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.
{ 41 comments… read them below or add one }
Dan what’s your take on XSB ? I own it for my Canadian bond allocation rather than XBB because I prefer short term bonds as they have minimized exposure to the big disadvantage facing all bonds – rising interest rates. I recognize it is more expensive than XBB and less widely traded, though. Would be interested to hear your thoughts.
You wrote “The e-Series funds, however, are only available to TD account holders.” Is that really true? I don’t have any TD accounts, yet I’ve been investing in the eSeries funds since about 2003. I just filled out the application and mailed it in to set up my eSeries account. I didn’t see anything about this requirement in the earlier blog post you linked to, but maybe it was in the comments?
@DM: I use only short bonds, too, though I use Claymore’s laddered ETFs: my allocation is split evenly between government and corporate bonds. It’s not that I’m concerned about rising interests rates, but simply that I like the lower volatility of short bonds. In my opinion, the role of bonds in a long-term portfolio is to smooth out volatility: if I want to take on more risk in hopes of higher returns, then I do that on the equity side.
@Brad: Sorry, I didn’t mean that you had to have a bank account with TD, only that you need to open an investment account with TD. You cannot purchase the e-Series funds through any discount brokerage other than TD Waterhouse. I’ve clarified the language in the post.
Excellent and informative post!
I started buying XBB soon after it was created in 2000. I like the all-in-one solution. As you say, it has a significant short bond position also.
What are your thoughts on Emerging market bonds?
@Sean: Thanks, glad you liked the post. If you’ve held XBB since 2000, I would think you have done quite well at 6% compounded during a difficult decade!
I have an allocation to emerging market equities, but not bonds. Emerging market bonds would clearly be added to a portfolio for potentially high yield and not for safety, and as I said in my response to DM above, I prefer to take risk on the equity side. However, it would be interesting to see how emerging market bonds are correlated with other asset classes. They may offer some diversification benefit, but I have not looked into this.
Have you looked at the BMO emerging markets bond ETF?
Good analysis Dan. I’ll be switching over to XBB from td e-series once I have a large enough portfolio. Always good to see index funds out performing their respective active funds. Makes me happy =)
Great post.
I own XBB in both my TFSA and RRSP, enough in the latter to DRIP more than one full unit each month. It’s great to have that secure compounding machine running for me. I also avoid high-yield bonds. Why not just have equities then – use XIU?
BTW – I need to read John Bogle’s book, I’m adding it to my list.
Cheers,
Mark
In the past i’ve compared PH&N total return bond fund to XBB and performance seems equal. As a result I haven’t sold out of my PH&N total bound fund.
Any thoughts about PH&N total bond fund?
JR
@JohnR: The PH&N fund costs 0.57% (D Series), so it’s cheaper that any bond fund in Canada other than the TD e-Series. And with PH&N’s long record of excellent fixed income management, I wouldn’t try to talk anyone out of that fund. Note that another reason it has outperformed bond index funds is that it has a higher weighting to corporate bonds than the DEX Universe, so you can expect higher returns and higher risk.
XBB has an MER of 0.33%. How about having a 10 year ladder of provincial strip bonds? Would the cost be less?
@Park: There’s no way of doing a fair comparison of the two, as far as I know. The cost of the a bond ladder depends on the commissions charged by the dealer, and this will vary. In addition, a provincial bond ladder would have a different risk profile from the DEX Universe Bond Index. I’m not saying there’s anything wrong with that strategy at all — bond ladders seem like excellent fixed income investments, and the one thing you would have going for you is that your cash flows would be known ahead of time, assuming that you hold all of the bonds until maturity. However, it’s very difficult to compare this to a bond index fund or ETF.
I am currently considering the SEI Long Duration Bond O , the SEI Long Duration Bond F and the PH & N High Yield D as my bond holdings in my RRSP. The MER’s are a bit higher but the returns are higher and the risk is balanced out as far as I can see. I am retired, and these as well as a 3 year cash position account for 50% of my holdings.
How would you rate tese holdings compared to holding XBB.
Thank You
Chuck
@Chuck: Are you sure you have access to SEI funds? The O-Series funds are for institutional investors, and F-Class funds are usually only available though advisors who then layer on another fee. In any case, these are long-term bonds only, and so should be compared to iShares XLB, not XBB, which has a different risk profile. (Long bonds are more sensitive to interest rate hikes.)
