Bond Ladders vs Bond ETF's

[snowback96]

A five-year GIC ladder - the maximum guaranteed term - has a duration that will be around 2 1/2 years. [3 years is the average term when set up 1-2-3-4-5; just before renewal the sequence becomes 0-1-2-3-4 with an average of 2; mean 2 1/2; the coupons reduce the duration below the term.] XSB has a similar duration (2.6 right now); to a first approximation you can sell XSB in one fell swoop and replace it with a 1-2-3-4-5- ladder with only minor interest rate sensitivity. Of more concern may be credit quality differences, since XSB includes corporates. Of course, you could also use a government bond ETF like CLF if you want to match that.

How does your choice on whether the GIC coupons are paid annually vs. compounded impact the duration? For example, if you choose to have a 5-year GIC "compound" the interest coupons, wouldn't the term exactly equal the duration (i.e. 5 years)?

[StuBee]

I believe, that you can look at a GIC that compounds annually exactly like you would look at a strip (i.e. the time to maturity is its duration). I presume that what Shakespeare is referring to is a 5 yr ladder of compounding GIC's with equal initial dollar amounts in each of the 5 rungs (or each of the 1, 2, 3, 4, and 5 year maturities). I imagine that the duration calculation would be completely different for GIC's that pay out their interest annually. Presumably they would be treated like ordinary bonds and the Macaulay equation would be used to calculate each of their durations and then an average of the five durations would be determined.

Just my two bits... I am not an expert.

StuBee

[like_to_retire]

Forgive me if I've moved this discussion to the wrong place, but could you please expand on this. I was of the viewpoint that one of the disadvantages of using fixed income ETFs was the lack of control of duration and yield and thus when approaching on in retirement, direct bond holdings with known duration and yield was the more appropriate strategy.

Another disadvantage of using fixed income ETFs during a rising rate environment is that the share price drops. If you require more than the distribution offers for your retirement cash flow and there is a requirement to sell shares, you'll be in worse shape opposed to taking 100 cents on the dollar from a maturing ladder rung each year.

ltr

[Shakespeare]

How does your choice on whether the GIC coupons are paid annually vs. compounded impact the duration?

The duration of a short to medium ladder is affected more by the average term than the coupon, since the total coupons are less than the capital amount maturing. A five-year ladder will have a duration in the neighborhood of 2 1/2 years unless short-term rates are enormous.

[like_to_retire]

One of the reasons often stated is that ETF's have the advantage in buying their bonds since they purchase such large quantities and that the individual buyer of bonds can't compete.

Now I see in this article that very large quantities work against the buyer.

“A buyer of $100-billion a month is always going to be paying top prices,” Mr. Crandall said of the Fed. “You can’t be a known buyer of $100-billion a month and get a good price.”

So which is it? Large quantites enjoy better or worse prices?

ltr

[jiHymas]

So which is it? Large quantites enjoy better or worse prices?

In Canada, in my experience, the sweet spot for corporate bond purchases on the secondary market is about $1-million / trade.

You can do much larger amounts in the primary market, or with bonds having less than a year to maturity.

The Fed's basic problem with it's buying programme is not the size so much (although that's a factor, of course) but rather that it's a forced buyer, can't walk away from bad prices ... and everybody knows that.

[kcowan]

When bond issues are reopened, is it always because of insufficient demand by the original closing date?

[like_to_retire]

The Fed's basic problem with it's buying programme is not the size so much (although that's a factor, of course) but rather that it's a forced buyer, can't walk away from bad prices ... and everybody knows that.

That's the exact point that's always confused me about large bond ETF's. They also have a requirement to continuously purchased large quantities of bonds. If they sat on the cash, I'm sure they'd be hearing from the ETF holders fairly quickly. So my thought was always, "why don't the sellers to the ETF's see them coming and charge a higher price, since (unlike individual investors) they can't walk away"?

ltr

[jiHymas]

When bond issues are reopened, is it always because of insufficient demand by the original closing date?

I don't understand what you mean.

So my thought was always, "why don't the sellers to the ETF's see them coming and charge a higher price, since (unlike individual investors) they can't walk away"?

