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There have been a number of messages on this board from people expressing great reluctance to invest in bonds right now, because of the likelihood that interest rates will rise and bond prices will fall. However, an article on the Vanguard web site expresses the view that it can be an advantage to bond owners for interest rates to rise. There can be initial "pain" followed by a longer term net gain. I am interested in knowing board members' opinions of the views expressed in this article. The url is

http://flagship5.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/VanViewsNCArticle.jsp?chunk=/freshness/News_and_Views/news_ALL_rateaffects_06242004_ALL.html
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Vanguard's claim that rising rates are not a problem for bond fund holders if you hold on for the long run is misleading, as I've commented before. For example, they've used charts showing long term returns, but run the charts past the time frame of the fund's average duration, which is cheating, since the real question is whether you are better off having money in the fund for a specified period or better off having money out of the fund, with the option of rolling the money over into the fund once the period has passed.

Simple arithmetic fact (some of us still believe 1+1=2, though I did previously say I would stop believing that if the Red Sox won the world series—I lied): if interest rates for bonds analogous to those held by a fund go up, the total return you will receive (dividends minus capital loss) for the period of the fund's average duration will always be less than the yield of the fund at the starting point (i.e., when you bought shares or could have sold and gotten out). Reinvesting dividends mitigates to some extent the affect of the capital loss, since you are buying new shares at lower prices, but the total will still always be less than the initial yield.

Depending which fund you have and how much rates go up, the total return may still be better than other available options for those who have limited choices, notably those dealing with retirement accounts or trying to assure liquidity. For example, if the corporate fund's yield goes up by 1% over the next couple of years (around it's average duration), your total return on the fund for 2 years will be around 6% (3% per year), which is less than the current yield, but better than a money market. Choices need to be made relative to available options. My complaint with Vanguard is they do not include among their fixed-income recommendations options other than funds. You won't see them recommend selling their funds and putting the money into CDs, even if all that option takes is opening a bank IRA.
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You won't see them recommend selling their funds and putting the money into CDs, even if all that option takes is opening a bank IRA.

Well, I don't expect to see commercials of Adoph Coors drinking a Bud either.

It's an easy point for VG to dismiss. Their baseline premise (despite their evolving more into managed funds) is that we shouldn't market time and only index. So they would tell us to stay into bond index funds, not even to migrate towards ST Corp in the rising rate environment, since our stock allocation should be doing the growth during the current trend. After all, what many of us are doing (shifting our fixed income allotment from bonds to MM and CD cash accts) is really a subdued form of market timing.

Maybe if there was an exodus out of VG (bond and MM funds) to banks, they'd create a CD Index fund. More likey, they'd create a bank spinoff, a la E*Trade, and just sell CD's themselves. Kinda Bogles the mind to think of that...
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SisypheanFool:
<Kinda Bogles the mind to think of that...>

UGH!!!!

Norm
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I think you can buy CDs in a Vanguard brokerage account.

As much as I value Loki's views on investments, I've been resisting setting up a 5-year CD or bond ladder to buffer income, because it's so easy to use V's short-term corp bond fund for an income buffer that deposits directly to my checking, and use V's total bond fund for the remainder of my fixed income allocation (I keep 5% in V's high yield fund). I let all dividends reinvest. A CD or bond ladder might be purer in concept and a wee bit less risky, but it would be a lot more bother. Well, maybe not a lot.

db
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"Their baseline premise (despite their evolving more into managed funds) is that we shouldn't market time and only index."

I'd say that it's not market timing when Greenspan himself has reiterated that rates are going up. There have got to be better investment vehicles than one which is almost 100% sure to lose you a significant part of your principal. You can say that what you gain in yield makes up for it, if you like. Or, you can hold your cash out in CDs until the rates have gone up and be able to not only eat the cake, but have it too.

Hedge
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Lokicious wrote:
Vanguard's claim that rising rates are not a problem for bond fund holders if you hold on for the long run is misleading, as I've commented before. For example, they've used charts showing long term returns, but run the charts past the time frame of the fund's average duration, which is cheating, since the real question is whether you are better off having money in the fund for a specified period or better off having money out of the fund, with the option of rolling the money over into the fund once the period has passed.

I think you may be misusing the term 'average duration'.

Average duration is a period of time in years that directly indicates the change in price of a bond fund resulting from a 1% change in interest rates (i.e. a 5 year average duration means the bond fund will fall about 5% in price if interest rates rise by 1%).

