Why Rates are Rising by Larry Swedroe,
What can history tell us about future interest rates? One-month Treasury bills have averaged a real yield of about 0.3%. To that, a forecast of long-term economic growth should be added, which for the U.S. is about 1.8% (well below the longer-term average of about 2.5%). That puts the real yield for longer-term debt at about 2%. An estimate for inflation must also be added. If you’re an optimist, the floor should be 2% (the Fed’s target), which would put the nominal longer-term yield at about 4%. If you are not as optimistic, and particularly if you are concerned about our inability to address the growing fiscal deficits and debt-to-GDP levels, you would forecast a higher figure, perhaps 3% or even more. Another negative for rates could be an increasing risk premium demanded by foreign holders of dollar reserves. The risks that rates rise or fall is at least balanced at this point.
Those investors concerned about the future direction of interest rates and inflation should consider increasing their allocation to Treasury Inflation-Protected Securities (TIPS); it is now a particularly attractive time, as real yields are well above 2%. As of September 27, the yields on five-, 10- and 20-year TIPS were 2.44%, 2.25% and 2.40%, respectively. Another option for those willing to accept some economic cycle (credit) risk and their illiquidity is to invest in private-credit funds, which invest in floating-rate loans that are senior, secured and sponsored by private equity firms, such as Cliffwater’s Corporate Lending Fund (CCLFX). CCLFX has a duration of only about one month and has a yield in excess of 11%.
We're down in the weeds and geeking out some here, so I want to remind anyone that feels overwhelmed of a few things.
Yes, to me the fixed income part of the portfolio is the harder part! For stocks/equities you can just get a total world fund like VT and be done, or just a reasonable percentage of VTI (total US) and VXUS (international without US). Fidelity recommends something like 35% VT and 24% VXUS for a 60% stocks, 40% fixed income portfolio.
For the fixed income part, the last piece of that for the typical Boglehead 3-fund portfolio is BND, Vanguard's aggregate bond fund. It has everything - short, medium, long-term bonds, treasuries, high quality corporate bonds, mortgage backed securities. I think it's great as a set it and forget it choice during accumulation phase of life.
But, in retirement/spending phase of life, many retirees exchange the aggregate bonds for a simple US treasury fund like VGIT (intermediate term). Why? You get less yield (no corporate, MBS now) but you get a better true inverse relationship with stocks, which is what most nervous retirees want to see - stocks down, bonds up. Also, safer, less volatile.
Some go with tips instead, but intermediate term tips funds didn't do well as they were expected to during the recent inflation spin-up. Short term tips (VTIP) do well because when inflation is rising, interest typically rises too (see: lately). But now you're back to trying to time the market. Not good. You pay a premium for inflation protection when inflation is dropping (see: lately), but some folks who are nervous about it and don't want to sweat it, and pay the tips premium out of choice. Remember, normal bonds have expected inflation priced in. TIPS are for higher than normal expected inflation.
It's important to have a plan. If the plan says your safety margin is more than adequate, you don't need to do these elaborate choices if you don't enjoy it, just pick a simple choice (simple means fewer mistakes) and go do something you enjoy. Life is short! Often, unless your portfolio is huge, these intricate moves don't matter much at all. And if your portfolio is huge, are they really necessary?
Boy, talk about sucking the oxygen out of the down in to the weeds geek fest room (thread), thanks a lot @hines202 (aka Bill) ????. Just kidding of course. You make great points, which is why I did such a big US Treasury buy last week, time to smell the roses. Of course, I will continue to geek out as it is just too much FUN!!
@pizzaman Nothing wrong with geeking out if that's your jam, and it clearly is 🙂 We all benefit from your geeking, carry on, sir!
I agree with Bill’s philosophy. The first step before planning is to have a clear goal for the bonds (and equity). For me the goal is to mitigate the equity risk: bonds are for safety, not return. I have only US AAA treasury bonds (Short, intermediate and TIPS). Risk/return goes to equity.
I am for simplicity, minimizing changes, not timing the market, basically buy-and-hold regardless of the market changes.
What's amazing about US Treasuries today is that not only do they mitigate risk, they actually make money. All Treasuries from 1 month (5.34%) to 30 year (4.96%) maturities are yielding more than inflation (3.8%) and inflation going down ????.
We're in the Biggest Treasury Bond Bear Market Ever, Bank of America Says
- The market for U.S. Treasurys has shed almost a quarter of its value since Treasury yields bottomed out in the summer of 2020.
- It's the biggest Treasury bond bear market in history, surpassing two similar periods in the 19th century, according to a Bank of America research note.
- Exchange-traded funds (ETFs) exposed to U.S. Treasurys, like the iShares 20+ Year Treasury Bond ETF, have been pummeled in recent years.
