Investing in munis while rates are rising

[Mark Aiken]

I'm trying to learn more about bond investing, as I have developed the
sneaking fear that the stock market may be entering a prolonged period
of tepid performance, and I'm looking for an appropriate hedge. Please
forgive any obviously stupid questions.

So far, I have uncovered the following general pieces of advice:

- For people in highish tax brackets, muni bonds are a good choice
since their proceeds are tax-exempt.

- However, one needs a considerable amount of money (I've heard

$100K) to invest directly in munis, since the individual bonds have

fairly high face values (I've heard >=$25K).

- Therefore, if you want to invest in munis but don't have a pile of
money, consider muni bond funds.

Also, I understand that it is generally expected that interest rates
will rise over the coming years [insert obvious disclaimer on
predicting the future here].

So far so good. However, I have also read that buying individual bonds
and holding them to maturity is very different from trading bonds, or
buying bond funds (which trade their holdings). As I understand it,
buying individual bonds presents only the risk that you will forgoe
higher returns if rates rise after your purchase, and/or that the bond
will be called when rates drop. If you are happy with the rate being
offered by the bonds you buy, or buy short-term bonds, this isn't the
end of the world.

Again, as I understand it, deliberately trading bonds, or holding a
bond fund that trades bonds, presents the additional risk of capital
depreciation when interest rates rise (since the lower-rate bonds'
price is pushed down). If you mispredict interest rates, you can end
up losing principal in addition to having forgone potentially
higher-rate investments. This doesn't sound like fun, particularly for
a newcomer to bond investing.

When I put this all together, though, I can't think of any way of
investing in muni bonds in my taxable investment account. I fear
buying a muni bond fund, since that seems to imply the risk that its
NAV will plummet as interest rates rise. On the other hand, I don't
have enough money or know-how to buy munis directly and hold them to
maturity, which would side-step this problem.

What am I missing? Is there an instrument I can invest in that is
similar, or equivalent, to buying and holding muni bonds to maturity?

If *you* had a bunch of money to invest in bonds, and it had to be in
a taxable account, what would *you* do in today's climate?

For bonus points, comment on whether it is a sound strategy to
construct a ladder of individual TIPS in retirement accounts.

Many thanks for any pointers,

Mark

 

[TB]

- For people in highish tax brackets, muni bonds are a good choice
since their proceeds are tax-exempt.

Many high-bracket investors stick with munis but really, you just weigh
the rates against each other, based on your tax bracket. For a lot of
people taxable bonds yield more, even after paying the tax.

- However, one needs a considerable amount of money to invest

directly in munis, since the individual bonds have

- Therefore, if you want to invest in munis but don't have a pile of
money, consider muni bond funds.

Even for larger chunks of money, funds can be better:
* you can invest & redeem odd amounts like $1352, at any time, without
needing to worry about things like "spreads" (as you do when you sell a
bond through your broker)
* your interest payments are reinvested easily & immediately which isn't
the case w/indv bonds
* you're diversified across probably hundreds of issues which means
you're diversified across issuers & across different maturities
* you just don't need to worry about keeping an eye on your bonds which
to me is easily worth the small expenses associated with a well-run fund.

But if you want to buy them individually, you can find bonds for $5k
face, or $1k in some. It'd be hard to put together a broadly diversified
portfolio but that may be OK, as long as you ladder them through time &
buy insured bonds.

Again, as I understand it, deliberately trading bonds, or holding a
bond fund that trades bonds, presents the additional risk of capital
depreciation when interest rates rise (since the lower-rate bonds'
price is pushed down). If you mispredict interest rates, you can end
up losing principal in addition to having forgone potentially
higher-rate investments. This doesn't sound like fun, particularly for
a newcomer to bond investing.

Same happens with individual bonds, it's just a question of whether you
decide to sell them (at a loss) or not. And with both, it's a relatively
minor issue as long as you stick to short-term bonds, which generally
means issues maturing in 5 years or fewer.

When I put this all together, though, I can't think of any way of
investing in muni bonds in my taxable investment account. I fear
buying a muni bond fund, since that seems to imply the risk that its
NAV will plummet as interest rates rise. On the other hand, I don't
have enough money or know-how to buy munis directly and hold them to
maturity, which would side-step this problem.

