Bond Bubble? My Thoughts

Somebody posed a question regarding the bond market in the comments section of another post, so I thought I'd also clarify my thoughts on that matter in this post as well. There has been a lot of talk about a bond bubble and investors are wary and seeking alternative investments. Is that a wise course of action?

First, I think having the proper perspective on this issue is in order. Even in a doomsday scenario for bonds, the losses would pale into comparison to the potential losses and risk involved with investing in stocks. To further illustrate this point, check out the Growth of $10,000 chart of Vanguard Total Bond Market (VBMFX) courtesy of Morningstar since 1986.  The blue line is VBMFX, while the orange is the average intermediate term bond fund, and the green line is the BarCap US Aggregate Bond Index.

Growth of $10,000 since 1986

Source: Morningstar, Inc.

As you can see, it's been pretty smooth sailing and the volatility of such high-quality bonds is not that grave.  The most severe pullback was the big "bubble" of 1994, which produced a maximum loss of about 4%.   Google Finance reports VBMFX's worst three-month return as -3.00%.  While we certainly could have a historic pullback, previous measures of risk and volatility are indeed helpful.  (Note that the average intermediate-term bond fund pulled back nearly 9% in late 2008 after the MBS mess.  Yet another illustration as to why high-quality index funds are the way to go.  Clearly, too many bond managers took unnecessary risk in the effort to reach for yield).

Compare this total bond fund (blue line) to VFINX (Vanguard S&P 500; orange line) for even more perspective.

Growth of $10,000 since 1986

Source: Morningstar, Inc.

The decreases that were more apparent on the first graph have all but vanished when you compare it to the volatility of equities.  The bumps are nothing but small pebbles on the bond side.  So, while there is definitely risk involved in the bond market (I'm not saying it always goes up), it's important to have the understanding that the risk is still paltry compared to stocks even in this time of low interest rates.

Having said all that, I don't think investors' concerns about the bond market are without merit.  We live in unusual times and find ourselves in unusual circumstances - on the surface, the cautionary tales about bonds at this point in time do seem to have some valid points as we have somewhat "the perfect storm" of conditions that would signal a bond bear market.  

When interest rates rise (and they will undoubtedly rise unless we fall into a similar situation to Japan in the 1990s with low interest rates for a long period), your bond funds will take a hit in the short-term.  The longer duration of the fund, the bigger the hit.   However, as long as you hold your bond fund longer than the average duration, you should still end up ahead of the game and not have to really worry that you'll end up with a loss in the position over the long-term.  In this article from Vanguard, it is suggested that rising interest rates actually benefit investors over the long-term as long as you reinvest your interest income (Bonds and rates: The reality behind the headlines, February 2010).  They provide the following data:

Bond Fund Total Returns (annualized)

           Change in yield                            Year 1                 Year 3              Year 5                Year 7                  Year 10

Rising Interest Rates	-0.8%	1.8%	3.5%	4.2%	4.7%
Constant Interest Rates	4.0%	4.0%	4.0%	4.0%	4.0%
Falling Interest Rates	8.8%	6.2%	4.5%	3.8%	3.2%

Source: Vanguard

You can read their assumptions in the attached article.  Essentially, though, they conclude that while falling interest rates lead to better performance in the short-term, consistently rising rates are actually better for long-term performance (7+ years) assuming investors stay the course and reinvest interest income.

They conclude: "[I]f you're holding bond funds as part of your long-term asset allocation, a rise in rates probably shouldn't prompt you to make any changes. Indeed, you can benefit by sticking with the bond allocation that's right for you."

Here are two more Vanguard articles with similar messages and talking about the current bond environment: Should you beware of a bond bubble? (August 2010) and Risk of loss: Should investors shift from bonds because of the prospect of rising rates? (July 2010).  They have much the same message - don't fret about a bond bubble due to rising interest rates since over the long-term the small decrease will be more than compensated for.  They believe that individual investors are best served by maintaining their asset allocation and holding for the long-term, since reinvesting interest income will put you ahead. This is undoubtedly true. If you're a long-term investor, shouldn't you only be concerned with the long-term performance?  

I'll provide a contrarian viewpoint courtesy of the Finance Buff's blog entry You Should Still Beware of A Bond Bubble (August 2010).  He posits that if interest rates go up as expected, bond values will go down. It doesn't matter that the losses are small compared to the potential losses in equities - it's still a loss.  Shouldn't investors actively avoid such obvious potential losses?  And while it's true that reinvesting interest income in your bond funds over the long-term will benefit you in a rising interest rate environment, the Finance Buff argues that the returns would have been even better if you sidestepped the short-term rise in interest rates and invested in bonds at a slightly later time.

