Investors are worrying about a lot of things these days, but the fear of rising interest rates remains near the top of the list. Not only are savings accounts and GICs yielding peanuts, but bond investors are worried that a spike in rates will send the value of their bond funds and ETFs plummeting.
The concern is certainly warranted. Remember that bond prices and interest rates are on opposite ends of a seesaw: whenever one goes up, the other goes down. But before you make drastic changes to the fixed-income side of your portfolio, make sure you understand the subtleties of interest rates and their effect on bond prices.
Overnight sensation
When people talk about interest rates, they’re usually vague about which ones. The media tend to focus on the overnight rate, which is set by the Bank of Canada in an effort to control inflation.
That rate was 0.25% in April 2009, and in 2010 it ticked upward three times to 1%, where it stands now. If you follow the mortgage markets, you saw that the banks’ prime rates (currently 3%) went up immediately following each of these three hikes in the overnight rate. That’s why variable mortgages and lines of credit got more expensive last year.
However, you may also have noticed that fixed-rate mortgages got cheaper in 2010. That’s because fixed-rate mortgages, which usually have a term of five years, are tied to the yield on five-year government bonds, not the overnight rate. And during 2010, five-year bond yields declined slightly. They fell further this past May, prompting the banks to lower fixed mortgage rates again.
Whenever there’s talk of rising interest rates, someone points out that long-term bonds are the most vulnerable. This is true, but again, it depends which rates you’re talking about. While short-term rates went up three times in 2010, the yield on 10-year bonds fell. As a result, the iShares DEX Long Term Bond Index Fund (XLB) returned a whopping 12.1% last year. The broad-based iShares DEX Universe Bond Index Fund (XBB) earned well over 6.4%, its best showing since 2004.
The lesson here is that the different parts of the yield curve do not move in lockstep, and various lending markets can behave differently over any given period. If you believe the Bank of Canada is going to raise short-term rates in the near future, then you should be worried about your variable-rate mortgage. But if you’re a long-term investor, you shouldn’t be dumping your bond index funds.
Rising rates aren’t new
Investors have faced similar scenarios before. In May 2004, Americans were filled with fear about rising rates. Typical of the media reports at the time, Kiplinger’s Personal Finance magazine warned investors to “Protect your bonds from the coming storm” as the Federal Reserve raised rates to tame inflation. Some pundits were even recommending inverse bond funds, which go up when bond prices go down.
It turns out that the forecasters were absolutely right about the central bank’s actions: Alan Greenspan hiked short-term rates 16 consecutive times until they reached 5.25% in July 2006. So did bond investors get slaughtered? Not at all: bond prices fell modestly, but the declines were more than offset by the interest payments. The total return on the Vanguard Total Bond Market Index Fund was about 3.5% annually from 2004 through 2006. Long-term bonds—which the magazine specifically warned against—did even better.
It’s happened in Canada, too. From 1987 to the middle of 1990, Canadians watched short-term rates soar from 7.7% to over 14% in 41 months. But the yields on five- and 10-year bonds crept up more modestly during this period, with several dips along the way. As a result, the overall bond market returned almost 4% a year from 1987 through 1990 after inflation.
There’s no arguing that bonds could see trouble ahead, but the dangers are often overstated, or at least misunderstood.
Good info, I’ve often wondered whether it’s really warranted to prefer XSB over XBB, when my investment horizon is 35 years.
Very solid analysis.
The key is to hold the bonds (M funds or ETFs) in a registered account.
Great post. Another point worth making is that rising interest rates are not certain, even now. Market timing interest rates is even harder than market timing equities.
e.g. People have been predicting rising rates for a year and a half or more, but nothing seems to come of it, and now there’s serious talk that interest rates won’t start rising in the U.S. until at least 2013. Meanwhile, the bond market is unlikely to force the BoC’s hand as long as Canadian interest rate policy is marginally tighter than the U.S. (My own view is that the BoC is willing to tolerate high inflation and negative real interest rates in an attempt to unwind the housing bubble and prevent the CMHC from imploding, but I’m not letting this opinion influence my asset allocation.)
