Unfortunately the arguments put forward by Vanguard are not 100% logical. The short story is that investors should still beware of a bond bubble.

Before I continue, I should define what a bond bubble is. I see the bursting of a bond bubble as "substantial rise in interest rate causing losses in bonds." As you must know, bond values are mathematically determined by the prevailing interest rate. If interest rates go up, bond values go down.

Now let’s look at some of the arguments in Vanguard’s articles.

"There is no bond bubble."

Denial is always the first line of defense. Vanguard wrote in its recent article Should you beware of a bond bubble?

Investors should be skeptical, according to Joe Davis, Ph.D., Vanguard’s chief economist. "A bond bubble would imply not only that U.S. interest rates have to rise dramatically in a short period of time (as if dictated by some law of gravity or reversion to the mean) but also that the increased demand we have seen for Treasuries has been irrational and unsupported by market fundamentals," Mr. Davis said. "I take some issue with both points."

Investors driven by poor performance of the stock market seek safety in bonds, especially US Treasury bonds. This has pushed down the bond yields to historical lows. The chart below shows yield on 10-year Treasury since 1962 (source: St. Louis Fed). It’s at a 50-year low except a few weeks in early 2009.

Saying there is no bond bubble is like saying interest rates will stay low and never go up again. Maybe, maybe not. Although it’s possible the United States will have another two decades of slow growth and low interest rates, like Japan since the 1990s, it’s also possible that growth will resume when we get out of the recession. 10-year Treasury yield is 2.6% now in August 2010. It was 4.0% in April 2010, just four months ago. Can it go back to 4.0%? Absolutely. 4.0% is still quite low. If it goes back to 4.0%, bond investors will suffer a loss.

Interest rates going up is a risk for bond investors. We should not dismiss it as if the risk doesn’t exist.

"There may be a bond bubble but it’s not going to burst any time soon."

Vanguard also wrote in the same article (emphasis mine):

"According to recent Vanguard research, the rise in the U.S. household savings rate has been another important factor in lowering U.S. interest rates, a recent development that could persist for some time given the current economic backdrop."

This is like saying playing chicken is OK because the train isn’t coming yet. Not a good strategy in my opinion.

"A bond bubble is not as bad as a stock bubble."

Vanguard’s article continued with:

"Mr. Davis also stressed that if a bond bear market caused by some future rising-rate environment does occur, most diversified, long-term investors should not regard it with the same level of apprehension as they would an equity bear market, where short-term portfolio losses can be more severe."

I get it. Cutting a finger off is not as bad as cutting an arm off. So? Although it’s true that a bond bubble is not as bad as a stock bubble, investors still lose money when a bond bubble bursts.

"You will make more money in bond funds over the long term if interest rates go up."

When interest rates go up, bond interest and matured bonds can be reinvested at a higher rate. Eventually you will make more money than if the interest rates didn’t go up. This argument is more subtle and confusing. It’s another one of those true-but-irrelevant logic traps.

Vanguard has shown this table in a few articles, including one published in February 2010, Bonds and rates: The reality behind the headlines:

The table shows that if interest rate goes up from 4% to 6% over two years, a bond fund with a duration of 5.8 years will earn 4.7% per year over ten years versus just 4.0% if the rates stayed at 4%.

You might be convinced until you understand what the table is really comparing. The fact that you will make more money over the long term if interest rates go up is not relevant to the question at hand: whether you should buy or stay in bonds today. All the higher returns are earned after the rates go up, not during the time the rates go up. You will be able to benefit from the higher interest rates anyway if you buy bonds after the interest rates go up.

If we back out the higher returns you will get after the rates go up (because they are the same whether you buy or don’t buy bonds today), we are left with the period of time during which the rates go up. Suppose interest rates go up from 2.6% to 4.0% in the next two years, a bond fund with a duration of 6 years will lose 1.4% * 6 = 8.4% on the principal. That will more than offset the interest payments during the two years and give the investors a net negative return. Clearly an investor is better off putting money in a 2-year CD paying 2% a year.

So should you buy or stay in bond funds today when interest rates are at historical low?

