A Bond Idea, probably a bad one

[dualstow]

This might have been brought up before, and perhaps even by me. Can't remember.

We all know it's a bad idea  to put all your money into any of the four assets without a working crystal ball. This is especially true for bonds, where you can see your purchasing power cut in half and get stuck with a poor yield.

We also know that historically, bonds have not hit the 35% rebalancing mark as often as often as gold or stocks. (Maybe not even as often as cash, which could shoot up when the other assets crash?)

Please talk me out of this: When bonds do see a run-up, I look at the paltry yield and think, I could sell these bonds at a profit, something better than the yield, and then buy them back at the next auction. I could hold the new bonds until they need to be sold per the pp-rule (20 years left), or kick them to the vp and hold them until maturity. In the latter case, it could mean small purchasing power, per paragraph 1 above, but there would be nothing like the 50% loss one sees from a stock market crash. And, since bonds are just 25% of the pp, and the pp is just ~ 1/3 of my total, it wouldn't be a big deal.

Would it?

[Stewardship]

This might have been brought up before, and perhaps even by me. Can't remember.

We all know it's a bad idea  to put all your money into any of the four assets without a working crystal ball. This is especially true for bonds, where you can see your purchasing power cut in half and get stuck with a poor yield.

We also know that historically, bonds have not hit the 35% rebalancing mark as often as often as gold or stocks. (Maybe not even as often as cash, which could shoot up when the other assets crash?)

Please talk me out of this: When bonds do see a run-up, I look at the paltry yield and think, I could sell these bonds at a profit, something better than the yield, and then buy them back at the next auction. I could hold the new bonds until they need to be sold per the pp-rule (20 years left), or kick them to the vp and hold them until maturity. In the latter case, it could mean small purchasing power, per paragraph 1 above, but there would be nothing like the 50% loss one sees from a stock market crash. And, since bonds are just 25% of the pp, and the pp is just ~ 1/3 of my total, it wouldn't be a big deal.

Would it?

If I'm understanding you correctly, then I think yes it is a bad idea 

If your bonds have appreciated in price, that means new bond issues have lower coupon payments (that's why your bonds appreciated in the first place.)  It all balances out, so you are transacting for nothing unless you're trying to capture more volatility with newer lower-coupon bonds, or unless it is part of a tax strategy.

However I do like the idea of kicking bonds with 20 years left to the VP rather than selling and replacing them with new 30-year issues, especially if you hold your bonds at Treasury Direct and don't already have a non-IRA brokerage account to transfer them to in order to sell.

[rickb]

This might have been brought up before, and perhaps even by me. Can't remember.

We all know it's a bad idea  to put all your money into any of the four assets without a working crystal ball. This is especially true for bonds, where you can see your purchasing power cut in half and get stuck with a poor yield.

We also know that historically, bonds have not hit the 35% rebalancing mark as often as often as gold or stocks. (Maybe not even as often as cash, which could shoot up when the other assets crash?)

Please talk me out of this: When bonds do see a run-up, I look at the paltry yield and think, I could sell these bonds at a profit, something better than the yield, and then buy them back at the next auction. I could hold the new bonds until they need to be sold per the pp-rule (20 years left), or kick them to the vp and hold them until maturity. In the latter case, it could mean small purchasing power, per paragraph 1 above, but there would be nothing like the 50% loss one sees from a stock market crash. And, since bonds are just 25% of the pp, and the pp is just ~ 1/3 of my total, it wouldn't be a big deal.

Would it?

If I'm understanding you correctly, then I think yes it is a bad idea 

If your bonds have appreciated in price, that means new bond issues have lower coupon payments (that's why your bonds appreciated in the first place.)  It all balances out, so you are transacting for nothing unless you're trying to capture more volatility with newer lower-coupon bonds, or unless it is part of a tax strategy.

However I do like the idea of kicking bonds with 20 years left to the VP rather than selling and replacing them with new 30-year issues, especially if you hold your bonds at Treasury Direct and don't already have a non-IRA brokerage account to transfer them to in order to sell.

Just like replacing higher yielding bonds with lower yielding bonds is a wash (assuming they're both 20+ year bonds, a given dollar amount of them will have about the same total dividend payment and roughly the same volatility), so is replacing lower yielding bonds with higher yielding bonds [which I think was the point of kicking them to the VP - not that they've reached 20 years]. 

