Short- and longer-term effects of rising interest rates on a bond fund

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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

skierincolorado wrote: Fri Oct 22, 2021 12:38 amSo most bond funds would not hold to maturity, which actually substantially boosts returns via roll yield. If a bond fund holds a ladder from 8 years to 4 years and then sells them, it's not holding the bonds to maturity. The yield will therefore be more than the YTM....
.Since you are doing a ladder holding to maturity - this doesn't apply. But for most real bond funds roll yield is a significant part of returns. Rolling down the yield curve to shorter durations = price increases (all else equal). This is especially true where the curve is steep - less than 10 years of duration...

So yes I *strongly* agree with your overall point. Bond returns can be quite good even when rates rise, especially once you factor in the roll return on most bond funds, and if the rate increase is modest. The 5 year rate is 1.16% today. Even if it is 1.66% two years from now, holding and rolling 5 year bonds will still have significantly positive reutrns.
Good. I understand there to be three oversimplifications in my crude simulation. In order to benefit from the roll return, we have to take into account the entire yield curve, rather than assuming a single "prevailing interest rate." And we have to assume that bonds sold prior to maturity. And we have to assume that the timing of the choice is based on optimization that is a function of the yield curve.

I'm not clear whether "roll return" plays a part in a bond index fund. To put it another way, what does the aggregate index assume about the timing of purchase and sale? (Maybe the managers of bond index funds are able to exploit roll return to overcome transaction costs in tracking the index?)

I also understand that these all work together to create an extra source of return--that is, bond funds should do better than the simulation.

Even in my oversimplified simulations, I find that the effect of a slow, gradual interest rate increase is much less than duration x interest rate change. And I can reproduce your observation that there isn't necessarily any loss at all.
Last edited by nisiprius on Fri Oct 22, 2021 7:02 am, edited 1 time in total.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

Skierincolorado makes the important point that when interest rates rise, there isn't necessarily any loss at all in a bond fund. It depends on "how much" and "how fast."

There is a balance of forces. "Pull to maturity" and coupon payments push upward, and interest rate increases push downward. However, the "force" of the downward push is tied more to rate of change than to the absolute interest rate. If the interest rate change is gradual, the downward push may be less than the upward push and there may be no loss at all.

If I may restate his point and mine, which are complementary:
  • Skierincolorado thinks that under realistic guesses for future interest rate changes, there may not be any losses at all, even short-term.
  • My point was that even if the rate increase is severe enough to create a loss, it's a short term effect, and holding the fund for an appropriate holding period gives enough time for longer-term effects to prevail.
In other words, do not misinterpret my illustration as an invitation to market timing. Even if you have foreknowledge that interest rates will go up, it does not guarantee a market timing opportunity.

It isn't necessary to take roll return into account to show this, which is good because I don't understand it well and my simulation doesn't allow for it.

Here is a simulation in which an interest rate increase causes no loss at all--again, in the simplified "bond ladder" with a single prevailing interest rate and bonds held from issue to maturity. These are 5-year bonds, and I show the interest rate increasing from 1.16% to 1.66% over a two-year period.

The duration of the bond ladder is 2.19 years, so one might incorrectly expect that an 0.5% increase would cause the fund to lose 0.5 x 2.19 = -1.1%, But as you see, the effect of the increase is a headwind, not a loss.

Under these particular assumptions, the interest rate increase creates a headwind, not a loss. I understand skierincolorado to be saying that in an actual bond fund, roll return would help even more.

Image

"Loss = duration x interest rate rise" is only accurate if the interest rate change is instantaneous.

Image
Last edited by nisiprius on Fri Oct 22, 2021 8:20 pm, edited 2 times in total.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Tom_T »

Given that example, I'm having trouble determining how to match duration to needs if the needs are spread out over several years.

For example, let us say that I lose my job and I have to partially rely on withdrawals for 1-5 years. Is a single bond fund (Total Bond or perhaps an intermediate fund) appropriate in this situation? Would the frequency of withdrawals make a difference, i.e. take them monthly or quarterly or even annually?

Or, is it better to have a year's worth of withdrawals in cash/short-term, and anything beyond that can remain in the bond fund? I am thinking that this gives the fund a chance to react to interest rate changes, as opposed to "rates went up today and I have to withdraw something tomorrow."
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by dbr »

Tom_T wrote: Fri Oct 22, 2021 7:11 am Given that example, I'm having trouble determining how to match duration to needs if the needs are spread out over several years.

For example, let us say that I lose my job and I have to partially rely on withdrawals for 1-5 years. Is a single bond fund (Total Bond or perhaps an intermediate fund) appropriate in this situation? Would the frequency of withdrawals make a difference, i.e. take them monthly or quarterly or even annually?

Or, is it better to have a year's worth of withdrawals in cash/short-term, and anything beyond that can remain in the bond fund? I am thinking that this gives the fund a chance to react to interest rate changes, as opposed to "rates went up today and I have to withdraw something tomorrow."
That depends on how large a fraction of your assets you are going to need to withdraw. The larger the fraction you are going to take the greater the need to align that liability with a matching source, in the case of one year probably cash. That is why young investors with small portfolios and large incomes to lose need cash emergency funds and retirees have portfolios so large there really aren't any emergencies that need separate funding.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by willthrill81 »

Great OP nisi.

Interest rate risk has not been the biggest risk to bonds. That honor goes to inflation, particularly unexpected inflation.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by secondopinion »

UpperNwGuy wrote: Thu Oct 21, 2021 6:18 pm
secondopinion wrote: Thu Oct 21, 2021 5:45 pm
UpperNwGuy wrote: Thu Oct 21, 2021 3:40 pm To me, any CD that matures more than 24 months into the future is a gamble. I'll stick to bonds for my investment portfolio and only use CDs for short term savings.
What kind of CDs are you looking at? If you buy those with dirt cheap rates, then yes it is bad. Remember, brokered CDs are usually not the deals.

But I assure you that some research will reveal some real gems.
I just looked at BankRate.com and don't see any real gems:
https://www.bankrate.com/banking/cds/cd-rates/
I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by UpperNwGuy »

secondopinion wrote: Fri Oct 22, 2021 10:41 am
UpperNwGuy wrote: Thu Oct 21, 2021 6:18 pm
secondopinion wrote: Thu Oct 21, 2021 5:45 pm
UpperNwGuy wrote: Thu Oct 21, 2021 3:40 pm To me, any CD that matures more than 24 months into the future is a gamble. I'll stick to bonds for my investment portfolio and only use CDs for short term savings.
What kind of CDs are you looking at? If you buy those with dirt cheap rates, then yes it is bad. Remember, brokered CDs are usually not the deals.

