typical.investor wrote: ↑Sun Jun 06, 2021 1:09 am
Just so you two don't end up fighting with each other, I'll jump in and you can fight with me.
1) I agree there is some problem with trying to sell an 18 year duration fund to rebalance into a shorter duration fund to reduce overall duration. When you do you sell? It has to be 18 years before or you will be undertaking interest rate risk by selling before the fund has recovered. If there there is rate hike 25 year (for instance) before your duration mark, you'd have to wait until 7 years before your duration mark in order not to sell at a NAV loss. But if there (for instance) is another rate hike 8 years before your duration mark, you are going to have to sell at a NAV loss. I clearly see abc132 as being correct to raise this issue.
2) It probably won't matter that much if you are reducing equity allocation as retirement approaches because instead of having to sell that 18 year duration bond, you can adjust duration by adding a shorter duration fund out of cash
3) Using two bond funds, despite what vineviz claims, isn't going to completely do the trick. Even an Ultra-Short-Term Bond Fund will have a duration of say a year. So even if you match the 18 year fund and the 1 year fund to meet your duration of 5 years, when spending time comes, a 1% rise in rates could mean a 1% loss in the short term fund you plan to spend out of.
4) duration matching is the greatest thing since slice bread, but since duration is a function of yield, you may have to recalculate your duration each time the yield changes.
5) It surely easiest for a set date - say a house purchase in 5 years or 4 years of college starting in 10 years. For a 30 years retirement, your time horizon for your first year of spending and your last year of spending is quite different, and simply targeting a middle value is going to subject you to the problems illustrated in point 1. Using an 18 year fund and a 1 year fund that you start spending from is going to lead you in years 2,3,4,5 etc to have less money in the 1 year fund due to your spending, but require you to have more. So to match the shortening duration, you will have to sell the 18 year fund which could be problematic if there has been a rate hike as you don't have time to let the fund recover.
6) As for the claim that "Matching bond duration to the investment horizon eliminates
interest rate undertaken by the investor. Period.", this is such an overstatement that no wonder there is strenous objection to the claim. The chosen phrasing renders it incorrect.
Here is what Morningstar I believe more accurately says:
Bond immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon.
Anyway, despite the complexity and limitations, I believe the underlying message is correct that matching bond duration to investment horizon can minimize interest rate risk.
Vineviz has said the above don't really matter, you are reducing risk even if in the reality that plays out you lose money. Think of adding bonds to your portfolio and then watching bonds lose money while stocks gain. This would be a similar phenomenon to getting unlucky with interest rates, as improving expected value or portfolio characteristics does not guarantee an improvement in actual value or portfolio characteristics.
The core of my position is
1) The duration when we plan to spend the bonds may not be near the actual duration of our bonds
2) If we rebalance we must sell before duration
3) Our actual duration is not really a known value.
4) If we really need our bonds, it is likely to be in the shorter term because that is when sequence of risk shows up.
1) rebalancing bonds to stocks according to a rule
2) rebalancing long bonds to take advantage of their volatility
3) scenarios where we need bonds earlier than planned
We should probably include 1-3 when we talk about a portfolio trying to take the least risk. When was the last time you did 1 and 2? (probably 2020, right?)
One 50% drop some time in the next 10 years for a 60/40 portfolio means 30% of the bonds should have something like a 5 year duration - just for one rebalancing event. That drops an expected 14 year use duration down to 11.3 (0.3*5 + 0.7*14 = 11.3), even if the sale of the bonds and repurchase are temporary. We take all that interest rate risk when rebalancing before our expected duration. If you rebalance, you minimize interest rate risk by using something less than the duration when you expect to spend the bonds and you can not eliminate interest rate risk because it is impossible to duration match your sale with rebalancing. Your AA, how and if you rebalance, these things matter.
For curiosities sake, I would ask anyone with a rebalancing rule for bonds to stocks and a rebalancing rule for long bonds to go through their portfolio for the past 25 years and calculate how much typical Boglehead rebalancing or actual lumpy spending reduces their actual bond duration as compared to when they expected to spend it permanently.
I believe the Boglehead intermediate bond fund is very sensible for many in their 60's when rebalancing, lumpy spending, and simplicity are included, although I have already said some long term bonds may be beneficial. It's something to think about, but the answer really depends on how you rebalance and how likely lumpy spending will be --> how sure you are you won't need to touch your bond fund.
I personally would want an actual portfolio analysis with expected actions before recommending long bonds for someone in their 60's. This would include their ability to tolerate short term losses of net value, their desire to rebalance, and their desire to continue rebalancing as they age. I like the intermediate recommendation over the duration matched recommendation as a general rule for the near or post retiree, and/or using something like I-bonds that just eliminates the interest rate risk automatically.
It seems likely to me that whatever your plan, in most realistic cases you will need to sell some bonds before they reach your planned duration. Adding long term bonds increases this risk because you have to sell some of them early if you duration match, and a more realistic scenario needs to counter the benefits of a supposedly perfectly duration matched portfolio - which is probably impossible in reality.
Anyone that rebalances and duration matches must
sell bonds before their portfolio duration. You are always selling something now that was intended to be used at the portfolio duration and taking interest rate risk to reduce stock/bond AA risk (and rightly so!). The added interest rate risk of rebalancing when extending duration is countered by any benefits of extending duration.