@Slacker: I’ll be looking at your point more closely in my next post. XSB should have less volatility than XBB, but with a 35-year horizon, how much does that matter?
@Chris: You make a great point. “Interest rates must go up” has become a cliché, but it ignores that fact that they could stay low for a long time. The opportunity cost of sitting in cash could continue to be high, as it was last year. I like that you have a view, but you are not so confident about it that you’re making big changes in your portfolio. As always, in the face of uncertainty, the wise choice is to diversify.
As someone who focuses on a bond ladder and holds to maturity, a rise in rates would be beneficial for the rollover
@qasimodo: The same is true for an investor who holds a bond fund and has a time horizon at least as long as the fund’s average duration. (More on this in a future post.) In the case of a bond ladder, some of the individual bonds will decline in value, so if you were forced to sell them you would face a loss, and holding them to maturity may incur some opportunity cost. But as you point out, rising rates will eventually benefit fixed-income investors who have a long horizon.
It does seem odd that investors are both frustrated with low interest rates and also worried that they may go up. :)
Canadian Couch Potato: The limitations / risks of the ladder exist but given that this is the FI portion of my holdings, the intention is to manage the timing of redemption while “opportunity” related to FI is addressed through incremental rollover. (Other opportunities would fall into a different portion of the portfolio)
It seems to me that the divergent reactions to rate movements are rooted in differing approaches. For me bonds are for predictability, planning and risk reduction. IMHO the (enormous) market trading bonds is more akin to trading (financial) commodities.
@qasimodo: I hope I didn’t sound like I was criticizing the laddering strategy. I think this an excellent way to spread out interest rate risk. And as you say, a ladder is more predictable a bond fund that has no maturity. All I meant was that, assuming a bond ladder and a bond index fund have the same duration, their interest rate sensitivity is the same, and both will ultimately benefit from rising interest rates as the bonds get rolled over with higher coupons. One strategy is not inherently riskier than the other.
“…if you’re a long-term investor, you shouldn’t be dumping your bond index funds.”
For my RRSP, I’m following your global couch potato portfolio using TD e-series. Since I’m only in my late 20s, I’m in it for the long haul.
In the short(er) term non-registered front, I’m still using e-series but a 70% bond allocation with a weekly PAP plan. In an *ideal* situation my non-registered funds are something I’d like to think of as an extra RRSP long-term fund and I’d rarely ever dip into it. I’m somewhat risk averse as well…Any advice? Should I reduce the bond allocation?
Cheers.
@Anonymous: I’d encourage you to think about your overall asset mix rather than looking at the RRSP and non-registered accounts separately. To use an extreme example, if you have $1,000 in a non-registered account (70% or $700 in bonds) and $10,000 in an RRSP (40% or $4,000 in bonds), your overall bond allocation is only 42.7% bonds.
More importantly, however, it’s very tax-inefficient to hold bonds in a taxable account. A TFSA or other tax-sheltered account is almost essential for bonds or you’ll be giving away a big chunk of an already low yield.
Thanks you for the tip with regards to bonds in taxable account.
Yes, I’ve maxed out my RRSP and my TFSAs, so I’ve been dabbling a small amount in a non-registered account. I’ve keep most of my rainy day funds in regular savings or GICs, but rates are pretty paltry.
I know this is hard to just answer since each person is tailored differently (and perhaps I should talk to a financial adviser in-person), but what would a fairly safe (if there is such a thing) and passive taxable investment be? Alternatively, I guess I could stick with the 40-60 global couch potato strategy everywhere. Sorry if I sound like a neophyte, which I probably am.
Appreciate all your help, and all the valuable info on your site.
What is the best option(s) for fixed income in a non-registered account? I am assuming there is no more room in any registered vehicle.
@Anonymous and Al: Unfortunately, the safest investments (bonds, GICs, money market funds) are all fully taxable. Preferred shares are possible option—they behave much like fixed-income securities, but they pay dividends, which are taxed more lightly than interest.
