Book Explicitly Recommends Against TBM [Total Bond Market]

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Book Explicitly Recommends Against TBM [Total Bond Market]

Post by LMK5 »

I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
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Re: Book Explicitly Recommends Against TBM

Post by Soon2BXProgrammer »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
Assumption: Where experts disagree, either option is probably a rational decision.

That being said, I personally hold very very low risk bonds, but maybe less of them, then others would recommend. I take my risk on the equity side.
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Re: Book Explicitly Recommends Against TBM

Post by Nowizard »

Bond investing arguably has more opinion differences than other areas of investing, and it appears that a (the?) key variable is based on an analysis of individual circumstances in terms of portfolio totals, whether investors are in accumulation or preservation/disbursal stages, willing to add complexity through such as establishing a bond ladder, feel that it is an area where active management is preferred, duration and type of bonds to include, risk tolerance, etc.

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Re: Book Explicitly Recommends Against TBM

Post by KlangFool »

OP,

No. I am not smart enough to agree to disagree with Larry. Hence, I use the default option: TBM.

If you are asking this question, it means that you do not know enough to agree or disagree either.

I use the Wellington Fund to actively manage 40% of my portfolio.

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Re: Book Explicitly Recommends Against TBM

Post by dbr »

It is really difficult to establish that the fate of an investment plan is sensitive to the nuances of exactly what choices one holds in bonds. That is true even if the nuances are in fact real. I don't think I know of an area where so many actual differences matter so little. And, generally I recommend Larry Swedroe for investment advice. I don't recall seeing any robust data that shows how any particular outcome might be a affected by the choice.

I would put this sort of discussion in the category of the more it is talked about the less it matters.
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Re: Book Explicitly Recommends Against TBM

Post by RickyGold »

OP,

I have held Total Bond Fund for decades and it has served me VERY well. Total Bond has an EXCELLENT track record. I think Swedroe is wrong on this, and I will not be changing my portfolio due to Swedroe's recommendations (though I hold him in high regard!).

Full disclosure: My portfolio is three-funds (total US stock, Total International Stock and Total Bond) in 35/65 allocation.
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Re: Book Explicitly Recommends Against TBM

Post by Tom_T »

You'll be fine with TBM, or Intermediate Bond, or Intermediate Treasuries. This isn't as if the wrong choice is going to ruin you, to emphasize what dbr said earlier. It's amazing that more time is spent debating bond funds than is spent debating stock funds (except for international :wink: )
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Re: Book Explicitly Recommends Against TBM

Post by retiredjg »

People have different preferences about bonds. The "default" here is total bond market but in truth any reasonable vanilla intermediate term bond fund will do the job, the lower cost the better.

Maybe a more important question is what bond funds you you have available in certain accounts. For example, many of us feel that bonds are best held in a work plan (401k, etc) or traditional IRA. For someone just starting out, that is likely the work plan - what is available there? might be the question you want to ask.

People who have strong preferences for or against a certain aspect of bonds might make a different choice (for example Larry S), but using the best bond choice in a work plan is a good plan for most people in my opinion.
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Re: Book Explicitly Recommends Against TBM

Post by quantAndHold »

Yeah, when I read that book and understood what he was saying, I realized that I really don’t want to hold mortgages in my portfolio.

Also in that book, he says something to the effect that in the long run when you add in defaults, Treasuries actually pay as well as corporate bonds, with less risk. So I hold Treasuries for the bulk of my fixed income portion. VGSH, VGIT, or VGLT, depending on what duration I want (usually a mix). I also hold some individual TIPS, bought when interest rates were higher. Sadly, they’re about to mature.

But really, I think this is all quibbles, and the main thing is just to *have* fixed income.
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Re: Book Explicitly Recommends Against TBM

Post by nisiprius »

I think it's a shrug. It comes with the indexing territory. To me, mortgage-backed bonds seem weird and unpleasant, but they're only 20% of Total Bond. Look inside any index fund and you'll see things that seem as if you might be better off without them. Do I really want everything? Even that? And yet.

Vanguard's GNMA Fund is older than Total Bond. Maybe a shrewd financial engineer can beat Total Bond on risk-adjusted return by omitting them. Maybe.

