The role of securitized bonds

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martincmartin
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The role of securitized bonds

Post by martincmartin »

A total bond index, like BND, holds three classes of bonds:
  • Government. This includes Treasuries, but also other things that don't have the full backing of the government. More on that in a separate post.
  • Corporate.
  • Securitized.
A big advantage of a total bond fund is its simplicity. For those who wish to minimize the number of funds they juggle, but don't want an all-in-one fund, the advice is a three fund portfolio that includes a single bond fund.

But for the rest of us, who don't mind holding our bonds across a few funds, should we include securitized?

According to the Bond Basics wiki:
  • Bill Bernstein says only short term Treasuries. So, no securitized.
  • Jack Bogle says TBM is "fine", but "vaguely wonders" about securitized because of negative convexity.
  • Larry Swedroe argues against TBM because of the negative convexity; presumably he's against securitized bonds too.
  • David Swensen says only Treasuries.
  • Rick Ferri is ok with investment-grade corporates and high-yield bonds, not sure about securitized.
So four out of five experts are against securitized, and no one is for it.

The wiki page on mortgage-backed securities says they "are among the most complex securities in the fixed income asset class." So my thoughts: any financial instrument that's complex is hard to value, and anything that's hard to value will tend to rise when times are good, then fall unexpectedly in bad times. Like sub prime during the 2008 recession. Or as Warren Buffett has said, "only when the tide goes out do you know who has been swimming naked."

For the goal of not running out of money in retirement, as opposed to eking out a little more gain during good times, is anyone aware of research on securitization and whether it helps or hurts during long bear markets?

And finally, any thoughts on whether to hold it if you don't mind the added complexity in your portfolio?
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nisiprius
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Re: The role of securitized bonds

Post by nisiprius »

Scholastic-style analysis and synthesis of the opinions of experts has its place. And I respect the opinions of the particular five people you've cited. Larry Swedroe in particular has long been vocal in recommending against Total Bond simply because of the 20% mortgage-backed bonds in it.

I think it's angels-dancing-on-the-heads-of-pins, particularly if we are talking about portfolios that have "normal" stock allocations in them.

In this case, we are fortunate because the Vanguard GNMA Fund is actually one of their oldest bond funds. There are people in the forum (not I) who have it as their core bond fund, simply because it is a few year older than Total Bond and apparently was once thought of as a good all-around choice.

I almost know what "convexity" is, and Vanguard says "In addition to other bond market risks, the fund is subject to prepayment risk" right in their basic product summary. And all I can say is that if there's some serious risk in them, worth taking the trouble to avoid, it's amazing that it hasn't shown up in forty-one years of market cycles, including a mortgage-driven global financial crisis and generally falling interest rates that presumably should incentivize prepayment.

I don't know how the composition of the Aggregate Index has varied, but just to do a back-of-the-envelope reality check let's assume it was always around 20% mortgage-backed. Let's assume we can do a sketchy proxy for an imaginary "securitized-bond-free" bond allocation as 125% Total Bond, -25% Vanguard GNMA.

So. Blue: pure Total Bond, securitized bonds and all.
Red: What Total Bond might have been without securitized bonds.
Yellow: pure Vanguard GNMA.

Source

Image

And now again, but with 60% in stocks:

Source

Image

I just think it's a shrug. If all the experts say securitized bonds are worse than normal bonds, they're probably right. But I'm not personally going to lift a finger or pay a dime just to be "expert-compliant." I can't believe there's major risk that hasn't ever shown up in forty years. And remember we're only talking 20% of Total Bond. If securitized bonds took a -50% hit that would only be a -10% decline in Total Bond, which would suck but would not be a catastrophe for me.
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martincmartin
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Re: The role of securitized bonds

Post by martincmartin »

Thanks for the thoughtful analysis once again nisiprius.

You get a bigger difference using VMBS; I'm not sure which is more appropriate. But to your point, once you subtract it from the total bond fund, the difference in performance of what's left over is still small.

Edit: and VMBS is only available from Jan 2010, so it's only comparing 10 years vs your 41 years. So not nearly as useful.
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Re: The role of securitized bonds

Post by Valuethinker »

nisiprius wrote: Thu Oct 28, 2021 7:40 am Scholastic-style analysis and synthesis of the opinions of experts has its place. And I respect the opinions of the particular five people you've cited. Larry Swedroe in particular has long been vocal in recommending against Total Bond simply because of the 20% mortgage-backed bonds in it.

