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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35383  
Subject: Bond and F-I FAQs: Part 4 C Date: 2/14/2007 2:32 PM
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Aaargh!! My head is spinning! Can't I just put my money into a Total Bond Market Index fund, get average returns, and live happily ever after?
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• A Total Bond Market Index fund will get you average returns.
---The question is, average of what?

• The theory behind stock indexing is that stock pickers have an equal chance of beating and losing to the average (not to mention the higher taxes and costs).
---With stocks, there is no “opt out” option: you have to participate in the stock market.

• With bonds and fixed income investing, assuming you have access to buying individual bonds, you can opt out, when you choose, by holding to maturity.
---You also have such options as CDs and Savings Bonds and even Money Markets and Savings Accounts that operate outside the bond market.
---It is usually possible to find CDs or individual bonds with yields and average ratings comparable to or higher than those of the Total Bond Market Index, with maturities in line its duration, thus avoiding interest rate risk, refinancing risk, and fluctuations from default risk. (You won't avoid actual defaults, if you buy bonds that could and do default.)

• Even sticking with bond funds, the performance of specific bond funds under different rate and economic conditions is much more predictable than for segments of the stock market.
---The Total Bond Market Index probably benefits over time by catching market shifts between longer and shorter maturities and shifts in the risk premium between corporate bonds and Treasuries.
---On the other hand, “refinancing risk” can be avoided by using other bond funds, including other bond index funds that capture shifts in risk premium, though not shifts between maturities.
---A simple 50/50 allocation between Vanguard's Long Term Index Fund and Short Term index fund, even without rebalancing, would have beaten the Total Bond Market Index Fund by more than 50 basis points per year, for 5, and 10 year periods (end of November, 2006), with a slightly higher average duration and interest rate risk. The same is true for the Intermediate Index Fund. However, these are both periods of broadly falling interest rates, so the numbers may not hold when interest rates rise.

• The Aggregate Bond Market Index seems to be more of a compromise than a true way of seeking average returns.
---In a flat interest rate environment, individual bonds and CDs can be bought to get a higher income return.
---In a rising interest rate environment, the income return on individual bonds and CDs will beat the total return on the fund.
---In a falling interest rate environment, a long or intermediate bond fund will achieve a higher total return, as will individual intermediate and long bonds, if bought when interest rates are high and sold when they fall. Moreover, if one holds onto the fund while interest rates stay down, instead of selling when they hit bottom, refinancing seems to subtract all the capital gains from lower interest rates.
---In a full interest rate cycle, the losses from refinancing suggest interest rates would have to be about 100 basis points lower each cycle for an investor trying to “dollar cost average” to break even on share price and just get the average income return, which would be analogous to laddering bonds or CDs.


Okay, so how about an Inflation Protected Securities Fund to protect against inflation?

• The income provided by a TIPS fund will increase with inflation.
---The higher the inflation (CPI-U), the higher the income from a TIPS fund.
---If CPI-U is higher than what was priced in when the TIPS were purchased, the fund will provide more income than a fund that had bought similar maturities of Treasuries. (More or less, a TIPS fund would have higher dividends than an Intermediate Treasury fund.)
---If CPI-U is lower than what was priced in, a Treasury fund will provide more income.

• TIPS funds pay dividends based on both the coupon and the inflation adjustment of the TIPS they hold.
---This is different than if you own individual TIPS, where you only receive dividends from the coupon rate, and the inflation adjustment goes to increase the face value.
---A fund's TIPS do the same thing, but a fund can use the cash flow from share purchases, plus other tricks, to add the inflation adjustments to the dividends it distributes.
---Whether funds can pull this off, if redemptions exceed new purchases, is an unanswered question.
---For people who need current income, paying the inflation adjustment as a dividend is better than waiting for the inflation-adjusted principal to be returned when the TIPS matures.
---Vanguard's TIPS fund pays dividends quarterly, unlike the monthly dividends of its other bond funds, and the dividend can be quite variable, because inflation adjustments vary considerably more than coupon payments.

• TIPS funds are subject to interest rate risk and reinvestment risk.

• The salable values of the TIPS held by a fund, on which its NAV is based, increase and decrease with changes in the prevailing fixed-yields of TIPS (with inflation-adjustment to face value factored in).
---When TIPS yields go up, their tradable value, and a fund's NAV, go down.