What am I missing? Is there an instrument I can invest in that is
similar, or equivalent, to buying and holding muni bonds to maturity?

Stick with mutual funds that invest in short-term, high-quality
bonds...these have very limited risk to NAV. Or buy individual bonds but
with maturities no more than say 5 years out.

Stick with funds that have a boring strategy that looks a lot like the
"buy & hold" you described.

If *you* had a bunch of money to invest in bonds, and it had to be in
a taxable account, what would *you* do in today's climate?

For bonus points, comment on whether it is a sound strategy to
construct a ladder of individual TIPS in retirement accounts.

Maybe for a piece of it but not the whole thing...IMO the
before-inflation yield is too low at the moment.

-Tad

 

[Jimmy Smith]

long term munis are not very liquid if you need to sell. if rates go up,
your principal will drop significantly. you lose your buying power.

I'm trying to learn more about bond investing, as I have developed the
sneaking fear that the stock market may be entering a prolonged period
of tepid performance, and I'm looking for an appropriate hedge. Please
forgive any obviously stupid questions.

So far, I have uncovered the following general pieces of advice:

- For people in highish tax brackets, muni bonds are a good choice
since their proceeds are tax-exempt.

- However, one needs a considerable amount of money (I've heard

$100K) to invest directly in munis, since the individual bonds have

fairly high face values (I've heard >=$25K).

- Therefore, if you want to invest in munis but don't have a pile of
money, consider muni bond funds.

Also, I understand that it is generally expected that interest rates
will rise over the coming years [insert obvious disclaimer on
predicting the future here].

So far so good. However, I have also read that buying individual bonds
and holding them to maturity is very different from trading bonds, or
buying bond funds (which trade their holdings). As I understand it,
buying individual bonds presents only the risk that you will forgoe
higher returns if rates rise after your purchase, and/or that the bond
will be called when rates drop. If you are happy with the rate being
offered by the bonds you buy, or buy short-term bonds, this isn't the
end of the world.

Again, as I understand it, deliberately trading bonds, or holding a
bond fund that trades bonds, presents the additional risk of capital
depreciation when interest rates rise (since the lower-rate bonds'
price is pushed down). If you mispredict interest rates, you can end
up losing principal in addition to having forgone potentially
higher-rate investments. This doesn't sound like fun, particularly for
a newcomer to bond investing.

When I put this all together, though, I can't think of any way of
investing in muni bonds in my taxable investment account. I fear
buying a muni bond fund, since that seems to imply the risk that its
NAV will plummet as interest rates rise. On the other hand, I don't
have enough money or know-how to buy munis directly and hold them to
maturity, which would side-step this problem.

What am I missing? Is there an instrument I can invest in that is
similar, or equivalent, to buying and holding muni bonds to maturity?

If *you* had a bunch of money to invest in bonds, and it had to be in
a taxable account, what would *you* do in today's climate?

For bonus points, comment on whether it is a sound strategy to
construct a ladder of individual TIPS in retirement accounts.

Many thanks for any pointers,

Mark

======================================= MODERATOR'S COMMENT:
Please trim the post to which you respond.

 

[Ed Zollars, CPA]

But I don't see how this results in advice about how to invest in
munis without losing one's shirt when interest rates rise. Can you
please elaborate on your advice?

I believe the response was directed towards the implications of the
response that buying the bonds and holding them to maturity "got
around" the loss of principal problem. It doesn't really--it just
masks it since you accept below market interest rates in exchange
for eventually getting back your *nominal* principal. And should
inflation take off (which is one thing that will tend to drive up
rates), what you are paid back with will be worth less (and in the
late 70s and early 80s potentially a *lot* less) than what you invested.

A mutual fund may make it clearer what has gone on--but in both
cases, your big problem is if you are forced to liquidate the
investment and dip into the principal.

The previous respondent on this thread suggested that I buy a bond
fund that holds primarily short-term munis, and that follows a
"buy-and-hold" strategy similar to what I would do myself if only I
had enough money. Do you have any comment on this advice?

