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Bond Investing Masterclass Bonus Episode

2023/8/30
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Money For the Rest of Us

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Walking the money for the rest of us. This is a personal financial on money, how that works, how to invest IT and how to live without worrying about IT on your host, David stein. Today is a bond investing master class bonus episode earlier this year, rereleased, an episode that has been quite popular.

Epsom for eighteen, he was a bond investing master class. What you need to know to confidently invest in bond. And we covered many aspects of bond investing, but clearly, we didn't cover everything this week. We have a family wedding, so we don't have a regular episode of the podcast, but we thought I would be helpful to build off that bond investing master class by sharing three segments of recent money for the rest of us plus episodes on aspects above.

Investing money for the rest of plus is a weekly premium podcast episode for members of our money for the rest of plus community and is typically we answer questions that plus man members have on various aspects of investing. The the purpose of plus membership is to help individual investors save time and gain confidence, investing by cutting through the market noise, they help our members build a successful, grounded decision making process for their investment portfolio. Will first share a portion of pless episode four forty four, just a couple of weeks ago, where we looked at the different types of yell beasely reds for bonds, including the trAiling twelve months yield, the yellow to maturity and the sec yield.

And we'll discuss some of the chAllenges in the current rising interest very environment in measuring bony's ds. Next we'll take a look at a segment from plus episode four forty five, which was released last week, where we take a deeper dive on something i've mentioned numerous times. At the best estimate of a bond one fund or etf return is IT.

Starting auto maturity will look at how long you need to own a flare etf to be able to earn that expect or return if interest strates rise or fall and and Better understand the math of why that starting yelled to maturity is so powerful in estimating a bonfons d or E T S. return. Finally, we are a portion of plastic ode for thirty seven where we look at an interesting bond type that yields more than U.

S. Treasury bonds, but has never default T, E. And have the implicit guarantee of U. S. government.

The bond issued by the federal hold bank, or F, H, L, B, will look at what the F, H, L, B is and why its bonds have done so well. We hope you enjoy this bonus bond investing master class. Let's turn to a discussion of yields for bond funds and E, T, S.

And this can be confusing topic because there's different ways to measure. Appreciate greg on time, member of our site in the form post listed an article which are linked to in the sonata the truth about yield by Jason bob and mark willard. Their work with jp Morgan or work at jp Morgan asset management came out early this year, and they pointed out a chAllenge in the current rate environment with the sec yield compared to the to maturity and now define those in this discussion.

The first though is the trAiling twelve month yield. This is the yield and investor would receive if they held a bond under etf over the last twelve months, so they received the dividing each month that came from the interest income on the bonds, so would be the yield they would receive. Now that's a backward looking measure, so not terribly useful, particularly in an environment where interest rates are increasing.

So the forward expected yield will be higher than looking backwards in time. And so that a simple measure is if you held the bond fund from the last year, what was the income you received? And that could differ from the ford income based on what interest rate to do IT.

The auto maturity is. And this is from the J. P. Morgan article, is the total return anticipated on a portfolio of bonds is swimming. The bonds are held to maturity. That is similar to the definition i've given over the years that total return that expect a return of holding the bonds to maturity, the yuto maturity is is the best estimate A A bond returns once you back out the fee, which J P.

Morgan caused the net ultimatum ity, now that total return calculation for you to maturity is an eternal rate to return calculation is essentially is figuring out the discount rate so that the the present value of those future interest cash lows equals the Price a of the bond or on a waited average basis, the Price of the etf, the net acid, you the etf and so you have all these cash flows out into the future interest being received and then IT estimates. Well, what discount rate is a take for these to bring these future cash lows into the present so that the value present value of those catches as equals the Price of the bond. And that's just the math of bond investing.

And the other maturity net faces is really probably the best measure of long term bond funds. F, J, P. Morgan.

In that paper, they did a study similar to what i've discussed in the past, where they looked at the starting ultimatums of the bloomberg aggregate index. This is U. S.

bonds. And then they say they are starting in the maturity. And then there's a graph that shows what was the six year analyzed return of the index compared to the starting auto maturity and was very close.

