Two types of bond ladders; When to replace a bond fund/ETF

[Freedom56]

ETA: Great advice, the following is just further explainer and additional questions:

The WHY here is because CEF's don't have to worry about forced redemptions (sell low) or forced purchases (buy high).

Freedom, one of my worries about CEF's is that many are leveraged, i.e. they borrow short to buy long. Just pointing this out to others who might get suckered into a CEF leveraged fund when short term rates are going against them (as in now).

OTOH, do you have any thoughts regarding decent non-leveraged bond CEF's? Especially ones that might invest in areas that are more difficult to purchase individual bonds (e.g. foreign or as a way to limit singe issuer risk, e.g. lower-quality bonds).

One more question/thoughts - are there any advantages regarding taxes on funds that have realized tax-losses on holdings? That is, possible rationale to purchase these in a taxable account?

The time to buy CEFs is about one month before the last rate hike. The portfolio coupon obviously has to be higher than current short term rates or leverage makes no sense. Many have financed their leverage at low rates from late 2020 through 2021 so they can maintain their distributions for now. However when those financing agreements expire, the leverage expense will increase substantially but they also have the flexibility to deleverage. CEFs trade on distribution rate and not asset value which allows you to buy these at substantial discounts to asset value.
You can research the various leveraged and unleveraged CEFs here by asset class.

https://www.cefconnect.com/closed-end-funds-daily-pricing

 

[Echard]

I am new to this website and found it as a result of having confusion over bonds vs bond funds. I've now spent weeks researching the issue, including many of the threads on this web site and elsewhere.

There is a lot of controversy on this site regarding the value of bond funds. In objectively reading the posts, I see a lot of: a) apples vs oranges mixing of assumptions; b) some very insightful thoughts about the limitations of bond funds; and c) some wrong characterizations of bonds vs bond funds.

A lot of the confusion comes from different assumptions by different posters. Setting aside the legitimate concerns about bond funds, like companies trying to issue debt at below market rates to be picked up by passive index funds, the fundamental issue between bonds and funds comes down to reinvestment actions of dividend and capital gain proceeds.

A bond fund maintains a relatively constant duration, and as interest rates vary, the "breakeven" date between holding bonds to maturity vs a fund is always changing. If rates keep rising multiple times, that "breakeven" date pushes out further and further. That is what is happening right now. Academic research shows that if rates rise 1% per year for several years in a row, it takes 2xDuration Years Minus 1 Year to breakeven. That's a long time.

So if someone needs to liquidate their holdings in the future before the breakeven date, they lose money as compared to just having bonds that mature on the date they need the money. They had to endure low distribution rates from the bond fund, and never received the capital gains that the bond funds would receive over time. So from that standpoint, investing in bond funds vs bonds is bad if you will need to liquidate funds at some point in the future. Even if you need funds at the duration date, you could lose money in a bond fund vs bonds if interest rates had kept rising during the years.

So this is the fundamental issue of holding bond funds vs bonds. What it implies is that as you get older, if you will eventually liquidate those funds you need to start thinking about transitioning out of funds and into bonds, so that you don't find yourself at the time of liquidation in a high rate environment and a beaten down NAV. Or, you can hope that rates are neutral or dropping, in which case you would actually make more money.

Some of the other characterizations of the negatives of bond funds weren't correct. Examples were given of selling bonds after the prices had declined, either in order to meet customer redemption requirements or to buy other bonds. Those actions by themselves have no additional impact on the bond fund. The NAV was already impacted by the rise in interest rates. Holding or selling a bond at that point makes no difference on the future return as long as the proceeds are reinvested in new bonds at the higher interest rate. It will be the same either way. The article referenced at the beginning of this thread highlights this. Also, redemptions don't matter either. The losses being "locked in" during the redemption are being born by the person doing the redemption, not people who remain invested in the bond fund.

A lot of the arguments I see in this thread and elsewhere come from people having different assumptions about when the money is liquidated from the bond investment, and whether funds are reinvested or not.

 

[copyright1997reloaded]

I am new to this website and found it as a result of having confusion over bonds vs bond funds. I've now spent weeks researching the issue, including many of the threads on this web site and elsewhere.

There is a lot of controversy on this site regarding the value of bond funds. In objectively reading the posts, I see a lot of: a) apples vs oranges mixing of assumptions; b) some very insightful thoughts about the limitations of bond funds; and c) some wrong characterizations of bonds vs bond funds.

A lot of the confusion comes from different assumptions by different posters. Setting aside the legitimate concerns about bond funds, like companies trying to issue debt at below market rates to be picked up by passive index funds, the fundamental issue between bonds and funds comes down to reinvestment actions of dividend and capital gain proceeds.