They can't walk away but they have a lot more choice than the Fed in their investments.

They can, for instance, participate in a new issue. Or (in most cases) they can park the money in a benchmark bond and gradually swap out of that into what they want. Or they can simply pay up and the difference will be their tracking error.

Note as well that when they issue new units, they will typically get a basket of securities in exchange, and so don't have to go to market.

Added Later: Which is not to say that they don't overpay and never get taken to the cleaners. Any systemic tracking error (in excess of MER) is evidence that they're overpaying (or being underpaid). Typically, an ETF's trading is done by a clerk (or jumped-up clerk with regulatory status) who aren't much good, don't much care, and have very little discretion anyway.

The most egregious example I know of with respect to an ETF being taken to the cleaners is CPD buying POW.PR.C last January ... and we only know about that because the market is small, CPD reports positions daily, and the market reports transaction prices.

This is my big problem with the regulators' beloved Trading Expense Ratio (TER). It only reports the direct, reportable, costs of trade - the commission and settlement expense. Unless the fund is paying a ridiculous commission, the less visible Market Impact Costs (which include the bid/ask spread, and can only be estimated in any case) are going to dwarf the commission. Which is not to say that commission costs should not be reported of course; only that TER doesn't even begin to tell the story.

I should also note that tracking error doesn't usually tell the whole story either, since the index itself can experience "meta-tracking-error" (vs. a notional constant superset which contains all issues that are added and deleted over the period). This is because index changes are typically announced a week (or so) in advance of the change; in the interim, relative prices move with the biases one might expect. <ad> I discussed this with respect to TXPR and preferred shares in the September, 2010, edition of PrefLetter </ad>

[Eric R]

I think that the large buyers ultimately set the price anyway. So if the ETF buyers pay extra, the small investors will follow.

As far as I understand it, the investor should be indifferent to a bond ladder versus a bond ETF of similar duration (excluding MER). One could look at a bond ETF as a partial ladder, eg an ETF with average maturity of 6 years will buy 8 year bonds and keep them for 4 years and then buy a new set of 8 year bonds at the prevailing rate. If rates go up, they will sell for less, but invest the proceeds in a higher yielding bond (assuming there is no change in the slope of the yield curve).

If one has to match duration to liability, a zero coupon bond would be the way to go, not a bond ladder or ETF.

[like_to_retire]

Which is not to say that they don't overpay and never get taken to the cleaners. Any systemic tracking error (in excess of MER) is evidence that they're overpaying (or being underpaid). Typically, an ETF's trading is done by a clerk (or jumped-up clerk with regulatory status) who aren't much good, don't much care, and have very little discretion anyway.

This may also account for something else I don't like about ETF's, in that they don't appear to much care whether they're purchasing premium bonds or not. Having a bond ladder outside my RSP has taught me to pay particular attention to this detail. Most bonds ETF's from Claymore and ishares are in a premium position. It's a guarantee that the NAV is going to drop and that you'll be paying more taxes than you might like.

I think that the large buyers ultimately set the price anyway. So if the ETF buyers pay extra, the small investors will follow.

I don't know if that's true or not. I think a bond will have a particular value dependent on interest rates and credit worthiness and then a dealer sets a spread depending on the investor who's purchasing at the time and the quantity they need. Do you think a dealer adjusts the spread for each sale to an institution and then has a fixed spread difference for individuals? So if they're able to overcharge an ETF on a particular sale, then they'll do the same to the individuals after that? I honestly don't know how it works.

ltr

[adrian2]

Via PrefBlog, an interesting opinion on the Canadian bond market:

In order to maximize value in their bond portfolios, investors should limit exposure to Canada’s corporate bond market, one of the most expensive and least diversified of its kind in the world, says Ed Devlin, executive vice president and portfolio manager at PIMCO Canada Corp.

“The fundamental problem with the Canadian corporate bond market is that there is are too many investors chasing too few issuers,” Mr. Devlin said in a recent note to clients.

He noted that 59% of Canada’s main corporate bond benchmark is concentrated in just 10 issuers. By comparison the percentage of the index concentrated in 10 issuers is 20% in the U.S., 26% in Great Britain and 35% in the Eurozone.

