To determine the best bond fund investment(s), you need to estimate what the true future total returns (TFTRs) of the candidate bond funds will be. The TFTRs should account for yield, personal expenses, fund expense ratio, default losses, interest rate, interest tax rate, holding period, capital gain or loss due to interest rate changes due to inflation, capital gain or loss due to other interest rate changes, and capital gain or loss tax rate. You do not always need to be this detailed in your calculations, but you should always consider each of these elements.
- Yield should be measured by yield to maturity (YTM), if none of the bonds in the fund can be prepaid (e.g., called) or the like. If some of the bonds in the fund can be prepaid, yield to worst (YTW) or option-adjusted yield (OAY) should be used. YTM, YTW, and OAY are true yield (TY) measures. Other measures of yield are not. (Please see "The True Yield of Your Bond Investments", if you have not already.) Since YTM, YTW, and OAY are calculated using the current market price of an ETF, any ETF premium or discount is accounted for in the calculation. A premium or discount is the amount above or below net asset value (NAV) an ETF is trading at. NAV is the value of the fund's assets. Attempt to avoid paying a premium. For mutual funds, there is no premium or discount. Mutual funds are bought and sold at their NAV. For a mutual fund, YTM and YTW are calculated using NAV.
- Personal expenses include things like ETF trading costs or fees your investment service may charge you to purchase and/or sell a mutual fund. It also includes the loads associated with load funds, but please do not ever buy a load fund. Personal expenses should include your costs to enter and exit the fund, even if you have no planned date to exit the fund.
- Holding period is the length of time you anticipate owning shares in the fund. If you plan to own shares in the fund indefinitely, make an educated guess for how many years "indefinitely" will actually turn out to be.
- The fund expense ratio is the percentage the fund charges to manage the fund. You can find this on the fund provider's website or websites like Morningstar. Look for funds with low expense ratios. Low expense ratios are part of what makes index funds generally superior to actively managed funds. Be aware that, sometimes, funds have an expense waiver or reimbursement; so the fund's expense ratio is temporarily lower than it will be in the future. You want to use an expense ratio percentage that is valid for the years you anticipate holding the fund.
- Default losses are NAV losses that a fund may experience due to some of the borrowers for the bonds in the fund not paying their debt or paying their debt in full. Default losses range from non-existent (e.g., for U.S. Treasuries) to relatively high (e.g., for junk [non-investment-grade] bonds).
- Interest rate is different than yield in that it only accounts for the future interest payments of the fund. It does not account for bonds in the fund currently trading above or below their par values. You can estimate the interest rate of a fund by using its last monthly distribution, multiplying by twelve, and dividing by the current price per share (or using its last quarterly distribution, multiplying by four, and dividing by the current price per share), if the last monthly distribution is not anomalous. It is better to do the calculation yourself than it is to use the distribution yield, if one is provided, because the distribution yield may have been based on a last distribution that was anomalous or miscalculated. Also, for an ETF, it may be uncertain as to whether the distribution yield was calculated based off of the ETF price or NAV.
- Interest tax rate is the percentage in taxes you will pay on the interest paid by the fund. It is the percentage of interest that is not actually a gain for you because of taxes. You do not want to adjust tax-free bond interest rates so they equate to taxable bond interest rates, as you often see done for municipal bond interest rates. You want to adjust bond (or CD) interest rates so they are minus taxes because this is the way it works in real life.
- Capital gain or loss due to interest rate changes due to inflation is the change in NAV you expect to experience due to interest rate changes caused by changes in the level of inflation (or deflation).
Capital gain or loss due to other interest rate changes is the change in NAV you expect to experience due to interest rate changes not caused by changes in the level of inflation (or deflation). For example, currently, you can expect longer-term capital losses in Treasury bond funds unrelated to inflation due to Treasury bonds being overbought. (Treasury bonds are overbought due to the Federal Reserve [Fed] making Treasuries purchases via the QE programs and a flight to safety due to the Eurozone crisis and U.S. fiscal cliff concerns.)
