Can bond funds be a good investment vehicle in the current scenario

[rescuebot]

Again, apologies for the naivety of the question. If the only way for the interest rates is up( whether in the next month or next year or over the next 5-10 years), and bond funds will always loose value in the face of increasing interest rates, how does one hope to make any money on the bond funds either short term or long term.

So, if one keeps systematically investing 1500 dollars in Vanguard total bond fund for the next 15 years...and the interest rates go up by 5% in the next 5 years and then plateaus and then perhaps falls at some distance point in future..Is the bond fund only going to shows returns as and when the interest rates fall?

Also, I understand that the stocks give money by 1) increase in stock price which can happen even if interest rates go up 2) by giving dividends

How do bond funds work? May be, I am just confused/ prefixed that the bond fund only gives money if interest rates fall and that is completely wrong notion.

Thanks for all the input.

[Zaphod]

Bond funds are constantly buying new bonds and selling old ones, etc...also with your timed buys you are not buying at a single price but averaging it out. Rates cannot only go up, and I'd say they probably wont go up too much or too fast. See Japan for an example. They buffer your account during volatile times, etc...Bond funds give a dividend as well, with bonds youre looking for stability not necessarily appreciation.

Stocks will reflect inflation as goods/services prices go up, etc....

[lernd]

Bonds have advantages and belong in just about any portfolio for a few reasons:

1.  Bonds hopefully perform differently than stocks do - in a down stock market, bond prices hopefully rise, helping hedge against a down stock market

2.  Bond funds usually pay a monthly dividend and therefore are a means of generating income (unless you choose to re-invest the dividends, in which case you can increase your total holdings)

3.  Certain bonds - mainly govt/municipal - can have tax free earnings.  If you are in high marginal tax rate, don't underestimate the benefits.  Growth outside a tax shielded account (IRA, 401K etc) is beaten down by taxable gains.

[jfoxcpacfp]

lernd wrote:

Bonds have advantages and belong in just about any portfolio for a few reasons:

1.  Bonds hopefully perform differently than stocks do – in a down stock market, bond prices hopefully rise, helping hedge against a down stock market

2.  Bond funds usually pay a monthly dividend and therefore are a means of generating income (unless you choose to re-invest the dividends, in which case you can increase your total holdings)

3.  Certain bonds – mainly govt/municipal – can have tax free earnings.  If you are in high marginal tax rate, don’t underestimate the benefits.  Growth outside a tax shielded account (IRA, 401K etc) is beaten down by taxable gains.

Click to expand...

Note that bond funds are a very different investment vehicle from bonds. Bond funds are an anomaly. A bond is a great resource for getting a little income while parking money for planned short-term cash flow needs. A bond fund has inherent risk and is not a good way to invest given that they perform so poorly over the long term in relation to diversified equity portfolios. They are not appropriate for the short term, either, because you don't have the measure of safety necessary for meeting short-term goals. Short term = 5 years or <

Of course, this strategy works only for people who have a plan in place, as opposed to those without a true financial plan and timeline for accomplishing goals.

[The White Coat Investor]

rescuebot wrote:

Again, apologies for the naivety of the question. If the only way for the interest rates is up( whether in the next month or next year or over the next 5-10 years), and bond funds will always loose value in the face of increasing interest rates, how does one hope to make any money on the bond funds either short term or long term.

So, if one keeps systematically investing 1500 dollars in Vanguard total bond fund for the next 15 years…and the interest rates go up by 5% in the next 5 years and then plateaus and then perhaps falls at some distance point in future..Is the bond fund only going to shows returns as and when the interest rates fall?

Also, I understand that the stocks give money by 1) increase in stock price which can happen even if interest rates go up 2) by giving dividends

How do bond funds work? May be, I am just confused/ prefixed that the bond fund only gives money if interest rates fall and that is completely wrong notion.

Thanks for all the input.

Click to expand...

The naivety isn't in the question, it's in the assumptions.