And that's why we use the yield maturity as our estimate for for bonds in the asset allocation assumptions on the website. Now let's turn to the S, C, C, iee. The c yield is a calculation introduced by the c in one thousand nine hundred and eighty eight to sort of standardize the yields being shown for bond funds and later for E, T.

S. This is calculated using the dairy yelled maturity over the last thirty days for government and corporate bond finn. And so IT effective is a similar yield maturity calculation, but IT backs out the fees.

And so if it's a government bond fund and we look at the c yield compared to the ultimatum ity, it's typically very close. The different just being the expense ratio on the fund, however. And and this I didn't realize that and surprisingly, that we talk about this standardized diem calculation.

I've never seen IT. I've searched. I've never been able to find this calculation and been at the source of frustration.

But apparently for securitized bond, so asset back securities or mortgage back securities where a package of dead instruments be a credit card receivables and receivables or mortgage receivables, their package into a bond and sold into the marketplace for calculating the sec, iee, they use the the purchase Price and then they adjust IT for payments. But it's not the market Price. And I i'd never realized that.

And what that means is in an environment where interest stator increasing and the value of bond are falling, that the S. C, iee under states, the actual yld on the fun, that basically there ends up being a bigger gap between the ultimatum ity, which is higher in the esc. Iee, intuitively, that makes sense because as interest rates go up, the value, the bonds go now and then if we're going to calculate the internal rate of return, that discount rate to bring those future casualties into the present, and we're trying to figure out the discount rates for those future cash was equal the current Price.

If that Prices is fAllen, then that discount will be higher, the ultimate will be higher, which is that the way the math is. But if we're using scale Prices, the sec yield will not be higher. And they give some examples, J P. Morgan and their paper showing the yellow maturity of some of their bond funds and the more securities, securities asset bc security, mortal back security that the bond fund holds, the bigger the gap in this environment where we've seen a big move up in rate and that I was seeing this discrepancy.

So for example, the core bond fund as a net yield maturity of five point three percent, but the S C C els three point nine percent, the short term bond fund has the ultimatum ity of five point eight percent, the C E three point four percent. Bottom line is, if we can get the yelled to maturity for a bond fund from the bond fn E T S website, that's the best measure of expect a return of holding the bonds for six, seven, ten year period. Some bond families don't share the ultimatum ity double line.

For example, they just show the esc. They don't show the the ultimatum ity. And depending on how many securities bonds to have that seal potentially is understating the actual potential return for the bond phone.

Let's turn to estimate bond returns. Last week, we in plus episode four forty four, we discussed some chAllenges with the s yield, which is a calculation in the us. That is generally based on yield maturity.

But there are some chAllenges when interest rate to rising in terms of the accuracy of the sec yelled relative to the to maturity and and I believe in that upset at some point, I mentioned that these yields you the maturity A C, C, IT can be used to estimate the returns of a bond fund or etf. I've certainly have discussed IT in numerous times on the podcast on plus episode and educational videos because it's a rule of thumb is very effective. Well, we had a question from a member that mention this rule.

He write, if I purchase a band, or a tips, or a bullet Cherry tea, a bullet Sherry, tf, tf has a set maturity date, I avoid principal risk and subject myself just to interest rate risk over the chosen period by principal risk is discussing that the value of that individual band can flush ate during the holding period as interest rates change, but at the end he would receive the principal back whatever he invested, and so there is no risk to the actual principle of the bond over the holding period. There is a interest rate risk though, because the interest rates could go up or they could go down and let's say they go down and then they're now lower than the initial yield ld on the bond. Well, that investor has to reinvest that interest in something and then the the rates are lower.

So that by interest rate risk, at least my interpretation, what is referring to is just the risk of differing yields. As we reinvest the cash flow we receive member continues. I would like to Better understand that principle.

Risk involved in holding a bond fund, let's say, as seven years average maturity or let's say, a seven duration. It's a more dynamic investment because I define there's moving part. There's underlying holdings that are are mature ing.

New holdings are being added. Your shareholders are coming into the funds. So perhaps additional bonds are being purchased. The chAllenge is having is this concept of said, the best expectation of return for a bn under etf, if held for seven to ten years, is its starting yelled to maturity. And that can be a difficult concept of grass because the portal folio could be totally different.