Canadian stocks are the most lightly taxed asset class, but they’re hardly “safe” in the short term. One thing many investors do is consider all of their accounts as a single portfolio with a given asset allocation, but then they hold all their bonds in the RRSP, and keep only equities in their taxable accounts. This isn’t helpful if you want to have some cash on hand for emergencies, but it’s a good strategy for long-term savings.
These posts may be of interest:
https://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/
https://canadiancouchpotato.com/2010/03/19/a-mutual-fund-refugee/
Many thanks for your clairity of writing; it helps me quite a bit!
Isn’t a bond fund an interest rate play rather than “fixed term” in my portfolio. If I buy fixed term (a bond ladder or a GIC ladder), I’m fixing my return for the term of the bonds and I have interest income but no capital exposure except for the credit risk. But if I buy a bond ETF, aren’t I subject to capital gains or losses depending on interest rates? How is this safer than equity ETFs? I must be missing something.
Mike I think your understanding is basically correct but I will attempt to regurgitate some points I have previously read about bonds that you may not be considering.
Holding a bond ETF, or a bunch of individual bonds does give you gains or losses when interest rates change but it isn’t a pure interest rate play because the underlying bonds do eventually mature and assuming there has been no default the principal is returned to you (or the fund). A hypothetical infinite-duration bond that is impervious to default might be considered a pure interest rate play.
The fact that the principal is always owed to the bondholder makes bonds generally less risky. (This property can also raise the price of bonds when equity markets panic, regardless of interest rates.) Bonds are also considered to lower your overall portfolio risk because they are not correlated to stocks. In fact stocks and bonds often move in opposite directions. So if you have both in your portfolio you should see less risk or at least less volatility. (I’m looking forward to Dan’s post about volatility and risk to explain this better.)
@Mike and Charles: I’m concerned about the description of bond investing as a “play” on anything. Bonds are a core asset class that should be part of almost any portfolio, regardless of market conditions or your beliefs about where interest rates might be headed.
Mike, to answer your question about how they are safer than equities: while it’s true that bonds can go up and down in value, they are nowhere near as volatile as stocks and therefore they dampen the overall volatility of a balanced portfolio. I just looked at the historical returns for US long-term bonds since 1926. They experienced a double-digit loss in exactly one year (–14.9% in 2009).
There is a common misunderstanding that holding individual bonds (in a ladder, for example) is somehow safer than holding a bond fund. This is not true. Holding individual bonds allows you to predict your cash flows more easily: bond funds have no maturity date, so you cannot bank on having X dollars on Y date. But a bond has the same sensitivity to interest rates whether its held in a mutual fund or in your personal account. This post may help clarify:
https://canadiancouchpotato.com/2010/03/29/bonds-v-bond-funds/
Nice post Dan. I personally hold XBB and CLF in my RRSP. My TFSA has no bonds, only a few Canadian dividend-payers at this time. I totally agree with your points about keeping bonds in any tax-deferred or free account. You’ll get clobbered with taxation otherwise.
I also agree with your thoughts about holding XBB long-term, say 25+ years or so, over an XSB. For one, I like the set and forget yield and the free share I get every month via the XBB distribution reinvestment. Two, I think every investor should have some short-bonds (I do); but I believe in XBB (or something similar, like a PH&N bond fund) as a great all-in-one bond product that many investors should not ignore over a long time frame. The rise and fall in rates will normalize over a few decades. At least that’s what has happened historically ;)
Thanks to Charles and the head potato for your thoughts. Here’s where I see a dilemma. I just read the referenced post about bonds versus bond ETFs but I’m not convinced yet. Sure, if I build a ladder of bonds over, say a ten-year term, then as rates move the “mark-to-market” value changes and I’m getting opportunity costs or gains. But if I hold the bonds to maturity, I’ve achieved a stable, predictable return that fits my fixed-income allocation. If on the other hand, I put the same amount in a bond ETF, mighten I end up with less or more proceeeds based on interest rate movements. In other words, do I get capital gains or losses that I would not otherwise get with a ladder, gains and losses that I can’t predict (which defeats my idea of fixed term being the predictable segment of my portfolio).
