Bond Funds or Bonds?

[daylatedollarshort]

No the main issue with the yield gap is due to funds holding too many low coupon bonds in their portfolio with extended durations that will keep their average coupon well below current rates for an extended period of time. You can't expect a fund with an average coupon of 2.8% to pay out distributions at current yields of 5%. This is the primary reason I warned people last February of the dangers of holding these passive bond funds as rates rise. Many people argued that I was wrong and that the SEC yields represent future distributions which includes coupon payments and capital gains. Well here we are one year later, and people are complaining about they yield gap between SEC, YTM, and distribution yields. I stated many times that bond funds are not bonds and not even good proxies for bonds. Instead of rehashing the past, it's time to move forward and accept that investors were duped by these asset managers and Bogleheads. What I can say that moving forward, is that it will be another brutal year for these passive bond funds as many investors head for the exits after they realize they were duped. Many will be angry as they were warned a year ago and held onto false hope. Remember, hope does not make a financial plan.

Okay, I'm a bit slow but I think I get it now. I did the math out on my simple example, 2 $100K bonds, 10% interest rate, 10 year term, market rates go to 15% right after the bond is bought, $100 share price. Each bond gets marked down to $74,906, share price goes to $74.91. The annual cash interest on the bond is only 13.35% to make up for getting back the full $100K at par. So that is the cash yield gap, in my example, the same as Pb4uski's example in a larger scale (I think, pb4uski can let me know if I have gotten it right).

The NAV loss happens when the market rates change and the bond is held on the fund's books for $74,906 instead of $100K. If interest rates don't change, and the bond is sold the next year, I don't see how that incurs any additional unrealized loss, as long as it is actually sold close to its book value. Using my example, the yield gap would be explained, as pb4uski showed us earlier, by the amortization of the principal, as part of the 15% instead of getting it all in cash to be distributed to the share holders. So I think that explains the yield gap, not the unrealized losses. Those should have already been accounted for in the NAV drop.

 

[Freedom56]

Okay, I'm a bit slow but I think I get it now. I did the math out on my simple example, 2 $100K bonds, 10% interest rate, 10 year term, market rates go to 15% right after the bond is bought, $100 share price. Each bond gets marked down to $74,906, share price goes to $74.91. The annual cash interest on the bond is only 13.35% to make up for getting back the full $100K at par. So that is the cash yield gap, in my example, the same as Pb4uski's example in a larger scale (I think, pb4uski can let me know if I have gotten it right).

The NAV loss happens when the market rates change and the bond is held on the fund's books for $74,906 instead of $100K. If interest rates don't change, and the bond is sold the next year, I don't see how that incurs any additional unrealized loss, as long as it is actually sold close to its book value. Using my example, the yield gap would be explained, as pb4uski showed us earlier, by the amortization of the principal, as part of the 15% instead of getting it all in cash to be distributed to the share holders. So I think that explains the yield gap, not the unrealized losses. Those should have already been accounted for in the NAV drop.

Keep in mind that with a bond fund, there is no guarantee that the principal will be fully amortized to achieve a 15% yield. A fund is force to sell when there are redemptions. So in that example, it may be forced to sell at a 25% loss. Funds also sell prior to maturity to maintain an average duration. So if rates stay constant, one year to maturity, that bond would trade at a discount and would sell at a loss. The problem today is not that funds are holding 10 year 10% coupon bonds. The issue is that they are holding 1.25% coupon 10 year notes so that problem gets magnified even more as rates aproach 6%.

 

[daylatedollarshort]

Keep in mind that with a bond fund, there is no guarantee that the principal will be fully amortized to achieve a 15% yield. A fund is force to sell when there are redemptions. So in that example, it may be forced to sell at a 25% loss. Funds also sell prior to maturity to maintain an average duration. So if rates stay constant, one year to maturity, that bond would trade at a discount and would sell at a loss. The problem today is not that funds are holding 10 year 10% coupon bonds. The issue is that they are holding 1.25% coupon 10 year notes so that problem gets magnified even more as rates aproach 6%.

To be fair, though, the bond fund may be forced to sell my example bond at loss, lower than book value, or if rates declined, it might choose to sell and make a tidy profit. Bond fund returns aren't always lower than nominal bonds, just more volatile.

 

[Freedom56]

To be fair, though, the bond fund may be forced to sell my example bond at loss, lower than book value, or if rates declined, it might choose to sell and make a tidy profit. Bond fund returns aren't always lower than nominal bonds, just more volatile.

