Choosing a Canadian Bond Index Fund

In my last post, I argued that virtually all long-term investors should have a significant allocation to bonds in their portfolio. That raises an obvious practical question: if you’re a Couch Potato investor, which bond index fund should you use?

Let’s begin by looking at the most widely followed fixed-income benchmark in Canada: the DEX Universe Bond Index. It consists of about 70% government issues (45% federal, 24% provincial and 1% municipal) and 30% corporate bonds. About half of the bonds in the index have maturities of five years or less, about a quarter mature within five to ten years, and another quarter extend past ten years. In short, this index has it all (with the notable exception of real-return bonds). If you’re looking for a single fund that covers the Canadian investment-grade bond market, look for one that tracks the DEX Universe.

Your bond fund choices

While there is a wide variety of fixed-income ETFs in Canada, only one follows this key benchmark, and that’s the aptly named iShares DEX Universe Bond Index Fund (XBB). Launched in 2000 (which makes it ancient by ETF standards), XBB has more than $1.6 billion in assets and an MER of just 0.33%.

The Claymore Advantaged Canadian Bond ETF (CAB) and BMO Aggregate Bond Index ETF (ZAG) track similar indexes and have low fees, but both are less than a year old and don’t have a track record or significant trading volume. I see no point in choosing them over the iShares incumbent.

As for index mutual funds that track the DEX Universe Bond Index, there are four to choose from:

TD Canadian Bond Index – e TDB909
TD Canadian Bond Index – I TDB966
CIBC Canadian Bond Index CIB503
Scotia Canadian Bond Index BNS386

How have they performed?

I waded through the Management Reports of Fund Performance for all of these funds to see how they have fared since 2001. The DEX Universe index is enormous and can’t be fully replicated: fund managers use representative sampling to try to match the index returns as best they can. I expected this to lead to some significant differences in performance, and it seems to have been a factor in few random instances. But over time the variation in returns is largely explained by the MERs:

iShares TD (e) TD (I) CIBC Scotia
2001 5.7% 7.6% 7.0% 7.1% 6.8%
2002 9.9% 8.3% 7.7% 7.9% 7.3%
2003 6.2% 6.0% 5.5% 5.7% 5.5%
2004 8.0% 6.5% 6.1% 6.1% 6.0%
2005 6.1% 6.0% 5.4% 5.5% 5.4%
2006 3.8% 3.6% 3.1% 3.1% 3.0%
2007 3.3% 3.2% 2.9% 2.6% 2.7%
2008 6.1% 5.7% 5.4% 4.0% 5.8%
2009 5.0% 4.6% 4.3% 5.1% 3.7%
Annualized 5.99% 5.71% 5.26% 5.22% 5.13%
MER 0.33% 0.48% 0.79% 1.06% 0.89%

It seems clear, then, that if you’re looking for a fund that comes closest to delivering the returns of the overall Canadian bond market, iShares’ XBB should be your first choice. By virtue of its low MER, it has consistently outperformed its more expensive peers.

If you’re looking for an index mutual fund rather than an ETF, the e-Series version of TD’s Canadian Bond Index Fund should top your list. The e-Series funds, however, are only available through a TD Mutual Funds account, or through TD Waterhouse. If you use another discount brokerage, consider the Investor Series version of this fund.

As overpriced as the CIBC and Scotia funds are, I can’t resist pointing out that both outperformed the average Canadian bond fund over the last 10 years, according to Morningstar. That’s not surprising, given that active management is useless in the efficient bond market, and that the average MER for Canadian bond funds is an absurdly high 1.70%.

As John Bogle says, when it comes to investing, you get what you don’t pay for.

65 Responses to Choosing a Canadian Bond Index Fund

  1. Eric G. February 17, 2013 at 2:55 pm #

    Most informative site I’ve seen – gives me a whole new perspective on investing. I’m 60 yrs. old & retired. I thought I’d put 20% of my RRSP ($85,000) into “secure” bonds”, both CDN & US. For CDN, I chose CLF & CBO – perhaps I should just have gone with XBB as it is cheaper than holding two ETFs when MERs are considered. My reason for CLF & CBO is that I like the laddered approach. As for a US “secure” bond ETF, any suggestions, or should I just stay with CDN ETFs. I know this is a personal choice, but I respect your opinion and would like to reflect on your thoughts.

  2. Canadian Couch Potato February 17, 2013 at 3:01 pm #

    @Eric: Thanks for the comment. The important differences between CLF/CBO and XBB are not so much the fees. CLF/CBO are short-term bonds only, while XBB includes longer maturities. Also, XBB is about 70% government and 30% corporate bonds, so an equal mix of CLF/CBO means slightly more risk because it would be 50% corporates. Either solution is fine; just making sure the differences are clear.

    In my opinion, investing in US-listed bond ETFs only makes sense if you have US dollars to invest and you do not want to convert them to CAD. This post may help:
    http://canadiancouchpotato.com/2012/03/01/ask-the-spud-should-i-hold-us-bonds/

  3. Eric G. February 19, 2013 at 10:31 am #

    Hi Dan:

    Does a 50/50 mix in CLF & CBO make sense?

