Author Archives: Scalper1

Summary BND offers a very low expense ratio that allows the interest to reach shareholders. The biggest risk factor for the fund is the diverging interest rate policies in the U.S. and Europe leading to potentially higher levels of volatility in rates. The exposure to MBS is unfortunate given the options investors have for using mREITs to acquire MBS at a discount to book value. Vanguard Total Bond Market ETF (NYSEARCA: BND ) is a solid bond fund. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient. The expense ratio for BND is a .07%. This is one of the funds that falls into my desired strategy of using highly liquid securities and a very low expense ratio to rely on the efficient market to assist in creating fair values for the bonds. Yield The yield is 2.45%. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk so higher yield funds will usually require an investor either take on duration risk or credit risk. In many situations, an investor will take on a mix of the two. Junk bond funds generally carry a high degree of credit risk but low duration risk while longer duration AAA corporate funds have only slight to moderate credit risk combined with a significant amount of duration risk. Theoretically treasuries have zero credit risk and long duration treasuries would have their risk solely based on the interest rate risk. The yield for BND is coming primarily from the interest rate risk on the fund. The average duration is 5.8 years and the average effective maturity is 8 years. Fluctuations in the interest rate environment will be a major source of changes in the fair value of the fund. Duration The following chart demonstrates the sector exposure for this bond fund: At the present time I’m concerned about taking on duration risk in early December because of the pending FOMC (Federal Open Market Committee) meeting. I believe it is more likely than not that we will see the first rate hike in December. I think a substantial portion of that probability has already been priced into bonds, so investors willing to take the risk prior to the meeting could see significant gains if the Federal Reserve does not act. The very interesting thing we are seeing in the interest rate environment today is a divergence in policy between the domestic interest rates and the interest rates in Europe established by the ECB (European Central Bank). The ECB has announced another decrease in their short term rates to negative .30% while the Federal Reserve is planning to increase short term rates. That disconnect is going to make bond markets very interesting over the next few years. Credit Risk The following chart demonstrates the credit exposure for this bond fund: High quality corporate debt may often show significant correlation to treasuries but it offers higher yields. The biggest weakness for a high quality corporate debt fund is the fact that some bonds may still fall into lower credit quality and eventually default. Even if the fund sells the bonds before they default, they will receive a much lower fair value for those bonds when the market assess that the bond is riskier. I find high credit quality corporate debt to be a fairly attractive space for bond investing because it offers higher yields than treasuries but is unlikely to suffer from high default levels. By combining high credit quality corporate debt with treasury positions BND is able to create a higher yield than the fund would otherwise have while maintaining exceptionally high credit quality overall. The one notable concern I have in this regard is that over 20% of their “U.S. Government” debt is coming through the form of mortgages, and investors have access to mREITs that are trading at enormous discounts to book value. Conclusion I’m not a fan of holding the MBS at book value, but other than that I find the fund to be a solid choice for bond investors. It offers a reasonable yield for the very low credit risk on the fund and a very low expense ratio so the interest from the securities is actually reaching the shareholders. The biggest risk here, in my opinion, is the challenges we may see in the interest rate environment as the United States and Europe intentionally move in the opposite directions.