Some Bond ETF Data

Source: www.capitalpixel.com

One of the challenges facing do-it-yourself investors in recent years has been the bond portion of their portfolios.  Frankly, most don't know how bonds work.  They come with an asset allocation that suggests 30% fixed income, but what next?

They aren't comfortable with the inverse relationship between prices and yields; they aren't familiar with different sectors of the fixed income market; they aren't familiar with the difference between brokers and dealers, and the different yield calculations are a puzzle. Throw into the mix the fact that yields have been at historical lows, and it is easy to see that many investors mismanage this part of their portfolio.

And bonds aren't easy to learn about.  If there was an all time list of boring books, undoubtedly bond investing books would rank high on the top of the list - maybe along with this post. Rumors are that doctors sometimes recommend them for sleep-challenged patients. 

But they are important to understand for the DIYer.

My work around, when asked how to learn about bonds, is the simple suggestion of tracking bond prices.  My preferred way to do this is by tracking bond ETFs.  I do this on an ad-hoc basis - meaning, when I feel like it.  Here's my table from Excel where I keep prices and where it is easy to calculate relative returns:

PRICE DATA 

DATE	HYG(PR)	AGG(PR)	SCHZ (PR)	MBB(PR)	CSJ(PR)	IEI(PR)	IEF(PR)	EMB(PR)	BKLN(PR)
19-Dec	87.67	110.17		108.05	104.02	122.19	106.15
23-Dec	89.04	109.9	51.41	107.93	104.03	121.74	104.97
6-Jan	88.92	110.11	51.57	108.05	104.18	121.87	105	108.5
17-Jan	89.2	110.58	51.82	108.32	104.38	122.3	105.77	108.31
12-Feb	90.25	110.41	51.82	108.19	104.75	122.19	105.24	110.98
23-Mar	90.5	109.7	51.53	107.85	104.88	120.78	103.09	112.7
31-Mar	90.72	109.85	51.49	107.95	105.09	121.1	103.28	112.71	24.58

The data shown is price data for various sectors:

HYG:  high yield, i.e., junk bonds.  These are below investment grade.  This sector is a top performer over long periods of time; but, when the first whiff of a downturn comes, their spreads can widen out dramatically and result in significant underperformance.
AGG:  indexed to Barclay's Aggregate Bond Index - the investment grade bond market.  Everything with more than 12 months to maturity.  This is the bond market benchmark equivalent to the S&P 500 in the stock market, i.e., it is the most widely used benchmark professional bond managers seek to outperform.
SCHZ:  Schwab's version of AGG.  Commission-free to Schwab customers.
MBB:  Mortgage -backed securities.  Offer really attractive yields, but subject to negative convexity. This just means they have great performance in stable yield environments but can underperform otherwise.  For example, if mortgage rates drop sharply, homeowners refinance leaving the bond holders significant principle to reinvest at lower rates.
CSJ:  indexed to 1- to 3-year credit bond index.  Has been a good holding in the low-yield environment.
IEI:  indexed to 3- to 7-year section of Treasury yield curve.
IEF:  indexed to 7- to 10-year section of Treasury yield curve.
EMB:  indexed to emerging markets bonds.
BKLN:  indexed to senior loan leveraged index.

Under normal circumstances, i.e., 10-year Treasuries yield 5% or higher, it would be perfectly fine to use AGG for the entire bond portion of assets.  It would be similar to using S&P 500 for the large cap stock portion of the asset allocation.

But, because yields are abnormally low and face the risk of a push up in yields, I typically put about half the bond portion in AGG or SCHZ and then spread the rest among some of the other sectors like CSJ, HYG, EMB, and MBB.  I have not used BKLN.  I am still tracking it to get a feel on how it trades.

IEI and IEF are used as yield curve trades whereby you take a position based on whether you believe the yield curve will steepen or flatten.

