Bond funds are deadly?

[rickb]

It seems extremely counter-intuitive that a very cash heavy portfolio would be the best way to beat inflation.

Don't confuse short term Treasury debt with zero duration currency.  I would have preferred if 1-year T-Bills were available because the ST Treasury fund actually has a duration of about 2.3 years.  Duration differences can matter a lot in tightening cycles or other sensitive climates.

In reality we would just ladder/stack the cash in individual 5-year CD's to get the best of all worlds anyway.  Bond funds are deadly.

What, exactly, do you think is "deadly" about bond funds?

A bond fund with a constant duration is the same as a continuously rolling ladder of the same duration.  So, if you ladder 5 year bonds, a fund that invests in 5 year bonds will be the same.  In an environment of rising rates, the current value of the ladder and the fund will drop by the same amount, and you will also recoup your principal in the same amount of time. 

Holding bonds to maturity is not some magic get-out-of-jail free card that lets you avoid principal loss if interest rates go up.  If rates go up, the current value of your holdings goes down - whether you're holding a ladder or a bond fund makes no difference whatsoever.  With a rolling ladder when your bond matures you "recoup" the face value, but that bond had a declining, shorter than your average, duration that is offset (in your ladder) by other bonds that have a longer than your average duration.  If rates went up, the nearly mature bonds in your ladder didn't drop in value very much but the newest bonds in your ladder (furthest from mature) dropped more than your overall ladder.  You don't see this same effect with a bond fund (because they concentrate their holdings at a specific duration), but the overall impact of a rate change is essentially the same.

This is perhaps somewhat counter intuitive.  Nonetheless, it's true.  For more on this, see https://www.bogleheads.org/wiki/Individ ... _bond_fund .

[MachineGhost]

What, exactly, do you think is "deadly" about bond funds?

By law bond funds must liquidate and return the proceeds to investors within a week.  There's no holding on to full maturity when investors panic sell their bond funds on yield rises and principal losses.  And what do bonds funds do when there are no bids in the marketplace?!!  Worse yet, bond liquidity has declined already due to the Dodd-Frank Act and market-making banks are getting out of the business.  Even holders of individual bonds that can actually hold to maturity do the stupid thing and sell at the worst possible time.

To paraphrase Trump, "It's going to be terrible.  Just terrible."  2013 was a small taste.

[rickb]

What, exactly, do you think is "deadly" about bond funds?

By law bond funds must liquidate and return the proceeds to investors within a week.  There's no holding on to full maturity when investors panic sell their bond funds on yield rises and principal losses.  And what do bonds funds do when there are no bids in the marketplace?!!  Worse yet, bond liquidity has declined already due to the Dodd-Frank Act and market-making banks are getting out of the business.  Even holders of individual bonds that can actually hold to maturity do the stupid thing and sell at the worst possible time.

To paraphrase Trump, "It's going to be terrible.  Just terrible."  2013 was a small taste.

So, you're saying if interest rates go up bond prices will go down and bond funds will have to sell (because of shareholder panic selling).  How does this affect someone who doesn't sell the bond fund any more than someone holding an individual bond?  If bond prices collapse, they collapse equally whether you're holding shares in a bond fund or individual bonds.  At that point (after the collapse) if you want to hold all your bonds to maturity (to "recoup" their principal value) you can do so even if your bonds are currently in a fund.  You have to first sell the bond fund (at its current value, which is what your individual bonds would also be worth) and buy similar individual bonds that you then hold to maturity. 

Perhaps not quite as convenient as starting with individual bonds in the first place, but other than the transaction cost of this sell/buy you're in exactly the same place - with exactly the same options.  You can keep your ladder going (same as stay in the fund) or hold the bonds in your ladder to maturity (same as selling the fund and buying individual bonds which you hold to maturity).

Again, where's the "deadly"?

