Tag Archives: bonds

Bond Investing

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dollar-544956_640Investing in bonds should be one of the simplest form of investing.  I lend a government, corporation, or other entity money and it agrees to pay me that money back at an agreed upon interest rate.  So long as they don’t default on the loan, I will get that return on your investment.  For individually issued bonds held to their maturity, that’s pretty much the deal.  However most people invest in bonds via mutual funds or ETFs and that makes things a little more complicated.  If you read any article on bond investing, it will inevitably state that the yield of a bond fund (interest it pays you) moves inversely to its price.  That might not make sense, if the bond is now yielding more, shouldn’t it be more valuable?  Sort of.  I always find it is easiest to explain with an example.

Remember a bond is just a loan.  Let’s say you lend $10,000 to Bill, at a 10 year fixed rate of 3%.  Bill has a history of paying his debts in the past and therefore you have confidence he will pay you back.  Let’s say next year Bill is looking for another 10 year loan, but circumstances have changed.  Maybe Bill is starting to struggle with his bills (ha!) or the interest rate environment has changed and now the best rate he can get is 5%.  Now, let’s say you don’t really want the original 3% loan you made to Bill and are looking to sell it to someone else.  Do you think someone will pay you $10k for it?  Why should they?  Your loan to Bill only pays 3%, you locked in that rate when you made the original loan, but they can issue a new loan to Bill at 5%!  The only way you can sell your loan to another investor is if you drop the price. The amount you drop the price of the bond is to make up for the lost revenue that the person would get between your 3% loan and the 5% loan they could make to Bill.  The same happens in reverse if current interest rates drop, your loan to Bill suddenly looks even more valuable and you can raise the price.  How much depends on the difference in interest rates and how much longer you have the loan.  In other words, if you want someone to be saddled with this 3% loan for 10 years, you’re going to have to drop your price more than if it were only a year.   This is why interest rates impact the prices of long term bond funds a bunch, and short term bond funds not as much.  You might even need to drop the price so much you lose money on the investment, even though Bill hasn’t defaulted!  That is not smart investing.

This is another example of why it pays to be long term on investments.  You don’t have to sell the bond.  You can keep it, be happy with the 3% you’re getting, and as long as Bill doesn’t default, you’ll get all your money back, with the interest you agreed upon.  Buying a little bit over time is a good way to even out the ups and downs of the bond markets just like with stocks.  It is important to understand that you aren’t buying bonds for these ups and downs in price.  A bond is a loan, you are buying it for its yield,    This is critical when evaluating loans as investments.  This can be illustrated looking a curve of the 10 year US treasury (10 year loans made to the US Government) and the return of the Vanguard Total Bond Market ETF (BND) 

Bond fund returns follow yield

The BND return is generally higher because it has some higher yielding bonds in it, but there is a critical conclusion here. As the 10 year US treasury bond yield, and interest rates in general, have declined over the past 35 years, bond fund returns have fluctuated wildly, but the average return pretty well tracks this yield. It has to, the yield of the bonds is what is making you money! The drop in interest rates has been great for home buyers because of lower mortgage rates, great for businesses borrowing money to expand, but a hit to anyone looking to make money by lending it to others. Looking at the chart above, seems clear that you should not expect average bond returns to be more than a couple percent, maybe even lower for the next few years.

Why the 50%-50% ratio of stocks and bonds in retirement

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apple-926456_640In an earlier post on asset allocation I talked about the notion of a 50/50 split of your assets between stocks and bonds at retirement.  I also mentioned the “4% rule” for calculating withdrawals from your accounts in retirement as a good number.  Where did these come from?  It’s not simply a compromise between the assets, and we can show why it makes sense.  With math!  Hurray!

Previously I showed how we can use Monte Carlo analysis to predict probabilities of certain events, by running many possible future outcomes using prior years’ mean (average return) and standard deviation (variation of a given year’s performance from the mean).  In the case of retirement, the goal is for the money to last for the rest of your life.  Let’s assume you are taking good care of yourself and you are going to have a nice, long 30 year retirement.  And because of inflation, you’re planning on increasing your withdrawals by 3% every year.  We can run Monte Carlo analysis for different asset allocations to see what is the probability you will still have some money left after living off your nest egg for these 30 years.  I did a simple analysis with only 100 cases just for illustration, most Monte Carlo analyses would use many more, but this should be reasonably close.  Also, here I’ve assumed that stock and bond means and standard deviations will mimic those of the past.  Again, not a guarantee.  Here’s what I got:

Probability of your money lasting if 100% in stocks: 83%

Probability of your money lasting if 100% in bonds: 39%

Probability of your money lasting if 50/50: 90%

These results should look weird.  So all stocks is pretty good, all bonds not so much, but if I allocate some of my stock money to these (worse performing) bonds my results get better?  Huh?  Yep.  Remember your goal for this money: last 30 years.  It is not maximize the most money I can possibly make, that would be in stocks.  What happens is the addition of the lower variable bonds help smooth out those cases where stocks get hammered, and increase your chances that your money will last.

Is 50%/50% perfect?  Not really.  Here’s my analysis for more stock bond ratios, for convenience graphed as % of assets in bonds:

This analysis shows an ideal is actually about 60% bonds, but what’s clear here is you need the growth power of stocks to help your returns, but there isn’t a lot of difference between 40%/60% to 70%/30% (bonds/stocks) in terms of probability of the money lasting.  I like to lean a little heavier toward stocks with bond yields so low lately, but I think anywhere in this range is fine in retirement.  The other thing to notice is, how comfortable are you with a 10% chance your money will run out before 30 years?  If not, the 4% rule might be more of a 3.5% rule.  Or, as I mentioned earlier, you can throttle back your spending in the years of stock/bond downturns.  Living to your means, always a good idea.

Asset Allocation

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chicken-1686641_640Where you put your money to attempt to maximize your returns while protecting your money is the subject of countless studies and makes up the primary job of many financial professionals.  My suggestion for asset allocation is far simpler than what many of these professionals would recommend, and due to ultra low fees, the returns are likely better.

The first questions that need to be answered for asset allocation is a) What is the money for? and b) How long until you need it?  For definitive expenses (like your emergency fund or saving for a major purchase in the next year or two), the money should be in something safe, like a CD or a money market fund.  For something like retirement or other longer-term investing, it’s more interesting.  Here is a starting example:

Age 25, Planned Retirement Age 65:  Years to Goal: 40 years

For anything 25+ years to the goal, my recommendation is a 90%/10% stock/bond ratio.  This isn’t magic, but certainly with a long time horizon, history has shown the vast majority of your money should be in stocks.  I prefer a diversified group of index funds of all sizes, both domestic and international.  You could go a long way to achieving this with just two funds: 60% in Vanguard Total Stock Market Fund (VTSMX) and 30% in Vanguard Total International Fund (VGTSX), The other 10% of the money can go into bond funds, such as Vanguard Total Bond Fund (VBMFX) and Vanguard Total International Bond Fund (VTIBX).  I’m a big fan of Vanguard for their low fees, but if your 401k does not offer these funds hopefully you can find some similar funds that have very low fees—less than 0.2% should be standard for an index fund.  For God sakes hopefully the funds they offer have no loads (sales commission). Aside—this is completely wasted money.  “Sales Loads” are money paid to the salesperson for “selling” you the fund.  They are so worthless you likely didn’t even know they sold you anything.  This is different from the higher fees that actively managed funds (vs index funds) charge, that money is actually for the person picking stocks for you, but isn’t worth it either. 

The suggested allocation looks something like this

  • 60% Vanguard Total Stock Market Index Fund
  • 30% Vanguard Total International Index Fund
  • 8% Vanguard Total Bond Market Index Fund
  • 2% Vanguard Total International Bond Market Index Fund

The above can be substituted for other equivalent index funds, you are looking for funds with fees of <0.2%.  This gives you a broadly diversified portfolio in just four funds.

Once you get within 25 years or so from your retirement age, you want your portfolio to start to get more conservative, meaning a shift from stocks to bonds, such that at retirement you have something close to 50%/50% split of stock and bonds.  I’ll have a future post on the logic of this allocation in retirement.  This can be achieved by shifting your allocation by 1.5% from stocks to bonds with each year. For the ratio of the above funds at years until retirement, for example,

  • 25 years to go (60%/30%/8%/2%)
  • 15 years to go (50%/25%/20%/5%)
  • 5 years to go (40%/20%/32%/8%)
  • At retirement (35%/18%/38%/9%)

Target retirement funds attempt to do this adjustment for you and there are some of these that invest in low-cost index funds, but I usually like to have this control myself.

That’s it, not complicated.