Hi, to the extent anyone has any questions about this part of their portfolios feel free to ask. I'm not going to tell you what to do but will let you know the risks / benefits of whatever investments you have or are thinking of investing (or shorting). As way of background I've been an analyst and trader within the investment field for over 10 years now. Currently, I'm a partner at a fixed income hedge fund in New York.
Fixed Income / Bonds
- Thread starter PaulNYC
- Start date
Fantastic! Thanks Paul.
How would you suggest people invest in bonds if they are fearful of a stock market correction?
What duration and type would you recommend?
Are bond funds a safe haven when we consider interest rate risk and rebalancing?
And 50 billion other questions
So there are two main risks with bonds: interest rate risk and credit risk.
Interest rate risk means that as interest rates go up the price of your bond goes down. The longer the duration (you can simply think of this as time until the bond matures, or is paid off) the more a change in interest rates is going to impact your bond's price. Depending on what you are worried about with your stocks will determine how you should think of interest rate risk with your bonds. When there is a fear of an economic slow down or crisis which causes stocks to sell off normally interest rates fall (and bond prices go up) because people are looking for a safe haven and are also expecting that the Federal Reserve (or other global Central Banks) will step in and do things that will benefit bond prices (such as buying bonds themselves). To the extent you are hedging against this type of risk for your bond portfolio you would actually want to be in longer duration bonds because they'll have a great price move in this situation and will help offset the losses of your stock portfolio. Note: that this is a hedge and if the economy does will rates are likely to rise over time and bonds could lose value as a result but stocks should outperform.
The bad situation for this trade would be if stocks sell off because people get worried about rising rates. This happened last year when Ben Bernanke began talking about slowing the Federal Reserve's purchasing of bonds that was put in place to help the economy. If stocks were to sell off because people are worried about rising rates (without a corresponding pick up in economic activity) you would lose both on your stock portfolio and your bond portfolio. There is a general thinking that if this got too far out of hand and it risked the economy's health that the Federal Reserve would step back in and begin purchasing bonds again so this might be short lived although painful. The only real hedge for this is to be in shorter duration fixed income products such as a short term bond fund or cash (or if you really think it's likely I guess you could be short but that's been a losing trade for a while now).
As far as credit risk goes if you are hedging against a stock market decline you generally want to be in higher quality investments. The lower the quality of the companies/entities issuing the bonds the more stock like they become. Distress debt is much more correlated with the stock market than high quality investment grade bonds (which could even be negatively correlated given the flight to quality impacted mentioned above).
Bond funds are just pools of bonds. If you stick to high quality fund managers (Fidelity... full disclosure I used to work in their bond department, Vanguard, etc) they should generally stick to their mandates. You can get different types of bond exposures (different duration and credit quality buckets). The bond funds will generally have the same interest rate risks/benefits as I mentioned above. They will have a team of credit analysts looks at the credit quality (what i used to do for them and what I do now in a somewhat different way) which should hopefully reduce credit risk or at the very least give you access to a diversified group of bonds that would cost you money to build yourself due to transaction costs. So for most this is the best way to get exposure to bonds unless you have a lot of money/time to build a bond portfolio yourself or pay someone to do it for you.
Hope this helps, feel free to ask me to explain things in greater detail and/or disagree with anything I've said.
Interest rate risk means that as interest rates go up the price of your bond goes down. The longer the duration (you can simply think of this as time until the bond matures, or is paid off) the more a change in interest rates is going to impact your bond's price. Depending on what you are worried about with your stocks will determine how you should think of interest rate risk with your bonds. When there is a fear of an economic slow down or crisis which causes stocks to sell off normally interest rates fall (and bond prices go up) because people are looking for a safe haven and are also expecting that the Federal Reserve (or other global Central Banks) will step in and do things that will benefit bond prices (such as buying bonds themselves). To the extent you are hedging against this type of risk for your bond portfolio you would actually want to be in longer duration bonds because they'll have a great price move in this situation and will help offset the losses of your stock portfolio. Note: that this is a hedge and if the economy does will rates are likely to rise over time and bonds could lose value as a result but stocks should outperform.
