View Full Version : I-Bonds, Yet Again
I’m always willing to review the facts in case I might be wrong about them. But the evidence suggests that I-Bonds aren‘t worth buying. To see why, use the following link to review their current rates. http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm
The semiannual fixed-rate (as of Nov 1) is 0.0%. The semiannual inflation-factor is 0.88%. In other words, the bond offers no interest at all, and it adjusts the principal returned to you by 1.76%. Do you really want to be making that bet? My credit union is offering 3% for checking accounts, or nearly twice as much money. The average multi-sector bond fund is offering a YTD return of 9.89% (according to Morningstar). Why would any investor be willing to accept the low returns of I-Bonds?
Again, each investor’s situation will be different, as will be their needs, means, skills and goals. But, by and large, I-Bonds are a financial product that targets the fears of the timid and the uninformed at the expense of their needs for growth in their portfolio. At the very least, do you not find it ironic that the institution that is creating the inflation (by expanding the money supply) is the same one offering to sell you insurance against inflation?
Charlie
try2bfrugal
11-25-12, 2:15pm
The bond funds YTD returns include market appreciation because interest rates have been declining. To find out the real interest rates you have to look at the SEC yield. If interest rates rise, the prices of the bonds in the bond funds (http://www.aaii.com/journal/article/how-interest-rate-changes-affect-the-price-of-bonds.mobile#table1)will drop in value and lower your overall return and you may lose money instead of making any net return at all. The longer the maturity of the bonds in the fund the more they will drop. Since the potential for interest rates on bond funds to drop further is low, but the potential for interest rates to rise likely, many investors are moving their money to CDs, I bonds or very short term bond funds right now. If you look at risk and reward, and not just reward, I bonds are a sweet deal right now compared to the rates of most CDs and the risks plus low SEC yields of most bond funds.
If your credit union is offering 3% on checking that is a good deal, but I suspect there is a fairly low cap on how much of your money will actually earn the 3%, if you read the fine print within the fine print.
try2b,
You're right. There is a cap of $25k (down from a previous $30k). But $25k is a reasonably-sized emergency fund, and that's what I use the account for.
To make a distinction between 'SEC yield' and 'total return" is to make the same mistake that most fixed-income investors do. Which spends better at the grocery store? Total investment gain is what matters. "How much reward is offered for accepting how much risk?" So, "yes", I-Bonds will offer less gain than a mutli-sector bond fund, because they are less risky. But do they have a better Sharpe ratio? and how well do they spend at the grocery store?
Everyone wants low-risk, high-return investments. But such things don't exist. So the choice --always-- is between putative safety and possible reward. One or the other, but not both at the same time. Unfortunately, most investors cannot afford themselves the luxury of choosing safety over growth. They have to take on risk, or else they will fail to meet their goals. I-Bonds should be off their menu of choices. So why are they encouraged to buy them? Because financial advisers know they cannot be sued for promoting them. Whereas if they put their client into the risky assets they need to be in, and markets turn down, then those same clients will scream they were misled.
What inflation-rate do financial advisers commonly work with? The long-term historical average of 3%. What gains-rates do they work with? The supposed long term 10% rates for stocks and a 7% rate for bonds. But what rates does the average investor actually achieve? According to Dalbar's 20-year studies of investor behavior, the average equity-investor makes about 3.49%, and the average fixed-income investor about 0.94%. In other words, in both cases, the average investor fails miserably, especially after they pay taxes on those gains and subtract a realistic rate of inflation. Worse, the average financial adviser only funds his/her client's retirement to about one Standard Deviation of their life-expectancy. In other words, the inclusion of I-Bonds and TIPS in the average investor's portfolio is cynicism at its worst. The investor is being set up to fail, but the adviser is being excluded from culpability.
I've been at this game a long, long time, and I'm good what I do. From Oct, 1984 to present, I've compounded my wealth at an annual rate of about 15.5% per year. Currently, I'm backing off from taking on the risks I once did, and my growth-rate has slowed to something closer to 8.2% to 8.5%. But I like to keep my hand in the game in case I need those skills to pull money out of markets. That's why I refuse to retreat to the putative safety of I-Bonds and TIPS. I-Bonds and TIPS are very complex derivatives that are difficult to manage effectively. Under the conditions in which they would supposedly offer a payoff, a situation in which high rates of inflation prevail, other more direct bets will pay off better. That's how I see things. Others can and should make whatever choices they think best for them.