I also collect data on the yields of the ETFs, although, admittedly, I'm not sure how the yields are calculated.  They are not yields-to-maturity corresponding to bond yields - which makes sense, given that they don't have a fixed coupon payment.  Here's that table for what it is worth:

YIELD DATA:

HYG(YLD)	AGG(YLD)	MBB(YLD)	CSJ(YLD)	IEI(YLD)	IEF(YLD)	EMB(YLD)
7.97	3.21	3.4	2	1.78	2.59
7.97	3.21	3.4	2	1.78	2.69
7.97	3.21	3.4	2	1.78	2.69	4.97
7.69	2.86	3.34	1.92	1.68	2.56	4.89
7.48	2.84	3.32	1.9	1.66	2.53	4.82
7.26	2.81	3.28	1.65	1.62	2.52	4.69
7.26	2.81	3.28	1.85	1.62	2.52	4.69

As you can see, there is quite a pickup in going from AGG to junk bonds represented by HYG.  Also, look at the spread between the longer maturity IEF and the shorter maturity IEI.  This represents the reward for taking the longer duration risk - i.e., when rates move higher the prices of longer duration bonds will fall more!

CSJ is worth considering for those parked in money funds or low rate CDs.

It is easy to get detailed information on any of these ETFs.  Just google the ticker symbol and  get the providers link as well as alternative links.  As a rule, aside from AGG and SCHZ, I never put more than 5% of total assets into any of the other concentrated ETFs.

Disclosure:  This post is purely for educational purposes.  Individuals should do their own research or consult a professional before making investment decisions.

Plan Your Bond Allocation

The key (IMHO) to successful investing is to have a well-thought-out plan.  Sometimes the bull will be on the rampage; other times the bear will amble in.  There will be trying times.  On occasion they will be so trying they trigger a "flight or fight" response.  This is when investors without a plan ( I have to say that the Dennis Hopper commercial will forever pop into my head when I talk about investment plans) tend to do exactly the wrong thing.  They throw overboard their investment program just when they should stay the course.  If you have ever participated in a bubble or seriously liquidated after a sharp drop in the market, you know exactly what I'm talking about.

With these considerations in mind, it is worth thinking about your plan for fixed income assets.  I find it ironic that this portion of assets, which is usually considered the "safest," tends to cause the most angst for a lot of investors.  Simply, most investors don't feel comfortable with bonds.  They struggle with the question of whether they should buy individual bonds or funds.  They worry about the impact of rates going higher, and they just feel outright cheated when they contemplate the thought that they could have a negative return when they in effect are lending money to corporations or the government, etc.

The bottom line is that many investors are stymied with this part of their portfolio and, as a result, hold an excess in cash (at practically zero interest) or buy CDs which lock them in at low rates.  Or they take up the laborious task of constructing a laddered portfolio of individual bonds.

I'm not in a position in this post to alleviate all of these concerns with fixed income assets, but I do think it adds perspective to look at a basic ETF bond allocation for the past few years to see one possibility in terms of allocating bond assets.

Returns from iShares

 CLICK TO ENLARGE  The table shows returns for 50% of the assets in the overall market represented by the low-cost Barclay's Aggregate Index (AGG) and the remaining 50% allocated among 5 other sectors.  The other sectors include a short corporate ETF (CSJ), a mortgage ETF (MBB), a high-yield ETF (HYG), an inflation-indexed ETF (TIP), and an emerging countries ETF (EMB).

The right hand column shows the return on the portfolio with the weightings.  In other words, with 50% allocated to the overall market in 2011 and 10% to the other sectors, the return would have been approximately 7.1%.

In normal times (with the 10-year Treasury yield at 5% -6% ), it would be sufficient to just hold the whole position, or at least most of it, in the AGG.  But these aren't normal times - short-term yields are at historically low levels, and most observers see the possibility of a sharp rise in rates sometime in the next 5 years.

In any event, the results show that this simple construction provided exceptional returns - well in excess of what was available in cash and in CDs.  In fact, retirees who achieved similar returns surely were well satisfied.

As always, the allocation for a specific individual will be somewhat different.  The purpose here is just to bring out the actual performance results of a particular allocation that can easily be implemented.  You can play with the returns in the table and add those of other sectors to calculate performance of allocations you would be comfortable with.

