Long Term Bond Investing

[EDDoc]

Hey guys, I'm a new resident just getting starting in my financial journey. I caught the personal finance bug here lately and have been reading a few books, most recently All About Asset Allocation by Richard Ferri. It's a great book for those who haven't read it. One of the topics he discusses is bond index investing, where he considers/encourages weighing fixed income more heavily towards long-term bond indexes as those have shown to have greater returns (although higher risks). I've taken a look at WCI's portfolio a hundred times, and he actually seems to have more weight in the short term bond market in his fixed income portion. He does, however, seem to follow the similar principles with his equity investments, where his portfolio is weighted more towards small cap value indexes. Honestly, I haven't seen very many people talking about this idea of adding long term bond indexes to your portfolio. In looking at my portfolio (small as it may be), I have a 90/10 distribution between equities and fixed income. I was thinking about splitting my fixed income between the Vanguard Total Bond Index (5%) and the Vanguard Long-Term Bond Index (5%). Going forward as I get older and my asset allocation shifts more towards fixed income, it seems risky to have half of my "safe" investment in such a volatile market. So I guess I have a couple questions:

1. How do you guys feel about weighing your fixed income portion more heavily towards long-term bonds over just a diversified bond index?

2. As your grow towards retirement, do people ever consider changing both the equities/fixed income splits (slowly transitioning from 90/10 to 60/40) and also the weight of each fund in the asset classes to lower risk? For instance, say you had equities weighted towards small value early in life and later on transitioned more towards total stock market index. In practice, this would be like having your total US equities (60% of your portfolio) split 50/10 between VTSMX and Small Value early in life and then possibly more like 35/5 as you get towards retirement? In terms of bonds, this would transition in a similar fashion going from 5/5 in Total Bond Index and Long-Term Index and ending up with about 30/10. This makes common sense to me, but you guys know more than I do. Does this sound reasonable to you?

Thanks,

EDDoc

[jfoxcpacfp]

I see you're new to the forum - welcome! These posts on PhysicianOnFire might interest you:

Bonds: What are they good for? Part 1

Bonds: What are they good for? Part 2

This perspective is not the norm around here, nor do I ever expect it to be, but that's ok. I'm just throwing it out there as food for thought.

[ajm184]

1.  Depends upon what you are trying to accomplish.  Most people use a bond allocation as 'cushion' risk/returns against the equity portion of their portfolio.  A bond portfolio that has a higher weighting of long term bonds will have more volatility given the interest rate (though there are a large number of other risks) component of a long term bond.  If you are looking for 'higher' returns by going to long term bonds, I would tend to either a. allocating to equities or b. going toward bonds with equity like features versus a long term bond.  I used the b. approach about 10 years ago, purchasing two T. Rowe Price funds that were international and non-US currency denominated.  I did it as a primarily to have a non-correlated asset to my equity portfolio.  For the time they were held, the returns were positive but 'meh'.  in retrospect, correlation is a point in time metric, so not my most well-thought out reasoning.

2.  Yes.  In my 20's I had 0% in bonds (unless you count cash).  In my 30's I have between 5% and 10% (again cash), though not in traditional bonds (see above).  Now, I have a 20% bond allocation (in my 40's) for which I will be rebalancing early next year towards.  Only bond funds I own now are VBTLX (Vanguard Total Bond Market Admiral) and VTABX (Vangaurd Total International Bond Index Admiral).

[EDDoc]

Thank you for the input and quick reply. In terms of the second point, I was trying to get a better idea about the actual allocation inside the bond portion of your portfolio. As you get closer to retirement, do you see yourself weighing more towards the Vanguard Total Bond Market fund and less towards the Total International Bond Index as the international bond fund is likely more risky and volatile? Or do you feel like it makes more sense to keep the percentages the same throughout your investing career?

[EDDoc]

ajm184 wrote:

1.  Depends upon what you are trying to accomplish.  Most people use a bond allocation as ‘cushion’ risk/returns against the equity portion of their portfolio.  A bond portfolio that has a higher weighting of long term bonds will have more volatility given the interest rate (though there are a large number of other risks) component of a long term bond.  If you are looking for ‘higher’ returns by going to long term bonds, I would tend to either a. allocating to equities or b. going toward bonds with equity like features versus a long term bond.  I used the b. approach about 10 years ago, purchasing two T. Rowe Price funds that were international and non-US currency denominated.  I did it as a primarily to have a non-correlated asset to my equity portfolio.  For the time they were held, the returns were positive but ‘meh’.  in retrospect, correlation is a point in time metric, so not my most well-thought out reasoning.

2.  Yes.  In my 20’s I had 0% in bonds (unless you count cash).  In my 30’s I have between 5% and 10% (again cash), though not in traditional bonds (see above).  Now, I have a 20% bond allocation (in my 40’s) for which I will be rebalancing early next year towards.  Only bond funds I own now are VBTLX (Vanguard Total Bond Market Admiral) and VTABX (Vangaurd Total International Bond Index Admiral).

