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Author: JCMcCarter Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Long Bond Protection Against Short Bond Rates Date: 1/23/2011 5:02 PM
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I've tried to do several searches on this board regarding this but without success. I'm sure that this has had to have been discussed in Fooldom so would appreciate if I could be pointed to a previous discussion. But if not, perhaps someone will come along and kindly educate me.

I am creating a passively managed portfolio in a new non-retirement brokerage account at Vanguard. I plan on using ETFs to manage a conservative diversification that will be about 55% in bonds.

Believing that interest rates have got to rise soon, I was reluctant to use the Vanguard Total Bond ETF (BND) recommended by John Bogle (in a recent article I read) because it has a duration of 5.0 years. I was leaning instead toward initially using the Vanguard Short Term Corporate ETF (VCSH) with duration of 2.7 years. That is about 1/2 of that of BND. I was concerned about duration because I have been told that it is a predictor of how much the bond(s) will lose in value to a rise in interest rates.

But then I read in the Jan. 11 issue of Smart Money (pg 20) that ... "Some pros say owning debt that doesn't mature for 7 years or more should give investors some protection if short term interest rates rise."

So now I am thinking that maybe I'm not so smart in my ETF choice because apparently long and short term rates do not move in the same direction at the same time.

So are there any words of wisdom as to how I might expect rates to perform after this long dry spell of low, low rates once they start to move upward? Is it conventional wisdom that, as the Smart Money article suggests, short term rates should rise significantly faster than long term rates?

Any discussion would be greatly appreciated!

James
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Author: codger41 One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32145 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 6:37 PM
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Wasn't Smart Money talking about high yield corporate bonds? I have read that some bond investors believe that high yield (i.e., riskier corporates) are not as vulnerable to rising rates because the issuing companies are already having to pay unusually high rates. High yield corporate bond funds are yielding around 8%. Thus other rates would have to rise substantially before high yield markets implode. And newer issued high yields would have to stay ahead of rising rates because of their higher credit risk.

OTOH, I may be full of it. And even if I am right a mixture of short term and high yield corporates might be best to spread the risk.

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Author: JCMcCarter Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32146 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 7:57 PM
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Thanks Codger ... Yes I can see where high yield bonds would represent a lower reduction in value than the hit a low yield bond would take in response to a general rise in interest rates.

But the tid-bit in Smart Money actually "recommended" (perhaps "mentioned" would be a better word of choice)and I quote ... "top-ranked Loonis Sayles Investment Grade (LIGRX) matures in more than nine years." So they were definitely going for a long duration vs. high yield.

James

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Author: brewer12345 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32147 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 9:37 PM
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My guess is that the article you mention may be making the distinction between the effect on bond prices of a rise in rates in different parts of the yield curve. If short rates rise, long rates may or may not rise. But if long rates do not rise, then your longer duration bond fund will outperform.

Personally, I think that there is low return potential in the bond market right now and a reasonably strong chance that rates will rise a fair bit. As such, I have reshuffled my bond exposure to be CDs (which I can always surrender for a penalty if rates spike), convertibles (which have equity exposure and tend to be less rate sensitive), and cash. What junk exposure I have had I am letting go, since I see increasingly aggressive behavior in the junk market and I want no part of the next blow up there.

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Author: Crosenfield Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32148 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 10:26 PM
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A bond fund never matures--because when one of the individual bonds in it matures (or is called) the fund manager replaces it with another bond.

If you'd like to park money at a reasonable yield that will become available in a year or two to buy bonds at a higher yield, you can do this with individual corporate bonds.

In this week's Barrons I read that the folks at Ford Motor company say that by the end of 2011 the company will have no debt. The way they could bring that about would be to call in their debt. I had one issue called just recently, so they have begun putting their money where their mouth is.

Another is agency bonds. The market is full of Freddie Mac and Fannie Mae stepups. I've had 3 such issues called in the past year. You can buy bonds with a coupon of 4 or even a point or so higher--with maturities way out, 2031 and the like. But if they are going to be called, and you buy the bond at a discount, you come up smelling like roses.