But is there serious risk? Really? And it hasn't shown up in forty years? Despite generally falling interest rates that would incentivize prepayment? Despite a global financial crisis that originated in mortgages?

If I were a DFA investor it wouldn't bother me that they don't include them (I don't think they do). But I'm a Vanguard Total Bond investor, and it doesn't bother me that it does.

From a longer posting I made earlier today here.

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 say it's been 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
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Re: Book Explicitly Recommends Against TBM

Post by Doc »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need.

...

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund.
Agreed. In fact I dogeared that page in my copy of the first edition of the book, March 2006.

There's probably a lot of Boglehead posts on the quote in the past. :sharebeer
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Re: Book Explicitly Recommends Against TBM

Post by Doc »

nisiprius wrote: Thu Oct 28, 2021 11:14 am I think it's a shrug. It comes with the indexing territory. To me, mortgage-backed bonds seem weird and unpleasant, but they're only 20% of Total Bond. Look inside any index fund and you'll see things that seem as if you might be better off without them. Do I really want everything? Even that? And yet.
Nisiprius likes to use long term growth charts to show differences or lack thereof for various "similar" funds. And those charts usually show that there is little difference in final amount over long periods. That's often correct but it's only part of the story.

Regarding "The Role of MBS in a Portfolio" Swedroe wrote on page 161 of the first edition of his bond book:

"However, from the perspective of price risk, reinvestment risk, and correlation with equites they cannot be recommended."

If you are a buy and hold forever investor these factors are not very important. But if you rebalnce between equites and fixed income then, not so much.

Nisi's chart shows little difference in the long run so why not avoid MBS and thereby avoid the short term problems that Swedroe highlights.

To be honest I do own some MBS. About 2% of my fixed income portfolio use broad indices which include maybe 25% MBS. :D
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Re: Book Explicitly Recommends Against TBM

Post by White Coat Investor »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
I bought into that argument, but MBSs have done well since then so hard to complain too much about their effect on TBM.
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Re: Book Explicitly Recommends Against TBM

Post by GaryA505 »

I don't think that there's a strong argument for TBM vs the other choices. I also think that there's an irrational promotion of TBM as the best choice.
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Re: Book Explicitly Recommends Against TBM

Post by nisiprius »

LMK5 wrote: Thu Oct 28, 2021 8:31 am...MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers...
Let's look. I've never done this before. I don't know how it will turn out. I'm going to look at three kinds of bond funds for their correlations with stocks. 500 Index for "stocks."

DFIGX, DFA US 5-year Government Fixed Income Portfolio, for a mortgage-free bond fund.
VBMFX, Vanguard Total Bond Market Index Fund, for a maybe-20%-mortgage-bond fund.
VFIIX, Vanguard GNMA fund, for pure mortgage bond fund.

I'll use a graphics program to superimpose the three rolling return charts. (Crude).

Source (but you have to keep rearranging the order of the symbols because it only plots the first three)

Image

I don't see any obvious indication that the blue line (mortgage-free) was a far better diversifier than the red line (pure mortgage). Total Bond had a higher correlation with stocks during 2008-2009, which I'm guessing is due to the inclusion of corporate bonds in Total Bond.
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Re: Book Explicitly Recommends Against TBM

Post by Tom_T »

Wasn't 2008 a complete disaster for MBS? Yet Total Bond had a 5.15% total return. Perhaps the fears are overblown?
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Re: Book Explicitly Recommends Against TBM

Post by secondopinion »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
That is true, the duration does increase when rates increase; however, most bonds do the opposite. In some regards, the duration risk is somewhat kept more constant in that regard (not to say the index will not change in duration by other means).

Second, the total bond market is not my idea of "high duration", versus what Swedroe says. Since the gold standard of yields is the 10-year treasury, that should be the basis of "typical" duration; Since that is about 9.4 years duration I am guessing for 10-year treasuries, BND (total bond market) duration being at 6.8 is not as risky. The maturity of BND is about 8.7 years versus the obvious 10 years of the 10-year treasury; even if you adjust for maturity dates, the duration of BND would be in theory 7.8 years (still less than 10-year treasuries). I do not see Swedroe argument meaning much when MBSs are only 1/3 of the total bond market (these days, the amount I think is less due to the increase in treasuries contained).