It depends on where you see interest rates are going. If you think interest rates are going down, instead of up, you should buy bonds, and buy long term bonds. Long term bonds pay more in interest than short term bonds. As interest rates go down, your long term bonds will also get a capital gain. Maybe the game will still go on for some time. Enjoy. Just remember to get off the railroad tracks before the train comes. I’m not comfortable with this risky strategy.

However, if you see a risk of interest rates going up, you are better off taking shelter in CDs. A 3-year CD paying 2.5% a year is much less risky than a 10-year Treasury paying 2.6%. The cost of being conservative this way is really low. Some CDs have a cheap embedded put option: if rates go up substantially before the CDs mature, you can pay a small early redemption penalty and reinvest at the higher rate. That’s even better.

Reference:

• Bonds and rates: The reality behind the headlines, Vanguard Insights, February 2, 2010
• Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors, Vanguard Research, March 2010
• Risk of loss: Should investors shift from bonds because of the prospect of rising rates?, Vanguard Research, July 2010
• Should you beware of a bond bubble?, Vanguard Insights, August 3, 2010

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Free ETF trades make it really easy for small investors to put together a diversified portfolio at extremely low cost because the minimum investment in a ETF is just one share, usually less than $100. See previous post Low-Minimum Index Funds and Commission-Free ETFs for Small Investors.

If you don’t have a problem with meeting the minimum initial investment requirement and you are already investing in traditional open-end mutual funds, should you switch to ETFs?

You probably should, at least for the majority of your portfolio.

Lower cost is the biggest advantage of ETFs over open-end mutual funds. ETFs are primarily index funds. If you are investing in actively managed mutual funds, they usually cost several times more than the comparable ETFs and they don’t necessarily deliver superior results.

If you like index funds for their low cost, you will like ETFs even more since ETFs usually cost less than comparable index funds. Some index funds charge purchase and/or redemption fees; ETFs don’t.

Getting the same investment at lower cost means more money in your pocket. Vanguard offers a cost comparison calculator. I tried it with several ETFs. The ETFs won every time. Here’s an example:

For $30,000 invested in Vanguard Value Index Fund for 20 years at an estimated return of 6% a year, the total cost is $2,865. The total cost of investing in the equivalent ETF is $1,581, or 45% less. Who doesn’t want to save the cost of investing by 45%?

More choices is another reason for choosing ETFs. Vanguard has 29 index funds, but it has 46 ETFs. Schwab has five index funds and 11 ETFs. If you want something not available as an index fund, you may find it as an ETF. More choices means it will be easier to assemble a portfolio exactly the way you want.

ETFs and index funds are not mutually exclusive. Nobody says you can’t have both. Having both not only is OK but maybe even better than having only funds or only ETFs.

If you are not familiar with ETFs, you may be concerned about their trading aspects: the premium/discount to NAV, the bid/ask spread, market orders versus limited orders, etc. etc. If you are a Vanguard customer, don’t be afraid. You don’t have to master trading when you are investing in Vanguard index funds and ETFs. That’s another unique advantage to being a Vanguard customer.

Vanguard index funds offer a unique feature that lets you convert mutual fund shares into ETF shares at the net asset value. Not all Vanguard index funds have an ETF equivalent and not all funds offer conversion, but the majority do (20 out 29 index funds allow conversion to ETF, see list). You can convert the bulk of your index fund holdings to ETFs and still leave a minimum amount in the index funds for periodic purchases and rebalancing. When you accumulate enough index fund shares that make it worthwhile, you can convert them to ETF again.

Because converting from fund shares to ETF shares is done at the net asset value, you can be oblivious to the premium/discount, the bid/ask spread, or market order or limited order. If you have index funds in a taxable account, you don’t have to worry about triggering taxes either, because the conversion is a non-taxable event.

Isn’t it nice to have the best of both worlds? Mutual funds are easier to buy; ETFs are cheaper to hold. Have your cake and eat it too. If you are used to buying index funds every month on a set schedule, you don’t have to change your routine at all. Just convert the bulk of your existing holdings to ETFs and convert again maybe once a year after you do your rebalancing.

Is it too much trouble? I take it that most people have a checking account and a savings account or CDs. The idea is that you use your checking account for day-to-day spending and you use your savings account or CDs for more stable savings. You do that because the savings account or CDs pay more interest. Having both index funds and ETFs is along the same line: index funds for dollar cost averaging and ETFs for long term holdings. I think it’s not too much trouble and totally worth it.

