How would one go about evaluating two different (but similar) bond etf funds?

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mikeski569
Posts: 49
Joined: Mon Nov 24, 2014 12:49 am

How would one go about evaluating two different (but similar) bond etf funds?

Post by mikeski569 » Fri Nov 17, 2017 2:52 am

How would one go about evaluating two different (but similar) bond ETF funds? I need to go through a list of bonds and determine funds that are a good substitute for one another. Our custodian is now charging a transaction fee for certain funds and I need to change the funds we use for monthly retirement contributions to avoid the transaction fee's.

For example two funds that are both Investment grade long term corporate bonds funds?

IShares (LQD) and SPDR (SPLB)

What's important to look at in determining whether the bonds are similar enough to be interchangeable or to quantify what are important differences.

Valuethinker
Posts: 33395
Joined: Fri May 11, 2007 11:07 am

Re: How would one go about evaluating two different (but similar) bond etf funds?

Post by Valuethinker » Fri Nov 17, 2017 5:53 am

mikeski569 wrote:
Fri Nov 17, 2017 2:52 am
How would one go about evaluating two different (but similar) bond ETF funds? I need to go through a list of bonds and determine funds that are a good substitute for one another. Our custodian is now charging a transaction fee for certain funds and I need to change the funds we use for monthly retirement contributions to avoid the transaction fee's.

For example two funds that are both Investment grade long term corporate bonds funds?

IShares (LQD) and SPDR (SPLB)

What's important to look at in determining whether the bonds are similar enough to be interchangeable or to quantify what are important differences.
Hi if you post the links to those 2 fund factsheets we could take a look.

Duration (Effective Duration/ Modified Duration) - tells you how sensitive the fund is to interest rates

Yield To Maturity - gives a rough guide to the long run return of the fund if you buy it now (average yield of the bonds in the fund).

Credit quality - the lower the average grade of the bonds in the fund, the riskier it is. Within investment grade you will find a lot of the better performing funds have simply done so by buying bonds of lower credit quality (down to BBB; BBB- is the bottom of investment grade, using Standard & Poors rating). That will come back to haunt bond investors as and when we hit the next recession.

Bond yields are priced as a "spread" over the safe US Treasury of same maturity. Thus "200 over" is 200 basis points (2.0%) over the US Treasury (or sometimes the A rated corporate bond) of the same maturity. Yield spreads for riskier bonds have been coming down (prices of the bonds therefore rising) and when we next hit a recession they will blow out again.

I would avoid High Yield Bond funds and especially ETFs on the same. The higher credit risk will materialize in hits to the NAV over time due to defaults, and there's a significant question whether the underlying assets are liquid enough if there was a "rush for the exit" in terms of ETFs being redeemed. If you must buy a HY bond fund then Vanguard offers a relatively conservative one. We are late in the credit cycle (too much money being borrowed too cheaply by companies that will struggle to repay it), defaults will start to rise and you want to be in a relatively safe fund. Note however the drop in the VG fund NAV since its inception in the 1990s.

In practice:

- lower credit quality has not historically paid off. You get a higher yield on the fund, but you lose it in defaults (usually the fund sells the bonds once they cease to be Investment Grade aka "Fallen Angels" but does not experience the default). Fund NAV volatility is higher - compare US Treasury Bond fund to an IG corporate bond fund and a HY bond fund 2008-09.

- most corporate bond funds should have similar durations. If interest rates go up +1% on a bond with Duration = 5.9 years, then all things being equal the bond fund should fall 5.9% (all things are never equal, it's just an estimate), if 6.9 then 6.9% etc. Unless the difference is 2.0 years or greater I do not get too worried. All things being equal, funds with bonds with longer average term to maturity have higher durations than ones with lower.

Other factors

- some bond fund managers are just more conservative (Vanguard for example). Recent performance may have been less good but safer (you can usually see that in higher average credit rating

- you want an ETF with a decent amount of assets. More than $100m for sure and probably say $500m? Some people here would argue for more, I think

- check bid ask spreads on the ETFs, gives a sense of underlying liquidity

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