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Nov 02 2012

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Why Bond Prices Don’t Concern Me





One of my readers asked me a question that I feel warrants a proper response here. 

He asked me whether I’m afraid of a bond market crash, and the reader wondered whether bond markets can plunge like stock markets.

The answer to both of those questions is no.

 Bonds have had a great run lately, as people have poured money into bonds to escape the uncertainty of the stock markets.  Bond prices have risen, and yields (interest rates) are currently low…much as a result.

 But bonds move so little.

For a reference, check out the chart below.

Barclays 1-3 Year Treasury Bond (NYSEArca) (2NOV12)This is a chart of the S&P 500 (in green) compared to the U.S. short-term government bond index (in blue).  Please note that these movements do not include interest rates on the bonds, nor do they include dividends for the stocks.

Notice that the S&P 500 gained 65% from 2003, then dropped 20% below the 2003 price, then surged more than 80% from that low.  This was a volatile period for stocks.

Bonds?  Yeah, they were volatile too.  You’ve heard it in the news.  Check out that blue line.  Not including interest, U.S. short term bonds are up about 6%, overall,  since 2003.  Note their relative stability compared to the stock index.  The bond indexed line (in blue) would normally be running almost perfectly flat.  It shouldn’t normally rise or fall much at all.  It should be relatively flat as it throws off interest, but that’s all.  Its popularity has seen it rise, and this is what people are afraid of.  Bonds prices could fall.




If bonds drop (let’s say) 6% people will freak, news headlines will run rampant, and it will be called the great bond crash.  If that happens, so what?  Bonds will be coming back down to earth.  You might not make money on bonds for the next couple of years (assuming a 3% interest rate per year and a sudden 6% price decrease) but the bonds you bought after the bond market “crash” would then earn higher interest yields.

If bonds become really unpopular, they could fall 10%.  Such a fall (in stocks) wouldn’t create too much concern in the stock market world.  But for bonds, this would be huge news.   If that were to occur, the interest yield on newly purchased bonds would increase.

This is how it works.  Assume that a bond index is priced at $100 a unit, and it pays $3 per year in interest for a 3% rate of return.

If the bond price fell 10% to $90, the bond index would still pay $3 per year in interest, but $3 is roughly 3.4% of $90, so the interest yield would rise for new purchasers.

Let bonds fall.  In fact, let them fall hard. 

I’ll be ready to rebalance my portfolio, as I always do, greedily adding what the world becomes fearful of.  And in the end, I’ll reap some nice profits.

Over the long term, you could do the same.

Rebalance, dollar cost average, stay the course, and ignore predictions.





About the author

andrew hallam

I'm a freelance finance writer, lucky enough to have been nominated as a finalist for two Canadian National Publishing Awards. I'm also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, a book explaining how I became a millionaire on a teacher's salary, while still in my 30s. Working to empower people financially, I'm available to motivate and inspire people on basic retirement planning and index investing. I'm happy to comment on your questions, first, please read the Terms of Use.

Permanent link to this article: http://andrewhallam.com/2012/11/why-bond-prices-dont-concern-me/

22 comments

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  1. avatar
    Rhys

    "Rebalance, dollar cost average, stay the course, and ignore predictions."

    Awesome, Andrew! This should be a bumper sticker.

    1. avatar
      Andrew Hallam

      Cheers Rhys!

  2. avatar
    Scott Kwasnecha

    http://www.thereformedbroker.com/2012/10/26/33-ti

    Thoughts on this Andrew?

    1. avatar
      Andrew Hallam

      Hi Scott,

      It doesn't say anything that I haven't said above. But I think I've been a bit more polite about it. If bonds fall 10%, people would freak. But it could happen. I say let it come. I will then sell some equities and rebalance. I hate to say that people are lemmings because that's not fair to the lemmings.

      Cheers!

      Andrew

  3. avatar
    ACMZ

    Ya! I can see it now, a bumper sticker that takes the entire back bumper. Cool! and then give a number 1-800-GET-RICH.

    1. avatar
      Andrew Hallam

      Perhaps we can create another one about the silliness of paying credit card interest while we're at it.

      1. avatar
        Barry

        Like the quote

        "If you think that nobody cares that you're alive – try missing a couple of credit card payments"

        Barry

        1. avatar
          Andrew Hallam

          Just the kind of therapy to push someone over the edge.

  4. avatar
    Toby

    Thank you for another excellent piece of writing. I always look forward to checking your website for the latest update.

    Short term bonds are a key part of my portfolio. They provide me with my plan for when the markets decrease in value. Having this plan allows me to sleep well at night. When the market has a mood swing overnight and drops like a lead brick dropped from tall building, I know I can sell some bonds and buy the indexes while they are cheap. This is not what the majority of investors will be doing. They will be selling. When the markets increase again, I will sleep happily knowing that I there at the grand sale and I had money to spend! Yes, bonds are a key part of my portfolio.

    Thank you for the great website Andrew!

    1. avatar
      Andrew Hallam

      Cheers Toby,

      You'll do well as an investor over your lifetime…very well!

  5. avatar
    My Own Advisor

    What can I say Andrew…..awesome post.

    My wife and I continue to keep a bunch of bonds in the form of XBB. Over time though, because we are very fortunate to have 1 DB and 1 DC pension plan, we'll reduce our exposure to bonds. The pension plans are what I consider a "big bond" and they will stabilize our portfolio.