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I was feeling pretty good about having my tourist dollars help a minority-owned small business until Friday evening when the real owners showed up. They arrived in two separate cars; one of them was a Lexus LX470 full-size luxury SUV. They also brought a maid, who cooked for them.

Although their arrival totally blew my fantasy of helping a struggling single mother, I was able to talk to the owners, who speak English. It turned out that they were a hardworking couple before they became capitalists who earn their living from their money as opposed from their labor.

They worked in the United States for nearly 30 years before they returned to their home country. The husband worked as a security guard; the wife as a nurse in nursing homes. They sent home money they saved and kept buying land over the years. Now they own many acres of land. The value exploded due to tourism.

Luck and saving money diligently both played out to their favor. Others would probably say buying land is super high risk but it paid off for them. If I can choose between luck and smart, I would choose luck. However because I can’t count on luck, I have to take the slow road saving money. If that couple didn’t save money like crazy, they wouldn’t have the money to invest to begin with. When they had money, they were able to take advantage of more opportunities, like getting a loan to buy the B&B in a tourist area and making more money off it, whereas the single mother and daughter could only work for wages. The rich gets richer and all that.

This encounter also piqued my interest in retiring overseas. It seems you can boost your living standard by quite a bit if you retire overseas. Cost of living is so much lower. When I went to the bank to get cash, I saw a sign specifically targeted at Social Security recipients. It must be quite common for Americans to retire there. I will look into that option when I’m ready to retire.

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Whenever the stock market gets a hiccup, there are always two schools of thought. Some worry a crash lies ahead. Some say it’s a buying opportunity. Fear and greed have been living with the stock market forever.

What should an investor do? If you believe a crash lies ahead, you should get out of the market, let it crash and get back in at a lower point. If you believe it’s a buying opportunity, you should buy more when stocks are on sale. If you believe neither or if you don’t know, you keep doing what you always do. Investing would be really easy if you know which way the market will go.

Because I’m still working and saving and investing, I tend to look for buying opportunities. I reason because I have to buy sooner or later anyway, I might as well buy ahead of schedule if prices are low. The overbalancing strategy I created for myself in 2008 worked well in the end although it felt like throwing money into a black hole in early 2009.

Is it a buying opportunity now? I looked at the prices of some ETFs that track the major asset classes.

Prices for international developed markets rolled back to the July 2009 level. I have bought some more.

Prices for the other asset classes only went back to levels last seen three or four months ago. I don’t remember much excitement about a buying opportunity at that time. So I don’t think they are low enough yet for me to do something out of the ordinary. To reach the July 2009 level like international stocks did, the US stocks will have to drop another 20%.

Is it the start of another crash? I don’t know. I wouldn’t mind having prices go back to March 2009 lows. That would be a buying an opportunity.

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Reader Random Poster asked:

"If you did not hold any value stock funds in your taxable account, but rather only, say, a total stock market index fund, would you still make the investment changes?"

I also exchanged emails with another reader Mike on calculating the tradeoff. I made this spreadsheet to help do the calculation:

Tax Cost Calculator

I start with this set of assumptions:

The 21% tax rate on dividends and capital gains consists of 15% federal income tax and 6% state income tax. The calculator shows the tax cost for holding stocks in a taxable account under these assumptions is 0.93% a year. Doing the opposite — holding muni bonds in a taxable account and holding stocks in a tax advantaged account — costs 1.15% a year. An investor is better off with holding bonds in a tax advantaged account. That’s the conventional wisdom, which is correct under the set of assumptions above.

However, the answer will change under a different set of assumptions. If you are in the AMT phaseout zone, you will have to add another 6.5% or 7% to the tax rate on dividends. For someone in a high tax state, the total tax on dividends can be over 30% after you add the state income tax and AMT phaseout.

If we change the tax rate on dividends from 21% to 30%, the tax cost for holding stocks in a taxable account goes up from 0.93% a year to 1.37% a year. The tax cost for holding munis in a taxable account stays the same at 1.15% a year. And that’s with a tax efficient fund that only distributes 2% dividends. What if we change the dividend yield from 2.0% to 2.5%? The tax cost for holding stocks in a taxable account goes up to 1.45% versus the same 1.15% for holding munis in a taxable account.

