Careful readers may recall that I promised them a post about bond ETFs about a year ago. Here is that post.
Avoiding Bond ETFs
Let's begin with a quote from Bill Bernstein's excellent Rational Expectations. It comes right after a section where he discusses how an ETF is nothing more than a different type of wrapping on a mutual fund.
There are certain circumstances where the [ETF] wrapper does make a difference, the most important area being bonds. I highly recommend that you avoid all ETF bond funds. To understand why, I’ll need to explain some of the trading mechanics involved. An ETF, unlike an open-end fund, trades throughout the day at a discount or premium relative to the net asset value (NAV) of the underlying shares. In most cases, the spread between the two is minimal because shares are both created and liquidated by independent agents: “authorized participants” (AP) who buy up the securities underlying the funds and bundle them into ETF shares that are then delivered to the fund company. The same process also works in reverse to liquidate ETF shares. Were a significant spread to open up between the market price and NAV, the AP, in theory, should simply arbitrage that away at a profit.This mechanism works well with stocks, which are highly liquid, but not with bonds, which are not. There is, for example, only one commonly traded class of Ford Motor Company stock. By contrast, Ford has a range of bonds of varying issue dates, coupons, and maturities. Since there are so many more individual bonds than stocks, the bonds can be highly illiquid. During a financial disturbance, when liquidity becomes even thinner and most corporate bonds trade only “by appointment,” the AP mechanism fails, often at considerable disadvantage to the shareholder. The open-end fund holder, who can always buy and sell at the 4 p.m. (eastern standard time) NAV, has no such problem.
What he is saying here is that you should avoid bond ETFs, at least for asset classes where liquidity becomes an issue. That definitely includes corporate bonds, and probably municipal bonds. It probably does not, however, including treasuries, either nominal or TIPS, as those tend to remain quite liquid in times of crisis. That's problematic for people who are principally using ETFs in some of their accounts. I use ETFs in my Schwab PCRA 401(k)- it is basically a brokerage window where I can buy any ETF, Schwab ETFs for free, and Vanguard ETFs for $8 or so, and all I have to pay my 401(k) provider is a $200 a year fee instead of 0.2-0.3% of AUM. My current holdings in there are the Vanguard total stock market ETF, the Vanguard emerging markets ETF, the Vanguard international small ETF, and the Schwab TIPS ETF. I don't actually hold corporate or muni bonds in my portfolio, so this advice doesn't really apply to me, but if you do include those asset classes in your investing plan, you might want to consider making sure you hold them in traditional mutual funds and not ETFs.
Bernstein's Bond Recommendations
While we're at it, we might as well take a look at what Bernstein does recommend you do with your bonds. He is firmly in the camp that recommends against taking much risk with your bonds, preferring instead to do it on the equity side. So he basically recommends all treasuries and CDs. He's not dead-set against either corporates or muni bonds (especially muni bonds for taxable investors) but there is definitely a bias against both of those asset classes as you can see here:
A reasonable fixed-income allocation for a largely sheltered portfolio might be equal amounts of CDs and Treasury bills or notes. A largely taxable portfolio might be equal parts munis, CDs, and Treasuries.
If you are going to hold munis and corporates, he recommends a traditional mutual fund.
The only bond funds you should own are open-end municipal and corporate bond funds (to the extent that you do own these two asset classes). The reason for this is simple. Without a great deal of effort and expense, the individual cannot put together a well-diversified low-expense mix of municipal or corporate securities. With munis, the choice is clear: Vanguard offers a wide variety of national and state-specific mutual funds.
However, he feels that:
For the lion’s share of your fixed-income assets, the entire mutual fund structure is, in fact, unnecessary….Unless your account size is tiny, it makes no sense to own a Treasury or government-bond fund, since you can buy these securities at auction and hold them at no cost. The same goes double for TIPS, the main purpose of which is to pay for future real living expenses. You can, with a little effort, tailor a ladder to do so with the proceeds as they mature. If, on the other hand, you hold a TIPS fund, not only do you pay unnecessary fund fees, but there will likely be periods when you will be forced to sell these securities at disadvantageous prices, as happened to many investors in 2008–2009. Much as I love Vanguard’s low fees, there’s almost no reason to pay them even a penny for their TIPS and government-bond funds.
Why I Still Use Funds
So why am I still using bond mutual funds for both my own portfolio and my parents' portfolio? Well, let's consider my fixed income portfolio. First, I've got 5% in P2P loans. The closest thing to a fund charges hedge fund like expense ratios and has a $250K minimum. So that's out. I've got to buy the individual “bonds” either on my own, or as I prefer, with the assistance of an automated service obtained as inexpensively as possible. Next, I've got 10% in the TSP G Fund, a unique fund which gives you treasury returns with money market risk. You can't buy that as an individual bond.
