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I held several Vanguard equity ETFs (VFIAX, etc.) I wanted to diversify into bonds (as discussed in "A Random Walk Down Wall Street"), so I sold some of them and bought BLV.

As stocks have declined, BLV has declined even more severely.

Do I misunderstand how to diversify into bonds?

  • Would you mind linking to the Random Walk article and to BLV? Thanks. – Lawrence Oct 8 '18 at 20:53
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Do I misunderstand how to diversify into bonds?

No. You diversified just like you're supposed to, by adding other asset classes (presumably with a low correlation of returns) to your portfolio. Diversification to a lower-risk asset like bond ETFs does not mean that the bond ETF will ALWAYS move less than the equity ETF, or that they will move in opposite directions. It simply means that on average, the movements of the bond ETF will be less than the equity ETF.

I would not panic too much if the bonds dropped more than the equity in a short time. It's possible that recent interest rate movements hurt the bonds, but did not hurt the equities as much (or other factors helped offset the losses sue to interest rates).

The downside is that you can not expect the bond ETFs to rise more than the equities going forward for the same reasons. One thing you might consider is to rebalance slightly, buying more bond ETFs while they're down, but that's up to you.

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Bonds, and even fixed interest in general, only provide assured returns if held to maturity (and sometimes, not even then). If they are actively traded, there is no guarantee of low volatility or capital return.

For example, say you bought a bond for $x that would mature with a capital return of $y. Your expected capital gain/loss is already different from that of the original purchaser, who would likely have paid $y for the bond, expecting $y back on maturity. If you sell the bond prior to maturity, you might get $z, and all those prices are likely to be different.

A bond fund that actively trades its portfolio of bonds inherits this volatility. If it sees bond prices plummeting, it might decide to sell to cut its losses, but it also thereby crystallises its losses.

  • "Actively trading" and "crystallising" losses isn't the point. The losses (relative to competing investments) have already occurred and are reflected in the value of the fund whether or not it sells the bonds. The fact that one could hold to maturity and avoid a "loss of principal" doesn't change the fact that one has an economic loss (e.g., locking in a low long-term interest rate just before inflation rises). – nanoman Oct 9 '18 at 1:03
  • @nanoman Not doing as well as a competing investment isn’t the same as an economic loss - you can’t equate the two. I thought the OP’s question was about surprise at the high volatility in a bond ETF. My answer addresses how an ETF could have high volatility when the underlying asset class is supposed to not have such high volatility. – Lawrence Oct 9 '18 at 2:05
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    This is an interesting issue. I maintain that the volatility of a bond fund is related to the duration of the bonds it holds, and not its trading activity (turnover) as your answer indicates. Even if almost all bonds are held to maturity, the fund's NAV will vary due to the strong effect of current interest rates on the current value of long-term bonds. Whether losses are realized or unrealized doesn't matter to NAV. ... – nanoman Oct 9 '18 at 5:14
  • ... The funny thing about bonds is that (risk-free) interest rates define the relation between the value of money at different times. If I bought a long-term bond at 3% and then rates reset to 5%, to say I haven't incurred downside volatility unless I sell seems like a head-in-the-sand attitude. Yes, I get the nominal principal back if I hold to maturity, but miss the reinvestment opportunity I would have if I sold. Either way, I've lost part of the time value of my money. – nanoman Oct 9 '18 at 5:15

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