So there you have it. Enter your own assumptions in the tax cost calculator and see which way is better for you.

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(A) Put taxable bonds in the tax deferred account and put value stock funds in the taxable account; OR

(B) Put value stock funds in the tax deferred account and buy tax-exempt muni bond funds in the taxable account.

With approach A, you earn more from the taxable bonds but you must also pay taxes on the dividends from the value stock funds. With approach B, you pay less in taxes but you also earn less because the yield on muni bonds is typically less than that on taxable bonds.

Right now I’m using approach A but I’m moving toward approach B. I’m selling taxable bond funds in my tax deferred accounts to buy value stock funds and I’m selling value stock funds in my taxable accounts to buy muni bond funds.

I’m making this move because the tax on dividends is going up, especially for someone already in or will cross into the magic $250,000 married, $200,000 single target line.

Dividends increase your Adjusted Gross Income (AGI). If they push you over to the target line, all kinds of interesting things start happening. You don’t want to go there if you have a choice.

In 2010, qualified dividends are taxed at 15% (or 21.5-22% in the AMT phaseout zone). Although Obama’s 2011 budget proposal keeps the tax rate at the same 15% for AGI under 250k married 200k single, and for "the rich" only increases it to 20% (26.5-27% in the AMT phaseout zone), the latest budget resolution passed by the Senate Budget Committee did not include that 20% rate.

If the current resolution becomes law, by default, dividends will be taxed as ordinary income for the upper income households. Remember Congress makes laws, not the President.

Dividends are seen as unearned. Taxing dividends is more politically acceptable than taxing wages. Taxing muni bonds, however, is not as acceptable because it will increase the funding cost for the states.

Not that there’s anything wrong with increasing taxes to cover budget deficits and reduce the growth of the national debt, as a practical matter, I will favor muni bond interest over dividends in a taxable account. I will go help my state government.

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The no-loss guarantee usually comes at the price of capping the upside. The chart below shows what a market linked CD will do versus a straight-up ETF that tracks the index. The horizontal axis is the average annual (not cumulative) return of the index.

What if you are conservative and you are willing to give up some upside for downside protection? Can you achieve the same result through more conventional investments? I’m interested in the answer so I did this case study.

I went into a branch of a major bank and asked if they sell index linked CDs. They do, but they wouldn’t just give me a brochure. The rep there said I must make an appointment with one specific person who’s authorized to sell the product. I did that. After a brief meeting, he gave me the disclosure document, which is similar to the prospectus for mutual funds.

The bank offers several different index linked CDs tied to different indexes ranging from the stock market to commodities and currencies. I picked the simplest one for this case study.

This particular index linked CD is a five-year CD linked to the Rogers International Commodity Index – Excess Return. Excess Return means Total Return minus 3-month T-Bill returns. The index return is calculated point-to-point, from the date the five-year term begins to when it ends. No interest will be paid during the five years. At the end of the five years, the investor receives 100% of the index return during those five years, subject to a cap of 60% cumulative. If the index return is negative, the investor gets the principal back without interest.

People who don’t like index linked CDs typically argue that one can synthesize it by investing part of the money in a plain vanilla CD that pays interest and the rest in a mutual fund or ETF that tracks the index.

It’s actually not that simple.

If you try to match the downside protection by putting a large percentage of the money in a plain vanilla CD, you won’t be able to match the upside potential of an index linked CD. If you try to match the upside potential, you leave the downside exposed.

The chart below compares the index linked CD with a combination of 75% in a plain vanilla 5-year CD plus 25% in a commodity index ETF. The plain vanilla 5-year CD is assumed to earn 3.5% APY, which is about the highest one can get at present.

The 75% plain vanilla CD plus 25% ETF combo will not lose money as long as the average return of the index for the next five years is above -13% a year (50% cumulative loss). Between -13% a year and +4.5% a year, the 75/25 combo beats the index linked CD. If the index return goes above 4.5% a year, however, the index linked CD starts to lead. The 75/25 combo can’t catch up with it unless the index return is more than 24% a year (190% cumulative gain over five years).