Charlie
try2bfrugal
11-25-12, 3:40pm
Well, you can do whatever works for you. If the risk potential of a huge decrease in bond fund values due to a rise in interest rates isn't a concern (http://www.ft.com/cms/s/0/cb8a6b02-1cfa-11e2-abeb-00144feabdc0.html#axzz2DGUAYXH2), then they are the right investment choice for you.
try2b,
I didn't say that I owned the fund, which I don't. In fact, I own no bond funds at all, just individual bonds, which allows me to sidestep the decline of NAV that occurs when interest-rates rise. But investors who are looking for income/return from bonds should consider the asset-class instead of buying I-Bonds or TIPS.
Charlie
try2bfrugal
11-25-12, 4:13pm
The risk is similar for individual bonds, though not quite as bad because if you hold the bonds to maturity you will get your principal back. But if you hold 6% bonds to maturity and interest rates rise to 10%, you cannot sell the bonds prior to maturity without taking a big loss, and they would be earning -4% compared to the the going interest rates until maturity, which with bonds could be for decades. That is why Warren Buffet said bonds right now should come with a warning label (http://www.bloomberg.com/news/2012-02-09/buffett-says-bonds-are-among-most-dangerous-assets-on-low-rates-inflation.html). If you have a bond ladder with individual bonds with enough variation in rates, risk and maturities to spread out the risk than I agree that is a smart move if you have the time and talent to make smart selections (I have neither).
I'm glad you mentioned Buffet, because here's his 10-year track record as of last Dec according to Morningstar, a underwhelming 4.21%. By contrast, the Barclay's Aggregate, a common idnex of bond performance, returned 5.78% over that same period, and any competent bond investor or bond fund manager did nearly double that. Bond investing is no harder than stock investing. You pull charts. Your grind through financials. You look at T&S. If the risk/reward reltaionship seems favorable, you execute. Otherwise, you back away and look for your next candidate.
So, why are investors discouraged from buying their own bonds? Because the good old boys don't want to deal with the nuisance that retail investors are. But those who can elbow their way into this very institutionally-dominated market can do quite well for themselves *provided* they have both patience and capital. That's where stock-investing does differ from bond-investing. Time-frames are much longer, and it takes a huge amount of money to manage the risks responsibly. But because bonds are puts, the risks are less than those of equity. That's what everyone so conveniently fails to mention. Stocks --the usually mentioned hedge against inflation-- pay better than bonds, because they are far, far riskier.
try2bfrugal
11-25-12, 5:40pm
The least risk portfolio is one that has a mix of assets so that in any economic environment there will be some winners and some loser and things will even out. Fixed rate bonds are risky when interest rates are expected to rise because their price will decrease.
Try2b,
Thank you for the efforts you made to defend buying Tips and I-Bonds, because it forced me to make explicit to myself why I dislike them so much. It a phrase, it’s a ‘fear trade’.
Think about how bonds are brought to market, specifically, how their coupons are set. Then think about markets discount information to --in effect -- re-set those coupons. From the point of view of fundamentals, are those puts fairly priced today? Obviously, they are over-priced. But they are readily being sold to fear-driven buyers. There are sound reasons why that is happening, easily confirmed by the work being done in behavioral finance. Investors are making their decisions with their emotions and then concocting seemingly rational reasons to justify them. Well, I don’t want any part of that trade, as shouldn’t anyone else if their intentions are to make money.
Again, thanks for your spirited defense. But we're going to have to agree to disagree and then let time sort out who was right.
Charlie
try2bfrugal
11-25-12, 10:29pm
I think TIPS are overpriced today. It would be hard for many people to live on inflation + .30%. But we have used dollar cost averaging over the years so our TIPS return is closer to 2% over the CPI. Plus we have low expenses that should be less than our SS benefits in retirement, and also pension income, so for us I don't see a lot of upside to take on any unnecessary risk. You have to do what works best for you and the level of investment risk you feel comfortable with.
Charlie, is your strategy to hold bonds to maturity. If not, what do you think would happen to your returns if interest rates were to go up. I don't think they can go down any more and the decline in interest rates is a reason why bonds have done so well.