So how is IT that the returns, both in terms of the principle and income return, can approximate that yield to maturity? Now one of the cave ots that I have said, as I typically set seven to ten years, but I was assuming a particular bond fun and intermediate bond fun like the vicar. Total bond market etf.

And the initial research that we did on this was at my former investment visor firm. And we used I think we used the bloomberg barkless aggregation ond index for the study. The duration at the time would have been about five years.

And so our analysis was sort of focused on that seven to ten year time horizon that the academic research doesn't focus on years. IT focuses on the multiple of the duration. So is the holding period two times the duration of the fund?

So in the case of B N D, now IT would be over twelve years or maybe it's one and a half times the duration. And so in nine year holding period, these rules of thun, our simplification there, they're backed by math, in this case, some calculus, complex calculus, based on my understanding of calculus. But let's give me mind the duration is that interest rate sensitivity of the fun, the outcome, whether the actual holding period return equals the starting to maturity, its impacted by whether interest rates increased, they fell or stayed the same.

If interest rates stayed the same, that's when this rule of Thomas most accurate, but in most cases, IT doesn't stay the same. And so we will look at some scenario there. Why does this rule of thumb, if interest rates increase, the net acid value of the etf or fun will fall, because underlying bonds that the each of her fun holds falls.

In Price reminder, the net acid value is the value of all the underlying holdings, in this case, bond holdings divided by the shares outstanding. So we're looking at the net asset value per shire, and that will fall as interest rate to rise. We won't get into why that's the case.

I've discussed earlier, such as in the bond market master class surface to say all bind to similar credit quality and maturity should have very close to the same yield yelled to maturity even though they have different coupon rates, and so the Prices have to flush ate in order to keep the yields of similar bonds the same. So without those bond funded T, F, and some of those bonds are mature, others will be sold. Additional bonds might be added, but if illustrative gone up those new bonds in the portfolio, they're earning higher yields and the existing bonds are earning a higher yield so that the composition of the fund d changes.

But ultimately, the bonds are generating a higher income. Since interest rates increase in that higher income, we coops the losses to the net acid value over time with those fishing amount. Time passes, it's the higher income that recouped the principal losses due to the rising interest rates. And as time passes, we basically get a total analyst holding period return that approximates the year ultimatum ity.

Now if your interest rates fall and the the value of those bonds go up and that acid value increases, then all the reinvestment and newborn added to the portfolio have a lower yield until that pulls down and effectives makes the overall return of the find equal of starting to maturity. I'll link to a paper. If you're really good at calculation, you can go through all the math for why that works.

IT makes sense intuitively to me, understanding bon math. But you go through the cat list. IT is chAllenging. Now, there was a table in this paper and IT went through different scenario. What about a three year bond etf or, uh, N E T F, A fun or portfolio, basically a five year average maturity, seventy five months, ten year, twenty year and an a corporate long term corporate.

And then IT looked at what was the average air difference between the act, true analyze return and the starting yell to to maturity? And then I looked at IT over, well, what what was that average air if the fund was held for two times the duration? So they went from three quarters of the duration to two and a half times duration.

And you going to link to the paper and you can the line that i'm focused on as a line called average F E. So that's the average air. Let's just focus on a ten year bond portfolio.

The average air was about seventeen basis points. If IT was held for two times a duration, if IT was held for one point seven times duration, IT was three basis points, you'd only got a larger air. If IT was held for just one point two five, the duration, let's say, bnd, with a six year duration, that would basically be holding IT for to tower a six year period.

If IT was held for three quarters of the duration and was an average age of one point four percent, we held up for two and a half times duration. The air was zero point six eight percent. Now sometimes he was positive, sometimes IT was negative, but by and large, IT doesn't have to be exactly two times situation, anywhere, generally from one and a half to just about two times duration.

The holding period, the starting yield to maturity, does a very good job, approximately the return again IT depends. They find that when interest rates go up significantly, that the actual return was slightly lower than the starting ultimatum, that IT didn't quite recoup all those losses over the time frame. And then has to do with basically the calculation that the concavity, there's a number different factors.