With expectation of rising interest rates, I want nothing to do with mutual funds of any type that own bonds. You will lose net asset value, particularly on longer term bonds.

Remember: bonds mature, bond funds do not.

Best wishes, Chris

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Author: joelcorley Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32150 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 11:34 PM
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codger41,

You wrote, ... I have read that some bond investors believe that high yield (i.e., riskier corporates) are not as vulnerable to rising rates because the issuing companies are already having to pay unusually high rates. High yield corporate bond funds are yielding around 8%. ...

The rational is that all bonds have a build-in risk premium that remains essentially constant as long as the company's fundamentals remain constant even as the risk-less rate of Treasuries rise and fall.

Let's assume you purchased a Treasury and two different corporate bonds, all with a 10-year maturity. For simplicity, let's say the Treasury is currently yielding 3%, while the corporate bonds are yielding 6% and 8% respectively - all new issues, essentially bought at par.

Now let's assume there is a sudden 2% increase in the yield of new 10-year Treasuries. All 10-year bond yields should respond by increasing by roughly 2%. So here is an estimate of the new market price for all three of your purchases:

Issue      Price
Treasury 84.36
Corp (6%) 86.35
Corp (8%) 87.48


As you can see the relative percentage change in yield should have a greater impact on the net present value of the Treasuries. This is the protection authors in articles like Smart Money are referring to. You loose less of your principal because the relative loss in earning power should be smaller.

Unfortunately rising interest rates can be a double-edged sword. A company that is struggling financially will find new financing in a rising rate environment even more difficult and expensive. That means its default risk will rise as well. The market may or may not acknowledge that immediately and the impact will depend on how well positioned the company is to pay off its bond issues from future cash flows.

BTW, a lot of people here seem to believe this loss is not real just because they hold their bonds to maturity. I assert that it is real because if I were buying the same bonds after the rate increase, I would earn much more over the next 10 years than the person that bought before the rate increase. The net result is that you loose out on future earning power because your yields were locked in today.

The problem here is deciding which is the greater risk. Loosing out on income today? Or gaining more income by investing at some future date? The problem is I don't have a crystal ball and can't tell you how long it will take before rates rise significantly.

- Joel

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Author: jackcrow Big gold star, 5000 posts 10+ Year Anniversary! Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32151 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 11:41 PM
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The indexing board is one really good resource for passive style index investing.
http://boards.fool.com/index-funds-100111.aspx?mid=28951740

When it comes to bond funds duration is often a useful tool to take a look at. What duration tells us is the predicted change in NAV relative to a change in interest rates. A duration of 7 strongly suggests that a 1% increase in interest rates, for that maturity, leads to a 7% decline in NAV.

Be careful about taking on "less than" 7 duration because if your duration 5 fund has to weather a 2% rise in interest rates you are likely to take a 10% loss on capital invested. If you look at that exchange carefully you are not likely to come out ahead. Current rates for a 5 year is 2% if that bumps up 2% your new rate is 4% but you lost 10% in NAV value.

There is no predictability between long a short rates. The shorter you get the more the Fed Funds rate impacts you, longer you get the more the market dictates rates. What this means in practice is that the Fed could ratchet rates up 2% in a year while the long end goes no where and the curve flattens or the long end yields even more. It all depends upon where people see the greatest advantage for their money balanced by their educated guess about future inflation and market conditions.

The shorter CD ladder with a willingness to eat the penalty is not a bad plan under current market conditions.

jack

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Author: jackcrow Big gold star, 5000 posts 10+ Year Anniversary! Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32152 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/23/2011 11:45 PM
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Joel,

BTW, a lot of people here seem to believe this loss is not real just because they hold their bonds to maturity. I assert that it is real because if I were buying the same bonds after the rate increase, I would earn much more over the next 10 years than the person that bought before the rate increase. The net result is that you loose out on future earning power because your yields were locked in today.