Disclosure:  This information is for educational purposes only.  I hold, and my clients hold, some of the ETFs mentioned.  Individuals should do their own research or consult a professional to make investment decisions.

Bonds (Part 3)

Buying individual bonds is not easy.  Anything under $1 million is an odd lot and will typically not get a good bid or offer price, they trade over-the-counter, are difficult to price, and come with a lot of bells and whistles.  Still, some DIY investors prefer individual bonds because of their specificity and directness. With individual bonds, you know exactly what you own and you have control over holding to maturity or selling.

If you aren't familar with how  over-the-counter markets work, check out the YouTube "Over-the-counter, over-the-top" by Paddy Hirsch, Marketplace senior editor.

Because the bond market is an over-the-counter market, it has been difficult to get transparency on bond pricing.  This, of course, has been beneficial to Wall Street which thrives on opaqueness.  The Financial Industry Regulatory Authority (FINRA) has remedied this to a degree by requiring trades to be reported so that investors can see recent trading activity in specific bonds.  This allows bond transactors in  government, corporate, and municipal bonds to see recent price and volume data at a bond specific level.

Trading Activity in Merck Bond

In Bonds (Part 2) I showed a specific Merck bond held in my Schwab account:

Source: Schwab

CLICK IMAGE TO ENLARGE  Suppose I was interested in selling this bond.  I can see that Schwab prices it at $123.9677.  How realistic is this?  Has this particular bond traded recently?  Or is this bond being priced using a matrix approach whereby the price is determined by similar bonds that have traded - sort of like pricing real estate?

Actually, trade data can be obtained at the FINRA site.  Click "Bonds" under "Market Data" and come to

Source: FINRA

 CLICK IMAGE TO ENLARGE Again, fill in the "corporate" bubble and click "Advanced Bond Search" as indicated.

On the next screen, at the "Search by" option select "CUSIP" from the dropdown list.  The CUSIP is a security identifying tag.  If you look back at the bond listing as shown by Schwab above, you'll see the CUSIP: 589331AE7.  This will take you to :

Source: FINRA

 CLICK IMAGE TO ENLARGE  Note that here you have the price of the last sale, $124.654, and the yield, 3.959%.  This, of course, is valuable info to keep a broker honest if you happen to be buying or selling this issue.  But we can get more trade data by clicking the bond's name and scrolling down to the "Search for Bond Trade Activity." Here we can specify a date range and click "get results." I specified a 10-day period and came up with the following trade activity:

Source:FINRA

CLICK TO ENLARGE IMAGE  Finally you have the trade specific info, including size of trade, date, price, etc.

With this type of data, a bond buyer can more readily ascertain whether bid and offer prices are reasonable.

The FINRA site has an excellent tutorial explaining the site and how to get information.  It also should be noted that they have numerous disclaimers which should be respected because, after all, they are collecting data from outside parties on the behalf of investors but obviously cannot be held accountable for that data.

Bonds (Part 2)

On Monday, we looked at some basic terms used to describe bonds.  At the end of the post, we saw the idea of accrued interest.  Simply, when you buy a bond in the secondary market (after it has been issued), you pay accrued interest to the buyer - the interest earned since the last interest payment.  The Treasury bond example we were considering paid interest on August 15 and February 15 (every 6 months) at a rate of 2.125%.

Assume we buy this bond today, approximately 30 days since the last interest payment.  How much in accrued interest would we have to pay?  It would be 10,000*.02125*(30/365) = $17.50.  If you don't feel like pulling out your calculator, use the online calculator provided by FINRA:

Source: FINRA Financial Industry Regulatory Authority

CLICK ON IMAGE TO ENLARGE

If we buy this bond today and sell this bond next week (wow! we're big time bond traders!), we will get the accrued interest we paid back plus an additional 5 or 6 days, whatever the case may be.







Bond Yields and Prices

The yield on a bond and its price vary in opposite directions.  This is a very simple concept that fools a lot of investors.  The yield that is under consideration is the yield-to-maturity.  This is important to grasp because there are a number of different yields pertaining to bonds:  the coupon yield, the current yield, the yield at cost, etc.