• The general expectation is that TIPS are less subject to interest rate risk than Treasuries of the same maturity, although there is no guarantee.
---This is because, when interest rates go up or down, part of the change is attributable to a changed perception by traders of what future inflation will be and part of the change is attributable to increases or decreases in “real yield” (above inflation).
---If the yield on a 10-year Treasury Note went from 4% to 5%, and half of that increase was due to a changed inflation expectation from 2% to 2.5%, the fixed-yield on a 10-year TIPS would go from 2% to 2.5%. So, the TIPS would have its value decreased in relation to a .5% increase in interest rates, while the Treasury would have a 1% increase in interest rates affecting its value.
---At any given time, how much of interest rate change is based on inflation expectations, how much on “real yield” varies, and attributing 50% to each is a guess, although not too far off from historical numbers.
---The average maturities on Vanguard's TIPS fund are higher than on its Intermediate Treasury fund, and duration is slightly higher (6.1 versus 5.1 at the end of November, 2006). However, if half of future change in interest rates comes from changed inflation expectations, its interest rate risk would be significantly less than that of the Intermediate Treasury fund.
---On the flipside, normally we would expect a TIPS fund to provide less of a capital gain during declining interest rates than a long or intermediate Treasury fund. (TIPS funds had high capital returns from 2000-2004, especially 2002, but that was an aberration, because TIOS were new and funds had been able to purchase 30-year TIPS, now discontinued, with high yields, just before yields crashed. At the end of November 2006, the average maturity on the Vanguard fund was down to 9.7 years and the average coupon was 2.7.)
---From Vanguard's disclaimer about “duration” on its TIPS fund: “This duration estimates the percentage change in the price of the fund for a given change in nominal interest rates on conventional Treasury securities. Actual inflation-protected securities (TIPS) price movements could be significantly different than implied by this estimate. The relationship of TIPS and conventional bonds varies and is difficult to predict with accuracy.”
http://flagship5.vanguard.com/VGApp/hnw/FundsSnapshot?FundId=0119&FundIntExt=INT


I'm worried about the trade deficit and a falling dollar. Are there any International bond funds?

• Yes, there are International/Global bond funds.
---Of course, you will be exposed to currency risk if it turns out the dollar strengthens against the currencies of the countries whose bonds the fund holds.
---Many International bond funds hedge with dollar assets, which may defeat the purpose of using the fund as your own hedge against a falling dollar.
---Some aggressive (and expensive) international bond funds do hold high risk, emerging market debt.
---More conservative international bond funds have most of their assets in European government and/or high rated corporate bonds

• Most International bond funds have loads and/or high expenses and trading costs.

• See this article by Scott Burns in the Dallas Morning News for more information: http://www.dallasnews.com/sharedcontent/dws/bus/scottburns/columns/2005/stories/012505dnbusburns.3faac5fa.html
---For no-load, un-hedged funds, Burns recommends American Century International Bond (ticker: BEGBX) with an expense ratio of .82% (which actually says it does hedge): http://finance.yahoo.com/q/pr?s=begbx&partner=mf
Holdings: http://finance.yahoo.com/q/hl?s=BEGBX
---And, T. Rowe Price International Bond (expense ratio, .86%): http://finance.yahoo.com/q/pr?s=rpibx
Holdings: http://finance.yahoo.com/q/hl?s=RPIBX
---For a more aggressive, load, high expenses, fund, with emerging market debt, he mentions Templeton Global Bond Fund: http://finance.yahoo.com/q/pr?s=TPINX
Holdings: http://finance.yahoo.com/q/hl?s=TPINX

• Burns also suggests using international CDs.
---“Another approach is to invest in certificates of deposit in other currencies. You can do this online with Everbank, www.everbank.com. They offer minimum $10,000 denomination CDs in a variety of currencies, including the euro. They also offer CDs with returns based on commodities, oil and strong central banks.” http://www.everbank.com/main.asp?affid=eb

• Also, consider a closed-end fund for international bond exposure (see below).


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Market Traded Bond Funds
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Are There Exchange Traded Funds for Bonds, and If So, How Do They Compare with Regular Bond Fund?

• Although newer and less common than Exchange Traded Funds (ETFs) for Stocks, there now are some ETFs representing various bond categories.

• As with all ETFs, these enable the investor to buy and sell shares at a specific time, instead of getting the share price at the end of the trading day (as with regular funds), which makes them popular with active traders.

• ETFs also allow for purchasing in shares in any dollar amount, most importantly in amounts less than the minimums required by many regular funds (helpful for those with little money to invest).

• Since ETFs trade like stocks, you need to pay a commission on every buy or sell.
---For anyone dripping money in or out of a fund over time, these commissions will cost much more than using a regular fund from a fund family, even though ETFs may help avoid some costs, such as low balance fees, charged by a regular fund.
---Whether you have to pay a commission for reinvesting dividends with an ETF depends on the brokerage.

• For more information, see: http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=75


What is a “Closed-End Fund”?

