Danger of Bond ETF's vs Direct Purchase

[moda0306]

We got talking about this in another thread, but I'm starting to think there's more danger in these bond ETF's than I originally thought.  See the following link:

http://www.greatponzi.com/articles/20081119-TLT.html

If these bonds are truly being lent out instead of held, then we're not only depending on the fund to be honest and able to get us the funds of our investment at 1:1 NAV, but that their contracts with short-sellers haven't gone bust.

Here's what I can tell so far.

They loan these bonds out after having received our money for our share in the ownership of the fund.  The people "borrowing" those bonds have to pay some kind of collateral (how much I don't know), and are likely short-sellers.  Of course, if during the term of their "borrowing" of the bond they collapse (as they were hoping for), most likely the traders will pay our TLT fund back with the bond and walk away with their money.

But what if long-term bonds explode like in 2008, and the short-sellers can't afford to meet their contract at the new price, and their "collateral" doesn't cover the new NAV of the bonds it was supposed to cover.

If I'm not mistaken, we're counting on the same bs contracts that look like they've got decent firewalls and protections, but are built on too many contracts with too much leverage, for the asset we're probably counting on most in a financial collapse to perform for us.

This is totally unacceptable in my opinion.  It amazes me they can do this with so much of the fund's assets.  Our investment in TLT isn't even covered by the FDIC, so we could very well be screwed over if the gov't decided to "let the market clear" outside of assets they've already guaranteed.

Maybe I'm just naive.

[stone]

moda, I totally agree. For me, what with it being so convienient to hold bonds directly, I don't see the point of risking holding a bond etf.

[murphy_p_t]

why do you implicate Vanguard in this?  is there any evidence of EDV having similar concerns?

[murphy_p_t]

moda, I totally agree. For me, what with it being so convienient to hold bonds directly, I don't see the point of risking holding a bond etf.

also, holding directly eliminates the expense ratio

[moda0306]

I always thought of it as a bit ridiculous to own physical bonds and mess with the buying/selling.

I had no idea they were running the safest asset in the world through a convoluted wall street contract process that negates much of what we're trying to achieve in the first place.  I figured it was just a matter of the following:

1) Fund buys bonds
2) Fund holds bonds!!!!!!!!!!!!!!!!!!!!!!!!
3) Fund chops ownership up and gives a piece to me

Not so, it seems.

I'm starting to wonder if diversifying stock funds institutionally now would also be a good choice, though I'm much less concerned about wall street tomfoolery in my stock portion.

[moda0306]

why do you implicate Vanguard in this?  is there any evidence of EDV having similar concerns?

My bad... I forgot TLT was i-shares.

[melveyr]

Ok so I can't copy and paste from the prospectus for some annoying reason.

But go ahead and search through the TLT prospectus for the word "lend."

Securities lending is listed as a risk... Disgusting.

[moda0306]

I am so pissed right now.  I usually don't feel populist rage against wall-street (mostly because the PP has taught me how to avoid their BS), but I'm just livid right now.

This is it.

I'm going physical with some gold.

I'm going direct with my bonds.

...at least most of them.

And you know there's an LLC barrier and employment contract separating anyone from any actual liability for if the SHTF.

I want to know what they do if somebody shorts long-term bonds (seems like this is immensely popular) and fails miserably, and their collateral doesn't cover the new bond value.

[craigr]

I always recommend owning bonds directly if you can. Funds are for convenience and have manager risk and other risks. But sometimes you don't have a choice. But if you do have a choice, own them directly.

[Gumby]

From the TLT Prospectus:

The Fund may lend securities representing up to one-third of the value of the Fund’s total assets (including the value of the collateral received).

Securities Lending Risk. The Fund may engage in securities lending. Securities lending involves the risk that the Fund may lose money because the borrower of the Fund’s securities fails to return the securities in a timely manner or at all. The Fund could also lose money in the event of a decline in the value of the collateral provided for loaned securities or a decline in the value of any investments made with cash collateral. These events could also trigger adverse tax consequences for the Fund.

