Bonds Held to Maturity (Redux)

[moda0306]

The thing is, I'm a fan of individual bond ownership, but for the right reasons, in the right doses and durations, and equipped with the right knowledge.

The boobs are the one not properly diversifying the risks of bonds with their other assets, or people that think as long as they have a nominal guarantee of a future principal repayment that they haven't lost anything if rates rise... not people trying to capture the income benefits of bonds with a bond fund.

[MachineGhost]

MG, who really is the "boob" in this discussion? The investor who holds 25% allocated to LTT's (bond fund) and Cash or the speculator who is overconfident in predicting the future direction of interest rates? Also, after being proven wrong, the individual searches for a solution to re-capture losses attributed to timing.

If "boob" investors can avoid the cycle above, I think they have come along way...Some times its better to be ignorant than believe you are smarter than everyone else.

That's a loaded question, but I'm not talking about boobs that are smart enough to invest in the "forced timing" of the PP here.  I'm talking about the yield chasing boobs that are ignorantly buying bond funds with nary a clue as to what they gotten themselves into.  The ignorance is the problem more so than feeble attempts at timing.  It's not a very good strategy to prey and hope for the best; it only works with the PP because all economic regimes are hedged except increasing real interest rates.  Sadly, neither do I think the PP gives investors an excuse to be arrogant about their slightly superior position over the boobs.  It's just a wider diversification among ignorance, that's all.

The first domino to fall will be high yield bonds.

[moda0306]

MG, who really is the "boob" in this discussion? The investor who holds 25% allocated to LTT's (bond fund) and Cash or the speculator who is overconfident in predicting the future direction of interest rates? Also, after being proven wrong, the individual searches for a solution to re-capture losses attributed to timing.

If "boob" investors can avoid the cycle above, I think they have come along way...Some times its better to be ignorant than believe you are smarter than everyone else.

That's a loaded question, but I'm not talking about boobs that are smart enough to invest in the "forced timing" of the PP here.  I'm talking about the yield chasing boobs that are ignorantly buying bond funds with nary a clue as to what they gotten themselves into.  The ignorance is the problem more so than feeble attempts at timing.  It's not a very good strategy to prey and hope for the best; it only works with the PP because all economic regimes are hedged except increasing real interest rates.  Sadly, neither do I think the PP gives investors an excuse to be arrogant about their slightly superior position over the boobs.  It's just a wider diversification among ignorance, that's all.

The first domino to fall will be high yield bonds.

High yields bond buyers or yield chasers are not the equivalent of bond fund users.  These are completely different issues. 

[MachineGhost]

There's no way to escape the disadvantage of bonds other than to diversify out of them with other asset classes. The reality and stability of eventual principal repayment is great, but those economic realities don't disappear just because your fund sells out of them before that happens. It's always reflected in market price, and there's no way around that. It's why it sucks to make a long-bond bet and then have rates rise significantly, whether or not you own a fund or a bond. You can only limit your exposure to that risk by diversifying. If rates are rising significantly, you should look elsewhere in your portfolio for protection. Not trying to pretend a failing asset isn't failing just because you will get a nominal amount paid back to you 20 years from now is a joke.  Your bonds got "murdered" just like my bond fund did. Same $hit. Different pile.

I think you may be overlooking the reality of WHY boobs invest in bond funds in the first place, instead of individual bonds.  If they are smart and savvy enough to buy an individual bond to recapture their bond fund losses, they didn't have a need to buy a bond fund in the first place (other than diversification for corporates)!!!  That's what I meant by human behavior.  They are going to be "one bitten, twice shy" to even do what you propose!  Note that I didn't read the boglehead thread so I may be barking up a tree for the sake of this argument.

Further, most people aren't playing on THAT long of the curve. And if you're buying corporates, that becomes especially problematic, since now you have to diversify into multiple different companies. I'd be interested to see an elderly couple manage not only duration and buying/selling, but figuring out what corporate bonds to buy and how to get enough diversification.

