Stocks — Part XII: Bonds

Well.  Here we are in Part XII of our series on Stocks.  And the subject is Bonds.  What’s up with that??

When I first began this series the plan was for maybe four or five segments.  Sure enough, those focused on stocks. But then we looked at some portfolio ideas and some other stuff, like bonds, got added to the mix.  Next thing you know we looking at different kinds of investment buckets, the prospect of Vanguard getting nuked and asking if everyone can retire a millionaire.  (Clearly, I should have called this my series on Investing.  Note to self:  make the change for the book.)

So now adding Bonds to the mix seems not such a stretch.  They are, in a sense, the more steady and reliable cousins to stocks.  Or so it seems.  But as we’ll see, bonds are not as risk free as many believe.

In any event, since we have included Vanguard’s Total Bond Market Fund, VBTLX, to the Wealth Preservation and Building Portfolio we should take a little closer look at the things.

The challenge is the subject of bonds is a BIG topic.  Most of the details are unlikely to be of interest to the readers of this blog on simple investing.  Heck, they’re not all that interesting to me.  Yet, unless you are comfortable just taking my word for it, you might want to know just what these things are and why they’ve found their way into our portfolio.

But how much info is enough?  Beats me.  So here’s what we’ll do.  In this post I’ll talk about bonds in Stages.  Once you’ve read enough to be comfortable owning the things (or not) you can just stop reading.  If you get to the end, the point where I’m too bored to write more, still hungry — google is your friend.

Info Stage I

Bonds are in our portfolio to provide a deflation hedge.  Deflation is one of the two big macro risks to your money. Inflation is the other.

Bonds also tend to be less volatile than stocks and they serve to make our investment road a bit smoother. Plus they earn interest.

Info Stage II

So what are bonds anyway, and how do they differ from stocks?

In the simplest terms:  When you buy stock you are buying a part ownership in a company.  When you buy bonds you are loaning money to a company, or to the government.

Since deflation is when the price of stuff falls, when you get paid back the money you’ve lent has more purchasing power. Your money buys more stuff than when you lent it.  This increase in value helps to offset the losses deflation will bring to your other assets.

In times of inflation prices rise, so money owed to you loses value.  When you get paid back your cash buys less stuff. Better then to own assets that rise with inflation.

We’ll only see this sharp rise in the one and fall in the other in times of rapid inflation or deflation.  Both of which are bad times.  In the more normal times of modest inflation our bonds and REITS will still serve us well.  Bonds will pay their interest and REITs their dividends.

Info Stage III

Since we own our bonds in VBTLX, a broad-based bond index fund, most of the risks in owning individual bonds go away.  The fund holds 5248 bonds, all investment grade and none rated lower than Bbb (see Stage IV).  This reduces default risk.  The fund holds bonds of wildly differing maturity dates, mitigating the interest rate risk.  The fund holds bonds across a broad range of terms, reducing inflation risk.

In the next Stages we’ll talk more about these risks, but what’s important to understand at this point is:  If you are going to hold bonds, holding them in a fund is the way to go.  Very, very few individual investors opt to buy individual bonds.  US treasuries and bank CDs being the exceptions.

Info Stage IV

The two key elements of bonds are the interest rate and the term.  The interest rate is simply what the bond issuer (the borrower) has agreed to pay the bond buyer (the lender — you).  The term is simply for how long the money is being lent.  So, if you were to buy a $10,000 bond at a 10% interest rate with a 10 year term from XYZ company, each year XYZ would pay you $1000 interest (10% of 10k) and at the end of 10 years they would repay the full $10,000.  If you hold the bond until the end of the 10 years, or to the Maturity Date, the only thing you have to worry about is the possibility of XYZ defaulting.

So, default is the first risk associated with bonds.  To help investors evaluate the risk in any company or government bond, various rating agencies evaluate their credit worthiness.  They use a scale ranging from AAA on down to D, kinda like high school.  The lower the rating the higher the risk.  The higher the risk the harder it is to find people to buy your bonds.  The harder it is to find people to buy your bonds the more interest you have to pay to attract them. Investors expect to be paid more interest when they shoulder more risk.

So, default risk is also the first factor determining how much your bond will pay you.  As a buyer of bonds, the more risk you are willing to accept the higher the interest you’ll receive.

Info Stage V

Interest Rate Risk is the second risk factor associated with bonds and it is tied to the term of the bond.  This risk only comes into play if you decide to sell your bond before the maturity date at the end of the term.  Here’s why:

When you decide to sell your bond you offer it to buyers on what is called the “secondary market.”  Using our example above these buyers might offer more than the 10k you paid, or less.  It depends on how interest rates have changed since your purchase.  If rates have gone up, the value of your bond will have gone down.  If rates have gone down, the value of your bond will have risen.  Confusing, no?  Look at it this way:

You decide to sell your bond from our example above.  You paid $10,000 and are earning 10%/$1000 per year.  Now, let’s say interest rates have risen to 15% and I have $10,000 to invest.  Since I can buy a bond that will pay me $1500 per year, clearly I’m not going to be willing to pay you $10,000 for your bond that only pays $1000.  Nobody would, and you’d be stuck.  Fortunately, however, the secondary bond market will calculate exactly what lower price your bond is worth based on the current 15% interest rate.  You might not like the price, but at least you’ll be able to sell.

But if interest rates drop, the roles reverse. If instead of 10% they fall to 5%, my $10,000 will only buy me a bond paying $500 per year.  Since yours pays $1000, clearly it is worth more than the $10,000 you paid.  Again, should you wish to sell, the bond market will calculate exactly what your higher price will be.

When interest rates rise, bond prices fall.  When interest rates fall, bond prices rise.  In either case, if you hold a bond to the end of its term you will, barring default, get exactly what you paid for it.