The Fund may also make brokerage and other payments to Affiliates or Entities in connection with the Fund’s portfolio investment transactions.

Pursuant to a securities lending program approved by the Board, the Fund has retained an Affiliate of BFA to serve as the securities lending agent for the Fund to the extent that the Fund participates in the securities lending program. For these services, the lending agent may receive a fee from the Fund, including a fee based on the returns earned on the Fund’s investment of the cash received as collateral for any loaned securities. In addition, one or more Affiliates may be among the entities to which the Fund may lend its portfolio securities under the securities lending program.

The activities of BFA, Affiliates or Entities may give rise to other conflicts of interest that could disadvantage the Fund and its shareholders. BFA has adopted policies and procedures designed to address these potential conflicts of interest. See the Fund’s SAI for further information.

From the iShares Trust SAI (Statement of Additional Information):

This combined Statement of Additional Information (“SAI”?) is not a prospectus. It should be read in conjunction with the current prospectuses (each, a “Prospectus”? and collectively, the “Prospectuses”?) for the following funds of iShares Trust (the “Trust”?), as such Prospectuses may be revised or supplemented from time to time:

Lending Portfolio Securities. Each Fund may lend portfolio securities to certain creditworthy borrowers, including borrowers affiliated with BFA. The borrowers provide collateral that is maintained in an amount at least equal to the current market value of the securities loaned. No securities loan shall be made on behalf of a Fund if, as a result, the aggregate value of all securities loans of the particular Fund exceeds one-third of the value of such Fund’s total assets (including the value of the collateral received). A Fund may terminate a loan at any time and obtain the return of the securities loaned. Each Fund receives the value of any interest or cash or non-cash distributions paid on the loaned securities.

With respect to loans that are collateralized by cash, the borrower will be entitled to receive a fee based on the amount of cash collateral. The Funds are compensated by the difference between the amount earned on the reinvestment of cash collateral and the fee paid to the borrower. In the case of collateral other than cash, a Fund is compensated by a fee paid by the borrower equal to a percentage of the market value of the loaned securities. Any cash collateral may be reinvested in certain short-term instruments either directly on behalf of each lending Fund or through one or more joint accounts or money market funds, including those affiliated with BFA; such reinvestments are subject to investment risk.

Securities lending involves exposure to certain risks, including operational risk (i.e., the risk of losses resulting from problems in the settlement and accounting process), “gap”? risk (i.e., the risk of a mismatch between the return on cash collateral reinvestments and the fees each Fund has agreed to pay a borrower), and credit, legal, counterparty and market risk. If a securities lending counterparty were to default, a Fund would be subject to the risk of a possible delay in receiving collateral or in recovering the loaned securities, or to a possible loss of rights in the collateral. In the event a borrower does not return a Fund’s securities as agreed, the Fund may experience losses if the proceeds received from liquidating the collateral do not at least equal the value of the loaned security at the time the collateral is liquidated plus the transaction costs incurred in purchasing replacement securities. This event could trigger adverse tax consequences for the Funds.

Each Fund pays a portion of the interest or fees earned from securities lending to a borrower as described above and to a securities lending agent who administers the lending program in accordance with guidelines approved by the Trust’s Board of Trustees (the “Board”? or the “Trustees”?). To the extent that the Funds engage in securities lending, BTC acts as securities lending agent for the Funds, subject to the overall supervision of BFA. BTC receives a portion of the revenues generated by securities lending activities as compensation for its services.

I have now lost all faith in every corner of Wall Street. I always assumed, naively, that I-Shares made an effort to keep their ultimate safe-haven ETF safe. I should have known that Wall Street would rather make an extra few bucks than serve their own customers seeking safety. I am glad that I own my bonds directly.