Says who?  Have you heard of the phenomenom called "yield chasing"?  You have to go way out of the safety zone of 7-year maturity to get any kind of decent yield nowadays, short of consistently buying high yield corporates at a discount (which no bond fund does, I asked).  PPers may be too smart to do it, but the boobs...?

I agree with the rest of your post but I think you're barking off into Ivory Tower Territory, not the actual reality of human behavior.  Shit, even I am "once bitten, twice shy" even though I have absolutely no valid reason to be other than I can't seem to come up with a bond timing model that works in both a bear and bull markets, so I do nothing.  That's because I prefer historical evidence and data rather than buying on a whim (and I personally find the vanilla PP too risky so y'all PP bastards better stop teasing me!).

[MachineGhost]

High yields bond buyers or yield chasers are not the equivalent of bond fund users.  These are completely different issues.

Really?  Why then would a boob buy bonds right now when all the media propaganda is that rates are going to rise, if they are not also a PPer?  Or just woefully ignorant.

[rickb]

The advantage of individual bonds, that everyone seems to be overlooking here, is the GUARANTEED INCOME STREAM AND PRINCIPAL REPAYMENT. 

Not quite everyone. It's the whole reason I started the thread.

I thought you started the thread to talk about whether or not you avoid losing money if you own individual bonds when interest rates go up (because you can hold them to maturity).

MG seems to be focused not on this, but on other differences between an investment in individual bonds you intend to hold to maturity vs an investment in bond funds. 

Within the PP you always want 25% of your assets in long term bonds, so if you buy individual bonds you sell them with 20 years left and buy new 30 year bonds.  This is essentially a rolling ladder with a very long duration.  If we're comparing this to owning a bond fund (like TLT, or an imaginary TLT that doesn't loan out 1/3 of its holdings) then my contention is there's not much difference.  If interest rates fluctuate (up or down), the current market value of this portion of your portfolio will rise or fall about the same amount either way - and you'll receive about the same amount of dividends either way.  Either of these is a fine way to hold the bond portion of your PP (I actually own individual bonds because of TLT's loaning practices).

If you're thinking you might want individual bonds so you can recover their principal if interest rates go up (by holding them to maturity), then we're not really talking about the PP bond allocation.  If you have individual bonds in your PP and when they reach 20 years left you want to hold them to maturity rather than sell them, you certainly can - but if you do this you're either not following the PP anymore or you basically have to sell them to yourself to hold in your variable portfolio.  It might be more clear to think of the latter case as two separate transactions - one where you sell the bonds with 20 years left and buy new 30 year bonds in your PP, and another where you use cash in your VP to buy the 20 year bonds you just sold.  However you think of it, the net effect is you're using cash (or something else you sell to raise the cash) in your VP to buy 20 year bonds you're intending to hold to maturity (in your VP).  After an interest rate increase you can do the same thing if your PP bonds are in a fund as well.  Just buy a set of 30 year bonds (in your VP) that are 20 years from their maturity date.  When these bonds mature, you'll have "recovered" your principal whether you started with individual bonds or a bond fund.

If we're not talking about the bond portion of the PP, but rather the differences between buying and holding LTTs to maturity vs owning a long term bond fund (like TLT) then I agree with most of what MG is saying.  These are very different investments, and one or the other is more appropriate depending on what you're trying to accomplish.  If you want to keep a fixed portion (say, 25%!) of your portfolio in long term bonds, you can't buy LTTs and hold them to maturity [unless you have another portfolio to "sell" them to, like the PP to VP scenario above].  If you want a guaranteed (nominal) dividend stream and a guaranteed (nominal) amount of principal at some fixed point in the future as part of your VP, then buying and holding individual bonds to maturity is the right answer.  But this is not the reason you hold long term bonds in the PP - you hold them primarily for their price volatility (and secondarily for the dividends).  And, like the volatility of the other assets in the PP, volatility cuts both ways.