The bad situation for this trade would be if stocks sell off because people get worried about rising rates. This happened last year when Ben Bernanke began talking about slowing the Federal Reserve's purchasing of bonds that was put in place to help the economy. If stocks were to sell off because people are worried about rising rates (without a corresponding pick up in economic activity) you would lose both on your stock portfolio and your bond portfolio. There is a general thinking that if this got too far out of hand and it risked the economy's health that the Federal Reserve would step back in and begin purchasing bonds again so this might be short lived although painful. The only real hedge for this is to be in shorter duration fixed income products such as a short term bond fund or cash (or if you really think it's likely I guess you could be short but that's been a losing trade for a while now).
As far as credit risk goes if you are hedging against a stock market decline you generally want to be in higher quality investments. The lower the quality of the companies/entities issuing the bonds the more stock like they become. Distress debt is much more correlated with the stock market than high quality investment grade bonds (which could even be negatively correlated given the flight to quality impacted mentioned above).
Bond funds are just pools of bonds. If you stick to high quality fund managers (Fidelity... full disclosure I used to work in their bond department, Vanguard, etc) they should generally stick to their mandates. You can get different types of bond exposures (different duration and credit quality buckets). The bond funds will generally have the same interest rate risks/benefits as I mentioned above. They will have a team of credit analysts looks at the credit quality (what i used to do for them and what I do now in a somewhat different way) which should hopefully reduce credit risk or at the very least give you access to a diversified group of bonds that would cost you money to build yourself due to transaction costs. So for most this is the best way to get exposure to bonds unless you have a lot of money/time to build a bond portfolio yourself or pay someone to do it for you.
Hope this helps, feel free to ask me to explain things in greater detail and/or disagree with anything I've said.
Thanks @PaulNYC great info. I think my personal concern is when you look at bond funds, perhaps especially those offered by quality managers, or by passive index funds is that when the interest rate change occurs, the rebalancing will lock in losses - my personal approach to bonds, is that I am not in them at this time, but if I was I would select single bonds that fit within my duration horizon.
I can't see the logic of buying a fund that would sell below face value in order to keep ratios intact - when a buy/hold strategy would avoid that. But I guess that calculations on this could be made to see if it is savvier to sell and buy with a better coupon... I just see it as an overall losing proposition in this current environment.
Credit risk is interesting to explore further, thanks for bringing it up, I had focused more on interest rate risk, but it is very valid - in fact it is why I am less impressed with so called alternative investments such as Prosper.com et al, as I feel the correlation is too high, should the economy suffer, these guys are going to default faster than the market tanks.
I can't see the logic of buying a fund that would sell below face value in order to keep ratios intact - when a buy/hold strategy would avoid that. But I guess that calculations on this could be made to see if it is savvier to sell and buy with a better coupon... I just see it as an overall losing proposition in this current environment.
Credit risk is interesting to explore further, thanks for bringing it up, I had focused more on interest rate risk, but it is very valid - in fact it is why I am less impressed with so called alternative investments such as Prosper.com et al, as I feel the correlation is too high, should the economy suffer, these guys are going to default faster than the market tanks.
Mountain Trader
Level 2 Member
Matt-
I agree with and share your concern about a fund locking in losses through rebalancing. The problem I have with buying individual bonds is the time, skill and data to determine purchase target, plus the obvious lack of diversification and ongoing professional management of my holdings, which a fund would supply.
I agree with and share your concern about a fund locking in losses through rebalancing. The problem I have with buying individual bonds is the time, skill and data to determine purchase target, plus the obvious lack of diversification and ongoing professional management of my holdings, which a fund would supply.
Welcome to the forum! I agree with your first part, about it being a bit of both, and that the market will drive prices (ideally, and ignoring the price fixing that is happening!) but I don't know what the difference is between a Bond and a CD, why is it more simple? As an investment tool both are effectively debt instruments, though we could state that CDs do offer less default risk due to the FDIC insurance, they are as exposed to the Interest Rate risk we are looking at.
They're definitely very similar, but I think the CD has a few small benefits. The FDIC insurance you mentioned is one. Also, if for some reason you wind up needing to sell early, with the CD you just have an early withdrawal penalty, rather than selling it to someone else. Policies differ from bank to bank, but there are very few cases where the penalty can eat into your principal. I also think the CD is not too different from any other bank account and is easier to understand than buying individual bonds through a broker for someone who's not too investment savvy.
Certainly, I like the idea of being able to surrender without losing face value, which does offer value. Important to watch those Ts&Cs though, I think my Citi CD kills 6 months or more of interest when I surrender... plus there are some lurkers out there than can penalize principal. Generally, though, I think you have a point. As an aside, there is a secondary market for CDs, not unlike bonds...
