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Previously, I wrote an article entitled "Determining the Best Bond Funds: True Future Total Return". If you have not read this article already, you may want to. In this previous article, I described the methodology behind and calculations within the spreadsheets used in this article.

I am covering the best long-term non-junk bond investments in this article. Later, I intend to cover the best all/intermediate-term non-junk bond investments (covering CDs as well), the best short-term non-junk bond investments (covering CDs as well), mortgage-backed securities, funds that contain multiple types of bonds, junk bonds, inflation-indexed bonds, and non-U.S. bonds.

I am using ETFs exclusively for this analysis because there are many low-expense-ratio index funds among the ETFs. Low-expense-ratio funds tend to have the best estimated future returns because less of your money is lost to fund expenses. Index funds are good to use for an analysis like this because, with non-index funds, fund management can greatly affect the results of the analysis. For example, one bond fund can appear to be a better investment than another bond fund, when, in reality, it is not. Also, buying and holding index funds minimizes the risk of having a poor year(s) of fund performance because fund management was poor.

Mutual Funds vs. ETFs

If you buy and/or hold mutual funds, versus ETFs, this series of articles is still applicable to you―to the extent there are mutual funds similar to the ETFs discussed, which there always or almost always are. However, if a mutual fund you are considering buying or holding is not a low-expense-ratio index fund, you may want to consider buying a low-expense-ratio index fund instead. To do this, you may need to buy an ETF versus a mutual fund, as the number of index mutual funds is limited.

Individual Bonds vs. Bond Funds

This series of articles is also applicable to you if you buy and/or hold individual bonds, versus bond funds. When you hold an individual bond, you can hold it until maturity, thereby guaranteeing that, if the bond does not default, you will not lose principal due to a change in interest rates. Also, when you hold an individual bond, you lose no principal to fund expenses.

When you are considering buying or holding and individual bond, you should still include a default loss estimate as a part of your estimated future return. Many people do not do this because they are thinking that, by far, more likely than not, the bond will not default. The possibility of default still exists though, and you should include a default loss estimate that equals the possibility of occurrence times the percentage of loss likely to be experienced if there is a default. (Some defaults are partial, e.g., 25%, 50%, or 75% of principal.)

There are tax differences when you hold an individual bond, versus a bond fund. In addition, when you buy or hold individual bonds, you should be more concerned about diversification. Typically, a bond fund holds hundreds of different bonds. If/when one bond defaults, the impact is muted. If you buy an individual bond and it defaults, you may lose 100% of your investment. If you buy two individual bonds and one defaults, you may lose 50% of your investment. Unless you can buy many individual bonds, you should buy a bond fund along with the individual bond(s) to give yourself proper diversification within the bond type. Of course, if it is a bond type that cannot default (e.g., shorter-to-maturity U.S. Treasuries or Ginnie Maes), diversification within the bond type is not a concern.

There is another point that should be made regarding the difference between individual bonds and bond funds. The vast majority of bond funds are only sort of long-term, intermediate-term, or short-term because the vast majority of bond funds are, actually, forever-term funds that invest in bonds in a certain maturity range (i.e., long, intermediate, short, or a combination of these). They are "forever-term funds" because they buy new bonds to replace bonds they sold and/or bonds that matured. When you buy a longer-term bond fund, you do not commit yourself to a longer investment holding period, as some individual bond purchasers do. You do commit yourself to greater volatility in share price though, and you should understand and consider the degree and probable direction of this volatility.

Analysis

Seven bond funds are included in the spreadsheets below. Five of these bond funds are municipal bond funds (i.e., PowerShares Insured National Muni Bond [PZA], Market Vectors Long Municipal Index [MLN], PowerShares Insured California Muni Bond [PWZ], PowerShares Insured New York Muni Bond [PZT], and PowerShares Build America Bond [BAB]), one is a corporate bond fund (i.e., Vanguard Long-Term Corporate Bond [VCLT]), and one is a U.S. Treasury bond fund (i.e., iShares Barclays 20+ Year Treasury Bond [TLT]). Other funds were not included because they were not competitive or necessary for comparison. Although BAB is a municipal bond fund, the interest it pays is taxable. (There is, possibly, a minor state or local tax break associated with the fund, depending upon the locality in which you reside.)

