Indexed vs. Active Bond Fund

[TromboneAl]

I have most of my short-term bond money in the VG Short-Term Bond Index fund.  However, I notice that most recommendations for bond funds are not indexed funds. 

The VG Short-Term Invest-Gr fund has almost the same 10 yr Growth of 10,000 characteristics as the indexed fund.  The expense ratio is only slightly higher.

Is the argument for indexed funds less strong for bond funds than for equity funds?

 

[brewer12345]

There is arguably some money to be made through active management of bonds, since the bond market is a lot less liquid and transparent than the equity market. However, in short term high grade bonds, the available juice is small enough that you as a retail investor wouldn't notice the difference (but it might be important to a leveraged financial institution).

Now junk is another matter.

 

[soupcxan]

Brewer, I thought that the bond market was supposed to be more efficient than the equity market because the metrics to evaluate bond prices are generally agreed upon (credit risk, duration, inflation risk, etc.) so most traders are on a level playing field. Compared to the equity market where there are a lot more information asymetries and other things that make the market less efficient. Thefore, active management doesn't add much to a bond mutual fund but could conceivably add something to an equity fund (of course this is also subject to debate) Is this not the correct reasoning?

 

[brewer12345]

Brewer, I thought that the bond market was supposed to be more efficient than the equity market because the metrics to evaluate bond prices are generally agreed upon (credit risk, duration, inflation risk, etc.) so most traders are on a level playing field. Compared to the equity market where there are a lot more information asymetries and other things that make the market less efficient. Thefore, active management doesn't add much to a bond mutual fund but could conceivably add something to an equity fund (of course this is also subject to debate) Is this not the correct reasoning?

Hahahahahahaha!!!


You got it backwards, my friend. Interest rate risk on risk free (or nearly so) fixed income instruments is well understood and easily priced (but treasuries still jump around every day). Credit risk is another thing entirely and is akin to equity market forecasting difficulties.

But the big difference with FI is that the market is far less liquid and transparent than the equity market. Consider a large junk-rated issuer that has public equity. Every share that trades on the exchange is indistinguishable from the next. But the same issuer might have dozens of different FI obligations, each with different terms and conditions and issued by different entities within the overall structure. If you really want to see a painful example, go look at Calpine.

 

[Maximillion]

I prefer to hold Bonds in a laddered form and in Today's environment I am keeping their maturities to 5 years at max, redeeming when matured and either spending proceeds of buying back into Market.

I hold 10% in High Yield , 10% Income Trusts, Today's low rates force an element of higher risk to be added, IMO.

Double Digit Rates are on the Horizon, Real Estate , slumping $, Gold, are all telling you that.

This is 1982-84 all over again.

 

[justin]

I have most of my short-term bond money in the VG Short-Term Bond Index fund. However, I notice that most recommendations for bond funds are not indexed funds.

The VG Short-Term Invest-Gr fund has almost the same 10 yr Growth of 10,000 characteristics as the indexed fund. The expense ratio is only slightly higher.

Is the argument for indexed funds less strong for bond funds than for equity funds?

T Al,

The two VG bond funds you mentioned are invested in similar bonds and have almost identical expense ratios. For those type of bonds, the important thing is cost (expense ratio), not active vs. passive management. In other words, an average actively managed fund invested in similar-type bonds, but with an expense ratio of 1% (instead of 0.2% at VG) would be expected to underperform the VG funds by 0.8% over the long term.

An interesting thing to note, however, is how some actively managed bond funds with high expense ratios try to outperform the index by going longer on the yield curve to get a higher coupon rate. The end result is a longer duration and more interest rate risk. In effect, you might be buying a short-term bond fund that actually holds intermediate term bonds (with the interest rate risk), but has a yield closer to short term bond funds.

 

[soupcxan]

Well hey, at least I'm able to provide some comic relief for the resident bond guru/captain piehole!

I guess I've just been told that active management on equities is debatable but active management on FI is unlikely to add much value because the returns are lower (so 1% overhead cost eats a greater percentage of your return) and because so much of the FI analysis is publicly available (from S&P, moodys, etc.), you can just trade off that rather than pay some fund manager to do it again for negligble incremental returns.

But if the FI market is so much less transparent and liquid than equities, why isn't the volatility of bonds so much less than that of equities?

You got it backwards, my friend.  Interest rate risk on risk free (or nearly so) fixed income instruments is well understood and easily priced (but treasuries still jump around every day).  Credit risk is another thing entirely and is akin to equity market forecasting difficulties.

But the big difference with FI is that the market is far less liquid and transparent than the equity market.  Consider a large junk-rated issuer that has public equity.  Every share that trades on the exchange is indistinguishable from the next.  But the same issuer might have dozens of different FI obligations, each with different terms and conditions and issued by different entities within the overall structure.  If you really want to see a painful example, go look at Calpine.

 

[TromboneAl]

Thanks for the analysis. I'll just stay in the index fund.

 

[brewer12345]

But if the FI market is so much less transparent and liquid than equities, why isn't the volatility of bonds so much less than that of equities?

Two reasons come to mind:

1) Bonds are a fundamentally higher claim on a given company's assets than equity.  They tend to be less volatile because they are higher in the capital structure and the payouts are more certain.  Certainty generally reduces volatility.

2) The very fact that bond prices are not that easy to observe and you get fewer observations (ie fewer trades) makes an asset look less volatile.  So if you see one trade a week, you miss all the potential intra-week ups and downs.

 

[haha]

When there is a normal to steep yield curve, there is profit in actively managing even treasuries. You can buy long dated bonds at a higher yield, then as they age a bit, sell them at the shorter, more expensive maturity. Bill Gross did this very effectively during the past few years when short rates were much lower than long.

Wouldn't work at all now of course.

Ha

 

[ats5g]

Hi Al,

Two pertinant articles:

Predictability of Fixed-Income Fund Returns

Bond Fund Returns and Expenses: A Study of Bond Market Efficiency

There's nothing all that special about Vanguard's non-indexed bond funds, except that they're very cheap and their asset size probably allows them to get extremely good institutional bond pricing. Indexing in bonds works just as well as in stocks simply because of the low, low costs.

I might go with the ST bond index funds b/c it holds both Treasuries and Corporate Bonds. This way you won't feel too bad if you hold ST Corporates and Treasuries do better, like in 2002 [i.e. hedge your bets]. It really depends on whether you want both Treasuries and Corps, or just Corps.

- Alec