• A closed-end fund is an alternative to the open-ended mutual funds offered from fund families that increase or decrease the number of shares, as investors buy new shares or redeem old ones.
---In a closed-end fund, all the shares are issued at once then initially sold through brokers (sometimes aggressively) at an initial offering price of, for example, $10 a share.
---Shares in a closed-end fund cannot be redeemed from the company (as with open-ended funds), but must be sold, like stocks and ETFs, on the open market.

• Closed-end funds are sometimes focused on a niche market and may be the only way to have access to that niche.
---Some closed-end funds use aggressive tactics (such as leveraging) to try to enhance returns.
---These tactics also make aggressive funds risky.

• The capital raised from the initial offering is used to buy bonds or related investments (some of these funds use derivatives for leveraging) and an initial net asset value is established.
---The net asset value of the shares, as with open-ended funds, is based on the salable value of the bonds it owns, and information about the NAV, which will change from day to day, should be available on a daily basis (e.g., in Barrons').

• The price of shares on the open market will typically be at a premium or discount to the NAV, depending on how investors assess the short-term or long-term prospects for the fund's investments, not just what they are worth on a given day (as when you redeem shares in an open-ended fund).
---If you buy a closed end fund at its inception, you are paying the set-up costs of the fund, and the odds are that after the initial offering, it will be a long time before the fund again trades as high as its initial offering price.

• As with stock IPOs, shares bought at the initial offering are usually restricted for a period of time (typically 3 months for the brokerages that brought the fund to market for the shares they received for their part in the offering).
---About 3 months after a new closed end fund opens, when the IPO brokerage's shares are no longer restricted, many of these will be sold, and a drop in share price (but not in net asset value per share) can be expected.
---If you watch carefully, you can detect a widening of the spread between share price and NAV).
---Then, and only then, is the time to buy (if you want to be in this niche fund in the first place.

• Here is a list of closed-end funds from etfconnect.com: http://www.etfconnect.com/select/FindAFund.aspx


What are “Term Trusts”?

• A term trust is a particular type of closed-end fund that has a drop-dead date at which it agrees to cash out or sell all its assets and return the proceeds to shareholders.

• A term trust bond fund pays dividends and hopes to return to shareholders the initial offering price, typically $10 or $15 per share (as stated in the prospects).

• Like bonds, a term trust will mature.
---Unlike bond face values (excluding defaults), there is no guarantee what the net asset value of a term trust will be at maturity, though management is bound to try to return the initial offering price.

• If the fund took its capital from the offering and bought a set of bonds all maturing around the drop dead date, the effect would be analogous to an individual buying a collection of bonds that were held to maturity at a particular date, providing diversification while avoiding interest rate risk.
---Two problems: bonds are called, and some term trusts use leverage.

• In a falling interest rate environment, term trusts may have bonds called well before the intended fund liquidation date and then have to buy short-term investments that yield very little.
---The result is, even if a fund does succeed in returning its target price its success may come at the expense of a greatly reduced dividend.
---For example, the Hyperion fund, HTO, which was liquidated at the end of November, 2005, ended up reducing its monthly dividend, once over 7c a share, to a tenth of a cent per share. (This is extreme, but during the life of a term trust, dividend cuts are a way of life.)
---If you own individual bonds that get called, you won't be able to reinvest at as high a yield as the called bond, but you can seek the best return available, whereas the fund would need to focus on liquidity to be able to return the share price on the liquidation date.

• A leveraged term trust (check the prospectus) typically uses the leverage to get an excellent initial yield (given the overall interest rate environment).
---This works well as long as the bond market is stable or moves in a direction that allows the fund to make good on the leverage before the drop-dead date.
---However, if the market moves in the wrong direction, the leverage will lead to losses, perhaps substantial losses.

• Typically, as the time until liquidation of a term trust becomes shorter, the investor will see a series of cuts in the monthly dividend, because even without calls, bonds will mature and the money will be put into short term instruments in anticipation of the liquidation date.

• It is common for a fund, on liquidation, to fall a little short of recovering the initial offering price (remember the costs of offering the fund were deducted before the initial investments could be made).
---However, since the market knows there will be a distribution at about a certain date, the spread between market price and net asset value will progressively narrow and vanish as the liquidation date approaches.
---During the 1990's, the discounts to net asset value on these funds were commonly over 10%. Adding the gain from the narrowing spread between price and net asset value as liquidation approached to the yield gave a very respectable total return.
---Note this fine return was on the backs of the initial investors in the trust, who, in some cases, saw significant losses from both a declining NAV, as the bonds had lost value due to rising interest rates, and a widening the spread between price and NAV.
---Those who recognized that, at liquidation, the spread would be zero and the bulk of the assets of the fund would once again be valued at 100c on the dollar (because they were held to maturity not sold at the tradable price), had a fine opportunity available.
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