Bond Funds or Bonds?

[daylatedollarshort]

The NAV reported by the fund in an estimate. Not all bonds trade every day. Some don't trade for months. So all the unrealized losses are not reflected in the NAV of the fund. It is only an estimate. When a fund is a forced selling mode due to redemptions, it does not set the price, the market does. Fixed income investors like me exploit that by placing low ball limit orders to catch these sell orders.

Isn't that stale pricing? In that scenario, they are selling bonds for much less than what they have on their books. The prices are stale. Unrealized losses (at least the ones the funds are aware of in advance) are supposed to be calculated in the NAV prices, aren't they?

"The NAV of a fund can go up and down because it also includes unrealized capital gains or losses. This is where the fund’s securities have not been sold, but their value has changed because of their market value has changed." https://www.financialpipeline.com/expert/why-do-i-pay-taxes-when-my-funds-nav-falls/

We did see most funds drop their NAV prices significantly last year, so they are putting some unrealized losses into the NAV price, maybe just not enough.

 

[audreyh1]

Yes, unrealized losses and unrealized gains are reflected in the NAV of a fund.

From what I’ve read, stale pricing effect is minuscule with bond index funds. It’s more of an issue for high yield, municipal and corporate bond funds. And generally exacerbated during short periods of extreme financial crisis like the March 2020 Covid panic drop. Not all of the time.

 

[pb4uski]

If the YTM is higher that the average coupon, it also suggests the the fund is sitting on unrealized losses. Look at the fund details on BND. It is sitting on substantial unrealized losses. You need to look at the realized an unrealized gains associated with the distribution. For the January distribution it realized a loss of -1.12% and has -9.81% of unrealized losses which it will realize as the months progress. This is pretty straight forward math. I'm surprised at how many people are still confused and while people remain confused, the bloodbath in bond funds that we saw in 2022 is resuming.

No, because YTM is established when bonds are purchased and do not change thereafter for that purchase lot.

So if the fund buys new issue with a 4% coupon at par, then the coupon rate and the YTM are both 4% and never change as long as the bond is held. If the next day rates spike and the value of the bond goes down, the coupon and YTM are still both 4%.

So the YTM is the weighted average of the YTM of all the purchase lots held by the fund and each one is unchanged once it is established until that lot matures or is sold.

YTM does NOT reset as the fair value of bonds change. So the only way that a fund can get a big discrepancy between coupon and YTM is to buy bonds at a significant discount.

 

[pb4uski]

....A funds distribution is determined by the income it receives (from the coupon payments) +/- capital gains or losses it realizes when securities are sold - fund management expenses. So if you add back the actual losses and pro-rated management expense to the coupon payments arrive at the estimated YTM reported by the fund. ...

Nope. Wrong. Not the way it works.

The YTM is the weighted average of the purchase YTM of each bond purchase lot.

 

[walkinwood]

No, because YTM is established when bonds are purchased and do not change thereafter for that purchase lot.

So if the fund buys new issue with a 4% coupon at par, then the coupon rate and the YTM are both 4% and never change as long as the bond is held. If the next day rates spike and the value of the bond goes down, the coupon and YTM are still both 4%.

So the YTM is the weighted average of the YTM of all the purchase lots held by the fund and each one is unchanged once it is established until that lot matures or is sold.

YTM does NOT reset as the fair value of bonds change. So the only way that a fund can get a big discrepancy between coupon and YTM is to buy bonds at a significant discount.

Here's the definition of YTM. As you can see, the price of the bond is in the denominator - hence YTM is inversely related to the market price of the bond.


https://www.investopedia.com/terms/y/yieldtomaturity.asp

 

[pb4uski]

Here's the definition of YTM. As you can see, the price of the bond is in the denominator - hence YTM is inversely related to the market price of the bond.


https://www.investopedia.com/terms/y/yieldtomaturity.asp

No, you're misinterpreting it. It says:

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Note: on a bond, not of a bond fund.

YTM is at purchase, for each bond. For the portfolio, it is the weighted average of the YTM of all the purchase lots owned by the fund.

