Bond ETF's Pricing

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Bond ETF's Pricing

Postby Pickering » 21 Dec 2010 19:52

I am retired and hold over 60 % of my portfolio in bonds - all ETF's ( as an new DIY Investor - it seemed less stressful ) Hold about equal values of CLF, CBO, XCB & XSB.
Being worried about interest rates - listened to you guys and kept short-term to minimize risk. Understand that with the signs of a recovering economy - rates likely to rise and as a result the yield curve steepens to reflect this. As yield increases, bond prices fall and the NAV of the ETF is reduced and as a result the unit price erodes.
Ishares has reduced the monthly distribution - while Claymore has had held constant - can only assume Claymore is subsidizing distribution with return of capital. This would be borne out by the fact that NAV reduction over 12 months is greater with Claymore.
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.
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Re: Bond ETF's Pricing

Postby like_to_retire » 22 Dec 2010 09:39

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.

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Re: Bond ETF's Pricing

Postby Darrell Greenwood » 23 Dec 2010 21:04

Pickering wrote:I am retired and hold over 60 % of my portfolio in bonds - all ETF's ( as an new DIY Investor - it seemed less stressful ) Hold about equal values of CLF, CBO, XCB & XSB.


I hold 25% of our portfolio in XSB for simplicity, none in taxable accounts.

Pickering wrote:Being worried about interest rates - listened to you guys and kept short-term to minimize risk. Understand that with the signs of a recovering economy - rates likely to rise and as a result the yield curve steepens to reflect this. As yield increases, bond prices fall and the NAV of the ETF is reduced and as a result the unit price erodes.
Ishares has reduced the monthly distribution - while Claymore has had held constant - can only assume Claymore is subsidizing distribution with return of capital.


I assumed this was related to the specific bonds held in each ETF. i.e., their coupon rate vs current yield.

Pickering wrote:This would be borne out by the fact that NAV reduction over 12 months is greater with Claymore.
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.


The yield to maturity and duration of XSB and CLF ETFs (info released daily) correlate nicely in my experience with the Canadian yield curve published weekly in the National Post. This gives me a easy way to see what I am getting in the way of return from my bond ETF.

I like like_to_retire's approach in evaluating a bond ETF as single bond.

FWIW, I am switching from 100% XSB to 100% CLF (as normal transactions in each registered account arise (saves half the brokerage for the switch)).

My analysis is I pay $270 per hundred thousand for MER to XSB, I will pay $160 MER per hundred thousand to CLF. The product is essentially the same, with a small amount of what I consider risk vs rate tradeoff. (When I first looked at CLF the liquidity was poor, that is no longer the case.)

From 21 or 22 Dec overview sheets
Code: Select all
CLF 2.101% Index Yield-to-Maturity               2.843 yrs Duration
XSB 2.220% Weighted Average Yield to Maturity    2.73 Weighted Average Duration (yrs)


Cheers,

Darrell
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Re: Bond ETF's Pricing

Postby MaxFax » 24 Dec 2010 13:53

Down to this point eveyrthing you say is correct.
Pickering wrote:Ishares has reduced the monthly distribution - can only assume Claymore is subsidizing distribution with return of capital.

You don't have to assume anything. Look at the issuer's website. They all publish the ETF's yield to maturity YTM. When this is lower than the distribution rate, the difference is a ROC. That is why when you buy/sell bond ETFs you ignore the distribution and look at the YTM.

Pickering wrote:As bonds are turned over, they will be replaced with bonds of even higher yields. I would suppose the distribution would increase as well.
Not really, The following math is not exact, but shows the point....
You own $1,000 market value bond with 5% distribution = $1,000*5%= $50
Market yields rise to 10%
Causing repricing of market value down 50% to $500.
Sell bond and buy new one the pays new 10% market yield.
New bond pays distribution = $500 * 10% = $50

Pickering wrote:will the NAV continue to fall as rates increase or will increased yields mitigate NAV erosion
Do you now see that the increased % yields will not result in increased $$distributions? The changes in market prices accomplish the equalizing of YTM.
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Re: Bond ETF's Pricing

Postby AltaRed » 24 Dec 2010 14:34

MaxFax wrote:
Pickering wrote:will the NAV continue to fall as rates increase or will increased yields mitigate NAV erosion
Do you now see that you will not have any increased yields?

Only at a single snapshot in time. Based on yield curve change, (not just a single interest rate increase), The NAV will recover over time (at duration) as old bonds mature and are replaced by new bonds paying higher yield. At duration, e.g. 2.7-2.8 yrs from now, using the 2 examples of XSB and CLF, NAV will have fully recovered to today's value, and the full effect of the higher return will be realized. It is even conceiveable that if short term BoC interest rates (<1 yr) increase, but longer term interest rates (> 1yr) decrease due to reduced threat of inflation, the bond ETF NAV could increase with a short term rate increase (not decrease).

The degree to which NAV continues to drop (or recover) is related to the pace of yield curve increases/decreases vs duration of the bond ETF. In a longer term increasing interest environment, the NAV of the bond ETF will continue to lag until interest rate increases stop + duration.