I think it's angels-dancing-on-the-heads-of-pins, particularly if we are talking about portfolios that have "normal" stock allocations in them.

In this case, we are fortunate because the Vanguard GNMA Fund is actually one of their oldest bond funds. There are people in the forum (not I) who have it as their core bond fund, simply because it is a few year older than Total Bond and apparently was once thought of as a good all-around choice.

I almost know what "convexity" is,
It is the second derivative of the price of a bond wrt a change in interest rates.

I find it is easiest to say it that way.
I just think it's a shrug. If all the experts say securitized bonds are worse than normal bonds, they're probably right. But I'm not personally going to lift a finger or pay a dime just to be "expert-compliant." I can't believe there's major risk that hasn't ever shown up in forty years. And remember we're only talking 20% of Total Bond. If securitized bonds took a -50% hit that would only be a -10% decline in Total Bond, which would suck but would not be a catastrophe for me.
I agree that the risk which is embedded in callable bonds is not one which has hurt investors much (or at all) in the last couple of decades.

(many corporate bonds, and some municipal bonds, are also callable)

That suggests the risk may have been overestimated.

Note that US mortgage bonds are generally subject to negative convexity due to the early repayment option that borrowers hold. This is not true of mortgages in other countries, generally (fixed rate periods on mortgages tend to be much shorter term).

Also there are other types of securitized bonds (I believe) in the US which do not incur prepayment risk.
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Re: The role of securitized bonds

Post by 000 »

It's all angels dancing on the head of a pin compared to the impact of inflation or deflation which I think will likely be the dominant factor in fixed income returns over, say, the next decade.

If I were to make a long term buy and hold investment into bond funds I would probably pick a single core nominal bond fund, like Vanguard's fund that is literally named as such, and pair it with a TIPS fund. I'm not necessarily convinced that further complexity would drive returns significantly.
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Re: The role of securitized bonds

Post by pizzy »

Second time in my life I’ve read “angels dancing on the head of a pin” and both times were this thread.
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Re: The role of securitized bonds

Post by secondopinion »

Securitized bonds are not really risky in BND, so I would ignore it unless you are in the short-duration bond or treasury-only clubs.
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: The role of securitized bonds

Post by martincmartin »

000 wrote: Thu Oct 28, 2021 9:07 pm If I were to make a long term buy and hold investment into bond funds I would probably pick a single core nominal bond fund, like Vanguard's fund that is literally named as such, and pair it with a TIPS fund. I'm not necessarily convinced that further complexity would drive returns significantly.
Ideally I'd like to do that too. However, I want to put traditional Treasuries in my my taxable account, since they have lower dividend payments than stocks or anything else in my portfolio, and corporate / securitized / whatever in a tax sheltered account, since dividends are high.

Since I want to optimize taxes, I want to split my fixed income between taxable and sheltered, so can't use a total bond market fund. I agree that if everything were in a sheltered account, a single TBM would be the way to go.
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Re: The role of securitized bonds

Post by bburton »

The discussion about convexity and risk misses the point a little bit about securitized bonds. The Bogleheads approach is about investing in a diversified way across the economy. Treasuries and corporate bonds are fine, but don’t encompass how the economy is financed.
Home mortgage? Financed through securitized bonds.
Credit card balances? Financed through securitized bonds.
Student loans? Financed through securitized bonds.
Office buildings? Financed through securitized bonds.
Car loans and leases? Financed through securitized bonds.
Smaller companies? Financed through securitized bonds (CLOs).

Maybe they’re more complicated, but there’s a big efficient market setting the prices anyway. (And as someone else pointed out, there’s convexity in corporate bonds too.) That’s why they’re in most of the broad bond indices.