That advice has two key components. First, it deals with your
concern about a fund trying to "trade" to make money. That seems
much less likely with a fund concentrating on short maturities.
Second, the concentration on near term maturities means that you
have a lower exposure to changes in interest rates impacting your
principal, since there's a short time period till the payoff of the
nominal principal. As well, you'll shortly be able to reinvest that
principal at the new (supposedly higher) interest rates.

That said, you'll also tend to find you get somewhat lower initial
yields with this strategy (the old risk/return issue), especially
when the market expects that over the long term rates will rise.

Finally, remember that you have to compare *after tax* yields on
municipal bond options vs. taxable bonds of comparable risk. Merely
be "exempt from tax" doesn't mean you come out ahead by holding
these bonds as opposed to taxable ones. In essence, to take this to
an extreme, earning 0.5% tax free is generally *not* going to be
better than earning a fully taxable 10% return. But since many
people react very emotionally on tax matters (avoid them at all
costs), quite often you'll find people with municipal bonds that are
giving them a significantly lower after tax yield than they could
get from similar taxable bonds.

 

[Paul Michael Brown]

However, one needs a considerable amount of money (I've heard

~$100K) to invest directly in munis, since the individual bonds have
fairly high face values (I've heard >=$25K).

For the "retail" investor in munibonds, there are also significant
transaction costs when buying and selling. Moreover, unless you have a ton
of money to invest it is difficult to construct a diversified portfolio if
you purchase individual bonds. On the other hand, if you are looking to
get the double tax exemption (or if you're looking to avoid issues subject
to the dreaded AMT) purchasing individual bonds permits you to ensure you
get the issuer and the bond that works best for you.

Therefore, if you want to invest in munis but don't have a pile of
money, consider muni bond funds.

This is the method I have chosen to hold munibonds. Specifically, I own
several different Vanguard munibond funds. The annual fee is less than 20
basis points. And I can fine tune the duration of my munibond investment
by shifting money among the funds.

Also, I understand that it is generally expected that interest rates
will rise over the coming years [insert obvious disclaimer on
predicting the future here].

True, but some folks are not so sure. If you want to read the case for
deflation and falling rates, surf over to the Prudent Bear web site. Bond
Guru Bill Gross at PIMCO has looked at the threat of deflation in his
commentaries as well.

Buying individual bonds presents only the risk that you will forgoe
higher returns if rates rise after your purchase, and/or that the bond
will be called when rates drop.

It's true that if you hold an individual bond until maturity (or until
it's called) you will get your principal back, plus whatever the yield
is. Now everybody *thinks* this "protects" them in a rising rate
environment. The problem is that you are tying up your money until the
bond matures. In some cases, that can take decades. (Especially if you're
desparate for yield and you buy bonds of longer maturities.) That is not a
risk you should ignore without some serious consideration. Suppose you buy
a bond today that matures in 20 years and you think you're doing great
because it pays five or six percent. Suppose further that interest rates
go up sharply in a year or two. (There are many scenarious for this.) Now
the going rate is eight or nine percent. You can either sit around for 20
years earning a below-market return. Or you can sell you bond at a
discount ("below par"). Finally, a lot can happen to the issuer in 20
years. Suppose that city elects some corrupt mayor who runs the city's
finances into the ground and the city defaults?

My point here is that being a retail purchaser of munibonds presents risks
not appreciated by most people. So you really need to do your homework.

A bond fund that trades bonds, presents the additional risk of capital
depreciation when interest rates rise.

This is true. If interest rates rise, the net asset value (NAV) on
munibond funds will go down and the value of your principal will go down
too. The amount by which the NAV will go down depends on the fund's
DURATION. (Which is *not* the same thing as the "maturity" of the bonds in
the fund.) The LONGER the duration, the GREATER the loss if rates rise.

If you mispredict interest rates, you can end
up losing principal in addition to having forgone potentially
higher-rate investments. This doesn't sound like fun, particularly for
a newcomer to bond investing.