[MachineGhost]

So, you're saying if interest rates go up bond prices will go down and bond funds will have to sell (because of shareholder panic selling).  How does this affect someone who doesn't sell the bond fund any more than someone holding an individual bond?  If bond prices collapse, they collapse equally whether you're holding shares in a bond fund or individual bonds.  At that point (after the collapse) if you want to hold all your bonds to maturity (to "recoup" their principal value) you can do so even if your bonds are currently in a fund.  You have to first sell the bond fund (at its current value, which is what your individual bonds would also be worth) and buy similar individual bonds that you then hold to maturity. 

Perhaps not quite as convenient as starting with individual bonds in the first place, but other than the transaction cost of this sell/buy you're in exactly the same place - with exactly the same options.  You can keep your ladder going (same as stay in the fund) or hold the bonds in your ladder to maturity (same as selling the fund and buying individual bonds which you hold to maturity).

Again, where's the "deadly"?

Bond funds can and will go lower than the NAV of the holdings from the panic selling, although I'm not sure how that works for open ended funds in illiquid situations with no bidders.  They probably just keep the junk on the books and don't mark it to the market.  It's all a mirage, right?  So in effect that would be a transfer of wealth from existing bagholders to the ones panic selling.

I think you're overlooking the self-reinforcing feedback loop here.  Bond funds are amplifying the downside risk of even individual bonds because of this legal requirement to raise liquidity which means they MUST sell at all costs no matter what the current bid is.  You tell me what happens when there is no bid on the individual bonds they MUST liquidate by law...  do prices keep dropping or do they just give up or...?  Without bond funds (and the corresponding panic sellers), there would not be this increased downside risk to individual bonds.  At least with individual bonds you are guaranteed to get it all back at maturity.  Bond funds can potentially stay in the red for decades from lack of buyers, continual panic selling and yield increases.  And bond funds hold thousands of different bonds; you have no way to specifically target a bond that is being panic sold in the portfolio to personally replace it with an individual issue.  However, we can be sure they will [try to] sell off the junk first before touching AAA.

Like I said, they're deadly.  This would apply to Treasuries too if there was that unthinkable sovereign debt default.  Fortunately, we get to see the rest of the world go through that first.

You see what I'm saying now, homes?

[rickb]

You see what I'm saying now, homes?

No.

Bond funds (open ended funds, not ETFs) can't go lower than the NAV of the individual holdings.  The daily price of an open ended bond fund IS the NAV of the individual holdings.  Bond ETFs (like, ahem, TLT) can certainly go lower than their NAV but you're saying "bond funds are deadly", not "bond ETFs are deadly". 

If bond funds are forced to liquidate at whatever market price they can find, then that's what those bonds are worth - holding individual bonds or a collection of bonds through a (open ended) fund makes no difference.  You can always trade your share in a bond fund for for a similar collection of individual bonds.

Essentially you're saying ETFs are bad (period).  The same logic applies to gold ETFs (e.g. GLD, IAU, and SGOL), or stock ETFs, or pretty much any ETF. 

Why are you so fixated on, specifically, bond ETFs?

[MachineGhost]

Why are you so fixated on, specifically, bond ETFs?

I'm specifically fixated on mutual funds, not ETF's.  ETF's don't have the legal requirement to raise liquidity by its nature.  CEF's certainly trade at extreme NAVs that you can't be seen with an OEF.  Example (not bonds):

[img width=800]http://i.imgur.com/Dg4Isud.png[/img]

I guess if you can't grok the pile-on-effect here of bond funds adding additional leverage to individual bond losses, then the fact that there are tens of millions of naive, yield-seeking investors currently in "safe" bond funds shouldn't phase you when yields start rising and they experience principal losses dwarfing their historically meager yields.