The only argument is if one cannot afford duration risk; but then the MBS are not the main offender unless the desired duration is below 5-6 years. But the root question is then whether a mixture of cash with bonds would be better instead (since short-term bonds are more cash-like).
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Re: Book Explicitly Recommends Against TBM

Post by retiredjg »

Doc wrote: Thu Oct 28, 2021 12:02 pm Nisi's chart shows little difference in the long run so why not avoid MBS and thereby avoid the short term problems that Swedroe highlights.
I can think of one reason...a very good place to hold bonds is in a work plan like a 401k. Picking the best bond choice in 401k is frequently a good strategy. If the best bond choice includes MBS, I think it would be a mistake to avoid it for that reason...unless there is another good bond choice that does not include MBS.

Once a portfolio is sufficiently large though, these types of avoidances might be easier.
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Re: Book Explicitly Recommends Against TBM

Post by Doc »

retiredjg wrote: Thu Oct 28, 2021 2:07 pm
Doc wrote: Thu Oct 28, 2021 12:02 pm Nisi's chart shows little difference in the long run so why not avoid MBS and thereby avoid the short term problems that Swedroe highlights.
I can think of one reason...a very good place to hold bonds is in a work plan like a 401k. Picking the best bond choice in 401k is frequently a good strategy. If the best bond choice includes MBS, I think it would be a mistake to avoid it for that reason...unless there is another good bond choice that does not include MBS.

Once a portfolio is sufficiently large though, these types of avoidances might be easier.
Holding bonds in a 401k has little to do with "which bonds". A good choice in your 401k might be a gov/credit index fund or two separate funds like a Treasury and a corporate fund. Then when the stock market tanks you could then sell T's and buy equities. You would then rebalance the fixed income when the "blip" recovered. There are also many corporate/Treasury funds available if you want to have only one fund for your FI.

I see Nisi revised his chart to use a three year rolling return. That's better. I suggest a more appropriate presentation might be a 3 week rolling return. Using price rather than returns is even more appropriate for evaluating the type of bonds that is best if your overall plan has your rebalancing in a stock market crash as opposed to a buy and hold forever plan that rebalances only on your mother-in-laws birthday.
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Re: Book Explicitly Recommends Against TBM

Post by nisiprius »

Tom_T wrote: Thu Oct 28, 2021 12:57 pm Wasn't 2008 a complete disaster for MBS?
For subprime mortgage-backed securities.
Yet Total Bond had a 5.15% total return.
It holds government-guaranteed mortgage-backed securities. Morningstar rates the Vanguard GNMA fund as having credit quality AAA, same as U. S. Treasury issues. And thus it rates Total Bond as being 70% invested in bonds rated AAA and having an average rating of AA. (And, yes, these are legitimate ratings... unlike the disturbingly wrong high ratings the ratings agencies ought not to have given to CDO's built out of subprime mortgages).

The risks of the MBS in Total Bond are not credit quality risks. They are subtle risks about the exact way this kind of bond reacts to interest rate changes.
Perhaps the fears are overblown?
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Re: Book Explicitly Recommends Against TBM

Post by secondopinion »

retiredjg wrote: Thu Oct 28, 2021 2:07 pm
Doc wrote: Thu Oct 28, 2021 12:02 pm Nisi's chart shows little difference in the long run so why not avoid MBS and thereby avoid the short term problems that Swedroe highlights.
I can think of one reason...a very good place to hold bonds is in a work plan like a 401k. Picking the best bond choice in 401k is frequently a good strategy. If the best bond choice includes MBS, I think it would be a mistake to avoid it for that reason...unless there is another good bond choice that does not include MBS.

Once a portfolio is sufficiently large though, these types of avoidances might be easier.
I actually hold a good amount of my fixed income outside of my IRA (that is, all my short term fixed income [except if they are high-yield or inflation-adjusted] and intermediate treasuries); right now, my tax situation favors doing this. It is also well-suited for money that I can touch in emergencies.