In this environment, they are selling at a loss. Passive bond funds sell the lowest coupon bonds first. Take a look at the holdings of BND. Some of these long duration low coupon bonds have almost 50% unrealized losses. You have to ask yourself, would an individual investor lock a coupon of 1.25% for 30 years? Most of the people on this forum will be in the afterlife when these bonds mature.

United States Treasury Note/Bond 1.250% 5/15/50 843,137 454,635
United States Treasury Note/Bond 1.375% 8/15/50 910,374 506,965
United States Treasury Note/Bond 1.625% 11/15/50 1,118,007 666,961
United States Treasury Note/Bond 1.875% 2/15/51 956,460 608,847

Even their shorter durations are positioned badly and they will lose money on these when then sell them next month.:

United States Treasury Note/Bond 0.250% 3/15/24 313,295 297,043
United States Treasury Note/Bond 2.125% 3/31/24 417,278 404,173
United States Treasury Note/Bond 2.250% 3/31/24 951,871 923,464

 

[daylatedollarshort]

In this environment, they are selling at a loss. Passive bond funds sell the lowest coupon bonds first. Take a look at the holdings of BND. Some of these long duration low coupon bonds have almost 50% unrealized losses. You have to ask yourself, would an individual investor lock a coupon of 1.25% for 30 years? Most of the people on this forum will be in the afterlife when these bonds mature.

United States Treasury Note/Bond 1.250% 5/15/50 843,137 454,635
United States Treasury Note/Bond 1.375% 8/15/50 910,374 506,965
United States Treasury Note/Bond 1.625% 11/15/50 1,118,007 666,961
United States Treasury Note/Bond 1.875% 2/15/51 956,460 608,847

Even their shorter durations are positioned badly and they will lose money on these when then sell them next month.:

United States Treasury Note/Bond 0.250% 3/15/24 313,295 297,043
United States Treasury Note/Bond 2.125% 3/31/24 417,278 404,173
United States Treasury Note/Bond 2.250% 3/31/24 951,871 923,464

The funds are supposed to account for the unrealized losses in their book values / NAV prices, not just when they sell the bonds and realize the loss.

 

[Freedom56]

The funds are supposed to account for the unrealized losses in their book values / NAV prices, not just when they sell the bonds.

When a fund sells a bond prior to maturity, there is no recovery of NAV. If the fund holds bonds that will take 30 years to recover, there is no effective recovery of NAV in the investors lifetime. In a rising rate environment there is permanent NAV loss that can never be recovered. Bonds mature at par. The market is now pricing three more rate hikes this year with the final one in June. How do you think these low yielding passive funds will perform in the face of more rate hikes? People sitting on money market funds at 4.5% and rising or in short term high grade corporate, treasury, or agency notes yielding 4.5%-6.75% will ride out the coming storm fine. These low yielding bond funds are headed into the storm in a leaky boat. As investors get into the habit of buying bond and holding them to maturity, it's unlikely that they will return to funds that they ditched in early 2022. We are heading into a different time. With $31T of national debt and climbing there is an obvious ceiling to rates but there is a floor also and it's far above zero.

 

[daylatedollarshort]

When a fund sells a bond prior to maturity, there is no recovery of NAV. If the fund holds bonds that will take 30 years to recover, there is no effective recovery of NAV in the investors lifetime. In a rising rate environment there is permanent NAV loss that can never be recovered. Bonds mature at par. The market is now pricing three more rate hikes this year with the final one in June. How do you think these low yielding passive funds will perform in the face of more rate hikes? People sitting on money market funds at 4.5% and rising or in short term high grade corporate, treasury, or agency notes yielding 4.5%-6.75% will ride out the coming storm fine. These low yielding bond funds are headed into the storm in a leaky boat. As investors get into the habit of buying bond and holding them to maturity, it's unlikely that they will return to funds that they ditched in early 2022. We are heading into a different time. With $31T of national debt and climbing there is an obvious ceiling to rates but there is a floor also and it's far above zero.

I'm not disagreeing with most of what you are saying except for when the NAV price is adjusted. The NAV should have already been adjusted when the market rates changed. In my example fund, this is when the NAV price went from $100 to $75. It doesn't change again if one of the bonds gets sold. I already adjusted the NAV price in my example fund when market rates changed. I changed the fair market price of my bonds from $100,000 to $75,000 which dropped my share price from $100 to $75. This is why the NAVs drop severely for bond funds when there is a big market rate increase. What matters to the NAV is what is on the books of the fund, not selling the bond unless their book value was way off (stale prices).