The data in the spreadsheets assumes a $100,000 investment, $16.73 in personal (trading) expenses, 10-year holding period, 25% federal income tax rate, 15% federal capital gains tax rate, and no applicable state or local taxes. The first spreadsheet calculates an Adjusted True Yield for each fund. This is the fund's estimated future yield with personal expenses, fund expenses, default losses, and taxes accounted for. For more information regarding True Yield, please see "The True Yield of Your Bond Investments". The second spreadsheet calculates a True Future Total Return for each fund. This is the fund's estimated future return with yield, personal expenses, fund expenses, default losses, capital gain or loss not already included in yield, and taxes accounted for.

The "capital gain or loss not already included in yield" component adjusts for future increases or decreases in interest rates due to an increase or decrease in inflation and a bond type currently being overbought or underbought. Inflation is currently lower than is usual. Treasuries are, currently, very overbought, whereas corporate bonds appear to be somewhat overbought and municipal bonds appear to be somewhat underbought. For information regarding this, please see "Future Inflation's Likely Impact on Bonds".

FundYield Type (YTM, YTW, or OAY)YieldSharesPriceAmountPersonal ExpensesPersonal Expenses %Holding Period (Years)Annualized Personal Expenses %Fund Expense RatioAnnual Default LossesLast DistributionDistributions Per YearInterest RateInterest Tax RateAnnual Interest Tax LossCurrent Price vs. Par Value Differences Gain or LossNon-Yield Capital Gain or LossAnnualized Non-Yield Capital Gain or LossAnnualized Non-Yield Capital Gain or Loss %Capital Gain or Loss Tax RateAnnual Capital Gain or Loss Tax EffectAnnual Adjusted True YieldAs of Date
PZAYTW3.43%3888$25.72$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.83%0.00%0.00%-0.40%NANA0.00%15%0.06%3.14%10/5/12
MLNYTW3.42%4,958$20.17$100,000$16.73-0.02%100.00%-0.24%-0.01%$0.06123.82%0.00%0.00%-0.40%NANA0.00%15%0.06%3.23%10/5/12
PWZYTW3.19%3,943$25.36$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.65%0.00%0.00%-0.46%NANA0.00%15%0.07%2.91%10/5/12
PZTYTW3.22%4,034$24.79$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.70%0.00%0.00%-0.48%NANA0.00%15%0.07%2.94%10/5/12
BABYTW4.47%3,353$29.82$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.14125.61%25.00%-1.40%-1.14%NANA0.00%15%0.17%2.88%10/5/12
VCLTYTM4.43%1,079$92.65$100,000$16.73-0.02%100.00%-0.14%-0.22%$0.33124.29%25.00%-1.07%0.14%NANA0.00%15%-0.02%2.97%10/5/12
TLTYTM2.75%825$121.15$100,000$16.73-0.02%100.00%-0.15%0.00%$0.26122.57%25.00%-0.64%0.18%NANA0.00%15%-0.03%1.93%10/5/12
FundYield Type (YTM, YTW, or OAY)YieldSharesPriceAmountPersonal ExpensesPersonal Expenses %Holding Period (Years)Annualized Personal Expenses %Fund Expense RatioAnnual Default LossesLast DistributionDistributions Per YearInterest RateInterest Tax RateAnnual Interest Tax LossCurrent Price vs. Par Value Differences Gain or LossNon-Yield Capital Gain or LossAnnualized Non-Yield Capital Gain or LossAnnualized Non-Yield Capital Gain or Loss %Capital Gain or Loss Tax RateAnnual Capital Gain or Loss Tax EffectAnnual True Future Total ReturnAs of Date
PZAYTW3.43%3888$25.72$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.83%0.00%0.00%-0.40%NANA-0.21%15%0.09%2.96%10/5/12
MLNYTW3.42%4,958$20.17$100,000$16.73-0.02%100.00%-0.24%-0.01%$0.06123.82%0.00%0.00%-0.40%NANA-0.21%15%0.09%3.06%10/5/12
PWZYTW3.19%3,943$25.36$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.65%0.00%0.00%-0.46%NANA-0.21%15%0.10%2.73%10/5/12
PZTYTW3.22%4,034$24.79$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.08123.70%0.00%0.00%-0.48%NANA-0.21%15%0.10%2.76%10/5/12
BABYTW4.47%3,353$29.82$100,000$16.73-0.02%100.00%-0.35%-0.01%$0.14125.61%25.00%-1.40%-1.14%NANA-2.16%15%0.50%1.04%10/5/12
VCLTYTM4.43%1,079$92.65$100,000$16.73-0.02%100.00%-0.14%-0.22%$0.33124.29%25.00%-1.07%0.14%NANA-2.49%15%0.35%0.85%10/5/12
TLTYTM2.75%825$121.15$100,000$16.73-0.02%100.00%-0.15%0.00%$0.26122.57%25.00%-0.64%0.18%NANA-3.87%15%0.55%-1.36%10/5/12