While one can calculate the current yield based on the current fair value of a bond at anytime after purchase, that typically isn't calculated in my expereince and isn't reported.

When you buy a bond the pricing screen tells you the YTM of your purchase based on the purchase date, price that you are paying, etc. If you go to buy the same CUSIP a month later the YTM will be different due to the passage of time, change in the market price, etc. So let's say you buy another lot and they are both the same $ amount. The portfolio YTM would be the average of the YTM of your two purchase lots.

 

[daylatedollarshort]

So that creates an incentive for fund managers to invest in low coupon bonds so that over the long run they get to retain more AUM and make more money. The amortization of discount is embedded in the NAV but in order to get it you need to sell some shares and it is mixed in with changes in value due to changes in interest rates and other things.

Thanks for posting that. That makes sense. It is also kind of diabolically clever on the fund manager's part.

 

[walkinwood]

No, you're misinterpreting it. It says:

.... If you go to buy the same CUSIP a month later the YTM will be different due to the passage of time, change in the market price, etc.

Now I get what you're saying. YTM for a single purchase of that bond never changes after you've made that purchase as long as you hold it to maturity.

 

[Freedom56]

No, because YTM is established when bonds are purchased and do not change thereafter for that purchase lot.

So if the fund buys new issue with a 4% coupon at par, then the coupon rate and the YTM are both 4% and never change as long as the bond is held. If the next day rates spike and the value of the bond goes down, the coupon and YTM are still both 4%.

So the YTM is the weighted average of the YTM of all the purchase lots held by the fund and each one is unchanged once it is established until that lot matures or is sold.

YTM does NOT reset as the fair value of bonds change. So the only way that a fund can get a big discrepancy between coupon and YTM is to buy bonds at a significant discount.

No you are wrong and completely misguided. How is it possible that a fund like BND have a portfolio of bonds purchased at a discount and -9.72% of unrealized losses? How is it possible that a BND is realizing capital losses every month? The YTM for a particular security changes every day. Do a fixed income analysis of your portfolio with Fidelity. Your YTM for any bond in your portfolio changes every day. When you buy a bond you are buying at a fixed YTM at that moment in time. However if the bond price changes so does the YTM for that bond and that is now reflected in your portfolio. At maturity you realize the original YTM when you purchased the security. Most bond funds don't hold to maturity and in this environment are realizing a capital loss when they sell.

 

[Freedom56]

Nope. Wrong. Not the way it works.

The YTM is the weighted average of the purchase YTM of each bond purchase lot.

YTM changes on a trade to trade basis depending on the price. Your logic is nuts. How does a fund with -9.72% unrealized losses have a portfolio of bonds purchased at discount? Go back and track the YTM of BND over the past year. The average coupon has remained constant but the YTM has been increasing as rates have been rising and the value of their NAV has been falling.

Just refer to the annual report for BND. It lists every security in the portfolio and the face amount (what it paid) and the current market value. If it held a portfolio of bond purchased at a discount, the face amount would be less than the market value and there wouldn't be billions in unrealized capital losses as shown in the report.

 

[pb4uski]

YTM changes on a trade to trade basis depending on the price. Your logic is nuts. How does a fund with -9.72% unrealized losses have a portfolio of bonds purchased at discount? Go back and track the YTM of BND over the past year. The average coupon has remained constant but the YTM has been increasing as rates have been rising and the value of their NAV has been falling.

Just refer to the annual report for BND. It lists every security in the portfolio and the face amount (what it paid) and the current market value. If it held a portfolio of bond purchased at a discount, the face amount would be less than the market value and there wouldn't be billions in unrealized capital losses as shown in the report.

Quite easily. If they purchase a bond at a discount and then interest rates rise and the fair value declines more so the fair value is less than their purchase price. So they buy 1 year, 1% coupon bond that yields 4% for $97. The next day, market yields spike 100bp to 5%, so that bond is not only worth $96. They have a $1 unrealized loss, do they not? In a rapidly rising rate environment it isn't unusual at all to buy bonds at a discount and have unrealized losses.

The face amount is not what they paid, it is the par value. They don't indicate what they paid.