I have no intention of defending I bonds or TIPS. For me, they are part of a diverse group of investments on the safe end of things and are better than CDs or other safe havens, and I also have equities on the other end of risk and bond funds in between. At various times in my investment history, one or the other has saved my rear or given a good year of returns.
Buying individual bonds just seems like a daunting learning and observation process to me. Maybe I'm over complicating things.
I've not been good at predicting interest rates, but it seems to me like all of the quantitative easy is going to catch up with us. As I understand things, the fed is basically introducing huge amounts of new money into the economy, so there remains the possibility of inflation and higher interest rates to control inflation. This might tend to give an advantage to inflation protected securities. And a disadvantage to bonds?
Roger
Roger,
When I buy a bond, my intention is to hold it to maturity. So, in that sense, I am very much an 'investor', rather than one of them naughty 'traders' whom everyone loves to disparage, even though there is no material difference between 'investing' and 'trading', between 'investing' and 'gambling'. In all cases, bets are being made about unpredictable events. But some people like the sanctimoniousness of the term 'investor'.
Though my intention is to hold to maturity, if the trade isn't working, then I'll try to get out of it. But, mostly, I ride the issue right into Chapter 11, because that's where I knew I'd end up when I bought the bond. On average, I probably lose 2%-3% of my positions to defaults and bankruptcies. OTOH, on some of my positions, I'm making over 100%. (My personal best was 522%). So, clearly, my profits are more than covering my inevitable losses, and I don't worry about them. They happen. They are part of the game. No biggie.
Bond investing is simplicity itself. If you can buy bell peppers and broccoli at the grocery store, you can buy bonds. The process is no different. "How much reward am I being offered to accept how much risk?" That's all you're doing as a bond-investor. You're pricing 'risk', and you're using the exact same tools a stock-investor does. "What's their balance sheet like?" "What are the growth prospect for the company?" "Where are present prices compared to past ones?"
In order for a stock-investor to do well, the company has to do well. In order for a bond-investor to do well, the company merely has to survive. That lesser threshold has less risk and offers less reward, about 3.5x less on average and over the long haul. But an 8% to 10% from bonds is good enough for the girls I go dancing with. So I don't mess with stocks, because I don't like the game. Bonds are easy, and the market has been very, very kind to me. So I don't go looking for trouble.
Where stock-investing and bond-investing do differ, however, is the amount of capital it takes to manage risks responsibly. A small account can make good money in stocks without getting itself into more trouble than it can manage. Spreads are tight. Liquidity is good. Commish is cheap. Historical data is abundant and free. But a small account is going to get killed in bonds, because the stuff it needs to be buying to turn a profit it cannot buy without putting itself dangerously over-weight the issuer. Plus, spreads are atrocious; commish is abusive; and historial data is non-existent. (But, also, in adversity there is opportunity.)
When interest-rates rise again --and, eventually, they will --- what I already own won't suffer a permanent impairment, because I'll simply hold to maturity. As for trying to game when rates will rise -- and whether inflation will rise-- that's beyond my pay-grade and the sort of gambling that I deliberately avoid. If it happens, I'll deal with it. Until then, trying to buy insurance against those events is expensive, foolish nonsense. The market itself will reprice assets far sooner, and far more accurately, than derivatives like TIPS or I-Bonds, and I'll ride the wave wherever it takes me.
Charlie
Thanks for taking the time to explain. When you say you might have a 2-3% default rate, to me this means you either have a large number bond lots, you have a high turnover, you've been doing it a long time...or a combination. Which seems to make it slightly more complicated than buying broccoli. Bond funds are convenient, but I suppose are more vulnerable to NAV fluctuation, since essentially the portfolio is never held to maturity. And there is less control over maturities. I have a couple of decent mainstream books on bond investing that I may dust off for a review.
Roger,
Name the titles of the books you have, and I can comment on them. But the one book you really do need to read is Ben Graham's classic intro to value-investing, The Intelligent Investor. Nothing I do --except for a bit of game theoretic stuff--- can't be found there. As a value bond-investor, just like a value stock-investor, you're trying to buy securities at sufficient discount to intrinsic-value to create a margin of safety for yourself. That's where broccoli comes in. When it's expensive, you move to cabbage or something else. But you're still working within the group of things that provide roughage and vitamins A, C, and D. When some sub-types of bonds are expensive, you move to others. But you're willing to buy "across the yield-curve and across the credit-spectrum" wherever the best opportunities are.
