Podcast 7: Making Sense of Bonds

I’ve always felt that being a defenseman is the toughest job on a hockey team. Forwards score most of the goals, and goalies can steal the show with a few timely saves, but fans rarely notice a defenseman until he makes a mistake. Bonds get that same lack of respect from investors: everyone seems to forget the times they provided a safety net when stocks plummeted, but if they lose a few percentage points they get kicked to the curb.

Part of the problem is that bonds can be difficult to understand. So in my latest podcast, I devote the full episode to answering common questions about the asset class investors love to hate.

I previewed this episode in my last post about why bond prices fall when rates rise, and I’ll continue with a series of blog posts that expand on some of the other issues discussed in the podcast:

  • If you started investing in bond ETFs about three years ago, chances are good that your holding is showing a loss on your brokerage statement. So you might be surprised to learn that broad-based bond index funds returned close to 4% annually over the three years ending March 31. I’ll take another look at why many bond investors think they’re losing money even when they’re actually netting a positive return.
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  • I continue to get asked why anyone would invest in bonds when interest rates have “nowhere to go but up.” Does anyone still think they can forecast interest rates?
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  • If you want to reduce the volatility in your portfolio but you prefer to avoid bonds, can you use cash or GICs instead?
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  • Investors who focus on yield may elect to use real estate investment trusts (REITs) or preferred shares as substitutes for fixed income. These asset classes might have a role in a diversified portfolio, but not as a replacement for bonds or GICs.

Stay tuned over the next couple of weeks as I take a deeper dive into fixed income.

 

19 Responses to Podcast 7: Making Sense of Bonds

  1. John April 19, 2017 at 12:39 pm #

    I love your work and I’ve been trying to subscribe to your podcast in iTunes but it’s not working.

    It’s listed in iTunes and I can click the “Subscribe” button, which seems to do something, but then the podcast never appears in my list. I’ve looked online to see what the issue might be but I’ve been unable to find a solution or even a description of this issue.

    I subscribe to many other podcasts without any problem. Perhaps others might know what to do or what the issue might be.

    In any case, thanks for all your good advice.

  2. Jason April 19, 2017 at 12:44 pm #

    Another great podcast, Dan. Very clear explanations.

    Definitely felt the absence of the Bad Investment Advice segment in this episode. 🙂

  3. Canadian Couch Potato April 19, 2017 at 1:09 pm #

    @John: Sorry to hear you have had problems subscribing. I have not heard from others with the same issue, so I’m not sure what to suggest. Are you able to manually download the previous episodes?

  4. rg April 19, 2017 at 1:50 pm #

    You never addressed target date maturity bond etf’s, I was hoping you would. With them, can you get all of your original capital back and collect the interest? With most of the bond etf’s right now, you’re looking at a loss of principal combined with gain of interest for net positive.

  5. Mr Total Return April 19, 2017 at 3:26 pm #

    Dear Dan

    Great work. What is meant by a total return bond fund?

    For example, the PH&N Total Return Bond

    TR

  6. Canadian Couch Potato April 19, 2017 at 3:45 pm #

    @Mr: I’m not sure this is a generally used term, but the idea here is that the fund does not focus on yield and income Instead, the bonds are selected based on their expected total return, which includes price appreciation. For example, an income-oriented investor would never buy a strip bond, which pays no coupon: instead, you buy them at a discount and they mature at face value. But a total-return bond fund might.

  7. John April 19, 2017 at 4:08 pm #

    @CCP

    Thank you for the reply. After your suggestion, I tried and was able to download (“Get”) individual episodes in iTunes. Amazingly, they download under another podcast I subscribe to (titled “Missing & Murdered). Obviously, there’s something wrong with my setup. In any case, this ends up being a workaround for now and allows me to listen to the podcast when I’m out and about.

  8. Carl April 19, 2017 at 4:49 pm #

    hi Dan, thank you for this information..very clear!!…quick question, do nominal bonds keep up with inflation? if so, which type of bond ETF (i.e short term, intermediate, long term) will be most appropriate to at least keep up with inflation? thank you for your great work

  9. Yohan April 19, 2017 at 9:19 pm #

    I moved to bond bear position after the US rate hike in 2016 because how dependent Canadians are to US products (exchange rate pressure) and its the first time US has higher rate than Canada since the crisis.