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Thank you for the input and quick reply. In terms of the second point, I was trying to get a better idea about the actual allocation inside the bond portion of your portfolio. As you get closer to retirement, do you see yourself weighing more towards the Vanguard Total Bond Market fund and less towards the Total International Bond Index as the international bond fund is likely more risky and volatile? Or do you feel like it makes more sense to keep the percentages the same throughout your investing career?

[TheGipper]

I actually think long term bonds are a GREAT diversifier and should have a role in almost any early accumulator portfolio.

Sure they are interest rate sensitive but their diversifying power lies in their overperformance in times of less than expected inflation (ie last 10 years!).  Despite the doom & gloom, VG long term bond index fund has returned 7.2% in the last ten years, in some periods outperforming equities.

Play around on portfoliocharts.com and you'll quickly realize the diversifying, low correlation power of long term bonds.

Short term bonds definitely have their role too, especially if they are used to rebalance to equities during downturns, and you'll find many more sophisticated bond folks advocating short term and medium term bond indexes only, but for an early accumulator, I think including a long term bond fund (perhaps as a tilt to a intermediate bond fund that includes corporate bonds) makes a lot of sense.

Don't be scared away by people that just parrot to you that they are interest rate sensitive ("duh").

 

[TheGipper]

And to Crixus's point.  Buying long term bonds now is really not akin to "buying high"  The expectation that interest have no where to go but up is already baked into the cake and long term bonds may still perform well if rates don't go up as much as expected.  This same warning against long term bonds could have been made 5 years ago and would have been dead wrong. Timing inflation and the bond market has shown to be just as impossible (maybe more so) than timing the equity market.

[Hatton]

I am nearing retirement.  I really think the bond portion of your portfolio is important.  The diversification will likely be Muni bonds in taxable and Vanguard total Bond in tax deferred.  I do have some international bond in tax deferred and couple of state specific individual long munis in taxable.  I have mainly intermediates (MUNI) and now some short term for anticipated expenses after retirement.  I am 67% equity at 60 for a reference.

[actuaryonfire]

TheGipper wrote:

And to Crixus’s point. Buying long term bonds now is really not akin to “buying high” The expectation that interest have no where to go but up is already baked into the cake and long term bonds may still perform well if rates don’t go up as much as expected.

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Nicely said and you stole my point. Crixus believes rates are low and will go up, we believe rates are low and will go up, and guess what? All the bond market participants believe that rates are low and will go up. So this expectation is built into the current pricing of bonds (called 'forward rates'). Investors in long bonds need compensation for the expectation of higher rates. This is one of the factors that drives an upward sloping yield curve.

So really your bet is not "do I think rates will go up" it is "do I think rates will rise faster than implied in the market today'?

TheGipper wrote:

I actually think long term bonds are a GREAT diversifier and should have a role in almost any early accumulator portfolio

Click to expand...

Agree - where do investors go when there is market panic? They buy Treasury bonds as a 'safe haven'. We even saw it when the US was downgraded from AAA. Investors bought Treasuries!

So in the past bonds have been a great diversifier and the long duration makes them particularly potent in this regard.

 

Is now the right time? Dunno, hard to call. But with the Fed raising rates at the short end and lots of buyers at the long end suppressing long rates, most people think we will see a flattening yield curve, and even possibly inverting as we go into the next recession. This means you will be less rewarded as a long bond holder. So I might hold off a bit until we see the impact of the next few rate hikes. [Not a recommendation just entertainment. And even that is a stretch I agree...]

 

[ajm184]

Probably not the answer you are seeking but within my bond asset allocation, 95% is in VBTLX and 5% in VTABX, doing a slight international tilt for bond diversity.  I am not seeking a higher return within international, rather looking for some diversification rate/coupon timing versus the US (different economies, different fiscal policies, differing points within economic cycle).

[jz]

Consider two philosophies of bond investing:

dry powder<------------------------------------------------------->income

(short term, treasuries, munis)                                               (long term, corporates, internationals, high yield)

My strategy is to have stable dry powder for times of stock market downdrafts.   Others strategize for constant income.  Agree with above, that we are currently in a rising rate portion of bond cycle.

[jz]

@valuedoc,   You listed interest rate, solvency, and liquidity risks of longer bonds.  How about the inflation risk of your MM or CDs?

[Zaphod]

actuaryonfire wrote:

TheGipper wrote:

And to Crixus’s point. Buying long term bonds now is really not akin to “buying high” The expectation that interest have no where to go but up is already baked into the cake and long term bonds may still perform well if rates don’t go up as much as expected.

