Bond Ladders vs Bond ETF's

[Pickering]

I have recently retired my portfolio is my only source of income ( will take CPP early ) and at to-days rates is adequate for all our needs. My goal is not to spend principle.
Portfolio allocation as follows
Fixed - 70 % ( xsb - 12 %, clf-17%, cbo-18%, xcb-8%, re-sets-10% and cpd-5%)
Equities - 30 % ( xfn,fie, bmo transcanada and encana)
Average weighted yield is 4.86%
The fact that a bond ladder will protect my principle is very attractive to me. My concern with the ETF is that there is no maturity date and the NAV's dictate pricing and there is no guarentee that at some point I can re-coup all my principle. Similar to a bond fund but without the high MER.
Am having trouble getting my head around paying a premium( at some point taking a capital loss ) and not achieving comparable yields. all the while, I do know what the endgame is.
Perhaps, is this not the time to be forming a ladder.
Any advice/comments appreciated.

[Doug]

http://moneywatch.bnet.com/investing/bl ... hoice/873/

"One should own individual bonds because bond funds give an unnecessary risk in that their value moves with interest rate changes. If interest rates go up, the value of the bonds and bond funds go down. But if you hold the individual bonds until maturity, in a laddered portfolio, you eliminate this risk since they generally mature at par. No such guarantee exists with funds since they are constantly buying additional bonds"

The link makes the argument that what the above paragraph states is a myth.

[like_to_retire]

The link makes the argument that what the above paragraph states is a myth.

The conclusion of that article is:
Low cost bond index funds provide professional management with very low costs. In return for paying as little as 14 basis points (0.14%) annually, you get diversification and liquidity.

Why would I pay someone 14 basis points for something I can do myself?

Liquidity? If rates are rising, the liquidity results in selling into a depressed NAV. Why would I want to do that when I can wait a short time until one of my ladder rungs pays me 100 cents on the dollar for my mature bond.

During accumulation years, my opinion is that bond funds (or ETF's) are fine, but in retirement, as soon as you need more cash than the fund can provide, the NAV becomes a concern. The impact of rising rates is a risk if you need any capital for income. Real bonds kept to maturity don't suffer this problem. If you require more income than the coupons from your ladder throws off, then at each maturity draw cash at 100 cents on the dollar. There's a defined exit point with real bonds and you're able to plan.

It's fine to ignore the dropping NAV of a fund (that is inevitable as rates rise) if you only require the income produced by the fund, but if not, you'll be selling depressed units and taking a loss that could go on for years, depending on the duration of the fund. When RRIF withdrawals become a reality, the bond funds can be a problem.

I understand the allure of the fund. I can think of quite a few advantages.

1. They have the advantage of automatic reinvestment of distributions, freeing you from having to find a home for the coupons that are thrown off by real bonds. During accumulation, this is a bonus.

2. Your hands aren't tied waiting for a real bonds maturity date to get some quick cash.

3. Funds have the advantage of offering the ability to sell small quantities to generate cash.

4. Short term funds have quick recovery from interest rate increases and they can give you that exposure to a collection of corporate bonds, since many short term funds use corporates to lift their yields.

5. Low price of admission for the small investor. Real bonds aren't really worth buying under $10K.

6. If you use funds for income, you don't care about the NAV as long as capital isn't required..

But I can also come up with advantages that real bonds have over funds too. I think they win out, especially in retirement, and when you're faced with an aggressive withdrawal requirement in a RRIF.

1. I get a defined rate of return and a known principle at maturity. I don't care about NAVs since a couple times a year a bond matures with its face value. I take the cash I need and repurchase a new bond at the rates of the day.

2. Why pay someone to do something you can do yourself at less cost.

3. I can control the duration of my holdings.

4. I control any capital gain liabilities.

ltr

[Doug]

Ltr, your points are well taken. I am in the accumulation phase, and I once had a bond ladder. However, it's much easier to add new money to a MF/ETF than it is to a ladder.

