The Asset Allocation thread is by far the most popular, but I fear it is becoming a catch all, I am guilt as charged. So I am pulling out the discussion on Bonds into its own thread.
I still struggle with understanding bonds, specifically why they go up and down, meaning how much money will they make me over time. This is from an AP article:
In the meantime, optimism is rising in financial markets not only for a soft landing but for an acceleration of growth. Last week, the Fed’s Atlanta branch estimated that the economy is growing at a blistering 5.8% annual rate in the current July-September quarter – more than double its pace last quarter. That estimate is likely too high, but it still suggests the economy is likely accelerating from last quarter’s 2.4% rate. Such expectations have helped fuel a surge in bond yields, notably for the 10year Treasury note, which heavily influences long-term mortgage rates. The 10year yield, which was around 3.75% in mid-July, has soared to 4.3%, its highest level in 15 years.
The jump in Treasury yields has likely been driven, in part, by the government’s ramped-up sale of bonds to finance gaping budget deficits. At the same time, the Fed is no longer buying bonds as it did during and after the pandemic recession to drive down borrowing rates. Many central banks overseas have also stopped or reduced their bond purchases. Banks and some investors are wary, too, given the potential for rates to rise further and reduce the value of their existing bonds.
So what does that mean??
What kind of bonds and bonds funds are people investing in?? I ask because if you look at bond funds like AGG and VBTIX, their 10 year returns are in the 1.37% range. Presently 10-year US Treasuries are at 4.40%. I understand you can sell bond funds whenever you want and treasuries might have future interest risk if you want to sell them before maturity and rates at that time may be higher, but a 3.03% advantage is hard to beat, no??
When you look at 10 year returns vs. current yields, you are comparing apples and oranges. The historical returns are awful because of the interest rate rise in 2022 that investors 10 years ago did not anticipate. Meanwhile the current yield on Treasuries are obviously priced based on current inflation and interest rate expectations.
Since your question seems like it shows a misunderstanding, I'm going to go back to basics. The Bogleheads.org wiki probably explains it better than I, but here's my shot at it.
As a bond buyer you are simply a lender, writing a contract to lend someone money for an interest rate and duration. You can choose the creditworthiness of who you lend to (Treasuries > Investment grade businesses > ”High yield” junk bonds). You can also choose the duration of the loan (term of a bond or average duration of a fund). There are some other variations that offer inflation protection (TIPS, I-bonds), no regular payments (strips), no federal taxes (Munis), etc.
Like any lender you have more risk that interest rates may rise during the term of the loan on longer loans, so you want higher interest rates to compensate you for that risk. Right now, expectations are that interest rates will be high, maybe even go up in the short term and then come down, so the yield curve is inverted, short term lenders are getting higher rates than long term. That highlights the third kind of risk, re-investment risk. That 5+% money market feels really good right now, but if 2022 plays out in reverse, folks holding lots of cash in money markets will wish you had lengthened maturities.
The PV function in Excel is useful to see how interest rate increases can hammer bond values. If you have invested $100 for 5 years at 1% with annual $1 coupon payments and interest rates are now 5%, then to equalize the present value vs. what an investor could get for a fresh 5% bond, your bond has to go down in price, the formula would be =PV(0.05,-1,5,-100), which is $82.68, ouch. But an increase from 5% to, say, 5.5% would cut the value of a 5 year bond to $97.48 - annoying, but hardly a crisis.
To better compare current Treasuries vs. total bond, you can look at the 4.8% yield to maturity of VBTIX with an average duration of 6.2 years. Since Treasuries have less credit risk, they yield a bit less than total bond funds. Some advisors advocate taking bonds are for safety, so you should take your risk on the stock side of things, so they stick with Treasuries or TIPS for bonds.
What’s right for you depends on your circumstances. An error that many made in 2021 was to hold bonds and funds with longer duration than the timeframe in which they needed the money. Funds keep duration roughly constant, so Total Bond funds with are not a good choice if you need the money next year. If you need money for a specific purpose, such as a bridge to SS, a solution is to use a ladder of bonds, with roughly equal amounts available to you each year for your spending needs (you can use the site tipsladder.com to see what to buy to make your own TIPS ladder). That decreasing duration as you spend it down could be simulated with a long and short duration bond fund and algebra to match duration, but a ladder is simpler conceptually. If I knew when I would retire, I might put some bonds in a ladder to cover the time to SS. As it is, I just hold bonds to balance portfolio risk, so I just hold BND (Vanguard Total Bond ETF).
Interesting, thanks. To dig a little deeper, what does 4.8% yield to maturity of VBTIX with an average duration of 6.2 years mean? If I hold the bond fund for 6.2 years I should get a 4.8% return on my investment? If I had bought VBTIX on Jan 1 2023, and sold it today, I would have made 0.08% return on my investment. I am a total-return investor vs an income investor, so for me investing in bonds is solely to reduce risk. You don't know how a bond fund is going to do over time, within reason. If you keep US Treasuries to maturity you know exactly what you are going to earn. So for me the only risk would be incurred if I sell before maturity. If I pick maturity lengths to match when I might need the money, I think I will be OK and very safe. Does that make sense??