The notion that the principal amount of a bond whose current market value has dropped "isn't really gone" because you can hold the bond to maturity and get the full coupon value is simply silly.  If you own a bond and interest rates rise, you've lost money.  Period.  What you're really saying is that you can invest the amount of principal you have left (like, say, in the bonds you're trying to get rid of) that will guarantee you a certain amount of money (the original principal value) at a certain point in the future (when the bonds mature).  If this is a reasonable investment for your VP go for it.  But it has nothing to do with what's going on in your PP.  If your bonds lost enough value that you need to rebalance, you'll be buying more bonds (at current interest rates) anyway.  The dollar amount you have of lower yielding bonds will pay total dividends about the same as this dollar amount of (new) higher yielding bonds (this is what has made the principal value of those bonds go down) - and if they're both 20+ year bonds the future volatility also will be about the same.

Unless you're looking for a guaranteed interest rate return in your VP - which is probably pretty close to whatever n-year bonds are paying (where n is the number of years left on the PP bonds we're talking about) - by transferring these "underwater" bonds from your PP to your VP you're wasting your time.  In fact, I'd argue that instead of transferring these bonds from your PP to your VP, you might just as well buy the new bonds in your VP or (even sillier) buy another set of bonds for your VP just like the bonds you have in your PP.

Bonds are worth their current market price (pretty much by definition).  Their coupon value is a component in their current market value, but pretty much any bond that matures in 20+ years will be equivalent to any other bond that matures in 20+ years - regardless of their coupon value or coupon yield.

[Stewardship]

I could hold the new bonds until they need to be sold per the pp-rule (20 years left), or kick them to the vp and hold them until maturity.

However I do like the idea of kicking bonds with 20 years left to the VP rather than selling and replacing them with new 30-year issues, especially if you hold your bonds at Treasury Direct and don't already have a non-IRA brokerage account to transfer them to in order to sell.

Just like replacing higher yielding bonds with lower yielding bonds is a wash (assuming they're both 20+ year bonds, a given dollar amount of them will have about the same total dividend payment and roughly the same volatility), so is replacing lower yielding bonds with higher yielding bonds [which I think was the point of kicking them to the VP - not that they've reached 20 years].

The bonds reaching 20 years is to me the point of kicking them to the VP.  I took that as an aside from dualstow's main question.  He can correct me if I misunderstood.

As you know, per the HBPP, upon a bond reaching 20-years, you're supposed to sell and replace it with a 30-year.  But if you want to keep the bond for whatever reason, you can just consider the now-less-than-20-year bond part of your VP, and rebalance your PP as needed to compensate.

[dualstow]

Thank you for the replies, guys. I'll do my best to clarify.

The first bad idea, selling bonds that have suddenly appreciated for a quick profit, is the main one. It's a little like buying a stock from a newsletter, noticing it has gone up 20% in a week and selling prematurely even if the newsletter author holds on. You can always buy a second time. (By the way, don't worry about tax. Estimated payments aside, I paid zero federal tax this year, despite plenty of dividends and capital gains). The difference is, you can buy back the stock and it could crash, but $10,000 worth of bonds will still be $10,000 if you hold until maturity, and you've collected some interest in the meantime. (Of course "$10,000" is just a number, and by the time those bonds mature, inflation will most likely have taken a large bite. A paper dollar, especially the US$, still looks much like it did decades ago, but we should visualize the new prints as smaller, like the shrinking candy bars we keep seeing on store shelves).

Now for the second bad idea. Whether or not one has executed the first bad idea, "bond appreciation capture", you eventually come to the point where some of your long bonds have only 20 years left on them. They are like expired medicine. The basic ingredients are there, but they don't have the power for which you bought them in the first place.

Stewardship wrote: The bonds reaching 20 years is to me the point of kicking them to the VP.  I took that as an aside from dualstow's main question.  He can correct me if I misunderstood.

You understand perfectly, Stewardship.

Whether you sell early because of bad idea #1 or because the bonds have "expired" for the purposes of your pp, you eventually need replacement bonds.  You have to have ~ 1/4 in bonds no matter what the yield, because you need the volatility that long bonds provide. I don't mess around within the pp, so there's nothing else to say about that.

The aside applies to the expired bonds, but it is also a rationalization for trying bad idea #1 in the first place. According to the pp rules, you sell the expired bonds. If you recharacterize them as vp bonds, they are sold for all intents and purposes and are no longer the pp's business. (Harry Browne said that you should use the proceeds of the sales to buy the new bonds, though, so you have to have funds from somewhere else to buy the replacement bonds in your pp).