[Peculiar_Investor]

Does anyone know if there has been a study or article that compared the frictional costs of a bond ladder vs. ETF? What I'm thinking is that when buying an ETF, the frictional cost is the MER, which is paid over the lifetime of the holding, while when an individual investor is building a bond ladder the frictional cost is bond pricing (bid/ask spread), which is a one time item. IMHO this is more relevant during the accumulation phase where other factors cited above are of lower significance.

I would assume that an ETF company would get much better pricing that Joe Investor as well as access to a deeper pool of bonds. I'd like to know if that pricing advantage overcomes the management fee paid?

[Shakespeare]

I would assume that an ETF company would get much better pricing that Joe Investor as well as access to a deeper pool of bonds. I'd like to know if that pricing advantage overcomes the management fee paid?

The ETF or fund also gets a yield boost from diversification to lower-rated bonds that the small investor could not purchase efficiently.

[Doug]

There will also be a bid/ask spread on the ETF. The less liquid the ETF, the greater the spread. Also, commissions on buying and selling the ETF, although often that is not an important factor nowadays.

[Springbok]

Over the years, I have lost money by owning Bond ETFs as well as low MER Bond funds like the ones at PH&N. I now steer well clear of them!

Most of us maintain a level of fixed income, so as to reduce the overall risk in our portfolios. GICs and bonds guaranty that you get your capital back at maturity and that you will earn a specified yield. Risk level is low. ETFs and MFs don't provide that and there is a real risk that you will not preserve your capital and perhaps earn a negative yield.

By all means own bond ETFs and MFs, especially if you don't have enough money to buy a GIC or a bond, but don't think of them as part of your Fixed income. Maybe they could be considered as a way of getting involved in bond trading in a small way??

[scomac]

I'd like to know if that pricing advantage overcomes the management fee paid?

It depends.

I'm of the view that an individual investor can overcome the frictional costs of the bid/ask spread. For starters, the commission is a one time expense and the rate doesn't vary by maturity, therefore the longer maturing the bond is the lower the commission will be on an annual basis. This is an often overlooked benefit of the 10 year ladder versus a 5 year ladder. Secondly, ETFs by nature of design, will hold a significant component in Canadas. The individual investor doesn't need to do this. You can take advantage of the yield premiums offered on provincials, municipals, agency debt and investment grade corporate bonds; liquidity isn't a concern because you're not trading. Whether the above is adequate to overcome the MER hurdle, IOW your costs of direct ownership are lower than the ongoing fund fees, will depend in large part on the size of the portfolio. Even at $10K/wrung in the ladder, you can DIY for <= an ETF MER if you are judicious with your purchasing.

As far as the numbers go, I think it's more or less a bit of a wash in deciding between a ladder or an ETF (AFAIC MF shouldn't even enter into the discussion because they're too expensive) and as such the decision would be swayed by other factors and the weighting placed by the individual investor. As an example, I really favour the certainty of return with a ladder; where as, I can appreciate the simplicity of the ETF when it comes to accumulating assets.

[Peculiar_Investor]

I'd like to know if that pricing advantage overcomes the management fee paid?

It depends.

I'm of the view that an individual investor can overcome the frictional costs of the bid/ask spread. For starters, the commission is a one time expense and the rate doesn't vary by maturity, therefore the longer maturing the bond is the lower the commission will be on an annual basis. This is an often overlooked benefit of the 10 year ladder versus a 5 year ladder. Secondly, ETFs by nature of design, will hold a significant component in Canadas. The individual investor doesn't need to do this. You can take advantage of the yield premiums offered on provincials, municipals, agency debt and investment grade corporate bonds; liquidity isn't a concern because you're not trading. Whether the above is adequate to overcome the MER hurdle, IOW your costs of direct ownership are lower than the ongoing fund fees, will depend in large part on the size of the portfolio. Even at $10K/wrung in the ladder, you can DIY for <= an ETF MER if you are judicious with your purchasing.

As far as the numbers go, I think it's more or less a bit of a wash in deciding between a ladder or an ETF (AFAIC MF shouldn't even enter into the discussion because they're too expensive) and as such the decision would be swayed by other factors and the weighting placed by the individual investor. As an example, I really favour the certainty of return with a ladder; where as, I can appreciate the simplicity of the ETF when it comes to accumulating assets.

