Bond ETFs for income

[Sig]

Yes but a bond etf does not mature. I’m asking specifically about bond ETFs

The bigger point you (and I use the royal you rather than you specifically) are missing is that the value of a bond at any point in time is exactly it's current net present value. So let's look at a scenario to explain.
You hold a 4% 10 year zero coupon bond. The day after you buy it, interest rates go 5%.
The price of the bond will fall because of that, let's say it falls by 8%.
At this point, you have a choice:
A. You can sell for an 8% loss and immediately reinvest in another 10 year bond at 5%.
B. You can hold to maturity and get your previous 4% for 10 years.

At the end of 10 years, you will have exactly the same amount of money regardless of if you choose option A or B. If you choose option A you will have less money invested at a higher interest rate. If you choose option B you will have more money invested at a lower interest rate. The end result will be the same. Exactly the same. So forget about a difference between holding to maturity vs. an ETF. There isn't one.

 

[gkishot]

I have a wealthy family member that is trying to obtain a steady stream of income using the money that have built up in the stock market over the past 10 years. We were looking at a bond ETF like VCSH or AGG. Also I found some junk bond ETFs that pay a higher yield. My question is

Since the bond etf does not mature, you have a risk of not being repaid the total amount of capital. The amount you get “repaid” just depends on the price of the bond etf when you sell it? Is that accurate. Can these bond ETFs go to zero?

Also, if a company defaults on the bond, how much of an affect will that have in the etf or yield, considering some of these ETFs hold thousands of corporate bonds.

What other risks are we looking at by using these instruments? Are they considered generally safe for preserving capital and creating income streams? Thanks.

You should always strive for total return. Yield is irrelevant. Your relatives are going to withdraw from the total balance anyway. Will they be happy to withdraw 10% annually from something producing 10% of interest, but having 10% price depreciation? So in my view buying income etfs for "steady income" is a questionable proposition.

 

[Muffhands]

The bigger point you (and I use the royal you rather than you specifically) are missing is that the value of a bond at any point in time is exactly it's current net present value. So let's look at a scenario to explain.
You hold a 4% 10 year zero coupon bond. The day after you buy it, interest rates go 5%.
The price of the bond will fall because of that, let's say it falls by 8%.
At this point, you have a choice:
A. You can sell for an 8% loss and immediately reinvest in another 10 year bond at 5%.
B. You can hold to maturity and get your previous 4% for 10 years.

At the end of 10 years, you will have exactly the same amount of money regardless of if you choose option A or B. If you choose option A you will have less money invested at a higher interest rate. If you choose option B you will have more money invested at a lower interest rate. The end result will be the same. Exactly the same. So forget about a difference between holding to maturity vs. an ETF. There isn't one.

I think I see what you are saying. If the price of your current bond drops and you sell for a loss to buy the higher interest rate bond you will have less money invested at a higher interest rate and you’ll end up with the same amount of money. But, If you do hold to maturity, you don’t sell for a loss and you can collect your original principle and reinvest in the higher interest coupon with the same principle? Wouldn’t that be more beneficial?

I know you say there is no different then between holding to maturity and ETFs but I’m having trouble translating it to relate to the ETFs. ETFs are constantly buying and selling bonds before maturity. Are you saying that when bond prices go down the yield increase always equals out to end up with the same amount of money? So as the price of the etf falls, the interest rate rise and you would end up with the same amount of money as if the price of the etf remained the same? Even in a scenario like 2008 when bond prices fall dramatically?

 

[Sig]

I think I see what you are saying. If the price of your current bond drops and you sell for a loss to buy the higher interest rate bond you will have less money invested at a higher interest rate and you’ll end up with the same amount of money. But, If you do hold to maturity, you don’t sell for a loss and you can collect your original principle and reinvest in the higher interest coupon with the same principle? Wouldn’t that be more beneficial?

I know you say there is no different then between holding to maturity and ETFs but I’m having trouble translating it to relate to the ETFs. ETFs are constantly buying and selling bonds before maturity. Are you saying that when bond prices go down the yield increase always equals out to end up with the same amount of money? So as the price of the etf falls, the interest rate rise and you would end up with the same amount of money as if the price of the etf remained the same? Even in a scenario like 2008 when bond prices fall dramatically?

For the second question, yes. If you held the EFT as long as you would have held the underlying bonds had you owned them, you'd have exactly the same amount of money. And I'm not sure bond prices fell dramatically in 2008, stock prices did but bond prices, at least Treasuries, actually went up to the point that Buffet rather famously sold a zero coupon Treasury for more than it's face value, implying a negative interest rate. If you're talking about corporate bonds going up because of the underlying risk of bankruptcy you're talking about idiosyncratic risk for each company underwriting the bond, which is a whole different discussion.