First, you assume that "the only way for the interest rates is up." That's a false assumption. It's possible that interest rates could go down or even muddle around about where they're at for decades.

Second, you assume that "bond funds will always loose value in the face of increasing interest rates." That's also a false assumption that reflects a lack of understanding. When interest rates rise, the price of a bond fund drops by an amount equal to the duration of the fund. For example, if the fund yields 2% and has a duration of 5 years, and rates increase 1%, the fund will now yield 3%, but will be worth 95% of what it was worth before. In five years, that higher yield will have made up for the drop in value at the time of the rise in interest rates, and from there forward, the return on that bond fund will actually be higher than it would have been if rates had never gone up.

Third, you assume that "the bond fund only gives money if interest rates fall" which is again, a false assumption. For example, if a fund yields 5% and has a duration of 2 years, and rates go up 1%, then that fund is still going to make 4% (2% capital loss plus 6% yield) in year one, then 6% per year after that. The fund pays a yield, which it pays whether rates are going up or down. The only question is what happens to the capital value of the fund (or bond.) The change in interest rates only affects the change in value, which is only part of the total return. The other part is the yield.

[The White Coat Investor]

jfoxcpacfp wrote:

lernd wrote:

Bonds have advantages and belong in just about any portfolio for a few reasons:

1.  Bonds hopefully perform differently than stocks do – in a down stock market, bond prices hopefully rise, helping hedge against a down stock market

2.  Bond funds usually pay a monthly dividend and therefore are a means of generating income (unless you choose to re-invest the dividends, in which case you can increase your total holdings)

3.  Certain bonds – mainly govt/municipal – can have tax free earnings.  If you are in high marginal tax rate, don’t underestimate the benefits.  Growth outside a tax shielded account (IRA, 401K etc) is beaten down by taxable gains.

Click to expand…

Note that bond funds are a very different investment vehicle from bonds. Bond funds are an anomaly. A bond is a great resource for getting a little income while parking money for planned short-term cash flow needs. A bond fund has inherent risk and is not a good way to invest given that they perform so poorly over the long term in relation to diversified equity portfolios. They are not appropriate for the short term, either, because you don’t have the measure of safety necessary for meeting short-term goals. Short term = 5 years or <

Of course, this strategy works only for people who have a plan in place, as opposed to those without a true financial plan and timeline for accomplishing goals.

Click to expand...

Some of those statements are ridiculous Johanna. I know you're not big on bonds, but you don't need to make stuff up about them.

Bonds aren't an "anomaly." They're an investment, and a very reasonable one at that.

All investments have inherent risk, not just bond funds.

A bond is not a great place to "get a little income while parking money for short term cash needs." As a general rule, it's better not to buy an individual bond unless you're going to hold it to maturity due to the relatively high transaction costs. If you need "a little income while parking money for short term cash needs", a savings account or money market fund is a far better choice-guaranteed principal, no transaction costs, and "a little income."

Saying a bond fund "isn't a great way to invest" is also not true. A bond fund can be an excellent part of a diversified portfolio. Are the expected returns on a bond fund lower than the expected returns on a stock fund? Absolutely. Is that a reason they are "not a great way to invest?" Absolutely not.

Are their long-term returns always lower than stock funds? No. They haven't been in many situations in the past and there is no guarantee they will be in the future. A simple look at returns shows these facts:

First, let's look at some stocks:

Vanguard TSM: 1 year return of -7.93%, 10 year return of 6.51%, since inception of admiral shares (2000) of 4.96%

Vanguard TISM: 1 year return of -16.44%, 5 year return of -0.99%, 7 year return of 1%

Vanguard EM Index: 1 year return of -24%, 5 year return of -5.45%, Since inception (2006) 2.78%

Now, bonds:

Vanguard TBM: 1 year return of 1.28%, 10 year return of 4.66%, since inception (2001) 4.46%

Vanguard LT Treasury fund: 1 year 3.68%, 10 year 7.33%, since inception (1986) 8.09%

I think saying bonds or bonds funds are neither appropriate for investments held longer than 5 years or less than 5 years reflects your opinion far more than the facts.

