Sunday, January 17, 2010 2 comments ++[ CLICK TO COMMENT ]++

Newbie Thoughts: A bond fund/ETF is very different from a bond

A user, ccyork, at GuruFocus' message board asked if the TIP ETF is the same as owning the TIPS bond. I wrote up a long response and I thought others would find it benefitial (I have edited it slightly here.) Some of you would know far more than me—hell, there are bond professionals reading this blog ;)—so feel free to correct me if I'm incorrect with any of the points.

Bonds vs Bond Funds/ETFs

Is there a difference between owning a bond itself versus owning a bond fund or ETF? Is the TIP ETF the same as owning individual TIPS bond?

The Answer

The simple answer is that the TIPS bond you buy from the govt is the same as what is contained in the TIP ETF. In fact, if you go to the official iShares site, you can see what TIP contains and check that against what the govt offers. So in theory, it is the same thing. In fact, most people who buy TIP do so because they want to get exposure to TIPS bonds.

I don't live in America and am not famliar with the rules but there is a possibility that the ETF is more tax-efficient than owning the bond. The difference is likely to be minor but it is worth reading up on, if you are investing a sizeable sum. I'm not too sure about this so you should check to see if the tax situation is indeed diffeferent. (Does anyone reading this know if a typical bond ETF is more tax-efficient than owning the bond? I'm wondering if the bond ETF can defer coupon payments or somehow translate them into capital gains while the individual bond coupons have to be taxed every year? Anyone know? Also does anyone know how the situation is in Canada?)

The tracking of the ETF will also not be identical because the ETF may hold a small amount of cash. If you look at that site, you'll notice that TIP holds around 0.12% in short-term securities and 0.9% in other; whereas if you went and bought a TIPS bond on your own, you will have 100% exposure to the bond.

As usual, you will pay the TIP ETF a management expense fee (in this case it looks like 0.2% per year) whereas if you bought the bond from the government, you pay nothing. If you held the ETF for 10 years, you would have paid, ignoring compounding, around 2% in total (0.2 x 10) whereas if you owned the bond outright there is no payments for MER. Some ETFs try to minimize the MER by holding other securities that pay higher interest but I'm not sure if that's the case here.

Investing Is Never Straightfoward, Is It?

Anyway, having said all that, investing in an ETF like TIP is quite different from buying a single TIPS bond. What I am about to say applies to any bond fund/ETF vs actual bonds (not just TIPS.) You may already know this but I'm just typing this up in case investors aren't familiar with it.

It is important to understand that a bond fund almost always keeps rolling over their bonds. If we ignore TIPS and look at normal bonds, you'll see what I mean. If you invest in a 10 year bond ETF, it will always have a weighted maturity close to 10 years (usually a bit less.) In other words, it would continuously sell maturing bonds and keep buying new 10 year bonds. You will always have a 10 year exposure (or whatever the actual exposure is—usually a bit shorter) every year.

In contrast, if you went and bought a 10 year bond, it will be a 9 year bond in one year from now, and it'll be like owning an 8 year bond two years from now, and so on. After 10 years, the 10 year bond will mature and you will have no exposure to it, whereas if you owned the 10 year bond ETF, it'll still have exposure to a 10 year bond.

Generally speaking, owning a bond ETF is like laddering individual bonds on your own.

If we look at the details from the iShares website for TIP, you'll notice that it doesn't own one TIPS bond. Rather, it owns upwards of 30 different TIPS bonds, with varying maturity dates and coupons.

Why does any of this matter? Becauase, as one can imagine, the performance will end up being radically different as time passes.

Looking at that iShares TIP page near the middle, it looks like the TIP ETF has a weighted average maturity of 8.7 years and a weighted average coupon of 2.26%. Well, even if you bought a TIPS bond that replicated those numbers today, the exposure will be radically different in 5 years. By that time, you bond's life would have declined whereas the ETF would essentially maintain a fixed exposure. Depending on how the environment unfolds, you may be better off with one or the other.

(Note that if the coupon re-sets or gets called or something like that, it gets more complicated but this is usually not the case with these long-term govt bonds.)

So to sum up, a bond fund will behave differently from owning individual bonds if you are investing for the long run. In the short run, they will perform similarly.


2 Response to Newbie Thoughts: A bond fund/ETF is very different from a bond

January 18, 2010 at 3:48 PM

Given that the effective duration on TIPS is lower than that on comparable maturity treasuries, I don't think that the "constant duration" characteristic is anywhere near as significant as it is on bond funds and ETFs. A more interesting difference (I say interesting rather than significant becasue I personally don't believe that here is a risk of deflation) is that new issue (not reopenings) TIPS brought from the Treasury are guaranteed to be paid back at no less than face regardless of any net deflation between issuance and maturity. With a fund or ETF, you are necessarily buying TIPS that already have an inflation factor over 1.000. Aldebert

January 19, 2010 at 6:07 PM

Thanks for the insight... I have personally never looked into TIPS or other real-return bonds because I have never been in the inflation camp. But it'll be interesting to see how these bonds perform going forward.

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