Finally, I've got 10% in TIPS. I've used both the Vanguard TIPS fund and the Schwab TIPS ETF for years. When I started, I certainly had a “tiny” account size. That probably doesn't apply any more as this slice of my asset allocation closes in on $100K. So what does it really cost me to get the convenience of the mutual fund structure? Well, Schwab is charging 7 basis points, no commissions, and a bid-ask spread of 0.08% each way. The Vanguard fund charges either 10 or 20 basis points per year, depending on whether you have more or less than $50K in it. For a $100K allocation, 10 basis points is $100 a year. Not exactly breaking the bank. If I figure my time is worth, after-tax, $100 an hour, I think I'm probably doing okay for now paying Schwab or Vanguard to handle this. In the future, however I will probably eventually start buying individual TIPS with most of that allocation.
Bond Fund Worries
I think most of the worry individual bond investors have about bond funds is a little overblown. The value of your bond goes down (and the yield goes up) when rates rise, whether you own it in a mutual fund or individually. Yes, with an individual bond you are guaranteed to get the original nominal principal back at maturity, but I think that's a relatively minor concern and mostly a psychological benefit. Rising rates are good for bond investors, as long as their investing horizon is longer than the duration of their bonds (and of course assuming no change in the rate of inflation.) Bad behavior of other investors in the fund (or the fund managers) is also minimized with a relatively safe fund like a treasury/TIPS fund at a place like Vanguard, Fidelity, or Schwab. So I would make your decision between a bond fund and individual bonds primarily based on how much hassle you are willing to endure in order to save a few basis points in expenses. For a counterargument, see this guest post from a few months ago, but keep in mind that the author's first criteria for thinking about individual munis is having at least $500K in that asset class, so this probably isn't an issue you need to spend a lot of time worrying about in the first half of your investing career.
What do you think? Do you use bond ETFs? What do you hold in your fixed income allocation? At what dollar amount do you think switching to individual bonds is worth considering? Comment below!
Is creating a ladder a good idea to have in retirement? I believe though no positive that simplicity is more valuable than just a couple of basis points saved by creating your own TIPS.
I wonder if in retirement I want to deal with managing this ladder on a yearly basis especially as my faculties start to fade. This is also the reason why I stick with a simple 3 fund (4 technically due to 1/2 my bonds are in tax exempt munis in a taxable account.)
I will not know the answers to my questions for at least another 30-40 years.
I don’t completely understand eft and how it differs from a real fund. I think it’s adding a level of abstraction and complexity that is not needed. So unless something is so simple I understand it, then I stay away from it. If I understand correctly (this example is for stocks not bonds but just stay with me) then when I pay $100 into an eft fund that is not put into the fund as stock, but as “cash” (money market etc), at some point someone (AP) takes that cash and buys stock. Since your just buying into the fund and the fund has cash earmarked to buy stock, you can do this 24 hours a day. Likewise since it has a cash account you can sell 24 hours a day. I also have a problem with the statement above “were a significant spread to open up…” Since I think it’s just as likely to be a loss as an arbitrage.
ETFs are great. There does seem to be a few situations where they make less sense. As for liquidity…im somewhat more on the fence about that as buying once at 4pm under absolutely opaque conditions in no way means you are getting a better price. Even buying things like munis individually doesnt mean you get a good price since there are cuts taken on each end of the transaction and its even more opaque.
Ok you guys call it opaque not abstract…duly noted..
I don’t really care about the great price since I don’t think I understand it and thus don’t know what I’m getting (risks) involved with it… Also if liquidity isn’t a major benefit of etf then what is (besides the low cost)?
I’m using bond etfs. I will be holding them VERY long term and don’t care about intraday liquidity. The fact that I can see the price move with changes in interest rate are a plus, not a negative, in my opinion.
No. When you buy an ETF you are exchanging your cash for a collection of stocks (or bonds) previously compiled by the AP. You are not putting money into a fund as cash like with a traditional mutual fund.
I am using BND -the ETF in my TD Ameritrade account. I doubt it would be very different from its mutual fund–thoughts?
I also use BND which is the ETF class of Vanguard’s Total Bond Fund VBMFX. Vanguard has a patent till about 2022 for this structure where the ETF is a class of its bond fund. It helped allay my liquidity concerns. I felt it also addressed Berstein’s concerns against bond etfs since they seem to use the dual structure to my benefit as opposed to the CIT structure that I discussed in the last post which hurt me.