Mountain Trader
Level 2 Member
Matt-
I didn't know there was a secondary market for CDs. Where? What are the typical mark-ups like?
I didn't know there was a secondary market for CDs. Where? What are the typical mark-ups like?
You can get them on Fidelity, low volume, not a good consumer market.
Here is some more info http://saverocity.com/finance/trawling-secondary-cd-market-bargain/
Here is some more info http://saverocity.com/finance/trawling-secondary-cd-market-bargain/
Mountain Trader
Level 2 Member
So these are the ones FIDO (and Schwab) sell, which they have hit hard with a mark-up. Used to be, back when you could get a 5-6% on a CD, their bump wasn't so bad. Now they are taking most of the income.
Example: GE Retail Bank, now called Synchrony Bank, has a 15 month CD for 1.2% APR. FIDO is offering 15 month CDs from the same bank with a rate under .7%. I'm not saying FIDO's deal is unfair, but for a $25-$50 transfer fee in and another on the way out, you pick up a lot of interest in between.
Example: GE Retail Bank, now called Synchrony Bank, has a 15 month CD for 1.2% APR. FIDO is offering 15 month CDs from the same bank with a rate under .7%. I'm not saying FIDO's deal is unfair, but for a $25-$50 transfer fee in and another on the way out, you pick up a lot of interest in between.
To my eye, these CDs are just like bonds that are being traded, there is certainly a generous chunk taken up away from retail level investors. I think you can do better in the primary market, but haven't looked in a while.
As someone mentioned you already "lost" the money when interest rates go up and you own a bond. What I mean by this is that if you own a bond that yields 5% with a duration of 10 and interest rates increase to 6% you've "lost" 10 points on that bond. Sure you can hold it to maturity and get what you were promised (assuming it doesn't default) but if you sell that bond and buy a bond that now yields 6% (all things equal) your outcome will be the same over time except for the transaction costs. The reason an institutional manager would sell a bond to buy another would mean they feel the transaction costs are worth some other benefit: more likelihood of the new bond's value increasing, better downside protections, etc.
People like Suzie Orman who tell you you're locking in losses when you sell a bond are completely wrong and they are really hurting people through this logic. Buying a single bond is a really bad idea for almost anyone. I get paid (pretty well) to look at the credit quality of companies every day all day and invest both long and short based on those views and even I get it wrong all the time. Unless you are buying only US Treasuries or Agencies you are taking on credit risk. The return profile on any of these investment are terrible if you are putting all your eggs in one basket. In the investment grade market (high quality companies) if everything goes exactly as planned you get around 1% more than US Treasuries for the life of your investment. If anything goes wrong you lose 60 points of your original investment on average. So you really need to look at credit risk equally as much as you do interest rate risk. And if you are buying anything other than securities that are "full faith and credit" of the US Govt you need to diversify a lot which means buying a bond fund for most people.
I've never used brokered CDs, but from what I know this is accurate. You can't redeem these CDs early, you either wait for them to mature or sell them on the market. And you receive whatever the market is willing to pay, meaning you may take a loss if interest rates rise. One thing you have to watch out for is callable CDs, meaning that the bank can take the CD and give you your money back whenever they want. So you may find a deal on a brokered CD that seems to good to be true (e.g. one I saw recently was a long CD with something like 2% from 2014-16, 3% from 17-19, 5% from 20-21, 7% 22-23, 9% from 24-29. Seems like a 15 year, ~6% CD, but the bank will call it unless interest rates rise sharply, in which case you would be able to get those rates anyway.
This. The psychological reluctance to accept that gains and losses exist in an investment that's priced regularly WHETHER OR NOT YOU CLOSE OUT YOUR POSITION is one of the main sources of average investor underperformance. Basically the average guy buys high and sells low relative to indices because they want to recover their cost basis on losers and they never sell their winners. That leads to losers becoming bigger losers or getting sold for no profit as soon as they recover cost basis, and winners getting held until they become losers. A small number of positions are lucky enough to grow steadily to never become losers. This issue is reflected in studies like the ones that show US equity indices average something like 11% over the last 50 years, but US equity funds average 7% and the average US equity fund investor averages 3%.