The yield-to-maturity (YTM) is the most important for investors.  People sometimes treat it as the return on the bond because it accounts for interest payments as well as the capital gain or loss at maturity.  In strict terms, it isn't the return for the simple reason that interest payments will be received and return depends on the rate of interest at which those payments are invested.  We, of course, don't know what those rates will be in the future.  For example, the bond considered above pays interest of $112.50 every six months over the next 10 years.  The return on the bond will depend on the rate at which those payments are reinvested.

To understand why bond prices and YTM move in opposite directions, we'll use two approaches.  First, consider you giving me an amount now and me giving you $100 one year from now.  If you give me $90 today, then the yield to you is 100/90 = 11.11%.  If, instead, you give me $80, the yield would be 100/80 = 25%.  If you gave me $95, the yield would be 100/95 = 5.26%.  Putting these in a table, we get:

Price     Yield
$80        25%
$90        11.11%
$95          5.26%

So, this is it.  As the price goes up, the yield goes down - it's this simple.  The more you have to pay for the $100 in the future, the lower the YTM.  The more you pay for any bond, which is just a series of future payments, the lower its YTM.

Let's make this slightly more realistic by looking at how price is determined on a 3-year bond.  For this purpose, let's assume interest payments are made once a year.  Assume the coupon interest is 4% and the principal amount is $100.  Then the following payments will be made:  $4 each year, including at maturity, along with the $100 principal at maturity.  A key factor is that money to be received in the future has to be discounted back to the present to determine worth today:

$100 = 4/(1+YTM) + 4/(1+YTM)^2 + 4/(YTM)^3 + 100/(YTM)^3

Here I have assumed that the bond is at par - i.e., it probably was just issued.  Notice that the discount rate is the YTM!  In other words, the YTM is just a by product of the bond pricing formula.  If the bond price was higher - $110.50, say - the YTM would automatically be lower and vice versa.  Once you get this, the whole mystery about bonds goes out the window.

Just for kicks, let's think a moment about holding the bond to maturity.  Assume we've bought the bond and that we are going to hold it for 3 years until it matures.  Do we want (from a total return perspective) yields to rise or fall?  The answer is rise because we want to be able to reinvest the interest payments at higher rates.  While this is going on, the bond will fall in price as it is "marked-to-market" on our portfolio.  Keep in mind, however, that the price of the bond will be par at maturity - this is what makes bonds different from stocks.  Buy any stock, and 3 years from now we don't know what its price will be!

Corporate Bonds

I'm not a fan of retail investors buying individual bonds, as I will discuss later.  Still I understand that some do-it-yourselfers like to buy individual bonds.  In the "do as I say not as I do" category, let me introduce a bond I bought some time ago before I started using funds:

 CLICK ON IMAGE TO ENLARGE
At this point, you should be able to understand a lot about the Merck bond shown.  You should be able to figure when interest payments are made (12/1 and 6/1 each year), how much they will be ($892.50), the maturity date (12/01/2028), the principal amount ($30,000), etc.  You should even be able to tell what has happened to yields since the bond was issued.

Next time we go further into the world of bonds.

Bonds

Few subjects confuse new investors as much as bonds.  Many struggle to understand that prices and yields move in different directions.  They aren't sure whether to buy individual bonds or a bond fund. They aren't sure where, in fact, to go to buy individual bonds or what bond fund to buy.  This series will examine the basics of bonds.

Terminology

Bonds have some basic terms that all investors should master:

• principal - bonds are typically sold in $1,000 units. The principal amount is the amount the investor will receive when the bond matures.  For example, if the investor purchases a $5,000  Microsoft bond that will mature in 5 years, he will receive interest for 5 years and then get back the principal of the bond.
• coupon - the coupon rate is fixed and determines the interest payment the investor will receive. For example, if the Microsoft bond has a coupon interest rate of 4.5%, the investor will receive $225/year ( 5,000* .045).  In actuality, most bonds pay interest twice/year, so that in this example the bond holder would get $112.50 every 6 months.
• yield-to-maturity - this is the yield that equates the discounted cash flows of the bonds to the price.  See below.
• maturity date - the date on which the principal is paid back.
• principal - the amount paid back at maturity.
• duration - a measure that takes into account the timing of the cash flows and is used to determine the volatility of bond prices.