I think both perspectives have a valid point.  Interest rates are going to go up; it's just a matter of when. When that occurs, your bond fund's NAV will take a hit. The longer-term duration funds will take a larger hit than the shorter-term ones. Over the long-term, this temporary hit will be compensated by reinvesting interest income at higher rates and you'll end up ahead if you stay the course.

Bonds are held as part of an individual's portfolio to moderate volatility and increase diversification.  Thus, you shouldn't completely abandon your bond holdings nor switch to equities with that allocation under any circumstance. Nevertheless, if you are uncomfortable with potential for short-term losses in the bond portion of your portfolio, I think there are a couple viable alternatives. 

First, you may elect to shorten the duration of your bond holdings.  Instead of selecting a Total Bond Market Index fund (VBMFX has an average duration of 4.7 yrs), choose a short-term index like VBISX (2.6 yrs). This will cut the potential for short-term losses in about half.  (Obviously this comes at the expense of expected returns. There is no free lunch.)

For more information on how bond prices interact with interest rates, see this bogleheads article: Bonds: Advanced Topics - Duration

"For example, a bond with a duration value of 5 years would be expected to lose 5% of its market value if interest rates rose by 1% (100 basis points)."  Thus, while the total bond fund might lose 5% of its value, the short-term index would lose only 2.5%.  These figures are not exact and for illustrative purposes as there are other factors that can affect such an outcome.
 
Secondly, you may choose to use CDs as an alternative to your bond position. This is what the Finance Buff suggests.  You could also use a combination of short-term bonds and CDs.  I think that's a reasonable course of action.   Or even all three positions if it's a significant sum of money - keep a total bond, short term, and CDs.  Spread your money across the strategies.

In the end, while the above two options will probably reduce the chance for a significant short-term pullback and you'll be less affected by the potential "bubble," you will not be able to time it perfectly as to when to get back in the bond market. Thus, you'll miss some opportunity and whether you come out ahead (when compared to simply sticking with your previous asset allocation to total bond) will largely be determined by luck.

Thus, if you're simply interested in your long-term performance, it probably makes the most sense to stick to your asset allocation plan. If you're concerned about short-term volatility in the bond market and have discipline to jump back in, it's reasonable to shift to shorter durations and/or CDs and then re-assess this position as time goes on. Will you come out ahead of the other strategy? Maybe.  Will your short-term volatility be decreased? Yes.

TD Ameritrade Joins the Commission-Free ETF Train

TD Ameritrade has followed the leads of Charles Schwab, Fidelity, and Vanguard to offer commission-free ETFs to its customers.  The firm will now offer over 100 ETFs commission free if held for at least 30 days.  These include the following: 47 iShare funds, 32 Vanguard funds, 12 State Street Global Advisors funds, 3 PowerShares funds, 2 Van Eck funds, 2 iPath funds, 1 WisdomTree fund, 1 Barclays Bank PLC fund, and 1 Deutsche Bank AG fund.  If held for less than 30 days (which should not happen for long-term investors anyways), TD Ameritrade will charge $19.99.  Competitive pressures are really getting to these firms!  This marks the only of the aforementioned four that is offering investors more than just funds from one particular family.  (You should have ample selection from the other three to create a low-cost diversified portfolio, so I wouldn't fret.)  Although WellsTrade has done this for the past few years - offering 100 commission-free online trades (any stock or ETF) as long as it's linked to a PMA package (requires a $25,000 minimum).  Lots of great choices of brokerage firms now for the low-cost ETF investor.

Vanguard Reduces Minimum Required for Admiral Shares

In yet another aggressive move, Vanguard has announced that they're reducing the minimum amount required to qualify for Admiral shares.  Admiral shares are a separate share class included for more than 50 funds that hold the same investments as the investor shares, but charge significantly lower expenses - typically about the same as the ETF class (in some cases even lower though).  The minimums are now as follows:

$10,000 for most broad-market index funds;

$50,000 for actively managed funds

Previously, to qualify for this share class required a $100,000 investment, so this is quite a substantial change.  This move makes sense in light of the fact that Vanguard ETFs now trade commission free through VBS, so those with smaller investments could previously get a lower expense by converting to the ETF class without any tax ramifications (due to Vanguard's unique fund/ETF structure).  Now, that conversion may not be necessary since one can acquire Admiral shares for basically the same cost as the ETF.  You can easily change the share class of your funds online by clicking on "Convert an Account" on the righthand side.  The cost basis information from your investor shares are transferred automatically, so you don't have to worry about tax ramifications.

