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Matthew J. Patterson  

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  • Guggenheim BulletShares 2011 Corporate Bond ETF Reaches Maturity, Closes As Planned [View article]

    You are assuming that a fund will pay out all of the proceeds of coupons received when it holds premium bonds, thereby driving down its NAV to the par value of the bonds it holds. In fact, most funds only distribute net income and retain the portions of coupons that represent amortized premium.

    For example, let's consider a fund that holds only one bond that it acquired for $110 that pays a 5% coupon and will mature at a par of $100 in exactly 5 years. Let's further assume that the fund has one share outstanding at a current NAV of $110. Each year for the next five years, the fund will receive coupon payments of $5. However, only $3 of these annual coupons will be distributed as net income. The remaining $2 of these annual coupons represent premium amortization that the fund retains.

    After the first year, assuming no changes in interest rates, the fund will hold a bond worth $108 and $2 of retained premium amortization. Therefore, its NAV will still be $110/share. This process will continue for the five-year life of the bond. At the time the bond matures, the fund will hold a bond worth $100 and $10 of retained premium amortization. Its NAV will still be $110/share. If the fund were to liquidate at this time, the fund’s shareholder would receive $110 of proceeds and realize no capital gain or loss.

    Even if the premium amortization were distributed to the fund’s shareholder over the life of the bond, it would be treated as a return of capital (and not net income) and would reduce the shareholder’s cost basis in the investment. Under such a scenario, the fund’s NAV would be reduced by the amount of premium amortization to the par value of the bond it holds (from $110 to $100). However, the shareholder’s cost basis would be reduced by the exact same amount (from $110 to $100), thereby offsetting any capital loss.
    Dec 29, 2011. 01:14 PM | 4 Likes Like |Link to Comment
  • Maturity-Targeted Bond ETFs Lock in Anticipated Yield to Maturity [View article]
    Thanks for the comments, clipit89. While you are correct that ETFs can trade at premiums and discounts, unlike in the case of closed-end funds, there is an arbitrage mechanism that keeps deviations from NAV relatively minimal. For example, premiums and discounts on bond ETFs typically aren't greater than 50 basis points (0.50%). In a previous Seeking Alpha piece, I discussed how these deviations from NAV essentially represent the cost of providing liquidity for short-term traders and, in that sense, are a positive thing for long-term investors. See

    You are correct, however, that the premium needs to be factored in in determining what your expected yield of the investment will be. To the extent you purchase a maturity-targeted bond ETF at a premium, you receive a lower yield than the stated yield of the ETF portfolio (which is computed assuming that value of the portfolio is equal to its NAV).

    I have to respectfully disagree that maturity-targeted bonds aren't catching on. The first maturity-targeted bond ETFs were only introduced in January 2010. There are now 17 maturity-targeted bond ETFs with total assets of $370 million, and the sector has added nearly $150 million in assets since January 1, 2011. All indications are that investors are realizing the potential of these innovative products.

    Alas, I cannot promise you that there could be no loss of principal with any investment product. What I can say, however, is that the impact of a bond default will have less impact on a diversified portfolio of bonds than a concentrated portfolio of bonds.
    Feb 22, 2011. 11:11 AM | Likes Like |Link to Comment
  • Bond Market Liquidity (or Why You Should Buy Bond ETFs Instead) [View article]
    Thanks for the comment, Bigcahunaus.

    I've posted a piece attempting to address your question. Please see
    Jan 11, 2011. 12:13 PM | Likes Like |Link to Comment
  • Dilution by a Thousand Costs: The Case for Index-Based ETFs Over Mutual Funds [View article]
    The impact of an early redemption fee in a mutual fund would depend upon its size, which is limited to no more than 2% under SEC rules.

    Certainly, redemption fees on mutual funds make ETFs more appealing relative to mutual funds from the perspective of short-term traders. Whether a given ETF would be better than a given mutual fund for a short-term trader will depend on a lot of factors, including commissions, management fees, liquidity of the ETF, etc.

    From the perspective of a long-term investor, early redemption fees help mitigate the dilution caused by frequent traders. Early redemption fees don't eliminate the potential for such dilution, however, because large inflows of assets (as opposed to redemptions) can also lead to such dilution.
    Nov 10, 2010. 08:49 AM | Likes Like |Link to Comment
  • Bond Market Liquidity (or Why You Should Buy Bond ETFs Instead) [View article]

    A comparison of bond ETFs and bond mutual funds is beyond the scope of this piece, but you raise an interesting question that I hope to address in the near future.

    With respect to buying bonds in the primary market, while you are correct that the issuer absorbs offering costs in a primary offering, most retail investors lack the assets and brokerage relationships to gain access to the primary market for corporate bonds. Moreover, issuance in the primary market ebbs and flows with market conditions and there can be no assurance that bonds meeting your specific needs will be available in the primary market at any given time.

    I agree with you that a careful buy-and-hold individual bond strategy can be an effective fixed income approach for some individual investors, particularly those with enough assets to buy bonds in round lots without sacrificing diversification. Most individual investors, however, would likely be better off buying bond ETFs because they lack the resources to assemble diversified portfolios of individual bonds without paying excessive dealer markups.

    Thanks for your comment.
    Oct 12, 2010. 10:17 AM | Likes Like |Link to Comment
  • Bond Market Liquidity (or Why You Should Buy Bond ETFs Instead) [View article]
    I agree that the expense ratio needs to be considered when evaluating the total costs of investing in an ETF. I was trying to limit my analysis in this article to implicit and explicit transaction costs. I look at the expense ratio as a service fee, which spares the investor the labor of analyzing, compiling and managing a basket of bonds. With the typical bond ETF carrying an expense ratio between 15 and 30 bps, I think the benefits of this service justify its cost for most smaller investors.

    I also neglected to mention commissions on ETF trades in the article. Of course, some brokerage platforms permit investors to trade ETFs without commissions. Investors who use a broker that charges commissions on ETF trades should add this cost to each leg of the bond ETF trade.
    Oct 6, 2010. 09:19 AM | 1 Like Like |Link to Comment