But I assure you that some research will reveal some real gems.
I just looked at BankRate.com and don't see any real gems:
https://www.bankrate.com/banking/cds/cd-rates/
I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
CD deals that happened "a while back" are simply not relevant to this discussion. I had my emergency fund in some excellent 24 month CDs at 2019 rates. Those CDs matured recently, and all the new CDs have no better rates than the ones listed in the BankRate link. That's why I keep the fixed income portion of my long-term investment portfolio in intermediate bond funds.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by secondopinion »

UpperNwGuy wrote: Fri Oct 22, 2021 2:28 pm
secondopinion wrote: Fri Oct 22, 2021 10:41 am
UpperNwGuy wrote: Thu Oct 21, 2021 6:18 pm
secondopinion wrote: Thu Oct 21, 2021 5:45 pm
UpperNwGuy wrote: Thu Oct 21, 2021 3:40 pm To me, any CD that matures more than 24 months into the future is a gamble. I'll stick to bonds for my investment portfolio and only use CDs for short term savings.
What kind of CDs are you looking at? If you buy those with dirt cheap rates, then yes it is bad. Remember, brokered CDs are usually not the deals.

But I assure you that some research will reveal some real gems.
I just looked at BankRate.com and don't see any real gems:
https://www.bankrate.com/banking/cds/cd-rates/
I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
CD deals that happened "a while back" are simply not relevant to this discussion. I had my emergency fund in some excellent 24 month CDs at 2019 rates. Those CDs matured recently, and all the new CDs have no better rates than the ones listed in the BankRate link. That's why I keep the fixed income portion of my long-term investment portfolio in intermediate bond funds.
They are relevant now as well. I can open a five-year CD for 0.7% that allows for adding money at any time (about $500 required to open). If there is more of a rate collapse, then the CD is helpful as a hedge (the main reason I opened it and why I am doing well); pair it up with bonds and you can see how profitable it can be. If the rates shoot upwards instead, just take the small penalty and reinitiate the CD at a far better rate (or buy bonds at a discount if you wish). If rates stagnate, then the last year or so serves as a booster for cash needed in the near future (and would be not appropriate for TBM).

Of course, 0.7% is not impressive; but do not underestimate the hedges that CDs may have.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by UpperNwGuy »

secondopinion wrote: Fri Oct 22, 2021 2:57 pm
UpperNwGuy wrote: Fri Oct 22, 2021 2:28 pm
secondopinion wrote: Fri Oct 22, 2021 10:41 am
UpperNwGuy wrote: Thu Oct 21, 2021 6:18 pm
secondopinion wrote: Thu Oct 21, 2021 5:45 pm

What kind of CDs are you looking at? If you buy those with dirt cheap rates, then yes it is bad. Remember, brokered CDs are usually not the deals.

But I assure you that some research will reveal some real gems.
I just looked at BankRate.com and don't see any real gems:
https://www.bankrate.com/banking/cds/cd-rates/
I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
CD deals that happened "a while back" are simply not relevant to this discussion. I had my emergency fund in some excellent 24 month CDs at 2019 rates. Those CDs matured recently, and all the new CDs have no better rates than the ones listed in the BankRate link. That's why I keep the fixed income portion of my long-term investment portfolio in intermediate bond funds.
They are relevant now as well. I can open a five-year CD for 0.7% that allows for adding money at any time (about $500 required to open). If there is more of a rate collapse, then the CD is helpful as a hedge (the main reason I opened it and why I am doing well); pair it up with bonds and you can see how profitable it can be. If the rates shoot upwards instead, just take the small penalty and reinitiate the CD at a far better rate (or buy bonds at a discount if you wish). If rates stagnate, then the last year or so serves as a booster for cash needed in the near future (and would be not appropriate for TBM).

Of course, 0.7% is not impressive; but do not underestimate the hedges that CDs may have.
I'll stick to intermediate bond funds, thank you.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by secondopinion »

UpperNwGuy wrote: Fri Oct 22, 2021 3:14 pm
secondopinion wrote: Fri Oct 22, 2021 2:57 pm
UpperNwGuy wrote: Fri Oct 22, 2021 2:28 pm
secondopinion wrote: Fri Oct 22, 2021 10:41 am
UpperNwGuy wrote: Thu Oct 21, 2021 6:18 pm

I just looked at BankRate.com and don't see any real gems:
https://www.bankrate.com/banking/cds/cd-rates/
I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
CD deals that happened "a while back" are simply not relevant to this discussion. I had my emergency fund in some excellent 24 month CDs at 2019 rates. Those CDs matured recently, and all the new CDs have no better rates than the ones listed in the BankRate link. That's why I keep the fixed income portion of my long-term investment portfolio in intermediate bond funds.
They are relevant now as well. I can open a five-year CD for 0.7% that allows for adding money at any time (about $500 required to open). If there is more of a rate collapse, then the CD is helpful as a hedge (the main reason I opened it and why I am doing well); pair it up with bonds and you can see how profitable it can be. If the rates shoot upwards instead, just take the small penalty and reinitiate the CD at a far better rate (or buy bonds at a discount if you wish). If rates stagnate, then the last year or so serves as a booster for cash needed in the near future (and would be not appropriate for TBM).

Of course, 0.7% is not impressive; but do not underestimate the hedges that CDs may have.
I'll stick to intermediate bond funds, thank you.
CDs, to me, are not investments that one just holds to maturity when things go against them. I am very aggressive with how I manage CDs because they hold a lot of hedging potential; I will actually take short-term losses if it maximizes my potential profitability. That is why I make money in considerable amounts with CDs. CDs that you can add money into after the fact (but not obligated to add) have massive potential for how little one has to invest.

Again, each to their own. But I know that I do very well with my activity with CDs.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by UpperNwGuy »

secondopinion wrote: Fri Oct 22, 2021 3:53 pm
UpperNwGuy wrote: Fri Oct 22, 2021 3:14 pm
secondopinion wrote: Fri Oct 22, 2021 2:57 pm
UpperNwGuy wrote: Fri Oct 22, 2021 2:28 pm
secondopinion wrote: Fri Oct 22, 2021 10:41 am

I do not use BankRate. Most of my success has been from the terms of agreement rather than the yield. The deals were a while back; I am riding off of really good terms made back in 2019 and still can earn about 3% per year for another 2 1/2 years on new cash as well as the existing cash. And as it approaches maturity, even my short term reserves for expenses can be stuffed in there as well as my investment money. All this by sacrificing about $500 to maybe a slightly inferior rate at the time. As a result, I can place up to $100,000 at these rates. A stellar bargain for a "inferior investment" at the time, no?