What if you put less in a plain vanilla CD and more in the ETF? Then you will start losing the downside protection. Look at this other chart:

If you put 50% in a plain vanilla CD and 50% in an index tracking ETF, that combo will lose money if the index return is less than -3% a year over five years (15% cumulative loss on the index). A 50% cumulative loss over five years is bad luck; a 15% cumulative loss on the index is quite conceivable. Between -3% a year and +4.5% a year, the 50/50 combo beats the index linked CD. If the index return goes above 4.5% a year, however, the index linked CD starts to lead unless the index return is more than 16% a year (110% cumulative gain over five years).

The conventional investments don’t quite cut it in terms of matching the risk/return profile of an index linked CD. In order to match it, you will need to use conventional CDs and call options. However, there are no easy ways for a retail investor to buy 5-year call options on a commodity index. The bank that sells the index linked CDs essentially buys the options on the capital market and packages them with a markup to retail investors.

What are some of the risks of investing in this index linked CD? The disclosure documents list many risk factors. Here are a few of them:

No early withdrawal. It’s a firm commitment for the full term. No early withdrawal is allowed except due to death of the investor. There might be a secondary market for these but I wouldn’t count on it. I would treat it as a solid lock-up. If I invest in a commodities ETF, it would be buy-and-hold anyway.

No interest if the bank is taken over by FDIC. Because the interest is only credited at the the end of the term, if the bank fails before the term is up, FDIC only guarantees the principal. This particular bank is already deemed too big to fail. I’m not too worried.

Negative cash flow in taxable account. If someone buys these in a taxable account (I won’t), he/she must accrue some projected interest along the way and pay tax on it. It’s all squared up in the final year when the CD actually pays interest. If it turns out you paid too much tax because the projected interest exceeded the actual interest, you will get back the excess tax paid in the final year. Not a big deal in my view. Just something to be aware of. One can easily avoid this hassle of figuring out taxes by buying the CD in an IRA.

Are index linked CDs good or bad? I used to think they are all bad. That’s also what I read and heard in the mainstream media (for example Nightly Business Report and Money Magazine). After I studied the details, I don’t think they are so bad that they must be dismissed out of hand. For an asset class that is known to be high risk, such as commodities, an index linked CD can be effective in managing risk. It retains more upside than a comparable allocation in conventional investments.

Whether an index linked CD is good or bad really depends on its terms and on how the investor uses it. I find this particular index linked CD quite acceptable. I may end up putting some money in it. However, some of the other index linked CDs offered by the same bank are not as good because they use a six-month averaging formula when they calculate the index return. If someone approaches index linked CDs as  replacement for income-producing CDs, that’s really the wrong angle. You have to treat these as alternatives to long-term investments.

I remain skeptical of index linked CDs’ cousin Indexed Universal Life Insurance (IUL), because an IUL comes with the baggage of life insurance, which one may or may not need. Even if one needs life insurance, the cost of such life insurance in an IUL may or may not be competitive.

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"I have several mutual funds with large unrealized capital gains. I expect tax rates will go up in the future. Does it make sense to sell them now while the capital gains tax rate is still low, repurchase them immediately after, and reset my cost basis?"

The answer, as usual, is "it depends."

It depends on when one expects to eventually sell these funds, to what extent the tax rates will go up, and how fast these funds will grow.

First of all, the concern for tax rates going up is legit. For high earners, the administration already proposed to raise the capital gains tax rate from 15% to 20%. There’s also that new 3.8% Medicare tax on unearned income starting in 2014.

Selling and repurchasing immediately is totally legal. Wash sale rules prevent an investor from taking a loss if substantially identical securities are repurchased right away. They don’t prohibit repurchasing the same funds immediately after realizing a gain.

However, resetting the cost basis this way will accelerate tax payment from the future (at an expected higher rate) to the current year (at a lower rate). There’s a tradeoff between the rate difference and the loss of tax deferral.