Average duration is always listed in the bond fund prospectus, and it gives you the most direct indication of how sensitive a bond fund is to interest rates, and is one of the first things you should review before buying into a bond fund.

... if interest rates for bonds analogous to those held by a fund go up, the total return you will receive (dividends minus capital loss) for the period of the fund's average duration will always be less than the yield of the fund at the starting point (i.e., when you bought shares or could have sold and gotten out).

You may be confusing average duration with average maturity, which are related but not normally equal. There are actually three types of average maturity:

Average Effective Maturity
A measure of a bond's maturity which takes into consideration the possibility that the issuer may call the bond before its maturity date. Also, a weighted average of the maturities of the bonds in a portfolio, taking into account all mortgage prepayments, puts, and adjustable coupons.

Average Nominal Maturity
A measure of a bond's maturity which, unlike average effective maturity, does not take into account mortgage prepayments, puts, or adjustable coupons.

Average Weighted Maturity
The length of time until the average security in a fund will mature or be redeemed by its issuer. It indicates a fixed income fund's sensitivity to interest rate changes: longer average weighted maturity implies greater volatility in response to interest rate changes.

This last one is usually the one stated in the prospectus.

Reinvesting dividends mitigates to some extent the affect of the capital loss, since you are buying new shares at lower prices, but the total will still always be less than the initial yield.

The bolded part of this statement is confusing to me. Why would you compare total (total return, I assume) with initial yield? Maybe you are saying that the total return during a period of rising interest rates will always be negative? If so, that is true only for short periods of rising rates.

Let's assume you purchase a fund at the start of a long period of rising interest rates, and hold it until the rates level off. How will you do?

Well, throughout the entire time of rising rates, you can expect the share price to decrease each year based on it's duration. And, you can expect the dividend to increase. The dividend income will increase slowly at first, and you will experience negative total returns for the first few years. But, as you hold the fund past it's average maturity, dividend increases will accelerate and then begin to exceed the amount of the rising rates, leading to positive total returns for the remaining years of the rising interest rate period if the period is long enough. This can easily make your overall total return become positive long before interest rates stop rising.

Now, I also think I understand what you are saying; that there is probably a better place for your money at the start of a rising interest rate period. However, you'd have to 'time the market' to take advantage of that. How do you know when the interest rate will begin to rise? How do you know when the rate will level off and begin decreasing? You can only guess about these things, so I think the best thing is to just decide on a long term strategy and stay with it.

So, I think Vanguard's article is really not misleading at all. It is indeed true that if you hold for the long term and reinvest your interest (dividends), bond funds can be a good deal even in a rising rate environment.

Russ
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I'd say that it's not market timing when Greenspan himself has reiterated that rates are going up.

It is the overnight rate that the FOMC has control over. Market forces control other durations.
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"Vanguard's claim that rising rates are not a problem for bond fund holders if you hold on for the long run is misleading, as I've commented before. For example, they've used charts showing long term returns, but run the charts past the time frame of the fund's average duration, which is cheating, since the real question is whether you are better off having money in the fund for a specified period or better off having money out of the fund, with the option of rolling the money over into the fund once the period has passed.

I think you may be misusing the term 'average duration'.

Average duration is a period of time in years that directly indicates the change in price of a bond fund resulting from a 1% change in interest rates (i.e. a 5 year average duration means the bond fund will fall about 5% in price if interest rates rise by 1%).

Average duration is always listed in the bond fund prospectus, and it gives you the most direct indication of how sensitive a bond fund is to interest rates, and is one of the first things you should review before buying into a bond fund.

... if interest rates for bonds analogous to those held by a fund go up, the total return you will receive (dividends minus capital loss) for the period of the fund's average duration will always be less than the yield of the fund at the starting point (i.e., when you bought shares or could have sold and gotten out).

You may be confusing average duration with average maturity, which are related but not normally equal. There are actually three types of average maturity:

Average Effective Maturity
A measure of a bond's maturity which takes into consideration the possibility that the issuer may call the bond before its maturity date. Also, a weighted average of the maturities of the bonds in a portfolio, taking into account all mortgage prepayments, puts, and adjustable coupons.

Average Nominal Maturity
A measure of a bond's maturity which, unlike average effective maturity, does not take into account mortgage prepayments, puts, or adjustable coupons.

Average Weighted Maturity
The length of time until the average security in a fund will mature or be redeemed by its issuer. It indicates a fixed income fund's sensitivity to interest rate changes: longer average weighted maturity implies greater volatility in response to interest rate changes.

