Sell bond index funds at a loss in order to buy CDs?

[COcheesehead]

Depends whether you believe they can maintain that going forward, given that they're actively traded funds with PDO being relatively new (Jan 2021 inception). I'd personally prefer to have the closest-to-guaranteed income stream available via treasury issues (mainly TIPS), even if in highsight it turns out to be less than what other sources might have produced. Everybody has different goals and where they choose to place their risk, especially during retirement.

Cheers,
Big-Papa

Both these funds over earn their distributions, by a lot. For fun let’s just say they dip a bit and now only pay 10% in distributions. Still nice - if you don’t care about the NAV.
One of the big difference of a bond ladder vs a fund is one has a value it will return to on a specific date - a par value. A fund does not. So isn’t that a guarantee in and of itself?

Complete disclosure, I’ve owned bond funds and have moved away. I run a taxable and tax free ladder now, so I am biased. I like having control over earning high interest, but also knowing I am preserving capital.

There are members on another forum I post on that have put large amounts of money in funds like PDI and the like and collect large sums of money. They don’t seem to care about the dwindling NAV either.

 

[big-papa]

Both these funds over earn their distributions, by a lot. For fun let’s just say they dip a bit and now only pay 10% in distributions. Still nice - if you don’t care about the NAV.
One of the big difference of a bond ladder vs a fund is one has a value it will return to on a specific date - a par value. A fund does not. So isn’t that a guarantee in and of itself?

Complete disclosure, I’ve owned bond funds and have moved away. I run a taxable and tax free ladder now, so I am biased. I like having control over earning high interest, but also knowing I am preserving capital.

There are members on another forum I post on that have put large amounts of money in funds like PDI and the like and collect large sums of money. They don’t seem to care about the dwindling NAV either.

Yep, I understand completely the benefits of an actual ladder and the control one can have if one is willing to put in the time and effort.

Regarding the return of principal on a specific date, one can make the argument that this still exists, effectively, with bond funds even when they don't actually hold the underlying bonds to maturity since it will be part of the overall cost when they buy/sell any of their underlying bonds. But as a holder of a bond fund, you definitely don't have direct control over that, as would be the case of an actual ladder you built and hold.

Cheers
Big-Papa

 

[Lsbcal]

Thanks, everyone, for the sage (albeit varying!), advice.

I've just about finished moving the money we need for the next 3-4 years into a CD ladder. That money was in money markets, so I didn't have to sell any bond funds.

The money we need for years 5-12 is the money I'm most concerned about. That money is primarily in various bond index funds. As I understand it, bond index funds should eventually "catch up" to the rising interest rates and the prices should start rising again, as the shorter term bonds in the portfolios age out and newer bonds are purchased. Is my understanding basically correct?

If so, then perhaps sitting pat is the right thing to do, or maybe just selling enough for a couple more years of spending and leaving the rest be.

I have no trouble at all leaving equity funds to rise and fall, but bond funds have been bad-mouthed by so many in this community that I thought perhaps I should take this opportunity to get out of them and into CDs. A few of you agreed with me. Others counseled me to hold my original course.

I look forward to more wisdom and advice.

There was a very bad bond market rout in 1994. Not as bad as this year but here is what happened back then to some Vanguard bond funds:

VMBFX = total bond market
VFSTX = short term investment grade

So it was a big mistake back then to sell in late 1994. Not clear history will repeat.

FWIW, I don't personally own any bond funds, just individual bonds. But might purchase some short term investment grade (VFSUX) if the SP500 takes off. This is a method I researched based on the past 30 years of bond behavior.

 

[Freedom56]

Regarding the return of principal on a specific date, one can make the argument that this still exists, effectively, with bond funds even when they don't actually hold the underlying bonds to maturity since it will be part of the overall cost when they buy/sell any of their underlying bonds. But as a holder of a bond fund, you definitely don't have direct control over that, as would be the case of an actual ladder you built and hold.

Cheers
Big-Papa

I don't see how you can make that argument. Look at two of the largest bonds funds BND and AGG. Both are now below their inception prices from 2007 and 2003. There is no maturity date for a perpetual bond fund and after they update their performance at the end of this month, many will have negative TOTAL returns over the past decade. Even short term bond fund are negative this year. Whereas rolling short term notes or CDs or floating money in a money market fund would result in more income and positive returns. Bond funds are holding too much low coupon debt and most sell bonds that are less than one year from maturity (duration stripping) at a loss. For example a bond or note with a 0.4% coupon with one year to maturity would be trading about $95 or less and fund selling that today would realize a loss. The fund more than likely bought that note when rates were near zero, but with rising rates they are forced into selling that note at a loss. Also as people exit these bond funds, the are forced to liquidate their holding at a loss. The fact that BND and AGG have failed to grow their capital after almost two decades is a clear indicator that these bond funds have no ability to preserve capital.

