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This is my first posting on this board and I am a relatively new investor (long-term buy & hold). I am trying to diversify my portfolio by adding bonds. I prefer the ease of an index fund. I am investigating the Vanguard long term bond index fund.

1) What's the economic difference between a long-term, intermediate-term, short-term, or full bond market index fund?

2) This is what I found under the section marked "Risk Attributes"

Historic Volatility Measures as of 05/31/2004
Benchmark R-squared* Beta*
Lehman Long Government/Credit Index 1.00 0.99
Lehman Brothers Aggregate Bond Index 0.93 2.17

*R-squared and beta are calculated from trailing 36-month fund returns relative to the associated benchmark.


What do R squred and beta mean? It seems to measure how closely this fund tracks with a given benchmark. Is that right? Why is it important to my investment decision?

3) Could you recommend links/readings/etc. that would bring me up to speed on investing in bonds.

4) Are there other funds competitive with Vanguard?

5) Does anyone have experience with these Vanguard funds?

6) Please confirm my understanding that a bond is govt debt. It's as if I am loaning money to a govt entity (state/fed) and they pay me interest in return. Is that accurate? Am I leaving out any important detail?

Thanks!
CMW
who is enjoying the heck out of all the info available from TMF!!!! : }
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Greetings CMW,

1) What's the economic difference between a long-term, intermediate-term, short-term, or full bond market index fund?

The term refers to how long the bond will be around assuming it isn't called. Long-term bonds are usually 20-30 years in length, intermediate is shorter like 7-10 and short-term is 2-3 roughly. Typically, the longer the term the more sensitive the bond will be to interest rate shifts as if rates go up 1% this means more if the bond isn't maturing for another 20 years compared to a bond maturing in another year or two so shorter-term is usually less volitile. A full bond market index fund will hold bonds of all maturities and thus has a mix of short, intermediate and long which should make it move like an intermediate with a bit more kick but that is just a guess from my part.

2) This is what I found under the section marked "Risk Attributes"

Historic Volatility Measures as of 05/31/2004
Benchmark R-squared* Beta*
Lehman Long Government/Credit Index 1.00 0.99
Lehman Brothers Aggregate Bond Index 0.93 2.17

*R-squared and beta are calculated from trailing 36-month fund returns relative to the associated benchmark.

What do R squred and beta mean?


Definition time from M*:

R-Squared vs. Standard Index
R-squared ranges from 0 to 100 and reflects the percentage of a fund's movements that are explained by movements in its benchmark index. An R-squared of 100 means that all movements of a fund are completely explained by movements in the index. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100. Conversely, a low R-squared indicates that very few of the fund's movements are explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the fund's movements can be explained by movements in its benchmark index. Therefore, R-squared can be used to ascertain the significance of a particular beta or alpha. Generally, a higher R-squared will indicate a more useful beta figure. If the R-squared is lower, then the beta is less relevant to the fund's performance.

Beta vs. Standard Index
Beta, a component of Modern Portfolio Theory statistics, is a measure of a fund's sensitivity to market movements. It measures the relationship between a fund's excess return over T-bills and the excess return of the benchmark index. Equity funds are compared with the S&P 500 index; bond funds are compared with the Lehman Brothers Aggregate Bond index. Morningstar calculates beta using the same regression equation as the one used for alpha, which regresses excess return for the fund against excess return for the index. This approach differs slightly from other methodologies that rely on a regression of raw returns.

By definition, the beta of the benchmark (in this case, an index) is 1.00. Accordingly, a fund with a 1.10 beta has performed 10% better than its benchmark index--after deducting the T-bill rate--than the index in up markets and 10% worse in down markets, assuming all other factors remain constant. Conversely, a beta of 0.85 indicates that the fund has performed 15% worse than the index in up markets and 15% better in down markets. A low beta does not imply that the fund has a low level of volatility, though; rather, a low beta means only that the funds market-related risk is low. A specialty fund that invests primarily in gold, for example, will often have a low beta (and a low R-squared), relative to the S&P 500 index, as its performance is tied more closely to the price of gold and gold-mining stocks than to the overall stock market. Thus, though the specialty fund might fluctuate wildly because of rapid changes in gold prices, its beta relative to the S&P may remain low.

It seems to measure how closely this fund tracks with a given benchmark. Is that right?

That's pretty close. R-squared is how much of the movements of the fund can be attributed to the index while beta is what multiplier it should have if one did a linear regression on the returns.

Why is it important to my investment decision?

Because you may want to know how well a fund follows a benchmark if you want to try to get different asset classes. It doesn't make a lot of sense to buy a small-cap fund if it behaves just like a large-cap fund, if you want a somewhat extreme example here. Beta is sometimes used as a risk measurement where some like lots of volitility and others want it as low as possible.

3) Could you recommend links/readings/etc. that would bring me up to speed on investing in bonds.

Here are a few ideas:
http://boards.fool.com/Message.asp?mid=18128614&sort=whole
http://www.investinginbonds.com/
http://www.nofeeboards.com/docs/bondsfaq.htm

Also some books on asset allocation will discuss bonds so you could look up William Bernstein's "Intelligent Asset Allocator" or "Four Pillars of Investing" or John Bogle's "Bogle on Mutual Funds" or "Common Sense on Mutual Funds" which likely discuss both stock and bond funds.

