Bond market Risk assessment

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powercherry5
Posts: 107
Joined: Thu Dec 12, 2019 3:46 pm

Bond market Risk assessment

Post by powercherry5 »

I am attempting to decide if it is worth me continuing to invest in BND and I wanted those more knowledgeable to make sure I am understanding the risk correctly.

Here are the facts as I see them, let me know if something is incorrect:
  • You can only make money on BND through the yield (1.95%) or NAV gains which are tied indirectly to interest rates going down
  • You can lose money on BND through NAV loses which are tied indirectly to interest rates going up
  • The interest rate risk for BND is 6.9% (derived from avg duration) per 1% move in bond yields (which are correlated to general fed interest rates
  • Convexity of bonds is the only thing that kind of offsets the Interest rate risk formula
  • While everything is possible, there is no one prominent saying rates may go negative with the current inflationary environment
  • There is also NAV changes based on market forces (supply/demand)
  • Even with lowering interest rates, market forces were so strong during the 2008 crash that bonds went down about 7%
So if I was to try and see what I am risking by investing or not investing into bonds. Here are the facts that flow from my last list based on investing $1,000,000:
  • I get $10,950 in yield after a year
  • If rates stay the same, NAV stays the same
  • If rates go down, I make money on NAV increases. Current Fed Fund Rate is .08 even though they are saying they are planning on raising, if they go down another .25 into negatives I make $17,250 (~1.725%). Possibly a little more because of convexity.
  • If rates go up, I lose money on NAV decreasing. .25% and I lose $17,250. 1% increase over a year and I lose $69,000
  • During a crash like the 2008 recession, I would potentially lose another $70,000 or so in NAV from market forces
So it seems like because of how low yields are, If I make the bet not to invest for a year because I think we will not go to negative interest rates and I think interest rates will go up in the next year..... My potential downside is mostly only the $10,950 in yield I would have missed. Meanwhile if my prediction is correct I am preventing $17,500 in NAV loses for every .25% move in rates and even a $50,000+ NAV loss from market forces if there is a market correction.

Does that sound correct?
3funder
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Joined: Sun Oct 15, 2017 9:35 pm

Re: Bond market Risk assessment

Post by 3funder »

If you DCA for several decades, you won't have to think about this stuff.
Global stocks, US bonds, and time.
km91
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Joined: Wed Oct 13, 2021 12:32 pm

Re: Bond market Risk assessment

Post by km91 »

You need to consider the potential upside/downside of any alternative investment you would make instead of bonds. If you were to invest $1m all into equities instead of fixed income you've just swapped bond risk for equity risk and are opening yourself up to potentially much bigger losses. Bond's fell 7% in 2008, how much did equities fall?
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martincmartin
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Re: Bond market Risk assessment

Post by martincmartin »

powercherry5 wrote: Tue Jan 18, 2022 12:30 pm You can lose money on BND through NAV loses which are tied indirectly to interest rates going up
This is not true. You only lose in NAV if the rate goes up more than is expected.

For example, suppose markets have priced in 3.5 rate rises by the Fed this year. Then:

- If rates only go up 3 times, the NAV will increase.
- If rates go up 4 times, the NAV will decrease.

So even though rates go up -- 3 times -- the NAV will also increase.

"Anything that's known by everybody is not worth knowing."

Also, even though rates are low, they can go lower, even negative, for a long time. Deflation is a thing.

Why are you holding bonds? For most people, it's because if they held 100% stocks and the market crashed, they'd panic and sell. So it's to stop their emotional brain overriding their logical brain. For some (like me), it's because they're about to retire and having significant bonds reduces sequence of return risk, minimizing the chance of running out of cash in retirement. See bond tent, or rising equity glide path. In either case, you want to hold bonds even though rates are historically low now.

If not bonds, where would you put your money? Cash? Stocks?
Tom_T
Posts: 4824
Joined: Wed Aug 29, 2007 2:33 pm

Re: Bond market Risk assessment

Post by Tom_T »

Also, it's far too simplistic to just apply the formula to the NAV. BND has over 10,000 bonds of different maturities. A rate hike doesn't affect all rates across the yield curve in the same way (or maybe not at all.) Also, there is no way for you to know what bonds the fund manager is turning over. He's buying and selling bonds all the time. You can't know what he's doing or when.