A bond’s face value refers to how much a bond will be worth on its maturity date. In other words, it’s the value that the bondholder will receive when their investment fully matures (assuming that the issuer doesn’t call the bond or default).

 

[Freedom56]

Quite easily. If they purchase a bond at a discount and then interest rates rise and the fair value declines more so the fair value is less than their purchase price. So they buy 1 year, 1% coupon bond that yields 4% for $97. The next day, market yields spike 100bp to 5%, so that bond is not only worth $96. They have a $1 unrealized loss, do they not? In a rapidly rising rate environment it isn't unusual at all to buy bonds at a discount and have unrealized losses.

You don't have a basic understanding of how passive index funds work. They buy the highest coupon and yielding bond in the index when funds flow in. They sell the lowest coupon bond in the portfolio when there are redemptions. This is how it has always worked. This is also why low coupon bonds fall the hardest when there is a sell-off. A year ago the average coupon of BND was 2.8% where it is today. The YTM a year ago was around 1.9%. Which means that bonds in it portfolio were on average purchased above par. Today the YTM is 4.3%. There are billions in unrealized losses. Go look at the holdings of BND and compare the face value to to the current market value. Just about every position is a loss. How could that be using your logic?

The YTM of a fund changes over time as the value of the assets change just like an individual bond.

 

[audreyh1]

An index fund has to track the index, so it seems like what the index holds would determine what is bought or sold so that they match the index allocation.

 

[Lsbcal]

Why do I get the feeling that this thread wanders into the weeds of second order effects?

 

[pb4uski]

....The YTM of a fund changes over time as the value of the assets change just like an individual bond.

Whatever you say. To me, the above has the same credibility as where you claimed a few posts ago that the face value was what they paid for the bond and that was easily disproven.

 

[Freedom56]

Whatever you say. To me, the above has the same credibility as where you claimed a few posts ago that the face value was what they paid for the bond and that was easily disproven.

Well a year ago I warned investors about bond funds in this post.

FEB-6-2022

"Passive bond funds will not shield you from market risk and consistently underperform a portfolio of individual bonds due to their tendency to buy high and sell low. For example, the funds that bought Apple 1.25% coupon 2030 notes at or over par are watching it trade at 90 cents on the dollar and could very well drop to a low of 70 cents on the dollar during moments of panic bond selling as rates rise. Passive bond funds sell their lowest yielding investments first. Active funds and individual bond investors avoid these bonds/notes causing precipitous drops until the yield to maturity becomes attractive again."

"A fund that sells this note today will realize loss whereas an individual bond investor can buy today and hold it to maturity and earn the 1.25% coupon plus the capital gain at maturity and effectively earn 2.5% yield to maturity (YTM). If this Apple note were to trade down to 70 cents on the dollar, the YTM would be 6%. Over the past 18 months, the bond market has been flooded with issues like these so it will get very ugly for bond funds as rates rise but set up one of the best buying opportunities for individual bond investors."

So who has credibility?

https://www.early-retirement.org/fo...onds-are-a-terrible-place-to-be-112820-3.html

If you own individual bonds and time your purchases to moments when bond fund managers are in panic selling mode, all you will lose is the premium as rates rise. You will lose this premium in any case as the bond approaches maturity. We are approaching a long overdue moment when yields become attractive as bond fund managers begin their liquidation. CEFs will also sell-off to levels well below asset value. Investor should be focused on two thing when investing in bonds:

1- Fixed coupon payments
2- Return of capital

This is not that different from buying CDs. Investors should then ask themselves whether they would buy a fund that invests in CDs with no guarantee of return of capital or buy individual CDs themselves? Passive bond funds will not shield you from market risk and consistently underperform a portfolio of individual bonds due to their tendency to buy high and sell low. For example, the funds that bought Apple 1.25% coupon 2030 notes at or over par are watching it trade at 90 cents on the dollar and could very well drop to a low of 70 cents on the dollar during moments of panic bond selling as rates rise. Passive bond funds sell their lowest yielding investments first. Active funds and individual bond investors avoid these bonds/notes causing precipitous drops until the yield to maturity becomes attractive again.

https://finra-markets.morningstar.com/BondCenter/BondDetail.jsp?ticker=C925719&symbol=AAPL5030516

A fund that sells this note today will realize loss whereas an individual bond investor can buy today and hold it to maturity and earn the 1.25% coupon plus the capital gain at maturity and effectively earn 2.5% yield to maturity (YTM). If this Apple note were to trade down to 70 cents on the dollar, the YTM would be 6%. Over the past 18 months, the bond market has been flooded with issues like these so it will get very ugly for bond funds as rates rise but set up one of the best buying opportunities for individual bond investors.