This last one is usually the one stated in the prospectus.

Reinvesting dividends mitigates to some extent the affect of the capital loss, since you are buying new shares at lower prices, but the total will still always be less than the initial yield.

The bolded part of this statement is confusing to me. Why would you compare total (total return, I assume) with initial yield? Maybe you are saying that the total return during a period of rising interest rates will always be negative? If so, that is true only for short periods of rising rates.

Let's assume you purchase a fund at the start of a long period of rising interest rates, and hold it until the rates level off. How will you do?

Well, throughout the entire time of rising rates, you can expect the share price to decrease each year based on it's duration. And, you can expect the dividend to increase. The dividend income will increase slowly at first, and you will experience negative total returns for the first few years. But, as you hold the fund past it's average maturity, dividend increases will accelerate and then begin to exceed the amount of the rising rates, leading to positive total returns for the remaining years of the rising interest rate period if the period is long enough. This can easily make your overall total return become positive long before interest rates stop rising.

Now, I also think I understand what you are saying; that there is probably a better place for your money at the start of a rising interest rate period. However, you'd have to 'time the market' to take advantage of that. How do you know when the interest rate will begin to rise? How do you know when the rate will level off and begin decreasing? You can only guess about these things, so I think the best thing is to just decide on a long term strategy and stay with it.

So, I think Vanguard's article is really not misleading at all. It is indeed true that if you hold for the long term and reinvest your interest (dividends), bond funds can be a good deal even in a rising rate environment."


Russ,

Thanks for sharing the definitions, but I don't think I'm misuing "duration." What I want is the measure for a bond fund that best approximates the actual holding period for a CD, T-bill, or other individual bond, so we can compare how much money we will have at the end of that period, under different circumstances. Duration, not average weighted maturity, seems to be the bond fund measure that best fits the bill. Another way of looking at it is duration is how long it takes to flush the average current bond holdings from the fund, which is analogous to your CD coming due.

And, yes, it is always going to be true that if relevant interest rates rise, even if you reinvest dividends, your total return on a fund will be less (for the amount you have in the fund at the starting point) than the initial yield, up until the time of the fund's duration. The NAV on the fund will drop by more than the added yield you get as rates rise.

Here's another way of looking at it: number of shares in the fund I would own if I stick with the fund or if I sell the fund and put the money in a CD that currently has the same yield as the fund for the same time frame (in the real world, time frame comparisons are imperfect). Let's take a hypothetical example of a $1000 in a 5-year duration fund/CD with a non-compunded yield of 4%. Let's say it's a new fund with an NAV of $10, so I would own 100 shares of the fund. In 5 years if interest rates are at 5%, the fund's NAV would be at $9.5. Assuming interest rates grew gradually over the 5 years, I would be buying new shares with reinvested dividends at an average yield of 4.5% and average NAV of $9.75, so I now own approximately 123.8 shares (I'm ignoring compounding). After 5 years, my CD would be worth $1200 (ignoring compounding). With $1200, I now buy into the fund and get 126,3 shares (at $9.5 per share). If I stuck with the fund, the total value of my 123.8 shares would be $1176 for a return of 3.52% per year. Had the fund stayed at 4% yield, the total value would be $1200, or a return of 4%, just like the CD.
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I'd say that it's not market timing when Greenspan himself has reiterated that rates are going up

I don't disagree that my investing direction has shifted based on similar comments. My fixed income allocation has been shifted towards GNMA, CD's and E/I Bonds. My cash holdings at VG shifted from Prime MM to ST Corp. My MMA's at banks (money sidelined from being put into CD ladders) are starting to get shifted back to 90-day T-bills.

But bottom line, I'm market timing. I'm chasing a trend.
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But bottom line, I'm market timing. I'm chasing a trend.

I guess I'll have to just respectfully disagree. We've been in a low interest rate bubble for a number of years. Any bets that the rates will decline further are, IMHO, foolish and potentially suicidal. It's possible to bet that they won't go up, but that's a bet I'm not willing to make. When the guy is coming straight at you in that big red truck, and he's honking his horn and waving his hands, it's not a trend. :o)

