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Author: trptrade Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35363  
Subject: Re: Timing bond purchases Date: 12/3/2009 8:28 PM
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At a theoretical limit of infinite years, constant interest rates, and no other market participants, laddering might be equivalent to a bond fund (I'm probably missing other criteria!).

Inside of that limit, it is not.

I'm going to flesh this out in characteristics and your main responsibility with each solution, I hope others will chime in if I miss anything.


- Bear bankruptcy risks of the specific companies whose bonds your purchase (nature of a bond), otherwise you get full coupon and principal payments in return
- Own individual bonds (more work going in than a fund, will have to buy new bonds each period of time)
- Can be challenging to sell individual bonds if your circumstances change and you need cash (e.g. see thread starting at 29205)
- Can precisely target your required "need" date (retirement, child in college, etc.)
- Pay bond purchase commissions
- Precisely known return at purchase (barring bankruptcy)

Responsibilities as an investor:
- Research the bonds (meaning the companies)
- Need to manage bankruptcy risk through diversification by holding a large mix of different companies. Go look at the partial portfolio listing in message 29159 to get an idea of how this would work (though I would note that Charlie [junkman02] does work at the lower end of the ratings spectrum, so if you're looking at AAA and government bonds, it will be much lower yields). Note that if you limit yourself to AAA and government bonds, there aren't a lot of AAA companies. While AAA bankruptcy risk is statistically low, I'd still be careful about how much concentration you have in any single company.

Bond Fund:
- Bear bankruptcy risks of the underlying companies (nature of a bond/bond fund)
- Own a single fund (appears easy) and can "dollar cost average" into the fund
- Easy to sell, primary risk appears to be pricing of the fund at the end of the day vs. previous day
- Fund will generally manage to a constant average maturity (target funds are the exception here)
- Pay bond fund fees
- Return will vary with the market, subject to other non-market risks.

Responsibilities as an investor:
- Research bond funds
- Need to manage maturity risks

"Maturity risks" here is a bit of a contrived term, by which I mean the risk of having assets you are forced to sell at a capital gain or loss. (Wish I could think of an actual term for this other than "inflation risk" which is not that great for this set of risks)

With a bond ladder, you can precisely target your "cash need" date, and ensure everything matures before that point (or sufficient funds mature at that point and you move some or all of them into risk-less assets while you wind down your other holdings to reduce risk). This may not be so with a fund (excepting target date funds).

Most funds are "intermediate" or "short" or some other description of the maturity they hold, which means they are maintaining a range of average maturity for the bonds. This is important, because it means on the date you sell the fund it will *still have the same average maturity* (give or take) as when you purchased the fund (because they have been rolling over the investments).

If, and ONLY if, interest rates are unchanged between now to when you sell, then you may (stress MAY, not WILL) come out "whole". If interest rates change, you bear principal gain/loss risk on the bonds. (It will be a loss if interest rates rise). This "interest rate risk" is the primary return that bond funds have experienced in the last 12 months.

I'm not intending to pick on or recommend any company - just found one early in the alphabet, but you can see this form of risk in a chart of AHBAX. You will see a huge plunge in the fund in Sep-Oct 08, followed by a rise from there. The plunge had to do with rising spreads on risky bonds (I chose a high yield and thus higher risk fund to amplify the example), not on interest rates (which were actually falling at the time, and thus would have been forcing the principal value upward - but was overwhelmed by the spread increase).

So what does that price change tell you? You bear risk that is concentrated on a single event (sell date). What you may find you need to do to manage that risk is to both "dollar cost average" into *as well as* "dollar cost average" OUT OF a fund as time progresses. Even that can't manage the entire risk, although it starts to manage the risk, it also starts to take a lot more time and can make it feel just as complicated to own a bond fund as it does to own individual bonds (because I'm not aware of any system that allows you to automate dollar cost averaging out of a fund)

Note through that period the fund does have yield, the charts will only show you the return on the principal. Some funds - can't find a quick example - will have a bias downward because they tend to purchase very high yield government bonds from the mid 80s, but purchase them at a premium. So they have great yields, but deliver capital losses to their holders. Note that this means you may pay higher shorter term taxes and have a capital loss at the end, which isn't all that great financially.

In addition, you also bear risk from being in a fund with others. This is the "non-market" risk I refer to above. Sometimes this is good. If the fund grows in assets significantly while you own the fund, you may see lower fees (or the bond fund might pocket the efficiencies, YMMV). You will also have a larger mix of "shorter term since purchase" assets in the fund, and that can reduce capital gains taxes... or make them worse. Fund growth can also mean the opposite, however, because what might be great returns to maturity could be diluted by other investors buying the fund. You can also end up with problems if a fund is forced to liquidate assets as people withdraw money, because they may be forced to sell assets at distressed prices (as happened late late year in bonds), thus that fund can never capture the yield to maturity of those bonds - leaving you holding the bag for the loss (note this cuts the other way as well, although I find that a lot less likely to happen)

These externalities (both being in a vehicle that has a constant maturity, including up to the day you sell), tax implications, as well as impact from other market participants, are important considerations when looking at a bond fund. You may find these are acceptable and find ways to manage the risk (e.g. dollar cost averaging out) - that's up to what you choose to do as an investor. Just don't consider a ladder completely equivalent to DCA into a bond fund.

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