So IT is complicated, but that's why we use rules of fun. But they also found that when interest rates fell, that the actual return was a little higher than the starting yield to maturity. But it's close.

It's it's much closer than using when we estimate stock returns because with stock returns, we have the the divided yield, the earnings growth. That then is that big impact potentially of a change evaluation and currency. So I am content with the fact that it's pretty accurate, not exactly, but it's pretty accurate.

He was fairly accurate even for the long term corporate bond portfolio with basically averages of looks like a zero point four percent to zero point five percent negative. So but sometimes even closer. But if it's within a half a percent over seven, ten, maybe twelve year period in this case are in multiple of one and half the two times the duration of the fun, that's pretty good.

And and i'm happy about that. I'll include the link in the shown. Hopefully, that explains IT is complicated.

But bottom line is, is just the fact that even though the underlying portfolio is changing and is different bonds, those bonds are either yelling more if interest rates increased or they yelling less if interest rates fell, and that income will impact the total return in any potential losses. Gains from to the principle because of fluctuating interest rates. Before we continue, let me pause and share some words from this weak sponsors.

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David, that's M O N A R C H M O N E Y. That comes last. David, for your extended thirty day free trial, let's take a look at F H. L. B. This is a private public agency established in nineteen thirty two at a time when there was a fear that banks would didn't have the capital to land on home mortgage.

The agency has been in business for ninety years and it's had a little bit of, I wouldn't call a mission creep, but just the purpose of why was established isn't really there anymore because most mortgage are bought by Fanny may friday mac, and many mortgage are issued by non banks such as rocket mortgage, the banks which have access to the federal homeland banks. They don't access IT to help with mortgage lending. In many ways, the F H L B has been the first line and liquidity for banks.

At present, the the overall size of f hrb is about one and a half trillion dollars, and there are eleven regional F H L B banks around the us. The owners of these banks, they're privately owned and it's mostly the shareholders are are banks and F H L B is set up to to generate a profit. And because the F H L B is essentially private, IT doesn't show up as a line item, for example, on the U.

S. Government budget. And it's not something that congress really gets involved in terms of elating capital because IT stands on its zone.

What the F H L B does have is the implied guarantee that they are debt, or if the F H L B got into trouble, that the youth government would step in and sure that the that holders were protected. That's what we saw with Fanny man friday mac in two thousand and eight other government agencies that had canada implied guarantee. The implied guarantee worked.

When the government took them over now the shareholders lost out the shareholders of Fanny man, pretty mac. But the bonds that they issued in the agency debt, those bonne r, weren't default IT on ryan donation, the C, E, O of the council of federal home land banks said the implied guarana is not something that's conveyed by the government. It's something the market perceives that were a safe place, that are debt that we issue is solid.

But there is the imployed guarantee, even though IT is an explicit, but this was a government agency set up by the U. S. government.

There is some debate as to what that implied guarantee is worth in terms of the ability of the F H lb. To borrow money at favorable interest strates. We look at the yields on F H L B bonds.

They're generally about a percent higher to even one point five percent higher than comparable us. Treasury ies. And so there is is a higher yield, but it's probably potentially if there wasn't that implied guarantee that the yellow would be even higher. I mention the f hrb.

Has evolved and what we see is that banks borough from the f hrb, because if they get into trouble, they don't want to borrow from the the fear reserve directly if they can avoid IT because of some of the stigma, the perception that they're running into troubles where as they're able to borrow from the F H L. B. So the silicon valley bank, for example, was a big bar right before they collapse.

The f hrb requires collateral from the thanks, and the F H B has what's called a super lean on any money they land, so they get the collateral. But if the bank collapses, the F H B is first in line to be repaid, typically by the F D I C, the federal deposit insurance corporation. As a result, the F H L B has has never lost money on any of its loans that that I could find are aware of.

And as a result, their debt that they issue, the bonds they issue, are really secure because the fh b has not to folded on its sponge. It's it's in a great position. IT gets the implied guarantee from the government, super lean position when lending to banks.

And because of that, there's not a time to do diligence that the F H L B does on banks. So it's really easy for a bank to borrow from the F H B N. And the eleven regional banks, in some regards, compete with each other to land to the banks granted to get catto.

