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Response to Roger Nusbaum on Bond ETFs

by: Will McClatchy July 10, 2007 | about stocks: GKA / GKB / GKC / GKD / GKE    

Will McClatchy

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Roger Nusbaum wrote on July 6 that most investors should buy individual Treasuries, not an ETF that maintains a constant maturity (see "Five New Bond ETFs, and Why They May Not Be for You").

I expected someone to take him to task, but I guess I will have to. According to Roger:

If you buy an individual treasury, your yield will be whatever it was when you bought it -- which makes managing this portion of your portfolio much easier.

Yes, easy enough but completely contrary to basic rules of asset allocation. The average investor should allocate assets relatively passively at modest or low cost between equities, fixed income and other asset classes in a well thought out asset allocation to keep risk and reward in acceptable balance.

Treasuries are an obvious choice to dampen risk. They can only do so in a consistent way if the interest rate risk remains constant. Which is what excellent new Ameristock ETFs do at the phenomenally low cost of .15% annual fee. It's just like rebalancing equities and bonds. If you let equities grow without selling some off and buying some bonds to get back to the strategic asset allocation split then you are not asset allocating. That's fine if you know what you are doing, but clearly this is not for the average investor.

Roger Nusbaum advocates that investors buy a very long bond and hold it for term. During its evolution its interest rate risk changes radically (from risky/yieldy to low risk/low yield). Not exactly for the average investor.

We are talking about basics here.

Disclosure: none

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This article has 9 comments:

  •  
    Jul 10 09:23 AM
    Will! Are you kidding me? Only one S in Nusbaum, one S! LOL.

    Seriously though, the audience for my thoughts, people who devote enough time to investing to read blogs, are more than capable of deciding 4% for ten years is too low but 6% might be pretty good (the example I used).

    I will say that the willingness to have a variable rate aspect to the treasury portion of a fixed income portfolio is a turnoff to a lot of people and I am surprised that you think it is a good idea.

    I posted this on my blog, on Real Money's columnist conversation and obviously Seeking Alpha picked it up. That is an audience of several thousand people and no one else drew your conclusion. While that proves nothing, is it possible you are in the minority on this?
    Reply
  •  
    Jul 10 06:16 PM
    Ssorry about the mispelling, Roger.

    I am happy to be in the minority. ETFzone considers its main mission to dispelling myths regarding ETFs. Let's follow your example in your blog:

    "If the yield on the ten year was 6% and you thought that was pretty good, you risk getting a lower rate with GKD if the yield in the marketplace goes down. That which might yield 6% today could yield 4% next year. If you buy an individual treasury, your yield will be whatever it was when you bought it -- which makes managing this portion of your portfolio much easier."

    After one year GKD, which maintains a constant 10-year average maturity, still has a 10-year maturity. But the individual Treasury is now equivalent to a 9-Year maturity because it has 9 years left. If as you say the marketplace yield (essentially interest rate) for a 10-year bond goes from 6% to 4%, then the value of both holdings will rise, because both entitle the holder to many more years of 2% higher-than-market interest. The longer maturity GKD will get a bit more of a boost from its extra year. So actually, in your example GKD is the winner at that moment in time. Each month at Treasury auction as GKD turns over its holdings for new 10 year Treasuries, GKD takes its winnings (or losses) and plows them into the next batch.

    I have no idea what you mean by "variable rate aspect to the treasury portion of a fixed income portfolio". GKD is not a variable rate product. It contains only fixed rate 10-year Treasuries. It does turn over its portfolio to maintain that 10-year duration, but that is not a variable rate as most people understand it.

    My main point is that investors need to be clear whether they are maintaining a portfolio with set asset allocation targets, or if they are saving for a balloon payment or steady income over a known period. Most pension funds asset allocate with set targets, as do most investors saving for retirement. Clearly if one is saving for balloon payments such as college education or if one has set income requirements over a known period and no longer, then an individual bond is perfect. But when you essentially say that "average" investors should not asset allocate with bonds, I worry about how that advice will be taken.
    Reply
  •  
    Jul 10 06:49 PM
    Variable rate...If you buy GKD today you have no idea what it will yield at any point in the future. The yield goes up and down in the future; variable so to speak.

    In trying to manage a portfolio for growth and income something that lessens predictability of income stream is less desirable.

    Your GKD is the winner comment doesn't really apply or appeal in the real world of people living off their portfolios which is who my clients are and what we all will probably need to do at some point.
    Reply
  •  
    Jul 10 09:23 PM
    Agreed. The yield bounces around with GKD, but at least the interest rate risk profile remains the same. It remains a long bond and does not morph into a shorter term bond. Unfortunately for some of your clients, when the long bond expires, they will have to reinvest and then they could be in trouble unless they plan on living only so many years.
    Reply
  •  
    Jul 10 10:36 AM
    Is it a choice between a variable rate OR variable price?

    bob lee
    Reply
  •  
    Jul 10 11:11 AM
    That might be a way to look at it with the diff being that with a bond, you know you will get par back at the end. There is no such guarantee with a bond fund.
    Reply
  •  
    Jul 10 09:19 PM
    If a bond fund owns 10-year bonds, you will certainly "get back par" in an economic sense even if the fund sells the bond before maturity. That is because the person who buys the bond buys to the right to "get back par". There is no economic penalty to a bond for selling, all else being equal.
    Reply
  •  
    Jul 10 06:18 PM
    What's with the variable rate/variable price stuff? Funds which own Treasuries act like Treasuries. Treasuries are fixed rate instruments. Their price fluctuates with interest rates, inversely.
    Reply
  •  
    Jul 10 02:55 PM
    I think it is the difference between managing for income and managing for total return. Bond funds/ETF's make it easy to alter duration, credit risk etc. That is if you are manging to a total return mandate. If you don't have a specific time horizon at the end, you are only going to roll that treasury into something else. I agree with Will.
    Reply
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