Info Stage VI

As you’ve likely guessed, the length of the term of a bond is our third risk factor and it also helps determine the interest rate paid.  The longer the term of a bond the more likely interest rates will change significantly before it matures and that means greater risk.  While each bond is priced individually, there are three bond term groupings: Short, medium and long.  Looking at US Treasury Securities for example we have:

Bills — Short-term bonds of 1-5 year terms.

Notes — Mid-term bonds of 6-12 year terms.

Bonds — Long-term bonds of 12+ year terms.

Generally speaking, short-term bonds pay less interest as they are seen as having less risk since your money is tied up for a shorter period of time.  Accordingly long-term bonds are seen as having higher risk and pay more.  If you are a bond analyst type, you’ll graph this on a chart and create what is called a Yield Curve.  The greater the difference between short, mid and long-term rates, the steeper the curve.  This difference varies and sometimes things get so wacky short-term rates become higher than long-term rates.  The chart for this event produces the wonderfully named Inverted Yield Curve and it sets the hearts of bond analysts all a flutter.

Info Stage VII

Inflation is the biggest risk to your bonds.  Inflation is when the cost of goods is rising.  When you lend your money by buying bonds, during periods of inflation when you get it back it will buy less stuff.  Your money is worth less.  A big factor in determining the interest rate paid on a bond is the anticipated inflation rate.  Since some inflation is almost always present in a healthy economy, long-term bonds are sure to be affected.  That’s a key reason they typically pay more interest.  So, when we get an Inverted Yield Curve and short rates are higher than long rates, investors are anticipating low inflation or even deflation.

Info Stage VIII

If you’ve read this far, I have a secret to share and a confession to make.  I no longer hold my personal bond allocation in VBTLX.  For now, I’m using VFIDX.  This is Vanguard’s Intermediate-Term Investment Grade Index Bond fund.

This change is buried here because it doesn’t fit with the basic concept of the Simple Path; namely an investment strategy that can be set and left to run with minimal attention.  Meeting that parameter is best served with VBTLX and its coverage of the entire bond market.  That’s still the recommendation I stand by for the Simple Path portfolios, and I’ll personally be returning to it in the future.

But if you have a more active investing inclination, as I do, you might want to consider VFIDX for the time being. Here’s my thinking:

  • A few short years ago we were teetering on the brink of a deflationary depression like that of the 1930s.  Very scary stuff.
  • The antidote is a nice solid bit of inflation.
  • This is exactly what the Fed is trying hard to spark.
  • The Fed has been aggressively pumping money into the system and has taken short term rates to zero.  Historic lows.
  • Surprisingly inflation has remained low, but that is sure to change.
  • Likely fast and hard.

In this environment short-term bonds are paying next to nothing.  Long-term bonds will get hit hard when inflation reignites.  Intermediate bonds pay a decent interest rate and their term makes them less vulnerable than long bonds to inflation.  It’s like Goldilocks and the Three Bears.  Papa’s bed is too big.  Baby’s bed too small.  But Mama’s medium term bond bed is just right.  For now, I’m hangin’ with Mama.

Info Stage IX

Here are a few other risks:

Credit downgrades.  Remember those rating agencies we discussed above?  Maybe you bought a bond from a company rated AAA.  This is the risk that sometime after you buy the company gets in trouble and its rating is downgraded.  The value of your bond goes down with it.

Callable bonds.  Some bonds are “callable,” meaning that the bond issuer can pay them off before the maturity date.  They give you your money back and stop paying interest.  Of course they would only do this when interest rates are falling and they can borrow money more cheaply.  As you now know, when rates fall the value of your bond goes up.  But if it gets called, poof! There goes your nice gain.

Liquidity risk.  Some companies are just not all that popular and that goes for their bonds.  Liquidity risk refers to the possibility that when you want to sell few buyers will be interested.  Few buyers = lower prices.

All of these risks are nicely mitigated simply by owning a broad-based bond index fund.

Info Stage X: Municipal Bonds

Municipal Bonds are bonds issued by local governments and government agencies at the state level or below, typically to fund public works projects like schools, airports and the like.

While offering lower interest rates than corporate bonds, they have the advantage of being exempt from the federal income tax and, often for the state in which they are issued, state income taxes. This makes them appealing to folks in high income tax brackets, especially if they live in a high income tax state. It also makes them less expensive in interest payments for the governments that issue them.

It is sometimes suggested that Muni bond rates are set so low that the tax advantage is actually negated. That is, after paying taxes corporate bonds are competitive. This, of course, depends on your tax bracket and the state in which you live. Those in places like California and New York that have high state income taxes will see more benefit than those like me who live in New Hampshire where there is no state income tax.

Vanguard has several funds devoted to munis, including several focused on specific states. Anyone interested can check them out here.

Info Stage XI

There are precisely a gazillion different types of bonds.  Basically they come from national governments, state and local governments, government agencies and companies.  Term length, interest rates and payment terms are limited only by the imagination of the buyers, sellers and regulators. Further….

…and here’s where my interest in writing about these things drifts away.  ~2200 words is enough.  Nothing further matters for us index fund bond investors.  But if you just have to know more, Google is your friend.  Be sure to report your findings in the comments.

Addendum 1: What would the bursting of the bond bubble look like? Not so bad, as it turns out.

Addendum  2: Selecting your asset allocation

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51 Comments

  1. Posted October 1, 2012 at 2:32 am | Permalink

    Don’t want to waste much of your time, but if it is raining and you cannot ride your motorcycle, and you are bored, can you please take a quick peek at the Vanguard Canada products?

    https://www.vanguardcanada.ca/individual/etfs/etfs.htm

    Mainly, I (and many of your Canadian readers I am sure) am interested in your opinion considering relatively low amount of assets and small number of holdings (with exception of US index one). For example, Canada Index ETF only has 100 or so stocks, and at times, certain stocks represented huge chunks of Index (for example, Nortel at one point represented 36% of the entire Toronto Stock Exchange, and most recently, RIM of course – and both had incredible drops).

    Also, I am still trying to figure effect currency exchange is going to play when buying Vanguard US Index funds (what do they mean by CAD$ hedged?)??? For example, I could buy Vanguard ETF’s in US dollars and through US stock exchange (via Questrade), and I could also buy them in Canada from my tax-free savings accounts or my RRSP account. I am just not sure what is better option, assuming that Canadian dollar is at historical heights and only has one way to go (down). I am assuming that it is better to buy in US funds but I am not certain (I am VERY green when it comes to investing).

    • Posted October 1, 2012 at 9:42 am | Permalink

      I second this post by Mr. RS. I am another green Canadian trying to figure out my investing plans outside of Canada. I’m excited for Vanguard Canada’s new ETF’s to launch in December and having a mind like yours take a peak at them and translate into your writing style would be greatly appreciated eh.

    • Posted October 1, 2012 at 3:02 pm | Permalink

      Hi Mr. RB and Mr. HB…

      Well, it is a rainy day today….

      Just took a quick look. VUS – https://www.vanguardcanada.ca/individual/etfs/etfs-detail-overview.htm?portId=9551- is (as a total US stock market index fund) a match for VTSAX, with an interesting twist and a bit higher expense ratio.

      They are operating this fund using, to quote from the description “derivative instruments to seek to hedge the U.S. dollar exposure of the securities included in the MSCI U.S. Broad Market Index back to the Canadian dollar.” All that means is operating the fund with the goal of mitigating the currency risk inherent as the Canadian and US dollars fluctuate in value relative to each other. This is probably why the expense ratio is a bit higher.

      If you were to buy VTI – https://personal.vanguard.com/us/funds/snapshot?FundId=0970&FundIntExt=INT – (the US ETF) your investment would be in US dollars. When it comes time to sell and convert back to Canadian dollars your return will be effected by any change in the exchange rate between the two currencies.

      Basically, you have then made two investments: One in stocks and one in the US dollar. If that is your intent, no problem. Just be sure to understand that’s what’s happening when you buy VTI, whereas VUS is attempting to remove it from the mix.

      Finally, you give me pause when you say “assuming that Canadian dollar is at historical heights and only has one way to go (down).” You may have excellent reasons for coming to this conclusion. But predicting the direction of currency values is a very tricky prospect. Be careful.

      I certainly have no idea what the future for the CA dollar holds, although since I like visiting Canada, down works for me. :)

      Hope this helps!

  2. Trish
    Posted October 1, 2012 at 11:59 am | Permalink

    Again, wish I had understood this long ago!
    So, generally, if I hold a bond until it matures, I don’t care about the yield.
    And holding a bond fund, I don’t even care about the individual funds. and if I think inflation is coming, then houses are better than stocks and stocks are better than bonds. Thank you!

    • Posted October 1, 2012 at 2:31 pm | Permalink

      Glad to help, but let me clarify a couple of points.

      “if I hold a bond until it matures, I don’t care about the yield.”
      Actually, we always care about the yield. It is the main reason to buy bonds. ‘Yield’ is a bit of a tricky word in the bond world, having a couple of different definitions. Which is why I avoided it in the post. But, for our purposes, think of it as the interest rate a bond pays.

      “And holding a bond fund, I don’t even care about the individual funds.”
      I think you meant to say: And holding a bond fund, I don’t even care about the individual bonds in the fund.

      “if I think inflation is coming, then houses are better than stocks and stocks are better than bonds.”
      Generally, yes. But, and as the seasoned RE investment pro I know you to be you know this, it depends on the specific houses and their location. ;)

      • Trish
        Posted October 3, 2012 at 3:33 pm | Permalink

        Okay, then maybe I’m not as clear as I thought. I thought interest is one thing, but yield is the difference in the attractiveness of the bond in the secondary market as interest rates change. So I’ll go back and reread things – slowly.
        And about those houses, yes, they’re not bad. I still have a few, maybe 6.
        But if I had known what I’ve learned from your blog long ago, I would reconsider buying anything!

        • Posted October 3, 2012 at 4:05 pm | Permalink

          or maybe I’ve not been as clear as I should be. It can be confusing stuff, so if you still have quetions please don’t hesitate.

          6 houses. wow!

  3. Posted October 1, 2012 at 12:21 pm | Permalink

    Good introduction piece, but I disagree on your last point there, Jim. The type of bond does have an important feature- tax exemption! Interest income exemption from federal and/or state taxes can have a sizable impact on returns, and is worth discussing.

    • Posted October 1, 2012 at 2:21 pm | Permalink

      Hi Gestalt….

      Nice to see you here.

      Point well taken, and this is the problem with writing about bonds: Where to draw the finish line. ;)

      Tax exempt munis (municipal bonds) are certainly a worthy topic and could easily be a post all their own. I’ve always been impressed with your knowledge on the MMM forums, so please feel free to add to my comments if you care to.

      In short, these are bonds issued by local governments and government agencies, typically to fund public works projects like schools, airports and the like.

      While offering lower interest rates than other bonds they have the advantage of being exempt from the Federal income tax and, for the state in which they are issued, state income tax.This makes them appealing to folks in high income tax brackets, especially if they live in a high income tax state.

      Since they are not held in our simple path bond funds, VBTLX and VFIDX, I merrily skipped ‘em for this post.

      Vanguard has several funds devoted to munis, including several focused on specific states. Anyone interested can check them out here:

      https://personal.vanguard.com/us/funds/vanguard/all?sort=name&sortorder=asc

      BTW, thanks for occasionally linking my posts on Reddit. I always see a flow of new readers when you do.

      • Posted October 1, 2012 at 10:02 pm | Permalink

        That’s a good explanation of Muni bonds. It should also be noted that interest from U.S. Treasury Bonds (which are widely held in our favorite bond index funds) is exempt from state and local taxes, which if you live in a high-tax state like me (NY), can boost your returns somewhat (in my case, over 6% in tax exemption). I’m sure your Nevadan readers will care less. It should also be noted that there is a school of thought that believes that the tax point is moot, as the returns on muni bonds are low enough (compared to corporate bonds) to offset the tax advantages they provide.

        I make sure that our readers in the subreddit are exposed to the most kickass FI articles from around the web. Keep on writing kickass articles, and I’ll make sure they get posted.

        • Posted October 1, 2012 at 10:12 pm | Permalink

          great points, especially the balance on return between munis and corp. no free lunch.

          Mmm….

          I should have hit you up for a guest post on this. Bonds are my least favorite investment topic. ;)

          Thanks for spreading the word!

  4. Tara C
    Posted October 1, 2012 at 5:26 pm | Permalink

    The Canadian Couch Potato recently reviewed the new Vanguard ETFs, I suggest our Canadian readers check out this really useful blog:

    http://canadiancouchpotato.com/2012/09/06/vanguard-announces-five-new-etfs/

  5. Sheep
    Posted October 1, 2012 at 5:50 pm | Permalink

    So, I’ve been worried about the inflation thing myself, and currently not being in bonds at all I’m wondering if I should just continue to stay out of them. But I’m wondering also in your case why VIPSX isn’t what you’d go for. Or how you would feel about I bonds (besides their very small purchase limit) or straight up TIPS. Is it that your timeframe is such that VFIDX will slowly go up as the current bonds in it expire and are replaced with higher-value ones and you just plan to ride it? Or is it that VFIDX hedges against multiple outcomes while VIPSX only hedges against inflation? Sorry if that doesn’t make too much sense.

    • Posted October 1, 2012 at 7:21 pm | Permalink

      Hi Sheep….

      Mostly because I see a negative yield and too much risk in VIPSX and the TIPS (Treasury Inflation Protected Securities) it invests in.

      10 year TIPS sold at a -0.75% yield at the last auction. That’s right, a negative return. This gets a bit tricky as you need to subtract inflation from the bond’s coupon rate to get the real picture. The inflation protection the government provides on the yield comes at a very high cost.

      But even more importantly remember what we learned in Stage V above. When rates fall, bond prices rise. The last few years TIPS (and other bonds) have done spectacularly well as the Fed has relentlessly lowered interest rates.

      But now rates are at zero. No place else to go but up. TIPS with their negative yield actually cost you money to own.

      If the Fed succeeds in reigniting inflation, their next step will be to raise interest rates to keep it from raging out of control. When that happens, TIPS will get killed. As will the long-bonds we discussed above.

      Intermediate bonds, like those in VFIDX, will get hurt too. But at least we are earning a positive yield on them and their shorter maturities will help.

      Either way, this is another reason you definitely want to own your bonds in a fund.

      Since funds hold so many bonds, all bought at different times with different maturity dates, some will be getting paid off freeing up money to reinvest in new bonds paying higher rates. That should soften the blow.

      In theory anyway.

      But if the Fed loses control of inflation, bonds will be a very bad place to be. But our REITS should improve at the same time. We own both, ’cause you can’t predict the future. At least I can’t. ;)

      • Sheep
        Posted October 11, 2012 at 9:27 pm | Permalink

        Arg, browser crashed and ate my reply but I basically wanted to say thank you for the reply. I think the TIPS thing does make sense to me because I guess the interest rate is set by the market when they’re sold. Also you inspired me to look more into I bonds and I read something that made me realize you always lose against inflation if you buy with a fixed rate lower than your tax rate.

  6. Prob8
    Posted October 1, 2012 at 9:40 pm | Permalink

    Nicely done. I was wondering when the post on bonds was coming. Even though we can’t predict the future, I’m finding it difficult to pull the trigger on bond buying with rates this low.

    • Posted October 1, 2012 at 9:54 pm | Permalink

      I’m with you on that one. My saving’s account yields more. But it’s great to hear someone actually discussing the dangers of DEflation. A topic that doesn’t get enough attention.

      • Posted October 1, 2012 at 10:03 pm | Permalink

        Hi FF….

        It does surprise me that deflation has gotten so little attention. Especially since a couple of years back we were teetering right on the brink.

        I chalk it up to the fact that only the very eldest of us around have any experience with it.

        If it happens, cash and bonds are where you want your money. Of course, if we get inflation instead the game changes completely. That’s why I hedge for both.

    • Posted October 1, 2012 at 10:08 pm | Permalink

      Thanks Prob8…

      …easy to understand your reluctance. The only reason to own them is for deflation protection and income. The first is looking less likely and there’s not much of the second to be had at the moment.

      With rates falling these last few years the cap gains have been nice, but it’s hard to see how that continues.

      Still, I’ll hold mine as part of a balanced diet. :)

  7. Posted October 2, 2012 at 6:03 pm | Permalink

    This is a great post! A small typo: I think that Stage XI should be Stage IX.
    If you’re ever looking for a new post topic, I’d love to see more on deflation. I’ve always been confused about it and about it’s consequences. It seems like it would be a good thing, and yet….

    This explains a lot about bond funds. Now I just have to figure out what to do with the EE savings bonds I got as a kid. I looked them up online and apparently they’re earning interest, but of course I’m not collecting anything, since right now they’re just pieces of paper sitting in a drawer. So confusing!

    Thanks for providing some clarity to the topic of bonds!

    • Posted October 2, 2012 at 10:23 pm | Permalink

      Thank you CR…

      …and thanks for the proofreading catch. Correction made.

      I’ve been pondering your question on deflation and there seems no short answer, so a future post it is!

      Not surprising that you find it a bit confusing. In some cases and in small doses it is a good thing. In other cases it is the ugly dance partner leading depression across the floor. We’ll look at both.

  8. Alram
    Posted October 3, 2012 at 10:59 am | Permalink

    Hello fellow Canadians and Mr. Collins (thank you for your great work, I am learning a lot from you). I just compared VTI and VUS myself and made the decision to go with VTI. I have been monitoring the Canadian dollar and it’s relative strength to the USD and went with the economists who convinced me that the CDN is 10% above it’s historical value. While in the short-term the loonie may stay high due to all the quantitative easing, I think Canada is about to suffer some weakness in housing which will gradually reduce our dollar. Certainly this is just one person’s opinion, but I’d rather bet on the USD over the long-term and hopefully enjoy the potential triple benefit of a rising US stock market, lower MER, and a little currency arbitrage for good measure. The .60 to .70 loonie is still very fresh in my memory!

    • Posted October 3, 2012 at 4:07 pm | Permalink

      Hey Alram…

      thanks for sharing your plan and, more importantly, your thinking behind it.

  9. Le Code Civil
    Posted October 5, 2012 at 12:30 pm | Permalink

    Just wanted to say thanks for this whole series. It’s entries like this that make me grateful for the blogging community. I never got into economics or finance at university partly because an article like this would have taken two weeks to cover in class, with all of the associated hand-holding. This was so much more comprehensible and useful to real-world me than any of the classes I took in econ back then. Please keep up the great work, it’s really helpful!

    Also, quick clarification question to make sure I’ve got this down — the reason you shy away from long-term bonds right now is because the rates are currently low across the board (short, intermediate, and long-term), and once inflation increases those rates will be insufficient to make up for the lost future value. Or is it because in a low-inflation or deflationary economy the short-term and intermediate rates are proportionately higher relative to long-term rates, compared to an inflationary economy? Or both? So right now you’re in intermediate, which has slightly lower rates than the long-term but also lower risk, and once inflation picks back up the rates for long-term will increase as well to make up for lost future value and at that point it makes more sense to shift back to long-term? It seems like if you buy long-term in a period of high inflation, when inflation drops that gives you the double benefit of less value lost through inflation than expected, as well as the leftover higher rate. I’m not even considering purchasing right now, just want to understand the interplay between inflation, rates, and yields.

    Thanks again!

    • Posted October 5, 2012 at 5:44 pm | Permalink

      Thanks LCC! (Intriguing handle you have there, BTW.)

      Let me break down your questions and try to clarify:

      “….shy away from long-term bonds right now is because the rates are currently low across the board (short, intermediate, and long-term), and once inflation increases those rates will be insufficient to make up for the lost future value.”

      Correct!

      “Or is it because in a low-inflation or deflationary economy the short-term and intermediate rates are proportionately higher relative to long-term rates, compared to an inflationary economy?”

      No. If we were to go into a long deflationary economy, US government long bonds would be your friend. US Government bonds to reduce default risk. Long term because your money will steadily gain value over the life of the bond as the price of goods and services declines. (I have a post on deflation coming soon.) Bond prices go up when rates go down.

      “So right now you’re in intermediate, which has slightly lower rates than the long-term but also lower risk….”

      Yes. The Fed is working hard to ignite inflation and I think they’ll succeed. ‘Don’t fight the Fed.’ as the Wall Street saying goes. With inflation will come higher interest rates and long bonds will drop in value. Short bonds have the lowest inflation risk, but currently pay nothing. Intermediate bonds pay a decent rate but don’t lock me in like the long bonds would. They are the happy middle choice.

      “…and once inflation picks back up the rates for long-term will increase as well to make up for lost future value and at that point it makes more sense to shift back to long-term?”

      Yes, but it won’t make up for future lost value. It will just mean long-bonds, in fact all bonds, will pay better rates with less risk. Unless, of course, the Fed over shoots and we get excessive inflation. If that happens the game changes again.

      This is why I still recommend https://personal.vanguard.com/us/funds/snapshot?FundId=0584&FundIntExt=INT, the Total Bond Market Fund for my recommended portfolios. It won’t give the top performance that all this dancing might, but it can absorb both scenarios and investors don’t have to worry about it.

      “It seems like if you buy long-term in a period of high inflation, when inflation drops that gives you the double benefit of less value lost through inflation than expected, as well as the leftover higher rate.”

      True, but a little like saying if you buy stocks when the market goes up you’ll make more money. The trick is to know when that is. In the early 1980s here in the US we had very high inflation. You could buy 30-year US Treasuries, probably the safest investment in the world, that paid 16, 17, 18%. Locked in for 30 years. Looking back it is hard to imagine a much better investment.

      Problem was at the time people thought inflation was going to continue to rise and that would have destroyed these bonds.

      Turns out, inflation fell and they were golden.

      Right around the same time Business Week ran a story with this headline emblazoned on the cover: The Death of Equities.

      The theme was that stocks had taken such an inflation beating that no one would ever be silly enough to own them again. Turns out that marked the beginning of the greatest bull market in history.

      Hope this helps!

      • Le Code Civil
        Posted October 6, 2012 at 1:28 am | Permalink

        That’s fantastic, clears things right up. Thanks again!

  10. S None
    Posted October 8, 2012 at 9:42 pm | Permalink

    I enjoy your blog. After reading your post on bonds I got to looking at the yield on my Vanguard short term bond index fund VBIRX and it was only 0.54%. Your VFIDX was >2% and the duration was not too much longer. I switched some funds to VFIDX for potentially better returns for the increased bond term. I then read an article by Larry Swedroe on why you should keep government bond (like VBIRX) instead of corprate bonds (like VFIDX).

    http://www.cbsnews.com/8301-505123_162-57524713/better-returns-more-stocks-or-riskier-bonds/?tag=cbsnewsMainColumnArea

    This reminded me why you want to hold uncorrelated investments. I am tired of low bond yields like everyone else, but I don’t need to have bonds crash with stocks.

    I am curious what you think about Swedroe’s article.

    • Posted October 8, 2012 at 11:03 pm | Permalink

      I agree with Swedroe’s article. Basically what he is saying is that bonds become riskier with lower credit ratings and that much below “a” they take on risk profiles similar to stocks. But 80% of what VFIDX holds is rated ‘a’ or higher and nothing is below ‘b’

      A ‘junk’ bond fund like this one is closer to what he is discussing:
      https://personal.vanguard.com/us/funds/snapshot?FundId=0529&FundIntExt=INT#hist=tab%3A2

      High yield and high, stock like, risk.

      You have identified the low rate VBIRX pays you and in return you are getting a low risk profile. It’s perfect if that is your goal.

      For me, the higher yield of VFIDX is worth the somewhat higher risk. But I’ve also got my finger on the trigger and am watching closely for signs of inflation.

      For the simple wealth portfolios I have created and recommend here VBTLX is the way to go, as I said in the post.

  11. Posted October 11, 2012 at 3:53 pm | Permalink

    I would still conclude that bond investments as well as stock investments are somewhat dangerous right now. In fact at any given time, there is some level of risk associated with any investment. It’s the nature of investing. Risk is a funny thing. When the stock market is rip roaring, most everyone is willing to take a little more risk than they really should, and when the market is depressed, most are so fearful that little to no level of risk can be tolerated. Neither of these extremes makes for good investing. Thanks for the post.

    • Posted October 12, 2012 at 12:08 am | Permalink

      Yep. Risk is a constant companion with each and every investment. Even cash in the bank, or mattress, carries a healthy dose of inflation risk.

      As you point out, we tend to be bold when we should be cautious and cautious just when it’s time to be bold.

      This is why, all the way back in Part I, I said:

      “Recognize the counterproductive psychology that causes bad investment decisions and correct it in yourself.”

  12. Edmund
    Posted July 20, 2013 at 9:58 am | Permalink

    Jim,

    I am a huge fan of your blog, even though I never posted here. We are of similar age and have very similar investment philosophy. I am really curious how you would invest if you were in our shoes.

    We invested all these years in 2 funds: Vanguard TSM and Vanguard total international SM. As we approach our exit point (not sure when – we have yet to pay for college, all savings are in retirement accounts), we started buying bonds – Vanguard TBM.

    Like you, I hate bonds, so I decided to start buying them slowly over time (started in 2010), instead of selling 25% of TSM when the time comes (which seems like what you did). Over 20 years I had no problem putting new money to TSM no matter what, and so I became very comfortable with that strategy.

    Now, every time I put even miniscule amount towards TBM, I cringe. So my question is this: given your own personal experience, what would you advise us to do?

    Continue adding bonds until we hit 25% mark, even though the expected real return over next 10 years for TBM is 0%? Or stop buying bonds going forward until we are closer to retirement?

    The youngest will graduate from college in 9 years, so that is the longest we will work; however, depending on stock market performance, and/or potential health issues, we may “finish” sooner.

    We are both self-employed, so we face different risks compared to W-2 employees, but in general our income source is stable and will likely remain so in the future. So as you can see, we do have quite a bit of flexibility.

    We are not risk-averse at all, so we don’t need bonds to reduce volatility. We will need them when we retire; and I will hate selling TSM irregardless, but especially if it’s down.

    So again – how did you approach bond buying investment period of your life, and what have you learned from it?

    Thanks!

    Edmund

    • jlcollinsnh
      Posted July 20, 2013 at 12:56 pm | Permalink

      Welcome Edmond….

      and thanks for the very kind words! Glad you like it here.

      First, congratulations!

      20 years investing in the total stock market is a great run and I’m sure has served you well. I can see why you cringe at the thought of selling to buy bonds. The good news is that in you situation, you don’t have to.

      You are still working and is sounds like you plan to continue for awhile. But you also wisely recognize it might not be you who decides exactly when that ends. So, you need bonds, but not all at once.

      Basically, I’d continue exactly what it sounds like you are doing: Buy the bond fund slowly over time until you hit the 25% level.

      By the way, there is nothing magic about 25%. It is just what I use as it is a fairly aggressive, growth position. The ‘common’ wisdom for guys our age is to hold 40-60% in bonds. That’s too conservative for my tastes, but the point is everybody can and should adjust the percentage to their own needs.

      In building your bond position over time this way you are “dollar cost averaging” (DCA) into them. Ordinarily I am not a DCA fan as it warps a portfolio’s asset allocation until it is completed. But in your case it provides two nice advantages:

      1. You avoid having to sell TSM shares to buy the bonds.
      2. You avoid some of the interest rate risk built in to bonds at the moment. With rates near historic lows and the FED hinting it is getting ready to let them rise, bonds are very risky here. Buying in slowly with DCA will dramatically soften any hit your bonds will take and will allow you to buy as they become more attractive.

      Now an astute reader of this blog will notice that #2 violates one of my basic concepts here: You can’t time the market. Usually I am making that point in regards to stocks, but it applies equally to interest rates and, by extension, bonds.

      But sometimes, and for interest rates in my judgement this is one of those times, things get so lopsided that a little timing/caution pays off. It is very hard to see how rates don’t rise from here driving down the price of bonds.

      But not impossible, which is why I’m not suggesting you wait to begin building your position.

      As for how I built my bond holding, I did it all at once. But I had some poorly chosen leftover investments I could unload to create the position. Unlike you, I wasn’t wise enough, soon enough in going all VTSAX. :)

      Hope this helps!

      • Edmund
        Posted July 20, 2013 at 2:04 pm | Permalink

        Jim,

        Thanks so much for sharing your thoughts!

        I really am not any wiser than you – I learned the hard way. I started buying individual stocks, thinking it is so easy to beat the market, why would anyone buy a mutual fund. Boy, was I ever wrong! So I sold all those stocks and went with TSM, and later on started buying TISM as well.

