but its still just $2.
Yes I know that. But I was referring to bond funds, not individual bonds. With a fund this won't matter, if your holding period is longer than the duration. Old, lower price, bonds rotate out, and new, higher yield bonds rotate into the fund giving you a higher yield. (provided the duration doesn't change over time I suppose).

faramund

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Re: The current case for bonds in asset allocation
« Reply #39 on: January 26, 2016, 05:35:42 PM »
Interest rates don't have to double to make holding bonds unprofitable. If you are holding long time bonds, every time interest rates go up - they lose value, and every time they go down - then gain value.

So the question is, over however long you intend to hold a bond for, will interest rates go up (or down) at all.

I believe that it is a little more complicated. Perhaps I'm misunderstanding you, but for me talking about duration is not about holding bonds to maturity (I was actually more thinking about a bond fund than individual bonds), but about interest rate sensitivity.

The longer the time to maturity, the more sensitive the bond is to interest rate changes. For bond funds, this is measured by the duration: https://investor.vanguard.com/insights/bond-fund-basics-duration

One the other hand the longer the time to maturity, the higher the yield.

So the key is to find the sweet spot, between a good yield and an acceptable duration (and thus interest rate sensitivity). Where the sweet spot is in term of yield & duration combo depends on your outlook on how fast and how high interest rates will rise.
Just remember that if your holding period is longer than the funds duration you're better off when rates rise, as the increased yield compensate for the lowered price of the fund.
Yes, but only for new bonds.

Say you buy bonds in 2015, and then in 2016 rates go up. Then your bonds from 2015 will lose money, but then if you buy new bonds after the rates go up - you will get a higher interest rates on those bonds.

If you buy $100 of bonds in 2015, and they pay 2% ($2). In 2016, if rates got up to 4%, then your bonds would drop in value, maybe to around $50.. so then that $2 would be 4%.. but its still just $2.
Yes I know that. But I was referring to bond funds, not individual bonds. With a fund this won't matter, if your holding period is longer than the duration. Old, lower price, bonds rotate out, and new, higher yield bonds rotate into the fund giving you a higher yield. (provided the duration doesn't change over time I suppose).
I only know about bonds 'in theory', but I thought there wouldn't be any real difference between what happens with individual bonds, or a bond fund. So I don't think I have anything more worthwhile to say about this (well, at least for now).

Indexer

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Re: The current case for bonds in asset allocation
« Reply #40 on: January 27, 2016, 05:34:59 AM »
First post.  I hope my questions are OK.  :)

I am not a 100% stock investor, but most of what is typically considered "fixed income" I hold in a high yield savings account and laddered CDs.  I do not own any bonds or bond mutual funds.  I think most people would refer to this as a cash holding. 

I do not have the best understanding of bonds so I want to discuss my main questions about them.  In discussions about asset allocation, I'm generally left wondering why anyone would buy bond mutual funds TODAY.  That doesn't make it wrong to buy bond mutual funds, but I do not because I cannot justify it in this environment.

With the current incredibly low interest rates and they likelihood of future rate increases, and with competitive offerings for high yield savings accounts and online bank CDs, is there a good reason to buy bonds for fixed income?  Do those reasons offset the risk of lost principal?  Specifically which types of bond mutual funds do you think should be owned for fixed income?

This is a pretty common misunderstanding. You don't buy bonds for growth. Long term they will lose out to stocks in almost all cases. You also don't buy bonds for 100% stability. Cash is better at that.

You buy bonds as a HEDGE. When stocks crash people seek safety. People either move money into cash or bonds. Banks can take on an almost infinite amount of cash so when money goes into cash all that happens is that deposit rates drop. Bonds have a very large supply, but it isn't infinite. So when money shifts from the stock market to the bond market existing bonds appreciate in value! This is especially true for high quality bonds like US government bonds. When the Vanguard Total stock index took a hit in 2008 the Vanguard Total bond index was up about 5%. That is why you own bonds. They allow you to control the risk/return profile of your portfolio, and they do it a whole lot better than cash.

