I do not ask myself whether a security is safe. If I want safe, I would keep my money in banks within the limit of FDIC insurance and in three month treasury bills purchased directly from the U.S. Treasury under its Treasury Direct program. Once an investor ventures beyond those types of investments, the question is no longer whether it is safe to invest in a particular security. The question that I ask myself is what are the risks. After identifying the risks, then I try to ascertain whether the potential rewards outweigh the risks. This is at best an imperfect process since it has to be undertaken with incomplete and sometimes erroneous information. I also have to recognize that I may be analyzing the information incorrectly and drawing incorrect conclusions from what I believe to be reliable data. But, the first inquiry is to identify the risks.
Most of the following discussion involves a single security, BND, an ETF for the Total Bond Market. I have discussed this ETF in several prior posts including the following new one:Total Bond Market Index (BND) and IEF as Non-Correlated Assets to Stocks
Vanguard identifies some of the risks connected to owning BND for you at its website: Vanguard - Risk Attributes
see also: Risks of Investing in Bonds
Some have recently asked whether the Vanguard Total Bond Market index is safe. That index is available directly from Vanguard as a mutual fund. VBMFX MSN Vanguard also has an ETF for this index, BND, that currently pays a tad over 4% based on a purchase at last Friday's closing price. Vanguard - Vanguard Total Bond Market ETF Overview Is it safe? The simple answer is no, not in the way a typical investor understands the word safe. The value of that ETF will fluctuate in value. It is possible that an investor may lose money by buying BND now. It is even possible that the investor may lose money even after taking into account the dividends paid by this ETF. So, in that sense, BND is not equivalent to a bank CD or savings account in an amount lower than the FDIC insurance limit.
I would not even ask myself the question how safe is BND. To me the only relevant inquiry is whether the actual and potential return from owning BND exceeds the potential downside to me from owning it, or simply whether the potential rewards outweigh the risks as I currently assess each of them. Each investor has to make their own analysis of those questions. I can only make a decision for myself, and my answer is that the risks now outweigh the potential rewards.
The potential reward comes from the current yield of 4% plus the possibility that the bonds contained in BND will appreciate in price, thus causing the NAV to increase, thereby affording a new investor the possibility of earning a capital gain by selling the shares. My current assessment is that it is more likely that BND will lose value in the coming years than to gain an appreciable amount in price. The best case scenario for the next five years would be in my estimation a stable share price. This is just based on my view of the likely course of inflation over the next five years. If an investor disagrees with me , and believes deflation or very low inflation is likely to continue, then that investor could reasonably conclude that BND may increase in price under those assumptions. No one can make that assessment for you. You have to make it for yourself.
There are three general advantages to BND: a very low expense ratio, diversification of assets within the U.S. bond market and diversification in an asset allocation scheme. With sufficient funds, experience at security selection, time to perform research, I can achieve those three advantages with more potential rewards than offered by BND and fewer risks. In my opinion, I have already done so as documented in numerous blogs over the past nine months.
My personal assessment is that inflation will become a problem within a year or two, possibly sooner, and that bond prices will start to compensate for the perceived increase in inflationary expectations and actual inflation by going down in price and up in yield. If that in fact occurs, BND will go down in value. This could be called interest rate risk, see generally: Rising Rates and Your Investments
There is also a certain amount of credit risk even when the bond fund has almost 4000 holdings, which is the case for BND. Vanguard - Fund Holdings
I would identify some important risks that are not discussed much by proponents of bond ETFs and bond mutual funds, or at least not discussed in the way that I understand them.
First, there is a risk of lost opportunity. To the extent that you use your funds to buy BND at $77 say with a 4% yield, then those funds are not available when BND falls to say $70, just by way of an example to make a point, and the yield rises to say 6%. Sure, you could sell the shares bought at $77 and wait more than 30 days to avoid the wash sale rule, and then buy shares at $70. But that difference is a loss of course, and it is what I call the risk of losing the opportunity to invest at a price more favorable to the investor. I do not view a bond fund paying me just 4% to be my optimal use of my limited resources. This is not to say that I am opposed to buying BND under all circumstances. I am just not willing to own it now when it pays me just 4%. I have had other opportunities that pay me more, which I have discussed at great length since I started this blog last October.