Back to the issues of bond investing that Paul is laying out well, you really have to manage
1. duration (essentially interest rate risk due to how long your bond's maturity is)
2. credit profile
3. your sub asset class within fixed income (munis behave differently than corporate or high yield or structured or emerging markets or leveraged loans)
4. your currency risk
5. inflation hedging properties, call/put features, a bunch of other things
That's a lot to do for most non-specialists in fixed income, not to mention high transaction costs and spreads for individuals in bonds. As Paul says, even the specialists have a tough time dealing with individual bonds. My personal opinion is that most need to stay away from individual stock or bond picking, and work on items 1-3 above for fixed income and then buy a decently rated fund that fits their decisions on 1-3 above, within a broader asset allocation strategy that determines what the right exposure is for that sort of fixed income anyway. As I have said in the Asset Allocation thread, that strategy is far more important for your investment performance than picking a few bonds or stocks that have low odds of success anyway.
PointsEarner615
Level 2 Member
Hi Paul, what's your take on TIPS? I've been buying i-Bonds regularly, but was thinking of broadening the inflation-protected portion of my fixed income portfolio to buying TIPS directly (next 10-year auction) through FIDO (no commission).
It would seem that with fixed income yields where they are, even Vanguard's low 20 basis-point expense ratio with their ETF offerings is a bit much, so I'm looking to cut out the middle man.
It would seem that with fixed income yields where they are, even Vanguard's low 20 basis-point expense ratio with their ETF offerings is a bit much, so I'm looking to cut out the middle man.
Cardbeagle
New Member
Hi. I am new to the forum and seeking opinion on triple leveraged sp 500 etf's like UPRO for 'gambling' money. I found out about this when reading about the floor - leverage strategy. The low return on TIPS put it on hold for me. Anyone into this?
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Nope, not into that.
How can you use TIPS as a return benchmark and then 3x the S&P?
How about benchmarking returns from the S&P and going from there?
PointsEarner615
Level 2 Member
The Larry Swedroe "Larry Portfolio" does a split of 75% Treasuries (5-year) and 25% stocks (small value/small cap), which does take out a lot of the volatility out of the stocks portion of the portfolio. But doing this purely with TIPS and 3x S&P 500 would seem to be disastrous -- the chance of a true black swan that wipes out the stock portion of the portfolio (what can go up 3x must go down 3x as well).
I'm all for using TIPS and I-Bonds in fairly major quantities but 3X ETFs are for day-traders, IMO. If it's just 3% of your total portfolio, that's a different matter, gamble all you want. Just remember to have the other 97% plugging away in broadly diversified asset classes.
I'm all for using TIPS and I-Bonds in fairly major quantities but 3X ETFs are for day-traders, IMO. If it's just 3% of your total portfolio, that's a different matter, gamble all you want. Just remember to have the other 97% plugging away in broadly diversified asset classes.
Where do you see the 10ytreas. rate in 3-6months? If no Fed intervention then it should drift up? I mean, at what point does it make sense to loan the government your hard earned money to get back 2.xx% for 10 yrs? Even though they say inflation is low, certain costs (cable, insurance, internet, cell phone, healthcare, education, food) have been increasing and will probably continue to increase for the foreseeable future, at least much higher than 2%.
One could imagine rates to drift upwards in the future, but whether that occurs in 3-6 months is a guess. I would say it is likely that it will happen to some degree.
With regard to inflation, it peaked at 2.1 this year, and as of Aug was 1.7% - you can find more on it here
If you need to be in treasuries for your asset allocation, it is important to consider 2 things:
1. Opportunity cost - if you sit until 6 months from now to 'see what happens' then you are forgoing 6 months of interest (or more accurately the spread between a liquid account offering about 0.8-09% and the 10 year you are looking at)
2. Laddering strategies. If you want to invest it might be wise to invest in shorter term strategies, IE if you have $10,000 to invest you buy $1,000 per year, keeping the balance in a savings account or 1 year bond, until, over 10 years you are fully invested, then each year you cash out one and can rebuy again.
PointsEarner615
Level 2 Member
The cable cord was cut long ago, so there's no inflation there. I buy T-Mobile's $30 a month pre-paid plan, and that hasn't gone up in over 2 years. I switch between Century-Link and Comcast to keep the internet monthly cost way down. Healthcare costs are low due to the significant other being a registered nurse -- it's like having a permanent health and nutrition coach. Food prices will likely decline due to reduced fuel prices, or not with drought in California increasing prices on certain things (avocados, nooooooo!). Lastly, the "education bubble" appears to have abated, with the state tuition flat-lining the past two years.