Long-term lurker here…. I have a 3 fund “lazy” portfolio for all my retirement accts (and some of my taxable as well). I do as well use BND as the bond allocation. Are you saying that’s a bad idea because it’s an ETF. Or, Dr. Mom, are you saying that because of the patentent structure Vanguard has that BND is immune to the problems this post is about?
Can’t guarantee immunity. I simply feel that how Vanguard has its ETF set up as a class of its mutual fund that each benefits the other in my opinion. I would agree with Bernstein outside of Vanguard ETFs. I have not ever read his opinion on Vanguard ETFs as a class of its mutual funds. I am not at Vanguard so I can access the ETF much cheaper. I don’t understand why other companies have not challenged them. It seems like a silly thing to patent.
BND (Vanguard Total Bond Market Index ETF) may be a poor choice for your taxable account depending on your tax bracket. You may be better off with a muni fund in taxable.
Since BND holds corporate bonds, it is NOT immune to the issues this post is about. However, someone willing to use a 3 fund portfolio for simplicity’s sake may not care about the issues brought up in this post. This is a rather fine point of portfolio construction. But Bernstein would suggest you use the fund instead of the ETF. I love Vanguard’s ETF/fund structure, but I don’t think it entirely eliminates this admittedly minor issue.
As a pediatrician I don’t think of immunity in absolute terms, but like in childhood vaccinations. BND only holds about 30% of assets in corporate bonds. The rest are governmental. Its assets total 163B comingled with the mutual fund shares making it more liquid than smaller ETFs. So while WCI is correct that it is not fully immune to issues of this post, I feel it has vaccinated itself and achieved enough immunity to them for me to be comfortable using it.
you do not need 500k to start a muni bond portfolio
build it one bond at a time or more if possible
There was a very recent 30yr period where bonds basically performed the same as stocks!!
Being redundant BONDS should always be a part of your portfolio(ask Bogle)
When you retire or get near YOUR MIDSET WILL CHANGE to preserve capital-assuming you reached your goal or hopefully exceeded it
FWIW-I have owned Vanguard hi yield corporate for many yrs and it was swamped with investors and think its now closed
Nothing wrong in my mind to use all types of bonds, INCLUDING ALL CORPORATES from long term to intermediate
When equities are booming everyone bashes bonds; the opposite is true as well
WAIT TILL the next 50% stock crash-You will see who is wearing trunks when the tide goes out
“build it one bond at a time or more if possible” wouldn’t diversification be a problem? If that one bond defaults your screwed
The Vanguard high yield corporate fund is not currently closed.
Would you have the same liquidity issue with VTEB (Vanguards municipal bond ETF) since it is a share class of the parent mutual fund (VTEAX/VTEBX)?
I have the same question. Especially because Vanguards similar funds: VTEAX & VTEBX both have a 0.25% purchase fee. It doesn’t seem worth it to pay such a large fee.
Exactly. I’m in MUB (and VWITX) currently, but would prefer not to have to pay a purchase fee since I put money in automatically both weekly and monthly.
Bernstein’s point about bond liquidity being a poor fit for ETFs makes sense to me.
While I slice & dice and value tilt my equities, my bonds are totally boring – just Vanguard Total Bond fund. Part of that is I find bonds way more confusing than equities, part is I don’t want the hassle of buying individual bonds, part is that fund offerings in my accounts are boring, and part is that I am young and my bond allocation is not that big so I don’t worry about it that much.
I’d like to have a specific allocation to TIPS, but there isn’t a TIPS fund in my 403(b) so the only way I’d be able to do that is in my Roth IRA, HSA, or taxable account, and so when combined with my age I’ve concluded its not worth it at present to hold TIPS funds in those accounts.
Bernstein states, “If, on the other hand, you hold a TIPS fund, …………………. there will likely be periods when you will be forced to sell these securities at disadvantageous prices, as happened to many investors in 2008–2009. ”
During the downdraft peaking on 2/11/2016, SCHP and TIPS _ APpreciated_. So did MUB and VTEB. Using them for rebalancing or current expenses would have worked well.
My amount is quite small, and for simplicity I just hold TIPS and US Treasury Bonds through ETFs. For me, it is just easier to keep it all in once place.
I also hold a general Bond ETF for diversification as my investable funds are not large enough to warrant buying individual bonds.
I know the recommendation is to buy TIPS, etc at auction. Can someone please explain how this is done? Can an individual investor actually compete in these auctions? And is this sort of like an Ebay type bidding war? How do you know if you got a good price or not on a particular bond? Thanks
There are a couple of ways to do it, but basically the easiest allows you to just piggyback on what the rate the big boys got. Check out treasury.gov for details. https://www.treasurydirect.gov/indiv/products/prod_auctions_glance.htm
Not much reason for hi income earners to have taxable fixed income
Build a MUNI BOND Portfolio long term investment grade
Nothing beats tax free income as well as a ROTH IRA which every doc should open as a resident
I’m in same boat. Have a chunk of change that we may need in a year. Have it invested in a state muni etf, thus tax free dividends, maybe 2-3% per year. Is that a bad idea? Would you park that somewhere else. Interest rates are so low I prefer not to leave it in a savings account.
