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Wednesday, November 05, 2008

Bonds FAQ

Someone with substantial assets recently asked me a bunch of questions about bonds, and they are interesting enough to put them up on this blog.

Q: Are Inflation-Adjusted Bonds a good idea?
Yes. David Swenson considers them a separate asset class from regular bonds, and in the past, I've recommended them as part of a portfolio when diversifying away from a heavily concentrated position. While in the past I've told people to look into I-bonds first, because of recent changes in the program I no longer think they are a good deal, and definitely they are insufficient for a person with substantial assets. Note that Swenson does not consider foreign bonds a separate asset class, unlike inflation adjusted bonds. And corporate bonds are in general not a good bet, since stock holders (who own the company) have a tendency to play games like paying themselves dividends and then declaring bankruptcy so the bond holders get left holding the bag. Very few bond-issuers like Warren Buffett put protections in for their bond holders.

Q: I was wondering how you decided to buy into a bond fund instead of buying bonds directly? Is it simply a matter of convenience?

Yes, it's a matter of convenience. You can buy treasury bonds directly through at no cost, which makes them a lot cheaper than through a fund. But then you have to do your own laddering yourself, and what if you wanted some corporate bonds (which are at a good price right now). Now if you want CA tax-exempt bonds (which are paying very well right now because of California's high indebtedness creating credit rating problems for CA), then things get a bit more complicated, and a bond-fund would be useful there, for diversification reasons (in case a particular municipality pulls off an Orange county-type default).

For TIPS, you also have tax issues as well, since the inflation adjusted bit doesn't get paid out until the bond matures, but gets taxed annually even though it hasn't been paid out yet. That doesn't mean buying TIPS directly is a bad idea, it just means that you want to do it from your IRA (or rollover 401k) if at all possible. If you must hold TIPS in a taxable account, then perhaps a bond-fund's convenience makes the expense worth while.

Q: I'm going to put some cash into bonds. Would you advise doing it gradually over the next few months, for dollar-cost averaging?

To really answer this question well, I'll have to explain the relationship between yield and bond prices. A bond is priced based on two factors: default risk (the chance that the bond issuer won't pay you back the principal), and current interest rate (as set by the "riskless" treasury bond). Obviously a California municipality has to pay a higher tax-adjusted interest rate than a treasury bond to get you to buy its bond, since there's a chance that the municipality might not pay you your principal back.

Now, what happens when the riskless interest rate goes up? Well, that bond you used to own is now worth less, because you can buy newer bonds (risk-adjusted) that pay a higher interest rate, so the price of your old bond drops. Conversely, if the riskless interest rate drops, your old bond is now more valuable, since new bonds pay less interest, so your older, higher interest bond is more valuable. Since interest rates usually change by a quarter percentage point or so every time the Federal Reserve meets, this price/yield relationship makes bonds less volatile, which is why they have a place in a diversified portfolio. Furthermore, interest rates tend to drop in a recession, when stocks tend to drop, so holding a proportion of your assets in bonds tends to provide a bit of a cushion when bad times happen.

Interestingly enough, TIPS don't vary as much with interest rates (though they do pay a real interest rate at times), but rather vary with inflation rates (which have a looser correlation with how well or badly the economy is doing), which is why Swenson thinks they constitute a different asset class. (Note that corporate bonds are directly correlated with how well the economy is doing, which is why Swenson prefers that you own stock directly instead --- if you're going to take the same risk as a stock holder, you might as well also participate in the rewards. As a counterpoint, however, Warren Buffett's recently been buying up corporate bonds, because he thinks they are a good deal right now --- but I don't have his acumen, so my way of playing that is to buy Berkshire Hathaway instead)

OK, so to answer your question, given that we're expecting a recession over the next few months, I don't expect the interest rates to go up, so I would not bother dollar-cost averaging. But if it makes you feel better, then do it. I don't expect any yield changes to be terribly nerve-wrecking, as explained above.

Disclaimer: I'm not a financial adviser, I don't even play one on TV, so don't make investment decisions based on this blog.

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