I look at holding Treasuries as a portion of a broadly diversified portfolio. When the market's on the down-side such as last week, the bond side does just nicely. Any why limit yourself to the 10-year Treasury? Look at TIPS, look at municipal bonds, look at REITs for a mixture of yield. If you're dealing with under $10K to invest in fixed income, take the I-Bonds offer, it's truly a free lunch. And you get an emergency fund to potentially tap after a year if needed.
With the new normal being increased concentrations of wealth going to the top .01%, a precarious middle scrambling to stay afloat, and a geopolitical situation that encourages more oil production, I really doubt if inflationary pressures are likely in the near future. It's not like the economy is just "raring to go" with bountiful job opportunities.
I look at holding Treasuries as a portion of a broadly diversified portfolio. When the market's on the down-side such as last week, the bond side does just nicely. Any why limit yourself to the 10-year Treasury? Look at TIPS, look at municipal bonds, look at REITs for a mixture of yield. If you're dealing with under $10K to invest in fixed income, take the I-Bonds offer, it's truly a free lunch. And you get an emergency fund to potentially tap after a year if needed.
With the new normal being increased concentrations of wealth going to the top .01%, a precarious middle scrambling to stay afloat, and a geopolitical situation that encourages more oil production, I really doubt if inflationary pressures are likely in the near future. It's not like the economy is just "raring to go" with bountiful job opportunities.
Cardbeagle
New Member
Here is info about the original floor leverage rule paper and a theoretical improved version. Also, my previous post had a typo. The fund should have been UPRO, not UPS.
info?
boredelaire
Level 2 Member
When interest rates drop, yields of open-end funds tend to drop as well, because new money is invested at lower rates. If you want a "fixed income" stream over a period of years, open-end funds are not ideal.
Sorry all, I thought this thread had died down so I haven't been checking it.
The expense ratio on LCCMX is 1.44% which seems insane for a short term bond fund with interest rates where they are. It's had decent returns over the past few years mostly because they've gone down in credit quality and low quality debt has performed great. Personally I would rather be in something like VBIRX which is higher quality with lower fees (10bps). The short duration higher yield bond fund is picking up pennies in front of a steamroller. It works great until you get run over.
WDHYX is similar to LCCMX in that you have a portfolio of short term debt that normally trades near par (100 cents on the dollar). The fund does have low fees 65bps vs 144bps for LCCMX but I still personally wouldn't own a short term high yield fund right now. If I was forced to pick I'd rather be in this one vs. LCCMX though.
When interest rates rise your individual bonds also fall in price. Please refer to my post from July 14th.
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TIPS are ok. I'd be find with an individual buying them on their own with a portion of their portfolio. Inflation has been low for a while but you are somewhat protected from inflation as measured by certain CPI index. I would do some research on CPI and see how it matches up against your expenses to see if this is a good personal hedge for you.
Honestly, I have no idea. There is somewhat of a disconnect between the bond market and the stock market right now. The stock market is pricing in a fairly good economic picture given it's at all time highs and people are putting a decent multiple on earnings (measured by something like P/E or EV/EBITDA). The bond market has stayed under 2.50% (10 year tsys). I would think at some point that if the economy continues to perform as it has over the past year than rates would rise. I still think there is a decent amount of slack in the labor market given how many people have left the workforce since 2008 so that along with technological advancements have kept inflation low. Some have argued that these productivity advance driven by tech will keep rates low for the foreseeable future.
PointsEarner615
Level 2 Member
Welcome back, @PaulNYC -- and thanks for the tips on TIPS!
I've been participating in the Treasury auctions for TIPS directly through FIDO and have learned a little bit since my earlier post. There's an upcoming 4-year, 4-month TIPS auction on 12/18 that looks pretty attractive (real yields up on the 5-year at 30 bps for the year).
I've pretty much eliminated most of my direct ownership of single company stocks -- so I've replaced "stock picking" with direct fixed-income purchases.
I've been participating in the Treasury auctions for TIPS directly through FIDO and have learned a little bit since my earlier post. There's an upcoming 4-year, 4-month TIPS auction on 12/18 that looks pretty attractive (real yields up on the 5-year at 30 bps for the year).
I've pretty much eliminated most of my direct ownership of single company stocks -- so I've replaced "stock picking" with direct fixed-income purchases.
boredelaire
Level 2 Member
If you want a fixed (i.e. rate guaranteed) income, and you're holding to maturity, you don't have to worry too much about price fluctuations. If you buy an open-end bond fund, your income isn't fixed.