Since the 2008–09 financial crisis caused bond yields to plunge to new lows, market forecasters have been predicting a rise in interest rates. And when bond investors think rates will increase, they tend to move to short-term bonds or cash. That has certainly been popular advice over the last three-and-a-half years.
As bond investors now know, the forecasters were spectacularly wrong about the direction of interest rates. Yields have fallen since the crisis, and as I wrote about in a recent feature for Canadian MoneySaver, anyone who moved to to short bonds or cash did far worse than investors who simply held the whole bond market. From 2009 through 2011, the iShares DEX Universe Bond (XBB) delivered an annualized return of 6.9%, compared with 4% for the iShares DEX Short Term Bond (XSB), and about 1.5% for cash.
The next three years
The fear of rising yields is even more palpable today, and the soothsayers may be proven right. But how badly would bond index funds suffer in a rising rate environment?
To get some insight, I ran some hypothetical scenarios to see how things might shake down if rates all along the yield curve climbed 100 basis points (1%) annually for the next three years. Then I asked BlackRock, provider of iShares ETFs, to estimate how that might affect XSB and XBB. The numbers in the table below are based on the following assumptions:
- During the entire three-year period, the profile of the two bond indexes—their duration and average maturity, for example—remain approximately the same as they are today.
- Credit spreads—the difference between the yield on government bonds and corporate bonds of the same maturity—remain where they are now.
- The rate increases occurs at the beginning of the year, resulting in an immediate decline in the value of the fund.
- Over the next 12 months, cash flows from coupon payments and the sale of bonds are reinvested at the new higher rates.
Estimated returns if rates rise 100 bps annually | ||
XSB | XBB | |
Year 1 | 0.30% | -2.80% |
Year 2 | 1.20% | -1.50% |
Year 3 | 2.20% | -0.30% |
Annualized return | 1.20% | -1.50% |
Total three-year return | 3.70% | -4.50% |
Source: BlackRock Asset Management Canada, Inc. |
What’s the takeaway message from this simulation? The first is that bonds probably didn’t perform as poorly as you expected. With our simulated rate increase of 1% annually across the yield curve, XBB suffered three straight years of negative returns, but the losses were modest. Rising rates will hurt certainly bond returns, but the talk of bonds getting “killed” is probably overstated. Remember, too, that rate increases like this are likely to happen only if the economy gets red hot, which would probably lead to higher equity returns on the other side of your portfolio.
But there’s something else to consider: the opportunity cost you would have paid if you sat in short-term bonds or cash during the last three years, waiting for the rate hikes that were “certain” to come. As my Canadian MoneySaver article explains in detail, if bond returns over the next three years turn out to be similar to those in our simulation, XBB would still outperform both XSB and cash during the full six-year period beginning in 2009.
Investors should accept that no one can predict interest rate movements, and it is expensive to try. Rather than making tactical shifts that amount to guessing, bondholders are likely do best when they choose a diversified fund with an appropriate duration for their time horizon, and then hang on for the long term.
Thanks for the really thoughtful analysis.
I was recently contemplating the equity side of my portfolio as we ended the quarter. I got all my monthly dividends and cash payments, along with the quarterly dividends paid by XIC and VTI.
Between your analysis of bonds and resisting calls for equity holders to “sell in May and go away,” I was reminded yet again that one cannot time the market, and there is are more reasons than that to stay invested when one’s time horizon is 15, 20 and more years.
I’ve only been invested in index funds for about a year now, but in that time I learn more and more that there is no point chasing returns by playing games. XBB matches my time horizon needs and there I’ll stay.
This is an important post because it is not talked about enough.
I agree that we should not be tactical about duration but need to point out that we are under a collective spell of confirmation bias in Canada because rates have been so low for so long.
The chart below shows 10 year rates over the past 30 years. The yield now is 1.73%. “Normal” yields are 3-6% higher. It wasn’t so long ago (10 yrs?) when a Presidents choice savings account yielded 5% (now its 3.65% lower).
Low rates have lead to personal debt to income levels of over 150% and an inflated housing/condo market amongst other stranger allocations of capital. This is one reason rates are being held down artificially for now – the consequences of letting them drift higher too soon could be a strong negative to banking system (through housing channel mainly) and economy generally (esp. resource and industrial aspects because of currency effects).
We also need to acknowledge that some sectors of the economy are highly sensitive to rising rates. Stocks are essentially a longer duration bet and so what determines stock prices the most is longer term rates. CIBC does research on this and they found that in general REITS, financials, power and pipelines and utilities are price sensitive in an amount exceeding 4.4% for every 1% rise in rates (ie they move at least that much in response to a rise or fall in the interest rate). REITs, power and pipe and bank stocks are most sensitive. The TSX is 4.4% sensitive. I had a conversation with them about whether the elasticity of price change was the same for rates rising as for falling rates because their research was conducted during the period of declining rates. They said a modest yield increase should have broadly the same absolute, proportionate effect on stock valuations as a decline.
So rates effect both stocks and bonds.