Second, BND does not have a maturity date. Put another way, BND does not promise to pay you the full amount of your investment at a time certain. FINRA The FINRA site contains some good discussions about the risks of bond funds. In a long term secular decline for bond investments, which does happen by the way, the NAV of a security like BND or a bond mutual fund will be going mostly down in value, with occasional spurts up. Like stocks, bonds can go into a long term decline, where the value of older bonds have to go down in value in order to rise to more current interest rate levels. If you had lived through the 1970s, you would understand without more how bonds can fail as an asset class. I discussed some data provided by Roger Gibson that showed how the long treasury bonds failed as an investment from 1946 to 1981. Afternoon Comments after Digesting the Saturday Papers/ How reasonable is a prediction of a 2% 10 year treasury yield and 475 on the S & P 500 On the other hand, if I owned a 10 year treasury, I would at least receive my principle back in 10 years even if that bond declined in value for many years before maturity. That is not the case with a bond ETF or a bond mutual fund. see, generally, Bond Funds vs. Bonds
Third, there is the risk that an investment like BND will not get you to the point where you need to go. Even without taking into consideration inflation risk and the loss of purchasing power due to inflation, or a reduction in total return due to taxes, a 4% yield will take 17.67 years to double. The Rule of 72
Every individual is different and has their own risk tolerances and situational risks. Just speaking for myself, I have no interest in a bond fund that pays me 4% particularly when I am concerned about inflation becoming a problem down the road.
See, generally:
And see Julian Robertson's view on inflation summarized in this recent seekingalpha article: Seek Al
Added: After checking my records, I sold BND at $79 in 2008. It closed 6/5/09 at $76.24, more than a year after I sold it. I sold the Vanguard ETF for short term bonds, BSV, also at $79 in 2008, and it is now at $78.4. The dividend on this one has gone down since I sold it, with the shorter maturity bonds rolling over into lower paying notes. Its current yield as of 6/5/09 is 2.2%, selling at a premium to its closing NAV. Vanguard -Overview
From my point of view, what have I missed exactly. The securities that I bought in the place of all of the bond ETFs that I sold, including BND, BSV, BIV, SHY and GVI, are summarized in the links contained in these Gateway Posts:
So, I ended up with more exposure to bonds and bond like investments such as preferred stocks after dumping those ETFS. My current holdings pay me a great deal more, with the floaters providing with a measure of inflation protection and a greater guaranteed yield, and several of the securities purchased are now worth more than 100% over my purchase price with a bunch gaining 50 to 100% in price. This is part of what I call dynamic asset allocation, a flexible approach to asset allocation. It requires reacting to opportunities presented to the investor by the market, and recognizing all of the risks and opportunities to securities owned compared to those which can be used as substitutions.
DISCLAIMER
I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. I have never worked for a financial institution and never will. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator. I am also aggregating financial news stories that I view as important and providing readers of these posts with links to those articles, sort of a filtered, somewhat intelligent, free search engine. Any discussion made by me of particular securities is not a recommendation to buy or to sell. Trade at your own risk. Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons. The sale may before or after the post. Before buying or selling any stock, even one recommended by a trusted financial advisor, please research it and make up your own mind which is what I always try to do. Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news. In this post, and all others by me, I am merely describing my reasons for purchasing or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale. The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile. By way of example, it is unlikely that I will ever need the funds contained in my retirement accounts. Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments. Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed. It is always important to follow the investment process. the investment process/links to further information on canadian energy or royalty trustsInvestment Process Part II: Bonds and Bond Like Investments NOT A RESEARCH SERVICE/Add of PWE Last Week These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities. All content in these posts is provided for informational and entertainment purposes only, and it is a form of entertainment for me. Anyone interested in a topic may want to review all discussions contained in the blog about it by using a relevant search term in the box at the top. Opinions are subject to change and they certainly evolve over time as information is assessed and analyzed for compatibility with prior opinions, the only process for a serious investor, and a topic of frequent discussion in this post.
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