On 10/5/12, I published an article on Seeking Alpha entitled "Determining the Best Bond Funds: True Future Total Return". In this article, I introduced a statistic called True Future Total Return (TFTR), and I presented an Excel spreadsheet tool for calculating TFTR. In brief, TFTR is an all-encompassing, but practically-calculable, measurement of the estimated future return for a bond fund, bond, or CD. TFTR accounts for yield, personal expenses, fund expenses, default/downgrade losses, interest rate, interest tax rate, holding period, capital gain or loss due to interest rate changes, and capital gain or loss tax rate. It serves as a core for greatly improved evaluations and comparisons of bond and CD investments and potential investments.
In this article, I am going to present enhancements for how TFTR is calculated. I am also going to further explain Adjusted True Yield (ATY), which is another statistic I introduced in the "Determining the Best Bond Funds: True Future Total Return" article.
True Future Total Return Enhanced
The last two articles I wrote, The Issues with Corporate Junk Bonds and The Issues with Corporate Junk Bonds: Conclusion, regarded corporate junk bonds. Corporate junk bonds have much higher default losses than the vast majority of other bonds. Also, the corporate junk bond ETFs I evaluated in the articles, iShares iBoxx $ High-Yield Corporate Bond (NYSEARCA:HYG) and SPDR Barclays Capital High-Yield Bond (NYSEARCA:JNK), have high fund expense ratios relative to other well-chosen, in terms of fund expenses, index funds. For these reasons, prior to writing the two corporate junk bond articles, it was important to enhance the calculation of TFTR.
The enhancement is simple. The formula for the Annual Capital Gain or Loss Tax Effect field has been expanded. The formula, with the new elements in the formula italicized, is now:
- (Annualized Personal Expenses % + Fund Expense Ratio + Annual Default/Downgrade Losses + Current Price vs. Par Value Differences Gain or Loss + Annualized Non-Yield Capital Gain or Loss %) x Capital Gain or Loss Tax Rate
The new elements in the formula are all capital losses. As they are capital losses, there is an associated, but lesser, positive capital loss tax effect. The Annual Capital Gain or Loss Tax Effect field is meant to capture all capital gain and loss tax effects, without getting too fancy. The enhanced formula does this.
You may have noticed the Annual Default Losses field is now named Annual Default/Downgrade Losses. The simplest explanation I can give for this additional enhancement is to quote from the notes section of my "The Issues with Corporate Junk Bonds" article.
"…the figures also accommodate the fact that some investment-grade bonds will lose their investment grade and need to be sold at, what will probably be, a lower price."
In reality, the situation is more complicated than this. Corporate bonds, whether investment-grade or not, tend to be downgraded more than they are upgraded. If a bond fund does not hold all of its bonds to prepayment (e.g., call) or maturity, only adjusting for probable default losses among its bonds is inadequate. By using default losses data applicable through to prepayment or maturity, we get an estimate of a bond fund's default and downgrade losses.
Adjusted True Yield Further Explained
In my "Determining the Best Bond Funds: True Future Total Return" article, I wrote:
"…if you put $0 in the Non-Yield Capital Gain or Loss column, the Annual True Future Total Return column contains an adjusted true yield (ATY), i.e., a TY adjusted for personal expenses, fund expenses, defaults, taxes, and tax benefits."
(Non-yield capital gains or losses are capital gains or losses due to interest rate changes, versus due to a return to par value, personal expenses, fund expenses, or default/downgrade losses.)
ATY serves multiple purposes. For one, it allows you to see the TFTR of a bond fund, bond, or CD investment assuming there is no capital gain or loss due to interest rate changes. In this case, it is merely an informational statistic, in that it solely provides a better understanding. ATY has another purpose though, one which you can see exercised in the articles I wrote previously wherein I analyzed bonds, versus bond funds, and CDs to be held to maturity. ATY is TFTR for bonds and CDs to be held to maturity. When bonds or CDs are to be held to maturity, ATY and TFTR are the same. In this way, the TFTR tool works equally well for evaluating bond funds, bonds, and CDs.
I do not know whether anyone out there is playing the TFTR or ATY home game. (The "home game" being when you duplicate the TFTR tool, or create a similar tool, for your own use.) If you are, the information above can help you refine and better understand the tool. For those not playing the home game, the information above provides a further understanding of the factors involved in evaluating bond funds, bonds, and CDs.
For those who are interested, please see my previous articles wherein I used the TFTR tool to evaluate ETFs including PowerShares Insured National Muni Bond (NYSEARCA:PZA), Market Vectors Long Municipal Index ETF (NYSEARCA:MLN), PowerShares Insured California Muni Bond (NYSEARCA:PWZ), PowerShares Insured New York Muni Bond (NYSEARCA:PZT), PowerShares Build America Bond (NYSEARCA:BAB), Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT), iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT), iShares S&P National AMT-Free Muni Bond (NYSEARCA:MUB), SPDR Nuveen Barclays Capital Muni Bond (NYSEARCA:TFI), Market Vectors Intermediate Muni ETF (NYSEARCA:ITM), Guggenheim BulletShares 2020 Corporate Bond (NYSEARCA:BSCK), Vanguard Intermediate-Term Corporate Bond Index ETF (NASDAQ:VCIT), iShares iBoxx $ Investment-Grade Corporate Bond (NYSEARCA:LQD), iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF), SPDR Nuveen Barclays Capital Short-Term Muni Bond (NYSEARCA:SHM), Vanguard Short-Term Corporate Bond Index ETF (NASDAQ:VCSH), HYG, JNK, and SPDR Barclays Capital Intermediate-Term Corporate Bond (NYSEARCA:ITR) and, sometimes, the bonds held by these ETFs (as if they were separate from the ETF). CDs were also evaluated, if/as warranted.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.