Help 'Splain Me, O Brilliant Ones... (The Evils of Long Term Bonds?)

[MomTo2Boys]

Okay, so, I'm reading a recent Suze Orman book (dead serious, I know she's not Einstein but she writes very down to earth and she's usually 100% easy to understand) and in this book she is going on and on and on in tons of different places about how you should NEVER EVER invest in any bond fund that holds bonds longer than about 1-5 years' duration, etc. She's vehemently against funds like TLT (our mainstay), and I'm reading very carefully and trying really, really hard to understand her argument about why they are so very evil and horrid... but I'm having a hard time following why she's so against them.

I truly want to understand.

She seems to be saying that the minute interest rates start going up, that our bonds will lose value, and that this will hit bond funds the hardest. (Interestingly enough, she's not exactly against bonds themselves, and even recommends owning them directly in a 1-5 year bond ladder...just not bond FUNDS and just not any bond at all longer than about 3-5 years.)

Now, I understand the whole rates-rise-so-bond-values-go-down thing (I always thought it to be sort of a net wash, like, the rate went up but the price went down so it all sort of stays the same), but she's saying that since 1983 we have been enjoying a heyday with our long term bonds and once interest rates start going up, that heyday will be OVER and it will be BOND ZOMBIE MAYHEM.

Am I allowed to quote a book? Or is that some kind of copyright issue**? Because her explanation for hating bonds longer than 3-5 years in duration is as follows:

"The big lesson here is that bond funds that own long-term issues will be the most vulnerable if interest rates rise. Remember, when rates rise the price of bonds declines. The longer the maturity, the bigger the decline. If you want to have your money in short-term bond funds (maturities of 3 years or less), that's okay; given the very short maturity, your potential loss will be much less in a rising rate environment. But I have to point out that in late 2011 the yield on a super safe 1-year bank or credit union CD looks a lot smarter to me."

Okay, now, I actually have no problem whatsoever with buying long term bonds in the PP. After a post I tossed up here a couple of weeks ago (before I started wading into the PP), I decided to buy both the secondary bonds off of Vanguard directly and some EDV. EDV was actually my very first purchase. The PP holding that makes me crazy is actually stocks- they scare the living daylights out of me - but I bought some of the darned stuff anyway. All that to say: bonds don't scare me, but I'm trying to figure out what she means.

Some day, when rates go back up, what will that do to the bonds/bond funds in the PP? If they go down in value, then they'll be going down because stocks, gold, or cash are going up, right? Or is there something magically bad that's going to happen to our TLT and EDV and direct-purchased long term bonds someday when rates start going up, just because rates are going up? How do long term bonds react (for our purposes) when rates go up?

[**If it is, it's not my fault. I live in China and we have no copyright laws here.]

[MachineGhost]

Some day, when rates go back up, what will that do to the bonds/bond funds in the PP? If they go down in value, then they'll be going down because stocks, gold, or cash are going up, right? Or is there something magically bad that's going to happen to our TLT and EDV and direct-purchased long term bonds someday when rates start going up, just because rates are going up? How do long term bonds react (for our purposes) when rates go up?

She is right as far as bond funds go because a bond fund has no defined maturity date where you can get 100% of your principal back that may have suffered a drawdown due to rising interest rates.  In a bond fond, the drawdown can go on for an eternity.  If the interest payments cannot offset the drawdown by the time you need the money, you will have a capital loss.

What is likely to happen is that in an economic recovery, interest rates will continually rise as capital flows are attracted to earning a higher return.  This will be bullish for stocks and cash, bearish for long-term bonds and gold.  In addition or alternatively, inflation expectations can increase, also driving up interest rates.  Whether or not gold will be favorable depends on if the available interest rates are below the rate of inflation.  If not, then you'll have a genuine economic recovery, otherwise it is stagflationary.

With direct purchased bonds, you won't really notice anything is amiss if you don't look at the secondary market for a quote.  You will get 100% of your principal back at maturity, less the loss of purchasing power due to inflation.

Stocks are hedged by long-term bonds are hedged by gold are hedged by cash.  It all works in tandem.

[MomTo2Boys]

Some day, when rates go back up, what will that do to the bonds/bond funds in the PP? If they go down in value, then they'll be going down because stocks, gold, or cash are going up, right? Or is there something magically bad that's going to happen to our TLT and EDV and direct-purchased long term bonds someday when rates start going up, just because rates are going up? How do long term bonds react (for our purposes) when rates go up?

