Bond Funds and Interest Rate Cycles

[2 yen]

I own XSB and XBB, both on DRIP's. I plan to turn off the DRIP's and take income starting in 15 years from now. I often read that XSB is less vulnerable to rising interest rates while XBB, as a longer duration bond fund, is likely to lose more value as rates rise. I have two questions:

a) How long are typical interest rate cycles? So, if, for example, rates shoot up over the next couple of years, when might a fund like XBB start to recover after a decline in prices?

b) If one is not looking to ever cash out of a fund like XBB, does question a above matter?

Thanks for any thoughts.

[randomwalker]

see graph of Fed Funds Rate here, macro and mico cycles

http://www.moneycafe.com/library/fedfun ... istory.htm

[Contrarian]

There is no predictable pattern to long-term interest rates. You are thinking of short term rates that the govt uses to control economic cycles. So, it does not make sense to ask when will the bond recover. The only possible trend might be the 2000 yr decline in real returns.

If you never plan to cash out of XBB, you still have the inflation risk of holding a long duration bond. You need to be worried mostly about inflation even though it looks unlikely it will reemerge. Also, you may not sell XBB but bonds are bought and sold and mature inside the fund. You'd ask this question if you have a 30 year strip bond or something.

George is the smartest guy here and he is nearly 100% in real return bonds for the long term. They yield about 1.7%. Once you understand why he would do that, you will understand investing.

I don't really have the guts to do what George is doing for some reason even though I know he is right.

[queerasmoi]

My thought is: The difference between a bond fund and a bond ladder is, with a ladder at any given point you can choose to stop buying longer bonds, and let the duration tick down until all the bonds mature. A bond fund automates the process.

So - look at the average maturity of the fund. XSB is around 3 years, XBB around 9. Respectively similar to owning a 5-year and a 14-year bond ladder. (5-year you can also do with GICs). When you have enough assets and you are an appropriate number of years from retirement, consider selling the fund and buying a ladder with the same length. Or you can sell a chunk of it each year to buy a bond or two, in such a way that you're always matching duration bought to duration sold.

[$seeker]

You may have already looked at this site but it is a very good summary of this topic.
http://www.bogleheads.org/wiki/Individu ... _Bond_Fund

Both sides have their points so like picking your asset allocation, I think you select bond or bond fund and learn how they swing with the market.

[ockham]

You may have already looked at this site but it is a very good summary of this topic.
http://www.bogleheads.org/wiki/Individu ... _Bond_Fund

Both sides have their points so like picking your asset allocation, I think you select bond or bond fund and learn how they swing with the market.

Thank you for the link; as you say, a very good summary.

[queerasmoi]

Just as an example, suppose you own an ETF that is similar to a 5-year bond ladder (XSB), with an average maturity of 3 years. Let's say I've accumulated enough to validate direct bond purchases, and my goal is to change it into a "real" bond ladder within 5 years. But I want to spread out the conversion a bit so that I'm not buying them all under the same interest rate conditions. So divide my holdings into 5 piles of 20%.

Year 1: Sell 20% for a 3-year bond/GIC, 80% XSB. Average maturity is still 3 years.
Y2: Now I have a 2-year bond. Sell 1/4 of remaining XSB for a 4-year bond, 60% XSB. Avg maturity still 3 years.
Y3: Now my bonds are 1 and 3 years. Sell 1/3 of remaining XSB for a 5-year bond, 40% XSB. Avg maturity still 3 years.
Y4: Now I have a 2 and 4-year bond, and one bond has matured. Buy a new 3-year bond, still 40% XSB. Avg maturity still 3 years.
Y5: Now I have 1, 2, 3-year bonds. Sell remaining XSB and buy a 4-year and 5-year bond.

So now without any abrupt shifts in portfolio duration, and without ever having to buy a bond at shorter than 3-year rates, I've converted the bond fund into a ladder. Now I have the flexibility of letting duration tick down anytime. One can play similarly with turning a longer bond fund into a longer ladder.