IOW, one needs to be a bit of a mathematician to precisely calculate cause and effect. Bond ETFs are probably not best for someone who micromanages by watching NAVs on a daily/monthly/annual basis.
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Re: Bond ETF's Pricing

Postby like_to_retire » 24 Dec 2010 15:16

MaxFax wrote:You own $1,000 market value bond with 5% distribution = $1,000*5%= $50
Market yields rise to 10%
Causing repricing of market value down 50% to $500.
Sell bond and buy new one the pays new 10% market yield.
New bond pays distribution = $500 * 10% = $50

Quite true if you sold that reprised bond for $500, but it will pay full PAR at maturity, and return the original $1000. The new 10% rate will now yield you $100.

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Re: Bond ETF's Pricing

Postby SLeazebag » 24 Dec 2010 19:57

like_to_retire wrote:
MaxFax wrote:You own $1,000 market value bond with 5% distribution = $1,000*5%= $50
Market yields rise to 10%
Causing repricing of market value down 50% to $500.
Sell bond and buy new one the pays new 10% market yield.
New bond pays distribution = $500 * 10% = $50

Quite true if you sold that reprised bond for $500, but it will pay full PAR at maturity, and return the original $1000. The new 10% rate will now yield you $100.ltr


I'm a bit confused. Presumably selling the bond would generate a $500 loss (perhaps a superficial loss) but won't this match the $500 future gain under the new bond to be realized at maturity, i.e part of the $100 yield is purchase discount. So ignoring the loss and the offsetting purchase discount, nothing has changed..over the whole period, the yield is 5%?
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Re: Bond ETF's Pricing

Postby like_to_retire » 24 Dec 2010 20:23

SLeazebag wrote:I'm a bit confused. Presumably selling the bond would generate a $500 loss (perhaps a superficial loss) but won't this match the $500 future gain under the new bond to be realized at maturity, i.e part of the $100 yield is purchase discount. So ignoring the loss and the offsetting purchase discount, nothing has changed..over the whole period, the yield is 5%?

Buying a new bond at $500 won't return $1000 at maturity. It will return $500. I don't understand your future gain scenario.

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Re: Bond ETF's Pricing

Postby SLeazebag » 26 Dec 2010 14:56

Sorry ltr, I misunderstood your post, which I now understand and agree with. :oops:

like_to_retire wrote:Buying a new bond at $500 won't return $1000 at maturity. It will return $500. ltr


I agree assuming the new bond is a par bond. But the new bond could be a deep discount bond and in the extreme could be the same or similar to the bond that was sold and hence the new bond could return $1000 at maturity. I know that it doesn't make sense for someone to do this but this is what I incorrectly understood from your post.
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Re: Bond ETF's Pricing

Postby Eric R » 28 Dec 2010 18:17

This is a very interesting topic. Based on the concept that an ETF can be treated as a single bond with a specific YTM at purchase, would it be reasonable when purchasing a fund (let's say treasuries) to compare it to the yield (or yield to maturity) of a single T bond with similar maturity or duration (before MER)? Could one consider the prices of these funds efficient compared to single bonds under most circumstances or is there a need to comparison shop?
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Re: Bond ETF's Pricing

Postby adrian2 » 30 Dec 2010 14:25

Pickering wrote:I am retired and hold over 60 % of my portfolio in bonds - all ETF's ( as an new DIY Investor - it seemed less stressful ) Hold about equal values of CLF, CBO, XCB & XSB.

Prefhound, initially analyzing XBB, with my underlining, wrote:A more accurate calculation gives an all-in after-tax yield of 0.98% if capital losses are usable (an effective tax rate of 1-0.98%/2.47% = 60%). The effective tax rate will be higher if capital losses are not usable (offset against gains) or if OAS clawback affects marginal tax rates.

A worse case is short-term bond ETF XSB, which has an after-tax yield of 0.5% and a 71% effective tax rate!

Thus, in today’s world of low yields, bond ETFs are a gift to the tax man in taxable accounts.
...
As another example, iShares XCB — Corporate bond universe ETF has an average bond price of $114+; and after-MER gross yield of only 3.02% (worse than GICS!) and after-tax yield of 1.26% for a 57% effective tax rate.

My own view is that taxable investors would be better off owning individual bonds with a higher than market (7%) weighting in utilities, that they preferably buy at or near par with careful attention to after-tax returns.

In today’s environment, bond ETFs don’t belong outside tax sheltered accounts for most taxpayers
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Re: Bond ETF's Pricing

Postby like_to_retire » 30 Dec 2010 15:12

In today’s environment, bond ETFs don’t belong outside tax sheltered accounts for most taxpayers


Yet, over the last ten years, an FPX Income Portfolio handily beats an FPX Growth portfolio.

Given the pitiful growth prospects and large deficits most developed countries enjoy right now, I imagine the next decade will be the same.

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Re: Bond ETF's Pricing

Postby adrian2 » 30 Dec 2010 15:20

like_to_retire wrote:
In today’s environment, bond ETFs don’t belong outside tax sheltered accounts for most taxpayers

Yet, over the last ten years, an FPX Income Portfolio handily beats an FPX Growth portfolio.

Given the pitiful growth prospects and large deficits most developed countries enjoy right now, I imagine the next decade will be the same.

FPX portfolios don't account for taxes, which was the main point of my previous post. As for Income vs. Growth, the past is the rear view mirror; you're welcome to believe interest rates will continue to drop providing more capital gains to the bond holders, or that Armageddon is around the corner wiping out equity holders -- my exposure to bonds continues to be negative while equities are more than 100%.
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