Holding Your Bond Fund for the Duration

Bond index funds have a place in almost all portfolios, even in a low-rate environment. However, it’s important to match the right bond fund to your investment goals. To do that you need to know two important details. You can usually find both of these numbers on the web page or fact card of any bond mutual fund or ETF.

The first is the weighted average term to maturity of the bonds in the fund. For example, the iShares DEX Universe Bond Index Fund (XBB)—which tracks the most popular fixed-income benchmark in Canada—is about half short-term (one to five years to maturity), one quarter intermediate-term (five to 10 years) and one quarter long-term bonds. The weighted average term to maturity of all the bonds in the fund is 9.3 years.

This number is important, because the fund will behave much like an individual bond of about this same maturity. Sure enough, if you look up the current yield on Government of Canada 10-year bonds you’ll find it is 3.07%, almost identical to XBB’s current yield to maturity (3.03%). Now you know that XBB will be sensitive to the prevailing interest rate on 10-year bonds: if this yield goes up, the fund’s value will fall. Other interest rates—such as the Bank of Canada’s overnight rate that you keep hearing about on the news—are pretty much irrelevant.

The second key figure is your bond fund’s weighted average duration. This tells you the fund’s sensitivity to interest-rate movements: the longer the duration, the more your fund will lose if rates go up.

Duration is a calculated with a complicated formula that considers a bond’s term to maturity and its coupon. The important idea is that the longer the maturity, or the lower the coupon, the longer the duration. This is why short-term bonds are less sensitive to interest rate swings, and why higher-yielding corporates are less vulnerable than government bonds:

Ticker Average
Term
Coupon Duration
iShares DEX Short Term Bond XSB 2.9 3.62% 2.7
iShares DEX All Corporate Bond XCB 8.3 5.21% 5.5
iShares DEX Universe Bond XBB 9.3 4.41% 6.3
iShares DEX All Government Bond XGB 9.5 4.00% 6.6
iShares DEX Long Term Bond XLB 22.8 5.72% 13.7
iShares DEX Real Return Bond XRB 20.9 3.40% 16.2

.
As you can see in the table, XBB (and similar broad-based funds) have a duration of just over six. That means if the relevant interest rate rises one percentage point—remember, in this case it’s the yield on nine- or 10-year bonds—then the fund can be expected to fall in value by about six percentage points.

And the bond played on

There are a couple of subtleties to be aware of here. First, interest rates at the long end of the yield curve tend to be less volatile than short-term rates: it’s unusual for 10-year bond yields to move more than one or two percentage points in a year. So the chance of a fund like XBB suffering double-digit losses in any given year is remote—at least if history is any guide.

The iShares DEX Long Term Bond Index Fund (XLB) looks even scarier with its duration of almost 14: a 2% jump in the yield on 20-year bonds would theoretically mean the fund’s value would decline by some 27%. But this has never happened. Since 1948, the worst one-year return on the DEX Long-Term Bond Index was –8.9% in 1956, followed by –7.4% in 1994. In the U.S., long-term bonds have seen just one double-digit decline in 85 years (that happened in 2009).

Another often overlooked point is that rising interest rates have a silver lining: new bonds are issued with higher coupons, and this will eventually lead to more income. (Doesn’t it strike you as odd that fixed-income investors complain about low rates while also worrying they might go up?) As bonds in a fund approach maturity and are sold, the proceeds are reinvested in higher-yielding bonds that help offset the price declines. That’s why bonds recover from bear markets much faster than stocks do.

Stay in for the duration

Which leads us to the key message for investors: as long as your time horizon is at least as long as the duration of your bond fund, you won’t lose any capital.

You’ve probably heard people say they prefer individual bonds to bond funds, because as long as they hold on until maturity, they won’t lose principal. Well, the same is true if you hold a bond fund for a period equal to its duration. You can be sure that XBB will not have a negative total return over any period longer than 6.3 years: any price decline from rising interest rates will be offset by higher coupons within that time frame. In fact, history suggests the recovery is likely to be more swift than that: even a three-year period of negative bond returns is extremely rare.

So, if you’re saving for a child’s education with a three-year time horizon, steer clear of XBB and choose a fund with a duration less than three—or just put your money in a GIC or high-interest savings account. But if you’re investing for a retirement that’s 10, 20 or 30 years down the road, a broad-based bond index fund should still be a core holding in your portfolio.

 

61 Responses to Holding Your Bond Fund for the Duration

  1. Chad March 8, 2015 at 1:29 pm #

    I’ve been really appreciating your posts – I have a question I have not found an answer to yet. I just finished reading Tony Robbins’ new book “Money: Master the Game” where some of the big investors like Ray Dalio and David Swenson recommend portfolios in ETFs/index funds. Both of these guys recommend allocating significant portions in long-term federal bonds – I am looking to do this – but the one’s I have found have low numbers of holdings (between 15 and 50) and I am curious to hear your perspective if this is diversified enough or does this increase the risk significantly?

    Thanks,
    Chad

  2. Canadian Couch Potato March 8, 2015 at 2:38 pm #

    @Chad: Be wary of following US-based investment advice too closely: the realities in Canada are often different. The broad-based bond funds in my model portfolios have bonds of all maturities, which is a good choice for investors with a long time horizon. Long-term bonds can be very volatile, and they generally do not offer much additional yield in exchange for that additional risk.