The analysis is more complicated. Granted, when rates rise the NAV of the
munibond fund goes down. But there is a BIG DIFFERENCE between buying an
individual bond and buying shares in a bond fund. If you buy the invidual
bond, your yield ("coupon") is FIXED for the life of the bond. But if you
buy shares in a bond fund, the yield fluctuates with the market.

Stay with me here. If rates rise, your NAV goes down and your principal
decreases. But at the same time, your YIELD goes UP. Obviously, the higher
yield offsets the decline in NAV. This is particularly true if you choose
to reinvest the monthly dividends. If rates rise, your dividend goes UP
and the price of the shares you are bying goes DOWN. Over time this works
to your advantage. In fact, there are studies showing that over many years
almost all of a bond fund's return comes from *dividends* not from NAV
appreciation. So the long term bond fund investor really doesn't care
about NAV. He'd rather see a high dividend. And when rates rise, so does
the dividend. Even though the NAV might fluctuate, if you hold onto a
munibond fund long enough your principal is going to be just as safe as if
you'd bought individual bonds. Don't believe me? Look at the 10-year rates
of returns for any munibond fund. You won't find any that have lost money.
(Vanguard has a very good explanation of all this on their web site.)

Of course, rising rates can be a VERY BAD thing for bond fund investors in
the SHORT term. The mistake people make when they buy munibond funds is
that they look for the one that has the highest yield. Problem is that's
the fund that has the longest duration. And if rates rise, that's the fund
where the NAV will decrease the most. Then they panic and sell at a big
loss.

KEY POINT: You must "fine tune the average duration" in your munibond
portfolio. If you're investing for the short term put your munibond money
in funds that have *very* short durations. There are munibond funds that
have durations so short there are similar to money market funds. Going
slightly farther out the yield curve, there a munibond funds that have
"short" or "limited" durations. If your time horizon is longer, consider
funds with an "intermediate" or "long" duration. Worried about the issuers
defaulting? There are munibond funds that invest only in insured issues.
Aggressive investor who wants to take advantage of issuers that have bad
credit ratings? Seek out a fund that buys "high yield" paper.

RULE OF THUMB: Don't buy a munibond fund unless you are prepared to leave
your money untouched for as long as that fund's DURATION. For example, the
duration on my Vanguard Long Term munibond fund is roughly six years. I
don't invest any money in that fund that I might need before 2010.

When I put this all together, though, I can't think of any way of
investing in muni bonds in my taxable investment account. I fear
buying a muni bond fund, since that seems to imply the risk that its
NAV will plummet as interest rates rise.

Here's what to do. Construct a "portfolio" of munibond FUNDS.

Using the Vanguard product lineup, I recommend five funds of varying duration:

1. Money market
2. Short
3. Limited
4. Intermediate
5. Long

(I'm sure you could do this with other fund companies as well.)

Vaguard requires a $2K minimum investment, so you'll need at least $10K.
(Better you should have more than $10K because you're going to want to put
more than the minimum in some of the funds.) Depending on your time
horizon and your call re the direction of rates, you can allocate your
money among the five funds. If you need the money soon and you think rates
are going up, overweight the money market and short funds. If you're 25
and investing for retirement, overweight the intermediate and long funds.
You get the idea. If you are dollar cost averaging (and you should be)
adjust the allocations by changing how you invest new money. That way,
you'll reduce tax accounting hassle. You want to avoid sales and exchanges
if possible.

SUMMARY: There is interest rate risk in ALL fixed income investments. So
regardless of whether you buy individual bonds or munibond funds, if rates
spike up sharply (like they did in April) you are going to take a hit. If
you can't tolerate that, put your cash in an insured savings account or in
a money market fund and don't be whining about a yield of less than one
percent. But if you're investing for the long term, munibonds can be a
good addition to your fixed income portfolio. (Especially if you're in a
higher tax bracket.) And carefully managed, I think that a "portfolio" of
munibond FUNDS is a smart way to invest in them.

 

[Paul Michael Brown]

But since many people react very emotionally on tax matters

quite often you'll find people with municipal bonds that are
giving them a significantly lower after tax yield than they could
get from similar taxable bonds.