 

[Exchme]

I worry this thread will confuse people into thinking there is something magic about individual bonds vs. funds.

Bonds and bond funds (of the same duration, credit risk, etc.,) both suffer the same loss of present value when interest rates rise. Since bond funds are traded, this is expressed as a reduction in NAV and an immediate change to current high yields. Individual bonds do not duck the loss. Instead, the individual bond spreads the loss out over the life of the bond as you continue to get paid a low rate while the rest of the world has move on to higher rates. The discounted cash flow gives the same present value as a fund, set by the market's expectation on the discount rate.

If folks stop and think for a moment, if there really were a difference in present value, that would be quite an astonishing thing. We would have to believe that some folks on this board see an opportunity that the professionals, armed with PhDs, supercomputers, tiny transaction costs and boatloads of cash somehow missed.

 

[COcheesehead]

Individual bonds are one the most predictable assets you can own. It’s just math. You know what you are going to get, when you are going to get it and what you will have in the end - short of default - and you will know all of this info when you buy it.
A bond fund? No
An equity? No

And I will not have any management expense drag or redemption drag as I would with a fund.

 

[Lsbcal]

I worry this thread will confuse people into thinking there is something magic about individual bonds vs. funds.

Bonds and bond funds (of the same duration, credit risk, etc.,) both suffer the same loss of present value when interest rates rise. Since bond funds are traded, this is expressed as a reduction in NAV and an immediate change to current high yields. Individual bonds do not duck the loss. Instead, the individual bond spreads the loss out over the life of the bond as you continue to get paid a low rate while the rest of the world has move on to higher rates. The discounted cash flow gives the same present value as a fund, set by the market's expectation on the discount rate.

If folks stop and think for a moment, if there really were a difference in present value, that would be quite an astonishing thing. We would have to believe that some folks on this board see an opportunity that the professionals, armed with PhDs, supercomputers, tiny transaction costs and boatloads of cash somehow missed.

Kind of agree with you. I did not buy bonds or bond funds when they were in the negative/low yield phase. Bond funds (particularly bond index funds) had to participate no matter what the rates were. Now it feels like it is a more normalized situation. And bonds in bond funds are always marked to market.

I am buying individual TIPS to fit our needs (covers my RMDs). I realize not everyone has tax deferred space to buy TIPS.

 

[njhowie]

And bonds in bond funds are always marked to market.

Well, there's one place where there is a distinct difference. Holding individual bonds they are likewise marked to market. However, when you buy/sell your fund, you are doing so at the mark to market. When I buy/sell my individual bonds it's never at the mark to market - I always buy below mark to market, and if/when I sell it is always above mark to market.

 

[Lsbcal]

Well, there's one place where there is a distinct difference. Holding individual bonds they are likewise marked to market. However, when you buy/sell your fund, you are doing so at the mark to market. When I buy/sell my individual bonds it's never at the mark to market - I always buy below mark to market, and if/when I sell it is always above mark to market.

When I buy TIPS I do it only with the view of holding to maturity. So I don't really worry about real rates going up and my bonds loosing money. Currently they are paying very good rates (based on history) above inflation. So with these, I am not trying to get great capital gains.

 

[Freedom56]

I worry this thread will confuse people into thinking there is something magic about individual bonds vs. funds.

Bonds and bond funds (of the same duration, credit risk, etc.,) both suffer the same loss of present value when interest rates rise. Since bond funds are traded, this is expressed as a reduction in NAV and an immediate change to current high yields. Individual bonds do not duck the loss. Instead, the individual bond spreads the loss out over the life of the bond as you continue to get paid a low rate while the rest of the world has move on to higher rates. The discounted cash flow gives the same present value as a fund, set by the market's expectation on the discount rate.

If folks stop and think for a moment, if there really were a difference in present value, that would be quite an astonishing thing. We would have to believe that some folks on this board see an opportunity that the professionals, armed with PhDs, supercomputers, tiny transaction costs and boatloads of cash somehow missed.

