By: Larry MacDonald
I have been wrestling with the question of whether it is better for the retail investor to buy bonds directly or bond exchange-traded funds (ETFs). At this stage, I’m leaning toward bond ETFs as the best way to go for long-term horizons (e.g. retirement funds). Let me throw out some thoughts why. If anyone sees any flaws, let me know before I plunk some money down!
Let’s summarize what the proponents of direct ownership claim:
• individual bonds have maturity dates and offer certainty of returns if held to maturity, unlike bond ETFs
• commissions and management expense ratios (MERs) make bond ETFs more expensive than the commission paid to buy bonds over the counter from dealers.
OK, what to make of this. The first thing to get out of the way is how to do the comparison. Comparing a bond ETF to a single bond doesn’t fly with me. The bond ETF is diversified in terms of default and interest-rate risk, which is good. A single bond is not diversified on those criteria, which is not good. So the comparison, it seems to me, should be between the bond ETF and a diversified ladder of bonds (1).
Now, if you look at bond ladders in use for long-term investing, most seem to be the rolling kind – i.e. maturing bonds are rolled into new bonds. So, the cost of owning bonds directly is not just the commission paid when they are first bought but also the commissions paid on rolling them. The costs of direct ownership would then seem to be more in line with bond ETFs, especially considering over-the-counter commissions are high in percentage terms (particularly for strip bonds).
In addition, a rolling ladder has no fixed maturity date and is subject to the same uncertainty of returns as the bond ETF. It is only when the ladder matures into cash that it offers certainty of returns (2) (3). There is a good discussion of these points, and the equivalency of bond ETFs and rolling bond ladders on the Boglehead Wiki.
Other reasons to prefer bond ETFs:
Another consideration is that it is hard to construct a diversified bond ladder with less than $75,000 or so. Small investors don’t seem to have much of a choice other than bond ETFs. An exception might perhaps be if the retail investor only went with government bonds: since default risk is low, the ladder would not have to be too big.
Yet another consideration: the convenience of owning bond ETFs. From the excellent summary on the HowToInvestOnline blog, we have:
• it’s easier to rebalance a portfolio with bond ETFs
• reinvestment of interest payments is easier with bond funds (not a concern for ladders of strip bonds, though)
• running a bond ladder is more work than owning a bond fund, e.g. got to assess bond issuer’s creditworthiness (except in case of government bonds)
Notes:
1) A bond ladder spreads a sum of money over bonds of different maturities. An example is $100,000 divided equally over 5 bonds maturing in 1, 2, 3, 4, and 5, years, or the same amount spread over each year of a ten-year ladder of bonds.
2) When the time approaches for taking cash out of a bond ETF, certainty of returns can be had by selling the ETF in parts and putting the proceeds into bonds that mature on the dates needed.
3) Perhaps one exception where a bond ladder might be better than a bond ETF over the long run is for those investors saving for retirement through a non-rolling ladder of inflation-indexed bonds, as Professor Zvi Bodie advocates for conservative investors. In Canada, inflation-indexed bonds are known as real-return bonds and in the U.S., as Treasury Inflation Protected Securities (TIPS).
15 Responses to “ Bonds versus bond ETFs ”
When you buy a bond, along with the risk, you get a known interest rae. It never changes.
When you buy any bond fund, you not only pay a management fee, but your rates will vary over the years.
If varying rates are unacceptable, and you ever want today’s rate until maturity, there is only one way to get it.
By Mark Wolfinger on Nov 25, 2009
Hi Larry,
I read your column just about every chance I get. They are very informative! I recently bought a stock and it pays a dividend of currently 11% and I wondered if you have ever heard about it. The symbol is DFN on the TSE and the company is called Dividend 15 Split. Have a look at it and decide if this is a sleeper in the woods. In this economic climate, a return of even 6% is a great reward which makes 11% twice as good.
Thanks for reading this note and keep up the good work!
John Daniel, St. Catharines, ON.
By John Daniel on Nov 25, 2009
Excellent article Larry,
You presented a very thorough coverage of the issue of individual bonds versus “bunch” of bonds. You did not specifically mention the products offered by Claymore, for whatever reason. I would like to hear you on Claymore 1-5 Yr Laddered Corporate Bond ETF (CBO:TSX). It seems to be this could be the best of two worlds with 0.25% MER and roughly 5.5% dividends. It is still to be seen in what category these distributions will fall into but I guess not the whole 100% will be taxable as interest income.
I like the line up that Claymore has to offer and my guess is that eventually, the sales of those ETF will pick up. Because we still need to build up volume.
Sincerely,
newque
By newque on Nov 25, 2009
Mark: I raised in the post a number of points concerning the basic argument that you reiterate for owning bonds directly. Did you have any comments on those?