A 75% stock/25% bond portfolio has historically had better returns and lower risk than a 75% stock/25% cash portfolio. It is a far more efficient portfolio. It is because stocks and bonds hedge each other to a degree that cash does not. By adding bonds to an existing stock portfolio you can decrease risk a lot without having a huge impact on returns. Historically a 100% stock portfolio has averaged around 10%, but can drop 50% in a crash. On the other hand a 60/40 has historically averaged almost 9% and tends to drop about 25-26% in a major(2008/1929) crash. Historically you would be giving up about 1% return per year to cut your volatility almost in half. Yes, that is pretty $&%^ing powerful!

Once you look at bonds that way who cares what interest rates do? On that note, economists predictions for interest rate movements are wrong over 50% of the time, and honestly if you plan on owning a bond fund for the long term you want higher interest rates! Sure existing bonds take a small hit in the short term, but having bonds paying out higher yields long term more than makes up for that. A great example of economists predictions being wrong would be late 2013-2014. After the fed ended QE everyone thought interest rates would rise quickly. Bonds took a big hit in late 2013. Then in 2014 thanks to global turmoil interest rates actually went down a bit, and bonds were one of the best performing asset classes in 2014. Stick to your long term plan. Ignore the talking heads. It is true with stocks, and it is true with bonds.

Oh, and my retirement savings are currently 100% stock. My current AA target just doesn't have bonds in it. I still have a good time frame and a very high tolerance for risk, but once my AA target does include bonds(in a few years) I will start adding them regardless of prevailing interest rates or interest rate expectations.
« Last Edit: January 27, 2016, 05:39:33 AM by Indexer »

aperture

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Re: The current case for bonds in asset allocation
« Reply #41 on: January 27, 2016, 06:38:34 PM »
A 75% stock/25% bond portfolio has historically had better returns and lower risk than a 75% stock/25% cash portfolio. It is a far more efficient portfolio. It is because stocks and bonds hedge each other to a degree that cash does not. By adding bonds to an existing stock portfolio you can decrease risk a lot without having a huge impact on returns. Historically a 100% stock portfolio has averaged around 10%, but can drop 50% in a crash. On the other hand a 60/40 has historically averaged almost 9% and tends to drop about 25-26% in a major(2008/1929) crash. Historically you would be giving up about 1% return per year to cut your volatility almost in half. Yes, that is pretty $&%^ing powerful!

+1 - spoken like Burt Malkiel himself. -Ap

MustacheAndaHalf

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Re: The current case for bonds in asset allocation
« Reply #42 on: January 28, 2016, 11:42:51 AM »
...
Do you think there is opportunity for significant capital appreciation right now?  I think bond investors are more likely to see capital depreciation, though I can't know for sure.
Nobody can predict interest rates, so I don't know.

If you don't want to see your loses, consider a 5-year CD instead of a bond fund.  Total Bond Market and 5 year CDs offer similar yields right now.  In a CD you will still have missed an opportunity for higher rates if they go up, but you won't see it.  It might be easier to stomach.

LAGuy

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Re: The current case for bonds in asset allocation
« Reply #43 on: January 28, 2016, 12:08:54 PM »
For the early retirement investor there's no good reason for a large slug of your investments to be in bonds. That goes doubly so at current yields, as yields are the biggest predictor of what kind of return you'll get in bonds. If you need bond appreciation for your bond investment to be worthwhile, then you're just speculating and you may as well be in stocks.

It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market. And if that's you as well, then great. Buy your bonds "so you can sleep at night." But here's the thing, your final investment allocation is going to look a lot like mine minus the bonds. That is, if you decide you need a million dollars to retire with your 30% bonds, you'll still be 70% stocks ($700,000). My all stock retirement is going to basically be the same, but 100% stocks and $700,000. You'll have definitely worked longer to get that nest egg. I'll have worked less, BUT maybe things don't work out for me and down the line I'll have to grab some income from somewhere. What's the difference? The bond investor DEFINITELY works longer. Me? MAYBE work the same as the bond investor.