Just thinking out loud here, but long term this is how I'd intend to move from a bond fund to a ladder

[like_to_retire]

Just thinking out loud here, but long term this is how I'd intend to move from a bond fund to a ladder

I personally feel it's smart to move from bond funds/ETF's into a bond ladder in retirement, specifically when RRIF age rolls around.

Each year when a bond matures, you can pull out the required minimum RRIF amount and then roll the remainder back into your ladder. You've pulled your RRIF payment out at 100 cents on the dollar. During a rising interest rate environment, that isn't the case with a bond fund when the NAV is depressed.

ltr

[scomac]

The one thing that isn't mentioned is the certainty of return with a bond ladder. The day you purchase a bond, you know exactly what your RoR is. I have a long bond ladder in my RRSP. I can tell you exactly what the future value is any given day, with bond funds or ETFs, you really have no more than an approximation of what it will be worth in the future.

[Shakespeare]

I can tell you exactly what the future value is any given day,

You can create a calculated value. But that will almost certainly be different from the actual market value.

[snowback96]

Just as an example, suppose you own an ETF that is similar to a 5-year bond ladder (XSB), with an average maturity of 3 years. Let's say I've accumulated enough to validate direct bond purchases, and my goal is to change it into a "real" bond ladder within 5 years. But I want to spread out the conversion a bit so that I'm not buying them all under the same interest rate conditions. So divide my holdings into 5 piles of 20%.

Year 1: Sell 20% for a 3-year bond/GIC, 80% XSB. Average maturity is still 3 years.
Y2: Now I have a 2-year bond. Sell 1/4 of remaining XSB for a 4-year bond, 60% XSB. Avg maturity still 3 years.
Y3: Now my bonds are 1 and 3 years. Sell 1/3 of remaining XSB for a 5-year bond, 40% XSB. Avg maturity still 3 years.
Y4: Now I have a 2 and 4-year bond, and one bond has matured. Buy a new 3-year bond, still 40% XSB. Avg maturity still 3 years.
Y5: Now I have 1, 2, 3-year bonds. Sell remaining XSB and buy a 4-year and 5-year bond.

So now without any abrupt shifts in portfolio duration, and without ever having to buy a bond at shorter than 3-year rates, I've converted the bond fund into a ladder. Now I have the flexibility of letting duration tick down anytime. One can play similarly with turning a longer bond fund into a longer ladder.

Just thinking out loud here, but long term this is how I'd intend to move from a bond fund to a ladder

I have recently been contemplating converting my XSB to a GIC ladder and was planning to do exactly what you're proposing and spreading it over several years. However, the more I think about it, I'm not sure this adds any value (or reduces any risk).

If you convert it all to a 5 year ladder all at once, you still maintain your 3 year duration. And if the yield curve changes, the impact is negligible and you adjust for it every year by buying a new 5 year GIC. So why not just git 'er done?

[scomac]

I can tell you exactly what the future value is any given day,

You can create a calculated value. But that will almost certainly be different from the actual market value.

Not quite if you are dealing with a ladder of stripped bonds. The future value will be equal to the maturity value of those bonds whereas the present value or market value is the discounted value of the matured bond. With a fund you could arrive at a calculated future value based on the current yield of the fund and use that as your discount rate in a time value of money calculation. Still this is a calculation that assumes the future will remain consistent with the present and as such presents a risk that isn't being incurred with a ladder of strip bonds.

[2 yen]

Thanks very much everyone! The bogleheads primer was very helpful. I think what I may do is just leave XSB and XBB as they are. Since I don't intend to sell and will not be taking income for 15 years, I think I can ride out any cycles. It seems to me that the psychological issue of seeing a decreased net worth during times of high interest rates may be more important to consider than the longterm implications of interest cycles, in my case. Contrary opinions are most welcome, however. I am very open to being convinced otherwise.