4) Are there other funds competitive with Vanguard?

I believe there is a PIMCO fund manager that is thought of as a Peter Lynch in the bond market named Bill Gross. There are likely a few other bond funds that are better than Vanguards though I'm not sure whether they will continue to stay that way and I would note that Vanguard's bond funds did get a bit of flack a while back when their index funds did a little deviating that backfired.

5) Does anyone have experience with these Vanguard funds?

I don't but I suspect others might. Also Vanguard has a lot of bond funds, IIRC.

6) Please confirm my understanding that a bond is govt debt. It's as if I am loaning money to a govt entity (state/fed) and they pay me interest in return. Is that accurate? Am I leaving out any important detail?

Some bonds are govt debt. Others can be corporate or consumer debt. A bond is loaning money to an entity subject to payback conditions. These conditions may include interest, options to convert the security into stock, and/or principal.

So here are a few major types of bonds out there in no particular order:

1) Treasuries: This is where you loan the money to the Treasury and get paid back interest. There are some inflation-indexed types, called TIPS, here that can have a principal adjustment every 6 months that is worth noting as something different than your regular Treasury.

2) GNMAs: These are mortgages bundled together where you may get paid back interest early which makes them different from a Treasury.

3) Other gov't debt: There are other federal government agencies that have bonds I believe in this case.

4) Corporate: This is where a company borrows money and either pays back in principal or possibly in stock in the case of convertible debt.

5) Savings bonds: These are another type where they don't mature or give immediate interest until they are cashed in. http://www.savingsbonds.gov likely has more details on these.

6) Foreign govt debt: This would be where you'd loan money to another government like say England or France or somewhere outside the US and try to get some extra return through currency fluctuation or higher rates there compared to here.

7) Municipal debt: These are state and local governments that have tax-exempt interest usually and are intended for those in higher tax brackets in taxable accounts.

8) Stable Value funds: These hold guaranteed interest contracts from insurance companies that are very similar if not exactly like a bond.

Couple of other minor notes:

1) If you have a money market mutual fund this is almost like a very ultra-short term bond fund with a stable NAV of $1/share. Look at the holdings and you'll see CDs, commercial paper, and other very short-term debt that the fund holds.

2) Some bonds are insured so that the holder is protected to some degree though this does come at a cost somewhere.

3) If a company does go into bankrupcy it is often the bondholders that will get equity in the newly formed company that may be worth something for those that go looking into junk bonds also known as high yield bonds.

I think that covers the basics as well as I know...

Regards,
JB
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Does the level of risk vary according to the term of the bond? Which term is generally speaking more or less risky and why? Vanguard's long term bond index had the highest returns (and yield). Doesn't that also mean it has the highest risk?

Are fed govt bonds generally less risky than corporate and municipal bonds?

Does anyone have experience with these Vanguard funds? I don't but I suspect others might. Also Vanguard has a lot of bond funds, IIRC.

What's IIRC?

Some bonds are insured so that the holder is protected to some degree though this does come at a cost somewhere.

Is there a special name for an insured bond or would I just have to plow through the prospectus to find out?

Thanks for your very thorough reply!!
CMW
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Greetings CMW,

Does the level of risk vary according to the term of the bond?

Term and credit quality are usually what determine the risks of a bond as you could imagine quite a difference between loaning money to the government versus loaning it to a company struggling with its finances.

Which term is generally speaking more or less risky and why?

The most risky is high-yield bonds which are risky mostly because of default risk. After that, the next are long-term bonds since you are usually locked into that rate for so long that you want to be properly compensated for things like inflation and possible interest rate risks. The last part is about why if I allow my money to be tied up for 20 years I should get more than if I just did 4 consecutive 5 year bonds.

If you want some historical notes on bond lengths and risks, take a look at http://www.efficientfrontier.com/BOOK/chapter2.htm and the T-bills compared with 5 and 20 year Treasuries over a fairly long time frame.

Vanguard's long term bond index had the highest returns (and yield). Doesn't that also mean it has the highest risk?

Yes, due to the NAV possibly fluctuating the most would be my guess. In 1999 the long-term bond index went down 7.9% compared to for intermediate that went down 3%, short-term went up 2.1% and total bond market went up .8%. Just something to be aware of is that bond funds can have negative years in some cases.

Are fed govt bonds generally less risky than corporate and municipal bonds?

For those of the same term, yes. If you take a long-term federal govt bond compared to a short-term corporate then the corp may be less risky.

What's IIRC?

IIRC = If I recall correctly.

Is there a special name for an insured bond or would I just have to plow through the prospectus to find out?

I would take the prospectus as you would want to know who is doing the insuring. Is it a company with billions that can handle defaults or could it be wiped out if there are a few defaults? Vanguard Insured Long-Term Tax-exempt(VILPX) is an example of a fund that invests in insured bonds if you want an example.

Regards,
JB
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CMW,

Since you like Vanguard, let me suggest you start by reading some of their information on bonds and bond funds (including interest rate risk). They have a lot of stuff that explains bonds, but this series they pulled together recently would be a good place to start. See this message for the link (and my comment).

http://boards.fool.com/Message.asp?mid=20970366
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