  4. Canadian Couch Potato February 19, 2013 at 10:33 am #

    @Eric: Sure, I think that’s a perfectly reasonable mix.

  5. Rahim March 10, 2013 at 11:45 pm #

    I’m also a long-standing client with RBC and decided to go with the RBC Canadian Government Bond Index fund as the bond component to my portfolio. I’m not sure if the specs of this fund has changed since this blog post was published, but the info sheet says that the benchmark for this fund is the “DEX Universe Federal Bond”.
    http://funds.rbcgam.com/pdf/fund-pages/monthly/rbf563_e.pdf

  6. Canadian Couch Potato March 11, 2013 at 9:17 am #

    @Rahim: The RBC fund holds only federal government bonds, while the DEX Universe also includes provincial, municipal and corporate bonds. It will have a different risk/return profile. When you say you are an RBC client, so you mean you use RBC Direct Investing? If so, then you do not need to confine yourself to RBC funds: TD’s Bond Index Fund (i-Series) is available from all discount brokerages: it’s the one I include in the Global Couch Potato.

    @Phil B: It’s important to know whether a monthly GIC actually pays you the interest every month (useful if you plan on spending it) or if it simply compounds every month (useful for long-term investors). If you want the interest to compound, it should not matter whether the compounding is done monthly, semiannually or annually: the rates should be adjusted so these choices are equivalent. But if the interest is being paid to you in cash, then your total return may be different, because you may not be able to reinvest the interest payments at the same rate.

  7. Rahim March 11, 2013 at 9:51 am #

    @CCP: thanks for the info! I’m an RBC mutual fund client (not RBC Direct Investing) so I’m restricted to selecting RBC funds. Unfortunately their index fund line-up is quite limited, but covers all areas (bonds, Cdn equity, US equity, Int’l equity) with reasonable MERs (0.66-0.72%), so as a newbie couch potato, I decided to stick with them for the time being (including the RBC Canadian Gov’t Bond Index fund as the bond portion of my portfolio). Once I accumulate more wealth/savings, I’ll consider switching over to the TD e-series.

    If there are any RBC fund managers are reading your blog, hopefully they’ll get hint that it’s time for them to expand their index fund line-up to compete with TD e-series!

  8. Milhouse April 20, 2013 at 7:02 pm #

    Hi Dan, I’m a bit late coming into this discussion. If you recall in the above article, you wrote that XBB at a MER of .33% is preferable to ZAG (MER 20%). It’s been two years since you wrote this piece, and I noticed that ZAG now has about a USD billion in assets. Would you now consider ZAG a choice comparable to XBB? (The brochure says that ZAG tracks the DEX UniverseXM Bond Index – I’m not sure if it’s the same as the DEX Universe Bond Index (without the “XM”)).

    Another question, how does XBB compare to VAB, if an investor wanted a broad bond index fund, for the purposes of cushioning the volatility of their portfolio? (“A little dry powder,” as John Bogle would say.)

    Cheers.

  9. Canadian Couch Potato April 21, 2013 at 11:10 am #

    @Milhouse: ZAB and VAB are both perfectly good substitutes for XBB if you prefer. The same is true when it comes to the various S&P 500 ETFs now available from BMO, iShares and Vanguard. The specific choice is a very small decision: just pick whichever one you’re most comfortable with. For the record, the “XM” in the index tracked by ZAG means “except municipals.” This is a very small difference that is unlikely to have a significant effect on the performance of that index compared with the DEX Universe.

  10. peter May 31, 2013 at 12:54 pm #

    While I would like to buy a bond fund, I’m finding it hard to understand why I would it. The return isn’t much higher than high interest accounts, if you move the money around to take advantage of short term offers like the 2.6% offered by PC Bank with no risk. It seems that there is a capital risk with bond funds because sooner or later interest rates have to go up. Plus you pay a MER. What am I missing here?

  11. dennis June 23, 2013 at 3:00 pm #

    I purchased the couch potato investments about 3 months ago and the bond index fund lost money all during this time I was surprised because I thought the bond funds would make some interest and not lose money.

  12. Canadian Couch Potato June 23, 2013 at 6:21 pm #

    @Dennis: Bond funds can certainly lose money over short periods when interest rates rise. The last couple of months have been particularly hard:
    http://canadiancouchpotato.com/2013/06/10/whats-happening-to-my-bond-etf/

  13. Matt June 23, 2013 at 7:49 pm #

    Bond funds can and will lose money. Interest rates have nowhere to go but up.

  14. Canadian Couch Potato June 23, 2013 at 8:09 pm #

    @Matt: That’s the same bold statement forecasters have been making for almost four years and they were dead wrong for a very long time. If it does come to pass this year, do they get to say they were right? Or should they acknowledge the opportunity cost of being in cash while broad-based bond index funds returned over 5% annually during the 36 months ending in May?

  15. Matt June 23, 2013 at 11:22 pm #

    Yes, bond funds have benefited from interest rates falling for the past 30 years. I am only advising that bond fund investors shouldn’t underestimate the potential for an increase in rates back to historical averages which would cause lower bond prices as a whole.

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