Excellent point. Let's not forget than federal income tax rates have been
reduced and the brackets adjusted. So lots of folks have a lower marginal
rate these days than five years ago. Also, unless you get into
state-specific munibonds (or munibond funds) you still have to pay state
tax. (And perhaps AMT. But I'll leave that to the tax geeks.)

So Mr. Zollars' point is well-taken: Do an apples-to-apples analysis to
make sure your rate of return AFTER tax is competitive.

 

[Rich Carreiro]

So Mr. Zollars' point is well-taken: Do an apples-to-apples analysis to
make sure your rate of return AFTER tax is competitive.

Exactly!

Far too many people think the idea is to minimize
taxes. The actual idea is to maximize after-tax
return. The two are *not* the same.

 

[Mark Aiken]

It's true that if you hold an individual bond until maturity (or until
it's called) you will get your principal back, plus whatever the yield
is. Now everybody *thinks* this "protects" them in a rising rate
environment. The problem is that you are tying up your money until the
bond matures.

I understand what "opportunity cost" means, but here's a point that
I'm not as clear on; consider two scenarios:

A: You buy a 20-year/5% bond, and hold it to maturity. You ignore
interest rate changes for the duration.

B: You buy the same bond. At year 5, you notice that the yield for
15-year bonds of this quality has spiked to 10%. You sell your bond
(at a loss), and buy a 15-year/10% bond at face value with the
proceeds (ignore the fact that that would make it a strangely priced
bond). You hold the new bond to maturity.

In which scenario do you make more money? The only reason I haven't
precomputed the answer is that I'm confused about how a bond's trading
price gets set: is a bond's trading price exactly the price that would
make its YTM whatever the prevailing yield is for that type of bond?

Despite my confusion, though, it would seem that one MUST end up with
more money in scenario A, otherwise everyone would always invest in
the longest bonds they could find, knowing they could cash them in and
trade up if rates change?

So it would seem that there is some measure of protection in holding
bonds to maturity, no?

In the rest of your (very informative) post, you explain that a
rising-rate environment isn't all bad for bond investors, since it
pushes up the yield paid by bond funds one may already own, which, in
the long run, improves one's total return. You also mention the rule
of thumb that one should be willing to leave one's principal untouched
for at least the Duration of any bond funds one is invested in.

I'm a little perplexed by this last point, namely, the advice that one
should buy a fund with a longer Duration if one is a longer-term
investor, and a shorter Duration if one is going to withdraw the money
sooner.

For short periods of time, this makes sense simply from a risk
perspective: you don't want short-term money in a fund whose NAV is
extremely volatile. But suppose I'm investing with a 10-year horizon.
Should I really avoid a fund with a 20-year Duration, but that pays a
better Yield?

The reason this is confusing to me is that it would seem that the NAV
for a bond fund should strictly reflect the trading value of the bonds
it holds. This means the NAV should move up and down with interest
rates, but not march steadily upward like the NAV of a stock fund over
long periods of time. As I understand it, the reason that one can get
away with investing in a riskier stock portfolio if one is a long-term
investor is the expectation that although stock prices will fluctuate,
the underlying capital appreciation trend will have "time to work" if
you wait for long enough.

Contrastingly, though, it would seem to me that the length of time you
hold a bond fund has nothing to do with how likely it is that you will
have a capital loss when you sell your shares. If you hold your shares
for 1 year or 20, if interest rates are rising in the same way when
you sell, wouldn't the fund NAV be equally depressed?

What am I missing? Please explain why, if I have a reasonably
long-term horizon (say, 10 years) I shouldn't invest in the
highest-yield funds I can find, even if their Duration is considerably
longer than 10 years?

Many thanks,

Mark

 

[Rich Carreiro]

I understand what "opportunity cost" means, but here's a point that
I'm not as clear on; consider two scenarios:

A: You buy a 20-year/5% bond, and hold it to maturity. You ignore
interest rate changes for the duration.

B: You buy the same bond. At year 5, you notice that the yield for
15-year bonds of this quality has spiked to 10%. You sell your bond
(at a loss), and buy a 15-year/10% bond at face value with the
proceeds (ignore the fact that that would make it a strangely priced
bond). You hold the new bond to maturity.

In which scenario do you make more money?

You make the same in either case.