The reality is that Total Bond has had a positive total return in years when "rates" went up. It's not guaranteed, and it might not happen this year, but to simply say 'duration=x, rate hike=y, my loss=z' is not going to work for BND. It's way more complicated.
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Beensabu
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Re: Bond market Risk assessment

Post by Beensabu »

The real question is if it is worth you not continuing to invest in BND. Is it?
"The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next." ~Ursula LeGuin
Explorer
Posts: 769
Joined: Thu Oct 13, 2016 7:54 pm

Re: Bond market Risk assessment

Post by Explorer »

Bonds are like the bun around the burger, or the tortilla around the burrito. Do not think about bonds in isolation.

Your car has shock absorbers in the 4-wheel independent suspension for a reason. Without the independent suspension, your touche will hurt on every bump in the road.

Think of bonds as the independent suspension.

I hope you find the analogy useful.
000
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Joined: Thu Jul 23, 2020 12:04 am

Re: Bond market Risk assessment

Post by 000 »

Duration matching might reduce your concerns as bonds will mature when funds are anticipated to be needed.

This can be done with an individual bond ladder (say, TIPS) or with iShares iBonds.
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Stinky
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Re: Bond market Risk assessment

Post by Stinky »

Another alternative is to consider multi year guaranteed annuities (MYGAs).

Given your obvious concerns about loss of principal in a rising interest rate environment, MYGAs could be a fit. They offer a fixed rate of interest for a fixed term, with full payout of principal and interest at the end of the guarantee period (without any market value adjustment). The full payout of principal may be attractive to you, given your obvious concern about rising interest rates.

Much MYGA information is available at blueprintincome.com. You'll see that, for example, there are 3-year MYGAs that pay as much as 2.50%.

Also, you can look at this lengthy thread. viewtopic.php?f=1&t=334589
Retired life insurance company financial executive who sincerely believes that ”It’s a GREAT day to be alive!”
skierincolorado
Posts: 2377
Joined: Sat Mar 21, 2020 10:56 am

Re: Bond market Risk assessment

Post by skierincolorado »

powercherry5 wrote: Tue Jan 18, 2022 12:30 pm I am attempting to decide if it is worth me continuing to invest in BND and I wanted those more knowledgeable to make sure I am understanding the risk correctly.

Here are the facts as I see them, let me know if something is incorrect:
  • You can only make money on BND through the yield (1.95%) or NAV gains which are tied indirectly to interest rates going down
  • You can lose money on BND through NAV loses which are tied indirectly to interest rates going up
  • The interest rate risk for BND is 6.9% (derived from avg duration) per 1% move in bond yields (which are correlated to general fed interest rates
  • Convexity of bonds is the only thing that kind of offsets the Interest rate risk formula
  • While everything is possible, there is no one prominent saying rates may go negative with the current inflationary environment
  • There is also NAV changes based on market forces (supply/demand)
  • Even with lowering interest rates, market forces were so strong during the 2008 crash that bonds went down about 7%
So if I was to try and see what I am risking by investing or not investing into bonds. Here are the facts that flow from my last list based on investing $1,000,000:
  • I get $10,950 in yield after a year
  • If rates stay the same, NAV stays the same
  • If rates go down, I make money on NAV increases. Current Fed Fund Rate is .08 even though they are saying they are planning on raising, if they go down another .25 into negatives I make $17,250 (~1.725%). Possibly a little more because of convexity.
  • If rates go up, I lose money on NAV decreasing. .25% and I lose $17,250. 1% increase over a year and I lose $69,000
  • During a crash like the 2008 recession, I would potentially lose another $70,000 or so in NAV from market forces
So it seems like because of how low yields are, If I make the bet not to invest for a year because I think we will not go to negative interest rates and I think interest rates will go up in the next year..... My potential downside is mostly only the $10,950 in yield I would have missed. Meanwhile if my prediction is correct I am preventing $17,500 in NAV loses for every .25% move in rates and even a $50,000+ NAV loss from market forces if there is a market correction.