With those holding bond funds, take a good look at what they have been earning in distributions since the beginning of they year. Most distributions have not budged even though money market, treasuries, CDs, and corporate bond yields have increased 4 to 5 fold. With current high grade corporate bonds now yielding 6-6.75% with the only risk of being called after one year, is it any wonder why people continue to dump bond funds despite the rout year to date. Investors are choosing to lock in 5 year CDs at 4.8% rather than buy a bond fund with a pathetic distribution yield of 2.4% with a mythical SEC yield of 4.6% and no capital protection. Yes as rates continue to rise, the value of the CDs or bonds will drop but the bond fund will drop even more. After 5 years, the CD holder has earned 4.8% annually and is able to compound that interest at higher yields, and 100% of the capital is returned. The bond fund has no such guarantees.

Bond funds are in the predicament they are because they just buy due to fund flows regardless of the yields. An individual bond holder would never lock 5 year notes at .5% or 30 year bonds at 1.5% or even imagine buying bonds at negative yields. However funds do that and have done that because they can. They lose "other peoples money" and still collect management fees and scam investors with hidden trading fees. There is no incentive to change anything. The longer the duration of the fund, the more doomed they are. An individual bond investor is constantly adjusting durations to optimize of the best yields and interest rate risk. They often just hold cash or select the shortest duration when yields are too low to lock in long term. This is normal behavior. Passive bond funds are always invested no matter how low the yields are. They are not designed for rising rate environments. Yes an individual bond will drop in value as rates rise. However, if the durations are short, they will quickly recover as the bond approaches maturity. As others have stated, bond are the most predictable assets just like CDs. You know what your yield and coupon payments are when you buy the bond and your capital is returned when you buy at par or you realize a gain if you buy below par at maturity or call. A bond fund offers no capital protection nor any predictable distribution. They are forced into selling at a loss every time rates rise. This is a fact of life.

If anyone believes if rates suddenly reversed course and started to fall again, that bond funds yielding 2.4% are going to outperform bonds individual bonds/CDs with coupons of 4.5-6.75% just defies common sense. The higher coupon bonds are always bought first and bid up.

 

[njhowie]

When I buy TIPS I do it only with the view of holding to maturity. So I don't really worry about real rates going up and my bonds loosing money. Currently they are paying very good rates (based on history) above inflation. So with these, I am not trying to get great capital gains.

You say capital gain, I say total return.

I likewise buy with a view of holding to maturity. However, when there is insanity in the bond markets where folks are bidding up prices to extremes (as we saw just a year ago), it is only prudent (in my view) to take advantage of locking in those gains, which may amount to 2, 3 or more years of interest payments.

 

[Freedom56]

Bond funds are not marked to market with their asset values. Stale pricing is a serious risk to bond fund investors. Most bonds rarely trade or if they do, it may be a small fraction of the outstanding amount for that issue. When you buy an individual bond or CD, brokerage firms update your price daily using a 3rd party pricing estimate which is very conservative and tends to undervalue your bonds by 3-4% or even more. For example I had bond schedule for a call at the end of September at a price just above par for the early call. The last trades on the bonds were in the range of $100.40 to 100.60. However the third party prices valued the bond all the way to the date of the call below par at $98-$99. Bond funds have no standardized method of estimating the market value of a bond. In an environment where rates are rising fast, most bond funds are overstating their asset values.

https://www.advisorperspectives.com...e-pricing-and-the-risk-to-bond-fund-investors

 

[daylatedollarshort]

It seems to me like a some fund marketing groups out there have done a good job of convincing at least some investors that bonds and bond funds both have equal market risk, to make bond funds seem less volatile than they actually are. Bonds only have market risk if you sell prior to maturity. Bond funds without maturity dates are volatile, as we saw last year when rates went to near zero, and the funds went up, and this year when rates are going up significantly, many of the bond funds are crashing now.

The fact that bonds have no market risk if held to maturity is pretty clearly in most investing books, including The Bond Book, and most investing web sites, including those for Fidelity, Investopedia and The St Louis Fed -"Of course, market risk is not an issue for investors who hold bonds to maturity because the face value, not the market value, of the bond is received at maturity."

Bonds are much less volatile than bond funds. That is simply math. You may or may not get your original investment back with the funds, and in longer maturity duration funds if rate go up significantly you could lose half your original investment.

You can back test an investment in almost any bond or TIPS fund 5 or 10 years ago, compared to that same investment in individual bonds or TIPS made at the same time, if you needed the money today, and see how that would have worked out.

ETA: The 5 year back test numbers may not show the same loss on as many funds as a week or two ago because current yields on some bonds dropped. The NAV numbers will change as often as current yields change.

 

[daylatedollarshort]

I worry this thread will confuse people into thinking there is something magic about individual bonds vs. funds.