Of course, why should one dodge MBS to begin with? One is receiving a premium for the risks they have; it is not uncompensated.
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Re: Book Explicitly Recommends Against TBM

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nisiprius wrote: Thu Oct 28, 2021 2:30 pm The risks of the MBS in Total Bond are not credit quality risks. They are subtle risks about the exact way this kind of bond reacts to interest rate changes.
Right that's exactly what Swedroe presents in his book. Those risks are "price risk, reinvestment risk, and correlation with equites ... "

Also "From a credit risk, perspective MBS, as long as the issuers are Ginnie Mae, Fannie Mae or Freddie Mac, are prudent investments that meet our criteria."
LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need.
We are getting way off the OP's original topic.
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Re: Book Explicitly Recommends Against TBM

Post by Call_Me_Op »

I love Larry, but sometimes he does seem to get too hung-up on esoteric points that make very little difference at the end of the day.
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Re: Book Explicitly Recommends Against TBM

Post by LMK5 »

nisiprius wrote: Thu Oct 28, 2021 12:20 pm
LMK5 wrote: Thu Oct 28, 2021 8:31 am...MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers...
Let's look. I've never done this before. I don't know how it will turn out. I'm going to look at three kinds of bond funds for their correlations with stocks. 500 Index for "stocks."

DFIGX, DFA US 5-year Government Fixed Income Portfolio, for a mortgage-free bond fund.
VBMFX, Vanguard Total Bond Market Index Fund, for a maybe-20%-mortgage-bond fund.
VFIIX, Vanguard GNMA fund, for pure mortgage bond fund.

I'll use a graphics program to superimpose the three rolling return charts. (Crude).

Source (but you have to keep rearranging the order of the symbols because it only plots the first three)

Image

I don't see any obvious indication that the blue line (mortgage-free) was a far better diversifier than the red line (pure mortgage). Total Bond had a higher correlation with stocks during 2008-2009, which I'm guessing is due to the inclusion of corporate bonds in Total Bond.
Great stuff!
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Re: Book Explicitly Recommends Against TBM

Post by tomsense76 »

Generally agree with nisiprius that this is at best a shrug. Munis have similar risks yet there are plenty who hold those.

The stock/bond ratio you pick is almost certainly going to affect risk more than flavors of bonds. That said, if you would rather hold something like a treasury fund, that seems fine and there are people who do this. Would go either intermediate term or hold a total treasury fund like GOVT. One can of course tweak this further, but it might be worth figuring out if that's actually needed (IOW what do you want to achieve?). Some people opt to tweak their stock/bond allocation when switching to treasuries due to their safer & lower returning nature.

Lots of past threads on this topic. Here is a subset:
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Re: Book Explicitly Recommends Against TBM

Post by Northern Flicker »

Mortgage-backed securities present in TBM have reduced not increased correlation with equities in the last 34 years:

https://www.portfoliovisualizer.com/ass ... &months=36

In the inflation of the 1970's bonds had a much higher outcome correlation with stocks. Duration extension caused mortgages to underperform treasuries then. Mortgages also generally were assumable then, and with increases in interest rates, homebuyers generally tried to assume existing mortgages from home sellers when possible, which meant that most mortgages never were paid off early, leading to extreme duration extension as mortgages with about a 7 year expected duration then lasting 20 years (standard amortization term then) instead. In other words, lenders greatly underpriced the assumability option.

Today, VA loans are the only significant source of assumable mortgages in TBM, as far as I know. I believe they are about 33% of GNMAs and I believe GNMAs are about 33% of MBS in TBM, and MBS are sbout 25% of TBM. Thus, I think assumable mortgages are about 2.5% of TBM, but I have not checked the aforementioned numbers recently.

Residential lenders got hammered by inflation and rising rates in the 1970's. It was the root cause of the S&L crisis. Extension risk for residential mortgages still is a significant risk today but it is not the same as when residential mortgages commonly were assumable. I believe the risk is likely to be priced more accurately today as well.

The part of TBM that has been the biggest driver of equity correlation over the last 35-40 years is corporate bonds.
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Re: Book Explicitly Recommends Against TBM

Post by Doc »

Call_Me_Op wrote: Thu Oct 28, 2021 3:44 pm I love Larry, but sometimes he does seem to get too hung-up on esoteric points that make very little difference at the end of the day.
Price chart from 2008 crash

PTRIX: Mortgage backed
SPY: S&P
VFITX: Intermediate Treasury

Image

Did you rebalance in the 2008 crash? Were the bonds you sold TIPS or nominal Treasuries?