Interest rates are, to me, the most important factor in the pricing/valuation of capital and therefore of portfolio values.
http://www.bankofcanada.ca/wp-content/uploads/2010/09/selected_historical_page13.pdf
The point in your article is well taken, but the yield on bonds are now so low that they seem very unattractive.
As Andrew pointed out in his comment, the yield to maturity (YTM) of a 10 year Canada bond is now 1.73%. The inflation target is 2% so it is highly likely that the real return will be negative.
Let’s say in an RESP account that there is child that is 10 years from starting school. Given the 10 year time horizon before money will be required, investing in more equities does not fit the risk profile. The alternative of investing in a 10 year government of Canada bond at 1.73% YTM is however a tough sell. What’s left?
Cash at 2% (in some saving accounts) almost seems to be a better alternative. Am I missing something from your post?
@Phillippe V: There’s no question that bond yields are pretty unattractive these days, but remember that people have been making this argument for at least three years now, and cash has come nowhere close to outperforming bonds.
There are not too many places where you can get cash returns of 2%: most high-interest savings accounts are paying about 1.3%, and the YTM on a broad-based fund like XBB is 2.3% before fees, so about 2% after fees. That’s a pretty significant difference.
It’s important to remember that a bond index fund has no maturity date, so YTMs are only an estimate. If you buy XBB today, you just don’t know what your return will be over the next five or six years: it all depends where interest rates go from here. If rates fall a bit more, cash will lose and bonds will win. If they spike, then cash will perform better. If they creep up gradually, then it’s not clear what will happen.
I agree that traditionally pipelines, preferred shares, utilities, REITs, safe bonds, etc. go down in value when rates rise, however, I am curious if because of the following that they will not drop in value as much these days?:
– current volatility
– long term euro unknowns
– long term usa unknowns
– long term world financial market unknowns
– low world growth estimates (that are constantly revised down)
Isn’t it possible that investors could be willing to pay more for stable cash flow, thus limiting downside?
I would appreciate comments…because I have been pondering this for a while.
There are some like ‘bond king’ Robert Kessler who think that a 10 year US treasury bond is still attractive! With the American economy contracting and the EU experiment a failure and even China faltering how can interest rates go up? So, we might yet see falling interest rates in Canada. Dan’s advise is good to me!
http://video.cnbc.com/gallery/?video=3000096464
@notknower: I’m not sure anyone can answer your question with certainty. Bonds and preferred shares will almost always fall with interest rate hikes, because it’s mostly about math. But with pipelines, utilities and REITs, there is a lot more to consider. Because these are stocks, they are subject to many of the same risks as any other stock: namely, they can plummet in value along with everything else in a crisis. I suppose there is a good probability that defensive stocks will fare better than the overall market in the case of another downturn, but there is no way that anyone can know that for sure. Equity risk is still equity risk, even if the stocks pay a yield.
Hmm.. I don’t have any specific sources to quote at the moment, but my understanding is that historically at least (although in multiple markets), it has been shown to be more efficient to take equity market risk than bond duration risk in order to drive returns. So in other words, for a constant amount X of “risk”, one would be better off on average by reducing bond durations and increasing the percentage of the portfolio in equities. Or in other, other words, by keeping bond durations as short as possible, you can minimize the amount of bonds required to meet the desired level of risk in your portfolio, giving you more space for equities, which are expected to perform better.
If the above is accurate, it seems to me that if anything it would be even more significant in the current interest rate environment.
Is the TD Canadian Bond Index – e (TDB909) short or long term ? I am a little confused, because this bond fund is in the fixed income category isn’t it ? Which means it should be safe and represents an increasing percentage of my portfolio over time, to offset potentially volatile equities ? And now here you are saying Bonds are likely to lose value when Interest Rates go up.
Nathan – interesting point.
Your comment would apply to the barbell strategies of Hybrid Portfolio Theory, Zvi Bodies Escalating Life Annuity and some of the strategies of Nassim Taleb. In all there is a high weighting (80-90%) in very low risk low duration (except TIPs) assets and a counter weight in higher risk high growth potential instruments. In HPT it is what they call high ROI opportunistic, VC, private stuff, high risk small caps, in Bodies portfolio it is longer dated call options on equity indexes and in Talebs it is high risk/high reward options on indexes or individual risky stocks that take advantage of surprise events.
In all these examples it is having very low or no duration assets balanced against high risk high duration, very high leverage. The purpose of the strategies is to be the most liquid (cash has the ultimate “optionality”) but to have 5 or 10 bag or more returns on the small bets made. Also the portfolios would weather major bad events such as financial crises or world catastrophes the best. It is taking maximum exposure to risk but protecting most of your capital.
Interestingly it is also the approach that uses Kahnemans Prospect Theory by having the risk controlled such that most of the portfolio does not change in value most of the time but the concentrated bets when they pay off make it grow, while when they do not, they have minimal psychological effect (the 2X feeling of loss Kahneman talks about)
In this environment, if it is a lower return world from stocks and bonds for a while then this type of portfolio structure might thrive because it is the most liquid and therefore most opportunistic. The problem is identifying the high risk opportunities. I think it might lend itself the most to the ultra HNW who, even if they just put 10% of a portfolio toward it can still have the leveraged growth components in obscure instruments.