The best way to get a handle on these terms is to go to an actual bond.  A list of Treasury bonds can be found at Bloomberg :

CLICK TO ENLARGE IMAGE Note that in the black bar we have clicked U.S. and that there are other countries listed for which you could get bond yields.  The yields of other countries are interesting to those following current events and, especially, the debt problems in Europe.

The list of U.S. Treasury bonds is special.  It is the list of what are called "on-the-run" bonds.  These are the most recently issued for each maturity and are the most liquid in the market.

To explain the terms listed above, let's concentrate on the 10-year maturity.  It matures on 8/15/2021.  On that date, holders of the bond will receive back their principal.  Notice that the coupon is 2.125%.  This rate stays constant throughout the life of the bond.  Assume we hold $10,000 in principal of the bond. Then we will receive $10,000 * .02125 = $212.50/year (actually $106.25/every 6 months).  The payments will be on 8/15 and on 2/15 each year.  At maturity, the bond holder will receive the final interest payment as well as the principal of $10,000.

Notice the price is listed as 101-31.  Bonds are priced in $100 units.  This price, since it is above $100, is said to be "above par."  When the bond was issued on 8/15/2011, it was issued at a price very close to par.  The reason it is above par is that yields have declined since the bond was issued.  Like stocks, bonds trade in a secondary market.  In a future post, we will examine the relationship between bond prices and yields.  Here we want to concentrate on what it would cost if we bought $10,000 in principal of this bond.

First ,we need to convert the price to decimal form because bonds trade in 32s/  The price is 101.96875. The cost for $10,000 in principal, therefore, would be 10,000*1.0196875 = $10,196.88.  When you buy a bond in the secondary market, you also have to pay accrued interest (i.e., the interest earned on the bond by the current bond holder up to the time of the sale).

Tomorrow we'll delve further into the world of bonds.

Interested in 2.35% for 11 months?

Being on the institutional money management side for a number of years, I had many conversations with colleagues about the huge discrepancy between what institutional traders transact bonds at as compared to individuals. In short, individuals face huge markups in the bond market when buying odd lots and huge markdowns when selling. For example, if you buy $50,000 principal amount of a 5-year IBM issue, you would pay a much higher price than an institution buying $5 million of the same bond. This is why today I recommend against individuals buying bonds and instead suggest bond index funds.

This goes beyond the fact that the bond market is an over-the-counter market and the institutional buyer gets coverage from numerous firms.

This, of course, always led to my wondering whether there wasn't a business opportunity available by giving better bid-offer spreads to the retail market.

My friends and I were never smart enough or energetic enough to figure out how to do this, but also the technology wasn't really there. Today this has all changed - at least the technology part. Investors are getting better opportunities to get competitive prices.

Along these lines, I recently came across a very interesting site at Zions Bank. Although I haven't used it, I have been following it and have to say that it looks promising for those, with time on their hands, who are in search of higher yields to follow ongoing auctions.

The site offers auctions (instructions available at the site) as follows:

Source: Zions Bank

CLICK TO ENLARGE  Note the Verizon 11-month bond yielding 2.35%. Again, if individuals have the time to do the research and follow the auctions, these types of issues at attractive yields are available for bid.
 
Click on "view auction" and you get:

CLICK TO ENLARGE  Here you see that there are 5 bidders and when the auction ends, along with detail on the issue.

Although I haven't used this auction site, I do find it interesting and potentially useful, especially for those seeking income.

I would be very interested to hear of the experiences other investors may have had with the site.

Who is Bill Gross and What is He Telling Investors?

When I was a kid in North Carolina, the pool lifeguard would end our "sharks in the water" game with a big "everybody out of the pool " proclamation. It was mainly to give the life guards a chance to catch their breath and the adults a little stress-free swim time. It turns out it was also advance training for navigating investment markets.