Was the difference esoteric?

(BTW Larry's is the best bond guru in my whole neighborhood so I may be biased. :wink: )
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Re: Book Explicitly Recommends Against TBM

Post by retiringwhen »

tomsense76 wrote: Thu Oct 28, 2021 4:40 pm Generally agree with nisiprius that this is at best a shrug. Munis have similar risks yet there are plenty who hold those.
I agree, I hold some VWLUX (Long-term Muni) with a duration of 5.6, but a Maturity of 15.6! It will get whooped if interest rates rise quickly!

TBM is only 6.8 duration vs. 8.7 Maturity.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

Stocks, mortgages, total bond 2008-2010:

https://www.portfoliovisualizer.com/bac ... ion3_3=100
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Re: Book Explicitly Recommends Against TBM

Post by LMK5 »

Doc wrote: Thu Oct 28, 2021 4:53 pm
Call_Me_Op wrote: Thu Oct 28, 2021 3:44 pm I love Larry, but sometimes he does seem to get too hung-up on esoteric points that make very little difference at the end of the day.
Price chart from 2008 crash

PTRIX: Mortgage backed
SPY: S&P
VFITX: Intermediate Treasury

Image

Did you rebalance in the 2008 crash? Were the bonds you sold TIPS or nominal Treasuries?

Was the difference esoteric?

(BTW Larry's is the best bond guru in my whole neighborhood so I may be biased. :wink: )
Interesting, but in looking at the total return data for each of the funds for 2008, 2009:
VFITX: 13.32%, -1.69%
PTRIX: -0.44%, 14.4%

What do you make of it? Regression to the mean for each fund in 2009?
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by alex_686 »

Let me throw in my 2 cents.

You should hold assets that best match your market expectations, risk tolerance, and goals. This is basic stuff that everybody accepts.

The basis that you should hold a market weighted basket is actually pretty weak. There is not much basis that this will produce the most efficient portfolio. i.e., highest return for the lowest risk. There is no evidence that it is the best fit for you.

Let us start with equities. The market weighted basket is actually pretty efficient. I could make a solid argument that the particular characteristics of a value stocks or small cap stocks would be a better fit for your goals. However the argument would be long, complex, and nuanced. The characteristics of the value factor move over time. This is seriously advance stuff.

Bonds are much easier. There are lots of solid arguments that TBM is not the best fit for your goals and risk tolerances. Can you construct something better? Should you invest in Treasuries or Corporates? Short or Long Term? This is simple stuff. Stuff that they cover in basic bond pricing. Stuff that a average Bogleheads can wrap their head around and make informed actionable decisions on.

I would lob MBS in the intermediate category. On the flip side I don't think it is going to have much impact to your portfolio so I am pretty relaxed going either way.
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telemark
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by telemark »

It's worth pointing out that the much-foretold rising rate environment has mostly failed to materialize, although we might be in one now, unless we're not. So the idea that MBS is bad in a rising rate environment hasn't really been tested.

Personally I prefer treasuries when I can get them (not always an option in a 401K) but doubt that it matters much in practice. If holding TBM is an error, it's an exceedingly tiny one.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by alex_686 »

telemark wrote: Thu Oct 28, 2021 7:31 pm It's worth pointing out that the much-foretold rising rate environment has mostly failed to materialize, although we might be in one now, unless we're not. So the idea that MBS is bad in a rising rate environment hasn't really been tested.
Well, pricing MBS in a rising interest rate environment is supper easy. Very basic bond pricing formulas and we do have excellent data for other periods which did have rising rates.

