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. His total return over the four years would be $235 (4 × $50 +$35) on a $965 investment, or 6% annually—the same as new four-year bonds selling at par. (You can check my math with this handy yield-to-maturity calculator.)

This example illustrates why bonds lose value when interest rates rise: their market prices decline in order to bring their yield in line with those of newer bonds. The longer the term of the bond (that is, the greater the number of years until maturity), the bigger the loss in value when interest rates go up.

If you own a bond mutual fund or ETF, virtually all of its holdings will lose some value when rates move higher. That’s why so many investors are reluctant to put money in a bond fund today: the Bank of Canada has all but assured us that rates will move up in the second half of this year. Isn’t buying a bond fund now guaranteed to lose you money?

Not necessarily. Remember that the vast majority of a bond fund’s return comes from interest payments, not from changes in its net asset value (NAV). If the fund’s market price drops 2% one year, but the bonds inside the fund pay 4% in interest, the investor’s total return is still 2%. Notice what happened to the first investor in our example above: he bought a bond for $1,000 and sold it a year later at a $35 loss. In the meantime, however, he collected $50 in interest. That’s a net gain of $15, or 1.5%. Sure, he’s disappointed, because he was expecting 5%. But he didn’t lose money.

It’s not surprising that many investors don’t appreciate this. When you check your account holdings, all you see is your funds’ net asset value, not the distributions you’ve received. In my own account, I have a bond ETF that’s showing a 2.5% loss since I bought it 10 months ago. I had to use a spreadsheet to figure out that my total return, including interest received in cash, is actually slightly positive.

One reader recently noted that the NAV of the iShares Canadian Bond Index Fund (XBB) was about $27 in late 2001, and is about $29.50 today, which looks like an anemic return of barely 1% annually. But when you include the quarterly interest distributions, XBB’s annualized return over the last nine years is 4.8% — almost five times higher. No wonder people are so pessimistic about bonds.

So, is it smart to buy a bond fund or ETF now? Who knows. You may well be able to get in more cheaply if you wait just a few months. But if the interest rate hike is smaller or later than you planned for, you may pay in opportunity cost.

In the next post, I’ll look at the difference between buying individual bonds and investing in bond funds and ETFs.

13 Responses to The Bond Dilemma

  1. Chris March 26, 2010 at 8:13 am #

    Dan,

    Here’s another question I’d like you to consider for the follow up to this post. I’m looking into building a bond ladder from Federal strips for my elderly parents. The only problem: they’re nearly impossible to find at any maturity, never mind 1,2,3,4,5 year that I’d need to get started (I’ve checked BMO, TD, RBC inventories). I can find the stripped coupons no problem, but the bonds seem to be amazingly popular. The few that I did find are overpriced, according to canadianfixedincome.ca. Should I be happy with the more plentiful Provincials (and the slightly higher risk) for them? Or am I going about this all wrong?

    Theory is all well and good, but if it’s not actually possible to implement, there isn’t much point. This reminds me of Wired Magazine’s Tech Index back when non-finance magazines and even Dilbert (remember the Point-Haired-Boss Index?) talked about investing. Their tech portfolio contained a bunch of Google shares purchased at around the IPO price. Yeah, sure.

    Thanks,
    Chris

  2. Ray March 26, 2010 at 2:42 pm #

    Thanks – that was really useful. I needed that example to get my head straight on the interest rate effect on bonds.

  3. AmeliaH March 26, 2010 at 3:10 pm #

    The thing to look at is the duration of the bond fund. The duration of XBB is 5.86 years. If rates rise a projected 1.5% to 2% in the next year the fund will lose 8.8 to 11.2% of its capital value. This equates to 2 to 3 years income from the fund.

    400 billion has flowed into bond funds in the last year from retail investors (North America) which is a pretty reliable contrary indicator to sell bond funds.

    Stick with short duration bonds or just cash and buy them when yields are higher.
    Don’t forget inflation is out there as well further eroding the value of longer dated bonds and bond funds.

  4. AmeliaH March 26, 2010 at 3:15 pm #

    Skip the bonds that are in the inventories of the big bank discount brokers. They are a ripoff and just cash cow for them.

    Consider bonds from CMHC and other federally backstopped institutions. You will get about a half a percent extra yield.
    Also consider provincials if you can get a deal.

    The best fixed income ladder option (I have elderly parents as well) is GICs from a variety of credit unions. Its a little extra work but you get 1 to 2% more yield. Keep each deposit less than $100,000 to make sure it is insured by the feds.