On the first question, the scenario is a 10 year holding period and 10 year bonds. Zero coupon to eliminate any potential confusion on reinvesting interest, the answer is the same either way because of how the bonds are priced. So you either get to hold your original bond for the entire 10 years and get the original principle at the end, or you sell at a loss, buy a replacement with that smaller amount of money but a higher interest, and end up at the same amount at the end of the day. I think you may be comparing apples to oranges if you say you hold to maturity and then reinvest. You have to assume that at the point you sold for a loss you immediately reinvested in a new product at the current (now higher) rate with a similar maturity date. In either case you can do what you like at that point 10 years from now, but in either case you'll have the same amount of money.

 

[Steve Ladd]

I trade intermediate term in stocks and stock ETFs. To a lesser extent I also trade in bond ETFs. In order to bridge the conceptual gap I pretend to myself that the bond ETF is a public company (you can buy its stock) whose business is buying and selling bonds. There are many types of bond ETFs, so it's like there are many companies doing so, each with a different strategy. In the case of VWOB and VCLT, two Vanguard products I sometimes hold, they also pay handsome dividends. Their value probably depends on this more than on the hope of price appreciation. These "companies" run the risks you have been discussing in this thread, so their market values fluctuate. But their price action is very slow compared to actual companies and ETFs of companies. Their price is only about a third as volatile. For a trend-follower they have less upside and less downside, unless you used margin to make the scenery change faster. In my case they also reduce correlation within my portfolio. But I don't hold them when I have better alternatives.

 

[Obelixtrader]

Buying Bond ETF which hold bonds to maturity. Powershares offer something like this. This ETF buy bonds with example 2023 maturity and they will hold bond to maturity than they received nominal value and in december 2023 will repay holders all money and ETF will be terminated.

 

[stockmarketbeginner]

Yeah but to me that just seems like timing the market. Isn’t that like saying certain times are bad for being in equities. I think if I’m looking for the long term (5-10 years) it doesn’t really matter what rates are doing right?

Bond funds keep buying new bonds as the old ones expire. They currently have bonds in their fund that are losing value. They were bought when interest rates are lower. Now the interest rates are higher, so those bonds are worth less. If the fund keeps buying funds into a rising environment, it keeps happening. It is like riding straight into the wind.

Rather than a bond fund, look into buying actual bonds and holding them to duration. If the interest rates rise, the street value of the bond will decrease. But if you hold it until duration, you get 100% of your money back, plus the stated rate of return. This assumes the bond does not default.

U.S. Treasuries have short, medium, and long-term durations. And you can buy them directly from the government at treasurydirect.gov.

But also consider tax consequences. Many states offer tax-free municipal bonds. But the default risk is higher than the U.S. government. Low-risk, but not zero-risk.

 

[stockmarketbeginner]

It is like riding straight into the wind.

For example, look at the charts of the following bond ETFs: AGG, BND, LQD, BIV. Do you really want to walk into that?

 

[Sig]

Bond funds keep buying new bonds as the old ones expire. They currently have bonds in their fund that are losing value. They were bought when interest rates are lower. Now the interest rates are higher, so those bonds are worth less. If the fund keeps buying funds into a rising environment, it keeps happening. It is like riding straight into the wind.

Rather than a bond fund, look into buying actual bonds and holding them to duration. If the interest rates rise, the street value of the bond will decrease. But if you hold it until duration, you get 100% of your money back, plus the stated rate of return. This assumes the bond does not default.

U.S. Treasuries have short, medium, and long-term durations. And you can buy them directly from the government at treasurydirect.gov.

But also consider tax consequences. Many states offer tax-free municipal bonds. But the default risk is higher than the U.S. government. Low-risk, but not zero-risk.

As I pointed out earlier in the thread, holding to maturity or selling and buying a new higher coupon bond with the proceeds in a rising rate environment will leave you with exactly the same amount of money at the end of the day. A quick Google on the concept of net present value may be enlightening.

 

[Muffhands]

For example, look at the charts of the following bond ETFs: AGG, BND, LQD, BIV. Do you really want to walk into that?

What is wrong with the charts? You have to keep in mind what might look like violent moves is actually low volatility fluctuations. Agg for example : a high of 113 and low of 106 over 4-5 years is very small movements. Plus u collect monthly interest payments on the way. That’s the purpose of fixed income.