Bonds and bond funds (of the same duration, credit risk, etc.,) both suffer the same loss of present value when interest rates rise. Since bond funds are traded, this is expressed as a reduction in NAV and an immediate change to current high yields. Individual bonds do not duck the loss. Instead, the individual bond spreads the loss out over the life of the bond as you continue to get paid a low rate while the rest of the world has move on to higher rates. The discounted cash flow gives the same present value as a fund, set by the market's expectation on the discount rate.

If folks stop and think for a moment, if there really were a difference in present value, that would be quite an astonishing thing. We would have to believe that some folks on this board see an opportunity that the professionals, armed with PhDs, supercomputers, tiny transaction costs and boatloads of cash somehow missed.

Did most of those experts know bond funds were going to crash this year? Because a lot of people on this forum did early this year and avoided some big bond fund losses. You can go back to January and February and see the posts. Kiplinger's recommends moving between bonds and bond funds to where ever one can get the best yields - Bonds Are Having a Rough Year. Here Are 3 Actions That Can Help | Kiplinger. I do actually think a lot of financial "experts" don't get that is an option.

Freedom56 has stated this pretty simply in past threads. You can get 4.5% in one year Treasuries right now with no market risk, or earn less yield in a fund with more market risk. A bunch of formulas and charts from people who throw around terms like indifference points and curves doesn't really change basic bond math. It is actually pretty simple.

 

[Freedom56]

What the bond fund marketing groups don't want to admit is that market timing is appropriate for fixed income investing and is generally normal behavior. How many people are complaining about low CD rates today? How many are complaining about buying a note from Goldman Sachs at with a 6.75% coupon and 5 duration years today, versus 1.6% and 6 years duration a year ago? The only decision is selecting the best duration as rates rise.

As most of the rate hikes are behind us, investors have to consider a scenario where rates stay at these levels for an extended period of time. This is not a period of high rates but a period of normal rates that we had prior to 2008/2009. The zero interest rate environment was abnormal. Those that believe a fund holding a portfolio of 1.6% notes with 5 years duration remaining is somehow going to outperform a bond with the same duration and 6.75% coupon are in complete denial.

 

[daylatedollarshort]

Once you've set this up, you really don't care anymore about the NAV or market value of the underlying bond funds being used.

So if you needed money today, and five years ago put $10K in a TIPS fund and $10K in 5 year TIPS sold at par, you wouldn't care that the TIPS gained 20% in principal and the fund lost NAV. I don't get that, but your money, your choices. I buy I bonds and TIPS to keep up with inflation.

 

[njhowie]

Bond funds are not marked to market with their asset values.

For the most part they are. How else do you explain NAV changing day to day?

 

[Freedom56]

For the most part they are. How else do you explain NAV changing day to day?

They update it for bonds that traded that day which impacts the NAV. On a given day only a small percentage of bond actually trade. Many bonds in a fund's portfolio haven't traded for months and the asset values reflect last traded values from early 2022. Many funds are surprising investors with downside revisions to NAV as they mark down their portfolio. This is why many advisors are warning investors of stale pricing of bond fund NAVs.

 

[Lsbcal]

They update it for bonds that traded that day which impacts the NAV. On a given day only a small percentage of bond actually trade. Many bonds in a fund's portfolio haven't traded for months and the asset values reflect last traded values from early 2022. Many funds are surprising investors with downside revisions to NAV as they mark down their portfolio. This is why many advisors are warning investors of stale pricing of bond fund NAVs.

Are you referring to somewhat speculative bond funds? What about Treasury funds or something like Vanguard Total Bond Market?

 

[daylatedollarshort]

For the most part they are. How else do you explain NAV changing day to day?

This research paper estimates the stale pricing loss for buy and hold bond fund investors in general at about 40 basis points per year - Download PDF | Stale Prices and the Performance Evaluation of Mutual Funds (researchgate.net).


ETA: Removed the part about stale pricing not being a problem for funds that only held frequently traded bonds, after seeing Freedom56's post and link.

 

[Freedom56]

Are you referring to somewhat speculative bond funds? What about Treasury funds or something like Vanguard Total Bond Market?

This applies to all bond funds. See the study linked below.

"Second, rapid growth in the bond fund sector has raised incentives for funds to use valuation discretion, for example, by engaging in return-smoothing.8 Such incentives are particularly strong for funds that have suffered from poor performance and when funds face higher risks of outflows."

You should call Vanguard and ask them how they calculate NAVs for their bond funds. The reason people are raising the alarm is that the reported YTM and average coupon do not correlate with the current prices for bonds of the same duration and rating.

https://www.sciencedirect.com/science/article/abs/pii/S0304405X21003706

 

[Lsbcal]

This applies to all bond funds. See the study linked below.