Bill Gross, manager of world's biggest bond fund at PIMCO, has cut government linked debt to a negative percentage of his Total Return Fund's $236 billion portfolio and is publicly renouncing Treasuries as an investment choice. This is his "everybody out of the pool" statement. Cash equivalents now comprise 31% of portfolio assets, up from 23%, the highest percentage in 4 years.

Gross is concerned about the impact of the Federal Reserve ending its QE 2 Treasury buying program. He asked, “The question remains, when the Fed stops buying Treasuries, does the private sector take the baton and run the last leg of the relay race?”

This is an important week in this unfolding drama due to some important inflation data being reported as well as Treasury auctions taking place. On the inflation front, the market will get CPI , PPI , and import price reports. The core rate of the CPI (ex food & energy) is expected at 0.2% (roughly 2.4% annual rate). Above that and it could spook the market.

The key auctions will take place on Wednesday and Thursday. On Wednesday, the Treasury auctions 10-year notes and on Thursday the 30-year bond. How these auctions go depends a lot on investor's inflation outlook.

This is all playing out with the ongoing budget talks and looming debt ceiling issues adding a bit of spice. It's not hard imagining a perfect storm brewing.

I Almost Became Famous

Many years ago, in a different universe, I had a streak of luck with a small fund. As I recall, it was a few million. It was a Treasury bond fund. I saw myself as a superb market timer; and when I took over the fund, I judged yields as being excessively high. I invested aggressively in 20-year and 30-year Treasuries. Treasury yields at the time were double digit.

As soon as the the investments were made, yields dropped like a rock. The push up in bond prices yielded a nice capital gain and, to capture my good luck, I realized the capital gain and put the proceeds in 1- and 2-year maturities. As soon as these buys settled, yields shot back up and I re-entered the market. This went on a few times during the quarter, and after a while I was feeling like King Midas.

When the quarter ended and the smoke cleared, I found my fund was the third best-performing fund in the country. Pensions & Investment Age produced the rankings and, in their quarterly performance issue, interviewed me along with other "top" managers/bond market rock stars.

I gave my burgeoning rock star status considerable thought, and it dawned on me that I could lock in this superior performance for a long time by "closet indexing." In the bond market, this would mean structuring the bond portfolio similar to the Aggregate Index - its benchmark. The portfolio would have the same average coupon, duration etc.

All of this is more complicated to explain than to carry out. By "closet indexing" I would retain the superior performance for some time while not taking a risky market timing posture. The superior performance would attract money, thereby increasing the size of the fund. Bringing money in, of course, is the purpose of institutional money management.

The reason I relate this story is twofold. First, you need to be careful in evaluating performance. A fund's performance may look good but really be the result of one period's luck. By coming into the fund and paying high fees to attain superior performance, you may be buying into a conservative approach - one which could be attained at much lower costs. Or worse, the manager comes to believe he or she is King Midas and it takes time to realize that the prior results were luck. Secondly, it is easier to produce exceptional results with a smaller fund. The history of Wall Street has many instances of funds which started out on fire and gradually turned mediocre as asset size grew.

As it turned out, I was recruited to go to another investment management company that offered me more opportunities. Still I wondered over the years how much money would have come in with the "closet indexing" approach for that fund.

Are you getting a fair price for your bond?

Click Image to Expand
Individuals are piling into bonds, and some are buying individual bonds rather than ETFs or bond funds. I don't condone this because it is time consuming, difficult to diversify, and almost impossible to determine if bid or offer is fair . But if you have the time, the resources, and the knowledge and insist on buying individual bonds, it is worthwhile following the price of active bonds in the Wall Street Journal. This is a free resource.
Active bonds
Go to www.wsj.com...click "Markets"...click "Market Data"...click "Bonds. Rates, & Credit Markets"...scroll down and find on the right-hand-side "Corporate Bonds: Most Active" and click...scroll down and find the list of actively traded bonds.

You hopefully have noticed that we have navigated through a lot of useful bond market information.