All of us prefer to make more money safely, but that’s not an option given to us. You either make less safely, or you take on some risk. If that extra 2-3% a year is worth the risk of perhaps losing 5-10% of it, then sure, put short term money in a state muni ETF. If it isn’t, then get your 1% in a high yield savings account and forget about it.
I like the idea of a municipal bond ladder in my taxable account but have zero time/expertise/interest to go looking for individual bonds to buy (and paying middlemen transaction fees). Does anyone have experience using the iShares iBonds series for this purpose (IBME through IBMK)?
Why not use the Vanguard funds? Then you can avoid the issues discussed in this post with bond ETFs and acquire diversification and expertise at a very low price.
One insight overlooked is that though the ETF Authorized Participants might have trouble arbitraging away NAV/Price discrepancies in realtime, Bond ETFs offer a second level of trading liquidity, of just the security itself, and not the underlying bonds. If the ETF becomes too cheap relative to the underlying bonds, either that is because the underlying aren’t being properly priced (you would get similar low prices if you had to sell the underlying bonds, plus the high trading costs (B/A spread) or that other investors, such as insurance cos. and other institutional investors would step in to buy the momentarily cheap ETF relative to the bonds, to help bring them back to equilibrium pricing.
Bond ETFs provide auto-reinvestment, which can lead to greater compounded performance over time, monthly distributions for liquidity, and arguably better overall trading cost/liquidity than a individual bond ladder.
Hi all I am new to all of this– senior resident. I am very interested in starting to invest. One of my attendings was telling me about Ohio and virginia State bonds via Vangaurd (that they average about 5% and tax free?)… but I don’t understand how the above comments do and don’t relate. I would need very simple language of PROS and CONS. I would also appreciate if someone could send me in a direction to how to diversify as one starts to invest.
Things to consider for advice: I am a military resident (but I still have all of my medical school loans- as I joined 4th year of medical school because it was the job I wanted). But i plan to do 10 years for a non-profit for the loan repayment program. Again I am very interested in these bonds, and investing but all the above information is written out of my range of understanding.
thank you in advance for any comments/direction/advice
The good news is that if you’re a rookie at this stuff, you can totally ignore this post and it is unlikely to make much of a difference in your financial life. This bond ETF vs bond traditional mutual fund is a very minor point.
Your attending is referring to this funds available at Vanguard:
The Ohio Long Term Tax Exempt Fund buys munis in Ohio and currently yields 1.6%, but that is free of both federal and Ohio state tax.
There is no Vanguard Virginia tax-exempt fund, but you could use the intermediate (yields 1.21%) or the long-term (yields 1.64% with significantly more interest rate risk) tax-exempt funds.
Frankly, if you’re a military resident, just work on maxing out your Roth IRA (stick it in a target date fund at Vanguard) and your Roth TSP (stick it in an L fund with the same date.) You can make things more complicated later if you like, but realize that portfolio is fine if you stick with it in the long run and fund it adequately.
So I was reading up on the ohio one and it states “Vanguard Ohio Long-Term Tax-Exempt VOHIX seeks tax-free current income. VOHIX invests a major portion of its assets in municipal bonds that are expected to provide income exempted from federal and Ohio state taxes. The fund generally invests in high-quality securities of the Ohio state and local governments and their affiliates. VOHIX is expected to maintain a dollar-weighted average maturity of 10 to 25 years. Vanguard Ohio Long-Term Tax-Exempt is a non-diversified fund and has a three-year annualized return of 7.2%.” Im not sure how the 1.6% you mention is the 7.2%, I do not quite understand annualized. In short I am a rookie that does not want to be a rookie. Lots to learn. That is why I love this site.
Annualized means the return per year. So if you make 3% in 6 months, that annualizes out to 6% a year (actually slightly more). If you make 16% in two years, that annualizes out to 8% a year (actually slightly less.)
It’s important to realize that annualized takes into account compound interest, whereas “average annual” does not. So you could have average annual returns of 25% (say 100% one year and -50% the next year) and annualized returns of 0%. To make matters worse, Vanguard’s website labels their returns as average annual when they mean annualized.
Since bonds are down, can we do tax loss harvesting into a bond partner and rebuy low to capture these losses?
Thanks
Yes, I’ve done that 2 or 3 times this year.