Thanks, I'm nearing the cusp of reaching the point in time where I need to consider the generated income from the fixed income portion of our portfolio and I've been trying to educate myself on the ins and outs of fixed income strategies. As I've stated here on a number of occasions, being in the accumulation phase and not having expertise in bond picking, I tended to purchase the broad index via XBB, the iShares CDN Bond Index ETF, so that I can match the index return. I foresee in the next 5 years or so the need to start building my own fixed income portfolio to align to our future needs. I've started doing so dabbling in this area over the past year but still have much to learn.

I really appreciate when those that have gone before me share their insights.

[kcowan]

I took over the bond ladder for my MIL about 6 years ago. Immediately saved a significant yearly charge from a portfolio manager. Switched from Scotia to TDW and save another $1300 a year. Because I evolved into it based on maturities, I learned as I went along.

I am with Scomac. For someone who is retired, maintaining a ladder is a small effort when compared to paying an MER and having uncertain principle.

[Doug]

There are many in this forum who have the skills necessary to buy individual corporate bonds. However, IMO, the average retail investor should not be buying individual corporate bonds and should buy corporate bond ETFs instead. Their increased complexity, such as the call feature, works against you. David Swensen makes the case that you want to put your money in investment products where the provider of the investment product has as closely aligned interests to your own as possible. For domestic government bonds, a government that takes advantage of its bondholders may be punished by its voters. For corporate bonds, a company that takes advantage of its bondholders may be rewarded by its shareholders.

About bond MFs, I think it is reasonable to use TD e-series, and CIBC if you can get the diminishing discount. However, for anything other than small amounts, you're probably better off with ETFs.

[BRIAN5000]

I am with Scomac. For someone who is retired, maintaining a ladder is a small effort when compared to paying an MER and having uncertain principle.

I thought Bogle's claim to fame was that he has proof that very few can outperform equity index's mainly because of fee's?

And this is even more true of index bond and money market funds?

If your beating the index's your either lucky or taking on more risk?

So the one's doing this on their own are doing as well as the index's because they have lower fee's?

the average retail investor should not be buying individual corporate bonds and should buy corporate bond ETFs instead.

The people on here doing this on their own are not average retail investors.

[queerasmoi]

To the OP, I would suggest that a Bond/GIC ladder is most appropriate for the withdrawal phase because you always have the option of taking money from maturing bonds, instead of having to sell part of a bond portfolio that has not yet matured. Furthermore, a bond/GIC ladder allows you to let the duration of the whole portfolio tick downwards by not buying any longer bonds over the years.

You may want to look into comparing available bond and GIC rates at various maturities to see what is the best match. High-grade corporate bonds have yields no better than high-rate GICs lately it would seem. Of course with a GIC you have less liquidity than with a bond.

[brad911]

...Am having trouble getting my head around paying a premium( at some point taking a capital loss ) and not achieving comparable yields. all the while, I do know what the endgame is.
Perhaps, is this not the time to be forming a ladder.
Any advice/comments appreciated.

As others have pointed out don't think of constructing a ladder as losing out vs. an ETF. As for timing the point of a bond ladder is to spread out your risk, lower that risk and maintain your initial capital. I don't invest in individual bonds, yet, because my fixed income portfolio isn't at the level yet where I can buy individual bonds in a 10 year ladder (~$50,000). Once I hit that level I'll start cashing out and making yearly purchases if rates are unfavourable or make initial purchases in long & short bonds to create the portfolio all at once.

As James Hymas has written on many occasions an investor, investing in only government bonds, has many disadvantages vs. an investor investing in a diversified portfolio of corporates and governments. It's all about your preferences because you're the only one managing this portion of your portfolio. If you're more comfortable with ETF's then continue investing in them knowing that their MER is a necessary cost for your time and risk tolerance knowing what you're giving up.

