Is XBB a reasonable alternative to Bond Ladder?

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marcharry
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Is XBB a reasonable alternative to Bond Ladder?

Post by marcharry » 17 Aug 2011 16:34

I am looking at the fixed part of the portfolio and checking a few assumptions made long ago when I first designed the portfolio (with help from all of you).

Is XBB a reasonable proxy for a bond ladder? Forget about cost (30 beeps versus bond desk vig). My concern is exposure on interest rate swings. XBB has about 50% of its holdings 1-5 years maturity, 25% 6-10yrs and 25% 11+, But its weighted average duration is 6.4 yrs, not far off the 5 year rule of thumb for the optimal risk/yield point.

So presumably bonds coming in, bonds going out - XBB is not overly exposed to rate changes in terms of real yield or principle in the form of NAV reflected in the stock price.

XSB with its weighted average duration of 2.6yrs is likely even less exposed - although the shorter duration will generally result in lower yields.

If need be of course the ETFs could be blended in any proportion to reduce the weighted average duration.

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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by adrian2 » 17 Aug 2011 18:51

See this for a strong argument against using bond ETF's in a taxable account.

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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by IdOp » 18 Aug 2011 11:43

marcharry wrote:My concern is exposure on interest rate swings.
Then I would compare XBB to a ladder having a duration around 6.5 years. That would require a ladder of longer than 13 years, so let's take a WAG and call it 15. If you want a rung every year, and $20k PV in each rung, then you need $300k in the ladder. If that is too much, then will a ladder with rungs every 2 years be acceptable?

Another thing to think about is what, if any, needs do you expect to have in the draw-down phase? XBB can be quite flexible there, compared to a ladder (assuming you just want to let its bonds mature).

In extremely general terms, XBB and some ladders may be comparable (both are FI, they may have similar durations and yields), but any way you slice them there will be differences, and there are a lot of ways to slice it.

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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by marcharry » 18 Aug 2011 16:15

adrian2 wrote:See this for a strong argument against using bond ETF's in a taxable account.
That is a good sidebar thank you. The FI is all in tax-deferred accounts - but it won't be forever.

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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by marcharry » 18 Aug 2011 16:35

IdOp wrote:
marcharry wrote:My concern is exposure on interest rate swings.
Then I would compare XBB to a ladder having a duration around 6.5 years. That would require a ladder of longer than 13 years, so let's take a WAG and call it 15. If you want a rung every year, and $20k PV in each rung, then you need $300k in the ladder. If that is too much, then will a ladder with rungs every 2 years be acceptable?

Another thing to think about is what, if any, needs do you expect to have in the draw-down phase? XBB can be quite flexible there, compared to a ladder (assuming you just want to let its bonds mature).

In extremely general terms, XBB and some ladders may be comparable (both are FI, they may have similar durations and yields), but any way you slice them there will be differences, and there are a lot of ways to slice it.
I appreciate your response - now I just have to make sure that i understand it. A classic 5 year bond ladder with equal rungs would have a 2.5 year duration I guess. So, the proxy for that is really XSB. To your point XBB is something akin to a 15 year bond ladder (I had not really thought of the average duration being 1/2 of the term of the ladder)

But how do I judge the degree to which XBB is exposed to interest rate risk? A 15 year ladder seems to me to go too far out but that is based on the 5-7 year rule of thumb. Of course one has to be willing to accept the returns associated with shorter duration.

I COULD roll my own and did in the past - but that requires me trusting the bond rating services to assess the credit quality. In the ETF the high level of diversification reduces this risk.

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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by AltaRed » 18 Aug 2011 16:39

Our own James Hymas argues for a bond ETF over a bond ladder. It is worth purusing the following thread....

viewtopic.php?f=33&t=110454&p=435985&hi ... tf#p435985
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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by marcharry » 18 Aug 2011 18:20

AltaRed wrote:Our own James Hymas argues for a bond ETF over a bond ladder. It is worth purusing the following thread....

viewtopic.php?f=33&t=110454&p=435985&hi ... tf#p435985
Thanks - yes that thread just about covers it + a few of the linked articles. Lots of excellent POVs in there.

I think that the simple answer is "yes"- XBB and XSB are in fact very reasonable alternatives. As always some people prefer to roll their own and enjoy the control, simplicity and clarity of doing so. The critical question is "how many issues do you need to own to feel reasonably diversified?" Most people with granularity risk will escape without incident - so, as always it comes down to what do YOU need to sleep well at night.
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Re: Is XBB a reasonable alternative to Bond Ladder?

Post by IdOp » 18 Aug 2011 18:22

marcharry wrote:But how do I judge the degree to which XBB is exposed to interest rate risk? A 15 year ladder seems to me to go too far out but that is based on the 5-7 year rule of thumb. Of course one has to be willing to accept the returns associated with shorter duration.
I think for XBB duration is a pretty good first stab at interest rate sensitivity. I don't know if there's a really practical way to go much beyond that. (If there is I'd like to learn about it.)

I agree that a 15-year (or thereabouts) ladder probably seems pretty long. Depending on your stage of life you might be winding the ladder down soon after starting it up. But I pointed it out exactly because it is the comparable ladder based on your stated primary concern. If such a ladder seems too unweildy, then XBB would be simpler.

But, if a 15-year ladder has too much interest rate sensitivity for you, then so too does XBB. So, your earlier suggestion of mixing XBB and XSB would be appropriate. One approach would be to try to find a split of X % into XSB and 100 - X % into XBB, such that you are comfortable with the weighted average duration, and the average YTM is acceptable. Then, re-think what is the best ladder you can come up with that's comparable with that. Compare the two from all angles, and see if one or the other wins out. Is one more of a no-brainer? Are there any show-stoppers?
marcharry wrote:I COULD roll my own and did in the past - but that requires me trusting the bond rating services to assess the credit quality. In the ETF the high level of diversification reduces this risk.
Very good point, if you want to have corporates for higher yield (about 33% of XBB is corporates), then you need a lot of issuers to diversify credit risk. On top of that there is the 67% of government bonds to mimick. With each bond needing a minimum purchase amount to get a reasonable price, it would require a fair amount of money. It would result in a large number of bonds which might be too tedious to deal with. So an ETF or mutual fund is likely preferable in this regard.

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