And I don't know anybody who says that MBS are bad in a raising interest rate environment. To be supper specific, MBS would do just as poorly as other bonds. People don't prepay their mortgages to refinance to a cheaper rate.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by telemark »

alex_686 wrote: Thu Oct 28, 2021 7:45 pm And I don't know anybody who says that MBS are bad in a raising interest rate environment.
Now that I read the opening post again, Swedroe says that the correlation between MBS and equities increases in a rising rate environment. That's not the same as saying MBS is bad, although that is how I originally read it.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by JBTX »

I would think MBS would be less desirable in a falling rate environment, because when rates fall homeowners refinance to lower rates, thus missing out some of the gains that falling rates bring to bonds. If rates are rising there is much less likelihood that they will refinance, and the MBS is likely getting a higher yield than a comparable treasury.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

The benefit of MBS in TBM is that corporate bonds and MBS respond to interest rate changes in different ways so holding both is a diversificatuon opportunity with respect to risk.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by rockstar »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
This book came out in 2006, so it's pretty genius that he's warning against MBS right before the real estate bubble imploded.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by HomerJ »

LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.
That book was released April 1st, 2007.

Since then, Vanguard Total Bond Market Index Fund has return 4.10% a year, with it's worst drawdown being 3.94% from April 2008 - October 2008 (but it recovered by December 2008)
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by HomerJ »

rockstar wrote: Thu Oct 28, 2021 10:37 pm
LMK5 wrote: Thu Oct 28, 2021 8:31 am I just read Larry Swedroe's excellent book, The Only Guide To a Winning Bond Strategy You'll Ever Need. What caught me by surprise was that the author explicitly mentioned that he did not recommend Vanguard TBM. The author explained that the duration of mortgage-backed securities increases during a rising rate environment, and since greater duration increases correlation with equities, MBS's correlation with stocks during downturns due to rising rates make them poor diversifiers.

In summary, on page 161 of the book, Swedroe states: "Vanguard's Total Bond Market Fund includes about one-third allocation to MBS. Therefore, we cannot recommend the fund. The first reason is that the duration of the Treasury and corporate bonds in the fund is greater than preferred. Second, the fund does contain MBS and has the associated risks."

Does this change anyone's mind about holding TBM? Would a 50/50 mix of Short Term Treasury and Intermediate Term Treasury funds be the better way to go from a diversification standpoint?
This book came out in 2006, so it's pretty genius that he's warning against MBS right before the real estate bubble imploded.
Except he was wrong because Total Bond Market Index Fund wasn't affected that much, even WITH a real estate bubble imploding.

Anyone following Larry Swedroe's advice in the past 15 years has less money than those who didn't. Maybe he was right, but just unlucky. That's certainly possible.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

telemark wrote: Thu Oct 28, 2021 7:53 pm
alex_686 wrote: Thu Oct 28, 2021 7:45 pm And I don't know anybody who says that MBS are bad in a raising interest rate environment.
Now that I read the opening post again, Swedroe says that the correlation between MBS and equities increases in a rising rate environment. That's not the same as saying MBS is bad, although that is how I originally read it.
So rates were up sharply in 2013, the so called taper tantrum. Performance of US stocks, GNMAs, and intermediate treasuries for the year:

https://www.portfoliovisualizer.com/bac ... ion3_3=100

No guarantee of the same moving forward. The amortization process for MBS returns principal for reinvestment monthly at par (along with interest) to be reinvested at the new, higher rates. Generally, the velocity of rate rises will determine whether MBS without credit risk overperform or underperform treasuries. If rates rise sharply enough, MBS will underperform due to duration extension, but if rate rises are sufficiently gradual, the amortization feature will enable them to beat duration-matched treasuries, as occurred in 2013.
Last edited by Northern Flicker on Fri Oct 29, 2021 12:47 am, edited 4 times in total.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by 000 »

MBS is probably the smallest problem with TBM.

Never understood the obsession with it.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

The benefit of TBM is broad diversification in a single fund at very low cost. It also avoids behavioral errors that can happen when individuals try to overthink their fixed income portfolio.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by willthrill81 »

I think that the bigger argument against TBM is the simple fact that its average effective maturity is only 8.7 years. Most investors have a much longer investment horizon than that. As such, the more logical choice for such investors would be something with a much longer maturity.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

JBTX wrote: Thu Oct 28, 2021 8:07 pm I would think MBS would be less desirable in a falling rate environment, because when rates fall homeowners refinance to lower rates, thus missing out some of the gains that falling rates bring to bonds. If rates are rising there is much less likelihood that they will refinance, and the MBS is likely getting a higher yield than a comparable treasury.
Prepayments from refis will mean that they will not get the boost from falling rates that treasuries get, but as long as the MBS have no credit risk, they won't see credit spreads blowout like corporate credit when the falling rates are due to a recession.