Hedge
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Lokicious wrote:
Here's another way of looking at it: number of shares in the fund I would own if I stick with the fund or if I sell the fund and put the money in a CD that currently has the same yield as the fund for the same time frame (in the real world, time frame comparisons are imperfect). Let's take a hypothetical example of a $1000 in a 5-year duration fund/CD with a non-compunded yield of 4%. Let's say it's a new fund with an NAV of $10, so I would own 100 shares of the fund. In 5 years if interest rates are at 5%, the fund's NAV would be at $9.5. Assuming interest rates grew gradually over the 5 years, I would be buying new shares with reinvested dividends at an average yield of 4.5% and average NAV of $9.75, so I now own approximately 123.8 shares (I'm ignoring compounding). After 5 years, my CD would be worth $1200 (ignoring compounding). With $1200, I now buy into the fund and get 126,3 shares (at $9.5 per share). If I stuck with the fund, the total value of my 123.8 shares would be $1176 for a return of 3.52% per year. Had the fund stayed at 4% yield, the total value would be $1200, or a return of 4%, just like the CD.

1. You have not included the effects on the fund's dividend due to it's average maturity. As bonds are held past their average maturity, the proceeds are reinvested in newer, higher yielding bonds.

2. You have not reinvested the dividends. Reinvesting is critical to achieving market-beating rates and can easily add a percentage point of return over periods of 5 years or so.

What would happen if this fund, which has a duration of 5 years, had an average maturity of 2 years? You would find the dividend starting to exceed the prevailing interest rate after only a couple of years; well before the interest rate of 5% was reached. This effect, can and does allow a fund to have a positive net return even during a period of rising rates.

Russ
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Lokicious wrote:
What I want is the measure for a bond fund that best approximates the actual holding period for a CD, T-bill, or other individual bond, so we can compare how much money we will have at the end of that period, under different circumstances. Duration, not average weighted maturity, seems to be the bond fund measure that best fits the bill. Another way of looking at it is duration is how long it takes to flush the average current bond holdings from the fund, which is analogous to your CD coming due.

I'm sorry, but the bolded text above has nothing to do with 'duration'.

'Duration' is an entirely artificial number whose only purpose is to give you a measure of the sensitivity of a bond (or bond fund) to interest rates. The fact that the number is expressed in years is only because the interest rate you are examining is an annual rate. There is no other significance of the years.

Duration is a weighted average of the times that interest payments and the final return of principal are received. The weights are the amounts of the payments discounted by the yield-to-maturity of the bond. The final sentence may be alternatively stated:
The weights are the present values of the payments, using the bond's yield-to-maturity as the discount rate.

To calculate the duration of a bond, you need to know its coupon, yield to maturity (YTM), and maturity. Here is an example:

Let's assume you own a single $10000 bond with 8% coupon that matures in 5 years and the YTM is 7%. How would you determine its duration?

The bond thus pays $800 a year from now, $800 in 2 years, $800 in 3 years, $800 in 4 years, $800 in 5 years and the $10,000 return of principal also in 5 years.

Now, to compute the weighted average of a set of numbers, you multiply the numbers (years) by the weights and add those products up. Then you divide that total by the sum of the weights.

In this case the weights are the present values $800/1.07^1, $800/1.07^2, $800/1.07^3, $800/1.07^4, $800/1.07^5, and $10,000/1.07^5, or $747.66, $698.75, $653.04, $610.32, $570.39, $7,129.86. The numbers being averaged are the times the payments are received, or 1 year, 2 years, 3 years, 4 years, 5 years, 5 years.

Thus, the numerator is: 1*$747.66 + 2*$698.75 + 3*$653.04 + 4*$610.32 + 5*$570.39 + 5*$7,129.86. This adds to $45,046.80

And the denominator is just the sum of the present values: $747.66 + $698.75 + $653.04 + $610.32 + $570.39 + $7,129.86. This total is $10,410.02

Now dividing those two 45046.80/1041.02 gives us a duration of 4.33 years.

This means that this bond has a duration of 4.33 years, which indicates that if we had a rise in interest rates of 1%, this bond would decrease in value by 4.33%. And, that is all that the duration tells us!

Some bonds actually have negative durations! Typically, a bond's duration will be positive. However, instruments such as IO mortgage backed securities have negative durations. You can also achieve a negative duration by shorting fixed income instruments or paying fixed for floating on an interest rate swap. Inverse floaters tend to have large positive durations. Their values change significantly for small changes in rates. Highly leveraged fixed-income portfolios tend to have very large (positive or negative) durations.

The duration and maturity are the same is with zero coupon bonds.

So, as you can see, you can't use the duration for anything other than as a means to determine a bond's sensitivity to interest rate changes. For anything related to time until a bond matures, you must use average maturity.