And do Bond ETFs only buy in at predictable intervals? No… they buy and sell based on redemptions and purchases by investors don’t they? This seems to add a further level of unpredictability and again makes the gains and losses subject to not just interest rates but market timing too.
If fixed term is supposed to be that portion of your investments that will grow (sometimes maybe below inflation) at a predictable rates, from my understanding of Bond ETFs, they don’t provide that coverage.
@Mike: Thanks for the comment. My subsequent post may help clarify some of the confusion here:
https://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/
There’s absolutely nothing wrong with bond ladders. You’re correct that a bond ladder has more predictability in terms of income and known maturity dates. My only point was that people think they are safer and less sensitive to interest rate movements, but they are not.
One logical error people make when comparing the two is that they assume they will hold all the bonds to maturity without also assuming they will hold on to their ETF for the same tame period. The fact is, if you invest in a bond fund with the same characteristics as your 10-year ladder (in terms of yield to maturity and duration) your results will be almost identical. They must be, since bonds do not behave differently in a personal account than they do in a fund.
RE: unexpected capital gains, this is a good point. I looked at the iShares bond ETFs and they have not distributed significant capital gains for several years, but I suppose this is always possible. Another reason for holding bonds in a tax-sheltered account.
Hi, Dan
In your article you mentioned that XLB returned about 12.1% over this last year :
“Whenever there’s talk of rising interest rates, someone points out that long-term bonds are the most vulnerable. This is true, but again, it depends which rates you’re talking about. While short-term rates went up three times in 2010, the yield on 10-year bonds fell. As a result, the iShares DEX Long Term Bond Index Fund (XLB) returned a whopping 12.1% last year. ”
Just over a year ago we purchased that ETF for my wife’s RRSP. We bought 800 shares June 3, 2010 @ $20.11.
As of this June 30, 2011 (and after latest distribution) we now have 823 shares (due to drip) @ $20.64. Using simple math our RoR works out to roughly 5.6%, not the 12.1% you indicate. Even taking today’s share price of $21.07, it still falls far short of 12%.
How did you arrive at your very positive return figure ? Is there a more sophisticated Returns calculator we should be using ?
Also, we have placed most of our income-producing investments (bond, REIT, and Vanguard ETFs) in RRSP’s. All other dividend/preferred ETFs and domestic stocks in our Margin account. Our TFSAs have some old Telus NV stock.
What is the best way to rebalance between the 2 types of accounts, especially when our RRSPs are max’d (we are now in early retirement) and no new money available for investments. Based on age, our allocation should be roughly 60/40. Currently, it is at 50/50. At first glance the costs of trading could be onerous between the two types of accounts and while trying to maintain separation.
How do we handle bonds outside of RRSP if we need to get back to 60%?
***
Through your detailed knowledge of Couch Potato philosophy we both have adopted the CP Plan ..albeit our version. We both continue to enjoy reading and applying your blogs and articles from here, Moneysense and CMS magazine. Thanks so much !
@Wayne: Thanks for the comment, and glad your finding my blog and articles helpful.
Regarding XLB, the 12.1% figure is the return on the fund if you help it for the whole calendar year of 2010. You bought the fund in June 2010, by which time it had already gained over 5% (including distributions), which you missed. The return you are measuring is for the last 13 months (June 2010 to June 2011, inclusive). All of these performance numbers are available on the iShares website: just visit the page devoted to the fund and click “Performance.” Note also that brokerage statements do not include the distributions as part of the return; they only include capital gains and losses, so they are not a good indicator of the true return of a bond fund.
As for rebalancing between RRSPs and non-registered accounts, this tricky, and there are no easy answers. You definitely do not want to be withdrawing from an RRSP during the process. I will consider doing a longer post on this at some point, but in general, you’re making a trade-off between tax-efficiency (asset location) and risk management (asset allocation). I would tend to err on the side of risk management. That is, if you want to be 60% in fixed income, you should probably stick to that, even if it means holding some of your bonds outside of tax-sheltered accounts. Better to pay a bit more in tax than to suffer an unexpected capital loss. (From a tax perspective, it would likely be better to keep the Telus stock in an unregistered account and hold bonds to the TFSA.)
