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Author: capgains00 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Ladders vs. Bond Mutual Funds Date: 5/25/2007 11:45 PM
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I'm having a hard time figuring out why bond mutual funds get a fairly bad rap on The Motley Fool compared to bond ladders. One reason is I see there are some Loomis Sayles bond funds (such as LSBDX) with a 10 year annualized total return of over 9%. Are bond ladder proponents saying I could have achieved that level of returns over 10 years using a bond ladder? I'm thinking maybe I'm missing something here.
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Author: iamdb Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20549 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 4:58 AM
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My reading is that the "bad rap" relates to fluctuations in value of a fund as prevailing interest rates fluctuate, i.e. the possilbity that the value of your investment could actually decrease. Of course this can happen to individual bonds as well unless they are held to maturity. Most people invest in bonds to reduce risk in their portfolios, so they look for investments in which their capital is secure. Vanguard argues that if bond funds are held for the average maturity of the bonds in the fund and if any dividends are reinvested, fluctuation in value is mitigated. A bond (or CD) ladder where bonds are bought at issue and held to maturity avoids this risk, even though the process of setting up a maintaining such a ladder entails labor and attention.

db

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Author: ResNullius Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20550 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 9:36 AM
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My reading is that the "bad rap" relates to fluctuations in value of a fund as prevailing interest rates fluctuate, i.e. the possilbity that the value of your investment could actually decrease. Of course this can happen to individual bonds as well unless they are held to maturity. Most people invest in bonds to reduce risk in their portfolios, so they look for investments in which their capital is secure. Vanguard argues that if bond funds are held for the average maturity of the bonds in the fund and if any dividends are reinvested, fluctuation in value is mitigated. A bond (or CD) ladder where bonds are bought at issue and held to maturity avoids this risk, even though the process of setting up a maintaining such a ladder entails labor and attention.

I don't have time this morning to fully flesh out my thoughts on this, but I too have been having trouble with the ladder versus fund issue. Yes, the value of a bond fund drops as interest rates go up. On the other hand, the yeild of a bond fund goes up as interest rates go up. Of course, as interest rates come down, the yield comes down and the value goes up. Holding over time would seem to take care of the difference between bond funds and laddered CDs, but I don't know for sure. Also, when you have a laddered CD, when interest rates go up, the rise is usually due to inflation, which in turn depresses the value of the yield on a previously purchased CDs, at least I would think so. For folks who plan to hold fixed income investments as a part of their long-term portfolio, I'm not sure why ladders are better than fund, other than I guess it's possible to purchase CDs at a lower expense rate than owning a most bond funds. I think cost might be the only long-term benefit, but who knows. I've got to mow the grass, so I guess this can wait. I've been over 90% in equities for several decades. My plan is to move at least 15% more into fixed assets over the several couple of years, which is why I've started paying more attention to this issue.

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Author: capgains00 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20551 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 10:43 AM
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when I say "bad rap" I meant most posts I read say something to the effect "you can do better for yourself with a ladder", and the posts often cite the effect of funds' expenses on returns, and of course there is also mention of the fluctuating value of your principal with funds. But just when I'm convinced bond funds are a mistake, I see the solid total returns of funds and I again wonder how it's possible to do better with ladders.

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Author: DreadPotato Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20552 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 10:45 AM
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My results with fixed income investmens over the last few years are as follows: Prefer buying bond and holding to maturity, but if monthy income is what you want then some funds like FMSFX can be an advantage, others can just add risk.
1/1/2003 through 5/26/2007

Date AvgAnnualReturn

TOTAL ETF's - US_Bonds 1.85%

TOTAL Fdlty - Investment Grade Bond Fund -4.07%

TOTAL Fdlty - Inflation-Protected_Bond Fund -1.39%

TOTAL Fdlty - Mtg_Securities Fund 3.62%

TOTAL US T-Bill's 4.36%

TOTAL US_Bonds 3.29%

TOTAL 1/1/2003 - 5/26/2007 2.43%



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Author: TwoCybers Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20553 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 12:07 PM
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Read this =
http://boards.fool.com/Message.asp?mid=25173438

It is from the FAQ.

I feel very strongly you are not looking at a mutual fund made up of normal government or corporate bonds. Get a prospectus and read it. You probably have some kind of derivatives to attain that return.