So, if you want to work longer now to have your warm blanket, go ahead and build up your bond allocation. If, on the other hand you want to retire sooner with the realization that down the line you might have to be flexible about working here and there then forget the bonds and just buy stocks. And that's really what these arguments come down to: for some people, the idea of going back to work after retiring is HORRIBLE. It has absolutely nothing to do with the merits of owning stocks versus bonds. Because as an investment in and of themselves bonds are qualitatively worse than stocks. So, if the idea of working here and there in your retirement sounds horrific to you, you already know: you're a bond investor.

CorpRaider

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Re: The current case for bonds in asset allocation
« Reply #44 on: January 28, 2016, 12:18:30 PM »
Do I think is potential for significant capital appreciation?  I don't know, when you look at European sovereign bond yields compared to treasuries...

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Re: The current case for bonds in asset allocation
« Reply #45 on: January 28, 2016, 02:53:31 PM »
It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market.

Well, there is the rebalancing idea. Stocks go down and bonds go up, rebalance and sell high, buy low.


Geekenstein

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Re: The current case for bonds in asset allocation
« Reply #46 on: January 28, 2016, 04:56:31 PM »
For the early retirement investor there's no good reason for a large slug of your investments to be in bonds. That goes doubly so at current yields, as yields are the biggest predictor of what kind of return you'll get in bonds. If you need bond appreciation for your bond investment to be worthwhile, then you're just speculating and you may as well be in stocks.

It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market. And if that's you as well, then great. Buy your bonds "so you can sleep at night." But here's the thing, your final investment allocation is going to look a lot like mine minus the bonds. That is, if you decide you need a million dollars to retire with your 30% bonds, you'll still be 70% stocks ($700,000). My all stock retirement is going to basically be the same, but 100% stocks and $700,000. You'll have definitely worked longer to get that nest egg. I'll have worked less, BUT maybe things don't work out for me and down the line I'll have to grab some income from somewhere. What's the difference? The bond investor DEFINITELY works longer. Me? MAYBE work the same as the bond investor.

So, if you want to work longer now to have your warm blanket, go ahead and build up your bond allocation. If, on the other hand you want to retire sooner with the realization that down the line you might have to be flexible about working here and there then forget the bonds and just buy stocks. And that's really what these arguments come down to: for some people, the idea of going back to work after retiring is HORRIBLE. It has absolutely nothing to do with the merits of owning stocks versus bonds. Because as an investment in and of themselves bonds are qualitatively worse than stocks. So, if the idea of working here and there in your retirement sounds horrific to you, you already know: you're a bond investor.

Mathematically yes, practically no.

The first, and most important thing any investor must do is determine their (real) risk tolerance.  Just because I may be fine with an 100% stock allocation doesn't mean the OP, or anyone else is.  That's important, because tinkering with a portfolio once it has lost 50% of it's value is a bad time for that.  Finding the correct asset allocation for your risk tolerance is the most important way to ensure you achieve your goals. 

Once you have a handle on that, and assuming your allocation is not 100% stocks, you get to decide what to do with the remainder.  Whether that remainder goes to bonds, to CD's, or to some other vehicle is dependent upon a number of other factors.  One factor is the type of account the portfolio resides in.  It's pretty easy to ladder CD's in a taxable portfolio, but other accounts - for example 401k's - may not have this option.  So, you get to pick from the choices you have.

Then, stick with the plan. 




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Re: The current case for bonds in asset allocation
« Reply #47 on: January 28, 2016, 05:28:16 PM »
I'm doing 100% stocks, if/when I decide to do bonds, I will not sell stocks to buy bonds.  I'll leave my stocks alone and just buy bonds.  I should note that I'm still in the accumulation phase, so whether stocks go up or down is pretty irrelevant for me while I'm still accumulating. 

LAGuy

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Re: The current case for bonds in asset allocation
« Reply #48 on: January 28, 2016, 07:57:21 PM »
For the early retirement investor there's no good reason for a large slug of your investments to be in bonds. That goes doubly so at current yields, as yields are the biggest predictor of what kind of return you'll get in bonds. If you need bond appreciation for your bond investment to be worthwhile, then you're just speculating and you may as well be in stocks.