 

[daylatedollarshort]

Well a year ago I warned investors about bond funds in this post.

FEB-6-2022

"Passive bond funds will not shield you from market risk and consistently underperform a portfolio of individual bonds due to their tendency to buy high and sell low. For example, the funds that bought Apple 1.25% coupon 2030 notes at or over par are watching it trade at 90 cents on the dollar and could very well drop to a low of 70 cents on the dollar during moments of panic bond selling as rates rise. Passive bond funds sell their lowest yielding investments first. Active funds and individual bond investors avoid these bonds/notes causing precipitous drops until the yield to maturity becomes attractive again."

"A fund that sells this note today will realize loss whereas an individual bond investor can buy today and hold it to maturity and earn the 1.25% coupon plus the capital gain at maturity and effectively earn 2.5% yield to maturity (YTM). If this Apple note were to trade down to 70 cents on the dollar, the YTM would be 6%. Over the past 18 months, the bond market has been flooded with issues like these so it will get very ugly for bond funds as rates rise but set up one of the best buying opportunities for individual bond investors."

So who has credibility?

https://www.early-retirement.org/fo...onds-are-a-terrible-place-to-be-112820-3.html

In general, I agree with you and sold all my bond funds early last year. You've done us all a huge favor in not only teaching us how to buy individual bonds, but also by pointing out the difference between distribution and SEC rates, and to pay more attention to the distribution rates.

Were at least some of those unrealized losses incorporated into the current NAV prices already, though? Because the bond funds' share prices did drop a lot in 2022. Theoretically, aren't all the unrealized losses supposed to be included in the NAV price?

"The largest bond fund, the $315.2 billion Vanguard Total Bond Market (VBMFX) declined 13.3%, its worst year ever. The $137.2 billion Vanguard Total International Bond Index (VTIFX) held up slightly better, losing 12.9%.", https://www.morningstar.com/articles/1131299/how-the-largest-bond-funds-did-in-2022

 

[Freedom56]

In general, I agree with you and sold all my bond funds early last year. You've done us all a huge favor in not only teaching us how to buy individual bonds, but also by pointing out the difference between distribution and SEC rates, and to pay more attention to the distribution rates.

Were at least some of those unrealized losses incorporated into the current NAV prices already, though? Because the bond funds' share prices did drop a lot in 2022. Theoretically, aren't all the unrealized losses supposed to be included in the NAV price?

"The largest bond fund, the $315.2 billion Vanguard Total Bond Market (VBMFX) declined 13.3%, its worst year ever. The $137.2 billion Vanguard Total International Bond Index (VTIFX) held up slightly better, losing 12.9%.", https://www.morningstar.com/articles/1131299/how-the-largest-bond-funds-did-in-2022

I brought up the issue with stale pricing many months ago and even pointed you to articles that discuss the issue of buying a bond fund that trades near NAV but the NAV calculation could be overstating the value of the fund. This is old news and frankly those who are buying treasuries, CDs, and Corporate bonds are unlikely to return to bond funds anytime soon. Once they have tasted risk free 5%+ yields and preservation of capital, I doubt investors will return to funds distributing 1.5-2.7% and losing capital as a bonus. The message to anyone contemplating buying a fund is compare the distribution yields versus buy MM funds, CDs, treasuries, corporate and agency notes. Buying a CEF that pays 8-9% distributions could be okay if you are willing to take risk and tolerate the volatility. But buying a passive bond fund that pays 1.5-2.7% in distributions while offering no capital protection in this rate environment is insane. We are in a different rate environment now and investments funds that thrived in zero rate environments will not thrive in this one.