Derivatives are fine until something nobody thought of happens. Then the world comes unglued. If you happen to have derivatives of the wrong type, you can loose your shirt and then some.

Gordon
Atlanta

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Author: capgains00 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20554 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 8:34 PM
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the FAQ was very informative and makes a strong case for buying CDs and bonds directly if you have that option. I'd read other TMF fixed income FAQs, but somehow I overlooked that one.

Am I correct the analysis for bond mutual funds would be essentially the same for bond ETFs?

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Author: kahunacfa Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20555 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 9:31 PM
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... A bond (or CD) ladder where bonds are bought at issue and held to maturity avoids this risk, even though the process of setting up a maintaining such a ladder entails labor and attention. - iamdb | Date: 5/26/07 4:58 AM | Number: 20549

It also requires a lot of capital to do properly, at least sevral hundred thousand dollars. Most retail bond investors are better served by carefully selected bond funds - featuring low fees.

Kahuna,CFA


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Author: TwoCybers Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20556 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 9:47 PM
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Am I correct the analysis for bond mutual funds would be essentially the same for bond ETFs?

I think so, but if others on this board disagree, they know more then I.

One of the greatest confusions for me in the whole fixed income area is frankly not knowing what I and others are talking about. For example, I see mutual fund and it calls itself fixed income or mortgage based. It is very easy maybe even "normal" to think you are buying a part of a pile of normal, everyday bonds or house mortgages. As I dig into things, I am getting the feeling the mythical mutual fund above or more likely not traditional bonds or mortgages, but some derivative.

All of this has led me to a very simple deal. For my Fixed Income while I am going to get CDs or tax free short terms muni paper such as SWTXX

Gordon
Atlanta

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Author: Wradical Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20557 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/26/2007 11:51 PM
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... A bond (or CD) ladder where bonds are bought at issue and held to maturity avoids this risk, even though the process of setting up a maintaining such a ladder entails labor and attention. - iamdb | Date: 5/26/07 4:58 AM | Number: 20549
---------------------------------
It also requires a lot of capital to do properly, at least sevral hundred thousand dollars. Most retail bond investors are better served by carefully selected bond funds - featuring low fees.
---------------------------------
You generally don't need anywhere near that kind of money.

It depends on what kind of bonds you're talking about. For municipals, where credit risk is a real issue, it would depend on what kind of a minimum purchase is available.

But for Treasuries or high-rated Corporate bonds, you can build a pretty good ladder with $50,000; 10 - $5,000 bonds, scheduled maturities of your choice. AFter all, building a bond ladder is not an exact science. You choose whether it's long or short, and how far apart the steps are. You do the same when you pick a fund to invest in.

The biggest advantage of a do-it-yourself ladder over a bond fund is that you avoid the run-on-the-bank risk, where interest rates rise, and bond values fall. Your bonds lose value - for the moment - either way.
But with a ladder of your own bonds, you can sit and wait and hold them to maturity, and still get the locked-in yield you bargained for when you bought.

In a fund, rising rates, and the resulting falling prices, may cause investors to sell, redeeming shares, and that in turn requires the fund managers to sell bonds at a loss to raise the cash to redeem them out. This generates realized losses for the fund, and the cycle continues and accelerates, making things worse.

Bill

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Author: iamdb Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20558 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/27/2007 8:46 AM
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Bill,

Your second quote about lots of capital is not attributable to me. Labor and attention depnds to some extent on the period of the ladder, but it always entails reinvesting maturing securities. I prefer a combination of Vanguard's short-term investment-grade securities, TIPS, and prime money market funds for convenience.

db

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Author: ResNullius Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20559 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/27/2007 9:00 AM
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I prefer a combination of Vanguard's short-term investment-grade securities, TIPS, and prime money market funds for convenience.

I've assumed the same thing, but I don't really know. For example, has anyone ever compared this type of combination of Vanguard funds to a well done ladder of CDs? I would be curious to see how they compare, given the interest rate variations and differences in fees. I've got a feeling that the difference is nominal at best, but I don't really know.