- https://www.investopedia.com/we-re-in-the-biggest-treasury-bond-bear-market-of-all-time-bank-of-america-says-8348729?hid=cf7663b321b1ba4c06f591c0f273ce622b2a3d21&did=10503146-20231006
I would assume that most bond funds have done poorly. So it begs the question, if US Treasury yields are so good now, probably better than the long term average of most bond funds of any kind, and you could ladder the Treasuries for when you think you would need the money, why would you put money into bond funds? Just asking ????.
You seem to have a couple of different ideas - one is buying long duration Treasuries and the other is that funds are worse than individual bonds. Let's tackle that last part first. Bonds are contracts to return money to you at a certain rate and give you the principal back at the end, effectively prior to 2022 we were all loaning money at 1%. With 5% current rates and 1% borrowing costs, those borrowers are making out like bandits and us lenders have had our portfolios crushed and inflation has erased a sizable chunk of the value of what's left (19% inflation since end of 2020).
Individual bonds suffered just as much as funds of the same duration. While you can ignore the loss of value by not looking, the loss is still there.
Funds have to have NAVs that the next buyer would pay, so they are repriced immediately and then earn at the new interest rate. So the comparison to new bonds is the Yield to Maturity or the SEC yield (usually pretty close to each other). Holding a rolling ladder of bonds to maturity only seems to eliminate this risk of loss, but in reality, you have simply traded the immediate loss of NAV in a fund for a prolonged loss of income relative to new bond issues (that low yield is precisely what new fund buyers priced in). If you do liquidate a ladder at any point, you get re-priced to the market just like a fund and if you don't liquidate, then after the duration of the ladder, you are also back to the same point as the fund.
Non-rolling ladders (or better yet a non-rolling TIPS ladder) are useful for certainty in planning for things like a bridge to SS, where the purpose is to have a given amount of money available each year. But just like a fund, a long TIPS with a -0.4% yield (yes rates were negative in 2020 and some of 2021) looks pretty awful compared to what could have been had (with hindsight) by holding money market funds and then buying the bonds at today's higher rates.
Short of a crystal ball to avoid bonds when inflation is about to start, there is no way to avoid the losses that unexpected inflation inflicts on bonds.
As for buying long term bonds, they are nearly as risky as stocks. For instance, VGLT, Vanguard's Long Term Treasury ETF, lost 7.3% just last month and 40% in the last 3 years! Their EDV (near 25 year duration) lost over 11% last month and 53% in the last 3 years. (Plus of course inflation ate 19-20% of the remainder). I know I don't have good insight on the future of inflation as I avoided bonds because of inflation risk during my accumulating years (when they actually did quite well) and bought them to "reduce risk" as retirement neared and that part of the portfolio got creamed. So I'm not changing duration or changing my asset allocation, history has proven that I'm no expert and even "experts" are wrong as often as they are right about future interest rates.
I guess I was not clear on what I was trying to say. Setting the stage -
- assume you are retired or will be shortly.
- assume general inflation will return to about 3% by end of 2024 (most common number in @nc-cpl's user survey).
- future real return for bonds is 2% (most common number in @nc-cpl's user survey).
- assume your US Treasuries will be held to maturity.
- assume you buy the Treasuries (not funds) from one of the big boys (Fidelity, etc) at no cost to you.
- assume Treasuries are held in an IRA.
- you have a well defined budget for annual living expenses (number you enter into PRC). This is the $ amount in Treasuries that will mature each year.
- Treasuries presently yielding about 5% for 1 to 10 year maturities.
- implement 10 year annual Treasury ladder.
Most common asset allocation from @nc-cpl's user survey is 60/30/10. Treasuries will not comprise all of the 30% bond allocation, just enough to cover annual living expenses for next 10 years. Based on above assumptions, Treasuries will have the same real ROR as bond funds.
Advantage of treasuries over bond funds for this 10 year period: 99.9% safe, $0 fees, $0 expenses ratio, guaranteed ROR, zero sequence of return risk. Thoughts.
A good article on risk: Long-Horizon Investing, Part 3: The Riskiness of "Low-Risk" Assets by Nathan Dutzmann,
Standard forms of risk/return analysis are generally divorced from specific goals. As such, they tend to measure absolute return against absolute risk, which could be stated as “make as much money as possible with whatever risk you can stomach.” In this framework, the primary variable in optimal portfolio construction is “risk tolerance” (e.g., as measured through survey responses).
A more true-to-life methodology is goals-based. At some point in the future, an investor wishes to have the money to do something or a combination of somethings: Produce a stream of retirement income, buy a new car, provide for medical expenses, leave a legacy, etc. Each of those goals has an appraisable future value (i.e., the price tag – typically inflation-adjusted – that will be required to meet the goal when the time comes). And in this framework, the primary variable in optimal portfolio construction is “risk capacity,” wherein the more vital or less flexible is any specific goal, the less risk should be taken in achieving it.