Here are past discussions on stale pricing.

https://www.advisorperspectives.com/...fund-investors

https://www.early-retirement.org/fo...in-order-to-buy-cds-115703-2.html#post2845728

 

[daylatedollarshort]

I brought up the issue with stale pricing many months ago and even pointed you to articles that discuss the issue of buying a bond fund that trades near NAV but the NAV calculation could be overstating the value of the fund. This is old news and frankly those who are buying treasuries, CDs, and Corporate bonds are unlikely to return to bond funds anytime soon. Once they have tasted risk free 5%+ yields and preservation of capital, I doubt investors will return to funds distributing 1.5-2.7% and losing capital as a bonus. The message to anyone contemplating buying a fund is compare the distribution yields versus buy MM funds, CDs, treasuries, corporate and agency notes. Buying a CEF that pays 8-9% distributions could be okay if you are willing to take risk and tolerate the volatility. But buying a passive bond fund that pays 1.5-2.7% in distributions while offering no capital protection in this rate environment is insane. We are in a different rate environment now and investments funds that thrived in zero rate environments will not thrive in this one.

Here are past discussions on stale pricing.

https://www.advisorperspectives.com/...fund-investors

https://www.early-retirement.org/fo...in-order-to-buy-cds-115703-2.html#post2845728

So are you saying the main issue with the yield gap is stale pricing? I'm a bit confused because when I brought that up earlier in this thread you posted that was a whole other issue.

 

[Freedom56]

So are you saying the main issue with the yield gap is stale pricing? I'm a bit confused because when I brought that up earlier in this thread you posted that was a whole other issue.

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.

 

[RobertTN]

I don't understand this change in holding bond funds due to a bad 2022. How is this different from stopping holding equities due to 2022? You have a long term plan that makes simplicity and long term gains the priority. One year changes the results, and scraps the whole plan? Recency bias is pervasive and makes us all feel safer. If you like to buy individual bonds, by all means keep doing that. But don't let one year change your long term plan of simplicity.
YMMV.

VW

Great point!

 

[foxfirev5]

Seriously, I don't see a lot of the debate here. When I compare the market value, YTM, coupon etc of my rolling CD/Treasury ladder to an intermediate treasury fund I see no noticeable difference. I can rationalize that I won't lose anything if I hold individual bonds to maturity, but I also see the NAV and monthly distributions of the funds increasing as well. In any event I'm planning on keeping my rolling ladder, LMP ladder and bond funds. Each serves a different purpose.

The only advantage that could be obtained would be a bond market timing call that I realized a long time ago I can not accomplish. It always looks easy in the rear view mirror. Rebalancing a little is as close as I'll get.

 

[COcheesehead]

Seriously, I don't see a lot of the debate here. When I compare the market value, YTM, coupon etc of my rolling CD/Treasury ladder to an intermediate treasury fund I see no noticeable difference. I can rationalize that I won't lose anything if I hold individual bonds to maturity, but I also see the NAV and monthly distributions of the funds increasing as well. In any event I'm planning on keeping my rolling ladder, LMP ladder and bond funds. Each serves a different purpose.

The only advantage that could be obtained would be a bond market timing call that I realized a long time ago I can not accomplish. It always looks easy in the rear view mirror. Rebalancing a little is as close as I'll get.

Par, the power of par. It’s not how fixed income begins that matters, but how it ends.

 

[foxfirev5]

Par, the power of par. It’s not how fixed income begins that matters, but how it ends.

Isn't it that way with everything?

Yeah, I'm done.

 

[Montecfo]

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.

Of course you would have the same issue if you held low coupon BONDS directly heading into 2022.

Comparing favorably high coupon rate bonds of today to low coupon rate bond FUNDS of the past is a bit unfair don't you think?

The average active investor in individual bonds would be holding those same low coupon bonds that those maligned bond funds are holding.

And no way to fix the problem except wait for maturities or sell at a huge loss, you know, just like those bond fund managers.

I assume you issued the same warning to yourself. The issue was certainly not unique to bond funds.

My messaging and strategy was to avoid DURATION, as I did, beginning in 2021.