[like_to_retire]

Via PrefBlog, an interesting opinion on the Canadian bond market:

In order to maximize value in their bond portfolios, investors should limit exposure to Canada’s corporate bond market, one of the most expensive and least diversified of its kind in the world, says Ed Devlin, executive vice president and portfolio manager at PIMCO Canada Corp.

“The fundamental problem with the Canadian corporate bond market is that there is are too many investors chasing too few issuers,” Mr. Devlin said in a recent note to clients.

He noted that 59% of Canada’s main corporate bond benchmark is concentrated in just 10 issuers. By comparison the percentage of the index concentrated in 10 issuers is 20% in the U.S., 26% in Great Britain and 35% in the Eurozone.

That's one of the things that always struck me as interesting in that Claymores CBO only has 29 bonds and XCB has a whopping 432. Quite a difference.

ltr

[Peculiar_Investor]

I've been gradually selling down holdings in XCB and building my own 10 year bond ladder. Over the weekend I was on the ishares site to check the price vs. NAV on XCB to determine potential sale price this week. In doing so, I wandered over to http://ca.ishares.com/product_info/fund ... ce/XCB.htm to check performance. I'm quite surprised by the amount of tracking error for this ETF. The 0.42% MER doesn't account for the difference.

XCB tracking error to 31-Dec-10.PNG (10.22 KiB) Viewed 730 times

Shouldn't an investor expect a positive tracking error (before MER) occasionally?

[Webber22]

Based on the iShares error tracking chart, a large discrepancy started just around the time Blackrock took over

http://ca.ishares.com/tools/tools.htm?i ... ch#trg_117

[adrian2]

Based on the iShares error tracking chart, a large discrepancy started just around the time Blackrock took over

As opposed to Barclays, who had a nickname "The Gang Who Cannot Shoot Straight", referring to iShares tracking error.

[Bylo Selhi]

As opposed to Barclays, who had a nickname "The Gang Who Cannot Shoot Straight", referring to iShares tracking error.

To be fair, that moniker came about a decade ago primarily with respect to a bunch of single-country ETFs (WEBS.) The author of the moniker gives a great explanation of why the gang couldn't shoot straight. Very little of that applies to broader ETFs today.

[adrian2]

To be fair, that moniker came about a decade ago primarily with respect to a bunch of single-country ETFs (WEBS.) The author of the moniker gives a great explanation of why the gang couldn't shoot straight. Very little of that applies to broader ETFs today.

Current tracking error as per iShares.ca charts (some funds I cared to check):

Code: Select all

Ticker Period   MER      Perf. Diff. (annualized)
XIN     3 yr.   0.5%        1.58%
XSP     3 yr.   0.24%       1.13%
XSP     5 yr.   0.24%       0.91%

Tripling or more the MER...

[newguy]

To be fair, that moniker came about a decade ago primarily with respect to a bunch of single-country ETFs (WEBS.) The author of the moniker gives a great explanation of why the gang couldn't shoot straight. Very little of that applies to broader ETFs today.

Current tracking error as per iShares.ca charts (some funds I cared to check):

Code: Select all

Ticker Period   MER      Perf. Diff. (annualized)
XIN     3 yr.   0.5%        1.58%
XSP     3 yr.   0.24%       1.13%
XSP     5 yr.   0.24%       0.91%

Tripling or more the MER...

In checking the math against SPXHCDTR:IND (the hedged to CAD S&P500 index) I noticed they're using it and not just doing a conversion on the end dates. The index already has some of the hedging costs incorporated so it can't be totally blamed on that.

newguy

[Peculiar_Investor]

While the follow-up discussion of ETF tracking error is useful, I'd like to return to focus to Bond ETFs (see topic). Given the size and efficiency of the bond market, I would have thought that it would be easy to minimize tracking error in a bond ETF. Although I don't hold them, I just checked XBB and XSB, and they do track much closer to their index, and do show both +ve and -ve tracking error.
http://ca.ishares.com/product_info/fund ... ce/XBB.htm

http://ca.ishares.com/product_info/fund ... ce/XSB.htm

Now it has me wondering what's different about XCB and it's usefulness for index investors?