A bond fund maintains a relatively constant duration, and as interest rates vary, the "breakeven" date between holding bonds to maturity vs a fund is always changing. If rates keep rising multiple times, that "breakeven" date pushes out further and further. That is what is happening right now. Academic research shows that if rates rise 1% per year for several years in a row, it takes 2xDuration Years Minus 1 Year to breakeven. That's a long time.

So if someone needs to liquidate their holdings in the future before the breakeven date, they lose money as compared to just having bonds that mature on the date they need the money. They had to endure low distribution rates from the bond fund, and never received the capital gains that the bond funds would receive over time. So from that standpoint, investing in bond funds vs bonds is bad if you will need to liquidate funds at some point in the future. Even if you need funds at the duration date, you could lose money in a bond fund vs bonds if interest rates had kept rising during the years.

So this is the fundamental issue of holding bond funds vs bonds. What it implies is that as you get older, if you will eventually liquidate those funds you need to start thinking about transitioning out of funds and into bonds, so that you don't find yourself at the time of liquidation in a high rate environment and a beaten down NAV. Or, you can hope that rates are neutral or dropping, in which case you would actually make more money.

Some of the other characterizations of the negatives of bond funds weren't correct. Examples were given of selling bonds after the prices had declined, either in order to meet customer redemption requirements or to buy other bonds. Those actions by themselves have no additional impact on the bond fund. The NAV was already impacted by the rise in interest rates. Holding or selling a bond at that point makes no difference on the future return as long as the proceeds are reinvested in new bonds at the higher interest rate. It will be the same either way. The article referenced at the beginning of this thread highlights this. Also, redemptions don't matter either. The losses being "locked in" during the redemption are being born by the person doing the redemption, not people who remain invested in the bond fund.

A lot of the arguments I see in this thread and elsewhere come from people having different assumptions about when the money is liquidated from the bond investment, and whether funds are reinvested or not.

While I agree with some of what you state, a simple question for you. Let's say a bond funds NAV declines because of their holdings declining in value, i.e. they have to "mark to market" everyday. Further, let's say that some of their holders of the fund see the NAV declined and decide to sell the bond fund. The bond fund now is seeing funds outflow vs. funds inflow. Can they a) ignore it (NO) b) sell holdings to fund the withdrawls (YES).

Thus funds are FORCED to sell in a market downturn if/when they see withdrawals.

The only question then becomes WHAT holdings they decide to sell. If they sell holdings with gains, they will be forced to also distribute said capital gains even though the fund NAV is falling. That might be quite distasteful to an investor who a) loses money (i.e. falling NAV) and b) now has a tax bill.

They could also sell "Losers" , i.e. bonds most impacted by the increasing rates/falling prices.

What they do is up to them, but as an investor, I like those decisions to be made by ME.

Having said the above, I like funds for their ability to diversify and remove narrow holding risk, and theoretically at least their ability to "pick" better than I.

 

[mrfeh]

I am new to this website and found it as a result of having confusion over bonds vs bond funds. I've now spent weeks researching the issue, including many of the threads on this web site and elsewhere.

There is a lot of controversy on this site regarding the value of bond funds. In objectively reading the posts, I see a lot of: a) apples vs oranges mixing of assumptions; b) some very insightful thoughts about the limitations of bond funds; and c) some wrong characterizations of bonds vs bond funds.

A lot of the confusion comes from different assumptions by different posters. Setting aside the legitimate concerns about bond funds, like companies trying to issue debt at below market rates to be picked up by passive index funds, the fundamental issue between bonds and funds comes down to reinvestment actions of dividend and capital gain proceeds.

A bond fund maintains a relatively constant duration, and as interest rates vary, the "breakeven" date between holding bonds to maturity vs a fund is always changing. If rates keep rising multiple times, that "breakeven" date pushes out further and further. That is what is happening right now. Academic research shows that if rates rise 1% per year for several years in a row, it takes 2xDuration Years Minus 1 Year to breakeven. That's a long time.

So if someone needs to liquidate their holdings in the future before the breakeven date, they lose money as compared to just having bonds that mature on the date they need the money. They had to endure low distribution rates from the bond fund, and never received the capital gains that the bond funds would receive over time. So from that standpoint, investing in bond funds vs bonds is bad if you will need to liquidate funds at some point in the future. Even if you need funds at the duration date, you could lose money in a bond fund vs bonds if interest rates had kept rising during the years.

So this is the fundamental issue of holding bond funds vs bonds. What it implies is that as you get older, if you will eventually liquidate those funds you need to start thinking about transitioning out of funds and into bonds, so that you don't find yourself at the time of liquidation in a high rate environment and a beaten down NAV. Or, you can hope that rates are neutral or dropping, in which case you would actually make more money.

