Pickering wrote:This is where I get confused and would appreciate any wisdom you guys might be willing to pass along. As yields increase - I would suppose the distribution would increase as well ??? As bonds are turned over, they will be replaced with bonds of even higher yields.
Is this not a situation not unlike owning individual bonds whereby if I do not need to cash the shares and spend only the distributions - the higher yields will increase unit prices back to my purchase price or in the worst case scenerio - we are looking at a yield to maturity situation where capital loss is factored into the yield equation and yet can expect net yields to increase over time.
In short, will the NAV continue to fall as rates increase or will increased yields mitigate NAV erosion and/or is this the time to liqidate and form my own ladder.
If you don't have the requirement to sell any of your ETF units, it's debatable whether the ladder or the ETF is better. You can argue either side. There's advantage s and disdvantages for both.
To get a better feel in your mind how the ETF will react to different situations, it's easier to think of the ETF having a single bond that you calculate the NAV for all situations.
One of the things that you have to watch for in an ETF is whether they own a lot of premium bonds. It will hurt the tax situation because of the premium distributions, and it will erode the NAV regardless whether rates rise or not. (The tax situation won't be important if you're dealing with an RSP, but it would for an open account).
Think of a single bond situation to work it through in your mind. If I purchased a 5 year $20000 bond with a 5% coupon and a 2.5% yield to maturity today, I would cost 111.68. So the NAV of my single bond fund would be $22336 with a weighted average coupon of 5% and a weighted average yield to maturity of 2.5%. It would pay a taxable 5% coupon, and would receive $20000 on maturity of the bond. My NAV would be $20000 at that time, ready to purchase a new bond. See what happened to my NAV even though interest rates didn't change? It dropped from $22336 down to $20000 over the term of the bond - and rates haven't changed. I also paid taxes on the 5% coupons even though I only realized a return of 2.5%. I do get a capital loss to claim, but it doesn't hold a candle to the extra taxes I paid on that interest. Look at XCB and see the weighted average coupons and yields to maturity. They aren't much different than the situation I described above.
So, continuing with my single bond fund, if I now purchase a new 5 year $20000 PAR bond at 4%, then the NAV will be $20000 and the weighted average coupon will be 4%, with the weighted average yield to maturity of 4%. If rates rise to 6%, then my NAV will be $19146. The NAV has dropped, but when the bond reaches maturity it will pay $20000, and the NAV will be back to $20000. This is where the duration of the fund comes into play. It determines how sensitive that NAV will be to the interest rate change. Either way, if you don't require any units to be cashed, you can see how the NAV will recover if you keep the bond longer than its maturity.
Anyway, that's just an easy quick way to think about ETF's and what will happen to the NAV and yields in different situations.