Bond returns are predictable in most interest rate environments. When we get into extremes that can skew the predictability. I have been purchasing some intermediate term bond funds (mostly treasuries but some corporate) because of the fact that I can reasonably expect a 4.5% annualized return if I hold the fund long enough. Below, there is an explaination of what "long enough" means.
The article I am attaching decomposes (through modeling so there is some room for debate) the return components of 10-year treasuries from 1981 through 2012. They conclude that the coupon contributed 72% of the return while 25% was due to rate shifts and the remaining 3% was due to roll return.
They then conclude: “The consistency of coupon and the varying influence of shift on returns (i.e. both positive and negative) means that coupon yield actually makes an excellent predictor of future returns.”
They also go on to state: “Lozada (2015)[6] finds that the optimal horizon to use yield as a predictor of return in constant duration or constant-maturity bond funds is at twice the duration.
The twice the duration as a holding period bothered me until I read another paper that states that the 2XD is the worst case assuming interest rates are rising for the entire holding period.
As the paper by JP Morgan points out for the Agg case they presented, the optimal holding period is just 1XD. If you look at the graph in the JP Morgan paper, when rates were going up the annualized returns were less than the starting yield but when rates started declining, the annualized returns were higher than the starting yield.
My takeaway is that maybe we should think about what yield we want over what time frame making sure we recognize that we may need to have a holding period of somewhere a little less than the duration up to 2X of duration. In my opinion, I think given the environment we are in today that the 2XD is unlikely.
I am also attaching a link to a website where you can estimate the impact of rising rates. There is some documentation of how the model works and what it does and does not take into consideration.
Here are the various links.
https://www.bankeronwheels.com/bond-etf-calculator/
https://blog.thinknewfound.com/2017/04/declining-rates-actually-matter/
OK, now my brain really hurts 😫. Accurate yields, SEC yields, securitized bonds, historical price, yield to maturity, current market pricing, historical purchase price, annualized return, coupon, rate shifts, roll return, etc......Lions & Tigers & Bears, O my. Who knew that deciding what bonds to invest in is harder then what stock funds to invest in, let alone asset allocation between bonds and stocks.
So lets make it simple. Lets say that I need money to live on between 5 and 10 years from now.
Option one: Buy $10,000 in 5 yr US treasury bond (presently at 4.43%), $10,000 in 7 yr US Treasury bond (presently at 4.35%), and $10,000 in 10 yr US Treasury bond (presently at 4.23%). Will hold each one to maturity. No fees to buy and sell. No expenses ratio. No state taxes.
Option two: Buy $30,000 in VBTIX. Sell portions of it as needed. Assume selling 1/3 at 5 years, 1/3 at 7 years, 1/3 at 10 years for easy comparison. Include fees, expense ratio, taxes.
Which is best?? Please don't say "it depends" 🤐. You can pick a different bond fund if you like. Safety (low risk) and return on investment has equal weight in my decision. Lets say I am going to purchase one of the two options tomorrow, which one? How do I input this decision into PRC?
Sounds like fun, yes?
Allan Roth is my new hero 🙂 Here's a way to really geek out on it: https://www.advisorperspectives.com/articles/2022/10/24/the-4-rule-just-became-a-whole-lot-easier
He did a great piece on bond efficiency versus fixed-indexed annuities (and Wade Pfau) here: https://www.advisorperspectives.com/articles/2023/08/14/bonds-inflation-indexed-annuities-efficient-allan-roth The comments section where he and Wade go back and forth is really good, but you have to register to see that part.
Back to the question though, buying bonds instead of bond funds is fine for cases where you're sure you won't need the liquidity, won't need the money sooner than you anticipate. If they're non-callable, as Treasuries are, you don't have to worry about the issuer pulling the rug out from under you if rates drop.
Most folks these days go for the simplicity and low effort of using low-expense bond funds. If you have a longer timeframe and/or want higher yields, aggregate bond funds like VBTLX/BND contain highly rated corporate bonds, mortgage-backed bonds, etc. If you want a better inverse relationship with stocks (i.e. you're nervous when the stock market drops and want that inverse correlation of bonds going up) then treasuries bond funds are better. In rising rate environments like we've seen recently, short term funds like VGSH are good to capture those rising rates. When things settle down, intermediate term funds like VGIT are fine. Some folks just set it and forget it with intermediate term funds, and move on to actually doing other things in life other than micromanaging their investments. Some do the same with inflation protected funds like VTIP, even when inflation is decreasing as it is now, just for the safety of that protection.
If you have a huge amount of money, things like this can be very important. Or, if you have very little, just enough, and need to make every dollar count. But for most folks, it's just not worth the time, there isn't a huge difference, and the time spent managing it is sub-minimum wage effort when you could be having fun. Same with strategies like putting all your bonds in pre-tax accounts and stocks in brokerage. Be careful of the complexity things like this add (complexity means more mistakes, mistakes are expensive) and what your time is worth.