Russ
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"1. You have not included the effects on the fund's dividend due to it's average maturity. As bonds are held past their average maturity, the proceeds are reinvested in newer, higher yielding bonds."

Yes I have. I have assumed a gradual increase in yields over the 5-year period, which is why the average yield I used in the calculations was 4.5% as dividends went from 4% to 5%. This is a higher yield than for the CD.

"2. You have not reinvested the dividends. Reinvesting is critical to achieving market-beating rates and can easily add a percentage point of return over periods of 5 years or so."

Yes I did reinvest the dividends. I reinvested them at 4.5%, as stated above. I ignored compounding for both the CD and the fund, but at these low yields over only 5 years, compounding is a very small effect (it would be slightly more for the fund, with 4.5% average yield than a CD with a 4% yield).

"What would happen if this fund, which has a duration of 5 years, had an average maturity of 2 years? You would find the dividend starting to exceed the prevailing interest rate after only a couple of years; well before the interest rate of 5% was reached. This effect, can and does allow a fund to have a positive net return even during a period of rising rates."

Can you find any examples of this?
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"So, as you can see, you can't use the duration for anything other than as a means to determine a bond's sensitivity to interest rate changes. For anything related to time until a bond matures, you must use average maturity."

I've basically been following Vanguard's insistence that if you hold a bond fund until the period of its duration, you should at least break even. I know duration is an artificial measure. But if you prefer to use average maturity for calculations, fine with me. At least for the recent past, all of the Vanguard funds have average maturities greater than durations. It still isn't going to make a difference: if in 5 years, interest rates relevant to a fund with average maturity of 6.6 and duration 5 are 1% point higher, the NAV will be down by 5%. The only way you can gain more than 5% by reinvesting dividends is if rates went up almost immediately, then stabilized, or went up over 1% then came back down. Of course, if rates stayed low early on, then went up near the end, you'd be more behind than my example.
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Lokicious wrote:
Can you find any examples of [duration that is greater than average maturity]?

I don't think you will find any normal bond funds where duration is greater than maturity. The closest you will come is with funds that invest only in zero coupon bonds. Then, duration and maturity are equal.

You will find durations greater than maturities only in specialized institutional funds that utilize leveraging, and that's probably not something the average investor would ever get involved with.

I was just trying to make a point that the term 'duration' is often misunderstood, and that when used correctly, it is a very powerful tool for evaluating the risk of a bond (or bond fund).

Russ
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This means that this bond has a duration of 4.33 years, which indicates that if we had a rise in interest rates of 1%, this bond would decrease in value by 4.33%. And, that is all that the duration tells us!

Fwiw, duration also tells us the span of time to fully recover the cost of a bond.
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SuisseBear wrote:
Fwiw, duration also tells us the span of time to fully recover the cost of a bond.

Yes, this is true by definition.

Ahhh, this is what Vanguard was getting at when they stated that if you hold a bond fund for it's duration you will break even.

Russ
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"Fwiw, duration also tells us the span of time to fully recover the cost of a bond.

Yes, this is true by definition.

Ahhh, this is what Vanguard was getting at when they stated that if you hold a bond fund for it's duration you will break even."

This is why I see duration as the best "time frame" for a bond fund for comparison to a true fixed-income asset (CD, bond).

In one of its discussions, Vanguard had a chart (which I couldn't find again on a quick look) that showed what happened with a fund during rising interest rates, reinvesting dividends. The chart extended a few years past the duration period and, indeed, at the end point the total return was greater than the fund's yield at the start. However, if you looked closely, you could see that at the point when the fund reached its duration, the total return was lower than the initial yield. This is what I find misleading.

There are certainly scenarios, and I'll accept certain specialized funds, where a bond fund under rising interest rates can do better than a fixed instrument with the same starting yield. But the starting point of this discussion was Vanguard funds, and if rates rise none of their funds, with reinvested dividends, will beat a fixed instrument with the same or higher starting yield for a specified time frame, unless rates go up very quickly or go up and then back down.
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Lokicious wrote:
This is why I see duration as the best "time frame" for a bond fund for comparison to a true fixed-income asset (CD, bond).

OK, let me try another approach. Think about the definition of the term 'duration' is as it applies to a single bond.

Let's say we have a single bond with a duration of 2.5 years, and a maturity of 4 years.

Based on the definition of 'duration' you can recover your COSTS if you sell your bond at 2.5 years (the duration) and you will 'break-even' at that time. Of course you have to include all coupons received plus the sales price of the bond. (this is only true if interest rates don't change during this period. I guess you realize that duration changes when interest rates change. In fact there is another type of duration called 'MacCauley modified duration' that will include this effect, but this is not commonly used).