The tradeoff favors resetting the cost basis now if:

• the investor expects to sell these funds in the near future anyway; OR
• the investor expects the tax rate to go up a lot; OR
• the investor expects a low growth rate from these funds

The tradeoff favors holding the funds and doing nothing if:

• the investor expects to hold these funds for many years; OR
• the investor expects the tax rate won’t go up too much; OR
• the investor expects a high growth rate from these funds

Given a long enough holding period and a high enough growth rate, the tax deferral can overcome a higher tax rate. How long is long enough? We need another spreadsheet! I created one to quantify the tradeoff. For example, under the following set of assumptions, the investor is better off resetting the cost basis if the expected holding period is 9 years or shorter.

The answer will be completely different under a different set of assumptions. You will have to play with the spreadsheet and see how it comes out with your own assumptions.

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Imagine this scenario: An investor (we’ll call her Susan) retires with a $700,000 portfolio. She plans to withdraw $28,000 in the first year of retirement and adjust that amount upward each year in keeping with inflation. In other words, Susan is using a 4% withdrawal rate–typically considered to be sustainable over a 30-year retirement.

Susan’s not looking to get rich, so she uses a moderate asset allocation for a new retiree: 40% stocks, 60% bonds.

In short, Susan is doing everything right — playing it "by the book" in every way.

Unfortunately, in the first year of Susan’s retirement, the stock market tanks, and her total portfolio declines by 16%. Obviously not a good year, but also not exactly a catastrophe.

Or is it?

The 16% decrease from the market coupled with the 4% withdrawal leaves Susan’s portfolio at just 80% of what it was at the beginning of the year. What was originally a 4% withdrawal rate with a 30-year time horizon (generally thought to be sustainable) is now a 5% withdrawal rate with a 29-year time horizon (very likely not sustainable).

Sequence of Returns Risk

The most obvious lesson here is one about "sequence of returns risk." Even a modest portfolio decline early in retirement is bad news! And, unfortunately, asset allocation — the most commonly-used tool for controlling risk in a portfolio — isn’t particularly effective at alleviating sequence of returns risk.

Paying Attention

But there’s also a lesson to be learned about the necessity of paying attention. There are a few things Susan can do to get back on track:

1. Cut back on spending,
2. Purchase a single premium immediate annuity with a portion of her portfolio, or
3. Find a way to increase her income.

But if Susan doesn’t notice the significance of that 16% portfolio decline, she won’t make an appropriate course correction. And if she doesn’t do that, she’s very likely to run out of money during her lifetime.

Planning Must Be Flexible

I’m a big fan of John Bogle’s famous admonition to "stay the course" when investing. But it’s worth noting that a strict "rebalance and continue as planned" approach probably would not work in Susan’s situation.

While the wholesale abandonment of a well-constructed investment plan is generally unwise, rigidly sticking to a plan and refusing to make adjustments isn’t a great route either.

About the Author: Mike is the author of Investing Made Simple. He also blogs at The Oblivious Investor where he covers topics such as the best index funds for building a low-cost portfolio.

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I was deciding whether to buy an air ticket a few weeks ago. I saw a good price when I did the search in the morning. I was at work at that time and I decided to make the purchase that evening. When I searched again in the evening, the good fare was gone. The price had gone up by $70. I paid $70 more than I could have.

According to Wikipedia, an opportunity cost is "the next-best choice available to someone who has picked between several mutually exclusive choices." The opportunity cost of waiting until the evening is locking in the low fare right then and there. Its economic value turned out to be $70. This example shows an opportunity cost is every bit real. It cost me real money out of pocket.

In the world of investing, opportunity cost is present at all times. The opportunity cost of investing in bonds is investing in stocks that turn out better, or vice versa. The opportunity cost of investing today is investing on a different day when the price is lower. The opportunity cost of holding on to an investment is selling it before the price goes down.

When an investor has an investment that lost value but the investor is still holding it, the investor is said to have had a "paper loss." There’s a saying "You don’t lose until you sell." Is that right? Is a paper loss not real? Sometimes the investment does recover. When it does, it’s as if the paper loss never happened.

As we’ve seen a paper loss is an opportunity cost and an opportunity cost is every bit real, it follows that a paper loss is indeed a real cost. I believe there is no such thing as a paper loss. A loss is a loss. Whether the investment recovers or not has nothing to do with whether the loss existed or not. If it recovers, there was a loss followed by a recovery. If it doesn’t recover, there was a loss and there is no recovery. In either case, there was a loss.

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