John: Thanks. DFN looks interesting. I’ll take a look at it and see if I can do a post on it.
Newque: Thanks to you too. Claymore ETFs are also interesting and I’ll see if I can do a post on them too.
By Larry MacDonald on Nov 26, 2009
How can DFN afford to payout over 11% dividends when the average dividends of the stocks held in the account is only 4.2% ?
This looks somewhat like a pyramid scheme.
By Lloyd D on Nov 26, 2009
If you intend to own bonds that have default risk (i.e., non-government bonds), then you need diversification to deal with default risk. Diversification is of minimal value to deal with interest rate risk. All bonds are hurt by rising interest rates. Long-term bonds are hurt worse. A bond ladder of only 3 or 4 bonds would solve the problem of interest rate risk as well as it can be solved.
Ladders make more sense for GICs because the money is locked in. GIC ladders help people deal with an unexpected need for money. Bonds can be sold in the event of an emergency, and so there is less need for a ladder.
I agree that the right approach is to examine costs based on portfolio size. However, owning bonds of every maturity from 1 to 20 years has almost identical interest rate risk to owning bonds of maturity 2, 7, 12, and 17 years.
By Michael James on Nov 26, 2009
Larry
2 comments.
First, if the MER of the ETF is too high the investor may be in the position of receiving a net return out of proportion to the assumed credit risk e.g. if the spread between provincial and federal bonds is 40 b.p. and the MER is also 40 b.p. the investor is getting a federal- credit rate of return while being exposed to the higher provincial credit risk. Not good!
Second, because of the lack of a maturity date of a bond ETF (particularly those invested in long term bonds), the ETF is ingerently more volatile then a ladder of directly held bonds, some of which will always be maturing and can be re-invested i.e. if rates go up dramatically surely the ETF investor will be hit harder.
Marc Ryan
IndependentInvestor.info
By Marc Ryan on Nov 26, 2009
Hi Larry, thanks for the link. One thing I experienced in 2008 with my bond ladder containing no government bonds is that the corporate bonds plummeted in value during the crisis,more or less in line with equities, whereas a whole of market ETF like XBB maintained its value due to the government holdings. As a result, I didn’t do any rebalancing. I could have made a lot of gains by holding XBB and invoking my rebalancing trigger of 5% deviation from asset class targets i.e. selling bonds and buying equities. My conclusion is that a truly well diversified bond ladder has to have quite a number of different bonds and at min $5k purchase that adds up to a large amount.
By CanadianInvestor on Nov 27, 2009
MJ
Thanks for input. So, if I understand, we can use a ladder of 3-4 government bonds with staggered maturities? I guess I would be concerned about selling bonds during an emergency when bond prices were down. And has anyone modeled and compared the interest rate risks of ladders with different maturities — that’d be interesting to see. The other thing, how would the cost of rolling a 3-4 bond ladder compare to the bond ETF?
By Larry MacDonald on Nov 27, 2009
Marc
Thanks for your input too. A few questions. If there are commissions to roll the bond ladder and they are in the same ball park as the bond ETF in terms of costs, then could the ladder have the same wedge between risk and return? Also, I got the impression from the Boglehead Wiki that bond ETF were similar to bond ladders, so won’t they have similar volatility (or maybe less if one was using a ladder like MJ describes with 3-4 bonds)?
By Larry MacDonald on Nov 27, 2009
Canadian Investor
Very interesting. There are so many angles to consider in this comparison. I wonder about just using a ladder of government bonds. Of course, the income stream will be lower but they did hold up well (actually went up in price) during the recent crisis and seem to offer one of few solid negative correlations to stocks in general. If you just want to smooth out fluctuations and rebalance, perhaps such a ladder of government bonds? Then again a general bond ETF held up pretty well and provided higher income.
By Larry MacDonald on Nov 27, 2009
One major item your article did not mention is the “cost” of purchasing the bonds. The small retail buyer pays well above the odds for his/her purchase. Buying bonds is easy but getting a reasonable price isn’t. Pick a low cost fund(well under .7%), add in the ease of investing small amounts as well as the reinvestment of interest and for the small investor it is a good strategy. May not be the best or the least cost But certainly easier.
By robert on Nov 28, 2009
Robert
Are you referring to my article? The article I wrote does mention the cost of buying bonds several times — see example below. In fact, it uses this cost factor as one reason for saying bond ETFs seem to be better. Or were you referring to some of the comments from the commentators?
By Larry MacDonald on Nov 28, 2009
the other benefit of investing thru etf is bond investing is a typical job where an individual investor doesnt have any mind into it. to understand macro of economies and micro of maturities, it needs to be an expert… etfs diversify it out with diff maturities and situation..
By sameer on Jan 1, 2010