Bonds: Rethinking Some 'Dirty Little Secrets'

Summary

• It seems that many have a very negative view of bonds in the current environment.
• There are legitimate risks involved in investing in bonds. The key is understanding them and being able to keep sight of the big picture.
• In this article, I will, either through references or within the article itself, touch on 4 different risks related to investing in bonds.
• The article will then tackle the question of investing in individual bonds versus one or more ETFs.
• Finally, we will examine a table with helpful data on 4 popular ETFs, and what we can learn from such an examination.

I have recently published several articles having to do with bonds here on Seeking Alpha. Due to the unsettled geopolitical and economic environment in which we find ourselves, I have been thinking about the value of short-term bonds and cash, and even more recently reviewed the question of including foreign bonds in a portfolio, despite relatively low current yields.

Interestingly, I find the overall reaction to bonds in the current environment to be quite negative. Both in the comments section of my own articles and in articles from other authors, I find this to be the case. It is not my intent to bash the viewpoint of others, simply to add my voice to the discussion. However, I must admit that I sort of stole the 'dirty little secrets' part of the title from a 2013 article right here on Seeking Alpha. You can look it up on your own if interested.

However, it is my goal to address some objections I have encountered along the way which I see as either overly trite or simplistic. Examples:

• "It's OK to buy carefully-selected individual bonds and hold them to maturity, but don't buy a bond mutual fund or ETF."
• "Why would I want to buy a bond ETF right now, when an entire year's dividends could be wiped out in one day?"

It's not that either of these statements is categorically wrong. However, by the time I am done with this article, I am hoping to add in a little nuance that may help you as you make your own decisions. Along the way, I am hoping to explain a couple of reasonably advanced concepts related to bonds in an easily-understandable way. I will also show how these concepts play out on a few bond ETFs, and how this may affect your choices as well.

Before we go any further if you are new to bonds you may want to start with this introductory article on my personal blog. It offers a nice overview on the characteristics of bonds, as well as a brief discussion around the two most basic risks of bonds; default risk and interest-rate risk. Some of these concepts may seem rather simplistic. But they may be important when evaluating the overall structure of your portfolio. As one example, you often hear REITs and Utilities being referred to as "bond substitutes." While they do share certain characteristics, there is a key difference between a bond and any stock. This key difference is covered in that article.

To dig a little deeper into the nuances of bonds, however, let's now move on to two slightly more advanced topics; reinvestment risk and duration.

Reinvestment Risk

This topic relates to the first objection above. Specifically, the concept that while it might be OK to buy an individual bond you plan to hold to maturity, it's not such a good idea to buy a bond mutual fund or ETF.

At an emotional level, the idea of buying an individual bond and holding it to maturity may feel comfortable. After all, you knew what you were buying when you bought it and, as long as you hold to maturity, you will get back exactly what you bargained for. So, for example, a bondholder who owns a bond with a 6% coupon in an environment of 4% interest rates may, emotionally, feel very good. After all, based on what he or she paid, they have "locked in" 6%.

The problem is, that investor still faces reinvestment risk. Put simply, when that 6% bond matures, now the investor simply has his original $1,000. And guess what? There are no more bonds with a 6% coupon because we are now in an environment of 4% interest rates, and that will be the coupon offered by a similar bond. Put a different way, when that bond matures the investor's income stream will decrease from $60 per year to $40 per year.

What that investor may not have realized is that, in an environment of 4% interest rates, that bond with the 6% coupon would likely have been worth more than face value! Put a different way, as opposed to waiting for those coupon payments, the investor could have received the value sooner by selling.

Yes, the way the market compensates for all of this is through price. Take a look at this nice graphic, courtesy of our friends at Vanguard.

In that graphic, we see that our bond with a face value of $1,000, a 6% coupon, and 15 years to maturity would have been worth $1,224. A bond of similar characteristics, but only a 4% coupon, would be worth $1,000.

Of course, in an environment of rising rates, all of this flips. Look at that bond with the 2% coupon. In this scenario, Vanguard calculates that this bond would only be worth $777.60.

All of this works its way through the wash, so to speak, by virtue of the calculation of Yield To Maturity. In this example, all four bonds have a yield to maturity of 4%, they simply get there through different routes.

Duration

Next, let's talk briefly about the 2nd topic; duration.

Duration is a slightly different thing than time to maturity. Take a look at the graphic below. This graphic depicts a 3-year bond with a coupon rate of 8% per year and a face value of $1,000 at maturity.

Source: tvmcalcs.com

The duration of a bond is a measure of how long, in years, it takes for the investor to recoup the bond's price via the bond's total cash flows.

If the bond depicted above was a zero-coupon bond, that graphic would look a little different. The investor would (unless prevailing interest rates were negative) pay some price less than $1,000 today, and would receive exactly $1,000 three years from now. The duration of that bond would be 3 years because all the money is repaid in one lump sum at the end of the term.

In contrast, look at what is happening with this bond. The investor is receiving $40 every 6 months along the way and then the face value, along with one last interest payment, at the end of the 3-year term. In other words, he is getting a portion of the total return before the 3-year term is up.