Notes:

(1) PZA, PWZ, PZT, and BAB usually have an expense ratio of 0.35%; but 0.07% is being waived until 4/20/13.

(2) As of 6/30/12, BAB had a yield to worst (YTW) of 4.49%. Based on this, I estimated BAB's YTW to be about 4.47% on 10/5/12.

(3) As of 8/31/12, VCLT had a yield to maturity (YTM) of 4.4%. Based on this, I estimated VCLT's YTM to be about 4.43% on 10/5/12. There was no YTW statistic for VCLT; but it is plausible that VCLT holds no or almost no bonds that have a YTW different than their YTM because iShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD) holds almost no bonds that have a YTW different than their YTM.

(4) The iShares website said TLT had a YTM of 2.86%; but, based upon the information provided on the iShares TLT Holdings web page, et cetera, it appears that TLT's YTM was actually about 2.75%.

(5) 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 indicated here. Also, in a given year, default losses can be much greater or less than they were in preceding years. It is true, though, that, historically, default losses on municipal bonds have been very small.

Results

In summary, the results were as follows:

FundAdjusted True YieldTrue Future Total Return
PZA3.14%2.96%
MLN3.23%3.06%
PWZ2.91%2.73%
PZT2.94%2.76%
BAB2.88%1.04%
VCLT2.97%0.85%
TLT1.93%-1.36%

MLN appears to be the most attractive investment. If I change the data so 0% federal income and capital gains tax rates are used, BAB has the best Adjusted True Yield. If I change the data so a 10% or 15% federal income tax rate and 0% federal capital gains tax rate are used, VCLT has the best Adjusted True Yield. In all other cases, MLN has the best Adjusted True Yield, unless you live in California or New York. MLN always has the best True Future Total Return, unless you live in California or New York. If you live in California or New York, PWZ or PZT may be better than MLN for you, depending upon how high you are in the state and/or local tax brackets.

PZA, PWZ, and PZT are better than MLN in that the holdings are insured; however, municipal bonds rarely default and the insurance does not cover payer negligence or bankruptcy. MLN is better than PZA, PWZ, and PZT in that all of its holdings are AMT-free. If you hold PZA, PWZ, or PZT and you are subject to AMT (alternative minimum tax), some, but a clear minority, of your interest income will be subject to AMT.

There is an additional, important factor that none of the data above accounts for. Tax rates figure to increase in the years to come. Regardless of who gets elected, the country has a lot of debt, a huge budget deficit, and current tax rates that have been temporarily lowered. If/when tax rates increase, MLN, PWZ, PZT, and PZA will be relatively more attractive investments; and their share prices will benefit relative to other investments.

Conclusion

Before investing in MLN, PWZ, or PZT, further research is warranted on your part; but, at the level of investigation reflected in this article, they appear to be the best choices for someone investing in a long-term bond ETF. If you own, or are considering owning, a genre of bond or bond fund not covered by this article, such as iShares Barclays TIPS Bond (NYSEARCA:TIP), Vanguard Total Bond Market (NYSEARCA:BND), or iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG), please be patient, as I intend to address these other investments in future articles.

Disclosure: I manage a portfolio with holdings similar to MLN and PZA and a position in LQD. 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.

Source: The Best Long-Term Non-Junk Bond Investments