She is right as far as bond funds go because a bond fund has no defined maturity date where you can get 100% of your principal back that may have suffered a drawdown due to rising interest rates.  In a bond fond, the drawdown can go on for an eternity.  If the interest payments cannot offset the drawdown by the time you need the money, you will have a capital loss.

Ah, I get it. Thank you for explaining that. That makes a lot of sense.

So, I'm guessing this is another argument for laddering direct-purchase bonds and owning those bonds outright, rather than owning a bond fund?

But if you like EDV (as I do), you still would need to buy the EDV, right?  There's no trick for the direct ownership of those, right?

[WildAboutHarry]

With direct purchased bonds, you won't really notice anything is amiss if you don't look at the secondary market for a quote.  You will get 100% of your principal back at maturity, less the loss of purchasing power due to inflation.

Right, but the HBPP runs the Long-Term Treasury part as though it were a constant-maturity mutual fund.  You buy a 30 and sell a 20.  If interest rates have risen sufficiently in that 10-year period you will have a capital loss.

[stone]

MomTo2boys, what helped me most to understand this was the year by year chart that Craig compiled ( Clive has also posted lots of these) where the performance of each of the PP assets is shown for each year back to 1972. During the 1970s, rates did rise and LTT did lose really badly BUT for the PP overall things were fine. Then during the 1980s and 1990s, gold became the asset that sucked, then stocks took on that title. With the PP, essentially always some component of it will be being really nasty. The saving grace is that the rest of the portfolio typically compensates and so a fall in the value of your LTT can become an opportunity to buy them at a great low price from which they can rise to save the day when one of the other components sucks.

Generally if a popular investment guru is saying that something sucks (eg LTT in this case) then that indicates potential upside because that is money out there that will change its mind and pile in once things turn out not to be as they expected .

[craigr]

Also when you blend the long term and cash together the effective duration drops from around 16 years to around half. Meaning the two assets together function much like an intermediate bond fund. However the barbell of long term and short term cash is more flexible. IMO.

[moda0306]

I would say that there are WAY too many financial/investment advisors that don't understand what the value of long-term guaranteed safe return bonds would be in a balance-sheet recession.  Namely, the nature of the structural problems in the economy (bad balance-sheets and vast deleveraging) is going to make LTT's and stocks in a position of inverse correlation.

This wasn't as much the case during crises of the 1970's (inflation, but good balance sheets), or the '80's (S&L shock, but still good consumer and non-bank equity balance sheets), or even the early 2000's (housing to bouey our balance sheets).

Now our debts are like money sponges.  Most people my age could have $10,000 show up in their bank account today and probably be in a position where they could very confidenty throw it at student, home, auto, or CC debt without thinking twice.  This is what drives the diversifying value of LTT's in a recession like we have today.

[Pointedstick]

Now our debts are like money sponges.  Most people my age could have $10,000 show up in their bank account today and probably be in a position where they could very confidenty throw it at student, home, auto, or CC debt without thinking twice.  This is what drives the diversifying value of LTT's in a recession like we have today.

Up until two months ago, that was me. Of course, do it often enough and eventually it all goes away! 

[MediumTex]

Suze is trying to keep people away from forms of volatility that are difficult to understand.  The drivers of LT treasury volatility are certainly hard to understand for anyone who thinks of bonds solely in terms of coupon payments.

With the PP, however, we need constant exposure to certain very specific types of volatility, and LT treasuries provide that for us.

The LT treasury holdings in your PP could be clobbered, but so could the gold or the stocks.  It's the way the whole portfolio works that is important to understand.

Remember: Focusing on individual asset classes is the worst kind of PP navel gazing.

[BearBones]

She is right as far as bond funds go because a bond fund has no defined maturity date where you can get 100% of your principal back that may have suffered a drawdown due to rising interest rates.  In a bond fond, the drawdown can go on for an eternity.  If the interest payments cannot offset the drawdown by the time you need the money, you will have a capital loss...

With direct purchased bonds, you won't really notice anything is amiss if you don't look at the secondary market for a quote.  You will get 100% of your principal back at maturity, less the loss of purchasing power due to inflation.

Correct me if I am wrong, but 2 points of clarification:
1. For the purpose of long-term treasuries in PP, this is not as relevant, since you will sell after holding only 10 years, not holding to maturity. Therefore, is there really any significance between holding LTTs directly vs holding TLT (other than counter party risk, etc)?
2. You get your money back at maturity, but it is not worth as much. Therefore, you still lose in inflationary environment.