[Zaphod]

The White Coat Investor wrote:

jfoxcpacfp wrote:

lernd wrote:

Bonds have advantages and belong in just about any portfolio for a few reasons:

1.  Bonds hopefully perform differently than stocks do – in a down stock market, bond prices hopefully rise, helping hedge against a down stock market

2.  Bond funds usually pay a monthly dividend and therefore are a means of generating income (unless you choose to re-invest the dividends, in which case you can increase your total holdings)

3.  Certain bonds – mainly govt/municipal – can have tax free earnings.  If you are in high marginal tax rate, don’t underestimate the benefits.  Growth outside a tax shielded account (IRA, 401K etc) is beaten down by taxable gains.

Click to expand…

Note that bond funds are a very different investment vehicle from bonds. Bond funds are an anomaly. A bond is a great resource for getting a little income while parking money for planned short-term cash flow needs. A bond fund has inherent risk and is not a good way to invest given that they perform so poorly over the long term in relation to diversified equity portfolios. They are not appropriate for the short term, either, because you don’t have the measure of safety necessary for meeting short-term goals. Short term = 5 years or <

Of course, this strategy works only for people who have a plan in place, as opposed to those without a true financial plan and timeline for accomplishing goals.

Click to expand…

Some of those statements are ridiculous Johanna. I know you’re not big on bonds, but you don’t need to make stuff up about them.

Bonds aren’t an “anomaly.” They’re an investment, and a very reasonable one at that.

All investments have inherent risk, not just bond funds.

A bond is not a great place to “get a little income while parking money for short term cash needs.” As a general rule, it’s better not to buy an individual bond unless you’re going to hold it to maturity due to the relatively high transaction costs. If you need “a little income while parking money for short term cash needs”, a savings account or money market fund is a far better choice-guaranteed principal, no transaction costs, and “a little income.”

Saying a bond fund “isn’t a great way to invest” is also not true. A bond fund can be an excellent part of a diversified portfolio. Are the expected returns on a bond fund lower than the expected returns on a stock fund? Absolutely. Is that a reason they are “not a great way to invest?” Absolutely not.

Are their long-term returns always lower than stock funds? No. They haven’t been in many situations in the past and there is no guarantee they will be in the future. A simple look at returns shows these facts:

First, let’s look at some stocks:

Vanguard TSM: 1 year return of -7.93%, 10 year return of 6.51%, since inception of admiral shares (2000) of 4.96%

Vanguard TISM: 1 year return of -16.44%, 5 year return of -0.99%, 7 year return of 1%

Vanguard EM Index: 1 year return of -24%, 5 year return of -5.45%, Since inception (2006) 2.78%

Now, bonds:

Vanguard TBM: 1 year return of 1.28%, 10 year return of 4.66%, since inception (2001) 4.46%

Vanguard LT Treasury fund: 1 year 3.68%, 10 year 7.33%, since inception (1986) 8.09%

I think saying bonds or bonds funds are neither appropriate for investments held longer than 5 years or less than 5 years reflects your opinion far more than the facts.

Click to expand...

Thats before looking at risks. Funds obviously have some characteristics of equities, however, bonds generally, and even bond funds have lower overall volatility and given their similar return and vastly different risk profile, its actually a pretty good deal.

[jfoxcpacfp]

I knew I'd get called out on that. Let's just say you and I differ on what constitutes a diversified portfolio.

We have been in a unique bond market for over 30 years now, thanks to most accommodative monetary policy ever implemented in the history of central banking. There have been only two 30-year periods when bonds outpaced equities. The first ended in 1861 and the second ended in 2011 The figures you lay out above belie the truth that this is a phenomenon that will likely never be seen again in the lives of anyone reading this blog. I don't know when or what will ultimately be the catalyst to cause this artificial bond "market" to implode, just that it will. The pure intent of bonds is not to slice and dice into funds but as a safe way for people to earn some money by loaning it to institutions needing liquidity.