Some of the other characterizations of the negatives of bond funds weren't correct. Examples were given of selling bonds after the prices had declined, either in order to meet customer redemption requirements or to buy other bonds. Those actions by themselves have no additional impact on the bond fund. The NAV was already impacted by the rise in interest rates. Holding or selling a bond at that point makes no difference on the future return as long as the proceeds are reinvested in new bonds at the higher interest rate. It will be the same either way. The article referenced at the beginning of this thread highlights this. Also, redemptions don't matter either. The losses being "locked in" during the redemption are being born by the person doing the redemption, not people who remain invested in the bond fund.

A lot of the arguments I see in this thread and elsewhere come from people having different assumptions about when the money is liquidated from the bond investment, and whether funds are reinvested or not.

Nice to see somebody thinking objectively. This site has been dominated by knee-jerk reactions in 2022.

I am quite happy interest rates have risen because a) I'm not selling any of my total bond fund shares and b) it means higher total return in the years ahead.

 

[Freedom56]

A bond fund maintains a relatively constant duration, and as interest rates vary, the "breakeven" date between holding bonds to maturity vs a fund is always changing. If rates keep rising multiple times, that "breakeven" date pushes out further and further. That is what is happening right now. Academic research shows that if rates rise 1% per year for several years in a row, it takes 2xDuration Years Minus 1 Year to breakeven. That's a long time.

Think about that statement for a minute. Rates will have risen 4.5% this year after the December rate hike. That means TLT which has an average 18 year duration and a distribution yield of 2.2% will take 81 years (4.5 x 18) to break even or BND with an average 6.8 year duration and a distribution yield of 2.4% will take 30.6 years (4.5 x 6.8) to break even. Your statement, "that's a long time" really understates the issue when you consider human mortality.

Bonds are for generating income. When coupons approach the low single digits, zero, or negative, they are no longer generating sufficient income and therefore un-investible. Passive bond funds ignore that reality and this is why they are bloated with so much low coupon debt.

 

[audreyh1]

That might be quite distasteful to an investor who a) loses money (i.e. falling NAV) and b) now has a tax bill.

A bond fund generally only pays out capital gains distributions when interest rates are falling, and these cap gains distribution payouts are quite modest.

Even if a bond fund is being forced to sell holdings in a down market, that is can be a buying opportunity for the individual bond fund investor.

 

[copyright1997reloaded]

A bond fund generally only pays out capital gains distributions when interest rates are falling, and these cap gains distribution payouts are quite modest.

Just like a stock fund, it depends on what their basis is in the security. For a long term bond fund, it is possible that they have bonds purchased 10-15 years ago. I just sold some TIPS that I had purchased circa 2009. I had a capital gain in them.

Even if a bond fund is being forced to sell holdings in a down market, that is can be a buying opportunity for the individual investor.

Yes, that is true. But only knowable in hindsight, and doesn't really answer my query regarding being a forced (due to funds flow) sale. My point is that the fund (also true for non-closed-end stock funds) need to take actions that they might not want to take due to the "madness of crowds" (i.e. scared investors).

 

[audreyh1]

Just like a stock fund, it depends on what their basis is in the security. For a long term bond fund, it is possible that they have bonds purchased 10-15 years ago. I just sold some TIPS that I had purchased circa 2009. I had a capital gain in them.

Yes, that is true. But only knowable in hindsight, and doesn't really answer my query regarding being a forced (due to funds flow) sale. My point is that the fund (also true for non-closed-end stock funds) need to take actions that they might not want to take due to the "madness of crowds" (i.e. scared investors).

The whole forced selling does not concern me at all. “Madness of crowds” is what markets do. For me it represents a buying opportunity.

My bond index funds did not pay any capital gains distributions this year, just as the estimate had indicated. I did not expect them either, because of the limited scenarios in which my bond funds have paid capital gains distributions.

 

[Freedom56]

I don't believe Bogleheads understand that bond fund distributions are low and even well below their average coupon because they are realizing capital losses every month. Consider this ultra short duration bond ETF, SPDR® Bloomberg 1-3 Month T-Bill ETF. This has to be one of the biggest grifts created by the fund industry. A money market fund currently yields almost 4 times this fund.

https://www.ssga.com/us/en/intermed...gLScQli2XR2Cd2EasUsaAtKBEALw_wcB&gclsrc=aw.ds

It has a duration of .16 years and claims an SEC yield of 3.47% and while we are in the 12th month of they year, this fund has a distribution yield of only 1.01% and that's up from .04% at the beginning of this year. So what happened to the break-even? Why are distribution still so low? Where are the "capital gains" payouts? This is an example of why passive bonds funds are a complete scam.

 

[Echard]

Yes, having the bond fund decide the taxation is an additional challenge with bond funds vs bonds.