  3. Chad March 8, 2015 at 3:15 pm #

    Thank you very much for the advice – I wondered as much looking at one of Vanguard’s long-term government bond funds with close to 2000 holdings where the most I could find in a Long-term Canadian bond fund was around 55 – so even if I did hold long-term funds for the duration the risk may not outweigh the reward

  4. Heidi November 29, 2016 at 12:17 pm #

    Hi there, just wanted to say thank you for sharing your knowledge on your blog. I was a financially ignorant/dependent working housewife 4 years ago and my divorce had force me to educate myself about my own money and become financially independent – and it all began with your blog (life changing) ….Starting with moving all my investments from one of the big banks (and ditching the financial advisor whom had ‘best interest at heart’ to managing my own ETF portfolio using your model portfolio . I feel much more secure about my future so thank you again.

    I know the basic concept of re-balancing/buy low & sell high, and when interest rates goes up, bond prices goes down but I am still confuse about when is the best time to buy Bond ETF? Doe the buy low rule still apply with Bond ETF when interest rates goes up? Is there a rule of thumb for Bond ETFs?

  5. Canadian Couch Potato November 29, 2016 at 1:54 pm #

    @Heidi: Many thanks for the feedback, and I’m happy to hear you have found the blog useful!

    When deciding whether to rebalance, simply look at the market value of your bond ETF holding. For example, if your portfolio is $100,000 and your target bond allocation is 40%, than the holding should be about $40,000. But as you note, when interest rates go up, the value of your bond holdings will fall, so this is likely when you will need to add to it. This is a good thing, since you will be adding more money when yields are higher, which is tantamount to “buying low.”

  6. Theodore March 31, 2017 at 5:12 am #

    @CCP

    Hi,

    I really appreciate your website!

    I have been using a full service broker with high cost mutual funds for most of my life. I recently sold the equity mutual funds in my TFSA and transferred it to a discount broker.

    I am trying to decide which bond ETF to purchase within my TFSA.

    I am retired and in my early 70s. I have a good government pension and don’t need to live off the income from my investments. My portfolio is currently 80% equities, 8% fixed income and 12% cash. I am aware that I am heavily overweight equities and want to increase the fixed income part of my portfolio. Most of the equities are in a taxable account so it is difficult to sell too much of it in one year without incurring a large tax consequence. If I sold all my mutual funds in my RRIF and bought fixed income, my portfolio would still be 70% equities.

    I am trying to de-risk my portfolio and want to use most of the 12% cash to buy a fixed income ETF. I have read most of your posts on fixed income but I am still unsure whether to purchase ZAG (BMO aggregate Bond Index) or VSB (CAD short term bond index). I want diversification away from stocks, want the bond ETF to rise in value when there is stock market correction or bear market and would ideally like to get a return of at least inflation.

    In your CCP model portfolio you use ZAG, however Justin Bender’s model portfolio’s uses either VSB or an Aggregate bond index similar to ZAG. Andrew Hallam has VSB in the fixed income part of his Globe and Mail strategy Lab Portfolio.

    You say that one should aim to keep a bond ETF for at least as long as the duration. ZAG has a duration of 7.33 years while VSB has a duration of 2.7 years. Who knows if I’ll be around in 7 years? Would you say that a retiree should have a shorter duration bond fund as opposed to someone who is younger and is in the capital accumulation part of his life? Is it fair to say that ZAG would increase in value more than VSB in the case of a stock market correction? Maybe the correct approach would be to buy both ZAG and VSB in order to have a duration of somewhere between 2.7 and 7.33 years?

    Although it’s impossible to predict where interest rates will go (look at the last 4 years), the FED has already began tightening and the market is predicting 2 or 3 more hikes this year. Maybe it’s best to buy VSB and then sell it and buy ZAG if and when rates are a little higher?

    I am new to do it yourself Index investing and any thoughts or suggestions would be greatly appreciated.

    Thank you,

    Theodore

  7. Canadian Couch Potato March 31, 2017 at 10:36 pm #

    @Theodore: This is a relatively small decision and I would not let it distract you from moving ahead with your plan. It comes down to whether you are willing to accept the higher volatility of ZAG/VAB in exchange for a higher yield or whether you would rather accept low volatility in exchange for a lower yield. GICs may also be an option. This might help:
    http://canadiancouchpotato.com/2015/05/18/how-changing-interest-rates-affect-fixed-income/

  8. Bibi May 11, 2017 at 8:38 pm #

    @CCP
    You wrote:
    You can be sure that XBB will not have a negative total return over any period longer than 6.3 years:

    I just want to make sure I’m comparing apples to apples. Let’ say I buy bonds and keep them to their maturity. So I will be be getting par value + interest. Then in your XBB example, not only I would be interested to not have my principal depreciate but also get interest. Is that what you meant by total return not being negative? In other words should the total return be equal to par value + interest?

  9. Canadian Couch Potato May 11, 2017 at 10:22 pm #

    @Bibi: The ideas are similar. But with a bond fund there is no maturity date, so what happens is that if interest rates rise, the value of the fund will fall, but new bonds will be purchased with higher yields, and eventually these higher yields will offset the initial loss. The duration is an estimate of the “breakeven point.”

  10. Bibi May 11, 2017 at 10:45 pm #

    @CCP
    Thanks for the quick reply.
    Sorry I didn’t phrase my question clearly. I am comparing buying bonds and keeping them to maturity with buying a bond ETF and keeping it for duration. It seems your point was that if I bought the bond ETF I would not lose money, but what I’m trying to say is that it’s not enough. I want to get my principle back + interest as I would had I bought the bonds directly.

Trackbacks/Pingbacks

  1. The real problem with inflation-protected bonds – Canadian Retirement Resources - June 2, 2016

    […] long maturities and low coupons of RRBs in Canada give them a very long duration—just under 16 years for the BMO and iShares ETFs. This means they are extremely sensitive to […]

Leave a Reply