 

Vanguard's mutual funds may be more appealing than ETFs to those who want to set up an automatic investing plan, don't want to place limit orders during the work day, and want to purchase at the NAV.  ETFs may appeal more to those who want the flexibility of intra-day trading and large lump-sum investors.

This is great news!  The brokerage firms have really been pushing each other to improve their offerings with aggressive cost-cutting measures in the last couple years.  In the end, it's the individual investor who wins.

Vanguard Adjusts International Equity in Target Retirement and Other Balanced Funds

Vanguard has announced that they're increasing international equity exposure of Target Retirement, LifeStrategy Funds, and the STAR Fund from about 20% of equities to approximately 30% of equities.    This is addition to the move of holding Vanguard Total International Stock Index Fund (VGTSX) instead of Vanguard European Stock Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund in the funds in an effort to simplify the holdings.  Lastly, this is all in conjunction with the changes to the International Stock fund's change from tracking the MSCI® EAFE + Emerging Markets Index to now tracking the MSCI All Country World ex USA Investable Market Index.  The new index covers 98% of the world's non-US markets and includes small-capitalization companies as well as Canada and Israel unlike before.  Not only that but Vanguard plans to introduce 5 share classes of the fund, including an ETF (with a 0.20% ER).  Previously, one had to invest in FTSE All-World ex-US to get access to the ETF VEU (0.25% ER).

Personally, I like the changes.  I always thought 20% international exposure was a bit low, especially considering Vanguard's own recommendation of 20-40%.  Here is Vanguard's rational courtesy of John Ameriks, a Vanguard principal and head of Vanguard Investment Counseling & Research:

First, a detailed quantitative analysis suggested that U.S. investors obtain maximum diversification benefits when non-U.S. stocks make up 20% to 40% of their equity portfolios. Related to that is the growth of non-U.S. stocks as a percentage of the global equity market and the declining costs of implementing and managing non-U.S. equity positions.


In addition, it is our view that we will be able to make this change with minimal transaction costs to investors at this time. Fundamentally, we believe that a modestly higher allocation to international equities has the potential to improve diversification and reduce volatility in these portfolios over the long term. Since 2006, Vanguard has advocated that U.S. investors hold 20% to 40% of their equity portfolios in non-U.S. stocks. We continue to hold that view, and this change places these funds firmly in the middle of that range.

While some may argue this is performance chasing (international markets have performed much better than US markets in the past decade), I would argue that their previous allocation was out of tune with their own research and the steadily increasing market capitalization of foreign markets (now 56% of the world market; if you want to track that, simply invest in VT).  In my mind, 30% is more reasonable to offer the potential of greater returns and increased diversification (nothing is guaranteed, of course).  I personally hold about 40% of my equities in international funds.  It's also a nice addition that this index will now include small-caps (much like the difference between the S&P 500 and the Wilshire 5000).  It is now not imperative to have a separate small-cap foreign holding unless you purposefully want to overweight.

Previously, while the single Target Retirement fund offered a great simple solution for investors who want to set it and forget it, it notably lacked foreign small-caps and it's exposure to international markets was a bit low. Now it seems to be a more viable all-in-one solution.  That comes with a couple of caveats.  Firstly, the stock/bond allocation hasn't changed so one should look at those when determining which fund best suits his or her objectives rather than looking at the end date.  Others do not find the shift from stocks to bonds to be appropriate, and rather shift from equities to bonds earlier in their lives.  Finally, I personally like some exposure to REITs and that still is not included in the fund.  However, you could do much worse than the Target Retirement Funds.  They are simple all-in-solutions that are inexpensive and highly diversified.  I am glad Vanguard made the changes to not only increase the foreign allocation, but also including small-caps, Canada, and Israel by following a different index for the international fund.  

Good job Vanguard!