On the topic of long duration bonds, that really is a big question. 18-36 years for those bonds to "breakeven" is a challenge. Under that scenario, you'd have to bet that rates would eventually moderate and you'd be reinvesting that whole time, otherwise it really doesn't make sense does it?

On the issue of low monthly/quarterly distributions of the bond funds, they SHOULD be moving upward pretty rapidly, but it's hard to calculate how fast those distributions should rise, creating further uncertainty.

 

[copyright1997reloaded]

I don't believe Bogleheads understand that bond fund distributions are low and even well below their average coupon because they are realizing capital losses every month. Consider this ultra short duration bond ETF, SPDR® Bloomberg 1-3 Month T-Bill ETF. This has to be one of the biggest grifts created by the fund industry. A money market fund currently yields almost 4 times this fund.

https://www.ssga.com/us/en/intermed...gLScQli2XR2Cd2EasUsaAtKBEALw_wcB&gclsrc=aw.ds

It has a duration of .16 years and claims an SEC yield of 3.47% and while we are in the 12th month of they year, this fund has a distribution yield of only 1.01% and that's up from .04% at the beginning of this year. So what happened to the break-even? Why are distribution still so low? Where are the "capital gains" payouts? This is an example of why passive bonds funds are a complete scam.

This is a weird one - they hold ONLY T-Bills, i.e. zero coupon. See attached.
I'm also attaching a spreadsheet of their holdings, in which I added a new column (profit/loss) for each holding. Their holdings are updated daily, so this is pretty much up to date.

ETA: The site won't let me upload the spreadsheet, so I converted it to a pdf.

 

[COcheesehead]

Some of the other characterizations of the negatives of bond funds weren't correct. Examples were given of selling bonds after the prices had declined, either in order to meet customer redemption requirements or to buy other bonds. Those actions by themselves have no additional impact on the bond fund. The NAV was already impacted by the rise in interest rates. Holding or selling a bond at that point makes no difference on the future return as long as the proceeds are reinvested in new bonds at the higher interest rate. It will be the same either way. .

Your statement is confusing at best and likely wrong. If a fund is forced to sell bonds due to redemptions, there are no longer funds to reinvest at the higher rate. The fund needs cash for redemptions. The loss is incurred and takes away from the NAVs ability to float back upward. Repeating this procedure over time is known as redemption drag and has a material impact on a fund.

 

[daylatedollarshort]

Yes, having the bond fund decide the taxation is an additional challenge with bond funds vs bonds.

On the topic of long duration bonds, that really is a big question. 18-36 years for those bonds to "breakeven" is a challenge. Under that scenario, you'd have to bet that rates would eventually moderate and you'd be reinvesting that whole time, otherwise it really doesn't make sense does it?

On the issue of low monthly/quarterly distributions of the bond funds, they SHOULD be moving upward pretty rapidly, but it's hard to calculate how fast those distributions should rise, creating further uncertainty.

Specifically, if you have read the Forbes and Kiplinger articles posted in this thread, what is incorrect in either ones' advice? Why not switch to individual bonds in a rising rate environment? Why stay with a bond fund and go down with the ship? The long duration funds aren't really a question for many of us here. Why would you stay invested in a fund on the hopes that some day the yields might go up, when you could be making more money elsewhere today with less market risk?

 

[Freedom56]

This is a weird one - they hold ONLY T-Bills, i.e. zero coupon. See attached.
I'm also attaching a spreadsheet of their holdings, in which I added a new column (profit/loss) for each holding. Their holdings are updated daily, so this is pretty much up to date.

ETA: The site won't let me upload the spreadsheet, so I converted it to a pdf.

You can buy a 1 month bill with a yield of 3.79% and a 3 month bill with yield of 4.313% today. So why does this fund still distribute only 1% with an expense ration of .1354% and such a short duration? I will wait for Boglehead to explain why their BS theories can't explain what is happening here. The reality is that short duration bond funds are realizing capital losses at a higher rate than longer duration funds and this is impacting their distributions. Then the hidden trading fees also come into play that the fund manager is pocketing or grifting from investors.

 

[daylatedollarshort]

The NAV was already impacted by the rise in interest rates. Holding or selling a bond at that point makes no difference on the future return as long as the proceeds are reinvested in new bonds at the higher interest rate.

Unless the NAV prices are stale, which is a known issue - "Whereas the potential for a fund run induced by costly liquidation of illiquid securities remains even if fund NAVs are accurate, we point to an even more severe problem: fund values can be predictably wrong over long periods and investors also appear to be aware of this; they respond more strongly to a temporary overvaluation in addition to poor recent performance. Stale NAVs can thereby further exacerbate the fragility of bond funds, making it a cause for concern from a financial stability perspective." Sitting bucks: Stale pricing in fixed income funds - ScienceDirect