There is nothing wrong with holding individual Treasuries, many people do that and it avoids fund fees and you don't have to worry about credit quality or callability. You give up some yield vs. corporates for the (hopefully) high credit quality. If you need the money at specific times like your example that is another point in favor of individual Treasuries (or TIPS) in a non-rolling ladder like you described vs. a fund. The reason is duration matching between your needs and your assets. For instance, in your example, at year 5, when you need some money in the next few months, holding that money in a fund with 6+ year average duration like VBTIX is not appropriate, another 2022 could come along and hurt you and then you have no time to recover.
It's possible to duration match using two bond funds, one longer than your longest need and one short term. Each year, you would recalculate how much long vs. short to hold to make the average duration equal your average need date. That will yield roughly the same outcome (except for fees) as holding individual bonds. Note that figuring out the fund glide path is no easier and less intuitive than just buying the individual Treasuries you need.
Next, understand that holding bonds to match spending needs at specific dates is different than holding bonds to control portfolio risk. For that function, a single bond fund like VBTIX is adequate and simpler.
@pizzaman I can only tell you what my preference is and why. I do what Richard suggests and invest in bond funds that have different durations to try and match liabilities. It is simpler and the expense ratios are minimal. If you buy and sell treasuries on the secondary market, you will need to deal with the bid/ask spread, so they are not free. If you buy new issues, then you might not have any fees - can't speak from experience.
I agree with Bill, for me, I rather do some other things other than keep track of all my individual bonds and CDs and then having to reinvest if I don't need to money. Just keep in mind that with bond funds, you need to hold them until the duration or greater or the YTM that you see is meaningless. Good luck.
Thanks guys for the excellent advice 😍. Understanding bonds is definitely my week point 😯. I don't mind tracking my CD's and bonds, I find it fun. I like @ricke statement....understand that holding bonds to match spending needs at specific dates is different than holding bonds to control portfolio risk. Thinking about it a little more, spending needs and reducing portfolio risk, I am somewhat conflicted 😕. Up until this year I was an 80% stock allocation guy and just run simulations out 30 years, done. One reason for the high stock allocation was, well, everything else sucked. Now that US Treasuries offer good returns and basically no risk (assuming you hold to maturity), you have options again. Fortunately my wife and I worked for companies that offered Roth 401k's and we maxed out our normal Roth IRA's. This has given us a great deal of flexibility, such that I don't worry about having to sell bonds before maturity, just sell out of the Roth accounts only as needed, no tax consequences. So I am thinking that US Treasuries is a good fit for me, decent predictable returns at no risk when I need the money🙂.
@pizzaman One option worth considering if you are sure, you will not need to money until bonds mature, are MYGAs. The sweet spot right now is a 5 year MYGA paying up to 5.55% from an A rated company. The interest is compounded so it eliminates the need to try to reinvest your interest from treasuries to ensure you will get the YTM. These rates change all the time so be aware of that.
The prospect of global interest rates remaining higher for longer is tipping the case for many investors to switch to bonds from stocks.
Fixed income offers a 180-basis-point yield premium over the dividend returns from stocks, according to data compiled by Bloomberg. That’s the widest in 15 years, and the gap is likely to persist or even widen as traders bet that the era of low rates has come to an end.
“Even the investment-grade bonds are giving you equity-like returns,” with half the volatility, Sanjay Guglani, chief executive officer at Silverdale Capital Pte Ltd., a Singapore-based fund manager who manages about $1 billion of assets, told Bloomberg Television. “This is a dawn of a new era for fixed income, we never had such a fantastic yields for almost 20 years.”
Global bonds are offering an average yield of 4.0%, data compiled by Bloomberg show, almost twice as much as the 2.2% dividend return for the MSCI ACWI Index. Fidelity International points out that positive real yields make the case for Treasuries even more compelling.
As brutal as it’s been for US bond investors, the math is finally turning in their favor.
The recent round of selling has left the Bloomberg USAgg Index’s yield-to-duration ratio — a measure of how much yields would need to jump to wipe out the value of coming interest payments — hovering around the highest levels in over a decade.
This week, that ratio rose to 83 basis points, indicating the average-weighted yield of the securities in the benchmark would need to rise by that amount to create losses large enough to offset one year’s worth of interest.
The yield on that index — a broad gauge of investment-grade debt — hit 5.2% Tuesday, before pulling back. That means it would need to jump to around 6% to produce negative returns from here.
Few are currently expecting yields to climb that high, even with speculation mounting that the Federal Reserve will hold monetary policy tight to ensure inflation doesn’t pick up again. As a result, bonds may have finally reached the point where interest payments are large enough to insulate investors from price losses, providing a floor for a market that’s struggling to emerge from the deepest downturn since at least the 1970s.
Feds left rates unchanged but indicated that they will raise rates one more time this year. As a result US Treasuries rates jumped up, at least the longer duration ones:
