When interest rates rise, the Bond market won't be decimated?

[JEDI]

"If you hold the bonds to maturity, you can never lose $"

ie:
short term bond funds have a 2-3 year maturity.
if interest rates rise .25%/month for 3 years, then it will be 9%.

if you buy a short term govt bond fund (3yr maturity) in may 2011, you will never lose $ if you hold it till May 2014 even if interest rates rise 9% over that tme period.

True? WHY?

 

[Ghiddy]

I probably don't know what I'm talking about, but I don't think that's true.

When interest rates go up, the value of the securities in a bond fund goes DOWN. Think about it. If the government is issuing new bonds that pay more interest, no one will want the older ones that pay less interest. They will only want those older ones if they can buy them at a discount such that they can at least earn a return at least as much as if they purchased the newer, higher interest bonds. And those old bonds are the ones that your short term bond fund is mostly made up of.

I think because of this short term bond funds are especially vulnerable to interest rate increases. Basically the opposite of everything you said is what is true.

 

[JS80]

Bond fund =/= bonds

 

[ShawnD1]

if you buy a short term govt bond fund (3yr maturity) in may 2011, you will never lose $ if you hold it till May 2014 even if interest rates rise 9% over that tme period.

True? WHY?

What do you mean why? You lend money to someone - they pay it back. You can't possibly lose money unless the bond cannot be paid back.

The trading value of the bond goes down when interest rates go up. This one just follows the common sense that drives demand. If someone wants to buy a new bond, they get it at maybe 4% interest, but you're trying to sell a bond that only gets 3% interest? Your bond sucks. Nobody wants it. You need to sell it at a discount before anyone will buy it.

 

[Ghiddy]

Bond fund =/= bonds

This.

If you hold a BOND to maturity, yes you get back the face value plus interest (unless it defaults).

Bond FUNDS are different. I'm fuzzy on how they work, but I think they continually buy and sell bonds, so you aren't guaranteed to get your principle back for any given time frame.

 

[LegendKiller]

As others have said, holding *A* bond will not "decimate" you. If you buy a $100,000 3% coupon bond maturing in 10 years, that bond will still pay $3,000/yr and mature in 10 years paying you your $100,000 principal back (assuming no default).

A bond fund has to mark the assets to market, which means that the bond's cashflows need to be re-present-valued at the end of the day at the current market prices. If interest rates go up for that type of bond, then prices will go down (lower PV).

The reduction in bond prices reflects the market re-valuing the old bond at the new prices, otherwise the old bond at the old rate wouldn't reflect the lost opportunity cost re: new, higher rate bonds. However, you don't need to revalue it personally, you still get your 3%.

Now if you try to sell it...that's different.

 

[ShawnD1]

This.

If you hold a BOND to maturity, yes you get back the face value plus interest (unless it defaults).

Bond FUNDS are different. I'm fuzzy on how they work, but I think they continually buy and sell bonds, so you aren't guaranteed to get your principle back for any given time frame.

Simply put, it's just like a mutual fund but it's bonds instead of stocks. It can go up, it can go down, it pays interest like a regular bond, and the value is very stable.
Just like a mutual fund, bond funds have management fees.

 

[dullard]

People are basically correct here (except for Ghiddy's conclusion and ShawnD1's assertion that bond funds are very stable). Unless it defaults, a particular bond will pay back all your money plus interest if you hold it until maturity. However, if you don't hold until maturity, the value may go up a lot or down a lot depending on interest rates. A bond fund will thus go up and down since they don't hold until maturity.

What I'd like to add is the next layer to owning bonds.

Since a particular bond won't go down if you hold it to maturity, you should normally hold it to maturity. The only reason to sell early if interest rates go up (and the bond temporarilly loses value) is if you need that money sooner for better reasons. Maybe you have an emergency or maybe you found a better investment. The trick to learn is that banks love stable bonds. Instead of selling for a loss, you can usually get a loan against that bond (often for very low interest rates) and let that bond go out until maturity. You just need to talk to a personal banker, not someone at your bank branch.

 

[AgaBoogaBoo]

People are basically correct here (except for Ghiddy's conclusion and ShawnD1's assertion that bond funds are very stable). Unless it defaults, a particular bond will pay back all your money plus interest if you hold it until maturity. However, if you don't hold until maturity, the value may go up a lot or down a lot depending on interest rates. A bond fund will thus go up and down since they don't hold until maturity.

What I'd like to add is the next layer to owning bonds.

Since a particular bond won't go down if you hold it to maturity, you should normally hold it to maturity. The only reason to sell early if interest rates go up (and the bond temporarilly loses value) is if you need that money sooner for better reasons. Maybe you have an emergency or maybe you found a better investment. The trick to learn is that banks love stable bonds. Instead of selling for a loss, you can usually get a loan against that bond (often for very low interest rates) and let that bond go out until maturity. You just need to talk to a personal banker, not someone at your bank branch.

Opportunity cost says that this is a loan taken out to invest with, because that's essentially what it's allowing you to do - trade on margin. It inherently takes on market risk at this point and, in my opinion, is no longer an investment, because it's suspect to market risk.

Interest rates are simply the cost of using someone else's money. If rates go up, and you're invest in a bond, then the price of it will fall because why will someone buy it from you unless it yields them an expected amount. If their two choices are between a savings account and a bond, and interest at the savings goes up, they will not take the bond unless the yield on it goes up. For the yield of the same bond to go up, the price has to come down.

You can hold it till maturity to get your principal, which is contractually guaranteed, but always keep the opportunity cost in mind. This is why investments should be made with a margin of safety so that you don't have to worry so much about macroeconomic changes. If you keep hunting for 50-cent-dollars, this isn't as much of a worry.

 

[ShawnD1]

People are basically correct here (except for Ghiddy's conclusion and ShawnD1's assertion that bond funds are very stable).

Yep, those pesky bond funds are so unstable alright

The whole point of buying bond funds is to stabilize your investments. As people get older, their investments slowly move from stocks to bonds because bonds are more stable. You pick a bond fund instead of individual bonds because it offers more diversity, and you can follow the entire index.

 

[dullard]

Yep, those pesky bond funds are so unstable alright .

Keep digging your hole.

Bond funds are stable, but they aren't "very stable". That was all that I commented on regarding your post. The word "very" is overused, and in this particular case, actually incorrect.

For example, I just went to Vanguard, clicked bond funds, and randomly picked a couple funds. What was the result? Long term investment grade (click the 10 year button): Went from just over $10/share in 2003 to just over $7/share in 2008. Want more recent data? Went from $10 in August 2010 to $9 in Feb 2011.

My next random pick, total bond market index. Went from $10.70 in 2003 to $9.70 in 2008. Went from $10.94 in Nov 2010 to $10.43 in Feb 2011. I'm sure the same result will happen with many other randomly selected bond funds. Of course, if you include dividends, the growth picture is different. But even that had periods of losses and gains.

Stable yes. But with multi-year gains and losses that total 10%, 20%, 30%, or more I cannot possibly call them "very" stable. In fact, if you read William Bernstien's books, he presents very clear data that bond funds alone are less stable (more risky) than some stock/bond mixture percentages. Look at the top graph, the standard deviation (risk) goes up by moving from 20% stocks / 80% bonds to 100% bonds. Why? Because bond funds aren't as stable as stock/bond mixtures.

Very stable would be CDs, money markets, treasury bills, TIPs, high quality individual bonds held to maturity, annuities (although they usually suck), etc.

 

[Joemonkey]

I'm confused

decimated means to lose 10%

why is that a big deal?

 

[dullard]

I'm confused

decimated means to lose 10%

why is that a big deal?

The worst 3-year period for bond funds in the 1900s was a 25% loss for the average bond fund. I personally wouldn't call that decimated. I wouldn't call it "very stable" either though.

 

[LegendKiller]

Keep digging your hole.

Bond funds are stable, but they aren't "very stable". That was all that I commented on regarding your post. The word "very" is overused, and in this particular case, actually incorrect.

For example, I just went to Vanguard, clicked bond funds, and randomly picked a couple funds. What was the result? Long term investment grade (click the 10 year button): Went from just over $10/share in 2003 to just over $7/share in 2008. Want more recent data? Went from $10 in August 2010 to $9 in Feb 2011.

My next random pick, total bond market index. Went from $10.70 in 2003 to $9.70 in 2008. Went from $10.94 in Nov 2010 to $10.43 in Feb 2011. I'm sure the same result will happen with many other randomly selected bond funds. Of course, if you include dividends, the growth picture is different. But even that had periods of losses and gains.

Stable yes. But with multi-year gains and losses that total 10%, 20%, 30%, or more I cannot possibly call them "very" stable. In fact, if you read William Bernstien's books, he presents very clear data that bond funds alone are less stable (more risky) than some stock/bond mixture percentages. Look at the top graph, the standard deviation (risk) goes up by moving from 20% stocks / 80% bonds to 100% bonds. Why? Because bond funds aren't as stable as stock/bond mixtures.

Very stable would be CDs, money markets, treasury bills, TIPs, high quality individual bonds held to maturity, annuities (although they usually suck), etc.

It's only logical that a mix of stocks/bonds would be more "stable" due to the correlation coefficient. However, what is the sharpe ratio for such mixtures? That, overall, is the key to the asset allocation equation, not "risk" at the core.

Now, granted, I like some higher risk bond funds, mainly due to the fact that many times that market isn't accurately priced.

I am also partial to ABS

But you are right, bond funds aren't always "stable". In fact, due to convexity duration, they can be downright whipsaw

 

[dullard]

However, what is the sharpe ratio for such mixtures?

I haven't seen a graph of that. If you run across one, send it my way.

 

[AgaBoogaBoo]

I haven't seen a graph of that. If you run across one, send it my way.

The problem with using sharpe ratios is that they rely on standard deviation as a measure of risk. All of Wall Street uses measurements like this and I'm willing to say that it's flawed.

If you have 2 stocks, stock A moves up and down with the market, and stock B moves in relation to the market but jumps up and down a lot, then stock A is seen as less risky. These equations fail to capture the value of price.

If both of those stocks were priced at $10, but then the market fell 30%, stock A would be $7 while stock B would be something less, call it $5. The less I pay for something, the less risky it is, right? If so, then stock B, all else equal, is actually less risky even though the financial wizardry will label it as "more risky" because it fell more than the market.

Purchasing securities is based on price - pay too much and you'll lose money no matter what it represents, pay less than it's worth and you can make money. This goes for stocks, bonds, whatever.

 

[dullard]

All of Wall Street uses measurements like this and I'm willing to say that it's flawed.

I basically agree. What often is called "risk" is just "volitility". Volitility is only risk if you are likely to panic and sell at a bottom of a volitile cycle. But, since booms and panic describe many, many investors, for them risk is an appropriate word.

And truely the biggest risk in financial life is NOT investing. Not investing has zero volitility and zero standard deviation. But it is probably the biggest risk a person can take as that means that person is completely unprepared for the future.

 

[ShawnD1]

If both of those stocks were priced at $10, but then the market fell 30%, stock A would be $7 while stock B would be something less, call it $5. The less I pay for something, the less risky it is, right?

I basically agree. What often is called "risk" is just "volitility". Volitility is only risk if you are likely to panic and sell at a bottom of a volitile cycle. But, since booms and panic describe many, many investors, for them risk is an appropriate word.

I've never seen "risk" and "volatility" used interchangeably.

the wiki definition of "risk" is exactly right:

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices

examples: Buying a bond issued in some African currency would be very high risk because of the exchange rates. While the bond might go up 10%, the currency itself might have experienced 20% inflation during that same time.
Buying a stock at a record high point is high risk.
Buying a company that mines gold would be high risk if the commodity price of gold is high; the price of gold going down means my gold company would probably go down as well.


Volatility is just a measure of fluctuation, down or up. Something like copper or some other commodity might be considered high volatility, but it is low risk if you buy it when the price is down.