Does that sound correct?
Major error alert. The price change of the bonds is not tied to the fed fund rate. It is ties to the interest rate of a 6.9 year bond. Which is around 1.8% currently. If there are three or fewer fed funds rate increases this year, or if the fed talk implies such, I would expect the 6.9 year interest rate to decrease and the price to increase. The 6.9 year interest rate already factors in 4 or 5 interest rates this year and persistent stubborn inflation and modest growth that will justify even higher rates in 2023 and later. If any of those things isn't true, if inflation weakens, if growth softens, if there is an external demand shock, or if the fed just decides to be more dovish, interest rates on 6.9 year bonds will decrease.

This misunderstanding is rampant.
skierincolorado
Posts: 2377
Joined: Sat Mar 21, 2020 10:56 am

Re: Bond market Risk assessment

Post by skierincolorado »

powercherry5 wrote: Tue Jan 18, 2022 12:30 pm I am attempting to decide if it is worth me continuing to invest in BND and I wanted those more knowledgeable to make sure I am understanding the risk correctly.

Here are the facts as I see them, let me know if something is incorrect:
  • You can only make money on BND through the yield (1.95%) or NAV gains which are tied indirectly to interest rates going down
  • You can lose money on BND through NAV loses which are tied indirectly to interest rates going up
  • The interest rate risk for BND is 6.9% (derived from avg duration) per 1% move in bond yields (which are correlated to general fed interest rates
  • Convexity of bonds is the only thing that kind of offsets the Interest rate risk formula
  • While everything is possible, there is no one prominent saying rates may go negative with the current inflationary environment
  • There is also NAV changes based on market forces (supply/demand)
  • Even with lowering interest rates, market forces were so strong during the 2008 crash that bonds went down about 7%
So if I was to try and see what I am risking by investing or not investing into bonds. Here are the facts that flow from my last list based on investing $1,000,000:
  • I get $10,950 in yield after a year
  • If rates stay the same, NAV stays the same
  • If rates go down, I make money on NAV increases. Current Fed Fund Rate is .08 even though they are saying they are planning on raising, if they go down another .25 into negatives I make $17,250 (~1.725%). Possibly a little more because of convexity.
  • If rates go up, I lose money on NAV decreasing. .25% and I lose $17,250. 1% increase over a year and I lose $69,000
  • During a crash like the 2008 recession, I would potentially lose another $70,000 or so in NAV from market forces
So it seems like because of how low yields are, If I make the bet not to invest for a year because I think we will not go to negative interest rates and I think interest rates will go up in the next year..... My potential downside is mostly only the $10,950 in yield I would have missed. Meanwhile if my prediction is correct I am preventing $17,500 in NAV loses for every .25% move in rates and even a $50,000+ NAV loss from market forces if there is a market correction.

Does that sound correct?
Major error alert. The price change of the bonds is not tied to the fed fund rate. It is ties to the interest rate of a 6.9 year bond. Which is around 1.8% currently. If there are three or fewer fed funds rate increases this year, or if the fed talk implies such, I would expect the 6.9 year interest rate to decrease and the price to increase. The 6.9 year interest rate already factors in 4 interest rate hikes this year and persistent stubborn inflation and modest growth that will justify even higher rates in 2023 and later. If any of those things isn't true, if inflation weakens, if growth softens, if there is an external demand shock, or if the fed just decides to be more dovish, interest rates on 6.9 year bonds will decrease. The market already capitulated to the idea of stubborn persistent inflation and 6 rate hikes in the next two years.

This misunderstanding is rampant.
hudson
Posts: 7098
Joined: Fri Apr 06, 2007 9:15 am

Re: Bond market Risk assessment

Post by hudson »

powercherry5 wrote: Tue Jan 18, 2022 12:30 pm I am attempting to decide if it is worth me continuing to invest in BND and I wanted those more knowledgeable to make sure I am understanding the risk correctly.