In a smaller account I suppose one could use high interest savings and GICs balanced against small bets on small caps, the venture exchange (there is an ETF for that now I think) and using specific options strategies if one was skilled that way.
@Nathan: It isn’t a simple risk vs return trade off. On the bond side it’s interest rate risk (with however much credit risk you like) and on the equity side it’s market risk. These are very different beasts.
For a very long term investment, I think short term high quality is preferred; CCP has said he keeps his bonds short and high quality in his own portfolios, and Dimensional Fund Advisers does this as well. Here it’s not only a question of what gives the best risk vs return but also what best anti correlates with equities and smooths out the ride.
Short and medium term, match the duration to your time horizon with the appropriate amount of equity.
While I’m at it @Todd: the funds should quote a duration, which will tell you if it’s on average short or long term. Bonds are fixed income in that if you hold for the duration you are guaranteed to get the yield-to-maturity. If interest rates go up, bond prices (of preexisting bonds) fall in the short term because of lost opportunity cost: I could have bought a new bond instead of the old one which would have had a better yield. Thus the old ones trade at a discount. The longer the bond, the more opportunity lost. Hold for the duration and it doesn’t matter though, your guaranteed the YTM in the end. It’s worth noting that unless your bond is very long, the price fluctuations will small compared to those of equity.
Kiyo
But isn’t a problem with longer duration ETFs and bond funds the fact that they keep duration constant? What happens if say rates rise continually during the entire holding period?
I get that the calculation is complex and depends on many assumptions. Its something that is vague however and I have tried to model and wrap my head around when I first bought bond ETFs – I liked the analysis above that Dan made as a example.
@CCP: This range of erudite post material makes for fascinating reading. I take everyone’s point — if “this” then “that”, and in general terms I understand the listed consequences. But in terms of the various Couch Potato variant strategies, my understanding of the underlying principle was that you avoid tactical thinking, which, it appears to me, everyone here is doing. You don’t change your initial percentage asset allocations according to external (i.e. not related to your own lifetime cycle) perceived events.
If there is any point about the CCP strategy that seems fuzzy to me, it is the recommended timing of your periodic rebalancing to the original proportions. Is it cast in stone, e.g., say annually in January, or whenever the proportions get majorly out of whack? Or when you get nervous? If it is the last two alternatives, what’s the difference between such timing and attempted tactical investing?
@Kiyo, for your information, apparently DFA now also has longer term bonds, please see the comment from Justin Bender under CCP’s post at
https://canadiancouchpotato.com/2012/05/29/inside-the-dfa-global-balanced-fund/
@Andrew: True, with a simple bond the duration decreases as the maturity nears. With an ETF the duration is constant. I should have said something like, if you hold for approximately the duration, you will get approximately the YTM. Specifically, interest rate changes that happen closer to your selling date will affect your final returns (because that is when the duration and your selling date are most mismatched). I think the effect is smallish.
Target maturity bond ETFs don’t have this problem. Alternately, balance to a shorter duration ETF as your horizon approaches.
@Philippe V.: Thanks for the correction.
This is an interesting discussion. How do Real Return Bonds figure into it? In the model portfolios only the Complete Couch Potato holds RRBonds. Are they something that only a small percentage of a portfolio should be in? Is it best to hold the index rather than individual real return bonds?
Oldie
Great point. I like that kind of discussion myself because I am an economist by training so I am interested in what if questions – but I also understand their limitations and my behaviour so far is that I make few changes, rebalancing, very infrequently – probably more infrequently than most. Bernstein in Investors Manifesto I thought recommended every several (3?) years or so. I would have to say the decisions to rebalance are tactical. How often? What are the limits that have to be reached? What to do if there is a sudden change in value (such as fall 2008)? What are the tax implications of rebalancing? Life circumstances change suddenly sometimes requiring a tactical change in portfolio asset allocation.
All these have if, then, what if elements and decisions that are tactical in that they are judgements about what the decision maker feels will probably bring the best outcome.
Also the idea of choosing an initial asset allocation is tactical as is the idea of changing the allocation to non-equity correlated over time as one gets older.
I find that I am more risk averse and a heavier saver over time because of what was summed up in a post (and comments) Dan made a few weeks ago “What are normal stock market returns?”.
What I like about the CP approach however is that it takes a lot of the decision making bias out of the process. I still put the most important decision (the asset allocation) into context by distinguishing cash flow needs in short and long runs, using scenarios, understanding how ETFs are correlated and understanding the potential level of regret under different scenarios.
Thanks Kiko. I forgot about target date bond funds as a new product.
Thanks to everyone for a great discussion. Many of you have already addressed the questions of other readers, so I will try to keep my own comments as brief as possible.