If you've implemented bad idea #1, you are lowering your chances that you will get to rebalance down from 35% in bonds. You gave up that + future interest payments in order to get an early profit. You are buying replacement bonds with perhaps a not-so-great yield, and not much is going to happen with them for the next ten years. Then they'll expire.

rickb wrote: The notion that the principal amount of a bond whose current market value has dropped "isn't really gone" because you can hold the bond to maturity and get the full coupon value is simply silly.  If you own a bond and interest rates rise, you've lost money.  Period.

This notion is the llusion that I have to break free from. Humans are loss-averse by nature, and the desire to not lose is even stronger than greed. This is probably why some of us sometimes fret over a drop in gold or another asset even when the pp iself is chugging along. I need to stop looking at a bond as something like a stock with insurance. "If it goes down, you can still get your money back."

I am willing to hold 25% of the pp in cash despite the fact that inflation will eat it. This is because A) the pp should beat inflation overall and B) cash has its purpose, even at low interest rates. I think I'm rationalizing, saying to myself: if I can hold cash with nearly zero interest, why can't my vp hold some bonds paying 3+%? It's kind of like cash, and will turn into cash eventually. But everything is a tradeoff. There are better investments out there, and it would make more sense to just have a smaller vp and closer to 100% of my total as pp. I just need to wrap my mind around it like rickb already has.

[rickb]

The first bad idea, selling bonds that have suddenly appreciated for a quick profit, is the main one.

(snip)

Now for the second bad idea. Whether or not one has executed the first bad idea, "bond appreciation capture", you eventually come to the point where some of your long bonds have only 20 years left on them. They are like expired medicine. The basic ingredients are there, but they don't have the power for which you bought them in the first place.

Whether you sell early because of bad idea #1 or because the bonds have "expired" for the purposes of your pp, you eventually need replacement bonds.  You have to have ~ 1/4 in bonds no matter what the yield, because you need the volatility that long bonds provide. I don't mess around within the pp, so there's nothing else to say about that.

The aside applies to the expired bonds, but it is also a rationalization for trying bad idea #1 in the first place. According to the pp rules, you sell the expired bonds. If you recharacterize them as vp bonds, they are sold for all intents and purposes and are no longer the pp's business. (Harry Browne said that you should use the proceeds of the sales to buy the new bonds, though, so you have to have funds from somewhere else to buy the replacement bonds in your pp).

If you've implemented bad idea #1, you are lowering your chances that you will get to rebalance down from 35% in bonds. You gave up that + future interest payments in order to get an early profit. You are buying replacement bonds with perhaps a not-so-great yield, and not much is going to happen with them for the next ten years. Then they'll expire.

So idea #1 is sell higher-than-current yielding bonds and buy current yielding bonds to make bonds 25% of your PP.

Assuming the higher-than-current yielding bonds are still 20+ years, this is basically just a high priced way to rebalance.  If you currently have some relatively high yielding bonds, please work the numbers.  I think you'll find the following:

1) The effective yield (the dividend divided by their current value) of your "high yielding" bonds is almost the same as what newly issued 30 year bonds pay as their coupon rate.  This is why bond values change - the price moves up or down to make the effective yield (or, perhaps more precisely, the yield to maturity) essentially match current rates. 

2) Because of #1, if you were to sell your high yielding bonds (to "lock in" the profit) and buy enough current issue bonds to make up 25% of your portfolio, the dollar amount you'll be getting in dividends is roughly the same as if you had simply sold down your high yielding bonds to 25% (i.e. rebalanced).

3) Going forward, whether interest rates go up or down or stay the same, the net effect on the value of your bonds will also be roughly the same (again, assuming 20+ year).  This is a little harder to compute, but there are some bond value calculators on the web (see https://www.google.com/#q=bond+value+calculator).  To do an A/B comparison, enter data about your current high yielding bonds to get their current value (i.e. face amount, months to maturity, coupon rate and today's rate), and then get a future value 2 years from now with interest rates 2% lower, the same, and 2% higher.  Now repeat with currently available 30-year bonds to find what their value would be 2 years from now with the same interest rate changes.

The point is any collection of 20+ year bonds with a given current dollar value is essentially the same as any other.  Regardless of the face value and coupon rates, a given dollar amount of bonds will have about the same effective yield and will move about the same amount in response to interest rate changes.

[dualstow]

So bad idea #1 is a race to nowhere, like a taxi accelerating to the next red light where he'll have to wait anyway.
I appreciate the elaboration, Rick. Very clear!