The gems are not always available. But spotting them can make the world of difference.
CD deals that happened "a while back" are simply not relevant to this discussion. I had my emergency fund in some excellent 24 month CDs at 2019 rates. Those CDs matured recently, and all the new CDs have no better rates than the ones listed in the BankRate link. That's why I keep the fixed income portion of my long-term investment portfolio in intermediate bond funds.
They are relevant now as well. I can open a five-year CD for 0.7% that allows for adding money at any time (about $500 required to open). If there is more of a rate collapse, then the CD is helpful as a hedge (the main reason I opened it and why I am doing well); pair it up with bonds and you can see how profitable it can be. If the rates shoot upwards instead, just take the small penalty and reinitiate the CD at a far better rate (or buy bonds at a discount if you wish). If rates stagnate, then the last year or so serves as a booster for cash needed in the near future (and would be not appropriate for TBM).

Of course, 0.7% is not impressive; but do not underestimate the hedges that CDs may have.
I'll stick to intermediate bond funds, thank you.
CDs, to me, are not investments that one just holds to maturity when things go against them. I am very aggressive with how I manage CDs because they hold a lot of hedging potential; I will actually take short-term losses if it maximizes my potential profitability. That is why I make money in considerable amounts with CDs. CDs that you can add money into after the fact (but not obligated to add) have massive potential for how little one has to invest.

Again, each to their own. But I know that I do very well with my activity with CDs.
I'm sure you do, but I'm a buy-and-hold investor and the idea of having to aggressively manage CDs doesn't interest me in the least.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by skierincolorado »

nisiprius wrote: Fri Oct 22, 2021 6:50 am Skierincolorado makes the important point that when interest rates rise, there isn't necessarily any loss at all in a bond fund. It depends on "how much" and "how fast."

There is a balance of forces. "Pull to maturity" and coupon payments push upward, and interest rate increases push downward. However, the "force" of the downward push is tied more to rate of change than to the absolute interest rate. If the interest rate change is gradual, the downward push may be less than the upward push and there may be no loss at all.

If I may restate his point and mine, which are complementary:
  • Skierincolorado thinks that under realistic guesses for future interest rate changes, there may not be any losses at all, even short-term.
  • My point was that even if the rate increase is severe enough to create a loss, it's a short term effect, and holding the fund for an appropriate holding period gives enough time for longer-term effects to prevail.
In other words, do not misinterpret my illustration. Even if you have foreknowledge that interest rates will go up, it does not guarantee a market timing opportunity.

It isn't necessary to take roll return into account to show this, which is good because I don't understand it well and my simulation doesn't allow for it.

Here is a simulation in which an interest rate increase causes no loss at all--again, in the simplified "bond ladder" with a single prevailing interest rate and bonds held from issue to maturity. These are 5-year bonds, and I show the interest rate increasing from 1.16% to 1.66% over a two-year period.

The duration of the bond ladder is 2.19 years, so one might incorrectly expect that an 0.5% increase would cause the fund to lose 0.5 x 2.19 = -1.1%, But as you see, the effect of the increase is a headwind, not a loss.

Under these particular assumptions, the interest rate increase creates a headwind, not a loss. I understand skierincolorado to be saying that in an actual bond fund, roll return would help even more.

Image

"Loss = duration x interest rate rise" is only accurate if the interest rate change is instantaneous.

Image
Wonderful summary and charts and thank you! These will serve as a useful reference for many of the concerns people have about bonds.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

secondopinion wrote: Fri Oct 22, 2021 3:53 pm...CDs, to me, are not investments that one just holds to maturity when things go against them. I am very aggressive with how I manage CDs because they hold a lot of hedging potential; I will actually take short-term losses if it maximizes my potential profitability. That is why I make money in considerable amounts with CDs. CDs that you can add money into after the fact (but not obligated to add) have massive potential for how little one has to invest.

Again, each to their own. But I know that I do very well with my activity with CDs.
Just to be clear. Do you check the terms and conditions of all your CDs to make sure they are free from language restricting early withdrawals? I don't mean penalizing them, I mean restricting them.

I mean language saying that early withdrawals are allowed "with the bank's permission" or "at the bank's discretion."

There is apparently no uniformity or regulation about that, and what one finds that such language is not rare, but also not invariable. Some CDs have it, some don't, and some have added it.

It is a confusing situation because it is virtually unheard of for a bank to deny early withdrawal, but there has also not been the kind of sharp rise in interest rates that would trigger a huge volume of early withdrawal requests. In 2012, Allan Roth reported on Ally Bank adding such language to existing CDs, but was satisfied when a bank representative assured him that it was still the bank's policy to allow early withdrawals. However, "it's our policy to allow them" is quite different from "you have the right to make them."

Do you simply accept the theoretical risk that a bank might play hardball on the terms and conditions, or do you vet the terms and conditions to make sure you aren't buying CDs that contain it?
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by ResearchMed »

nisiprius wrote: Fri Oct 22, 2021 8:29 pm
secondopinion wrote: Fri Oct 22, 2021 3:53 pm...CDs, to me, are not investments that one just holds to maturity when things go against them. I am very aggressive with how I manage CDs because they hold a lot of hedging potential; I will actually take short-term losses if it maximizes my potential profitability. That is why I make money in considerable amounts with CDs. CDs that you can add money into after the fact (but not obligated to add) have massive potential for how little one has to invest.

Again, each to their own. But I know that I do very well with my activity with CDs.
Just to be clear. Do you check the terms and conditions of all your CDs to make sure they are free from language restricting early withdrawals? I don't mean penalizing them, I mean restricting them.

I mean language saying that early withdrawals are allowed "with the bank's permission" or "at the bank's discretion."

There is apparently no uniformity or regulation about that, and what one finds that such language is not rare, but also not invariable. Some CDs have it, some don't, and some have added it.

It is a confusing situation because it is virtually unheard of for a bank to deny early withdrawal, but there has also not been the kind of sharp rise in interest rates that would trigger a huge volume of early withdrawal requests. In 2012, Allan Roth reported on Ally Bank adding such language to existing CDs, but was satisfied when a bank representative assured him that it was still the bank's policy to allow early withdrawals. However, "it's our policy to allow them" is quite different from "you have the right to make them."