@Oldie: The rules for rebalancing are definitely not written in stone. As a rule of thumb, if you are not inclined to make a lot of changes to your portfolio, once a year is probably just fine. If you happen to be an investor who makes a single annual contribution, this is also convenient, as you can add new money and rebalance all at the same time. In general, it probably makes sense to keep one eye on the situation and rebalance after major market moves, but don’t think of this like market timing. If the stock market happens to drop 30%, you are not rebalancing because you are predicting a rebound in the near-term: rather, you are rebalancing because the risk profile of your portfolio has changed. In early 2009, for example, a portfolio with a target of 60% equities was probably down to about 40% equities. If your target is 60% equities, then you want to get back to 60% equities, regardless of market conditions. These posts may help:
https://canadiancouchpotato.com/2011/02/24/how-often-should-you-rebalance/
https://canadiancouchpotato.com/2011/02/22/why-rebalance-your-portfolio/
https://canadiancouchpotato.com/2011/03/03/how-to-lower-your-rebalancing-costs/
https://canadiancouchpotato.com/2011/03/07/does-rebalancing-boost-returns/
@Andrew and Kiyo: One way you can manage duration is your time horizon changes is by simply combining two ETFs. For example, if you hold equal amounts of XBB (duration about 7 years) and XSB (duration about 3 years) then your portfolio duration is about five years. If you’re investing for a fairly short term goal (for example, a child’s education) you can change the proportions over time to lower the duration. A portfolio of 25% XBB and 75% XSB has a duration of about four years, for example. So you can adjust once a year or so, in line with your time horizon. This is actually the way BMO’s target date ETFs work:
https://canadiancouchpotato.com/2011/02/14/bmos-target-maturity-corporate-bond-funds/
@Darby: Opinions differ on real return bonds, but in general, I think it makes sense to use them for about one-quarter to one-third of a fixed income portfolio. There are couple of things to consider when you invest in RRBs. First, real return bonds in Canada have long maturities (about 20 years on average). Like all long-term bonds, they are quite sensitive to interest-rate increases: they will fall in value if the rates on long-term bonds go up. They are also sensitive to inflation: if the CPI turns out to be lower than expected, they may also prove disappointing.
As for whether to hold them individually or through an index fund: that really depends on how much you are investing and how much work you want to put in to structuring the portfolio. An ETF allows you to buy all the real-return bonds currently available in Canada, and you can rebalance by buying or selling small amounts each year, which is harder with individual bonds.
Dan,
If the XBB duration is about 7 years, at what point would you begin transferring over to XSB, and at what point should you own 100% XSB and 0% XBB, say for example, if you required the funds for year 2030?
Thanks, Que
@Que: The basic idea is to make sure your time horizon is longer than the duration, or you run the risk of suffering some capital loss. So technically, if you don’t need the money until 2030, you cold hold XBB alone until about 2023. Then you would try to match the duration of the bond portfolio to the time horizon—e.g., a duration of five in 2025, of three in 2027, etc. If XSB has a duration of two years, then even that is too long once you get to 2028: at that point you would need to start moving to cash.
Keep in mind that this is only an issue if you need 100% of the money on the target date. If you are simply investing for retirement, however, you don’t need to go through this complicated process.
@Canadian Couch Potato: For those of us using TD e-Series mutual funds, there isn’t an e-Series fund that is the equivalent of XSB. Would you recommend using the TD Investor Series TDB967 – TD Short Term Bond then ?
@Todd: With an MER of 1.11%, the TD fund has to take more risk to get returns closer to XSB, and it does: it is about 70% corporate bonds, versus 30% for XSB. If you are not comfortable with that, you may want to consider a GIC ladder instead.
My education trained me to become a biochemist, the world of business being the farthest thing from my mind or interest.Sooner or later one must smell the colour of money, and to those out there who have fallen into the ‘my advisor will be my best money friend’ please wake up and read what is a great educational series put forth by Dan B. and the fabulous insights by his very knowledgable readers. If business and the world of investing was taught at school in a similar manner, this would be the recommended course for those of us in the other world(mRNA, Higgs Boson, endoplasmic recticulum, etc.). Dan and invaluable, insightful contributors please keep posting my investing education! To all please keep this great web site at the forefront.
This is a very timely topic for me.
Great Post!!!
Dan,
I have recently started reading this blog. I must say the information is absolutely amazing, very well researched/thought-out articles, not to mention that comments are also very insightful. Keep up the good work.
my question is about one of the assumptions:
“Over the next 12 months, cash flows from coupon payments and the sale of bonds are reinvested at the new higher rates.”
is there a particular reason why calculation was done only where the “dividends” from etf are reinvested over the next 12 months? What happens when the “dividends” are reinvested in each of 3 years? I would presume that the loses would less because one would pick up more units of etf at lower price and since more bonds would have been added at higher rates providing even more distribution. It would interesting to see some actual numbers.
@Onkar: Thanks for the kind words, and I’m glad you are enjoying the blog.
I want to clarify the assumptions in the above post. Much of the reinvestment occurs within the fund itself, not in an individual investor’s account. In most cases, all bonds in the fund are sold when they have one year left to maturity, and the cash is used to purchase new bonds in order to track the index: these new purchases . The return estimates I give here assume that all cash distributions are immediately reinvested in the fund, i.e. total returns.