[dualstow]

The advantage of individual bonds, that everyone seems to be overlooking here, is the GUARANTEED INCOME STREAM AND PRINCIPAL REPAYMENT. 

Not quite everyone. It's the whole reason I started the thread.

I thought you started the thread to talk about whether or not you avoid losing money if you own individual bonds when interest rates go up (because you can hold them to maturity).

That's correct, Rick, but one could not start such a discussion if the guaranteed principal repayment was overlooked. It gave impetus to the whole question, How can one lose money, despite a change in interest rates, with guaranteed principal repayment?

[moda0306]

Not quite everyone. It's the whole reason I started the thread.

I thought you started the thread to talk about whether or not you avoid losing money if you own individual bonds when interest rates go up (because you can hold them to maturity).

That's correct, Rick, but one could not start such a discussion if the guaranteed principal repayment was overlooked. It gave impetus to the whole question, How can one lose money, despite a change in interest rates, with guaranteed principal repayment?

A promise to pay in the future doesn't mean you haven't lost money today.  It means that you own an asset that carries as one of its traits long-term nominal return stability.  This is a good thing to own as part of a diversified portfolio, but it doesn't wipe away the present reality of your net worth, especially if you consider the inflation risk with an asset like that. A nominal future promise could be quite unappealing if inflation were to rise to 5% and nominal rates to 7%, and I'm still holding my 3.5% individual long-term treasury bond.

[dualstow]

If you're thinking you might want individual bonds so you can recover their principal if interest rates go up (by holding them to maturity), then we're not really talking about the PP bond allocation.  If you have individual bonds in your PP and when they reach 20 years left you want to hold them to maturity rather than sell them, you certainly can - but if you do this you're either not following the PP anymore or you basically have to sell them to yourself to hold in your variable portfolio.

I have always maintained this. It's mentioned in the earlier thread ("Bad Bond Idea"), and in this thread there's even a caveat for new investors, post 1, line 1.

A promise to pay in the future doesn't mean you haven't lost money today.

Moda, no disagreement there. This is what Rick said early on.

[buddtholomew]

MG, who really is the "boob" in this discussion? The investor who holds 25% allocated to LTT's (bond fund) and Cash or the speculator who is overconfident in predicting the future direction of interest rates? Also, after being proven wrong, the individual searches for a solution to re-capture losses attributed to timing.

If "boob" investors can avoid the cycle above, I think they have come along way...Some times its better to be ignorant than believe you are smarter than everyone else.

That's a loaded question, but I'm not talking about boobs that are smart enough to invest in the "forced timing" of the PP here.  I'm talking about the yield chasing boobs that are ignorantly buying bond funds with nary a clue as to what they gotten themselves into.  The ignorance is the problem more so than feeble attempts at timing.  It's not a very good strategy to prey and hope for the best; it only works with the PP because all economic regimes are hedged except increasing real interest rates.  Sadly, neither do I think the PP gives investors an excuse to be arrogant about their slightly superior position over the boobs.  It's just a wider diversification among ignorance, that's all.

The first domino to fall will be high yield bonds.

Using the BH community as a barometer, investors have replaced bonds with CD's or significantly shortened duration. This is market timing in response to a prediction and more of a problem to the long-term success of an investor than ignoring the pundits and maintaining an allocation throughout the economic cycles.

[MachineGhost]

That's correct, Rick, but one could not start such a discussion if the guaranteed principal repayment was overlooked. It gave impetus to the whole question, How can one lose money, despite a change in interest rates, with guaranteed principal repayment?

As I was trying to feebly point out, you can't if you're in individual bonds and never bail.  For this purpose, bond funds are a scam unless -- as moda pointed out -- you're smart enough to take your realized losses and switch to individual bonds with your remaning capital, matching the same yield-to-maturity as when you locked in the loss with the bond fond.  That may or may not be the same maturity, yield or duration as when you sold, depending on how much time has passed.  It would do no good to take a loss on the bond fund then buy freshly minted on the runs with the remaning capital because you've accounted for no allownace to recoup the locked in loss.