Do you simply accept the theoretical risk that a bank might play hardball on the terms and conditions, or do you vet the terms and conditions to make sure you aren't buying CDs that contain it?
Wait...
"...adding such language to existing CDs..."
:confused

I'm not questioning if someone did add language to an existing agreement. But is that enforceable!?
(I'm not referring to how difficult or expensive it would be to fight it. My question is whether this really is a case where one party can unilaterally change the terms...!?)
IF the original terms including permitting the CD issuer to make changes on their own, that would cover them. But I've never heard of such a thing. ANY terms could be added, like "we hereby change this CD such that we 'll only pay 10% of the principal at maturity". Yes, that's a bit absurd, but... it's the principLE as well as the principAL :!:

RM
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by AnEngineer »

kelway wrote: Thu Oct 21, 2021 5:44 pm
nisiprius wrote: Thu Oct 21, 2021 8:26 am Some investors are being overly spooked by a misunderstanding of a) the appropriate holding time for a bond fund, and b) the short-term versus long-term relationship of interest rates to bond fund behavior.
I really appreciate you making this post. I've been spooked and in fact kind of knew that what you posted is true, but I was still considering stable value funds etc. as I don't like the negative symbol in the short term.
While the point of the OP is well taken, I still don't see the point of investing in bonds when a stable bond fund is available with a higher yield and interest rates are expected to rise.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by dbr »

AnEngineer wrote: Sat Oct 23, 2021 8:46 am
kelway wrote: Thu Oct 21, 2021 5:44 pm
nisiprius wrote: Thu Oct 21, 2021 8:26 am Some investors are being overly spooked by a misunderstanding of a) the appropriate holding time for a bond fund, and b) the short-term versus long-term relationship of interest rates to bond fund behavior.
I really appreciate you making this post. I've been spooked and in fact kind of knew that what you posted is true, but I was still considering stable value funds etc. as I don't like the negative symbol in the short term.
While the point of the OP is well taken, I still don't see the point of investing in bonds when a stable bond fund is available with a higher yield and interest rates are expected to rise.
Since 401k stable value funds are bespoke (someone used that word recently and it is descriptive) to the company and plan it is difficult to asset the risk that might be associated with the fund in terms of contract default, malfeasance, unfortunate consequences such as lack of liquidity, and so on. For a fraction of a fraction of a portfolio experience would suggest these are just non-issues. To put more than half of a considerable accumulation of assets in one single such fund might generate some second thoughts. Otherwise, your observation probably makes sense.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

I have made two new graphics... both illustrating the last period of "rising rates."

I'm intentionally using the Fed funds rate, even though it's the wrong rate to look at, because it is what is often used in rhetoric claiming to prove the inescapability of a bond fund apocalypse.

The Putnam Income Fund and the Fidelity Investment Grade Bond Fund are real bond funds. Ibbotson Associates SBBI US IT Government is a data set representing the total return of intermediate-term government bonds, and thus is known for sure not to have contained anything below investment grade during the time period shown.

Image

Image
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by secondopinion »

nisiprius wrote: Fri Oct 22, 2021 8:29 pm
secondopinion wrote: Fri Oct 22, 2021 3:53 pm...CDs, to me, are not investments that one just holds to maturity when things go against them. I am very aggressive with how I manage CDs because they hold a lot of hedging potential; I will actually take short-term losses if it maximizes my potential profitability. That is why I make money in considerable amounts with CDs. CDs that you can add money into after the fact (but not obligated to add) have massive potential for how little one has to invest.

Again, each to their own. But I know that I do very well with my activity with CDs.
Just to be clear. Do you check the terms and conditions of all your CDs to make sure they are free from language restricting early withdrawals? I don't mean penalizing them, I mean restricting them.

I mean language saying that early withdrawals are allowed "with the bank's permission" or "at the bank's discretion."

There is apparently no uniformity or regulation about that, and what one finds that such language is not rare, but also not invariable. Some CDs have it, some don't, and some have added it.

It is a confusing situation because it is virtually unheard of for a bank to deny early withdrawal, but there has also not been the kind of sharp rise in interest rates that would trigger a huge volume of early withdrawal requests. In 2012, Allan Roth reported on Ally Bank adding such language to existing CDs, but was satisfied when a bank representative assured him that it was still the bank's policy to allow early withdrawals. However, "it's our policy to allow them" is quite different from "you have the right to make them."

Do you simply accept the theoretical risk that a bank might play hardball on the terms and conditions, or do you vet the terms and conditions to make sure you aren't buying CDs that contain it?
No such restrictions; I read such terms very carefully. They say they will charge the penalty in bold words, however (and it is slightly steeper than some places, but minor enough to still make breaking it worth it if needed).

What banks do for the shareholders is often at the expense of the saver. I choose credit unions because there is less of that. It is not like I trust the shady; I vet the few really carefully and stay loyal for a long while if they stay competitive.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by skierincolorado »

nisiprius wrote: Sat Oct 23, 2021 10:54 am I have made two new graphics... both illustrating the last period of "rising rates."

I'm intentionally using the Fed funds rate, even though it's the wrong rate to look at, because it is what is often used in rhetoric claiming to prove the inescapability of a bond fund apocalypse.

The Putnam Income Fund and the Fidelity Investment Grade Bond Fund are real bond funds. Ibbotson Associates SBBI US IT Government is a data set representing the total return of intermediate-term government bonds, and thus is known for sure not to have contained anything below investment grade during the time period shown.

Image

Image
And that's for a 10% increase in the FF rate! Some might say it worked out because rates started higher.. but that's not the case. Rates rose 0.3% (from .89% to 1.20%) in the last 6 months, and yet VGIT has a positive total return since March 31. The curve is quite steep so the roll yield is compensating for some of the rate increases. An actual 5 year bond bought on March 31 would not see it's yield increase from .89% to 1.20%, because it is only a 4.5y bond today and 4.5 year bond yields are under 1.1% yield. Instead of a 0.3% rate increase, it was a 0.2% rate increase on the actual bond you (or your bond fund) held.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by kelway »

AnEngineer wrote: Sat Oct 23, 2021 8:46 am
kelway wrote: Thu Oct 21, 2021 5:44 pm
nisiprius wrote: Thu Oct 21, 2021 8:26 am Some investors are being overly spooked by a misunderstanding of a) the appropriate holding time for a bond fund, and b) the short-term versus long-term relationship of interest rates to bond fund behavior.
I really appreciate you making this post. I've been spooked and in fact kind of knew that what you posted is true, but I was still considering stable value funds etc. as I don't like the negative symbol in the short term.
While the point of the OP is well taken, I still don't see the point of investing in bonds when a stable bond fund is available with a higher yield and interest rates are expected to rise.
I suppose the stable value fund won't zag if things hit the fan.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by dbr »

kelway wrote: Sat Oct 23, 2021 12:39 pm

I suppose the stable value fund won't zag if things hit the fan.
The return on a stable value fund varies over time even when the principal is guaranteed to be stable. Risk being the variability of return, stable value funds are not risk free. That also takes no account of inflation. Generally SV fund yield lags the timing of bond yields, being slower to go down and slower to go back up. At one time 4%-5% was available in such a fund and now 2% seems attractive for some reason.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by quattro73 »

