Total Bond Fund versus Corporate Bond ladder

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Total Bond Fund versus Corporate Bond ladder

Postby mpt follower » Wed Jan 30, 2013 7:41 am

I have held a Total Bond fund for as long as remember and I have done so because building an individual investment gade bond ladder (like Thau recommended then) was not possible for me given my limited availability of money. I could not create the diversification that a total bond fund can provide.
However, in the past days I became aware that there are ETFs of investment grade corporate bonds with defined target dates that allow one to build a multi-year bond ladder, achieving (I think) significant more capital stability (see http://www.morningstar.com/advisor/t/56 ... h-etfs.htm). I think that this is much more critical now with the potential of rising interest rates potentially causing NAV erosion of bond funds and the fact that I am retired and partially live out of the income of my bond portfolio and cannot wait until the next business cycle to recover.
My question is simply whether my logic makes sense.
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Re: Total Bond Fund versus Corporate Bond ladder

Postby Call_Me_Op » Wed Jan 30, 2013 7:52 am

There are two apparent advantages to the corporate bond ETF ladder - a decreasing duration over time (unless you roll the ladder) and less interest-rate sensitivity for a given maturity. However, there is still higher credit risk, which can affect the value of your ladder during a financial downturn - and the total bond fund has greater diversification. So I don't think it is a clear win either way - much depends upon economic parameters looking forward.
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Re: Total Bond Fund versus Corporate Bond ladder

Postby john94549 » Wed Jan 30, 2013 9:53 am

I understand individual bonds. I understand laddering. I understand coupons aka dividends aka interest.

I do not (most assuredly do not) understand how these ETFs "work".

I have a number of questions. Perhaps some of the bond gurus could chime in.

All these ETFs seem to start out around $20, then shoot up to $21 (or more) fairly rapidly, then flat-line, or jiggle around. Why is that?

All these ETFs pay out in current dividends less (actually, much less) than the coupons of the underlying bonds (less ER). Why is that? Why do the dividends vary month-to-month? Is the paper churned?

I assume, as with brokered CDs, the coupon payments made to the fund, less expenses and dividends paid out to investors, are not re-invested (compounded) but act as "retained earnings". Where are they put? Are they reflected in the ETF price? If that were the case, and the "delta" was around 3%/annum, wouldn't the share price show a nice, steady upward trajectory until liquidated? Except for "drag" (see immediately below). Or, are the coupon payments (less ER and amounts paid out) used to buy more paper of the same vintage until the last year before liquidation? If so, wouldn't the effect on share price be the same, or nearly so?

In a rising-rate environment, how much drag is exerted? Stated another way, if you own a bunch of 2018 paper at 6% and I can go buy equivalent paper at 7%, I will buy your paper at a discount. So, the folks buying at $21/share today might get less (maybe, much less). Can this be quantified?

The concept is interesting. Very interesting. But I'd want to know a whole lot more, and see a couple of years worth of performance in a rising-rate environment, before I'd plunk any serious money into these ETFs.
Last edited by john94549 on Wed Jan 30, 2013 10:42 am, edited 1 time in total.
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Re: Total Bond Fund versus Corporate Bond ladder

Postby johnep » Wed Jan 30, 2013 10:39 am

I do not know exactly how to assess the value and stable pricing of these etfs. The 2018 corporate bond etf (BSCI) has an average yield of 6.07% and avg maturity of 5.58 years. It also has an average price of 120.22% which I believe means you pay that amount for privilege of 6% yield. I have not calculated what that translates to as effective yield (M* did not provide that), but it does not sound like it would not be any better than Vanguard's InvGr Corp, and maybe not as good after higher fees and premium.

Also, would the etf adjust its NAV whenever interest rates change, thereby affecting the value of the fund? If so, that would seem to defeat the premise of stable value. In that case, the only advantage these types of etfs would have would be to more precisely select bond maturities.

I would like to hear from one of our bond experts on this. Based upon what I understand, it does not sound like a good investment.
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Re: Total Bond Fund versus Corporate Bond ladder

Postby grabiner » Wed Jan 30, 2013 9:43 pm

Rolling a ladder of corporate-bond funds doesn't give any advantage, because the overall holdings are the same. If you have a corporate-bond fund holding bonds with duration 1-10 years, the fund will roll over the one-year bonds as they mature to buy ten-year bonds. If you instead buy ten funds maturing in each of the next ten years, and then sell the one-year fund as it matures and buy a new ten-year fund, you will also hold bonds with duration 1-10 years at all times.
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