    NEVER buy a strip bond in an unregistered account. You will pay some serious tax that will negate entirely the yield you will get.

  5. dojo April 3, 2010 at 2:08 pm #

    I currently hold XSB and XBb with a plan over the next 5 years to gradually move entirely into XSB and eventually a GIC ladder.

    With interest rates with nowhere to go but up, I’m thinking I should just go ahead and move the XBB to XSB all at once, now.

    Seems like a “no-brainer”. Am I missing something?

  6. Canadian Couch Potato April 4, 2010 at 8:13 am #

    Dojo: The trade-off is that you are giving up a bit of yield: XBB pays a higher distribution, which will balance some of its capital loss when rates go up. If you are planning to move to XSB now and stay there for five years, there’s no guarantee that XBB would not have outperformed over that time.

    As a crude example, say that interest rates go up today and XBB loses 3% of its value, while XSB loses only 1%. If XBB pays 1% more in distributions annually, its total return will catch up to XSB in two years. By the third and four years, it would be ahead (assuming interest rates don’t move again).

  7. Neil Murphy April 5, 2010 at 7:27 am #

    You should not be abandoning a major asset class simply because the next short period seems unfavourable. You should be following your Investment Policy Statement (IPS). You do have an IPS right? If you have an IPS with ranges then you could perhaps be moving to the minimum end of that range for Fixed Income.

    However, you should still have exposure to the asset class for proper diversification. If interest rates are going up, which they appear to be, the most prudent thing to do is to shorten duration of the fixed income portfolio.

    Additionally, one of the exclusively fixed income managers that we deal with feels that the spreads between corporate bonds and government bonds will narrow as rates rise. This means that government bonds will lose more value then corporate bonds when the rates finally head north. Therefore, it makes sense to consider shorter term corporate bonds versus the DEX for the time being.

    Fortunately there is one ETF solution out there. Claymore has a 1-5 Year Laddered Corporate Bond ETF (CBO). Management fees are 0.25%. The duration is 2.599 years vs. the iShares XBB 5.86 years. The shorter duration and the fact that you are holding corporate instead of government bonds means it will not lose as much money when interest rates rise. The coupon yield is almost the same at just over 5%. You will give up about 3/4% on your yield to maturity with the CBO vs. the XBB.

    By purchasing a product like this you should be able to reduce the impact of the impending interest rate hike while at the same time maintaining a sensible position in fixed income securities.

    Neil Murphy
    Weigh House Investor Services

  8. dojo April 12, 2010 at 8:55 am #

    Thanks for your thoughts and here’s a little something else I read today on this topic. I thought Neil would particularly like the last line of this article.

    http://moneywatch.bnet.com/investing/blog/wise-investing/investing-conventional-wisdom-is-always-sure-often-wrong/1352/

    Doug

  9. f July 15, 2010 at 3:53 pm #

    at this time i do not see an alternative to bond funds. equities are negative for the year/decade and hard to predict in the near future. GICs give nothing. any investment grade bond is as safe as GIC and gives 2-4 times as much. my current plan is to divide between all three bond durations – short, intermediate and long.

  10. Dong November 23, 2010 at 11:46 am #

    What is the general opinion regarding PN&N bonds funds ?

    0.58% MER and outstanding track record

  11. Johnny March 17, 2012 at 10:43 am #

    Hi Dan,

    Am I incorrect that buying a Government bond at par and holding it to maturity will give you back your principal and cupon payments at maturity? So, rising interest rates only lower your return if you choose to sell before maturity. So, where’s the risk? The only risk is if you pay more than par value or if the Government defaults (very unlikely). I was thinking of buying a RBC Bank bond with a 5 year maturity and at par paying a cupon of 5%. I think that at maturity I get back all the money I invest plus the 5% annual cupon payments. I am new to investing in bonds but, am reading as much as I can about them.

  12. Canadian Couch Potato March 17, 2012 at 10:57 am #

    @Johnny: Your thought process is correct, but are you sure that you can buy a five-year bond at par and yielding 5%? Five-year investment-grade corporate bonds are yielding about 3% these days. If the coupon is 5%, you are almost certainly going to pay a premium for the bond, so when it matures at par you will take a capital loss. Make sure you are looking at the “yield to maturity,” not the coupon.

    http://canadiancouchpotato.com/2010/11/22/bonds-gics-and-the-yield-illusion/

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