Bond funds may have an average duration of x but that is a vast mix of durations, and they have a steady stream of maturing cash flows that are re-invested t the prevailing rate. Plus new inflows from investors. So they would be constantly buying new issuances at the current rate giving some buffer and if they don’t sell older bonds early at a discount, the loss is not realized.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by BitTooAggressive »

RickyGold wrote: Thu Oct 21, 2021 11:06 am Wow, another great post from Nisiprius. Makes me feel better as I own a boatload of Total Bond Fund.

Also, check out this article by Mark Hulbert:

https://www.marketwatch.com/story/you-c ... =home-page

If my understanding is correct, and interest rates rise, I won't lose any money as long as I hold my Total Bond fund for about 10-years.

I am good with that, as my holding period for Total Bond is forever!
So is breaking even after 10 years a good investment considering inflation has not even been factored in? what if we are in a steadily rising interest rate environment for 10 years?

Bonds are horrible in this environment. I do have a high quality short term bond index fund that I will add to as I approach retirement in the next 6 years.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Forester »

One chart is the nominal return, the other is the actual return both after coupons reinvested? Bond investors of the late 1960s did not break even until 1985 to say nothing of the opportunity cost.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

Forester wrote: Sun Oct 24, 2021 5:34 am One chart is the nominal return, the other is the actual return both after coupons reinvested? Bond investors of the late 1960s did not break even until 1985 to say nothing of the opportunity cost.
Interest rate risk and inflation risk are two separate things and need to be kept separate.

I am not saying bonds are a great investment. I am trying to make sure that people don't fall for exaggerated alarmism based on misunderstandings of interest rate risk. It's easy to understand that inflation is going to hurt any fixed-dollar asset. We know what inflation will do to physical cash, a bank account, etc.

The relation between "interest rates" and bonds is more complicated, and there are several ways people can misunderstand it--badly enough to cause financial harm. I honestly believe that many people think things like that there could be a bond market crash comparable in magnitude to a stock market crash "because the Fed is going to raise 'interest rates'" and because "when interest rates go up, bond funds go down."

Why would they misunderstand it? What do you expect when they are constantly being exposed to rhetoric like this:
In 2010, in the Wall Street Journal, Jeremy Schwartz and Jeremy Siegel wrote:Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more…. A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds….
It is important to note that interest rates actually did rise by the amount they were raising the alarm about. But do you remember the devastating bond market crash of 2011? Nope, neither do I.

I'm trying to help people get an intuitive understand of what the effects of an interest rate rise might look like.

And I get tired of the tedious-but-inevitable business that always crops up eventually: "but inflation," followed by "but TIPS."
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Zeno »

I always learn from your posts, nisiprius. Thank you very much for all the work you put into educating folks like me. I truly appreciate it.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Booogle »

nisiprius wrote: Sat Oct 23, 2021 10:54 am I'm intentionally using the Fed funds rate, even though it's the wrong rate to look at
What is the right rate to look at?
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

Booogle wrote: Mon Oct 25, 2021 6:18 am
nisiprius wrote: Sat Oct 23, 2021 10:54 am I'm intentionally using the Fed funds rate, even though it's the wrong rate to look at
What is the right rate to look at?
If you're looking at intermediate-term bonds, the rates their market value is responding to are, of course, intermediate-term rates.

Vanguard Total Bond has an average maturity of 8.6 years, somewhere between 7 and 10 years, and the 10-year rate is easy to find, often cited, and reasonably close.

The reason I used the Fed Funds rate is that when overconfident alarmists talk about why bonds are doomed, they often justify it by a lot of blather about what the Fed is doing, or says it's about to do, or what they think it will really do instead. Usually they are talking about the rate the Fed "sets"*, which the rate for an overnight loan. Longer-term rates, like the 10-year rate, are set by the market. Sometimes the Fed directly participates in the market for longer-term bonds and tries to influence it, but the influence is subtle enough that academics have to write papers trying to spot the effect and figure out how big it was. It's far short of "control."

So here is the relationship between the Fed Funds overnight rate which like to talk about when name-dropping "but the Fed is going to" (blue) and the ten-year rate which is close to what the market values of intermediate-term bond funds are responding to.

Image

And during the time period of interest, here's the "what really happened" chart updated to include both the Fed Funds and the ten-year rate:

Image


* (Phineas T. Whoopee has explained to me repeatedly that even the overnight rate is not "set" by the Fed. Even the overnight rate is basically a market rate, that technically is only influenced, not set, by the Fed.)
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by prioritarian »

AnEngineer wrote: Sat Oct 23, 2021 8:46 am and interest rates are expected to rise.
Bond funds do fine during periods of modestly rising interest rates. And even if interest rates rise sharply bond funds tend to recoup those losses over time -- which was the entire point of the excellent OP. If one is concerned about losses due to a transient interest rate increase then duration matching should be more of a focus than "market timing" hypothetical interest rate spikes, ATMO.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by AnEngineer »

prioritarian wrote: Mon Oct 25, 2021 11:00 am
AnEngineer wrote: Sat Oct 23, 2021 8:46 am and interest rates are expected to rise.
Bond funds do fine during periods of modestly rising interest rates. And even if interest rates rise sharply bond funds tend to recoup those losses over time -- which was the entire point of the excellent OP. If one is concerned about losses due to a transient interest rate increase then duration matching should be more of a focus than "market timing" hypothetical interest rate spikes, ATMO.
The context of what I was saying was important:
AnEngineer wrote: Sat Oct 23, 2021 8:46 am While the point of the OP is well taken, I still don't see the point of investing in bonds when a stable bond fund is available with a higher yield and interest rates are expected to rise.
The "interest rates are expected to rise" is perhaps better stated as interest rates are not expected to fall. If I can get a reasonably safe (and the point above about the risk with high allocations to stable value funds is well taken) higher yield with another investment then why would I consider buying bonds at all? The exception I see is if rates are going to fall, then I may do well with bonds from some combination of price appreciation and possible subsequent yield loss in the stable value fund.