It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market. And if that's you as well, then great. Buy your bonds "so you can sleep at night." But here's the thing, your final investment allocation is going to look a lot like mine minus the bonds. That is, if you decide you need a million dollars to retire with your 30% bonds, you'll still be 70% stocks ($700,000). My all stock retirement is going to basically be the same, but 100% stocks and $700,000. You'll have definitely worked longer to get that nest egg. I'll have worked less, BUT maybe things don't work out for me and down the line I'll have to grab some income from somewhere. What's the difference? The bond investor DEFINITELY works longer. Me? MAYBE work the same as the bond investor.

So, if you want to work longer now to have your warm blanket, go ahead and build up your bond allocation. If, on the other hand you want to retire sooner with the realization that down the line you might have to be flexible about working here and there then forget the bonds and just buy stocks. And that's really what these arguments come down to: for some people, the idea of going back to work after retiring is HORRIBLE. It has absolutely nothing to do with the merits of owning stocks versus bonds. Because as an investment in and of themselves bonds are qualitatively worse than stocks. So, if the idea of working here and there in your retirement sounds horrific to you, you already know: you're a bond investor.

Mathematically yes, practically no.

The first, and most important thing any investor must do is determine their (real) risk tolerance.  Just because I may be fine with an 100% stock allocation doesn't mean the OP, or anyone else is.  That's important, because tinkering with a portfolio once it has lost 50% of it's value is a bad time for that.  Finding the correct asset allocation for your risk tolerance is the most important way to ensure you achieve your goals. 

Once you have a handle on that, and assuming your allocation is not 100% stocks, you get to decide what to do with the remainder.  Whether that remainder goes to bonds, to CD's, or to some other vehicle is dependent upon a number of other factors.  One factor is the type of account the portfolio resides in.  It's pretty easy to ladder CD's in a taxable portfolio, but other accounts - for example 401k's - may not have this option.  So, you get to pick from the choices you have.

Then, stick with the plan.

I think if you lack risk tolerance, maybe you shouldn't be investing and thinking about early retirement. Even with a large bond percentage in a downturn, you're still going to be carrying 60-70% stocks. And you're still going to be seeing a stomach wrenching loss in your portfolio. And now, we're to believe that Mr Safetypants is going to move their precious bonds into stocks right at the moment when it seems like the whole world is on fire? When, like in the depths of 2008-2009, people were having serious discussions that Bank of America might go bankrupt?

And for bond lovers, that's usually the only case they can point out where bonds are worthwhile. Go look at the investment quilts. For that one year where bonds outperform stocks (and only because stocks did poorly, not because bonds did great or anything) you've got another nine years or so where bonds and cash are in an epic battle for dead last place.

The only time I can think to invest in bonds: when you've already got more money than you'll ever need. Why roll the dice at that point? And that's what people that are accumulating large bond portfolios are essentially doing. Working and paying taxes  to the government longer in order accumulate more money then they will probably need. All done in service to the comforting warm blanket of lending your money back to the very same government. Crap, I almost sound Libertarian (I'm not by a long shot).

Gonzo

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Re: The current case for bonds in asset allocation
« Reply #49 on: January 28, 2016, 09:10:40 PM »

You buy bonds as a HEDGE. When stocks crash people seek safety. People either move money into cash or bonds. Banks can take on an almost infinite amount of cash so when money goes into cash all that happens is that deposit rates drop. Bonds have a very large supply, but it isn't infinite. So when money shifts from the stock market to the bond market existing bonds appreciate in value! This is especially true for high quality bonds like US government bonds. When the Vanguard Total stock index took a hit in 2008 the Vanguard Total bond index was up about 5%. That is why you own bonds. They allow you to control the risk/return profile of your portfolio, and they do it a whole lot better than cash.


That's the most compelling argument I have heard for bonds.  Thanks for posting.