Although permanent loss in a well-diversified equity portfolio is always a human achievement, the same cannot be said for bond funds.

[The White Coat Investor]

jfoxcpacfp wrote:

" /> I knew I’d get called out on that. Let’s just say you and I differ on what constitutes a diversified portfolio.

We have been in a unique bond market for over 30 years now, thanks to most accommodative monetary policy ever implemented in the history of central banking. There have been only two 30-year periods when bonds outpaced equities. The first ended in 1861 and the second ended in 2011 The figures you lay out above belie the truth that this is a phenomenon that will likely never be seen again in the lives of anyone reading this blog. I don’t know when or what will ultimately be the catalyst to cause this artificial bond “market” to implode, just that it will. The pure intent of bonds is not to slice and dice into funds but as a safe way for people to earn some money by loaning it to institutions needing liquidity.

Although permanent loss in a well-diversified equity portfolio is always a human achievement, the same cannot be said for bond funds.

Click to expand...

I'm often surprised how willing people are to use words like "always."

Consider a diversified equity portfolio in China, Russia, or Egypt at certain periods of time. There was an awful lot of permanent loss when private companies were nationalized.

Bond funds aren't going to "implode." That's a scare tactic unworthy of a financial professional. Draw up what the worst case scenario looks like in a good bond fund. It doesn't look like an implosion. It doesn't even look like the downturn the stock market had in the last quarter and has most years.

Your idea of a diversified portfolio does not include the largest asset class in the world. Mine does. That's the difference.

[jfoxcpacfp]

Nice try! Now I'm sure that you and I have different definitions of what constitutes a well-diversified equity portfolio. I wouldn't call a portfolio constituting singular Chinese, Russian, or Egyptian companies stocks a well-diversified equity portfolio, even though you think so. If you can actually refute my "always" statement, I'll change it. In the meantime, I will continue to say that the only way to maximize potential in the stock market is to own a well-diversified equity mutual fund portfolio, rebalanced periodically, and managed according to the dictates of a sound financial plan which is updated for life and goal changes. The plan always controls the process and, therefore, the portfolio. (btw, my definition of a well-diversified equity mutual fund portfolio captures the world market and has been articulated elsewhere in this blog.)

I was not using a scare tactic and I wasn't practicing free association. (Just google bonds+implode.) I do have a concern that many of the thousands of WCI readers who lurk on this blog may have little or no understanding of the difference between riskier bond funds and (relatively) less-risky bond funds and also view bond funds as "just another asset class". It's not.

The "biggest asset class in the world" is far more a reflection of the ignorance and fear of the investing masses, rather than innate investing intelligence. I do not invest my clients' money to be popular and be like everybody else. I invest in what works and has always worked, which is the least-risky method of all.

[lernd]

jfoxcpacfp wrote:

lernd wrote:

Bonds have advantages and belong in just about any portfolio for a few reasons:

1.  Bonds hopefully perform differently than stocks do – in a down stock market, bond prices hopefully rise, helping hedge against a down stock market

2.  Bond funds usually pay a monthly dividend and therefore are a means of generating income (unless you choose to re-invest the dividends, in which case you can increase your total holdings)

3.  Certain bonds – mainly govt/municipal – can have tax free earnings.  If you are in high marginal tax rate, don’t underestimate the benefits.  Growth outside a tax shielded account (IRA, 401K etc) is beaten down by taxable gains.

Click to expand…

Note that bond funds are a very different investment vehicle from bonds. Bond funds are an anomaly. A bond is a great resource for getting a little income while parking money for planned short-term cash flow needs. A bond fund has inherent risk and is not a good way to invest given that they perform so poorly over the long term in relation to diversified equity portfolios. They are not appropriate for the short term, either, because you don’t have the measure of safety necessary for meeting short-term goals. Short term = 5 years or <

Of course, this strategy works only for people who have a plan in place, as opposed to those without a true financial plan and timeline for accomplishing goals.

Click to expand...