In other words, the comparison point is important. The OP does a good job of comparing buying bonds with stuffing cash under a mattress, but there are other options which may make sense. It also demonstrates how I focus my thinking on bonds, which is that you know the future value at a specific point in time, but before and after that are uncertain. If the terms given that future value are decent, it's a good investment.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by garlandwhizzer »

As nisi has shown, rising rates do not destroy bond returns in nominal terms in a rising inflationary environment. The problem is that persistently rising rates is usually associated with persistently rising inflation. Inflation and rising rates together is a potent combination against real returns from fixed income. Unlike bonds, widely diversified equity is a good hedge against long term inflation. Given today's low rate environment where yields are well less than inflation nominal bonds, especially long term nominal bonds, carry considerable risk of zero or less real returns for a decade or more if rising persists. I don't personally believe it will persist, but it is a non-zero probability.

Bonds still provide safety from equity volatility but in terms of real returns I expect about zero from them, perhaps less, for a decade or so. Unfortunately 10 years from now you don't get to buy things with today's nominal dollars. Today's dollar values will be diminished by 10 years of compounded inflation. Real purchasing power is the only kind that matters in the future. Treasuries lost real purchasing power for 4 decades running between 1940 and 1980 for example. Needless to say 40 years of negative real returns is devastating for a bond heavy portfolio. The 40 years after that, 1980 - 2020 was the greatest bond bull market of all time. It recently ended. Don't expect a replay.

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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by prioritarian »

garlandwhizzer wrote: Mon Oct 25, 2021 12:17 pm
Bonds still provide safety from equity volatility but in terms of real returns I expect about zero from them, perhaps less, for a decade or so. Unfortunately 10 years from now you don't get to buy things with today's nominal dollars.

Garland Whizzer

I think much of the bond fear/bond market timing on bogleheads is rooted in the premise that inflation can only go up. I disagree and my asset allocation (AA) is based on the idea that breton woods II, technological innovation, and shifting demographics (and verboten topics) will maintain the current long-term disinflationary trend. Regardless of who is correct, I'm not going to market time my bond holdings and will continue an AA based on duration matching and, to a lesser extent, back-tested equity diversification.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by secondopinion »

prioritarian wrote: Mon Oct 25, 2021 1:53 pm
garlandwhizzer wrote: Mon Oct 25, 2021 12:17 pm
Bonds still provide safety from equity volatility but in terms of real returns I expect about zero from them, perhaps less, for a decade or so. Unfortunately 10 years from now you don't get to buy things with today's nominal dollars.

Garland Whizzer

I think much of the bond fear/bond market timing on bogleheads is rooted in the premise that inflation can only go up. I disagree and my asset allocation (AA) is based on the idea that breton woods II, technological innovation, and shifting demographics (and verboten topics) will maintain the current long-term disinflationary trend. Regardless of who is correct, I'm not going to market time my bond holdings and will continue an AA based on duration matching and, to a lesser extent, back-tested equity diversification.
The problem is major bond holders are more at risk of inflation than major stock holders are; these also happen to be individuals that cannot afford much risk. The panic is real because the risks are real; sadly, it should have been already factored into the portfolio construction instead of taking a scare to realize it.

US treasuries are being seen as very safe and hence are being demanded at even lower real rates. When real yields are negative despite the historical suggesting positive real yields, this suggests an increased tail risk; not only does it has to adjust for new levels of sustained inflation (should it happen, that is) but also adjust for the diminished opinions of the US treasury. By the time all this happens, the real losses are major. However, the more likely result is not this but relatively stable real dollars after 20 or so years.

As I said, the risk depends on how much is held in bonds.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by RickyGold »

BitTooAggressive wrote: Sun Oct 24, 2021 2:53 am
RickyGold wrote: Thu Oct 21, 2021 11:06 am Wow, another great post from Nisiprius. Makes me feel better as I own a boatload of Total Bond Fund.

Also, check out this article by Mark Hulbert:

https://www.marketwatch.com/story/you-c ... =home-page

If my understanding is correct, and interest rates rise, I won't lose any money as long as I hold my Total Bond fund for about 10-years.

I am good with that, as my holding period for Total Bond is forever!
So is breaking even after 10 years a good investment considering inflation has not even been factored in? what if we are in a steadily rising interest rate environment for 10 years?

Bonds are horrible in this environment. I do have a high quality short term bond index fund that I will add to as I approach retirement in the next 6 years.
Bonds may or may not be horrible...depends on whether interest rates are going up for a long time and by how much. I don't think anybody knows the answer to that question. I certainly don't. That is why, in addition to bonds, I also own stocks. Diversification is the key!
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by BitTooAggressive »

RickyGold wrote: Tue Oct 26, 2021 9:33 am
BitTooAggressive wrote: Sun Oct 24, 2021 2:53 am
RickyGold wrote: Thu Oct 21, 2021 11:06 am Wow, another great post from Nisiprius. Makes me feel better as I own a boatload of Total Bond Fund.

Also, check out this article by Mark Hulbert:

https://www.marketwatch.com/story/you-c ... =home-page

If my understanding is correct, and interest rates rise, I won't lose any money as long as I hold my Total Bond fund for about 10-years.

I am good with that, as my holding period for Total Bond is forever!
So is breaking even after 10 years a good investment considering inflation has not even been factored in? what if we are in a steadily rising interest rate environment for 10 years?

Bonds are horrible in this environment. I do have a high quality short term bond index fund that I will add to as I approach retirement in the next 6 years.
Bonds may or may not be horrible...depends on whether interest rates are going up for a long time and by how much. I don't think anybody knows the answer to that question. I certainly don't. That is why, in addition to bonds, I also own stocks. Diversification is the key!
I agree Ricky diversification is probably the most important thing in investing.

The thing is if interest rates don’t go up you are getting negligible yield. When they do go up you will take a hit based on duration and how long/fast they rise.

For me right now, I am not retired yet, they only provide some ability to rebalance if the market goes down , and is a start for what I want in my cash like bucket.

I assume interest rates will go up sometime in the future and then I would be comfortable about holding some intermediate bonds. Just not now.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by neurosphere »

neurosphere wrote: Thu Oct 21, 2021 6:01 pm On my to-do list is to make similar graphs, but instead of comparing funds with different interest rates scenarios, to illustrate the effect on funds of different durations in response to a given set of interest rates changes.