I should also clarify that when I say “over the next 12 months,” I don’t just mean in the first year of my three year example. I mean “during each of the three 12-month periods.” So you are right that in years two and three, the coupon payments (distributions) would indeed be higher. That is why the fund’s total return gets a little better each year: the price drop is more or less the same, but it gets offset by higher and higher coupons. This is the silver lining of rising rates.
This post is extremely timely for me as I am moving to a couch potato portfolio and am being made very nervous by all the gloom and doom around bonds. Thanks so much for the blog and specifically for this post.
Two questions: I have read in several places that the danger with bond funds is that if prices drop people will sell and managers will be forced to sell holdings in order to meet redemptions. As I understand it, this could lead to a loss that cannot be recouped over time. Have I understood this correctly? Is it a risk worth worrying about?
@CCP:
“If the stock market happens to drop 30%, you are not rebalancing because you are predicting a rebound in the near-term: rather, you are rebalancing because the risk profile of your portfolio has changed.”
Thank you; this succinct statement is the answer I was trying to get for ages, to the half -formed question (what’s the difference between “rebalancing” and trying to time the market) that remained in my mind after reading as much as I could about Couch-Potato investing. For some reason, I have missed the above explanation in my prior reading material. Maybe I skimmed over it too fast — but I’ll try and re-read everything I’ve got — it’s possible the question was never anticipated, and so the explanation wasn’t given.
This is a great topic!
Since the economic crisis of 2008, I have spent a significant amount of time and energy learning about the various financial investment assets available to invest in. This web site has proven to be very helpful. Before this time, I was tied into Mutual Funds and relied on my Financial Advisor to steer my future investment security.
Bonds have recieved very little press as far as I am concerned and have been under stated in the benefit, return and risk or lack of risk they provide. This article does a good job to dispell the severity an invest rate hike would have on the value of a bond fund. I find that this argument is used either by those who don’t understand Bonds or by those who have a vested investment in selling stocks. This has been my general observation.
My Financial Advisor was against me becoming a DIY Investor and did everything in his power to dissuade me from investing in Bond ETFs back in 2007/2008. I road out the storm and in 2012 after educating myself on the risks and benifits of Bond ETFs, I learned how Bond ETFs behave, I monitored their performance over time and knew I was ready to go on my own.
The global market is in economic turmoil and world governments are doing everything in their power to stimulate growth. I am fully invested in Bond ETFs, heavily waited on the long side and diversified in Corporate (ZLC), Govenment (ZFL) and High Yield (XHB and HYI). The High Yield has been added to replace my position in stocks (20% of my portfolio). They add a higher yield with less volitility than the stock market and XHB has been very consistent on returns with little fluctuation on it’s price irrespective of the markets volatility.
Many people say you should ladder to hedge against an interest rate hike and I say why? The economy is not getting any better and if anything it will get worse. Government’s are over leveraged and GDP is anemic. Ben Bernanke and the FED said that they will hold interest rates where they are until 2014. The BoC and Mark Carney said that they will hold rates until mid 2013 and we all know that the BoC will not act ahead of the US FED. So their is no fear of an interest rate hike in the near future. This is why Canada’s Finance Minister came out with the stricter lending requirements for home mortgages, because he knows the BoC will not be able to raise interest rates to cool the housing market without damaging economic recovery in every other sector of the economy. A very good move if you ask me.
The FED has short term interest rates close to zero, so what other options do they have if they need to add further stimulation to the economy? They can only do one thing and that is to lower the long term yeild which intern increases the value of long term bonds! It is a win win situation!
I know someone will say what about default risk on your bonds? And I will respond by saying “how is that any different than the default risk on a stock?” In fact their is a difference a very big difference. Bond holders are considered secured creditors and are at the top of the list when it comes to getting paid after assets are liquidated. How many stock holders where made hole after Nortel went bankrupt? Last I read the Bond holders recovered 80% of their investment!
These are just a few of my thoughts and justifications for investing in long term Bond ETFs, I would welcome any and all feedback!
P.S. Thanks for the fantastic site and for being a part of my investment development.
Yvt,
Raffael
Hi Dan,
I have been following your blog for a while and find it amazing source of clear and practical investment information. Keep up good work.
Love your in dept info on any subject your touch and thoughtful replies of other bloggers.
Especially I found interesting discussion on comperisam of bonds with bond ETF-s and how to manage different durations by combining long and short term bond ETF-s.
Say if I want to invest RESP funds in bond ETF-s and my time horizon is 10 years assuming year 10 is 4th year of university. Assuming will need to cash 25% of portfolio in each year 6 – 9 to fund each year of 4 year university. The bond ETF ladder could look as follows:
Year 1. 100% XBB
Year 2. 50% XBB/50% XSB
Year 3. 30% XBB/ 70% XSB
Year 4. 15% XBB/ 85% XSB
Year 5. 100% XSB
Year 6. 75% XSB/ 25% Cash
Year 7. 50% XSB/ 25% Cash
Year 8. 25% XSB/ 25% Cash
Year 9. 25% Cash
Did I got this right?