Yeah, I own a lot of bonds, hundreds of positions, and I've been doing the gig a dozen years now. So, in effect, I'm running my own bond fund. But bond funds have their place, too, because there are sub-groups of bonds that are tough for retail investors to access in any other way. But good-enough money can be made working with just a palette of Treasuries, Agencies, Munis, and Corporates, with an occasional Convert or Foreign Sovereign thrown into the picture.
Charlie
Charlie
The two bond books I have left are "The Bond Book", by Thau and "The only Guide to a Winning Bond Strategy You'll Ever Need", by Larry Swedroe. I've read and (probably forgotten) much of the first, but have really never done more than browse the second.
I owned and read many of the Bogglehead type books, like the Four Pillars of Investing, before retiring a few years ago, but they seemed pretty heavily weighted to stocks and and outdated after the meltdown. I donated most of them to the library.
Roger
try2bfrugal
11-26-12, 7:31pm
Charlie
The two bond books I have left are "The Bond Book", by Thau and "The only Guide to a Winning Bond Strategy You'll Ever Need", by Larry Swedroe. I've read and (probably forgotten) much of the first, but have really never done more than browse the second.
I owned and read many of the Bogglehead type books, like the Four Pillars of Investing, before retiring a few years ago, but they seemed pretty heavily weighted to stocks and and outdated after the meltdown. I donated most of them to the library.
Roger
I think we have the same reading list. If you haven't read it already, Thau has an updated bond book post 2008 that is really good.
I feel the same way about the Boglehead books. I see Bogle as a really good salesman who has an investment company that makes money on management and transaction fees no matter how much of your money his funds lose in a given year, even if that amount is half your life savings. The guy has a lot of people convinced that those kinds of losses from time to time are normal and acceptable.
Rogar,
First, my apologies that I’ve been misspelling your user name.
Thau’s book is no worse than any of the introductory bond books. I don’t like it and greatly prefer Sharon Saltzgiver Wright’s intro. But any of them do an adequate job of introducing basic vocab and concepts, just as will the many excellent articles on bonds at Investopedia. Bernstein is an idiot whose book should have gone into the trash, not to the library, as also anything by Bogle. Both worship at the altar of Modern Portfolio Theory, and neither has a clue as how to manage risk. Both commit the fatal error of believing that ”past is prologue”, which is it until, of course, it isn’t, for reasons well laid out by Mandelbrot and Taleb in their technical and popular papers and books. I haven’t read Swedroe’s book, so I can’t comment. Marilyn Cohen is good on bonds. Crenscenzi is OK. But the book by Barnhill et al is better than all of them. Don’t be put off by the title or price. Their book deals with far more than just high yields, and it does so in a systematic, digestible way that is engaging as good novel and has wide application.
But the real way to learn bond investing is by doing it, namely, using a bond search-engine to look for bonds and then figuring out which ones should (or shouldn’t) be bought. In other words, the way to learn to price risk is by pricing risk. “If I bought this bond, would I be paid enough to accept its apparent risks?” Screen time --lots and lots of it-- is the only way to learn how to buy bonds. Any of the discount brokers will sell you bonds. But E*Trade and Zions Direct have the best and easiest search-engines whose output can be downloaded into a spreadsheet, where a lot of your analytical work will be done. In other words, of the 500 bonds per output page you’ll be presented with if you use relaxed search parameters, which three or four issuers are worth digging into further?
Initially, you won’t work be able to work fast. But soon enough, you need to get yourself to the point where you can slam though a couple thousand bonds, zero in on a couple issuers, construct a yield-curve, slam through their financials and whatever else you need to look at, and then get to back to live prices while the opportunity still exists. And then you do it over again, position by position, until you’ve either run out of money or opportunities. For sure, the searching and vetting process can be made as complicated as you want it to be. But if you keep your weekly shopping for bell peppers and broccoli in mind, you won’t go far wrong. Bond investing won’t be any harder once it becomes as practiced.
Charlie
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