DGI Adventure – 07-07-16 Fixed Income Fund Watch List Part 3 of 3 – Bond ETFs

I’ve already figured out the funds I plan to buy for my fixed income closed end fund (CEF) portfolio. I came up with that portfolio after filtering through my bond fund watch list parts one and two, which I published in May. Of course all of my watch lists will always remain published back at the mother ship.

My original intention was to get all three parts of this watch list published in May, but that didn’t happen.

Then I planned to get the third part published in June, but that didn’t happen either. The best laid plans…

Anyway, here’s the third part…finally:

Instead of CEFs, this time I’m looking at exchange traded funds (ETFs). Like CEFs, ETFs are similarly bought and sold like stocks on the open market, but the NAV and the market price don’t diverge significantly…not because of active management, but because of market dynamics. An authorized participant (AP) can always buy up the underlying assets of the index and exchange with the fund for redemption units (blocks of ETF shares), or they can buy up a redemption unit’s worth of ETF shares and exchange with the fund for the underlying assets. This is the creation/redemption process that makes ETFs tick.

If the market price and the NAV start to diverge too much, arbitrage keeps things in line. 

So as far as bond investing goes are ETFs also better than open ended mutual funds right?

I think so. There’s a lot of debate about what will happen to bond funds in a bond liquidity crisis. It seems obvious to me that open-ended mutual funds will be a mess. Those funds have to redeem daily at the net asset value (NAV) price. But if they can’t sell the underlying assets to meet the redemption requests, the bond prices will crash, further blowing up the NAV, likely driving more redemption requests, etc. It’s kind of like a run on a bank, and it’s all kinds of bad. CEFs don’t have this issue, because the fund managers can do whatever they want with the money in the funds (okay not WHATEVER they want…but they don’t have to meet idiot redemption requests). Investors have to get in and out by selling shares on the open market. So the discount to NAV values might get whacky, and the NAV might even drop because the “value” of held assets might get weird from whatever chaos is being wrought by the open ended funds, but the savvy manager doesn’t HAVE to sell anything. And it’s not a loss until you sell…

So what will happen with the ETFs? I don’t know. One theory goes that the APs might not want to play anymore if there isn’t any liquidity for the underlying assets. So the arbitrage mechanism holding the ETFs together breaks, and all hell breaks loose? I guess?

I don’t know, but I’m pretty comfortably holding highly liquid issues in ETF form. I’m not so sure about the less liquid high yield stuff. I think I prefer that being in the (relatively) controlled environment of the CEFs.

So what’s the point of all this?

When I was plotting all this fixed income business out, I mentioned that LDLAX would be hard to replace. I had about $25K invested in this fund, and I considered it to have a dual purpose: 1) emergency fund (~6months worth of expenses), 2) some income. I was comfortable considering this an “emergency fund” because of the relatively high credit quality in conjunction with the very short duration. Sure the NAV could lose some value in a bond crisis, but all in all I felt pretty confident that investment would remain worth roughly $25K give or take (that would be a pretty comfortable 6 months…we could make do with less…).

Out of the 10 CEFs I’ve chosen, I don’t consider any of them to be a true replacement of LDLAX. PPT and PIM are the two closest equivalents I was able to find in the CEF universe. They actually have even shorter effective duration, but there’s some black magic (swap spread derivative voodoo) going on if you have a duration less than 1 year but average maturity over 8 years. I don’t trust black magic for my emergency fund.

Maybe there’s an equivalent CEF out there with a higher expense ratio. I filtered out any funds with expenses over 1.5%. Sorry, but I’m not interested in paying much over that for any fund. Seems like plenty to me.

So like most things in life, I guess there’s a trade off. Thanks to closed end funds, I’m getting a higher yield on my fixed income investments, but in exchange I probably have to accept a little less income from my emergency fund. I’m okay with that.

So I went to the ETF universe to look for LDLAX’s replacement. Here’s what I found.

Part 3 of the fixed income watch lists: Short Duration Bond ETFs.

Just for reference, here’s the table I made of my previous fixed income funds:

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So to the LDLAX “benchmark” so to speak, is an average effective duration of ~2 years, BBB or better average credit quality, with a decent (3%) yield.

After much research, I wasn’t able to find anything close across all three of those metrics. It seems I have to give up some yield if I intend to maintain a similar risk profile to LDLAX.

I would like to have at least a 2% yield, as that is ostensibly the Fed’s inflation target. (i.e. I would like my emergency fund to at least “keep up with inflation”).

Bond ETF #1: Vanguard Short-Term Corporate Bond ETF (VCSH)

It has over a 2% yield, and the average duration is 2.77 years, which isn’t quite (but almost is) a full year higher than LDLAX. The average debt quality is actually an upgrade from BBB to A, so I guess I can swallow this as a “lower yielding” LDLAX “alternative”.

Bond ETF #2: iShares 0-5 Years Investment Grade Corporate Bond ETF (SLQD)

The average duration is only a little shorter than VCSH at 2.49 years. And for that the yield dips well below 2%. Now this is where your definition of yield starts to change things. The SEC’s definition says this yields a little over 1.5%. If you multiply the current distribution by 12 (monthly) it’s more like 1.8% at time of writing. I remain perplexed by how distributions are calculated for ETFs and mutual funds.

Bond ETF #3: iShares Core 1-5 Year USD Bond ETF (ISTB)

Same credit quality as LDLAX, but with a slightly longer average duration, and a significantly lower yield? This is just a bunch of investment grade corporate debt, which is what LDLAX was invested in. So the difference between passive and active management is a 50% reduction in yield? That 1.25% LDLAX expense ratio suddenly looks like it was worth it.

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