In this view, realizing a goal is a bit like reaching a mountain peak. You know the height of the peak in advance, and you have a choice: The risk-free option is an investment that guarantees to get you to the mountaintop – no more, no less – for a predetermined price. With the same dollar amount in risky assets (at least those with a risk premium, see below), you will exceed the peak4 on average and in most cases, but you also risk falling short.
Quick math question. Comparing profit from a 5 year CD at say 5% (assume it only pays out at the end of 5 years) to a 5 year Zero coupon US Treasury. Assume state tax is 5%. Since Treasuries are state tax exempt, what yield would the Treasury need to be to be equal to the CD? Assume held in a taxable account.
Bloomberg's take on near term US Treasury Market:
Beware the New Treasury Buyers Sparking Fear in World’s Largest Bond Market
“We have an abnormal supply-demand situation in that the quantity of debt the government has to sell is a lot” and will “remain a lot,” Ray Dalio, the founder of Bridgewater Associates, said earlier this month in an interview with Bloomberg TV’s David Westin. Dalio, like fellow Wall Street titan Larry Fink, said he expects 10-year yields to exceed 5% in the near future. “The buyers are less inclined to buy the debt, for a variety of reasons” including that “many have gotten whacked. There’s lots of losses.”
“It’s going to be a bumpy road finding that equilibrium in rates as these are more price-sensitive buyers,” Jay Barry, co-head of US rates strategy at JPMorgan Chase & Co., said in an interview. “This will result in a higher term premium and steeper yield curve over time.”
A run of weak auctions this week was capped by a particularly lackluster sale of 30—year bonds, with the securities being sold at a yield well above the prevailing market rate on Thursday, a sign of soft demand.
“It does appear that supply – particularly from the demand side – is becoming a lot more worrisome and creating headwinds for the Treasury market,” said Gennadiy Goldberg, head of US rates strategy at TD Securities Inc. “If the macro does not win out and we are stuck here for longer than we expect – at these rates – and there’s not a recession, then the supply headwinds will become more and more relevant and impactful.”
https://finance.yahoo.com/news/beware-treasury-buyers-sparking-fear-140000808.html
Q3 Bond Market Meltdown: Why and What's Next?
Another article that states:
Investors should be eyeing up bonds rather than stocks despite the market meltdown that's led to fixed-income prices cratering in recent months, according to UBS.
The Swiss bank said Monday that it expects the key 10-year US Treasury yield to fall from it's current level of 4.7% to just 3.5% over the first half of 2024, which it estimated would net bondholders returns of around 13%.
"We see bonds as an effective hedge to investor portfolios," they added, noting that the 10-year could deliver returns as high as 19% in a scenario where the US economy falls into a recession.
The strategists said they hold a "neutral view" on equities, predicting that the benchmark S&P 500 stock-market index will edge up just 4% between now and June 2024.
https://us.yahoo.com/finance/news/favor-bonds-over-stocks-ndash-185907596.html
Wow!!! As a short term play (just a few years) should I sell more of my bond funds, and maybe stock funds as well, and get more US Treasuries? Ya, that's timing the market, but what the heck! Only kind of serious, but does point out some options.
The term "yield-to-worst" is defined in the article as "a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. It is a type of yield that is referenced when a bond has provisions that would allow the issuer to close it out before it matures."
Many bonds can be called, so if you are counting on interest rates going down and you getting rich, the issuer of a callable bond can pull the rug out from under you. It's one of the reasons that I would only either buy a fund so the pros can analyze that, or, if I had a specific date I needed the money, I would build a ladder out of Treasuries or TIPS as they don't have credit risk or call risk and are sellable without a big bid/ask spread.
I'm a Vanguard customer and haven't shopped a lot of bond funds, but the Total Bond Market funds at the big brokerages will be very close to the 6.2 year average duration of the Bloomberg index the article referenced. If the article is right that interest rates will be peaking soon, then bonds may be an unusually good buy as everyone else is still fighting the last war and too scared to get back in the water. (Or not, I can't predict the future).
Someone that was right in 2020-2021 about the rise in inflation and has been making the call that the Fed's job to bring it back down is now done whether they realize it or not is Scott Grannis, a retired private sector economist that blogs at scottgrannis.blogspot.com. His contention is that what messed the Fed up early in the inflation cycle and is still messing them up now is the delay in Owner Equivalent Rents. They are about 1/3 of the inflation indices and lag reality by 18 months, so the Fed has been driving by looking far in the rearview mirror and driving us into the ditch. Without those, inflation is already under 2% and the owner equivalent rents peaked several months ago and so will be subtracting from reported inflation as we go forward.