Let me try another way...  since OEF's have no outlet to allow the market price to flunctuate above and below the actual NAV along with the legal requirement to provide liquidity within a week to all selling unitholders, the pressure cooker relief valve will have to be the only place left...  an illiquid bond market, which will tank the NAV in an endless feedback loop.  The contagion effect will spread from junk to AAA and then to all corporations that hold all other corporation's bonds (they all do).  Systemic risk.  Look at the huge negative divergence between junk and the stock market:

[img width=800]http://i.imgur.com/3nx0EyT.png[/img]

The bond market is NOT like other markets.  It is a bank driven, dealer market still largely operated by telephone and the old boy network.  Unlike the specialists, they are not legally obligated to make a market nor provide liquidity and they're getting out of the game due to Dodd-Frank restrictions.  The liquidity is just not there for a massive exit out of bond funds by naive, panic-selling bond fund holders.

Why do you think the Fed had to step in when the commercial paper market completely froze up in 2008?  That is exactly what people do when they panic; they [try to] sell first and stop buying when credibility becomes questioned.  Who are these bond funds going to liquidate to besides clever -- but terribly few in number -- investors like me?

Another scary factor to consider is if a bond gets downgraded below investment grade, the bond fund has to legally get rid of it and no other bond fund can buy it.  Again, to whom are they going to dump their massive bond position to?

[rickb]

The bond market is NOT like other markets.  It is a bank driven market largely operated by telephone and the old boy network.  The liquidity is just not there for a massive exit out of bond funds.

Let's back up. Are you saying that owning bonds via an open ended bond fund is worse than owning individual bonds? 

Seems to me the picture you're painting says if you own bonds (directly or in a [open ended] fund) you're fucked.  Perhaps bond funds contribute to this, but the bottom line is you're fucked regardless of whether your ownership is through a fund or through individual bonds.  Right?

[MachineGhost]

Let's back up. Are you saying that owning bonds via an open ended bond fund is worse than owning individual bonds? 

Seems to me the picture you're painting says if you own bonds (directly or in a [open ended] fund) you're fucked.  Perhaps bond funds contribute to this, but the bottom line is you're fucked regardless of whether your ownership is through a fund or through individual bonds.  Right?

Yes.  If you're savvy enough to own individual bonds and stay out of bond funds, I think you're smart enough not to panic sell before maturity and fuck yourself permanently.  You don't have that legally guaranteed contract to ever reach maturity with 100% principal repaid as a bond fund unitholder by its very nature.

And yes, you're also fucked if you 1) overpay for bonds and/or 2) sell before maturity.  You have no control over either one in a bond fund because they MUST buy all available paper on the cash inflows, price be damned, just as they MUST sell all available paper on the cash outflows, price be damned.

In other words, bond funds are the crowded trade of the decade.  All thanks to the Fed.

[jafs]

So, if I get this right, a bond etf is as safe as holding individual bonds?  Although that way, you don't have a guaranteed buyer if/when you want to sell.

[rickb]

So, if I get this right, a bond etf is as safe as holding individual bonds?  Although that way, you don't have a guaranteed buyer if/when you want to sell.

I'd say an open ended bond fund (not ETF) is as safe as holding individual Treasury bonds.  ETFs can trade at an arbitrarily large discount (or premium) to their NAV - at least theoretically.  And, as previously discussed, TLT (which is an ETF) has other issues as well.

[jafs]

I think MG has a point about those.

They are required to buy back shares at any time and give cash back to sellers.  That cash has to come from somewhere, and if there are a lot of sellers and few other buyers of those shares, where would that money come from?

[rickb]

I think MG has a point about those.

They are required to buy back shares at any time and give cash back to sellers.  That cash has to come from somewhere, and if there are a lot of sellers and few other buyers of those shares, where would that money come from?

When you buy shares of an open ended bond fund, the fund creates new shares and buys bonds on the open market. When you sell shares, the fund sells bonds (and destroys shares).  Most funds keep some of their assets in cash as well.   

[jafs]

Right.

But in order to sell the bonds, they have to find buyers, and if everybody wants to sell, that may be difficult.

[rickb]

Like MangoMan said - the Treasury bond market is the most liquid market in the world.