[DanH]

In checking the math against SPXHCDTR:IND (the hedged to CAD S&P500 index) I noticed they're using it and not just doing a conversion on the end dates. The index already has some of the hedging costs incorporated so it can't be totally blamed on that.

newguy

Watch out when using the iShares tracking error calculator for non-Canadian ETFs. iShares sometimes doesn't use the right benchmark.

Case in point (from last summer): XWD & XEM tracking errors much better than they appear

[newguy]

In checking the math against SPXHCDTR:IND (the hedged to CAD S&P500 index) I noticed they're using it and not just doing a conversion on the end dates. The index already has some of the hedging costs incorporated so it can't be totally blamed on that.

newguy

Watch out when using the iShares tracking error calculator for non-Canadian ETFs. iShares sometimes doesn't use the right benchmark.

Case in point (from last summer): XWD & XEM tracking errors much better than they appear

Yes, I remember we discussed this a while ago. That's one of the reasons I checked the benchmark they were using. You can see S&P's methods here. (see fact sheet or methodology pg.45) I just compared those returns with what iShares calls the index (but using bloomberg for the data).

newguy

sorry PI, but there's no info about those benchmarks. It's all very proprietary in Canada.

[jiHymas]

Now it has me wondering what's different about XCB and it's usefulness for index investors?

I note that XCB's largest holding is some Innovative Tier 1 Capital from TD Bank.

ETF sponsors love to goose their reported yields with IT1C and sub-debt. The former, particularly, went on a wild ride in 2010.

XCB was the least offending of the three ETFs examined when I wrote on the subject but maybe that has changed. If I was going to spend time checking it out, I'd start there.

[Bylo Selhi]

Current tracking error as per iShares.ca charts (some funds I cared to check):

Since the underlying US-based ETFs don't have tracking error issues, the error must arise here, whether it's the cost of hedging, inappropriate use of benchmark, calculation errors or whatever. It hardly proves that the "gang" can't "shoot straight" with respect to indexing. What it says about their ability to "shoot straight" in other areas is a separate, unrelated issue.

Note also that their wholly Canadian ETFs like XIU and XIC don't seem to have any trouble staying on target. So if there's a lesson here, it's stick to large (asset base) and broad (market coverage.)

[adrian2]

Since the underlying US-based ETFs don't have tracking error issues, the error must arise here, whether it's the cost of hedging, inappropriate use of benchmark, calculation errors or whatever. It hardly proves that the "gang" can't "shoot straight" with respect to indexing. What it says about their ability to "shoot straight" in other areas is a separate, unrelated issue.

Note also that their wholly Canadian ETFs like XIU and XIC don't seem to have any trouble staying on target. So if there's a lesson here, it's stick to large (asset base) and broad (market coverage.)

Here is a previous post of mine. Since then, iShares.ca has conveniently removed the tracking error chart for XRE and XTR, two of my other holdings. Nice way of skirting the issue of gross incompetence.

Tracking errors in calendar year 2009 for other iShares funds:

XCS 1.25% = 0.55% trustee fee + 0.7% other miscellaneous factors
XRE 1.75% = 0.55% trustee fee + 1.2% other miscellaneous factors
XTR 1.58% = 0.55% trustee fee + 1.03% other miscellaneous factors

Pretty easy to blame "other miscellaneous factors" instead of admitting incompetence! Vanguard usually achieves a negative tracking error, while these guys have consistently a tracking error higher, sometimes much higher, than the MER!

As for all this being due to universal hedging issues that affect everybody, quoting myself again:

For the year ended December 31, 2009, the Fund [XIN] returned 18.11% vs. the Index return of 23.45%.

FWIW, for the same period:
Altamira International Index Currency Neutral (similar mandate) has returned 22.26%, despite a MER of 0.53%
TD International Index Currency Neutral - series e has returned 19.53%, despite a MER of 0.50%

ISTR a slogan: Barclays [Blackrock], the guys who cannot shoot straight.