Rafael holding some equities, reits with some decent income along with bonds in a balanced portfolio has less risk and volatility than an all bond etf portfolio. As Dan brings to our attention no one knows where any asset class is going at any time. I want short on bond etf s and paid. I have begun to add more long through a multi asset etf. Never guess or assume.
Hi Dale,
No doubt that no one can predict the direction of the market. Any investment carries a certain amount of risk and I agree that a balanced portfolio can even out the volatility.
My rant was not an attack on anyone’s investment strategy, but a lack of understanding of why people are so concerned about Bond’s and Bond ETF’s during our current economic times, when based on my understanding, research, historic analysis and personal experience indicates that Bonds are one of the better financial instruments to invest in during these particular uncertain times.
Any other feed back is appreciated!
Hey Raffael. I agree that bonds are always an integral component of any portfolio. I’d guess the point is that an all bond (etf) portfolio carries the same amount of risk that an all equity portfolio holds. If rates do rise dramatically, and we don’t know when that will happen, bond etf’s would take a big hit. Longer bond etf’s could drop some 40-60% real quick.
It’s possible and likely that equity etf’s could offer some very low or even negative correlation to interest rate increases. Lowering volatility and portfolio shocks seems to be important for most investors. It helps avoid panic situations.
That said, I’m now 70% bonds in my accounts. But will move to 50-50 if equities offer a very generous pullback.
I’ve found that 70-80% bonds to equities offers the least amount of volatility, while maintaining some equity exposure.
@Gordon: Thanks for the comment, and glad you’re enjoying the blog. I think your RESP strategy is right on target. Your duration should gradually shrink from about seven years in Year 1, to about 2.5 or so in Year 5, and eventually to zero in Year 9. As a result, any rise in interest rates along the way is unlikely to have any meaningful impact on your portfolio.
Keep in mind, though, that you could still suffer a small loss in the early years. If you are 100% XBB in Year 1 and the fund falls 2% or 3%, and then you sell half the holding in Year 2, you’ll lock in the loss. While it’s important to match the duration of your bond fund to your time horizon, that implies that you will actually hold the fund for that whole period. Some posts that may help:
https://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/
https://canadiancouchpotato.com/2010/11/05/taking-risk-in-an-resp/
@Dale and Raffael: For what it’s worth, I come down somewhere in the middle of your positions. It’s obviously a great idea to keep a healthy portion of a portfolio in bonds to smooth out volatility and provide protection in the event of a market crash (although it should be pointed out that only government bonds provide this protection” high-yield bonds can get clobbered along with stocks). But I also think it’s important to have realistic expectations for bonds. Anyone who has invested in bonds since 1982 may have an unrealistic view: bonds have returned about 10% annually over the last 30 years, even outperforming stocks, but this is highly unlikely to continue. That’s not a market call, it’s just math. Interest rates cannot fall 14 or 15 percentage points (like they have since 1982) when current yields are 2%.
That said, the risk of bonds getting devastated seem exaggerated to me. Re: “If rates do rise dramatically, and we don’t know when that will happen, bond etf’s would take a big hit. Longer bond etf’s could drop some 40-60% real quick.” That’s almost impossible to imagine. Remember that long-term bond yields tend not to move that quickly, and that yields on long bonds are not set by central banks: the market determines them. For a long-term bond ETF to drop 40%, yields would have to more than double from the current 2.25% to over 5% virtually overnight. It’s difficult to imagine something like that happening. The worst loss on long-term bonds in US history was about –20% in 2009. But for some perspective, that was bracketed by 33% gains in both 2008 and 2011.
Wow, this is getting to be a very in-depth treatment of bond and bond ETF economics.
@CCP:
Following the exchange between Raffael and Dale, I pick up the point that a Bond ETF alone in a portfolio is not absolutely safe, and balancing it with Equities ETF in the same portfolio (say, 70% Bonds, 30% Equities? Correct me if I’m wrong) will level out the volatility to the minimum.
If this is the case, then the laddering of Bond ETFs for a specific time horizon (e.g. Gordon for his 10 year RESP) is correct enough for the timing of the ladder, but incomplete, in that it doesn’t include the Equities ETF component to reduce volatility during that 10 year countdown. Is my understanding correct that the principle of Bond-Equity balance for safety applies here too?
Re the conversation between Gordon and CCP: Would Gordon’s scenario be one in which it would be appropriate to use target-date ETFs? The amount he needs beginning 6 years from now would then be laddered into ETFs maturing as needed. There would be no need to realign the portfolio every year and need to sell any XBB before you’ve held it for its full duration.
@F. Johnson: Yes, another option for Gordon would be to use a ladder of four target maturity ETFs. This could be set up so one quarter of the amount matures in each of Years 7, 8, 9 and 10. The only issue here is that we are assuming that Gordon already has the entire amount saved and he simply wants to invest it for 10 years. If he is still adding money each month his RESP, this structure gets a little difficult to manage.