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Author: brucedoe Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20560 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/27/2007 1:02 PM
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Kahuna

Why do you say that a bond ladder takes several hundred thousand dollars? I used to maintain a 1-5 yr ladder in newly issued Treasuries until the roof fell on rates in a number of years ago (We did $10,000 lots, but I don't see anything wrong with even $1,000 lots.). Once the ladder was set up, I just bought a 5-yr Treasury bond with the proceeds from the maturing bond. It did take some bobbing and weaving to set up the ladder as 4-yr treasuries were no longer issued by the time I got to it. It would take even more bobbing and weaving today. At any rate, I was happy and didn't realize I was drastically underinvested.

The low rates of recent years smoked me out of the Treasury ladder because I thought I needed to get 5% or more interest. So I started buying some long-term corporates (never done before in my 50+ years of investing) and even went down to A rated bonds like those of BAC (though Merck dropped from AAA to A+ while I had it). I would take quite a bath on some of these if we had to sell today (A GE AAA bond maturing in 2029 at 5.13$ is down more than 10%.), but we don't have to, fortunately, so I continue to gather the 5+% interest, and, on several of these, monthly. As we are in our late 70s, some of these maturity dates will be an issue for our heirs.

Incidentally, we don't have any bond funds but don't have anything against them. We used to have a lot of municipal bond funds when we lived in Virginia, but had to sell because keeping them was awkward when we moved to North Carolina. The USAA fund was the best, but we couldn't add money to the fund or reinvest the interest once we left Virginia as this fund is not licensed in North Carolina.

Please note I am certainly a amateur on bond investing, but I decided I would keep these corporate bonds even if interest rates got up to 8%. On that basis, I guessed what I was doing was all right.

brucedoe

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Author: brucedoe Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20561 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/27/2007 1:05 PM
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I made a mistake. We do have a modest amount of the Vanguards Inflation Protected Securites Fund (VIPSX).

brucedoe

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20562 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/27/2007 2:52 PM
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<there are some Loomis Sayles bond funds (such as LSBDX) with a 10 year annualized total return of over 9%. Are bond ladder proponents saying I could have achieved that level of returns over 10 years using a bond ladder? I'm thinking maybe I'm missing something here. >

You mentioned that, since you wrote this post, you have read the FAQs. That's good.

Let me just summarize a few things that you may have missed, when you wrote this.

1. The total return of a fund includes the capital gain on the value of the bond (reflected in the NAV of the fund), due to a general drop in interest rates, over the past 10 years.

If you look at the link below, you will see that prevailing long-term interest rates have generally dropped, over the past 10 years.
http://www.martincapital.com/chart-pgs/CH_mmnry.HTM

Because of this general trend, the NAV would have risen, over the past 10 years. However, long-term bond rates are no longer dropping. They have been stable to rising, since the Federal Reserve began raising short-term interest rates from the ridiculously low levels of 2002-2004.
http://stockcharts.com/charts/gallery.html?$TNX

Where will they go from here? There's a lot of disagreement, on that important issue.

When your fund chose to publish their 10-year returns, instead of their 5-year returns, they did it for a reason. The 5 year total returns are probably lower, because the NAV rose most, when interest rates had their strongest dropping trend...which was more than 5 years ago.

2. The yield of a bond largely depends upon its safety and security. Bonds that are totally safe (Treasuries and FDIC-insured bank CDs) will have lower interest rates than corporate bonds, which have a possibility of default, or mortgage bonds, which have refinance risks. If you dig deeply into the holdings of a bond fund, you will probably find lower-rated (though still investment grade) bonds.

Even highly-experienced investors, such as brucedoe, found themselves reaching for yield, and investing in less-safe corporate paper, during the time that the Federal Reserve deliberately and artificially depressed interest rates. But, it's important to be aware of the risks you are taking. When comparing rates, be sure that you are comparing apples to apples.

3. Much new corporate paper is so-called "covenant lite." Clauses, hidden in the fine print, allow the issuer to defer interest payments, without penalty. This is bond poison, as far as I am concerned. I would never invest in a "covenant lite" bond. However, they may be tucked into a bond fund's portfolio, and you would never know.

4. Many bond funds juice their returns with derivatives. The derivatives market is breathtakingly huge. There are ten times as many derivatives written on Treasury bonds, as there are actual Treasuries outstanding. I don't want to own a card, in a house of cards, thank you. There is a huge risk that the gigantic derivatives market, which is based on recent computer models, and has never been tested by a severe market downturn, will collapse.