Wouldn’t it be anti-Boglehead to make the active decision to exclude all those fixed income sectors from your portfolio?
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Re: The role of securitized bonds

Post by martincmartin »

bburton wrote: Fri Oct 29, 2021 10:44 am The discussion about convexity and risk misses the point a little bit about securitized bonds. The Bogleheads approach is about investing in a diversified way across the economy. Treasuries and corporate bonds are fine, but don’t encompass how the economy is financed.
Home mortgage? Financed through securitized bonds.
Credit card balances? Financed through securitized bonds.
Student loans? Financed through securitized bonds.
Office buildings? Financed through securitized bonds.
Car loans and leases? Financed through securitized bonds.
Smaller companies? Financed through securitized bonds (CLOs).

Maybe they’re more complicated, but there’s a big efficient market setting the prices anyway. (And as someone else pointed out, there’s convexity in corporate bonds too.) That’s why they’re in most of the broad bond indices.

Wouldn’t it be anti-Boglehead to make the active decision to exclude all those fixed income sectors from your portfolio?
This is a very good point which has got me thinking: What is the Boglehead approach to investing? What is it that has us choose a diversified cap-weighted index of stocks, plus some bonds, and avoid market timing, trading in response to trends, etc?

And you make an excellent point about a big, efficient market setting prices.

I do think there's a second element to it too, of looking at research in order to avoid inefficiencies. For example, there's a big, efficient market for actively managed mutual funds, with both large and small players competing for the retail investor's dollars. That doesn't mean we should all own actively managed funds beside our index funds. So there's an element of using research to find and reject the snake oil salespeople, like active fund managers and "alternative investments."

So the question is whether securitized bonds have a hidden inefficiency, analogous to the high expense ratio and trading costs of actively managed funds. And I think this is a science question, not philosophy. In other words, you need to look at data, such as returns for them, what happens in downturns, etc. Just the way active fund managers are a science question: before you look at the data, it's reasonable to think that someone who spends all day analyzing & picking stocks might outperform the average. It's the data that tells us not.

And I think the data is more or less "meh". So at that point maybe all we're left with is philosophy to guide us. :)

Anyway, interesting point that has got me thinking, exactly what I was looking for in posting the question. Thanks a lot!
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Re: The role of securitized bonds

Post by secondopinion »

bburton wrote: Fri Oct 29, 2021 10:44 am The discussion about convexity and risk misses the point a little bit about securitized bonds. The Bogleheads approach is about investing in a diversified way across the economy. Treasuries and corporate bonds are fine, but don’t encompass how the economy is financed.
Home mortgage? Financed through securitized bonds.
Credit card balances? Financed through securitized bonds.
Student loans? Financed through securitized bonds.
Office buildings? Financed through securitized bonds.
Car loans and leases? Financed through securitized bonds.
Smaller companies? Financed through securitized bonds (CLOs).

Maybe they’re more complicated, but there’s a big efficient market setting the prices anyway. (And as someone else pointed out, there’s convexity in corporate bonds too.) That’s why they’re in most of the broad bond indices.

Wouldn’t it be anti-Boglehead to make the active decision to exclude all those fixed income sectors from your portfolio?
Probably is anti-Boglehead if you count Boglehead as taking the total bond market versus other alternatives. In my opinion, there has to be a risk influenced reason (and a major one at that) to exclude these.

Every decision is active; even staying with total bond market is an active choice. You can put it on autopilot, but that too is an active choice to continue it. Welcome to the world of making active decisions; some just take less brain power than others.
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: The role of securitized bonds

Post by chazas »

Well, I work in the structured finance industry. I create asset-backed securities (ABS) and mortgage-backed securities (MBS). “Securitized bonds” isn’t really a term, it sounds like a resecuritization, though I know what you mean.

These instruments aren’t inherently bad at all. Each asset class (mortgages, autos, credit cards, etc.) has its own structural features and risks based on the characteristics of the underlying asset. Big institutional investors have the capability to model the cash flows and make their own judgments about the assumptions used in the issuer’s disclosures - they don’t “buy the ratings” so much any more, which was one of the drivers of the financial crisis. They are not meant for retail investors like you and I, who don’t have the capability to make those judgments.

So I wouldn’t buy them directly (and couldn’t, generally limited to qualified institutional buyers, or QIBs). Would have no qualms about buying them in a managed bond fund. This thread raises an interesting point about including them in index funds, but I guess if you’re laying your bets across the entire spectrum here it’s no different than betting across the spectrum of corporate credit and equity.
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