Note: You do not need to estimate (8) and (9) separately, but, sometimes, it is better to do so. In the spreadsheet below, (8) and (9) are covered by a single column called Non-Yield Capital Gain or Loss. It is called "Non-Yield" because it does not include capital gains and losses already included in Yield. The capital gains and losses included in Yield are due to differences between current prices and par values for the bonds held by a bond fund. ETF premiums and discounts also contribute to capital gains and losses in included in Yield. For a further explanation of capital gains and losses included in Yield, please see my article entitled "The True Yield of Your Bond Investments", for which I provided a link above, and "Ignore Total Return in Evaluating Bond Funds". For further information on "capital gain or loss due to interest rate changes due to inflation" and "capital gain or loss due to other interest rate changes", please see "Future Inflation's Likely Impact on Bonds".
- Capital gain or loss tax rate is the percentage in taxes you will pay on your capital gains or not pay due to your capital losses. It is the percentage of capital gains or losses that is not actually a gain or loss for you because of taxes.
|Fund||Yield Type (YTM, YTW, or OAY)||Yield||Shares||Price||Amount||Personal Expenses||Personal Expenses %||Holding Period (Years)||Annualized Personal Expenses %||Fund Expense Ratio||Annual Default Losses||Last Distribution||Distributions Per Year||Interest Rate||Interest Tax Rate||Annual Interest Tax Loss||Current Price vs. Par Value Differences Gain or Loss||Non-Yield Capital Gain or Loss||Annualized Non-Yield Capital Gain or Loss||Annualized Non-Yield Capital Gain or Loss %||Capital Gain or Loss Tax Rate||Annual Capital Gain or Loss Tax Effect||Annual True Future Total Return||As of Date|
Annual Default Losses: Do not depend on the figures I place in this column to be correct. These are guesstimate figures I developed months ago. Actual default losses may be more or less. In fact, they may be much higher than I have indicated here. Also, in a given year, default losses can be much greater or less than they were in preceding years. The variance is most pronounced in junk bonds.
Data Entry vs. Calculation Columns: The columns whose names are not underlined are data entry columns. The columns whose names are underlined are calculation columns.
Calculations: Some of the calculations in this spreadsheet are not precise. They are meant to be simple and get you rather close to what your TFTR is.
- Amount: Shares x Price
- Personal Expenses %: - (Personal Expenses / Amount)
- Annualized Personal Expenses %: Personal Expenses % / Holding Period (Years)
- Interest Rate: (Last Distribution x Distributions Per Year) / Price
- Annual Interest Tax Loss: - (Interest Rate x Interest Tax Rate)
- Current Price vs. Par Value Differences Gain or Loss: Yield - Interest Rate
- Annualized Non-Yield Capital Gail or Loss: Non-Yield Capital Gain or Loss / Holding Period (Years)
- Annualized Non-Yield Capital Gail or Loss %: Annualized Non-Yield Capital Gail or Loss / Price
- Annual Capital Gain or Loss Tax Effect: - (Current Price vs. Par Value Differences Gain or Loss + Annualized Non-Yield Capital Gail or Loss %) x Capital Gain or Loss Tax Rate
- Annual True Future Total Return: Yield + Annualized Personal Expenses % + Fund Expense Ratio + Annual Default Losses + Annual Interest Tax Loss + Annualized Non-Yield Capital Gain or Loss % + Annual Capital Gain or Loss Tax Effect
In the spreadsheet above, I used iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) as an example. I assumed a 1,000 share purchase, a $7 buy trade, a $9.73 sell trade, a 10-year holding period, a 25% U.S. income tax rate, a 15% U.S. capital gains tax rate, and no applicable state or local taxes. Your situation will probably differ from this. I also assumed LQD will return to its price on 11/1/07, minus adjustments for fund expenses and defaults, because, in the long run, this is what I think will approximately happen. You may have a different perspective regarding LQD's future price. If you build a spreadsheet like the one in this article for yourself, you can enter data applicable to your situation; and you can reflect your own perspective regarding a bond fund's future price.
In using the spreadsheet, 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.
For the example herein, LQD has ATY of 1.74%.In upcoming articles, I intend to use the spreadsheet in this article to analyze other ETFs―ETFs like iShares Barclays TIPS Bond (NYSEARCA:TIP), Vanguard Total Bond Market (NYSEARCA:BND), iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG), iShares Barclays Aggregate Bond (NYSEARCA:AGG), SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK), iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ), Vanguard Short-Term Bond (NYSEARCA:BSV), iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY), and iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT). I hope the results are useful to you.
Disclosure: I manage a portfolio which includes a position in LQD. 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.