[Benko]

Considering my gold is in the form of GTU (not GLD) I am now very uncomfortable with my TLT. 

Any suggestions to replace TLT for those of us who would rather not own bonds ourselves?

Thanks.

[Gumby]

Considering my gold is in the form of GTU (not GLD) I am now very uncomfortable with my TLT. 

Any suggestions to replace TLT for those of us who would rather not own bonds ourselves?

Thanks.

It'll help us help you if you explained why you'd rather not own the bonds directly. Most investors have never purchased bonds directly before, so it's entirely understandable if the process of buying bonds is too unfamiliar. We can walk you through the basic process if that's the only concern. Who do you use for your brokerage service?

[doodle]

Are mutual funds subject to the same lending issues as ETF's? I know that Fidelity has a couple treasury funds with low expense ratios.

FSBIX - Short bonds

FLBIX - Long Bonds


If you hold more than 100,000 in each fund you qualify for FSBAX and FLBAX which come with a .10 expense ratio.

[Benko]

I use Scottrade since they are cheap.  I have only been investing for a month or so (less time than I've been on this forum) unless you count letting things sit in my retirement account all in the money market "option", and in my checking account (don't ask).

I can do what I need to for investing, but would STRONGLY prefer to make things as simple as possible.  Having long term bonds in some online fund that I never have to touch is simpler than buying the bonds, selling them (was it every 5 years?) and keeping track of the piece(s) of paper.  Life is complicated enough.  I realize that sounds nuts, but that would be my preference if it didn't increase risk significantly.

Thanks for your help.

[Gumby]

Buying Treasury Bonds for the Permanent Portfolio is as easy as buying a stock once you learn the basics. The only difference is that you are buying bonds in $1000 increments (so, 2 bonds = $2000), instead of individual shares and they have an end date (aka "Maturity Date"). There are no pieces of paper to keep track of, it's all done electronically now. You simply buy the longest bonds you can get your hands on (the longest, 30-year bonds are currently maturing in 2041), don't worry about the coupon rate, and you just hold them for a decade (sell them in 2021) and buy new 30-year bonds. That's exactly what TLT does. You would also possibly sell some of your bonds during a rebalance.

I'm not familiar with Scottrade, but my understanding is that while Scottrade does not charge a fee, they will "act as principal" when you buy Treasury Bonds — which is a cryptic way of saying that they will sell you the bond at a premium so that they make some money off of you. Consider opening up a Fidelity or Schwab account if you want to purchase and sell Treasuries with no fee.

It's not really that difficult to keep track of when to sell your bonds because each bond is titled with its maturity date. So, you would see something like "US TREASURY BOND 3.75% 2041" in your portfolio with the quantity and value of those bonds in your portfolio screen. When the year 2021 comes, you would easily see that the 2041 bonds in your portfolio are ready to be refreshed with new bonds.

If I have time (possibly tomorrow), I can probably post some screenshots to show you how easy it is.

[l82start]

Buying Treasury Bonds for the Permanent Portfolio is as easy as buying a stock once you learn the basics. The only difference is that you are buying bonds in $100 increments (so, 20 bonds = $2000), instead of individual shares and they have an end date (aka "Maturity Date"). There are no pieces of paper to keep track of, it's all done electronically now. You simply buy the longest bonds you can get your hands on (the longest, 30-year bonds are currently maturing in 2041), don't worry about the coupon rate, and you just hold them for a decade (sell them in 2021) and buy new 30-year bonds. That's exactly what TLT does. You would also possibly sell some of your bonds during a rebalance.

I'm not familiar with Scottrade, but my understanding is that while Scottrade does not charge a fee, they will "act as principal" when you buy Treasury Bonds — which is a cryptic way of saying that they will sell you the bond at a premium so that they make some money off of you. Consider opening up a Fidelity or Schwab account if you want to purchase and sell Treasuries with no fee.