However, most people would not sell their bond at 2.5 years. They would wait until 4 years (maturity), at which time they recover their entire principle, and reinvest in a new long bond in their ladder. This is exactly how a bond mutual fund normally operates. They do not normally before maturity, so duration has no meaning to a bond fund except to indicate its sensitivity to interest rates (or as Vanguard pointed out, the length of time for an investor to reach the break-even point).

The only time you would want to base time related decisions on duration when investing in a bond fund would be if the fund normally sold assets at duration. However, if they did this, especially in a rising rate environment, they would take a capital loss on every bond, plus, they would incur much higher expenses due to selling on the secondary market. I have never heard of any fund that would want do that as a normal business practice.

I would highly recommend you base your holding time related decisions on the average maturity, and your interest rate risk related decisions on average duration.

Russ
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Lokicious wrote:
This is why I see duration as the best "time frame" for a bond fund for comparison to a true fixed-income asset (CD, bond)

One more thought:

If you do decide to use duration of a bond fund for comparison with a CD or individual bond, you will have to make sure you use the DURATION of the CD or individual bond, and not the maturity, or the comparison will be apples and oranges.

Russ
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There is one thing I that hasn't been addressed by Vanguard or even rkmacdonald and Lokicious about reinvesting dividends in a bond fund. A lot of retirees investing in bond funds are investing for current income. Also a lot of retirees are forced to take their minimum required distributions from IRA's. For them it could be a hardship to reinvest dividends. I suspect one of the reasons Vanguard is encouraging reinvesting dividends in a rising interest rate environment is so people don't realize how bad they are doing and sell out completely. For example say someone invests $ 100,000 in a bond fund and in a 2 year period they earn 5,000 in dividends each year. Assume interest rates go up during this period and their principle drops 12%. If they had taken their dividends in cash, they would see their balance was $ 88,000 and would probably freak out. However, if they reinvested their dividends, they would see that their balance dropped only perhaps a little over $ 2,000 and not be that concerned. One of the truly sad things about this scenario is that they have a capital loss of $ 12,000 that they probably will never take advantage of taxwise. Even if they did (by selling out), it would take them 4 years to take advantage of it without other capital gains.
Norm
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ok, so as rates go up, you lose principle, and if you reinvest dividends you gain shares (at lower prices). when the rates go down again, now you are on the plus side because of those extra shares. to me, it works both ways....but i also dont need the cash to live on in retirement.
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There is one thing I that hasn't been addressed by Vanguard or even rkmacdonald and Lokicious about reinvesting dividends in a bond fund. A lot of retirees investing in bond funds are investing for current income.

That is true. If a retiree depends on the income they can't reinvest it. On the other hand, a retiree shouldn't necessarily be taking on the risk of longer term bonds (which suffer the most from interest rate increases), or if they do, they should understand these risks.

I suspect one of the reasons Vanguard is encouraging reinvesting dividends in a rising interest rate environment is so people don't realize how bad they are doing and sell out completely.

Are implying that reinvesting the dividends is not a financially prudent thing to do for the long term investor, and that Vanguard's motivation for this recommendation is simply to "hide" losses and stay with vanguard? If Vanguard investors were fully "aware" of the losses in their bond funds if rates go up, and they decide to sell, where exactly would they put that money instead and with whom?

One of the truly sad things about this scenario is that they have a capital loss of $ 12,000 that they probably will never take advantage of taxwise. Even if they did (by selling out), it would take them 4 years to take advantage of it without other capital gains.

If the money is in an IRA, there is no loss ANYWAY that can be taken advantage of. And if the money is not in an IRA, then there would only be a loss in NEWLY funded accounts. Anyone that invested in intermediate-long term bond funds longer than a couple of years ago is sitting on really big GAINS. If interest rates rise, then investors will give back some of their gains.

The situation you describe really only affects a retiree who depends on current income who recently put money in a longer duration bond fund, who doesn't have the luxury of reinvesting the dividends. In this case, the decision to invest in longer duration funds would be a bad one, and the retiree made a bad decision or received bad advice. Is Vanguard giving such advice?

Overall, I think Vanguard is giving very good advice, but of course they cannot cover all of the nuances of bond investing. For those with a longer term horizon who have the luxury of reinvesting the (rising) dividends, interest rate risk is not much of an issue. Vanguard even provides charts to show exactly how long it might take to make back any losses in the fund if you reinvest dividends. It seems obvious to me that if you DON'T reinvest the dividends, you aren't going to make your money back if rates go up.