Here are the facts as I see them, let me know if something is incorrect:
  • You can only make money on BND through the yield (1.95%) or NAV gains which are tied indirectly to interest rates going down
  • You can lose money on BND through NAV loses which are tied indirectly to interest rates going up
  • The interest rate risk for BND is 6.9% (derived from avg duration) per 1% move in bond yields (which are correlated to general fed interest rates
  • Convexity of bonds is the only thing that kind of offsets the Interest rate risk formula
  • While everything is possible, there is no one prominent saying rates may go negative with the current inflationary environment
  • There is also NAV changes based on market forces (supply/demand)
  • Even with lowering interest rates, market forces were so strong during the 2008 crash that bonds went down about 7%
So if I was to try and see what I am risking by investing or not investing into bonds. Here are the facts that flow from my last list based on investing $1,000,000:
  • I get $10,950 in yield after a year
  • If rates stay the same, NAV stays the same
  • If rates go down, I make money on NAV increases. Current Fed Fund Rate is .08 even though they are saying they are planning on raising, if they go down another .25 into negatives I make $17,250 (~1.725%). Possibly a little more because of convexity.
  • If rates go up, I lose money on NAV decreasing. .25% and I lose $17,250. 1% increase over a year and I lose $69,000
  • During a crash like the 2008 recession, I would potentially lose another $70,000 or so in NAV from market forces
So it seems like because of how low yields are, If I make the bet not to invest for a year because I think we will not go to negative interest rates and I think interest rates will go up in the next year..... My potential downside is mostly only the $10,950 in yield I would have missed. Meanwhile if my prediction is correct I am preventing $17,500 in NAV loses for every .25% move in rates and even a $50,000+ NAV loss from market forces if there is a market correction.

Does that sound correct?
Most of your statements are correct. I'm not an expert on the fine details.
Would I leave $1M un-invested because I was worried about interest rates? no
If I was going to invest in bonds would I go for BND? maybe...maybe not; I like higher quality holdings.
Would I go short because interest rates are predicted to rise? No. I ignore all predictions. I learned long ago that interest rate predictions have no value.
Would munis fit your situation?
Have you looked at TIPS?
What did Bill Bernstein say about buying bonds? viewtopic.php?p=5160087#p5160087
dbr
Posts: 46137
Joined: Sun Mar 04, 2007 8:50 am

Re: Bond market Risk assessment

Post by dbr »

powercherry5 wrote: Tue Jan 18, 2022 12:30 pm
So it seems like because of how low yields are, If I make the bet not to invest for a year because I think we will not go to negative interest rates and I think interest rates will go up in the next year..... My potential downside is mostly only the $10,950 in yield I would have missed. Meanwhile if my prediction is correct I am preventing $17,500 in NAV loses for every .25% move in rates and even a $50,000+ NAV loss from market forces if there is a market correction.

Does that sound correct?
I would make two comments, one addressing your current proposal and the other addressing risk in general.

1. Bond funds are assets to be held for extended time. A possible estimate on that is to not mess around with a bond fund unless it is part of a portfolio to be held for twice the duration, or just generally for a long time. This means that trying to parse out that you will or will not lose or gain something in the next year is a nonsense exercise for bond funds. If you really care then put that money in a savings account, a one year CD, a bond that matures only a year from now, an MYGA or something like that.

2. From a portfolio theory point of view bonds are an asset just like all the other assets and are characterized by an expected return and a variability of return. The latter is called risk. The mechanisms for generating variability in the return are not particularly relevant but the general drivers are credit risk (bonds can default) and term risk (interest rate changes produce NAV changes). There are modeling tools in Portfolio Visualizer for estimating these factors.

As a porfolio component you really only want to look at expected return, which is the mean value of the distribution of possible returns, and variability, measured as the standard deviation of annual returns. Getting estimates of the future expected return can be dicey. You can look at the current SEC yield as a possible short run estimate or at the historical average, prone to secular shifts in longer term averages. In Porfolio Visualizer you can look at an estimate if risk. If you are looking at the Vanguard total bond fund the SEC yield is 1.7% and the SD is 3.8%. That means about 2/3 of the time the annual return will be somewhere between -2% and +5%. To that add additional uncertainty regarding how predictive that center point of 1.7% really is.
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