Bond Index ETFs/Funds

[Deleted User]

I'm interested in the mechanics of these.

Do they hold the bonds till maturity? Say they do and then receive the bond amount (£100 for example), do they pay this out to the fund holders or reinvest this? Do they reinvest it in new bonds entering the index, or the existing bonds in the index?

bowlhead99

Trackers will aim to mirror the contents of an index, so they will sell things before maturity if they cease to qualify for the index or if not holding them wouldn't result in a significant divergence from the performance of the index.

For example if it's an index of long term bonds maturing in over 10 years time and time goes on, a bond they hold is going to mature in 9.5 years time, they should have already sold it, even though it hasn't matured. It would be sold at whatever the market price happens to be. Likewise if the fund aims to hold all bonds that exist with sufficient liquidity but one particular bond is maturing in a few months and only makes up 0.01% of the investible universe of bonds anyway, they can probably dump it without waiting for the payout.

The proceeds from selling the bonds will be spent on other bonds so that the remaining proportion of bonds closely matches the index, within reason, otherwise you can get large tracking errors and the fund fails to meet its objective. That spending activity can involve buying more bonds as they are issued, or if you already have some of all the bonds issued, buying more.

Where the funds are effectively open ended, declining demand for the fund product will result in them selling off the holdings to meet redemptions. If a fund grows in size and uses the new investor proceeds to buy 10,000 bonds at average £200 each, and then a couple of years later investors are leaving so they sell the 10,000 bonds at £150 each to pay for the redemptions, the fund will make a £500,000 loss. The realised and unrealised losses are shared by all the investors who were in the fund at the time, including the ones who are leaving and the ones who are staying. A loss has been realised even if the fund would have broken even in 'capital plus interest receipts' if it had been able to hold onto the shares for a higher sale price or receive all the annual interest coupons until maturity.

webjaved

So investing into Bonds is not the way to go then?

bowlhead99

webjaved wrote: »

So investing into Bonds is not the way to go then?

Why do you think that?

It's not the way to go if you want the returns and certainty of a cash deposit product

It's not the way to go if you want the potential growth of equities

But most people don't want exclusively one or other or both of those two things above. Most people want a mix of assets in their portfolio, and bonds (which encompasses a huge range of products with different risk/reward opportunities) will be one of the categories of things they hold.

[Deleted User]

bowlhead99 wrote: »

Where the funds are effectively open ended, declining demand for the fund product will result in them selling off the holdings to meet redemptions. If a fund grows in size and uses the new investor proceeds to buy 10,000 bonds at average £200 each, and then a couple of years later investors are leaving so they sell the 10,000 bonds at £150 each to pay for the redemptions, the fund will make a £500,000 loss. The realised and unrealised losses are shared by all the investors who were in the fund at the time, including the ones who are leaving and the ones who are staying. A loss has been realised even if the fund would have broken even in 'capital plus interest receipts' if it had been able to hold onto the shares for a higher sale price or receive all the annual interest coupons until maturity.

Would the £500k loss not only be had by the leaving investors?

Do you think this also happen in an ETF? ETF confuse me as I think they are "open ended" but I believe when you buy shares in an ETF, the market makers are buying shares in the bonds/stocks at the same time, rather than just giving the fund manager cash as in an OEIC.

bowlhead99

newbinvestor wrote: »

Would the £500k loss not only be had by the leaving investors?

The loss has been 'had' by all the investors because the fund sold assets for less than it paid, and all investors share proportionally in the assets, profits and losses based on the amount of equity they have during the period.

Practically speaking, the investors who didn't choose to sell have not turned their personal paper gain or loss into an actual gain or loss until they choose to sell their shares or units in the fund ; HMRC considers you have a real gain or loss for CGT only on your actual disposals of fund shares, when you are using a corporate OEIC or ETF, because such vehicles aren't tax-transparent.

Do you think this also happen in an ETF? ETF confuse me as I think they are "open ended" but I believe when you buy shares in an ETF, the market makers are buying shares in the bonds/stocks at the same time, rather than just giving the fund manager cash as in an OEIC.

Basically it is the same activity just a different legal structure.

When the ETF manager allows a certain number of shares of the ETF to be created or redeemed/destroyed at the same time as it receives extra assets or pays away its existing assets... it shouldn't really matter if those assets are cash or a bundle of equities. Functionally the performance will be the same, and from an individual retail investor's perspective you are only assessed for tax when you actual sell or otherwise dispose of your ownership of the ETF.

webjaved

bowlhead99 wrote: »

Why do you think that?

It's not the way to go if you want the returns and certainty of a cash deposit product

It's not the way to go if you want the potential growth of equities

But most people don't want exclusively one or other or both of those two things above. Most people want a mix of assets in their portfolio, and bonds (which encompasses a huge range of products with different risk/reward opportunities) will be one of the categories of things they hold.

It was your previous post, I couldn't see any positives from it, hence me asking the question, but you've cleared that up with your reply now. Thank you for that. I don't think I will be dipping into Bonds. I'll leave that to James Bond.

bowlhead99

webjaved wrote: »

It was your previous post, I couldn't see any positives from it, hence me asking the question, but you've cleared that up with your reply now.

Also, the negatives can work in reverse.

For example, investors joining an open ended fund at high market prices and leaving at low points requiring the manager to sell at bad prices to meet redemption requests, cause the fund to crystallise a permanent loss without waiting for the long term break even. But likewise people doing it in reverse (buy cheap sell high) create the opposite effect. And the effect isn't unique to bonds, it would be the same with equity, real estate etc etc. It is only a problem if people are looking for the exit when markets become illiquid.

Thank you for that. I don't think I will be dipping into Bonds. I'll leave that to James Bond.

Not everyone always wants bonds.

From time to time, the opportunity set within certain types of asset classes may represent not the nirvana of 'risk free return', but the nightmare of 'return-free risk'.

However, bonds can be a very broad category from short and long dated government bonds to investment grade and junk grade corporate bonds, foreign and emerging market bonds and miscellaneous other credit opportunities. You might not see the point in bond type ABC but prefer the profile of type XYZ, as part of a portfolio which also has cash or equities or real estate and commodities etc etc

Some market participants have no choice (within reason) other than to buy certain types of bonds and may bid the price of those bonds up beyond what others would see as a 'fair' price, and those high prices can rub off on other fixed income investments. So sometimes there can be decent reasons to avoid some sub set of the bond market. However, people who avoided certain types of assets because they appeared too expensive will typically kick themselves when those assets become even more too expensive - ie. they produced a nice return, which you missed, and are now even less desirable, even though it was with hindsight a mistake to write them off as undesirable last time...

I don't know whether JB is a fan of investment grade fixed income financial instruments. He is a bit of a rogue and doesn't like to be too predictable. Stirred, not shaken - may be just the tonic.

eskbanker

bowlhead99 wrote: »

I don't know whether JB is a fan of investment grade fixed income financial instruments.

Pretty sure he left all financial management matters to Miss Moneypenny but could have sworn he expressed a preference for sheltering all his investments from tax in one of the films, think it was 'For Your ISA Only'....

*gets coat*