        Like you, I understand investors “should” own bonds, most commonly cited “age in bonds” by the saint Jack Bogle. But we are aggressive investors, and are very comfortable with it, never sold in 2002 or 2008. It’s what we thought our kids – invest in stocks while young, worry about bonds later in your life. We always knew we will need bonds later, and decided somewhere between 20-30%, depending on circumstances. So 25% is the average of that, and has really nothing to do with your number, it just indicates to me our thought process and risk tolerance are very similar to yours.

        By this time last year, we got to 15%. When we rebalanced earlier this year (with new contributions only, we never had to sell to rebalance), a lot went to TBM to get back to 15%. By now, we are down to 14%. Like you, I don’t like timing the market, but bonds still look very expensive, that’s why I cringe when I add our hard earned money to TBM these days. So last 2 months, our retirement contributions have been sitting in cash, because I just cannot bring myself to add new money to TBM just to keep overall percentage of bonds at 15%. I never had this hesitation with TSM, whether it was hitting new highs or new lows, or anywhere in between. I now understand how people afraid of stocks feel.

        Are you suggesting to keep buying bonds, but not increase TBM allocation over 15%? Or not buying bonds at all, and keep putting new money to equities only, until rates rise? (Market timing, which did not serve me well in distant past, so not sure how that would play out). Or, keep buying more, so as to increase TBM AA by 1% each year, so 15% in 2013, 16% in 2014, and so on?

        I know I could do what you did – just wait, and convert all at once. But that is truly risky – I would not want to do that if another 2008 arrived. On the other hand, putting money into investment that is going to earn 0.5% real return over the next 10 years seems like the stupidest investment idea ever! I guess I am looking for suggestions I have not thought of from a person with similar values and risk tolerance.

        Thanks again!

        Edmund

        • jlcollinsnh
          Posted July 20, 2013 at 3:39 pm | Permalink

          With 15% in bonds already, if your target allocation is 25% in ~9 years from now when you plan retiring you could either:

          1. Add slowly to the position over the next 9 years to add the next 10%. This should give you money to keep adding to your stock positions, too. or
          2. Hold what you now have in bonds and just add the 10% in a lump when the time comes.

          #2 would be my path. I’m aggressive and if still working 15% would give me enough bonds until I stopped. It would also give me a nice pool to draw on if stocks were to take another major hit.

          • Edmund
            Posted July 20, 2013 at 4:23 pm | Permalink

            Thanks, Jim. That’s what I was thinking as well. I appreciate you taking your time to reply. Keep up the good work, I enjoy reading your life stories.

  13. Clint
    Posted September 20, 2013 at 11:52 am | Permalink

    Reposting from a while ago, per your request:

    There’s a lot of noise these days about the “bond bubble bursting.” Is this a perfect example of the kind of noise one should tune out if in for the long haul (20+ years), or is this an actual long-term concern that should make one wary of bonds? I’ve even seen some on the Bogleheads forum and wiki suggesting all kinds of alternatives to bonds…

    I’m 34, in the wealth building stage, and currently allocating 20% to VBTIX.

    Thanks so much. I can’t tell you how much I appreciate, enjoy, and share your investing series.

    • Clint
      Posted September 20, 2013 at 4:59 pm | Permalink

      Specifically, I hear a lot about TIPS and corporate bonds. In addition to my question above, is there any reason to think about adding these as well?

    • jlcollinsnh
      Posted September 22, 2013 at 9:37 am | Permalink

      Hi Clint…

      Welcome and thanks for your patience!

      ““bond bubble bursting.” Is this a perfect example of the kind of noise one should tune out if in for the long haul (20+ years), or is this an actual long-term concern that should make one wary of bonds?”

      Exactly. Both.

      From these levels it is hard to see interest rates not rise — in fact they already have slightly — and that will be bad for bonds. But this is also predicting the future, something that is vanishingly difficult to do.

      The better question is to ask, “Why do you hold bonds and do those reasons still apply?”

      As I say in the article, I hate bonds. But I hold them now because…

      1. I no longer have a working income and have moved into the “Wealth preservation phase.”

      2. My bonds provide a hedge against deflationary events.

      3. They pay a little income while they go about their work in #2.

      If, like you, I were 34 and in my wealth building stage I wouldn’t bother with them. Especially in today’s environment. At the moment, I consider them the riskiest things I own. But for me they fill a role and so I hold my nose and hold them.

      As for alternatives, I don’t bother much. That is a form of market timing that is inconstant with my simple approach to this stuff.

      Although, if you read deep enough into that post above, you’ll see I’m currently holding VFIDX. This is Vanguard’s Intermediate-Term Investment Grade Index Bond fund.

      So, there you go! :)

      • Clint
        Posted January 7, 2014 at 4:36 pm | Permalink

        Not to belabor the point, but I want to put this to bed in my mind :)…

        In my 401K, I’m actually given VFIUX (Vanguard Intermediate-Term Treasury Fund Admiral Shares, ER .10%) as an option, as well as DIPSX (DFA Inflation-Protected Securities, ER .13%).

        I’m probably more comfortable holding at least a small bond position (maybe 10 – 15% of my otherwise entirely VTSAX or equivalent portfolio, if for some “dry powder” at the next correction). That said, any value on my 20 year timeframe to split up my bond position into VBTIX and/ or one of the above?

        Thanks!

        • jlcollinsnh
          Posted January 8, 2014 at 2:04 pm | Permalink

          Welcome back, Clint. Been awhile. ;)

          With a 20 year time frame and using your bond position to rebalance into stocks on dips, VBTIX should serve you well and it is what I’d use.

          Were you to add DIPSX and/or VFIUX in effect you would be overweighing into Treasuries. Less yield for a bit less default risk.

          No right or wrong answer. Depends on your needs, risk tolerance and goals.