It's not really that difficult to keep track of when to sell your bonds because each bond is titled with its maturity date. So, you would see something like "US TREASURY BOND 3.75% 2041" in your portfolio with the quantity and value of those bonds in your portfolio screen. When the year 2021 comes, you would easily see that the 2041 bonds in your portfolio are ready to be refreshed with new bonds.

If I have time (possibly tomorrow), I can probably post some screenshots to show you how easy it is.

can you put the treasury bonds in a RothIRA or IRA or do they need a separate/special account to hold them?  

[KevinW]

I have now lost all faith in every corner of Wall Street. I always assumed, naively, that I-Shares made an effort to keep their ultimate safe-haven ETF safe. I should have known that Wall Street would rather make an extra few bucks than serve their own customers seeking safety. I am glad that I own my bonds directly.

This seems to be a recurring theme: Wall St. just can't resist the temptation to muck around with everything they touch.

Browne was on to something with his prescription for: individual bonds, physical bullion, multiple T-bill MMFs, and multiple stock index funds.  Half the portfolio has no fund sponsor to worry about, and the other half has a strict structure which ought to keep sponsors on a short leash.

[moda0306]

Can stock etfs, mutual funds, or even worse, treasury money market funds do this?

[murphy_p_t]

previously, I was thinking SHY/SHV would be safer than Vanguard MM fund...now I'm thinking that highly doubtful...guess I need to do some more reading of prospecti

[murphy_p_t]

...makes i bonds look even more attractive for deep cash

[smurff]

Moda0306 wrote:

I am so pissed right now.  I usually don't feel populist rage against wall-street (mostly because the PP has taught me how to avoid their BS), but I'm just livid right now.

This is it.

I'm going physical with some gold.

I'm going direct with my bonds.

...at least most of them.

And you know there's an LLC barrier and employment contract separating anyone from any actual liability for if the SHTF.

I want to know what they do if somebody shorts long-term bonds (seems like this is immensely popular) and fails miserably, and their collateral doesn't cover the new bond value.

Gumby wrote:

I have now lost all faith in every corner of Wall Street. I always assumed, naively, that I-Shares made an effort to keep their ultimate safe-haven ETF safe. I should have known that Wall Street would rather make an extra few bucks than serve their own customers seeking safety. I am glad that I own my bonds directly.

It sounds like the two of you are ready to occupy Wall Street.

[t-bear52]

I've never purchased individual bonds before. Sounds like I should start!
With TLT it's easy to look up the performance to calculate how your PP is doing.
How do you do so when you hold the bonds individually? (sorry for the newbie question!)

[WildAboutHarry]

How do you...[look up performance]...when you hold the bonds individually?

Try the link:

http://online.wsj.com/mdc/public/page/2 ... nav_2_3020

[stone]

moada, "Can stock etfs, mutual funds, or even worse, treasury money market funds do this?"

stock etfs certainly can, I wittered on about that on the investment trust thread. I do not know whether investment trusts (closed end funds) can or do. My hope was that the structure of closed end funds makes them more robust because the issue of net redemptions never occures for them. I also like the fact that some stock closed end funds in the UK are more than 100 years old and to me that was a reasuring stress test.

http://www.ft.com/cms/s/0/3354514e-effc ... ab49a.html
Providers are permitted to lend out all of an ETF’s constituent assets.
In practice, effective lending rates tend to be much lower but Morningstar data show there are instances where virtually all of a physical ETF’s assets have been lent out for at least 12 months (on a near constant basis). The iShares FTSE 250 ETF lent out an average of 92 per cent of its assets over the year to June.

[WildAboutHarry]

In a very cursory and unscientific study of Vanguard and Fidelity LT Treasury Fund prospecti, I did not find the word lend or lending (although caLENDar did show up).

So if you want to use bond funds the question becomes: "Is security lending (TLT) better than, worse than, or the same as potentially holding 20% agency/mortgage bonds (Vanguard an Fidelity)"?