    I recognize we are very lucky to have these plans, which allows us to take a bit more equity risk for the long haul. I have a post planned to discuss this…I hope you check it out. I've love to hear your thoughts about it.

    All the best my friend,

    Mark

    1. avatar
      Andrew Hallam

      Thanks Mark,

      With those DB pensions, you'll have the game licked. I wish I had one! Your investments become a heck of a lot of icing.

      Cheers!

      Andrew

  6. avatar
    Alesso

    Hi Andrew,

    It's hard not follow you on your investment idea. We are thought not to think like you do but i belive you are right, that's why i'm starting to invest in indexs!

    Thanks for that eye oppening!!

    Cheers

  7. avatar
    Stanley

    Hi Andrew

    I keep an eye on your website. Thanks for your insight. Your making the world a better place.

    I wanted your insight on fidelity index funds. I am using the spartan fund FIBIX. I wanted to know what other funds should I add to the line. Thanks a lot for your guidance.

    Regards

    Stanley

    1. avatar
      Andrew Hallam

      Hi Stanley,

      Those are great funds. If you were roughly my age, you may want to try this:

      45% of your money in the Fidelity Intermediate Bond Index

      30% of your money in the Fidelity U.S. (S&P 500) Stock Index

      25% of your money in the Fidelity International Stock Index

      Cheers,

      Andrew

  8. avatar
    Rob

    Hey Andrew,

    Always great advice. I'm curious your thoughts on Robert Wiedemer's prediction of another 'super crash' coming with markets potentially dropping as much as 90%? IS this something you are looking forward to to snatch up cheap stocks? And how would you protect your money already invested from depreciating so drastically?

    THANKS for all the advice!

    1. avatar
      Andrew Hallam

      Hi Robert,

      I would love to see something that irrational occur with the stock market. I wouldn't try to "protect" anything. You have seen my portfolio. I would rebalance, which would put me in an attacking position, rather than a defending one. My suggestion is to ignore forecasts. They just get your hopes up–in this case, anyway!

      Cheers,

      Andrew

      1. avatar
        Robert

        Thanks Andrew. I definitely try to just stick with your advice and ignore predictions. Best case scenario I guess would be if another crash did occur, hope to be a little heavy in the bond index and then go crazy buying up cheap stock index's.

        Thanks again, your posts and your book have completely fixed my spending and saving habits in only one years time!

  9. avatar
    Daniel Czewski

    Hi Andrew,

    I wanted to take a moment to thank you for your book. I’m in the middle of transitioning my investments from actively managed mutual funds into index funds, with an eye on avoiding any delayed service charges for selling funds prior to their maturity dates.

    The only thing I’m feeling iffy about is the annual rebalancing. I think I understand how it benefits the investor, but it seems strange to let the calendar decide when it should happen. I had the idea that maybe I should pay attention to the % allocations and rebalance when those are off more than they should be. So I did a “what if” spreadsheet of TD e-series index funds over the past decade, with a 40% allocation to bonds and the remainder even divided between Canada, US and International. If I trigger a rebalance only when by bond allocation is off by more than 6% (hi or low), or when any stock allocation is off by more than 3%, I see great results.

    Annual rebalancing turns 100,000 into 125,576 in that decade, while triggering based on these percentages turns the same investment into 173,932. (In both cases including dividends). I still have only 9 occasions to rebalance in the decade, but 4 of those are in the fluctuations of 2008 and 2009.

    Thoughts?

    1. avatar
      Andrew Hallam

      Hi Daniel,

      I personally rebalance when my alignment is out by 10% or more. I also buy the lagging index each month, so some kind of rebalancing occurs monthly through purchasing.

      Annual rebalancing does make things easier for most people. You backtested, however, a single short period. In other decades, the annual rebalancing on a specific day of the year could end up with better results. For example, if the markets dropped 10% in August, we can assume you and I would have rebalanced. But if they fell another 30% by December, the person waiting to rebalance on January 1, would have earned higher overall returns. There’s no way of really knowing by backtesting over short (or long) periods. Knowing there’s no magic to it, I hope, will relieve your curiosity rather than add to it. Don’t search for that perfect time. Going forward, you won’t find it.

      Cheers,
      Andrew

  10. avatar
    alan speck

    Hi Andrew, thanks for clarifying the prospect of bonds bombing. What if, say, stocks and bonds fell at the same time? Is that a possibility in the near future? I currently hold the Vanguard bonds (VAB). Would you suggest a better bond index? Is this one short term enough? Thanks for your great insights, Alan.

  11. avatar
    Greg

    I understand that bond rates follow mortgage rates relatively closely?

    I am starting to channel some funds into an index portfolio, maybe adding 10k – 15k each 6 months for the next couple of years. I am considering the strategy to hold the bond component of my index protfolio in my mortgage offset account. This will return the equivalent of approx 5% pa in interest savings and at no risk of capital loss (ignoring potential fluctuations in property prices).

    I am currently an expat, but I am planning to return to Australia in the next year or so, so this will all be done within the Aus taxation environment. I am repatriating funds at the moment.

    I have not seen you write anything in regard to investors who also have mortgage, and I am interested in your views. I am thinking holding bonds, or cash in an offset account are effectively the same asset class.

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