Think about it -- in scenario B, the price of the bond you've been
owning has dropped such that over the remaining 15 years of its life
it'll have a YTM of 10%. In other words, the bond you've been owning
is now a 15-year bond with a 10% YTM. So when you go looking for
15-year 10% YTM bonds to purchase, you may as well buy the bond you
just sold. But of course, that's the same as not having sold the bond
in the first place. Hence the two outcomes yield (ha the same
final value.

[And remember, you can't buy a 15-year 10% YTM bond at *face value*
with the proceeds of the sale of your original bond -- you sold the
original bond at a loss, so the proceeds are less than the face
value of a new bond.]

The only reason I haven't precomputed the answer is that I'm
confused about how a bond's trading price gets set: is a bond's
trading price exactly the price that would make its YTM whatever the
prevailing yield is for that type of bond?
Bingo.

So it would seem that there is some measure of protection in holding
bonds to maturity, no?

The only protection there is from holding to maturity is
that in doing so you're guaranteed to get your principal
back in its entirety.

the long run, improves one's total return. You also mention the rule
of thumb that one should be willing to leave one's principal untouched
for at least the Duration of any bond funds one is invested in.

I'm not the original poster, but I disagree with that rule of thumb,
for precisely the reasons you point out.

Relatedly, remember that the duration of a fund will (not counting
active decisions by the manager to change it) stay the same. So if
you buy into a fund with an average duration of 10 years, six years
later it'll still have an average duration of 10 years. But if you
buy a bond with a duration of 10 years, six years later it'll have a
duration of around (but definitely not exactly!) 4 years.

Hence my disagreement with the proposed "rule of thumb."

The reason this is confusing to me is that it would seem that the NAV
for a bond fund should strictly reflect the trading value of the bonds
it holds.

Well, yes. That's true of any mutual fund regardless of it's type
(aside from a money-market fund) -- the NAV will, by definition,
strictly reflect the trading value of whatever securities it holds.

What am I missing? Please explain why, if I have a reasonably
long-term horizon (say, 10 years) I shouldn't invest in the
highest-yield funds I can find, even if their Duration is considerably
longer than 10 years?

Because unlike individual bonds, bond funds never mature.

What I might be willing to agree to is that if your horizon
is long enough to cover a complete interest rate cycle,
then invest in funds with a duration that is the length
of the cycle.

But good luck defining such a cycle!

 

[Tad Borek]

I'm confused about how a bond's trading
price gets set: is a bond's trading price exactly the price that would
make its YTM whatever the prevailing yield is for that type of bond?

Mark,
To add to Rich's answer...one way to see very practically how this works
is to look at the Treasury yields for the bonds listed in the daily Wall
Street Journal. You'll see that all Treasury bonds of a certain maturity
date might be yielding say 2.10%, but those include a range of original
coupons and issue dates. A "two-year bond" can be a 30-year bond in year
28, a five-year in year 3, or a brand new 2-year. The prices for all
have adjusted so that the yield to maturity is the same 2.10%. So the
holder of the 30-year bond can't boost yield by swapping...to the market
it's the same bond and will be priced with the same yield.

What am I missing? Please explain why, if I have a reasonably
long-term horizon (say, 10 years) I shouldn't invest in the
highest-yield funds I can find, even if their Duration is considerably
longer than 10 years?

Because as you go to longer durations, the price drop should yields
change will be much greater than the extra yield you'll earn. And you
might decide that the price-drop risk is too large compared to the
extra, say, 2% or 3% yield.

The rule of thumb, not precise, is to multiply duration times the
percentage change in interest rates...that's the price drop/rise you'd
expect. If duration is 12, as with a 20 yr 5% bond, then a 2% change in
yields would result in a 24% or so drop (or rise) in price. (google:
DURATION CALCULATOR there are plenty out there).

Given the low rates today most people are waiting for that price-drop
scenario; historically, long-term bonds have yielded closer to 7-7.5%
instead of just 5-5.5%, and sometimes they've been much higher.

Is the extra yield worth the risk of a 20%+ drop? A lot of people say
"no" and stick with short term bonds (or funds).