If you are using actively managed bonds funds, then it’s hard to do better than PH&N. (These you can certainly buy without an advisor, either directly or through a discount brokerage.) Again, however, note that high-yield bonds are high-yield precisely because they are more risky. XBB holds only investment grade bonds. These two funds have very different objectives.
In the long run it seems very difficult to beat or even just to come close to match a broad index such as the DEX Universe for Canadian bonds.
Charting the PH&N bond funds against a bond index, which can be done under the “Markets & Research” tab at TD Waterhouse, shows that over the longest periods available PH&N does not perform better than the index.
At Morningstar you can compare the TD e bond fund with PH&N using a graphic tool that plots their returns on a horizontal scale and their volatility on a vertical scale. The longest period available is unfortunately too short to call it long term. It shows PH&N returning more than the e fund, but with higher volatility.
Both the TD e bond fund, TDB909, and iShares index bond fund XBB have lower fees compared to PH&N. In the long run it’s quite likely that they will surpass PH&N, at least on a risk adjusted basis. XBB seems to track the index better than the TD e fund, no doubt because XBB has a lower MER, 0.3%, compared with 0.48% for the e-fund. The sampling rate may also be a significant factor. The index lists 1094 issues. XBB holds a sample of 352. TD does not seem to disclose the size of the sample in the material it makes available on the Internet regarding its e index bond fund.
Your comparison is very interesting and educational. However I missed RBC Bond Index fund shown in the comparable table. Any reason? I think it is one of the largest index fund.
Peter
@Peter: Great question, thanks. The RBC bond index fund does not track the DEX Universe. It holds only federal government bonds, so its risk-return profile is very different. For example, in 2008 it was up 11% and in 2009 it was down –0.9%. Look how that compares with the other bond index funds — the difference is entirely explained by the presence or absence of corporate bonds.
Isn’t interesting to see the variety of investment styles expressed in the comments to the last two CCP articles on bonds? One seems to be an all equity portfolio in the form of dividend stocks, another one appears to be 100% fixed income with bonds and cash. Put them together and you get a classic, time tested style based on a balanced, income investing philosophy.
By contrast index investing seems to be a new untested philosophy. Or is it? Here in the reference section of the CCP one finds books where good researches are explained. And more advanced manuals such as those by William Berstein, for example, explain convincingly that a balanced approach, mixing different asset classes by using broad index funds, will perform better and with lower risk over a long time horizon compared to any 100% solution, be it all equity or all bonds. Why?
One simplified answer is that if your 100% equity portfolio was showing a 50% loss, even if only on paper, at the bottom of one of the worst crash since the depression, you would need a 100% gain just to return to the value you were enjoying before the drop.
Regarding the protection offered by an all fixed-income strategy, there are market conditions that would still be a challenge on the down side while rarely offering as much as equity on the upside.
Why fight the market when you can joint it…
Excellent website and excellent topics! You are definately swaying us to venture into ETFs for the first time ever.
With interest rates going up, we read:
“With a duration of five years, a one-percentage-point increase in interest rates would theoretically cause a bond ETF to fall five percentage points in value. So shorter durations are preferable if you’re worried about your bond holdings.”
Thus, for a 1 year duration, should we invest at all in these ETF’s? (1 year till we are back in Canada and can invest normally)…
What do you think of these ones?
Claymore 1-5 Year Laddered Government Bond ETF (CLF)
and
Claymore 1-5 Year Laddered Corporate Bond ETF (CBO)
vs the 2 you recommend…
iShares DEX Universe Bond Index Fund (XBB)
and
iShares DEX Short Term Bond Index Fund (XSB)
Many, many thanks. We read Canadian Couch Potato everyday and also subscribe to Canadian Business and Money Sense too.
@Mike: Thanks, glad you like blog. Taken together, Claymore’s CBO and CLF would be similar to XSB. They all hold short-term bonds only, and XSB is 70% government and 30% corporate. Right now it looks like XSB has a slightly lower duration (2.7) than the Claymore funds (both around 3.1).