That is certainly a legitimate critique, reinvestment risk is real. It often boils down to how different personalities respond to different types of risk.

jack

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32153 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 9:20 AM
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In this week's Barrons I read that the folks at Ford Motor company say that by the end of 2011 the company will have no debt. The way they could bring that about would be to call in their debt. I had one issue called just recently, so they have begun putting their money where their mouth is.

If you can provide a link, I would love to see that quote. (I did some googling and couldn't find it.) What I have been fairly consistently reading is that Ford has said that they will have more cash than debt, not that they will have no debt. Once of their strategies to conserve cash in the long term has been to pay off some of their higher rate debt, so they don't have to pay high rate interest, so I expect they will continue to call higher rate debt selectively. But unless they can build their cash enough so that they still have significant cash after paying off debt (and from what I read right now, they still have more debt than cash, so it would be a significant cash increase), I doubt they would pay off all their debt.

It's kind of like the argument of whether or not to pay off the mortgage, if you have investments that will return higher rates than your mortgage rate. What is Ford going to announce for their 2010 ROI later this week, and what is management's expectation for ROI in the future? If the Ford debt has higher coupons than that, it's probably a good call candidate. If the ROI is higher, management may want to invest the cash in their operations, instead of paying off debt.

AJ

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Author: JCMcCarter Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32154 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 11:34 AM
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Thanks for the responses, which while not telling me anything I didn't know, has helped clarify my current dilemma. Specifically, now is not the time to invest a large portion of a fledgling portfolio into a bond fund, regardless of its stated duration.

I have been using a 5 year bond ladder in my (rather sizable) IRA for over 10 years. Not only to guarantee that funds will be available at some future date, but also to add diversification to my holdings.

In a large account it is possible to buy many different bonds to flesh out one's bond ladder. And of course, the more bonds you hold, the more reasonable it is to take on more risk and reap the benefit of higher yields. Unfortunately, I only have about $46,000 in this new account to spread over any individual bond purchases. Also Vanguard has a $50 minimum commission for each purchase so to minimize costs, I feel compelled to make a minimum purchases of around $10,000. That would result in the purchase of 5 individual bond purchases and force me to buy highly rated bonds, often paying less than CDs.

Jack suggested using a "... shorter CD ladder with a willingness to eat the penalty is not a bad plan under current market conditions."

Unfortunately, I believe that when you are forced to sell a CD on the secondary market via a broker, the principle, not just the interest is at risk. So the prospect of "eating the penalty" in a period of rising dividends is not very attractive.

So I guess for the immediate future, I will use short term CDs for safety and stability in this new portfolio. I just have to accept the reality that losing a small amount to inflation is better than losing a larger amount to rising interest rates.

Thanks for all that have taken the time to respond.

James

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Author: jackcrow Big gold star, 5000 posts 10+ Year Anniversary! Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32155 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 12:52 PM
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James,

I know it is convenient to have most assets under one house but paying $50 per ticket does not have to be lived with if you are willing to shop around. Both E-Trade and Interactive Brokers provide much better pricing which means you could purchase a much broader portfolio from the outset.

nfortunately, I believe that when you are forced to sell a CD on the secondary market via a broker, the principle, not just the interest is at risk.

I'm not suggesting brokered CD's which carry the same market risks as bonds. I'm talking about good old fashioned bank CD's with an interest penalty. The math is pretty straight forward and can be done in advanced. If CD or bond rate increase X% then it pays, in the long run, to cash in the CD early and eat the penalty so that you can redeploy your cash in a higher yielding asset. IIRC folks on this board have found CD's who's penalty is only 3 months of interest with the more typical being in the 6 month range. If we bought a low yielding 5 year CD we already know that they are not paying us a whole lot of interest any way, the penalty is not that steep for the liquidity that can be gained.

jack

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Author: Crosenfield Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32156 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 1:00 PM
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I love Vanguard funds, but why would you use their brokerage, especially for bonds? They don't have the inventory you'd find with e-Trade or Zions. Those two don't have that high a commission, either.

That said, in buying bonds, the spread between bid and asked is generally much more important than the commission. ]

Best wishes, Chris

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Author: JCMcCarter Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32157 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 1:45 PM
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Chris said ... I love Vanguard funds, but why would you use their brokerage, especially for bonds?