VBILX is an intermediate-term bond index without MBS, just treasuries and corporate bonds. TBM offered slightly more protection from the 2008/2009 equity downturn.

https://www.portfoliovisualizer.com/bac ... ion3_3=100
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by HomerJ »

willthrill81 wrote: Thu Oct 28, 2021 11:18 pm I think that the bigger argument against TBM is the simple fact that its average effective maturity is only 8.7 years. Most investors have a much longer investment horizon than that. As such, the more logical choice for such investors would be something with a much longer maturity.
I disagree (but I could be wrong!).

I like shorter duration bond funds, so they get turned over faster, and the bond fund auto-corrects for any interest rate changes.

In fact, I don't like that 8.7 years number... I thought the average duration of TBM was like 6 years.

So, I check and BOTH of us are right... What's the difference between duration and maturity? Duration is 6.8 years, and maturity is 8.7 years.

I don't like that duration is inching up. Maybe the bond managers are reaching for yield with longer duration bonds?
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by Northern Flicker »

The duration of TBM fluctuates for two reasons: duration changes in response to interest rate changes, and changes to the index duration based on what bonds are issued and what are in the free float. I think bonds bought by the Fed in aggregate are shorter than the duration of TBM, and bonds bought by the Fed are not in the index free float, so this would contribute to an increase in duration.

I think TBM is a fine way to allocate to nominal bonds, but I do prefer establishing a fixed income portfolio using bond funds that each implement a single bond subclass.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by mrspock »

I adore Larry’s books, however it’s important to realize he’s being technically correct and optimal, but overly complex for most investors IMO. As such, I don’t follow his wisdom on this front.

I’m willing to be slightly less optimal, and maybe take slightly more risk (in an already very safe asset class) in the interests of simplicity and scaling. It’s as simple as that. Complexity has its own inefficiencies which folks like Larry don’t capture well: people inevitably screw things up.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by nedsaid »

mrspock wrote: Fri Oct 29, 2021 3:18 am I adore Larry’s books, however it’s important to realize he’s being technically correct and optimal, but overly complex for most investors IMO. As such, I don’t follow his wisdom on this front.

I’m willing to be slightly less optimal, and maybe take slightly more risk (in an already very safe asset class) in the interests of simplicity and scaling. It’s as simple as that. Complexity has its own inefficiencies which folks like Larry don’t capture well: people inevitably screw things up.
Great post. Total Bond Market Index is plenty well good enough. Shoot, I have owned Fidelity GNMA fund since 1999 and it sailed through the 2008-2009 financial crisis. Also, keep in mind that both Vanguard and Fidelity GNMA funds now have average maturities at about 2-3 years. The fund managers are well aware of the risks that Larry brings up hence the short maturities and duration.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by aristotelian »

I am not a huge fan of either corporate bonds or GNMA. I still hold quite a bit of total bond market along with Treasuries and I Bonds. For many people total bond market is the only low cost option in their 401k which is generally the most tax efficient account for holding bonds. If that is the case I wouldn't hesitate to use it.
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Re: Book Explicitly Recommends Against TBM [Total Bond Market]

Post by DaufuskieNate »

The current short average effective maturities of GNMA funds are evidence of the risk Larry is talking about. Effective maturities of mortgage-backed bonds represent an estimate of when the bonds will pay back, taking anticipated prepayments into account. Low interest rates are causing re-financing of mortgages. The GNMA fund managers are receiving principal payments early and are forced to re-invest in new, lower-yielding bonds. When rates go up, re-financing will slow down, average effective maturities will go up and the funds will be locked in at lower rates for a longer time. Think of it this way, when people are re-financing mortgages they are receiving a cash flow windfall of sorts. Who's paying for that? The investors who hold the debt. This is the risk of mortgage-backed bonds. Investors need to evaluate whether the rate premium they receive compensates adequately for the risk.
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