XBB would give you much more exposure to intermediate and long-term bonds. Its duration is over 6. Over the long term, one would expect XBB to deliver higher returns than short-term bonds, but with more interest-rate risk.
They are all excellent ETFs, in my opinion.
Thank you very much for your quick and helpful reply. We did notice (and appreciate) that you reply to others on here quickly with great advice.
I just asked our investment advisor about purchasing an ETF and he got back with this about costs… is this normal?
“I would charge you 1% commission for this purchase; normally it is 2% which is also our posted rate”
@Mike: Frankly, I’m surprised your advisor didn’t try to talk you out of it.
Honestly, I’m not sure what standard practice is for advisor-purchased ETFs. If you’re investing $3,000 and he charges you $30, that’s the same as what you’d pay at many discount brokerages. But if you’re investing a large amount, then 1% seems excessive. Is he also charging an ongoing fee of 1% of your assets?
Thanks for the advise. I did not realized the RBC Index fund is different. Since it is all Govt bond is it safer?
Peter
@Peter: I think that’s reasonable to expect, as there is virtually no risk of default.
What about tax implications for XBB or TD-e etc held outside a registered account?
@Al: ETFs tend to be more tax-efficient in terms of reducing or eliminating capital gains, but interest is interest and it’s taxed the same whether it’s paid by an ETF or a mutual fund.
CCP – Thank you for your help and assistance thus far.
To answer your questions: Do most advisors talk you out of buying ETFs (why)? And are you saying that you could buy an ETF at a discount transaction rate ($30) elsewhere yourself rather than going through an advisor? I imagine it’s setup that you could do on your own then via online somehow? Yes the amount in vested would be a very large sums into different ETFs (as your site suggests) so 1% is a lot upfront, I believe it would be “for this purchase” thus a 1 time fee for every buy transaction. So with the extra 1% everytime is it worth going with the ETF over these 2 of his recommendations (that are commission free)
My advisor says there is no commission to buy or sell mutual funds thus he is recommending the:
PH&N BOND FUND
and
Russell Income Pooled Portfolio.
Thanks.
@Mike: Many advisors are paid by collecting hidden commissions on mutual funds; many are not even licensed to sell ETFs. Only a small number of advisors have anything good to say about index investing: they all tell you they can pick market-beating funds. Over the long term, they almost never do.
However, from your comments I’m guessing that your advisor is paid directly and transparently by you, not by hidden commissions. (Perhaps he takes a fee of 1% of your portfolio annually?) Otherwise he wouldn’t be suggesting PH&N funds, which are excellent, low-cost funds that don’t pay commissions to advisors. I don’t know anything about the Russell funds.
Do-it-yourself investors can buy ETFs (as well as stocks, bonds and funds) through online discount brokerages and manage their portfolios themselves. However, if you’re unfamiliar with this, you may well be getting good value by paying an advisor to help.
Great site, love it.
I am currently rolling out my DIY Couch Potato portfolio using TD e-Series Index Mutual Funds (Option 2 from the “The Global Couch Potato” model portfolio). The upside of these funds for me being low-ish MER’s and the ability to add in small amounts each month without paying commissions for each transaction.
I effectively have five registered accounts to work with, and for simplicity sake, I was considering a break down like this:
My RSP – US Equity Index (~$300/mth)
Wife’s RSP – International Equity Index (~$300/mth)
My TFSA – Canadian Equity Index (~$400/mth)
Wife’s TFSA – TD Canadian Bond Index (~$400/mth)
Family RESP – TD Canadian Bond Index ($5000/yr)
There have additional cash equivalent to 6 months salary so the TFSA’s shouldn’t need to perform that kind of role. Investment timeline for TFSA’s are probably 5-10 years. RESP’s are 16-20 years; RSP’s 30+ years.
So, my question is: Is it wise to divide the Funds across my accounts in this way? Or should I be holding all four funds in each registered account?
Thanks & regards.
@Gregor: Thanks, glad you like the site.
Because your different accounts have different time horizons, you’ll want to be careful here. I don’t think it makes a lot of sense to think of all your assets in terms of the Global Couch Potato’s 60-40 stock-bond allocation. They way you’ve set things up here, your TFSAs (with a 5-10 year horizon) are 50-50, while your RESP (16+ years) is 100% bonds, and your RRSPs are 100% equities. Does that align with your goals?