For investors who need low-risk constant income streams, they are perhaps better served by savings accounts, CDs etc. Vanguard does have an "Income Fund" for current retirees, but I don't know what's in it. I assume it's high-quality, short-duration debt, not affected much by rising rates.

But I'll agree with your arguement that a current retiree who depends on income should very well understand the risks of investing in mid/long duration bonds.

FFL
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OK, let me try another approach. Think about the definition of the term 'duration' is as it applies to a single bond.

Let's say we have a single bond with a duration of 2.5 years, and a maturity of 4 years.


I don't understand how this is possible. Can you give an example? Maybe I'm confused about duration and maturity.

I can imagine that I buy a 30-year bond (it's duration) that I have bought 25 years after issue. In this case it matures in 5 years. So I have a bond with a 30 year duration but a 5 year maturity. The duration is long, but the maturity is short.

I can't come up with an example of buying a single bond with duration shorter than it's maturity. Is this possible? Or have I mixed up my terms?

Another question. Due bond fund ever buy bonds on the open market, or do they take the cash from maturing bonds and use it to buy newly issued bonds?

FFL
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"ok, so as rates go up, you lose principle, and if you reinvest dividends you gain shares (at lower prices). when the rates go down again, now you are on the plus side because of those extra shares. to me, it works both ways....but i also dont need the cash to live on in retirement."

Russ and I have been arguing about whether duration is useful as a basis for comparing a fund's time frame with fixed-time instruments, such as CDs or individual bonds. I'm certainly not going to claim that such a time frame is within the technical definition of time frame.

However, I won't concede the basic arithmetic point that, if we assume interest rates rise in a relatively linear fashion, higher yields plus reinvested dividends at lower NAVs, cannot compensate for the NAV loss to the shares held at the starting point until after the time period represented by the fund's duration at that starting point. I challenge anyone to crunch numbers for an example that shows otherwise.

Of course, if rates go back down again, the NAV will go back up. The problem, with historically low interest rates, is this is an if, not a when.

As to retirees who take the money out rather than reinvesting dividends: it seems to me a lot of folks in the finance industry, as well as financial advice columns for the lovelorn, assume retirees will be able to live off interest/dividends indefinitely, so they are more concerned with finding instruments that provide for good yields than whether these instruments are likely to sustain a loss to principle. I, for one, would love never to need to draw down principle in retirement. I think I can pull that off, if I can time my death better than I can time the market.
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" . . .a lot of retirees are forced to take their minimum required distributions from IRA's."

What are the rules about minimum required distributions from IRAs? Are there minimum required distributions from both Roth and traditional IRAs?

Thanks.

WMC
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What are the rules about minimum required distributions from IRAs? Are there minimum required distributions from both Roth and traditional IRAs?

First off, Roth IRAs have NO required minimum distributions (RMD). You can live to 120 (or whatever) without ever taking a dollar out of your Roth.

But for traditional IRAs, you have to take money out beginning at about age 70.5 (I think). You are required to take out a percentage of your IRA based on life expectancy for someone your age. I don't know all the rules, but you'll find them by doing a basic web search for IRA and RMD.

FFL
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What are the rules about minimum required distributions from IRAs? Are there minimum required distributions from both Roth and traditional IRAs?

Here's a link to Vanguard on RMDs (for IRAs and 401Ks, not relevant to Roths). The detailed piece is a PDF file. I'm sure there's a link somewhere (maybe even on TMF) to a web site with same information not in PDf form.

http://flagship2.vanguard.com/web/planret/AdvicePTManageRetHowToManageYrRet.html

Starting at age 70.5 you have to withdraw money from non-Roth retirement accounts, paying taxes at your marginal rate on all pre-tax contributions you've made plus interest/gains (none of this lower rate for capital gains and dividends, which has little or no relevance to most members of the "investment class," whose stock holdings tend to be in retirement vehicles). The PDF has the exact numbers, but it starts with taking out less than 4% of assets per year, is somewhere around 5.25% at age 80, and about 9% at age 90. At some point, unless you are making pretty good earnings, you have to draw down principle. You also need to have sufficient liquidity in each account to cover your RMD, which means if you are using less liquid assets, such as CDs or individual bonds, you need to get a ladder in gear enough in advance to insure something coming due each year. It also means, if you are in a bond fund or dividend paying stock fund, that has yield less than your RMD, you will have to sell shares in the fund, even if at a loss, which you cannot write off on taxes, to cover the minimum, regardless of whether you need the money for your living expenses.
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Correct.....but why? would anyone "want to" do either of these these two things....<VBEG>

First off, Roth IRAs have NO required minimum distributions (RMD). You can live to 120 (or whatever) without ever taking a dollar out of your Roth. (Presumably leaving the balance to Heirs?)