When I buy a bond, I want safety. I want to know that the interest rate will be paid (no "covenant lite"!). I want to own the bond, not a derivative. I want to hold it to maturity, so I won't lose principal, if interest rates rise.

If I am considering a bond fund, I want to know where the total return came from, and how likely the conditions would be to continue.

Wendy



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Author: Tredos1 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20571 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/29/2007 12:23 PM
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It also requires a lot of capital to do properly, at least several hundred thousand dollars. Most retail bond investors are better served by carefully selected bond funds - featuring low fees.

Kahuna,CFA


I would agree with this, if I'm going to set up 5 years worth of ladder to cover 5 years worth of expenses then I need something like 500k worth of bonds in the ladder. That's doable, but it's also a lot of money.

Tony

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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: 20573 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/30/2007 8:04 AM
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I think the FAQs make pretty clear under what circumstances certain bond funds may outperform laddering. But they will almost certainly not outperform laddering, even if the fund has higher yielding bonds than an individual is willing to risk buying for a ladder, if relevant interest rates go up. And the idea that the increased yield makes up for loss of NAV on a fund is at best bad math, at worst outright fraud in attempting to persuade people to buy funds. The correct math is included in the FAQs.

I don't know what TMF recommends, because this board is better equipped than TMF staff for discussing bond and fixed-income issues. The dominant view on this board has been, with ample documentation, that bond funds are better avoided in historically low interest rate environments, because the risks from interest rates going up, perhaps dramatically, outweigh the potential gains from rates going down or the possibly higher yields if rates stay steady.

Then, there's the issue of what is meant by a "bond ladder." If you are looking at Treasury or high investment grade corporate bonds, there is really no point in a fund. If you are trying to get higher yields by getting low investment grade corporates (to parallel investment grade corproate funds—junk is something else), then it is going to be difficult to diversify enough to reduce risk with limited capital. But, currently, if you were to choose between Vanguard's long term corporate fund and laddering 20 low investment grade bonds, 1 default would be about the same risk as a 50 basis point increase in interest rates affect on the fund.

Of course, there are other funds with higher yields. But those are because of higher risks.

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Author: TheNajdorfDefens Big funky green star, 20000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 20577 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/31/2007 3:32 PM
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Muni bond ladders are always always always a terrible idea unless you are investing $1mm+ in each maturity.

You are getting ripped off on every trade. You don't know where the market is, unless you are sitting on a muni desk.

Why do you think brokers push bond ladders so hard?

Munis aren't even subject to the 5% markup rule - Tower Amendment.

Naj

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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: 20578 of 35357
Subject: Re: Ladders vs. Bond Mutual Funds Date: 5/31/2007 6:06 PM
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Muni bond ladders are always always always a terrible idea unless you are investing $1mm+ in each maturity.

Munis are their own fiefdom.

At Vanguard, where markups seem pretty small, commissions on corporates are $25 plus $2 per bond (presumably $1000). So, if you are buying in $5000 lots, that's $35, which works out to be 7 basis points for a 10 year maturity. Even at $1000 per, the commission is only 27 basis points. I haven't looked at the details for a while, but I think you could probably build a ladder of 10-20 years and get about 6% after commission in the BBB to A range, maybe closer to 5.75% in $1000 lots. When Pen Fed is having a fire sale, it's clearly not worth it. But how much capital it really takes for this kind of ladder with corporates depends on your view of risk.

Before Jack Crow disappeared, we argued about this risk. His view was you could use average default probabilities no matter how many bonds you had (i.e., if there is a 1/100 risk of BBB bonds defaulting, you could assume a 1% risk if you bought 20 bonds, meaning you would need to be getting more than a 1% premium over safe bonds/CDs to justify the risk). My view was you had to factor in 1 default, whether you bought 20 bonds or 100 bonds. That would basically mean you would need to be able to buy 100 bonds to reduce risk to justify a 1% premium.

The real risk is probably somewhere in between. But, personally, I probably wouldn't do a ladder of low grade corporates with less than $150,000 buying 50 bonds for $3000 each (about 10 basis points lost to commissions).

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