@Oldie: One of the most interesting (and paradoxical) ideas that came out of Modern Portfolio Theory in the 1950s was that adding a risky asset class to a portfolio can actually lower overall volatility. There is no magic formula, but in general, a portfolio of 80% bonds and 20% equities is likely to have lower volatility and higher expected returns than a portfolio of 100% bonds. That is why even the most conservative retirees should probably include a small slice of equities in their long-term portfolio: it actually lowers volatility.
That said, you still need to have an adequate time horizon that will allow the equities to recover from a downturn. That is not the case with an RESP investor. Gordon needs to be 100% certain that all of his capital is available in a specific year that he is paying the tuition. Any time your horizon is less than five years or so, you should probably not take any equity risk at all if you can’t afford to make up any shortfall.
@CCP
Sorry to belabour the point, but I want to make sure I get all your messages:
1) The lesson of your title article is that even bond etf’s are not completely safe, but trying to protect your bonds by predicting the market tactically and switching to short term bond etf’s is not a viable or profitable long-term strategy (except to tailor the bond term to lower your volatility in the context of your own cash-out horizon strategy).
2) Adding equity etf’s, usually a risky asset class in itself, can paradoxically provide stability and superior expected returns if added at, say 20% to a portfolio holding bond etf’s
3) Concerning the last point, you also need “an adequate time horizon” to allow the equities to recover from a downturn, which is why this strategy wouldn’t be appropriate for a 10 year horizon.
It’s this last point that I don’t fully understand. You demonstrated that a 100% bond etf (like XBB) portfolio would drop in value if interest rates rose. But that’s exactly what Gordon would own in year One of his 10 year RESP plan. If, rather, he had 20% in Equity etf’s would not the rise in value of the Equity component protect him? As you stated, if there were to be a 1% rise in interest rates for 3 years, the bonds etf would accumulate a 4.5% loss over 3 years (less, I guess, as you transfer to XSB), but wouldn’t you get a significant offsetting appreciation in the value of your 20% in Equity etf’s in real time?
Anticipating your answer, perhaps the benefits of Equity appreciation may not happen, and you could get a situation with decrease in both Bond and Equity component values. Or run the risk of a significant loss of value of your 20% Equity component, but not be able to compensate by increased Bond component value, because prevailing interest rates are so low now you essentially can’t get any lower. I suspect this must be the answer, and Gordon just has to white knuckle it the first year with 100% XBB, because that’s the optimum strategy, which is to say, the unavoidable risk is managed to its minimum.
Oldie, you may find this interesting. My 70% bond – 30% equity mix has not dropped more than 2.5% (at any time) from new highs that it has made over the last 2 years or more. Even during a 20% plus drop in the tsx. And again I made the mistake of going shorter (cbo) and going very light on US equities. I made the mistake of thinking and trying to make macro calls. I would have done better with some longer bonds and more US exposure. No one knows nothing is probably the best investment advice (realization) going.
@Oldie:
1) and 2) are both correct.
3) There is no guarantee that equities will spike during a period when bond returns suffer. Government bonds and stocks have some negative correlation, but correlation is only a tendency, not a certainty. I actually think it makes sense to include a small equity component in an RESP until you are about four or five years away from needing the money, but Gordon’s post suggested he wanted to keep everything in bonds, so that’s what I assumed.
I would be cautious about phrases like “optimum strategy.” There is really no such thing, because asset class correlations are not constant over time. We can make intelligent assumptions, but we can’t predict exactly how a portfolio will perform in the future.
I wish we had this discussinon back in 2007 before my portfolio fell off the investment cliff and lost significant value!
This is a great topic and fantastic discussion.
Someone mentioned that if interest rates rise rapidly that the Long Bond Fund will lose value. This is true and it is very important that you diversify your Bond duration to meet your time horizon. If your time horizon is long i.e. 15 + years then a Bond ETF like BMO’s ZLC is great, it will provide excellent yield and will benefit from the BoC bringing down the long term interest rate, as the fund value will rise while the yield stares to comes down. As for the interest rate risk, the fund will behave like a bond does upon maturity. The Bond does not lose it’s PAR value at maturity and the Bond ETF will not either, as it recuperates from interest rates hikes with an increase in yield. This will hold true as long as you hold the Bond ETF for the duration.
I would definitely keep a portion of my investment in short bonds and/or short target date maturity bond ETFs, as well as, a cash position. This will minimize exposure to volatility and will provide opportunity to buy stocks cheap if their is a correction in the near future. I do believe in keeping a balanced approach and am a Couch Potato Investor at heart but these volatile markets and global economic conditions had me tweaking my positions only because of my increased level of understanding and comfort level with Bonds ETFs has grown. Here is my investment break down;
70% Long Term Bond ETF (ZLC);
20% High Yeild Bond ETF (XHB and HYI);
5% Short Bond ETF Target Date (ZXA); and
5% Cash.