Book Review: A Random Walk Down Wall Street

I recently re-read the classic investing text A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (W. W. Norton & Company, 464 pp) by Princeton Professor Burton Malkiel.  In my opinion (and many others), this is the single best investing book ever written.  Malkiel covers a wide array of topics including stock valuation theories, bubbles, technical and fundamental analysis (even explicitly covering individual technical strategies and debunking the conclusions of repeated outperformance), modern portfolio theory, behavioral finance (a particularly interesting topic in my mind), efficient-market theory, and then a guide to come up with a portfolio that will challenge those on Wall Street.  Before creating a portfolio for the first time, get this book.

There are certainly easier texts to read for beginners.  Thus, if you're just starting and want a more simplified approach than a 450+ page text, you might look elsewhere.  However, Malkiel writes in a very accessible manner such that even neophytes can understand more complex theories.  I'd say that the average investor would be able to follow A Random Walk Down Wall Street more easily than The Intelligent Investor, for instance.  There's a reason that the book has been repeatedly updated over the course of 35 years and has sold over a million copies.  What I especially enjoy about this book is not only the broadness of topics covered, but also how Malkiel methodically analyzes various strategies and supports his conclusions with ironclad findings.  He doesn't dismiss other points of views simply by saying "trust me," but rather provides ample evidence to backup his viewpoint.  Malkiel worked in the financial industry for several years and has been in academia for quite some time, churning out economic studies.

The first portion of the text covers stocks and their value.  Malkiel divides each section clearly to explain various topics in a concise manner.  This also provides a simplified manner in which to jump around a bit, if so desired.  One doesn't need to read the text from page 1 to page 464 in order to gain great insight.  Rather, it's certainly doable to skip to the section that most interests you.
Near the beginning, Malkiel posits the two main theories and approaches to asset evalution: the firm-foundation theory and the castle-in-the-air theory.  Down to their most basic premise, the former simply argues that each investment derives its value from the analysis of present company metrics and market conditions as well as future prospects.  That is, the stock's trading price is tied to the firm's earnings and growth patterns; when the price becomes at odds with those fundamentals, the market corrects itself.  One would consider Benjamin Graham, Warren Buffett, and David Dodd to subscribe to this perspective.

On the other hand, the castle-in-the-air theory posits that stock prices are determined simply by what other people are willing to pay for it.  That is, how will the crowd react to various reports and news of the firm.   Will the crowd view the stock in an optimistic and favorable light?  That will cause the price to increase, and the castle-in-the-air specialist seeks to make the move prior to most others.  John Keynes is the most famous economist to hold this view.

Malkiel then goes on to describe "the madness of crowds," illustrated perfectly with the tulip bulb craze in Holland in the late 16th century when prices spiraled out of control.  The book then gives a brief history of stock evaluations from the 60s to the 90s, giving a great historical look at investing and the market.  To conclude part one, the author discusses bubbles, specifically highlighting surfing on the internet.

Part two is the big debunking of Wall Street (my words) section.  Essentially, Malkiel describes how various contenders such as fundamentalists and technical analysts play the game and why such strategies fall short.  In part three, he describes the modern portfolio theory in a clear manner that defines risk and how diversification works in practice.  He then covers behavioral finance, giving space to overconfidence, herding, and loss aversion among other topics.  Finally, Malkiel head-on addresses various beliefs as to why the efficient-market theory doesn't hold true.

Finally, at part four, Malkiel gives real-world advice for individual investors and how to make one's portfolio better.  This is really the meat and potatoes of the text and if you simply want guidance to your individual portfolio and asset allocation, I'd skip to this section.  Malkiel recognizes that many investors cannot accept the indexing model, and thus offers four rules on picking individual stocks, while emphasizing the odds are stacked against outperformance when choosing individual companies to invest in.

In the end, Malkiel shuns Wall Street's antics and its rampant marketing that the pros always win.  He credits the majority of the outperformance of the select few fund managers to dumb luck saying that very few individuals actually possess the capabilities and foresight to continually pick winners.  After eliminating the selection bias of surviving funds, you'll see how poorly Wall Street truly performs and that the fees they charge you are excessive.  Malkiel professes to a low-cost diversified set of index funds that gradually grow more conservative as you near retirement.  As he concludes, "The indexing strategy is the one I most highly recommend [...] Investing is a bit like lovemaking.  Ultimately, it is really an art requiring a certain talent and the presence of a mysterious force called luck.  Indeed, luck may be 99 percent responsible for the success of the every few people who have beaten the averages [...] If you know you will either win or at least not lose too much, and if you index at least the core of your portfolio, you will be able to play the game with more satisfaction."

Rating: 5 out of 5