Nisi, I have bookmarked your post. Thanks.
Still on my to-do list! But now I'm planning a version that compares two or more funds with different different durations under various interest rate situations. I think my excel skills are up to the task...we shall see. :)
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by neurosphere »

garlandwhizzer wrote: Mon Oct 25, 2021 12:17 pm Bonds still provide safety from equity volatility but in terms of real returns I expect about zero from them, perhaps less, for a decade or so. Unfortunately 10 years from now you don't get to buy things with today's nominal dollars. Today's dollar values will be diminished by 10 years of compounded inflation. Real purchasing power is the only kind that matters in the future. Treasuries lost real purchasing power for 4 decades running between 1940 and 1980 for example. Needless to say 40 years of negative real returns is devastating for a bond heavy portfolio. The 40 years after that, 1980 - 2020 was the greatest bond bull market of all time. It recently ended. Don't expect a replay.
Doesn't rebalancing provide a strong mitigating force in a rising rate environment? Especially for accumulators who have less in bonds, longer time horizon, and are adding money? As rates rise the previously bought bonds (thinking of bond funds actually) decrease in value but yield goes up and yes still potentially losing to inflation. But rebalancing and/or new money is now buying "cheaper" bonds with higher yields.

Although if one retires at 60 with a 50/50 portfolio just as a 40 year bear market for bonds is starting, that's gonna sting, which I assume is exactly your point to begin with. BUT if there is a 20 year bear following by a 20 year bull, then things might be ok (as long as sequence of returns risk doesn't take the portfolio to zero first). :wink:
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by jimkinny »

nisiprius wrote: Sat Oct 23, 2021 10:54 am I have made two new graphics... both illustrating the last period of "rising rates."

I'm intentionally using the Fed funds rate, even though it's the wrong rate to look at, because it is what is often used in rhetoric claiming to prove the inescapability of a bond fund apocalypse.

The Putnam Income Fund and the Fidelity Investment Grade Bond Fund are real bond funds. Ibbotson Associates SBBI US IT Government is a data set representing the total return of intermediate-term government bonds, and thus is known for sure not to have contained anything below investment grade during the time period shown.

Image

Image
I think these graphs are pretty misleading. In the original post you wrote that inflation was not a considration and in this post you use a period of high inflation without accounting for the returns in inflation adjusted dollars. I just read that for the 10 years of the 1970s that inflation averaged 6.8%. It seems to me that using real dollars would actually reflect what really happened a lot more than your graphs shown. What really happened is a lot worse than your graphs indicate.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by rockstar »

So the take away is that if rates do go up, I can breakeven or lose against inflation. Is the OP suggesting we'll have a lost decade for bonds?
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by CIPHERSTONE »

Thank you for your post. I'm not an experienced investor, but I've been following the way. My bond investment is at 26% of my portfolio. To date its lost 1.17% of its value. Seeing the many people concerned over bonds has honestly made me wonder if I wouldn't be better off just keeping those bond investments as cash. Zero growth but no loss, at least in the short term. Like I said, I'm not super experienced.

If I understand what you wrote correctly, your saying that would be the worst thing I could do because it would result in an actual loss of that 1.17% value. If I understand you correctly, if I look out 2-3 years it will actually work out in my favor?

In short, stay the course even though its losing money right now?
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by ApeAttack »

CIPHERSTONE wrote: Wed Dec 15, 2021 9:13 pm Thank you for your post. I'm not an experienced investor, but I've been following the way. My bond investment is at 26% of my portfolio. To date its lost 1.17% of its value. Seeing the many people concerned over bonds has honestly made me wonder if I wouldn't be better off just keeping those bond investments as cash. Zero growth but no loss, at least in the short term. Like I said, I'm not super experienced.

If I understand what you wrote correctly, your saying that would be the worst thing I could do because it would result in an actual loss of that 1.17% value. If I understand you correctly, if I look out 2-3 years it will actually work out in my favor?

In short, stay the course even though its losing money right now?
Over the long run, a US total bond fund will outperform cash sitting in a checking account. If it doesn't, that means the nation is having bigger issues.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by BitTooAggressive »

nisiprius wrote: Thu Oct 21, 2021 8:26 am Some investors are being overly spooked by a misunderstanding of a) the appropriate holding time for a bond fund, and b) the short-term versus long-term relationship of interest rates to bond fund behavior.

"Interest up, bonds down" is a short-term relationship. Vanguard says that the Vanguard Total Bond Market Index Fund, for example, "may be appropriate for investors with medium-term investment horizons (4 to 10 years)," so that is the kind of time frame we should be looking at. "Interest up, bonds down" is not true in the longer term.

There are other considerations for bonds but they should be considered separately. (e.g. "But inflation." "But TIPS.") The purpose of this posting is to address one single point: even interest rates were certain to rise, that not mean you are certain to lose money if you keep holding the bond fund. In fact, it is the opposite. You will likely make money if you keep holding the bond fund for the appropriate holding period, roughly equal to the duration; you will lose money if you don't keep holding, and sell the fund during the period after the interest rate rises.

Here are three computer simulations of a rolling bond portfolio with a duration roughly similar to that of the Vanguard Total Bond Market Index Fund. In the simulation it's about six years. The current rate on a 10-year Treasury is about 1.45%. Because bond funds are not bond ladders, and because there is variation for different terms in the yield curve, this is no sense an accurate simulation, but it is qualitatively right.

Simulation #1 assumes that the interest rate stays at 1.45%.
Simulation #2 assumes that it rises to 3.45% over the next two years and then levels off.
Simulation #3 assumes that it rises to 5.45% over the next two years and then levels off.

Would a long-term investor rather have interest rates stay the same or rise?

There is a rule of thumb--for a bond, it is exact, but for a bond fund it is only a rule of thumb. It is: the "duration" of the bond fund is the period of time over which short- and long-term effects of an interest rate increase balance out. An interest rate increase is bad for an investor who holds for less than the duration, good an investor who holds for longer than that. Does the rule of thumb roughly hold in these simulations?

The recovery of a bond fund after an interest rate rise is strongly influenced by bond math, not on loose "mean reversion" effect. Assuming a high-quality bond that does not default, an individual bond's market value has a known value at one point in its future: it returns to face value at maturity. So what goes down not only must come up, but it does so on schedule.

#1, interest rate remains constant at 1.45%.
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#2, interest rate rises to 3.45% over the next two years.
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#3, interest rate rises to 5.45% over the next four years.
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Comparison: black, no rise; green, 2% rise in rates; red, 4% rise in rates.
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What if internet rates rise to 12 percent over a ten year period?
BitTooAggressive
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by BitTooAggressive »

CIPHERSTONE wrote: Wed Dec 15, 2021 9:13 pm Thank you for your post. I'm not an experienced investor, but I've been following the way. My bond investment is at 26% of my portfolio. To date its lost 1.17% of its value. Seeing the many people concerned over bonds has honestly made me wonder if I wouldn't be better off just keeping those bond investments as cash. Zero growth but no loss, at least in the short term. Like I said, I'm not super experienced.