-Tad

 

[Mark Aiken]

Because unlike individual bonds, bond funds never mature.

I'm not quite clear on this concept. Do you just mean that, as another
poster points out after you, long-term bond funds have much more
volatile NAVs, and that the increased capital risk may not be worth
the higher yield?

Do you mean by "bond funds never mature" that, unlike individual
bonds, there is no way of ensuring that you can recoup your capital
when buying a bond fund, as you can with individual bonds simply by
holding to maturity?

Here's what I'm left wondering after the latest round of
clarifications: I understand that longer-term bonds and bond funds
place one's capital at greater risk. However, shouldn't it be possible
to objectively express a risk vs. Duration curve, and choose a
Duration that offers the greatest reward vs. risk? It sounds like that
is effectively what people are doing when they shun the longest-term
bonds and bond funds because the extra NAV volatility "isn't worth the
higher yields".

Can anyone offer comments on determining what length of bond offers
the best reward, considering the capital risk?

Mark

 

[Rich Carreiro]

Do you mean by "bond funds never mature" that, unlike individual
bonds, there is no way of ensuring that you can recoup your capital
when buying a bond fund, as you can with individual bonds simply by
holding to maturity?
Yes.

Here's what I'm left wondering after the latest round of
clarifications: I understand that longer-term bonds and bond funds
place one's capital at greater risk. However, shouldn't it be possible
to objectively express a risk vs. Duration curve, and choose a
Duration that offers the greatest reward vs. risk?

Yes, of course it is.

And when you do that, you discover that short-term
is almost always where to be.

Request Ibbotson's _Stocks, Bonds, Bills, and Inflation_ from
your library (or via inter-library loan) and look at the
hard numbers.

 

[Ron Peterson]

Can anyone offer comments on determining what length of bond offers
the best reward, considering the capital risk?

IIRC, 4 or 5 years is best. But consider laddering your bonds to get a
variety of maturity dates and get a uniform cash flow to reduce your
need for emergency funds.

If interest rates go reasonably high like 8% consider some long term
bonds.

 

[Tad Borek]

Here's what I'm left wondering after the latest round of
clarifications: I understand that longer-term bonds and bond funds
place one's capital at greater risk. However, shouldn't it be possible
to objectively express a risk vs. Duration curve, and choose a
Duration that offers the greatest reward vs. risk?

For choosing a fund category to buy into, you're probably more
interested in the basic division into say cash, short-term bonds,
intermediate-term bonds, and long-term bonds. Those are the basic
choices here. By "cash" I mean money market funds or 3-mo CDs or a
T-bill (ie very short-term bonds).

And what you see from the long-term historical data is that returns have
averaged a bit higher as you go from bills to say 2-year bonds, but
beyond short-term bonds (ie 5-yr) there has been very little increase in
yield, with a very large increase in NAV risk. If you're comfortable
speaking in terms of standard deviations (to define "NAV risk") you
should look into the Ibbotson reference that Rich mentioned. A summary
of that data is included on DFA's web site at www.dfaus.com - go to
Strategies, Fixed Income. (No I don't work for them, I use their funds
in my practice). The graph there pretty much sums it up...the issues
over 5 years just haven't paid off given their risk. Even at 2 years
it's looking questionable. Remember this is over the long haul and it
varies all the time - right now you get an extra ~3% from long bonds.

Can anyone offer comments on determining what length of bond offers
the best reward, considering the capital risk?

You can get much more sophisticated in defining where the risk/reward
sweet spot is (beyond just looking at the chart of returns vs. standard
deviation) and opinions will vary. I think DFA describes their approach
on that site, it's based on a "variable maturity" strategy - other firms
do similar things as well. This is how they choose bonds within a given
maturity range.

For the simple question of selecting a mutual fund category, "short-term
bonds" passively managed, as with Vanguard, will suit many people just
fine. I find a lot of people are sold on the concept just by looking at
the long-term history. "OK, right around here it looks like the chart
flattens out, so why bother with the NAV risk?"