I would make the case that a single bond is far riskier than a fund of bonds (that holds hundreds if not thousands of individual bonds).  I liken buying individual bonds to buying individual stocks in that way.  Bonds come in all shapes and forms with varying degrees of risk (and return) as do the corresponding bond funds.  I'm not saying a portfolio of 100% bonds is a good idea (individual or funds), but I think bonds are widely considered to be a part of a well diversified portfolio based on one's age.

I am curious about what others think of muni bonds (and muni bond funds) as an investment vehicle outside of tax sheltered accounts.

[jfoxcpacfp]

lernd wrote:

I would make the case that a single bond is far riskier than a fund of bonds (that holds hundreds if not thousands of individual bonds).  I liken buying individual bonds to buying individual stocks in that way.  Bonds come in all shapes and forms with varying degrees of risk (and return) as do the corresponding bond funds.  I’m not saying a portfolio of 100% bonds is a good idea (individual or funds), but I think bonds are widely considered to be a part of a well diversified portfolio based on one’s age.

Click to expand...

I'm not sure you made the case. Given that US Treasuries have never defaulted and that the global corporate default rate on AAA bonds since 1981 has been zero (and extremely low for A and AA bonds), I do not see how you can equate a well-planned bond strategy for liquidity and safety to the activity  of spinning the bottle to choose a bond strategy or speculating in junk bonds. You do have a choice in the matter, you know.

Bondholders are loaners, which is as it should be. Stockholders are owners. Bond funds are a delightful way to participate in the risk of ownership combined with the lower returns of being a loaner (albeit by slicing and dicing), which, imo, is the worst of both worlds. The fact that you liken bond ownership to stock ownership displays a marked lack of understanding of financial markets.

Just because "bonds are widely considered to be a part of a well diversified portfolio based on one’s age" doesn't make it a prudent decision. It is a better than nothing decision if you do not bother to create and adhere to a financial plan encompassing both your short- and long-term goals. Before following the herd, dig a little deeper.

This article by Ruth Konigsberg is worth reading.

[chrisCD]

I have a fairly traditional, conservative portfolio (60/40, but moving towards 70/30).  It is relatively small compared to many others here.  In place of bonds, I have been using CDs since outside of purchasing ETFs, I don't meet minimum requirements for individual bonds, at least munis.  While others posted about some fairly large losses that would scare the bejeezus out of most people, my fixed income portion had a positive that surpassed the negatives on the stocks so I was still in the black.  My point, psychology is also important.  Many people can not stomach losses and we see over and over again, people selling low and buying high.  My positive number allows me to not sweat it.  It also allows me to move a little more to the risk side and over time, I should have a better overall return.

I have also read some recent articles on when you invest and when you have to start withdrawing can also play a huge role in overall return.  So even though a higher mix of stocks over long periods of time has shown to provide higher returns, forced draw downs in down markets can have devastating affects on the ability of the portfolio to survive.  Being able to draw from cash or portions of the portfolio that are in the positive (bonds?) can allow you to make it to the "end'.

cd :O)

[YYjames]

@Johanna

I don't agree with WCI on many things, but he is right on this one. What is the global money in the market? like 200-250 trillion? Majority of that is in debt/bonds. So that will all implode? If that were to implode, it'll take the equity markets with it. Doesn't matter if you have a well diversified portfolio.

@chris

Why would I hold a CD - for psych reasons? you lose some capital etc in markets or alternative investments but yield alone outpaces that loss.

[G]

I must spend too much time on this site, because I knew exactly what everybody was going to write just based on who was posting.  Two good books that are applicable to this discussion: 1) Why Bother With Bonds; 2) Affluent Investor.

I use bond funds and won't be talked out of it.  However, my job (and certainly my profession) is stable and I can reasonably predict that I will make $X for a given amount of time (barring failed health, aliens blowing up the planet, etc).  Sounds kind of like a CD or conservative investment, right?  So with that conservative investment, I can increase the amount of risk I use in my investing...but I still use a small portion in bond funds.