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Friday, November 26, 2010

Vanguard Chief warns of A Bond Bubble in Long Term Bonds

Vanguards website shows something  I have never seen on the front page: a link labelled "danger risk ahead" with a link to an article by chief investment officer Gus Sauter warning investors(dumb money?) who have been plowing into long term bonds: I certainly concur.

Vanguard's investment chief cautions bond investors
November 22, 2010
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Bonds have been on a roll, with double-digit returns posted by several fixed income categories this year. Such a winning streak may tempt you to think you've got a free lunch: return with no risk.
That's hardly the case.
Vanguard believes bonds and bond funds can play a valuable role in nearly any investor's portfolio. At the same time, we also believe it's important to have a balanced perspective and keep your eyes open to risks.
Chief Investment Officer Gus Sauter spoke with about his outlook for the bond market and why you should have tempered expectations.
What's your main concern right now?
I'm increasingly worried that people aren't aware of the risks in the bond market. We have very low interest rate levels. But at some point, the economy will strengthen and those interest rates will rebound. Investors who have pushed out further on the yield curve by investing in longer-term bonds will then see a greater decline in the principal value of their investments.
When you're seeking yield by moving into longer-term bonds, you're exposing yourself to greater fluctuations in principal. Those fluctuations are likely to be negative at some point in the future, and they'll be negative by a greater magnitude for longer-term bonds than for shorter-term bonds.
 Many, if not the majority of investors are not aware of the concept of bond  duration which is used by professionals instead of maturity as a measure of risk of a bond or bond fund/etf. Simply stated duration measures the change in price for a 1% change in interest rates: a one year bond will decline 1% for a 1% decline in interest rates for a 10 year duration the change in price would be 10%. Morningstar or the fund/etf provider will have the duration on their websitte for a fund/etf So looking at this chart it is pretty clear that further appreciation of long term bonds(falls in yields) is unlikely.
The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years. Source: Federal Reserve Board.

There is a straightforward way to reduce the risk of a bond portfolio: shorten the duration. To give the most extreme example moving from TLT the 20+ year etf to the shy short term treasury etf reduces the duration from 15.16 to 1.82. Of course the yield falls massively as well from 4.06% to .27% . Investors may want to look for a mix of short and intermediate bonds, corporates treasuries and agencies to boost the yield of their bond holdings while reducing the duration of their holdings. Sauter doesn't give specific advice but he does write the following:

That certainly doesn't mean you should avoid a sensible allocation to bonds; it just means you need to be aware of the risks,,,.
….The problem is that when you're at historically low rates, as we are now, you're not likely to get much more principal appreciation. In other words, yields aren't likely to go significantly lower, and at some point when the economy does strengthen, they're likely to push higher. When that happens, you'll actually have principal depreciation that will at least partially, and perhaps entirely, offset some of your yield. And we know that the yield component itself is less than it has been over the last 30 years….

When interest rates do start to push higher, the big question is how fast they'll move up. If rates move sharply, we could experience a year or more where investors receive a meaningfully negative total return from bonds. That's certainly happened in the past. And it's very possible, if not probable, at some point in the future.

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