 

[LegendKiller]

I've never seen "risk" and "volatility" used interchangeably.

the wiki definition of "risk" is exactly right:

examples: Buying a bond issued in some African currency would be very high risk because of the exchange rates. While the bond might go up 10%, the currency itself might have experienced 20% inflation during that same time.
Buying a stock at a record high point is high risk.
Buying a company that mines gold would be high risk if the commodity price of gold is high; the price of gold going down means my gold company would probably go down as well.


Volatility is just a measure of fluctuation, down or up. Something like copper or some other commodity might be considered high volatility, but it is low risk if you buy it when the price is down.

There are certain schools of thought in finance, which obviously ABB subscribes to that believe in the "margin of safety", that the price you buy at is far more important than intermediate fluctuations. This may be true depending on whether you believe that you can get in at the right price, you can analyze properly to determine that price and you can foresee issues that may influence the business cycle which you base your price on.

Buffet has often said that risk isn't standard deviations, it is the chance of your stock going to 0. This is true on a stock-centric perspective, but how do you measure a portfolio of stocks, you cannot possibly come up with a homogenous benchmark of "risk" for 100 stocks, or even 20 stocks and 20 bonds.

The standard deviation would account for that risk when compared to the whole market, but that's assuming that the price fluctuations (or lack thereof) account for information in the market, efficient market hypothesis.

However, as we've seen, markets aren't all that efficient at times. But nor are individual humans pricing in stocks. Seth Klarman hasn't been all that spectacular with his margin of safety, nor has Buffet.

It's easy to pick on school of thought and fit the world around it but it's far more difficult to measure performance of that school against the broader market. That's why the Sharpe Ratio has it's faults, but all tools have faults, understanding those faults is the key to using the tool effectively. That's why the Sharpe Ratio is still OK for measuring relative "risk" of a broad portfolio, as a broad portfolio compared to the market, will include the price fluctuations of the market and additional data (and lack thereof) of the market.

 

[ShawnD1]

Buffet has often said that risk isn't standard deviations, it is the chance of your stock going to 0. This is true on a stock-centric perspective, but how do you measure a portfolio of stocks, you cannot possibly come up with a homogenous benchmark of "risk" for 100 stocks, or even 20 stocks and 20 bonds.

Going to 0, going down, either way you lose money. These definitions of risk are close enough :biggrin:

Getting a number for the risk of a bunch of stocks and bonds shouldn't be too hard. IMO, one could calculate that by using a weighted average. There's a term for when someone does that with stock price (adjusted price base or something), so it would probably work for risk as well. Just take the risk of a stock, multiply by how much money you have in that stock, and do that for every stock. Add all of these numbers together. Divide by the total amount of money invested. It would look like
[(A*X) + (B*Y) + (C*Z)] / (X+Y+Z) = weighted average of A, B, C

Keep in mind the above thing isn't exactly scientific. The way you associate a number with "risk" is completely up to you.


Spreading it out over lots of different stocks or lots of different bonds also greatly reduces the chance of it going to 0 even though it might not reduce the chance of it going down in general. Is there a market term for that?

 

[Imp]

I have no clue on bonds. I thought GICs were similar, but after taking the first 2 classes of a course (which I dropped cause it was so effing boring), turns out bonds are actually trade-able with some complexity behind them.

 

[LegendKiller]

I have no clue on bonds. I thought GICs were similar, but after taking the first 2 classes of a course (which I dropped cause it was so effing boring), turns out bonds are actually trade-able with some complexity behind them.

Bonds are massively complex and the market is far larger than stocks. I work in the ABS bond market, nothing is more complex than trying to model out 10/1 ARM RMBS bonds.

 

[Blackjack200]

You should buy stocks right before the dividend pays out and then sell them for instant profit.

 

[LegendKiller]

You should buy stocks right before the dividend pays out and then sell them for instant profit.

 

[GotIssues]

You should buy stocks right before the dividend pays out and then sell them for instant profit.

No need to worry about that pesky ex-div date or stock price reduction based on the dividend payout.