Radical Guide to Bonds: Comparing the Options - Bonds vs. Bond Funds vs. Bond ETFs
This guide is about smart and low-cost means to invest. It is hard to say what is the lowest cost solution for exposure to the bond market. It is not straightforward. You’ve got to weigh a number of factors. Let’s put these into the following table:
|Bond Ladder||Indexed Bond Fund||Bond ETF|
|Tax Events - Interest||Yes||Yes||Yes|
|Tax Events - Capital||Controlled||Yes||Possible, but small|
|Cashflow Certainty||Certain||Uncertain||Mostly certain|
|Initial Transaction Costs||Known, if controlled with selling groups, auctions and use of online brokers||Known commission||Known commission|
|Ongoing Trade Costs||Some at redemption||Not known fully||Not known fully|
|Interest Risk||Yes, opportunity cost from rising rates||Yes, NAV likely drops below initial cost||Yes, ETF price likely drops below initial cost|
|Loss of Invested Capital||Possible from credit event||Possible from credit event and sell-off||Possible from credit event and sell-off|
Instead, in looking at a couple of factors, we can say:
- Cashflow certainty. A bond ladder is designed for the complete cashflow certainty. If it weren’t, why would any investor bother with it? Funds vehicles are less certain with respect to their cashflows.
- Trade Costs. With funds and ETFs, ongoing costs are not fully known, upfront. With ladders, costs are known before the trade so long as the investor can always purchase product through selling groups and auctions.
- Diversification. Best diversification is in the indexed bond funds and ETFs; the least amount of diversification is with bond ladders.
- Risk - Interest. If rates rise, and bond values fall, what happens? For funds and ETFs investors, with higher rates, they will likely experience a drop in NAVs and realize some underperformance. For ladders, the investor is missing out on investing in the whole ladder at higher rates. We term that an opportunity cost.
- Loss of Invested Dollars (principal). All three vehicles may experience selloff in the market or credit events, resulting in losses. No one can predict the levels going forward.
We have covered a lot of territory. Our guide opens only a small window on the bond markets. We only touched upon retail investing, but many institutions drive this market.
And while the markets remain clouded for the retail investor, we hope that we have shed some light on low-cost trading opportunities.
Go to the next chapter for the final word and summary for this guide.
June 3, 2005 | Permalink
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