Archive | March, 2010

Bonds v. Bond Funds

In my previous post, I looked at the uneasiness many investors have about bonds when interest rates are poised to go up. Some readers have argued that this discomfort can be alleviated by buying individual bonds rather than index funds or ETFs. Let’s look at whether their arguments hold up.

Individual bonds do offer benefits: you know precisely how much interest you’ll be paid, and how much you’ll receive when the bond matures. The payouts from bond funds, by contrast, aren’t known in advance, and funds never mature. This can make planning difficult for those who rely on their bond portfolio for current income, or those who need a specified amount of money on a certain date in the future. No quibbles with that.

The other main argument in favour of individual bonds is much less convincing. It goes something like this: “If I invest $10,000 in a bond fund, its value will go down when interest rates rise. But if I buy an individual bond, I don’t have to worry about interest rate movements, because as long as I hold the bond to maturity, my principal is guaranteed.”

Behavioural economists love this kind of logic.

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The Bond Dilemma

With interest rates poised to rise later this year, I’m getting a lot of emails and comments from readers who are wary about investing in bonds. There seem to be a lot of myths and misunderstandings about bonds, which isn’t surprising: fixed-income investments can be difficult to get your head around.

Let’s start with the most relevant issue: when interest rates rise, the value of bonds goes down. To understand why, imagine buying a five-year bond with a face value of $1,000 that pays 5% interest annually. Now imagine that 12 months later interest rates have risen one percentage point. Your bond now has four years left to maturity and it’s still paying $50 a year in interest, while new four-year bonds are paying 6%, or $60 a year. If you decide to sell your bond now, you won’t get $1,000 for it. Why would anyone buy your bond with its 5% yield when they can get one that pays 6%?

Of course, your bond isn’t worthless: you just need to drop the price to make it more attractive. If you sell it for $965, the buyer would still earn $50 annually in interest, plus he’d make a $35 capital gain when he collects the full $1,000 at maturity.

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A Mutual Fund Refugee

I hear from a lot of investors who are mutual fund refugees: they’ve abandoned their overpriced, inappropriate funds and the advisor who sold them, and they’re trying to move ahead on their own. Darren, a reader in British Columbia, recently wrote to me with his story and gave me permission to share it.

Darren and his wife, Sarah, are in their 60s and have been retired for seven years. Until last year, most of their RRSP savings were in mutual funds handled by a adviser they thought was trustworthy. Only after the markets plunged in 2008–09 did they fully understand their situation: the adviser had all of their savings in equities. Not only did they lose a huge chunk of their nest egg, but when they went to sell their funds in disgust they faced the added insult of deferred sales charges. “After that episode we have become rather jaded with financial advisors,” Darren says.

A year later, he and Sarah are still sitting on $283,000 in cash, plus $57,000 in stocks from Darren’s former employer, a telecom, which he does not want to sell. They’re ready to get back into the market and want to build an ETF portfolio they can manage themselves.

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Under the Hood: iShares Core Portfolio Builders

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The funds: iShares Conservative Core Portfolio Builder Fund (XCR) and iShares Growth Core Portfolio Builder Fund (XGR)

The indexes: Both XCR and XGR are actively managed funds that do not track an index.

The cost: The MER of each fund is 0.63%. This is the all-in cost, as the MERs of the underlying funds are waived so investors are not charged twice.

The details: The iShares Core Portfolio Builders are ETF wraps: all-in-one portfolios made up of iShares ETFs in various asset classes: bonds, equities, and commodities. They appear to be designed for investors who like the idea of investing with ETFs, but aren’t comfortable building their own portfolios from scratch.

Although their names suggest quite opposite strategies, both ETFs are extremely bond-heavy: the Conservative version (XCR) currently holds 76% in bonds, 19% in equities, and 5% in commodities. The Growth fund (XGR) is 63% bonds, 26% equities, 9% REITs and 2% commodities.

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Under the Hood: Claymore Corporate Bond

This post is the first in a planned series called Under the Hood, where I’ll take a detailed look at a specific ETF or index fund.

The fund: Claymore 1–5 Year Laddered Corporate Bond ETF (CBO)

The index: CBO tracks the DEX 1-5 Year Corporate Bond Index, which appears to have been custom-made for this fund. The index lays out a set of rules for building a laddered portfolio of short-term, investment-grade corporate bonds. It includes 25 bonds divided into five equal “buckets”: five of the bonds have a term to maturity of 1–2 years, five others have terms of 2–3 years, and so on up to 5–6 years.

The cost: The MER is 0.28% as of June 2009, including a management fee of 0.25%.

The details: Claymore launched this ETF just over a year ago and it has been very popular, with an average daily trading volume of about 115,000 shares. It’s a well-designed index: the laddering technique is an excellent way to achieve a balance between good yield and a minimum of interest-rate risk. (In most cases,

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How Much Risk Do You Need to Take?

Every book on index investing stresses the importance of asset allocation: the percentage of equities and fixed-income investments in a portfolio. Of course, more stocks means more risk but higher expected returns, while boring old bonds provide safety and promise less growth. But just what is the long-term difference in risk and returns between stocks and bonds? How does a 50-50 portfolio compare with one that holds just 20% bonds, or 20% equities?

Paul Merriman, who runs the Seattle-based investment firm that bears his name, recently wrote an article that included a table of historical stock and bond returns going back to 1970. It compares the performance and risk of portfolios with various stock-bond mixes. The returns are hypothetical, but they represent a reasonable estimate of what you might expect from a portfolio of low-cost index funds that track the broad markets.

Merriman assumes that the equity portion of each portfolio is split equally between the S&P 500 and international stocks, and the fixed income side is half intermediate-term, 30% short-term and 20% inflation-protected Treasuries. They also deduct a 1% management fee and assume the portfolio is rebalanced monthly. Here’s a summary of the results:

Annualized return
Standard deviation
Worst 12 months
Worst 60 months

100% fixed income

10% equities

20% equities

30% equities

40% equities


60% equities

70% equities

80% equities

90% equities

100% equities

There are a couple of lessons in these numbers.

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Put Your Assets in Their Place

Couch Potato investors hear a lot about asset allocation, but asset location is also an important consideration. Asset location refers to the type of account you use to hold the stocks, bonds, cash and real estate in your portfolio. It’s important because the growth and income from your investments are treated in different ways by the taxman:

Interest from bond funds and bond ETFs (as well as individual bonds, GICs and money market funds) are taxed at your marginal tax rate, just like employment income.

Dividends from Canadian stocks are eligible for a generous dividend tax credit from the federal government. For the 2009 tax year, eligible dividends are first grossed up (increased) by 45% and declared as income; the investor then receives a tax credit of 19% on the grossed-up amount. Some provinces offer an additional dividend tax credit.

Foreign dividends are taxed at your marginal rate. In addition, many countries (including the US) levy a withholding tax on dividends, often between 10% and 15% (this may be recoverable in non-registered accounts).

Capital gains are profits earned from selling a security for more than you paid for it.

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