RESP is one component of my overall portfolio. Since it is registered account it is the place where I keep part of overall portfolio fixed income portion. RESP is also account where I like to count on investment proceeds on particular draw dates. That is why is structured as bond ETF ladder. I plan to contribute each of next 7 years , before end of high school. Each year contribution value will be added to XSB portion but adhering to defind ratios for each year. For example instead of seling 50%XBB to buy 50% XSB after year one I will say sell 40% of XBB and add contribution to purchase XSB, again maintaining ratio for the year.
raffael not sure if it works like that. A long etf will keep replenishing with long bonds as other bonds mature. That said duration is a moot point in the long run. The risk is how long do rates rise for. My understanding is that interest rate increase environments are usually severe but swift. Generally over within 18 months or so. That said your portfolio could experience some equity like volatility and paper losses. Take a look at the permanent portfolio for nice total return and low volatility. We can learn a lot from that asset mix.
@Dale: Bond ETFs do not hold typically hold bonds until maturity. A fund like iShares XLB, for example, must sell any bond as soon as it is 10 years from maturity, because at that point it is not a long-term bond anymore.
Duration is not a moot point if it exceeds your investing horizon. If the duration of your bond fund is seven years (as with XBB) and you need the cash in three years, you may find yourself with a loss of capital. So Raffael is right that you should probably have a long horizon if you want to use long-term bonds (XLB’s duration is almost 14 years).
Well, I’ll be…
I signed off for a few hours and came back to find the old forum beavering away. And I learned yet one more vital fact.
“Bond ETFs do not hold typically hold bonds until maturity. A fund like iShares XLB, for example, must sell any bond as soon as it is 10 years from maturity, because at that point it is not a long-term bond anymore.”
Kind of obvious, now you put it that way, but there you go, I needed to be told before I knew! Wow, I have moved from knowing very little about bonds to being at least on passing knowledge with quite arcane bond characteristics, just from reading the little lectures and then carefully following the animated discussions that result!
THIS IS AN AWESOME WEBSITE!
In keeping with the spirit of questioning triggering more thoughtful answers, @Gordon, now that you’ve sort of explained why you only have bonds in your RESP…
“it is the place where I keep part of overall portfolio fixed income portion. RESP is also account where I like to count on investment proceeds on particular draw dates. That is why is structured as bond ETF ladder. ”
This would make some sort of sense if the anticipated withdrawal of the cash was imminent. But
I think you explained that the first dollar scheduled to come out was still 6 years down the road. From what I’ve just learned, that seems like a long time to hold bonds or bond equivalents if you accept the general premise that bonds in isolation can be volatile. You may rationalize by thinking that these bonds are not in isolation, because they are only part of your big “Mega-Portfolio” with equity held elsewhere in other holdings outside your RESP. But if the value of your bonds goes down early in the game say, due to an unexpected rise in interest rates, by the time you have sold the bond (as per your planned schedule) for a loss and bought more bond component (also as per plan), the sum compounded total of your losses cannot be offset by your gains in the Equity portion elsewhere, as there is no way to bring these gains from outside into the RESP (any more than the allowable contribution dollar limits) so you end up selling the 75% XSB in year 6 for less education dollars than you planned, or to put it another way, bond ETF’s in isolation can have some volatility whose risk can be mitigated somewhat by adding, say, a 20% equity component, and holding this proportion at least until you get a little closer to winding down the RESP fund. Do you have a worse scenario that is just as likely to occur that you are trying to avoid by holding only bond ETF’s (and later cash) from now on until the closing of the RESP?
@ccp, i think we’re saying the same thing, sort of. etf’s are not like buying individual bonds, because there are always bonds going out and coming in.
if you buy a 7-year average duration bond etf, though, the only thing that matters when you want to ‘cash out’ is which way are interest rates moving when you want to cash out. if they are rising again (there could have been a couple of cycles) you could face a capital loss. because near the end of your period, your time frame is one year and you’re still holding a basket of long bonds.
that said, you may have suggested to shorten along the way, but at that point you could be taking capital losses to reinvest into shorter bond etf’s.
Raffael, you might want to take a look at some US dividend etf’s to sprinkle in, as well as xei for Canada (pays over 5% and holds a great basket). there are utility etf’s for nice income.
xtr is a very nice high income multi asset class etf. and there are detractors but i really like the bmo zwb covered call writing on canadian banks. 9% yield. i am biased because i have bought low and have capital gains (position) on that as well, but i believe over the years that will prove to be a great investemnt for income and captial gains.
But again. 20-30% equities can moderate volatility and offer the opportunity to boost income above what bonds will currently pay.
Dale, I am a fan of covered calls because of the increased yields they provide.
ZWB and ZWU look like great products. I did hold ZWB for a short time but I am moving away from stocks at this time do to the global uncertainty. As I mentioned in my previous posts.
I think I will sit in Bond ETF’s for a little while and rebalance and adjust my portfolio in 6 months to reflect the global market conditions at that time.
I am not an active trader but I do believe that these turbulent times do require more active management of ones assets. I will reconsider those investments at that time. XTR looks very interesting, especially when you look at it’s volatility over the last 3 years.
ETF’s are a great product, have you ever considered building your own stock portfolio replicating the holdings of an ETF? Bond ETFs and Covered Calls excluded as these funds would require either a much more active approach or not enough diversity in terms of Bond Funds.