But if you can learn money and get collado for the amount that you've land, solid color like government bonds and you are first in line if the bank goes under, pretty good deal. And as result, it's potentially pretty good deal for us as investors to buy F H L B bonds. The F H L B is overseen by the federal housing finance agency.

That agency, as directed by sand thomson, has been looking at the h lbs mission of the one in half three dollars that IT has several hundred million dollars, about three hundred million dollars a more ghost toward mortgage program. So it's not like the the fh b ignored it's Mandate. It's just that it's sort of worked. Now while IT is involved in margins problems, banks don't need the F, H, L, B to assist with mortgages. What they use four is liquidity.

So when deposits were fleeing, such as from Charles swab, bank swab took some of its bandholz ings that he didn't want to sell at a lost IT move them to held to maturity bonds and then it's been borrowing from the F, H, L, B as a source of liquidity to pay out depositors, those depositors that wanted to pull their money. Other banks have been doing the same thing. And there's nothing really wrong with this.

It's just here is a nine year old agency that is now much more involved in providing liquidity to banks than IT is an assisting with mortgages. We've had some discussions in the member forms in the past about F, H L B bonds. They can be complicated because the F H, B is known for issuing cobble bonds, which they call optional principal bonds.

They are mostly what are known as per mute start bonds that they have specific called dates, typically quarterly. And then they can call the bonds a small percentage. Are european collaboration just a single call day? But they have color bonds, which is the book of the bonds.

They have some nono bonds, and then they have Better known as advertising issues, which are a type of carbo bone. But instead of that call coming at the disco of the F H B banks, there's an amatis ation schedule where principal is redeemed based on some formula or index. A cobo bond is a bond that can be redeemed early by the issue.

If you own a color bal bond, maybe IT has an attractive field, and the issue decides that IT doesn't want that bond outstanding anymore. So I will send back the principal baLance that's old. Any occurred interest in the bond will be redeemed early.

And as a bonhomie have no control over that if if it's the and IT can be redeemed early by the issue. And F, H, L, B has been known for issuing mostly coont. That's why when analyzing them, there is typically a yield calculation called yield to worst, and it's an estimate of what the yield to maturity would be if the bond was redeemed earlier, called when you buy an fh b bond.

It's really important to read the documentation. There's A A link that I could in the show notes where you can put the custom number for a specific bond from H, F, L, B and get the bond confidence in the documentation to understand how IT works. And that's really important for these amatis ing bonds.

Where is a typical fh be bond IT will at maturity, IT will pay back the principle. In the meantime, IT pays interest, but there's always the chance that can be called. Now the f hrb won't call abban unless they have an economic and senate to do so.

So I did look example at the bonds that are eligible to be called in the next five days. And IT showed what percentage were being called, and none of them were because all of them had coupon payments of less than two percent. The most recent three year ban, for example, that F, H, L, B issue had a yield to maturity of five point seven five percent.

Fact it's coupon was five point seven five percent. So why is you at five point seven five percent to call a bond that paying two percent? Cuba, the interest rates. And so the bond would be called if the market interest rates have fAllen below the coupon rate on the specific bond and that we don't know what interest strates are going to do.

But we have to recognize that, that possibility you can buy these bonds from your broker swap felt or others, but read the documentation and understand the potential for the bond to be called if market interest rates fall. So one thing that could be done is to to purchase bonds that have lower coupons, but because they are less likely to be called, then born to have higher coupons and generally the yelled to mature pretty often on those bonds to be low, you can have to look. But ultimately these these bonds are attractive because they do have higher yields than comparable U.

S. treasuries. But they are also very low risk because of the employee e guarantee from the federal government and because of the activity of the F H L B with the super lean status when making loans and the clatter.

So this is just another option if you're in buying individual bonds, F H L B agency, please make sure you read the the bond perspectives confidence. Bond indenture, I think, is the official term before buying an issue so you understand specifically what you're buying. Hopefully, you have enjoyed these three segments from plus episode on bond investing.

You can get more information on plus membership, what's all included at money for the rest of us, dot com. Everything i've shared with you in this supersession for general education, i've not considered your specific risk situation. We've not provided investment advice. This is simply general education on money investing in the economy. Have a great week.