The most common tool used to represent this is known as Macaulay Duration. This formula produces the weighted average return to maturity of the cash flows from a bond. You can find Macaulay duration calculators online, such as this one on investopedia.com. Or you can learn how to build your own version in Excel, which is what I did to produce the example below.

In this example, I calculated the duration for the bond represented in the graphic above (the 'Base Case' column). You will see that it comes to 2.74 years.

To help you even further with the intuition of how this all works, I created two variables. In each case, the item I changed is featured in red. Here are the concepts being featured:

Fewer Coupons - In Variable 1, note that I propose a bond with exactly the same terms, except that it only pays 1 coupon (of $80) per year. Notice that the duration of this bond, at 2.79 years, is slightly longer than the base case. Think about it. Due to the time value of money, $40 in 6 months and then another $40 in 12 months is slightly better than $80 in 12 months. All other things being equal, you would pick the bond with semi-annual coupons, represented by the shorter duration.

Higher Yield - In Variable 2, I raised the coupon rate from 8.00% to 10.00%. In this case, notice that the duration has decreased slightly, to 2.69 years as opposed to 2.74 years. Again, think about it. The $1,000 at maturity hasn't changed, but the coupon payments in the interim are larger ($50 every 6 months as opposed to $40), therefore you are receiving a slightly higher percentage of the overall total a little sooner.

How All Of This Plays Out In Bond ETFs

With that background, perhaps the question of how this all plays out in bond ETFs may become a little clearer. In the case of an ETF, you are buying a basket of, in many cases, literally thousands of bonds. As opposed to a single bond which you may be holding until maturity, bonds within the fund are coming to maturity and being replaced on a regular basis.

As it turns out, this is not as big a deal as it may seem. Remember that graphic from Vanguard above? Let's say, for example, that the ETF is holding a 15-year bond with a 4% coupon and it matures today. Hypothetically, they will be able to replace it with either that 6% bond, but at a price of $1,224, or that 2% bond, at a price of $777.60. In either case, it is a bond with a yield to maturity of 4%.

At the end of the day, you might be able to do better with a portfolio of carefully-selected individual bonds. But with that would come transaction costs, such as trading commissions and the bid/ask spread. Bear in mind that you are getting both great diversification, as well as the (hopefully) lower overall expenses that come from the fact that an ETF can buy and sell in much larger lots.

Additionally, because the fund is dealing in such quantities, the risk profile does not tend to change much as bonds are bought and sold. Finally, if the fund holds thousands of bonds, the risk of default is buffered as opposed to a portfolio with perhaps just a few individual holdings.

Four Bond ETFs - A Comparative Look

Finally, let's put it all together. I specifically selected four bond ETFs and have broken out some key data points in the table below. In each case, the name of the ETF is a link that will take you to the provider's information page, in case you wish to dig in further. Have a look.

	(NYSEARCA:BSV)	(NASDAQ:BND)	(NYSEARCA:AGG)	(NYSEARCA:BLV)
ETF Name	Vanguard Short-Term Bond ETF	Vanguard Total Bond Market ETF	iShares Core U.S. Aggregate Bond ETF	Vanguard Long-Term Bond ETF
Index Tracked	Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index	Bloomberg Barclays U.S. Aggregate Float Adjusted Bond Index	Bloomberg Barclays U.S. Aggregate Bond Index	Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index
Number of Holdings	2,524	8,457	6,852	2,094
Average Coupon	2.16%	3.09%	3.25%	4.39%
Average Maturity	2.8 Years	8.4 Years	8.19 Years	24.1 Years
Average Duration	2.7 Years	6.1 Years	5.87 Years	14.9 Years
30-Day SEC Yield	2.83%	3.13%	3.09%	3.94%
Yield To Maturity	2.93%	3.34%	3.33%	3.97%

Click to enlarge

First, let's talk about the two in the middle, BND and AGG. You will notice that both these wonderful ETFs track the same basic underlying index. Yet there are some slight variations in things such as average maturity and duration. This is because the ETFs quite often use sampling techniques to replicate the index they wish to track while minimizing trading costs. If you were to follow the link for BND in the table, you would find that the index contains 10,012 bonds. BND actually holds 8,457 of these while AGG holds 6,852. This accounts for the small variations in average coupon, duration, and the like. Still, these two funds are remarkably similar.

Moving back now to the big picture, you can start to get some idea of the comparative risk/reward profile. Aside from BND and AGG, I selected BSV as an example of an ETF with much shorter duration, and BLV as one further out on the long end. Remember, the longer the average duration, the more at risk you are if interest rates rise.

And that brings us to that final objection, that "an entire year's dividends could be wiped out in one day." While there is no escaping interest-rate risk, the goal is to keep it manageable. Along that line, take a look at that article on foreign bonds that I linked in the first paragraph of this article. It might make a little more sense based on what I have laid out here.

Summary and Conclusion

I believe there is a place for bonds in every portfolio. I hope this material has been helpful as far as assessing the associated risks, while at the same time offering a counterpoint to broad, sweeping generalizations which may not be helpful.

As always, feel free to drop your comments below.

Until next time, I wish you...

Happy investing!

Disclosure: I am/we are long AGG, BND, BSV. 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.