Invest In Long Term Bonds Now?

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Back in June 2012, a reader asked in a comment on my post What to Do When Interest Rate Is So Low:

What would you think about this Vanguard Bond Fund for the next couple of years of low interest rate – VWESX [Vanguard Long-Term Investment-Grade Fund]?

I said I wouldn’t be comfortable with it because of the mismatch between “next couple of years” and “long-term.”

I was wrong. Vanguard Long-Term Investment-Grade Fund went on to become Vanguard’s second best performing bond fund in 2012, only after its high yield (aka junk) corporate bond fund.

A little while ago another reader commented on my post Bill Gross Got Lucky Again saying Vanguard Long Term Bond Index Fund easily beat PIMCO Total Return Fund in the last 10 years, which in turn easily beat Vanguard Total Bond Market Index Fund in the last 10 years. Just invest in the long-term bond fund for the long term; no active management magic was required.

Investment advisors usually recommend investing in short- or intermediate-term bonds. Here I’m quoting The Only Guide To A Winning Bond Strategy You’ll Ever Need by investment advisors Larry Swedroe and Joseph Hempen:

The rules of prudent fixed-income investing are:

… …

Purchase assets with a maturity that is short- to intermediate-term, avoiding long-term bonds.

So it appears Swedroe and Hempen were also wrong. If someone read their book when it was published in 2006 and avoided long-term bonds, they would have missed a large gain.

Why did long-term bond funds do so well? Because interest rates came down. If you knew interest rates would come down you would be better off investing in long-term bond funds. But you didn’t know. So investing in long-term bonds could only be attributed to being lucky.

Being lucky does wonderful things but counting on luck isn’t a viable strategy. What about now? Should one invest in long-term bonds now?

The answer is still the same. If interest rates stay the same or go down, you will get a better return in long-term bonds. If interest rates go up, you will get a worse return. Although some people say interest rate must go up, they have been wrong for years. There is no reason that interest rates, especially long-term interest rates, can’t stay at the current level for years on end or even go further down. Although long-term bond investors were lucky, their luck may still continue to run for the foreseeable future. Or it may come to an abrupt end. Good luck figuring that one out!

After putting a bunch of money into principal-guaranteed vehicles, I’m thinking of shifting my muni bond fund from intermediate-term to long-term. Why? Because I can. When I eliminate the interest rate risk on the short and intermediate portion with savings accounts, CDs, I Bonds and what not, I have more capacity to take risk on the long end. Wall Street has a fancy name for this called the barbell strategy.

In addition, Vanguard’s so-called long-term muni bond fund isn’t that long anyway. Compared to the intermediate-term muni bond fund, the long-term fund adds only 1 year to the average maturity and the average duration (6.x years vs 5.x years). For the added 1 year, I get a 0.5% higher SEC yield and a 0.75% higher distribution yield. I think it’s worth the switch.

[Photo credit: Flickr user Wonderlane]

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Comments

  1. KD says

    Harry, it is really interesting to read your evolution over time. Small-cap value funds, muni bond funds and now long term bond funds. I had all these and my evolution has been to the opposite direction. 3 fund portfolio with 54/26/20 – Domestic stock fund/Intl stock fund/ total bond fund. The reason being, I could not gauge the risk I was taking with my tweaks and I couldn’t keep up with the changes in the market place – esp. quite the amazing rebound from depths of 2009.

    But you are quite the pro at taking calculated risks esp with covered calls etc. So I think, yes, the strategy will work for you. Thank you as always for the insight.

  2. says

    Your advice was “wrong,” but it was still good advice. This is an exaggeration to make a point, of course, but say I came to you and asked whether I should play roulette. “Forget it,” you say. “Of all the casino games, it’s one of the most tilted toward the house.” Then I come back from Vegas and tell you I ignored your advice and made $1000 playing roulette. Does that mean you gave bad advice?

    Since I suspect you’re planning to hold that bond fund for the six-year duration anyway, the strategy you’re describing doesn’t seem imprudent at all. If you really want to take a calculated bet on long-term bonds and end up with something to write about, why not buy something like EDV or an individual high-quality 30-year muni?

  3. Austintatious says

    I’ve been listening to those whose opinions I respect, and others, tell us that it’s unwise to stay in long bonds because that rise in interest rates we all know is coming is just around the corner. When rates are this low, it makes sense that they can only go up. Indeed, that’s been the conventional wisdom for at least a couple of years or more, and it’s clearly been wrong. In my humble and admittedly far less qualified opinion than many of whom I speak, their opinions are even more off base, now, that they were before. I say that because, up until relatively recently, investors have never had the remarkable and expressly stated intent of the Federal Reserve, that as a matter of policy, it’s going to keep rates at or near zero until the unemployment rate is down to a specific level, assuming that the inflation rate doesn’t take off. That statement of the Fed’s policy, which appears very likely to be in place for the next two to three years, is a remarkable thing, in my view, because it actually gives us some insight into the typically unpredictable direction of interest rates. Can or should it be perceived as a guarantee that the Fed will keep rates low? Of course not. But it clearly allows us to assume the likelihood that rates are not going to climb precipitously in the next two to three years, catching those of us holding long or intermediate bonds with our investing pants down around our knees. Yes, the Fed can change its policy on a dime, and rates could suddenly start rising tomorrow, but how likely is that to occur? Isn’t that a reasonable question for investors in bonds to be asking? And isn’t it reasonable, in view of the Fed’s unprecedented statement that it intends to keep rates low for years to come, that the kind of rise in rates we’ve been hearing about for year’s, now, ain’t very likely to occur, for years to come? After all, until just recently, we could go a lifetime and never get this kind of insight regarding the future of an investment, and from an agency whose policies directly affect the investment and that has the capacity to actually back it up. I might be proven wrong tomorrow, but I’m thinking that those still holding long bonds just may be the smartest of us all.

  4. says

    Matthew – I wouldn’t risk my money only to generate something to write about. EDV is all Treasuries. Not so hot because I would have to compete with big money. A carefully selected 30-year muni would be more interesting especially if it’s a small lot on the secondary market when someone just wants to be out of it at any price, but then I would have to worry about diversification and liquidity. The Vanguard long-term muni bond fund is perfect. It lets me invest in long-term munis in name but not extend too far out. I still get the diversification and liquidity from a fund.

  5. larry swedroe says

    IT seems to me that you’re making the most grevious of errors, confusing strategy with outcome. Either a strategy is right or it’s wrong BEFORE we know the outcome. Only fools judge strategies by outcomes without considering what alternative universes might have shown up. What if in fact instead of a deflationary recession like we had we experienced an inflationary one like we had in the 1970s, when stocks and long bonds both did poorly. Would you have come to the same conclusion?

    Having said that Kevin Grogan and I wrote a paper which demonstrated that whether one should own long or short to intermediate bonds depended on (among other things) your equity allocation. Those with high equity allocation should consider longer bonds and vice versa. This article appeared in the Journal of Investing
    Other issues should include your ability to take the risks of unexpected inflation

    Best wishes
    Larry

  6. says

    Larry – Maybe you read too fast. It said the good outcome could only be attributed to being lucky and that counting on luck isn’t a viable strategy.

  7. John says

    Given the fact that interest raise will rise in the future (although no one knows when) would it not be more prudent to to totally exit ALL bond funds to avoid losses?

    Minimal bond allocation can be maintained in terms of I-bonds which would tide over the inflation risk. I’m talking about a 35yr old individual

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