          • Clint
            Posted January 8, 2014 at 5:07 pm | Permalink

            Thanks again!

  14. Susan
    Posted January 12, 2014 at 9:34 pm | Permalink

    Hi Jim,

    Per your recommendation, I’m working my way through the Stock Series again, and have spent a good part of the weekend reviewing our entire portfolio. Our retirement accounts are with Fidelity, and I am in the process of investing the bond portion of the portfolio in those accounts, after re-reading this section of your series. The plan was to put one third of the bonds in Fidelity’s total bond index fund (in my husband’s rollover IRA with 15 to 20 years until we’d access it), and two thirds into VFIDX (my Keogh, 8 year time horizon until I’m 59.5 and latest I’d like to retire.). Unfortunately, I have just found out that I cannot purchase VFIDX (Admiral Shares) – only the Investor Class equivalent VFICX which carries almost double the expense fees. Is there a Vanguard ETF version that I should choose instead? I am able to purchase the ETFs through Fidelity. I think the closest to VFIDX would be VCIT? Or just go with VFICX, which is still relatively low at .20?

    By the way, thank you again for your encouragement! Just by doing my homework, we will already save nearly $3000 in yearly expense fees by dumping the Fidelity Freedom target year retirement fund that my husband had his rollover IRA invested in, and replacing it with equivalent percentages of low cost index funds. You should have seen his face when I showed him the calculations! I couldn’t believe it either!

    Best regards,
    Susan

    • jlcollinsnh
      Posted January 13, 2014 at 11:47 pm | Permalink

      Hi Susan…

      $3000 in annual fees. Yikes! Fine bit of “found money” that.

      Obviously you are doing a fine job of analyzing this stuff on your own. VCIT looks to me like the closest ETF match for VFIDX as well.

      Nice job!

  15. Richard
    Posted June 6, 2014 at 7:36 pm | Permalink

    Hi Mr. Collins!

    In one of the comments above you said:

    “By the way, there is nothing magic about 25%. It is just what I use as it is a fairly aggressive, growth position. The ‘common’ wisdom for guys our age is to hold 40-60% in bonds. That’s too conservative for my tastes, but the point is everybody can and should adjust the percentage to their own needs.”

    I know you have mentioned in part V: ” The typical investment advisor’s rule of thumb is: subtract your age from 100 (or 120). ” I also know you said you disagreed with that.

    So – how does one determine what percentage is appropriate for them?

    Thanks!
    Richard

    • jlcollinsnh
      Posted June 7, 2014 at 9:04 am | Permalink

      Bonds smooth out the ride, but stocks power the returns.

      The question as to what percent bonds has as much to do with temperament and ability to stand the inevitable market plunges as anything.

      Only the individual investor can decide that for themselves.

      Reading the stock series here will help understand just what one is dealing with when investing in the market.

      After that, you have to know yourself…

    • jlcollinsnh
      Posted June 20, 2014 at 11:22 am | Permalink
  16. JB
    Posted July 3, 2014 at 5:07 pm | Permalink

    hello Mr. Collins!

    First time poster here. Since the fund minimum for VFIDX is $50,000, would you recommend the investor class version, VFICX (double the expense ratio), as a good alternative? I have about 75% in VTSAX and could not decide what to do w/the remaining 25%–as I did want to go 100% stocks for my asset allocation.

    I really appreciate the time and effort you have put into your stock series, it has been a pleasure reading your posts.

    • jlcollinsnh
      Posted July 3, 2014 at 6:45 pm | Permalink

      Welcome JB…

      Glad you’ve enjoyed the posts.

      As you know, my bond fund recommendation is VBTLX with its ER of .08% and interest payment of 2.57%.

      VFIDX is what I’m personally using at the moment and subject to change without notice. Its ER is .10% and it pays 3.24%, or a net payout gain of .65%. Pretty thin for the extra risk.

      If my reasons for holding VFIDX make sense to you, VFICX will give you exactly the same portfolio, but as you noted, with a .20% ER. That cuts the payout advantage to a thinner still .55%. Whether that is enough for you is a very personal choice and a question only you can answer.

      As for holding bonds at all or going 100% stocks, this post might help:
      http://jlcollinsnh.com/2014/06/10/stocks-part-xxiii-selecting-your-asset-allocation/

      Good luck!

      • JB
        Posted July 3, 2014 at 7:47 pm | Permalink

        Mr Collins,

        Thanks for the reply! So, based on that slight payout advantage, I’m leaning towards just staying with VBTLX for now. Also, I have read the Asset Allocation post multiple times, but there is one question that I can’t seem to determine a good answer for. If someone is in the “wealth acquisition” stage, is it still worthwhile to have a percentage of investments in an alternate financial instrument like bonds–note, this is for IRA/Roth accounts vs a standard taxable investment account.

        The purpose of these bond investments would (hopefully) be the purchasing power in a bear market to increase your holdings of index stock funds by selling bond funds and buying stock funds, then re-purchasing those bond funds when the market recovers. If I had 100% of my investments in VTSAX, for example, then I would be unable to capitalize on the opportunity to buy more of that fund when the inevitable market downturn occurs, beyond any remaining traditional IRA/Roth contributions for that year.

        I look forward to your thoughts.

        • jlcollinsnh
          Posted July 3, 2014 at 7:59 pm | Permalink

          Your understanding is sound, JB.

          Bonds smooth the ride and give you some capital to shift to stocks in bear markets. The trade off is that in bull markets, whatever portion you have in bonds misses the upswing.

          Since the research seems to say 100% stocks and 75/25 have produced almost the same results over time, it depends on how you want to get there. And a lot on how actively involved you want to be, mostly for that smoother ride.

          This is really fine-tuning. Once you are at this stage, you’re results will be determined much more by how well you stay the course with whatever allocation you choose.

          Make sense?

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