[Doug]

There are those who advocate a bond ladder, such as a 5 year bond ladder. Claymore has bond ETFs that give one a bond ladder in an ETF form. IShares short term bond index fund replicates the DEX Short Term Bond Index. Is the iShares index fund the equivalent of a bond ladder? If one ignores expenses and the heterogeneity of the ETF, will the return of the iShares ETF be similar to that of a ladder? My uneducated guess would be yes to both questions, but please correct me if I"m wrong.

[$seeker]

You may also wish to see this thread for further ideas on this topic
viewtopic.php?f=33&t=110905

[scomac]

Is the iShares index fund the equivalent of a bond ladder?

No. There is nothing in the prospectus of XSB mandating it to have equal weighting of the various maturities. The distribution of maturities will reflect the relative market value of the various maturities of which there could be a fair divergence especially when corporate financing dried up from mid 2008 to mid 2009.

If one ignores expenses and the heterogeneity of the ETF, will the return of the iShares ETF be similar to that of a ladder?

Over the long term the two should have very similar rates of return, however there could be significant differences at any specific snapshot in time. For the long term investor who is accumulating assets, this will be irrelevant, but for the investor in withdrawal mode, there is potential for a negative impact in RoR when the withdrawals are greater than the income generation from the underlying portfolio. That said, this impact will be restrained by the short-term nature of the holdings. It could be much more dramatic for a 10 yr. ladder vs. XBB.

[kcowan]

So long term returns should be evened out with the drag from the MER being offset by the preferred buying rates from the bond desks.

To me, a ladder is best used to get a regular supply of funds to live on through their maturity cycles.

[scomac]

So long term returns should be evened out with the drag from the MER being offset by the preferred buying rates from the bond desks.

On a equal credit quality basis, yes. However, if an investor is willing to construct his/her own ladder of investment grade bonds, they can often pick up a significant yield boost by ignoring the ETFs need to hold federal gov't bonds and building a ladder of provincial and corporate bonds. You are taking on some additional credit risk, but with spreads where they are today, you are being adequately compensated. This isn't always the case though, so this current advantage can disappear. Analysis is required.

To me, a ladder is best used to get a regular supply of funds to live on through their maturity cycles.

Agreed.

[Shakespeare]

A ladder is most appropriate during RRIF withdrawal in later years where the mandatory minimum exceeds cash flow. Before that, its benefits tend to be more arguable - in particular, the "valuations don't change" argument often used does not reflect mark-to-market accounting.

[kcowan]

So long term returns should be evened out with the drag from the MER being offset by the preferred buying rates from the bond desks.

On a equal credit quality basis, yes. However, if an investor is willing to construct his/her own ladder of investment grade bonds, they can often pick up a significant yield boost by ignoring the ETFs need to hold federal gov't bonds and building a ladder of provincial and corporate bonds. You are taking on some additional credit risk, but with spreads where they are today, you are being adequately compensated. This isn't always the case though, so this current advantage can disappear. Analysis is required.

Have you seen any work on that? I note that I have GE Cap, Shaw and GTAA all of which would not qualify for ETFs.

I never take a loss on a corporate because I always have enough maturing to sustain my budget.

[scomac]

Have you seen any work on that?

Not specifically although there is plenty of anecdotal evidence in support of that. Hank Cunningham mentions this in his book as one of the chief advantages to constructing ladders versus using funds.

[kcowan]

Have you seen any work on that?

Not specifically although there is plenty of anecdotal evidence in support of that. Hank Cunningham mentions this in his book as one of the chief advantages to constructing ladders versus using funds.

Thanks. I will look him up.

[Pickering]

Read your replies and learned lots. but what happens now. Interest rates are likely to start going up in June or July.
My average cost on CBO is about 20.63 and CLF 20.77 - coming up on the March distribution - CBO looks like it may hold a NAV of about my cost after the distribution, but CLF is likely to close March in the 20.35 range.
I am an income investor, and see no reason to sell if my principle is protected long term.
My question is , is a 5 year laddered ETF similar to a actual bond ladder ie will the replacement bonds over the next few years increase the Nav so as to protect my investment.
The distributions alone will continue to fiance my retirement - no need to sell unless it is determined that the bond ETF is a bad investment.