    Currently I am holding no bond and moved them into GICs.

  10. Canadian Couch Potato April 20, 2017 at 8:18 am #

    @Carl: This cannot be known in advance. All one can do here is to look at the current yield to maturity of a bond or bond fund and compare it to the most recent inflation figures and assume neither will change significantly. Right now inflation is running at about 2% (a reasonable long-term assumption) and the yield on a broad-based bond fund is about the same, maybe a little less after fees. Short-term bonds are yielding less than inflation.

  11. Alex April 21, 2017 at 8:41 am #

    Hi Dan,

    What are your thoughts on repaying low interest debt instead of bonds (for example, a Mortgage/HELOC)? This would have the same upside as GICs (and the same down sides as GICs) but would provide a higher return.

  12. Canadian Couch Potato April 21, 2017 at 8:45 am #

    @Alex: I don’t think the question should be considered in terms of “pay off debt vs. buying bonds” specifically. It’s really more about whether to pay of debt before investing, period. The details matter a lot, but it usually makes sense to pay off debt before investing in a non-registered account. If you’re in a high tax bracket, you can make a better argument for prioritizing an RRSP over low-interest mortgage debt.

  13. jeff slomke April 21, 2017 at 3:33 pm #

    another great pod cast, this site has the best financial advice out there

  14. NRD April 21, 2017 at 3:42 pm #

    That was a great podcast, Dan, thank you as always. I recognize there is a place for both bond ETFs, GICs and cash. However, I am wondering what has to happen to interest rates for VSB (short term bond fund holding 30% corporate debt and with YTM=1.3%, Duration 2.8 and Average Maturity of 3.0 years) to beat a one year GIC at 2.09%, a 2 year GIC at 2.12% and a 3 year GIC at 2.2%.

    I know I can’t predict interest rates. I know that Japan has had 15 to 20 years of a near zero interest rate environment for 15 to 20 years so things can stay low or even decline.

    Still, it would be helpful to know what kind of a pattern of interest rates over the next 2-3 years would have to transpire for me to get a better return on VSB than with these kind of GICs.

    Does anyone understand the dynamics of bond ETFs to hazard a guess?

  15. Canadian Couch Potato April 22, 2017 at 1:01 am #

    @NRD: Thanks for the comment. Duration is a measure of interest rate sensitivity: if VSB has a duration of 2.8 it means that the fund will rise in value by about 2.8% if short-term interest rates fall by one percentage point, or fall 2.8% if rates rise one percentage point. Realistically such a large move is unlikely, so it may be better to think in terms of 28 basis points in price change for every 10 basis points in rate movement.

    With that in mind, rates would have to fall significantly for VSB to return over 2%. But remember that the main reason GICs pay more is that they are illiquid. You cannot sell a 3-year GIC, but you can sell a bond fund any time. Investors are compensated for the “illiquidity risk” of the GIC. So if you know for sure you will not need the money before maturity, then use a GIC. If you want the flexibility, then a bond ETF offers that.

  16. John J April 24, 2017 at 11:34 am #

    Hi Dan, another reason to hold bonds can be illustrated with math. Bond is less volatile than equity. For the exact same average annual return, a less volatile portfolio will end up with more money than a volatile one.

    A portfolio with year one 20% return, year two with -20% return, year 3 with 20% return, year 4 with -20% return and year 5 with 5% return. That’s an average annual return of 1%. A $100 investment at year 0 will turn into $96.77 at the end of year 5. However in a less volatile portfolio consistently returning 1% each year, a $100 investment will turn into $105.10 at the end of year 5.

    I guess the message is that for the exact same average annual return, a less volatile portfolio will end up with more money than a portfolio with more volatility…and bonds make your portfolio less volatile.

  17. Canadian Couch Potato April 24, 2017 at 12:13 pm #

    @John J: It’s true that less volatility means greater compounding with the same average return. But your example only works when you are combining asset classes with the same long-term expected return (like, for example, Canadian, US and international stocks). But bonds have a lower expected return than equities, so we cannot assume that an all-equity portfolio and a balanced portfolio will have the same average return. The reduction in volatility comes at the cost of lower returns.

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