Chris my largest holdings are at TDAmeritrade and up until recently all of my brokerage services were handled there. However equity trades trades are $9.95 but only $2 at Vanguard at their Select Services level. In fact I'm considering moving my TDAmeritrade over to Vanguard so that I qualify for their Flagship Services which offer 25 free trades annually and then $2 each above the the first 25.

I was really taken back when I saw the $50 minimum commission associated with bond purchases at the Select Services level at Vanguard but found that comparing the purchase of $2000 each of two different bond issues at TDAmeritrade (without any commission) and at Vanguard (with the $50 commision) the end result was that the bonds were more than 10 basis points cheaper at Vanguard.

Actually, if you purchase new issues (Bonds or CDs)at Vanguard there is no commission. However on the secondary market they are $5 each ($50 minimum) at the Select Services level or $2 each ($20 minimum) at the Flagship Services level.

As you indicated, being at one brokerage has its advantages. They all have to make money or go out of business. As long as the trades are well executed and trading costs are reasonable I'm happy.

Obviously, from my bond purchase example, the cost of a trade may not be apparent until you make actual comparisons.

James

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Author: JCMcCarter Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32158 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 2:04 PM
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Jack said ... I'm not suggesting brokered CD's which carry the same market risks as bonds. I'm talking about good old fashioned bank CD's with an interest penalty.

Actually I had about $150,000 at Dollar Savings Direct in a series of 16 month CDs that were paying 2.25% YTM but they are coming due now and are auto-renewing at 1.1% for another 16 months. I am not happy with that rate and got to thinking that I should cancel them as they renew and pull the money out and put it in a Vanguard brokerage account.

The main advantage being that I can now use that money to created a 3rd (for me) diversified portfolio. Of course now I am in the positon of building a portfolio that I think has a good chance of doing better than 1.1% had have a good chance of preserving my principle against inflation over the next five years or so. That was why I was was looking for fellow Foolish thoughts on bond ETFs and their associated durations.

By the way, I do have some CDs in my bond ladder at TDAmeritrade but I plan to let them mature and use the proceeds toward another rung in the ladder. I find it sad when "AA" Corporate bonds pay less than a CD. One sould get something in return for increased risk.

James

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Author: Crosenfield Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32159 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/24/2011 2:23 PM
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"One should get something in return for increased risk."

Right!

ETFs and funds spread risk around because they hold lots of issues.

I'd still go for agency or maybe Ford bonds, sold at a discount, with coupons in the 4-7 range, realizing there is a high probability of getting called and having to repeat the process of making a selection again, perhaps within 2011.

Someone here recently had an account with TD Ameritrade, and their inventory wasn't great.

Best wishes, Chris

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Author: iceberg0 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 32166 of 35400
Subject: Re: Long Bond Protection Against Short Bond Rate Date: 1/25/2011 8:43 PM
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<<I was concerned about duration because I have been told that it is a predictor of how much the bond(s) will lose in value to a rise in interest rates.>>

You can get 2.82% uncompounded and not lose in value in 5yrs. with reinvestment of BND coupons no matter how rates reasonably rise.

For BND, the avg. duration is 5 years and maturity 7 years w/today’s rate 2.82%. If you can plan to reinvest the monthly distributions, the pre-tax total return of your initial investment plus coupons will have minimal impact at the 5 year mark no matter what reasonably happens to interest rates – you will earn pre-tax ~2.82% p.a. w/~original principal returned. If (when?) rates go up, your increased return from reinvestment at higher rates converges mathematically to offset the NAV reduction if held to the 5yr. duration point. Here reinvestment risk & price risk tend to offset.

That’s the Macaulay duration immunization deal. It is not perfect – as usual there are other risk factors ETF market price (discount/premium), tax effects, BND expenses & the duration point could (will?) change as a function of ever changing rates & rules. Spreadsheet time for rebalancing.

I’m not familiar with the BND reinvestment process but the BND prospectus says for your Vanguard account: Transaction Fee on Reinvested Dividends: None through Vanguard.

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