[MachineGhost]

Using the BH community as a barometer, investors have replaced bonds with CD's or significantly shortened duration. This is market timing in response to a prediction and more of a problem to the long-term success of an investor than ignoring the pundits and maintaining an allocation throughout the economic cycles.

I guess it all depends on the mechanisms BHs use to manage the duration risk; I don't believe in predictions only historical evidence (and at this point we could easily go the way of Japan, so its a fool's game).  BHs don't think like we do in terms of economic regime hedging, so I do share your premise that they are likely making a mistake, especially replacing long-term bonds with CD's, unless they are close to retirement.  BHs may be overinfluenced by the performance of 5-year Treasuries in that simba spreadsheet which is an unrealistic and too short simulation.  5-year CDs/ladder is essentially superior to a 5-year Treasury/ladder.

The sad fact is, anyone is going to incur 80-90% real losses on LT bonds during a bond bear market like from 1942 to 1981.  The PP has not been battled tested through decades of such a bond bear market.  The 70's were the late innings of the game, not the whole game.  So the risk is non-trivial.  If gold does not perform (and it sure didn't last year with bonds tanking or the last 3 years overall), the PP is royally screwed.  We need to keep in mind that PP is a hypothesis at best and the real world has a nasty habit of invalidating them.  We need a couple more crises under a floating exchange rate regime before the PP can turn into a rock solid theory, especially that of gold (even now the widespread belief continues to be that gold is a hedge against inflation which is a false meme; if perceptions change, the performance of gold can change and not necessarily for the better in regards to the PP).  That's why I advocate a little broader diversifcation into real assets; history shows investors are a fickle bunch and you never know what's gonna be the fashion de jour of the moment or under what context you find yourself in.  Smuggling gold out of Nazi Germany just wasn't going to happen, but rare stamps sewed into your pants pocket worked great.

[buddtholomew]

The sad fact is, anyone is going to incur 80-90% real losses on LT bonds during a bond bear market like from 1942 to 1981.

How did a barbell strategy with 6-8 year duration fair over this time frame (nominal and real)? I am eager to learn how well insulated the fixed income portion of the PP is relative to an individual holding only long-term treasuries. I suspect the real losses are substantially less, but still disheartening.

[barrett]

Wait, that 80-90% figure is way off, isn't it? That 1942-1981 time period looks terrible but LTTs were paying interest all those years. That lessons the impact of the rising rates though they were obviously not the dream investment during those 40 years.

[MachineGhost]

How did a barbell strategy with 6-8 year duration fair over this time frame (nominal and real)? I am eager to learn how well insulated the fixed income portion of the PP is relative to an individual holding only long-term treasuries. I suspect the real losses are substantially less, but still disheartening.

Not much better, as I recall.  The real issue is whether or not gold -- if freely traded -- would have offset the bond losses.  I am not 100% confident about that given the PP's short out-of-sample performance since 1987.

However, it occured to me that we could get closer to the actual experience by putting the gold allocation into a cash placeholder.  So here it is from 1962 (when T-Bills start):

[img width=825 height=825]http://i58.tinypic.com/2dih9hj.png[/img]

And 1950 (when SPX starts) with 50% of the PP earning no interest until 1962:

[img width=825 height=825]http://i59.tinypic.com/fadl68.png[/img]

So do we have enough wiggle room against inflation here before gold's theoretical performance?  Note that the stocks don't include reinvested dividends until 1980.

[MachineGhost]

Wait, that 80-90% figure is way off, isn't it? That 1942-1981 time period looks terrible but LTTs were paying interest all those years. That lessons the impact of the rising rates though they were obviously not the dream investment during those 40 years.

80%-90% is the total real maximum drawdown.  Nominal it was about only 50%.  So inflation [expectations] was really bad.

I wish there were longer historical data available for real assets.  All we can do is make an educated guess.  I think it's a good bet, based on human behavior, that negative real rates forces investors into real assets.  It may not always be gold because legal and practical context matters a great deal.