If I understand what you wrote correctly, your saying that would be the worst thing I could do because it would result in an actual loss of that 1.17% value. If I understand you correctly, if I look out 2-3 years it will actually work out in my favor?

In short, stay the course even though its losing money right now?
I have moved my bond allocation to shorter term duration bond funds. About 75% in VTAPX and 25% VBIRX. The rise in rates will be a little less painful.

In my current 401k, which is a small portion of my portfolio I do use VAIPX as opposed to a stable value option.
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nisiprius
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by nisiprius »

BitTooAggressive wrote: Sat Dec 25, 2021 6:44 amWhat if interest rates rise to 12 percent over a ten year period?
You can always imagine sufficiently bad conditions to produce results as bad as you wish. However, keep in mind that bond investments made money--lost a lot of real value due to inflation but did not lose dollar value--from 1940 to 1980, and that in 1973, after 23 years of rising rates, Benjamin Graham still wrote that investors should never have less than 25% in bonds.

To repeat: this is not a precision simulation of Total Bond and it does not incorporate a yield curve or anything like that. It is a reasonable qualitative view of how a rolling bond ladder, with duration similar to Total Bond, responds dynamically to interest rate changes. The bond fund drops to $897 at the bottom.

Obviously, this is bad. Obviously, it would be better to have the money in the bank. Holding for the duration will not immunize you until the interest rate stops rising. Nevertheless, it is not comparable to a stock market crash.

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An interesting question is "what happens if the interest rate rises to 12 percent over a ten year period and never stops, just keeps rising at that same rate forever. Contrary to what some people imagine, that does not result in a permanent loss of value.

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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by BitTooAggressive »

nisiprius wrote: Sat Dec 25, 2021 7:12 am
BitTooAggressive wrote: Sat Dec 25, 2021 6:44 amWhat if interest rates rise to 12 percent over a ten year period?
You can always imagine sufficiently bad conditions to produce results as bad as you wish. However, keep in mind that bond investments made money--lost a lot of real value due to inflation but did not lose dollar value--from 1940 to 1980, and that in 1973, after 23 years of rising rates, Benjamin Graham still wrote that investors should never have less than 25% in bonds.

To repeat: this is not a precision simulation of Total Bond and it does not incorporate a yield curve or anything like that. It is a reasonable qualitative view of how a rolling bond ladder, with duration similar to Total Bond, responds dynamically to interest rate changes. The bond fund drops to $897 at the bottom.

Obviously, this is bad. Obviously, it would be better to have the money in the bank. Holding for the duration will not immunize you until the interest rate stops rising. Nevertheless, it is not comparable to a stock market crash.

Image

An interesting question is "what happens if the interest rate rises to 12 percent over a ten year period and ? never stops, just keeps rising at that same rate forever. Contrary to what some people imagine, that does not result in a permanent loss of value.

Image
My point is that the time horizon for rising interest rates could be significant, especially for those already retired.

Also it hurts portfolio values especially when you consider inflation. Who wants to stay in bonds with interest rates rising and yields way below inflation? It is a terrible proposition.

I certainly don’t believe in any logic either when people talk about the bond market pricing things into it because the Feds intervention has destroyed the fair discovery of bond prices….which has also inflated US sock prices.

So to say sit and hold in your bond portfolio and you will recover is really not true because real return factoring in inflation is what matters. Plus you have an opportunity cost of what you could have invested in.

Having said all that I certainly don’t have the answers either than a well diversified portfolio which for me includes US and International stocks, large cap, small cap, and short term bonds for now.

I would probably slant towards international bond funds if I thought their governments were more responsible than ours but I don’t think they are.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Zeno »

nisiprius wrote: Sat Dec 25, 2021 7:12 am
BitTooAggressive wrote: Sat Dec 25, 2021 6:44 amWhat if interest rates rise to 12 percent over a ten year period?
You can always imagine sufficiently bad conditions to produce results as bad as you wish. However, keep in mind that bond investments made money--lost a lot of real value due to inflation but did not lose dollar value--from 1940 to 1980, and that in 1973, after 23 years of rising rates, Benjamin Graham still wrote that investors should never have less than 25% in bonds.

To repeat: this is not a precision simulation of Total Bond and it does not incorporate a yield curve or anything like that. It is a reasonable qualitative view of how a rolling bond ladder, with duration similar to Total Bond, responds dynamically to interest rate changes. The bond fund drops to $897 at the bottom.

Obviously, this is bad. Obviously, it would be better to have the money in the bank. Holding for the duration will not immunize you until the interest rate stops rising. Nevertheless, it is not comparable to a stock market crash.

Image

An interesting question is "what happens if the interest rate rises to 12 percent over a ten year period and never stops, just keeps rising at that same rate forever. Contrary to what some people imagine, that does not result in a permanent loss of value.

Image
I always learn from your thoughtful posts, nisiprius. Thank you very much.

We are 65/32/3 at ages 58/62. That portfolio is up 8.5x this year. Our bond funds such as BND are doing just fine — and doing their job. I focus on how the portfolio as a whole performs.

Thank you again for educating me about many topics, the performance of bond funds being one of them.
bdr1000
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by bdr1000 »

Thank you nisiprius, very helpful post(s).
AA: 75/22/3: 50% VWRL | 25% MSFT | 22% VAGP | 3% Cash. | Age 50. Early retiree 7 years now, renting my property whilst fulltime travelling, focused on health & happiness
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by vchiu25 »

Since most of the return on bond are based on interest rate and not price change. Wouldn’t it mean it’s better to sit on cash rather than bond until interest rate stabilize?
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by Robot Monster »

nisiprius wrote: Thu Oct 21, 2021 8:26 am Comparison: black, no rise; green, 2% rise in rates; red, 4% rise in rates.
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Glad this thread was bumped, had forgotten about it. The graphs are great, but especially this one. Really drives home how rising rates are good for long-term investors.
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Re: Short- and longer-term effects of rising interest rates on a bond fund

Post by willthrill81 »

It should be pointed out that while the risk of unexpected inflation has been the biggest threat to bonds on a real basis, it can be compounded in the short-term by rising interest rates. When said inflation manifests itself, the go-to response from the central banks is to raise interest rates. So, bonds have a double whammy, and that's precisely what we've seen this year.
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