"Second, rapid growth in the bond fund sector has raised incentives for funds to use valuation discretion, for example, by engaging in return-smoothing.8 Such incentives are particularly strong for funds that have suffered from poor performance and when funds face higher risks of outflows."

You should call Vanguard and ask them how they calculate NAVs for their bond funds. The reason people are raising the alarm is that the reported YTM and average coupon do not correlate with the current prices for bonds of the same duration and rating.

https://www.sciencedirect.com/science/article/abs/pii/S0304405X21003706

I took a very brief peak at your link. It sounds like they are talking about funds that hold fairly illiquid bonds. Treasury funds do not fit that description. I'm not sure what funds they are referring to but they seem to reference high yield bond funds a lot. I don't own any bond funds and have never bought high yield funds preferring to instead buy a proper mix of equities (risk) and moderate risk low duration bond funds (when I choose to own bond funds).

 

[Freedom56]

I took a very brief peak at your link. It sounds like they are talking about funds that hold fairly illiquid bonds. Treasury funds do not fit that description. I'm not sure what funds they are referring to but they seem to reference high yield bond funds a lot. I don't own any bond funds and have never bought high yield funds preferring to instead buy a proper mix of equities (risk) and moderate risk low duration bond funds (when I choose to own bond funds).

Most corporate bonds are illiquid and most funds hold corporates with treasury bonds or they are near 100% corporate bonds. Take a look at Vanguard's total bond fund and you will find thousands of corporate bonds and many that rarely trade. Again the YTM, coupon, and duration do not correlate with bonds yields that are current. This is a strong indicator that funds are using stale pricing. If a high grade note from Apple with a duration of 8 years is trading at a YTM of 6.2% why would a bond fund with the same duration trade with a YTM of 4.7%? There are many in the financial community out there who are seeing these discrepancies and are raising the alarm.

 

[Lsbcal]

Most corporate bonds are illiquid and most funds hold corporates with treasury bonds or they are near 100% corporate bonds. Take a look at Vanguard's total bond fund and you will find thousands of corporate bonds and many that rarely trade. Again the YTM, coupon, and duration do not correlate with bonds yields that are current. This is a strong indicator that funds are using stale pricing. If a high grade note from Apple with a duration of 8 years is trading at a YTM of 6.2% why would a bond fund with the same duration trade with a YTM of 4.7%? There are many in the financial community out there who are seeing these discrepancies and are raising the alarm.

I will have to assume you are right about Total Bond Mkt. But what about short term investment grade (VFSUX)? And what about intermediate Treasury (VFIUX)? Those are the ones I would be interested in.

 

[Freedom56]

I will have to assume you are right about Total Bond Mkt. But what about short term investment grade (VFSUX)? And what about intermediate Treasury (VFIUX)? Those are the ones I would be interested in.

You and others that worship Vanguard need to see for yourself what VFSUX is holding. You can download the most recent holdings data and you will realize why this fund will never be able to distribute more than 2.3% for the next three years. See the link below. It is holding far too much low coupon debt. The top three holdings are:

BMCNFS3 TREASURY BOND 1.03% $684,603,869.40 $737,000,000.00 0.75% 11/15/2024
BMZ2XK5 TREASURY NOTE 1.00% $660,703,125.00 $750,000,000.00 0.38% 1/31/2026
BP82NF8 TREASURY NOTE 0.97% $644,425,000.00 $692,000,000.00 1.13% 1/15/2025

I really don't know why anyone would hold a fund that would buy a treasury note with a 0.38% coupon with a maturity of 2026. No doubt it made that purchase last year but since this fund does not hold securities to maturity, it will sell most of its holdings at a loss if rates stay around where they are today.

The fund is holding a lot of bank notes from the very same banks that many of us are buying. The problem is it is holding notes like 0.75% 2025 note from TD bank. However new issue 2025 notes from TD bank are in the now in the range of 6%. The same can be said about notes from CIBC, Bank of Montreal, Goldman Sachs, Citigroup, Credit Suisse, JP Morgan, Bank of America, Scotia Bank, Wells Fargo and others. The YTM of this fund is well below the average coupon for bonds in the secondary market with the same duration. This a warning sign that the net asset value is stale and being overstated. Not that YTM has any bearing on what this fund would earn given that it does not hold securities to maturity.

https://advisors.vanguard.com/inves...nvestment-grade-fund-admiral-shares#portfolio