KBM (Live "rich" (but too long) & die "poor")

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Correct.....but why? would anyone "want to" do either of these these two things....

One reason not to spend your ROTH dollars at all is for estate planning. If you wish to leave money to charity or to your heirs, it can pass on to them tax free in the ROTH, effectively extending the tax-advantged nature of the Roth. That is, I don't think the heirs have to withdraw the money in the Roth right away. But I'm not up on my inheritance rules, so don't quote me.

If one was hoping to time it just right die broke while leading the good life, yes, you would want to spend from your Roth at some point. But if you think you (and or your spouse) might live to, say 95, then that's 25 years from the time you HAVE to start taking money from your traditional iras. If you hope to have your money last 25 years, you may not want to initially spend more than the RMD from your traditional IRA. Thus the money in the ROTH can continue to appreciate, hopefully, tax-free for quite some time until you need it.

All in all, a combination of traditional and roth accounts can lend some flexibility to estate planning, RMD issues and taxation.

FFL
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Author: Foolferlove | Date: 12/8/04 12:11 PM | Number: 11364
I wrote: <<OK, let me try another approach. Think about the definition of the term 'duration' is as it applies to a single bond.

Let's say we have a single bond with a duration of 2.5 years, and a maturity of 4 years.>>

You replied:
I don't understand how this is possible. Can you give an example? Maybe I'm confused about duration and maturity.

I can imagine that I buy a 30-year bond (it's duration) that I have bought 25 years after issue. In this case it matures in 5 years. So I have a bond with a 30 year duration but a 5 year maturity. The duration is long, but the maturity is short.

I can't come up with an example of buying a single bond with duration shorter than it's maturity. Is this possible? Or have I mixed up my terms?


My whole point for jumping into this thread was to try to clear up some of the improper useage of the terms 'duration' and 'maturity'.

Most people do not understand the term 'duration'. A bond's duration is always less than its maturity (unless it is a zero coupon bond).

The term 'Duration' is defined by the length of time to recover your costs. This number of years is meaningless except for one purpose: it tells you how much the bond value will change in response to a 1% change in interest rates. If you have a bond with a duration of 3 years, it means that if interest rates rise 1%, the value of the bond will decrease 3%. The value of the bond is only important if you plan to sell it before maturity.

The term 'maturity' tells you how long it will be until you get the face value back.

Please go back and read my previous posts on this thread. I even did a sample calculation of duration for a single bond.

Another question. Due bond fund ever buy bonds on the open market, or do they take the cash from maturing bonds and use it to buy newly issued bonds?

It just depends on the fund. Bond funds are guided by their description, definition, and risk profile. Some funds buy mostly new issues, but others buy on the secondary market.

Russ
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Please go back and read my previous posts on this thread. I even did a sample calculation of duration for a single bond.

Ah, ok. Yes. I was confused.

I understand the definition of duration as it refers to how long to get one's money back. But I ASLO thought this was the same as the term of the bond (i.e. a 5-year treasury). As in, a 5 year treasury also has a 5 year duration. So a bond fund of averge duration of 4 years is comprised of bonds that have an average term of 4 years. I see that is not the case now. Thanks!

FFL
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Author: Foolferlove | Date: 12/8/04 7:04 PM | Number: 11372
I understand the definition of duration as it refers to how long to get one's money back. But I ASLO thought this was the same as the term of the bond (i.e. a 5-year treasury). As in, a 5 year treasury also has a 5 year duration. So a bond fund of averge duration of 4 years is comprised of bonds that have an average term of 4 years. I see that is not the case now.

Example: Go to http://www.vanguard.com and look up VBMFX (Total Bond Market Index). You will see that it's Duration is 4.3 years. Then, click on 'Holdings', and you will see that it's Average Maturity is 7.2 years. The Duration of 4.3 years tells us that if interest rates rise 1%, this fund will lose 4.3% in value.

Russ
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Russ...TY for your patience throughout this entire thread. A helpful exercise on your part, and a reminder/education for many of us.

Attaboy...
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