As Monetcfo put it, "But if someone bought that same fund now, those steep historic losses are in the rear view mirror. There is not some recurring or ongoing loss associated with it."

 

[COcheesehead]

I'm not disagreeing with most of what you are saying except for when the NAV price is adjusted. The NAV should have already been adjusted when the market rates changed. In my example fund, this is when the NAV price went from $100 to $75. It doesn't change again if one of the bonds gets sold. I already adjusted the NAV price in my example fund when market rates changed. I changed the fair market price of my bonds from $100,000 to $75,000 which dropped my share price from $100 to $75. This is why the NAVs drop severely for bond funds when there is a big market rate increase. What matters to the NAV is what is on the books of the fund, not selling the bond unless their book value was way off (stale prices).

As Monetcfo put it, "But if someone bought that same fund now, those steep historic losses are in the rear view mirror. There is not some recurring or ongoing loss associated with it."

The mark to market price of a bond - a component of a fund’s NAV - does not equal what it can be sold for. So when a fund sells a bond prior to maturity, they will receive what a buyer will pay that day, plus incur the expense to do so.

 

[daylatedollarshort]

The mark to market price of a bond - a component of a funds NAV - does not equal what it can be sold for. So when a fund sells a bond prior to maturity, they will receive what a buyer will pay that day, plus incur the expense to do so.

And they might sell it for more or less than the fair market value they have on their books. That is a different issue than double counting the loss.

 

[pb4uski]

... A fund is force to sell when there are redemptions. So in that example, it may be forced to sell at a 25% loss. Funds also sell prior to maturity to maintain an average duration. ....

While I agree that a fund or ETF may need to sell bonds where net flows are extreme, I think that is uncommon as redemptions would have to exceed the funds liquidity and new money and bond maturities. I'm not sure how often that happens in reality.

I'm also skeptical of the claim that funds must sell prior to maturity to maintain an average duration.

 

[COcheesehead]

And they might sell it for more or less than the fair market value they have on their books. That is a different issue than double counting the loss.

Sigh. You don’t understand. I’ll leave it at that..

 

[daylatedollarshort]

Sigh. You don’t understand. I’ll leave it at that..

In my example, the bond may sell for more or less than the $75K I have it on my books for, but I don't have it on my books for $100K. That $25K loss has already been accounted for in my adjusted NAV price.

 

[jldavid47]

I'm also skeptical of the claim that funds must sell prior to maturity to maintain an average duration.

It depends on what is in the prospectus. If the prospectus states the fund must maintain a 5-6 year duration, for example, and if the average duration falls below 5 years then the fund manager has no choice but to sell some lower duration bonds to bring the average back up.

 

[Freedom56]

I'm also skeptical of the claim that funds must sell prior to maturity to maintain an average duration.

Are you really skeptical?

"This is stated explicitly in the methodology of leading fixed-income indices such as the Bloomberg U.S. Bond Aggregate family against which many bond funds are benchmarked. In their words,

“There is usually a lengthening of an index’s duration each month due to cash and bonds that are being dropped from the index often having lower durations than the bonds that remain in or enter an index.”

As the article states:

"With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record."


https://www.forbes.com/sites/raulel...s-and-buy-some-bonds-instead/?sh=7a2a571f628a

 

[Montecfo]

As the article states:



"With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record."





https://www.forbes.com/sites/raulel...s-and-buy-some-bonds-instead/?sh=7a2a571f628a

Bonds too.

 

[Freedom56]

It depends on what is in the prospectus. If the prospectus states the fund must maintain a 5-6 year duration, for example, and if the average duration falls below 5 years then the fund manager has no choice but to sell some lower duration bonds to bring the average back up.

These are the rules:

"Duration Extension Methodology
At the close of the last business day of each month, the Bloomberg Indices are reset and bonds formally enter and exit the index, while cash that has accumulated in the Returns Universe during the month is removed. At this moment, the Projected Universe has become the next month’s Returns Universe and the realized duration extension is simply the difference in the end of-month Returns and Projected durations. At month-end, the extension is known with certainty and easily derived by comparing the duration of the two published universes. There is usually a lengthening of an index’s duration each month due to cash and bonds that are being dropped from the index often having lower durations than the bonds that remain in or enter an index. Occasionally, there is a duration shortening when the opposite is true (bonds
exiting the index have higher durations than the residual index). In either case, passive managers must therefore react to this change and lengthen (shorten) their duration exposure accordingly each month to remain duration neutral."

You can find all the details on page 48.

https://assets.bbhub.io/professional/sites/27/Fixed-Income-Index-Methodology.pdf

 

[Freedom56]

Bonds too.