Click to expand…

Nicely said and you stole my point. Crixus believes rates are low and will go up, we believe rates are low and will go up, and guess what? All the bond market participants believe that rates are low and will go up. So this expectation is built into the current pricing of bonds (called ‘forward rates’). Investors in long bonds need compensation for the expectation of higher rates. This is one of the factors that drives an upward sloping yield curve.

So really your bet is not “do I think rates will go up” it is “do I think rates will rise faster than implied in the market today’?

TheGipper wrote:

I actually think long term bonds are a GREAT diversifier and should have a role in almost any early accumulator portfolio

Click to expand…

Agree – where do investors go when there is market panic? They buy Treasury bonds as a ‘safe haven’. We even saw it when the US was downgraded from AAA. Investors bought Treasuries!

So in the past bonds have been a great diversifier and the long duration makes them particularly potent in this regard.

 

Is now the right time? Dunno, hard to call. But with the Fed raising rates at the short end and lots of buyers at the long end suppressing long rates, most people think we will see a flattening yield curve, and even possibly inverting as we go into the next recession. This means you will be less rewarded as a long bond holder. So I might hold off a bit until we see the impact of the next few rate hikes. [Not a recommendation just entertainment. And even that is a stretch I agree…]

 

Click to expand...

I dont know that rates have anything baked in. We've had numerous hikes now and the 10Y is at the same level it was when we started. Rates dont seem to move until well into the hiking when inflation or some other thing kicks in.

I suspect rates will eventually rise, right when everyone is convinced they never will. Yes, I think the ceiling is certainly much much lower than prior, but rise some it may.

All those long term bond returns have a massive 35+year tailwind boosting them. Even if they do their best, given normal zero bound constraints their upside is still far diminished from a return perspective compared to prior regimes. They can still serve a volatility smoothing purpose, but wont provide the protection people have come to expect. Most likely of course, just given current levels. Who knows in reality.

[Zaphod]

thevaluedoc wrote:

jz wrote:

@valuedoc,   You listed interest rate, solvency, and liquidity risks of longer bonds.  How about the inflation risk of your MM or CDs? 

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How does inflation risk put MM or CDs at greater risk than a long bond fund? I would argue the opposite.

So as of today, my vanguard Prime MM fund yield is 1.25% (which should increased to 1.5% after today). The Treasury MM is 1.1%. The long term treasury bond fund is 2.5% with ~17y duration. The long term bond index is ~3.5% with 15 year duration.

If inflation increases, the purchasing power of the $100 I have in a MM will decrease by the same amount as the $100 dollars that I have in a long bond fund assuming that rates don’t rise. In this situation, I would still get a 1-2% better return on the long bond fund. However, my understanding is if inflation increases, then the rates would also increase. Consequently, the long bond fund will decrease by approx the duration x increase in rates (i.e. 1% increase in rates leads to a 15-17% decrease in long bond fund). Therefore, I would be willing to take a 1-2% difference in unrealized gains between the MM and long term bond fund to avoid the 10-20% decreased if rates rise even 100bp in an inflationary environment. Just for perspective, the 10y UST rates rose from 7% to 15% between 1978 and 1981. If short term rates increase which would likely happen during an inflationary environment, MM funds will actually increase in value given their short term duration (and differs from a short term bond fund). The Fed could still keep rates artificially low on the short end (i.e. avoid a US default) so increases in MM may not keep pace with inflation but the Fed can’t control the long end and in such a case I would expect the 10y UST and other long bonds to be absolutely decimated (pun intended). Or did I miss something?

Post script: There is one scenario where I see inflation may help long bonds. If we have an inflationary spike (which I wouldn’t be surprised in the next 1-2 years) that forces interest rates to rise unexpectedly, the derivatives/carry trades may implode causing a massive contraction of the money supply and rates would fall. The problem then would be getting any financialized asset out of the system, IMHO.

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Also depends on how the fed unwinds their balance sheet. Many are talking about how they should do a last in first out to try to effect the longer durations more and not flatten/invert the yield curve as opposted to a first in first out that may do the opposite. Idk how powerful that would be either, but I'd take it into consideration.

Being long duration in the past has been wise and you were paid for the risk traditionally. Since the spreads are really neglible right now, I'll just wait until further in the cycle and when rates actually show some gusto to move and duration takes their first big hit, I'll likely start adding there. Wont touch before hand, you can get too much return even in shorter durations with much less rate risk.

[TheGipper]

Getting back to the simpler portfolio construction question of OP

If bonds make up 25% or less of your portfolio, probably fine to just stick with a single bond fund. Doesn’t matter much which. Total bond fund. Intermediate index. TIPS. Take your pick.

As bonds become a larger part of your portfolio and especially when you enter withdrawal phase I like the concept of diversifying with 2-3 bond funds. Short term treasury fund to buy more stocks and live off in market downturns, +/- TIPS for inflation protection, and a longer term bond fund for “deflationary” or less than expected inflation times. With periodic rebalancing among bond funds.