Splitting things between your accounts and your wife’s shouldn’t make any difference (assuming you plan to retire around the same time), but you should think in terms of three piles of money, each with an appropriate asset allocation: one that you need in 5+ years (pretty conservative), one that you need in 16-20, and one that you won’t need until 30+ years.
This post might be of interest, too:
http://canadiancouchpotato.com/2010/03/09/how-much-risk-do-you-need-to-take/
Hello Dan,
I have been following the bond articles, thanks for the insights. Been thinking of splitting about 89k evenly between Claymore’s CBO and CLF. Trying to get more income. My questions are:
a) At 65, am I being to conservative even though the globe is in financial turmoil?
b) Can I lost my money in these ETFs, after all I do not have time to build a new nest egg?
c) I am new to any thing other than savings accounts and GICs, so if it is wrong please let me know!
Thank you,
Retire Now?
@RetireNow: Thanks for your comment. Only you can decide whether you are being too conservative. Yes, a bond ETF can certainly lose money: when interest rates rise, bond funds tend to fall in value, and some funds hold bonds that carry some risk of default. However, CLF and CBO are quite low-risk: the risk of default is close to zero, and because they hold only short-term bonds, they are not too sensitive to interest rates. If you’re new to ETF investing, however, you may want to take things slowly rather than investing all 89K at once. Good luck!
Hello Dan,
I just read the following Fortune Magazine article about bonds (http://finance.fortune.cnn.com/2010/10/05/buffett-hints-at-bond-bubble/) would it pertain to Canada?
Thank you,
Retire Now?
@RetireNow: Like any other asset, bonds can become overpriced if there is excessive demand. But otherwise, Buffett’s comments are just more market forecasting that has no value for investors. If you’re worried about bond bubbles and interest rate risk, you may want to consider building a five-year GIC ladder. That way your capital is 100% protected and you minimize interest rate risk.
Great article,
Hello, I recently invested in the RBC Canadian Bond Index and the RBC Short Term Income funds. This money was previouly in T Bill Funds that I switched out of to get a greater return. Are these generally safe, with regards to say an interest rate increase over the next few months resulting in a 5-10% loss?
@Chris: To estimate how much a bond fund would fall if interest rates rise, look at the fund’s duration. On the RBC Canadian Bond Index Fund, the duration is currently 5.3 years, which means that a 1% rise in interest rates would cause the fund to lose about 5.3%. On the Short Term Income Fund, the duration is 2.6 years, so it is likely to fall only half as much if interest rates rise.
Thank you, so should I be looking at the 2 and 5 year Government of Canada bonds yields? Besides interest, is this the only thing that effects the value of the fund or does it rise when new investors purchase units of the fund?
Great website, I am in the process of copying one of your model portfolios. I am a longtime RBC client so your 3rd option appealed to me (Option 3:)
- Canadian equity: RBC Canadian Index (RBF556)
- US equity: RBC US Index (RBF557)
- International equity: RBC International Index (RBF559)
- Canadian bonds: TD Canadian Bond Index – I (TDB966)
My question: is there an RBC bond index fund that you would recommend that is comparable to the TD Canadian Bond Index?
@Michael: RBC’s only bond index fund holds only government bonds. Most other bond index funds (including the TD fund in my model portfolio) also include about 30% corporate bonds. Note that if you’re using RBC Direct Investing, you don’t have to confine yourself to RBC’s own funds. You can buy funds from any company in the discount brokerage account. However, if you have an RBC mutual funds account and you cannot buy funds from other providers, then the RBC Canadian Government Bond Index Fund is a perfectly good choice:
http://funds.rbcgam.com/pdf/fund-pages/monthly/rbf563_e.pdf
Hi,
I am investor with limited access to the Canadian market. I was wondering what CDN bond funds are available for purchase from outside Canada (for example a CDN bond indice ETF on the US market) and whether you would suggest them?
@Jonathan: Thanks for stopping by. I am not aware of any Canadian bond ETFs available on US exchanges. You can by a Canadian equity ETF from iShares US, but not fixed-income. Sorry.
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