-Tad

 

[Rich Carreiro]

should look into the Ibbotson reference that Rich mentioned. A summary
of that data is included on DFA's web site at www.dfaus.com - go to
Strategies, Fixed Income. (No I don't work for them, I use their funds

Specifically:
http://www.dfaus.com/strategies/fixed/

 

[fwed1066]

The dfaus.com data was interesting. While it mentions long term returns
for 1,5, and 20 year bonds, it doesn't mention returns for 2,3, and 4 year
bonds. I can't seem to find this information anywhere on the web or
financial libraries. The Dfaus.com date also does not discuss municipal
bond returns, which I hear tend to have a steeper slope. Information on
this would be helpful for my asset allocation on the bond portion of my
portfolio.

 

[Tad Borek]

The dfaus.com data was interesting. While it mentions long term returns
for 1,5, and 20 year bonds, it doesn't mention returns for 2,3, and 4 year
bonds. I can't seem to find this information anywhere on the web or
financial libraries. The Dfaus.com date also does not discuss municipal
bond returns, which I hear tend to have a steeper slope. Information on
this would be helpful for my asset allocation on the bond portion of my
portfolio.

That's true, you don't see much other data. I have some stuff available
to me (I'm an advisor) but I don't know how to get it for free.

For something b/t 1 & 5 year bonds you might approximate by looking at a
fund or index with a duration that usually sits in that range. EG dig up
one of the "1-3 year Treasury" indices. Lehman's is the basis for the
iShare with ticker symbol SHY so if you do some research on that you
might find some long-term historical data (not on the iShare, it's
fairly new, but on the index it's based on). You'll need to find the
duration associated with that index, it'd be under 2.0. But it may be a
reasonable proxy for a "2-year bond" (or one & a half anyway).

Next you might look at one of Vanguard's ST bond index funds which have
duration in the mid 2's. It's a fund, not an index, but at least you
have some longer-term data readily available.

I think you'll find that the data sit neatly between 1 & 5 which is why
you typically only see 1 & 5 represented. Maybe as significant, it'll be
hard to invest in say 3-year Treasuries unless you manage a portfolio
yourself.

RE: munis...the tricky thing is the variation in tax rates and brackets
over time, which will influence the spread between munis and Treasuries.
Otherwise the two should mirror each other with an adjustment for taxes,
if the market's working. Because tax brackets change (unpredictably and
randomly) there's always going to be a layer in there that doesn't fit
neatly into asset allocation theory. You need to have long-term
predictions regarding the changes in future tax rates (and your own
income level), and the timing of those changes, which isn't possible
really.

It may be better to do your asset allocation based strictly on
yield-curve information, meaning you pick your allocation to bonds,
generally. Then you constantly revisit your short-term bond allocation
and flip between taxables and munis based on your actual tax bracket and
the current yield spread (gap b/t Treasuries and munis). This is
feasible because short term bonds rarely have much capital gain or loss
associated with them, so it's not like stocks where you need to weigh in
tax issues - and where you might need to pick your choices for the long
term.

It's of course a different story with long-term bonds but if you buy the
DFA stuff you probably won't have any long-term bonds in your
allocation. Or if you do it's munis, that fit more into a "wealth
preservation" approach for a higher-wealth investor where taxes drive
the investment decisions more than class-return data do.

-Tad

PS If you have something specific in mind I'd be happy to run some quick
data for you on a 1-3 year index - send me an email.

 

[beliavsky]

I don't worry too much about the interest rate risk of long term
municipal bonds (LTMB), because of the possibility of tax loss
harvesting. If I buy a LTMB fund and rates fall, I just keep the fund
and owe no capital gains taxes (unless the fund itself realizes
gains). If the fund price falls, I can sell it and have Uncle Sam take
about 1/3 of the loss (it depends on one's tax bracket, and one can
only deduct up to $3000 in losses against ordinary income annually,
although losses can be carried over to future years). Given the tax
timing option and the difficulty of timing the muni (or taxable) bond
market, owning LTMB seems attractive to me in general.

Bond prices tend to fall when the economy is stronger than expected,
as in 1994 and 1999, and they rise when the economy is weak or (God
forbid) there is a shock such as a terrorist attack. To some extent
they hedge one's career risks. Stocks do not, especially if one works
in the private sector.