This post may help:
https://canadiancouchpotato.com/2010/03/19/a-mutual-fund-refugee/
Sorry, I assumed your 12.1% comment was for YTD. Your explanation now helps clear this up — thanks.
As for the Allocation dilemma, gee I forgot about your link @ “a mutual fund refugee” and followup comments. It was well worth a re-read. Yes, it is rather difficult to put all our assets into proper perspective when we have several accumulated investments spread around.
Suffice to say though, our plan is quite similar to that of Darren and Sarah’s. But our plan also makes use of another thought that refers to today’s confusing investment atmosphere : “National Bank’s Andy Filipiuk who suggests a way of hedging against the big four investment uncertainties: inflation, deflation, recession and prosperity”
— (last poster ‘Dale’)
Quote: “(From a tax perspective, it would likely be better to keep the Telus stock in an unregistered account and hold bonds to the TFSA.)”
We did think about that. And I understand the reasoning behind adding more bonds to the percentage, and that could be the place to put them. But since we had the Telus shares we decided to use them to fill our TFSAs. From what I know, upon selling the stock from those accounts no tax will be owed on either cap gains or dividends ..unlike RRSP where it will all eventually be taxed as income.
I assume then that bond interest would be treated the same way. That being said, there is the possibility of doing a swap of some sort. But first we would have to find the money to buy bond funds (we are hesitant in divesting of the Telus stock as it has become ‘part of our family’ over the years).
Yeah, I agree it seems an tricky balancing act and I will look forward to your expansion on this post (along with others’ comments) on how they generally go about this process: ie, pitfalls and tradeoffs.
@Dan: You’ve hinted at this a bit in some of your comments here, but I’d love to see a full-blown article on how to handle taxable vs. non-taxable accounts. Some folks have maxed out their RRSPs and TFSAs, and have no choice but to start holding some investments in taxable accounts.
I know the basics that everyone keeps repeating, like “hold interest-bearing investments in tax-sheltered accounts”, but that’s on par with “pick the ETFs with the lowest expenses”. Well, duh. But as your blog has shown consistently, there’s more to that than meets the eye. I’d love to see an analysis of this situation from a guy like you who specializes in saving every basis point.
@Patrick: Thanks for the suggestion. Other than asset location (which asset classes to hold in which types of accounts), what sorts of things were you hoping to learn? Suggestions for specific tax-friendly products?
These may help in the meantime:
https://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/
https://canadiancouchpotato.com/2010/03/19/a-mutual-fund-refugee/
@Dan: Thanks for the links! Looks like you’ve already covered some of what I wanted to know.
I think part of my problem is I don’t even know what I don’t know. I do know that dividend taxes are very complicated and can affect income-tested benefits, so it’s possible some folks would even want to keep dividend-paying stocks out of their taxable accounts. I suspect the trade-offs might depend on one’s tax bracket, not only now, but also when one withdraws from RRSPs. I know keeping low-volatility assets like bonds accessible in the short term is at odds with putting them in an RRSP. I think it things might change if one owns a farm or small business. I know there is interest (ie. plain old income), dividends, and capital gains; are there other classes of income? If one owns a house (along with the associated tax-exempt capital gains and non-tax-exempt mortgage interest), how does that affect things?
You’re not writing a tax-planning blog here, so I’m not sure whether all this adds up to a topic that interests you.
@Patrick: Some quick thoughts: in addition to interest, Canadian dividends, and capital gains, some investment returns are considered “other income,” such as foreign dividends. These are fully taxed, just like interest.
Regarding the effect of dividends on income-tested benefits, see this piece I did for MoneySense:
http://www.moneysense.ca/2011/01/18/dividend-downer/
Owning a house shouldn’t make any difference to any of this.
Cheers!
@Dan: Ok, excellent. Thanks a lot!
@Dan: “You make a great point. “Interest rates must go up” has become a cliché, but it ignores that fact that they could stay low for a long time.”
I heard a quote once about speculative investing that I can’t find now, to the effect that if you make the right call, but you’re six months early, then you made the wrong call.