An investor that holds individual bonds is not resetting their portfolio duration every month to maintain an average duration. The statement is in reference to bond funds forced into selling shorter maturities at a loss every month and replacing them with a longer maturity per the bond index rules.

 

[daylatedollarshort]

Bonds too.

The title of the article in the link your replied to is literally:

This Is Why You Should Ditch Your Bond Funds And Buy Some Bonds Instead

"To be sure, bonds can still be excellent investments. It is just that bond funds are not good proxies for individual bonds – at least not in the same way equity funds are good proxies for individual equities. This is a crucial distinction that has big implications when it comes to the construction of an investment portfolio."

"The crucial point when investing in individual bonds is that they must be held to maturity to receive the promised yield. Otherwise, they confront the same problem as bond funds: uncertainty about the exit value, liquidity risks and high vulnerability to rising rates."

"Investors should understand that bond funds and individual bonds are fundamentally different instruments, unlike equity funds and individual stocks which share many investment characteristics. With rising rates, individual bonds held to maturity are poised to deliver a much better performance than bond funds held for similar periods. The case for switching out of bond funds and into individual bonds at this time is strong for those who seek effective diversification against equity positions."

 

[daylatedollarshort]

Since bond funds are supposed to incorporate unrealized losses into the NAV price, then how would selling the bond change the NAV price? In my example the NAV price gets adjusted from $100 to $75 when the 10% bonds are repriced to yield 15%. If rates are still 15% when the fund needs to sell, how would this change lower the NAV price again? The fund already took the hit when the market value of their bonds changed, didn't they? If the fund sells the bonds for close to a 15% yield to maturity price, then there is no additional NAV loss. That loss was already on the books and baked into the NAV price.

 

[Freedom56]

People should read the Bloomberg fixed income index methodology and then recite "How do I lose my money? Let me count the ways:"

Index rebalancing - buying and selling for no other reason than maintaining an index balance all while losing money in this environment.

Duration extending - Monthly selling of shortest maturity and buy of longer maturities at a loss (buy high / sell low)

Index exit - selling bonds dropped from the index

Index entry - Buying new issue bonds added to the index and bidding the price up all at the expense of the bond fund holders.

The Yield to Maturity calculation is the most creative of all.


https://assets.bbhub.io/professional...ethodology.pdf

 

[pb4uski]

It depends on what is in the prospectus. If the prospectus states the fund must maintain a 5-6 year duration, for example, and if the average duration falls below 5 years then the fund manager has no choice but to sell some lower duration bonds to bring the average back up.

Or buy longer duration bonds to bring the average back up, right?

 

[jldavid47]

Or buy longer duration bonds to bring the average back up, right?

I suppose that is possible but given liquidity requirements not likely unless the fund had significant inflows.

 

[Montecfo]

An investor that holds individual bonds is not resetting their portfolio duration every month to maintain an average duration. The statement is in reference to bond funds forced into selling shorter maturities at a loss every month and replacing them with a longer maturity per the bond index rules.

You provided this quote:

"With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record."

My comment is:

With the Fee in rate hiking mission, bonds are ALSO doomed to continue their money losing record.

Rising rates reduce the value of bonds, whether held in funds or directly.

It is just a fact.

I would add the fact that the bond owner's average duration changes every month.

These are simply characteristics of bond funds and bonds. You continue to present your views as if bond funds are always better than bonds. It is just not the case.

Each has pros and cons.

And you suggest bond funds are always selling bonds at a loss. This is also not so. In fact the normal case is they sell at a gain because most of the time the yield curve is not inverted and thus bonds gain value as the remaining term shortens.

You are suggesting that the dramatic rate rise of the past year is somehow typical. In fact it is unprecedented.

 

[jldavid47]

Since bond funds are supposed to incorporate unrealized losses into the NAV price, then how would selling the bond change the NAV price?

It doesn't. What changes is the ability for NAV to recover. Selling the bond locks in the loss.

Bond funds are a good investment if the trend in interest rates is down. They are a disaster if the trend in interest rates is up and trends in interest rates tend to persist for decades.

 

[VanWinkle]

It doesn't. What changes is the ability for NAV to recover. Selling the bond locks in the loss.

Bond funds are a good investment if the trend in interest rates is down. They are a disaster if the trend in interest rates is up and trends in interest rates tend to persist for decades.

With the current government debt, I would bet that interest rates will find their way down in the near future. Down has been the direction for decades and it will persist IMO. Can you give me your logic for rates continuing to rise for the next 2 decades?

VW