[MachineGhost]

I think MG has a point about those.

They are required to buy back shares at any time and give cash back to sellers.  That cash has to come from somewhere, and if there are a lot of sellers and few other buyers of those shares, where would that money come from?

ETF's have "authorized participants" that agree to make a market in and arbitrage the shares; when they fail or do not make a market, the ETF price can trade at a premium or discount to the NAV and act as pressure cooker relief valve without affecting the underlying markets of the holdings.  More or less the same for CEF's.  Not so for OEF's at all.  If you have a 100.0000% Grade-AAA Pure Treasury OEF, there is no worry.  But any dilution from that perfect ideal and you start seeing fireworks...

Another nice factor that makes bond funds deadly is they borrow and use leverage to juice up the yields to make the fund more enticing to naive investors.  Well, leverage works on the downside just as it does on the upside...

You don't even have to be in a bond fund for them to be deadly.  So I continue to stand by my statement.  Is it applicable to our Treasuries?  Not unless there's a sovereign debt crisis.  But it does effect the other assets indirectly.  All non-Treasury bonds are Prosperity assets.

Anyone still disagree?

[Pointedstick]

I'm going to admit that this discussion is over my head. What's the TL;DR version?

[MachineGhost]

I'm going to admit that this discussion is over my head. What's the TL;DR version?

Bond funds are deadly! 

Doesn't affect us PPers much.  But hey, I'm no expert.  I could be wrong!

[rickb]

I'm going to admit that this discussion is over my head. What's the TL;DR version?

My version:

1) in normal times there's little difference between a bond ladder and a bond fund.  The common notion that holding individual bonds is "safer" than holding a bond fund because you can "recoup" any losses by holding the individual bond to maturity is a myth.

2) MG is thinking bonds are a crowded trade and everyone might run for the exits at the same time, and if this happens, bond funds might have liquidity issues - whereas if you hold individual bonds you could ride out the storm [although the current value of your individual bonds would still be hammered]

3) this likely doesn't affect orthodox PPers, since the market for Treasuries is so large [the real danger is the possibility of a "no bid" market]

No one has mentioned this, but I'll add that I'm pretty sure the Fed would never let the Treasury market go no bid.

[MachineGhost]

No one has mentioned this, but I'll add that I'm pretty sure the Fed would never let the Treasury market go no bid.

The Fed doesn't play that role, the Treasury does in collusion with the Fed and Primary Dealers (hopefully that is still operational reality and not MMT).  In fact, the government ordered the Fed to support all Treasuries at par during and after WWII.  Come to think of it, that was technically the equivalent of today's QEternity and the eventual end result was the multi-decade bond bear market that bottomed in 1981.  Next week is going to be very interesting.  I've reduced my duration exposure as much as feasible just in case.

[rickb]

No one has mentioned this, but I'll add that I'm pretty sure the Fed would never let the Treasury market go no bid.

The Fed doesn't play that role, the Treasury does in collusion with the Fed and Primary Dealers (hopefully that is still operational reality and not MMT).  In fact, the government ordered the Fed to support all Treasuries at par during and after WWII.  Come to think of it, that was technically the equivalent of today's QEternity and the eventual end result was the multi-decade bond bear market that bottomed in 1981.  Next week is going to be very interesting.  I've reduced my duration exposure as much as feasible just in case.

I'm talking about the secondary market, not the primary market.  My understanding is the Primary Dealers are required to bid in the primary market and the Fed cannot directly participate (but it's at least rumored that the Fed has been supporting prices in the primary market by promising Primary Dealers that it will immediately buy Treasuries from them in the secondary market).  The NAV of bond funds always reflects a secondary market price, so the problem you're hypothesizing is a no-bid secondary market.

[buddtholomew]

Bond funds aren't deadly, people are deadly 

[MachineGhost]

Bond funds aren't deadly, people are deadly 

[buddtholomew]

Haha, thanks MG!