Bond Basics 2: Why Your ETF Isn’t Losing Money

In my latest podcast, I answer a series of frequently asked questions about bonds. The second of these came from a reader named Andrew: “I have been investing using your Couch Potato strategy for just over three years now,” he wrote. “However, does it still make sense to invest in bonds when they are continually losing money?”

As it happens, bond ETFs have not been “continually losing money” at all. Indeed, over the three years ending March 31, broad-based funds such as the BMO Aggregate Bond Index ETF (ZAG) and the Vanguard Canadian Aggregate Bond Index ETF (VAB) returned close to 4% annually, with positive returns in each calendar year. A $1,000 investment in either ETF would have grown to about $1,120 over that period. So why would an investor think he had lost money?

I don’t blame Andrew for being confused, as this one trips up a lot of investors. The problem lies in the way brokerages display the holdings in your account. Rather than calculating the total return on your investments—which would include both price changes and all interest payments and dividends—your list of holdings reflects only the change in market price. This makes sense for calculating capital gains and losses, but it can be highly misleading for investors who want to measure performance.

Let’s break this down to understand what’s happening.

Half the story

Say you bought 500 shares of ZAG about two years ago, on March 31, 2015. On that date the ETF was trading at $16.37 per share, so your shares cost you $8,185. Two years later, on March 31, 2017, ZAG was trading at $15.70, so your 500 shares were now worth $7,850, a decline of about 4%. When you log into your account, your holdings will look something like this:

Symbol Quantity Book Value Market Value Change ($) Change (%)
ZAG 500 $8,185.00 $7,850.00 -$335.00 -4.09%

At this point you’re cursing your decision to buy bonds, as this supposedly safe part of your portfolio has lost you $335. Right?

Wrong. The problem here is you’re ignoring all of the interest payments ZAG made over the last two years. It turns out those cash distributions amounted to about $0.93 per share, which more than offset the decline of $0.67 per share. That made the difference between a loss and a gain on your investment. You started with $8,185, and after two years you had 500 shares worth $7,850 plus $465 in interest, for a total of $8,315. That modest gain is hardly cause for celebration, but it’s certainly not a 4% loss.

Unfortunately, you may not have noticed this because the interest payments are paid into the cash balance of the account. At some point you probably reinvested that cash when buying new shares of some other ETF. But if you calculate your rate of return properly, using the total value of your account at the beginning and the end of the period, you’ll see a positive return.

Why this happens

As discussed in the previous post in this series, bond prices fall when interest rates rise. But even during periods when rates stay more or less the same, you will still see the price of most ETFs decline gradually, even over long periods.

This happens because most bonds today are premium bonds, which means they trade at more than their face value. This situation has come about because interest rates have trended downward for many years now, so most bonds issued in the past have coupons higher than prevailing rates. Investors pay more than face value to get those higher rates, but premium bonds will eventually mature at face value, resulting in a capital loss.

If your ETF is filled with premium bonds—at it almost certainly is—it will experience a series of small losses like this as the bonds approach maturity. That translates into a gradual drop in the ETF’s price during any period where interest rates do not fall significantly.

One way to anticipate this price decline is to look at two characteristics of your bond ETF, which you can find on its web page: the fund’s average coupon and its yield to maturity. The former tells you roughly how much you can expect in interest payments, while the latter estimates your total return, including interest payments and any price change.

If the coupon is higher than the yield to maturity—and again, these days it almost always is—then the fund is dominated by premium bonds. Today the average coupon on ZAG is about 3.35%, while its yield to maturity is 1.91%:

That means if interest rates don’t change, you should expect the price of this fund to decline by roughly 1.44% (that’s 3.35% minus 1.91%) a year. It will never be that tidy because interest rates change constantly, but the key point is that any bond ETF filled with high-coupon premium bonds should be expected to fall in price over time.

Where to get accurate numbers

If you want to know how your bond fund has performed in the past, the best method is to look it up on the ETF provider’s website. ZAG’s webpage, for example, reports the following total returns for the period ending March 31, 2017:

One important note: whenever ETFs report their returns, they assume all cash distributions are reinvested immediately. With an ETF this is impossible, even if you are using a dividend reinvested plan, because some portion of the interest or dividends will always end up as part of your cash balance. So your personal rate of return will never be precisely what’s reported on the provider’s website. But it will be close enough. And at the very least, you will no longer believe you’re losing money with your bond ETF during years when you’re actually netting a gain.

 

36 Responses to Bond Basics 2: Why Your ETF Isn’t Losing Money

  1. Scotty April 26, 2017 at 11:28 am #

    Thanks for the post Dan.

    Hypothetical question: if you could get a 3% high-interest savings account (indefinitely, not just for a promotional term)…would you switch the bond allocation to it?

    I guess a better question would be, at what rate would it make sense to switch to a straight up savings account?

    I feel like when a savings account is yielding 1-2% above aggregate bond YTM it’d be worthwhile to switch (even though you lose the negative correlation benefit).

  2. Canadian Couch Potato April 26, 2017 at 12:13 pm #

    @Scotty: I would say that a 3% guaranteed savings rate would offer a very compelling reason to forgo bonds. I just don’t know how any bank could offer such a rate indefinitely when even 5-year GICs are paying only about 2%.

    http://canadiancouchpotato.com/2015/05/07/should-you-replace-bonds-with-cash/

  3. Braj April 26, 2017 at 12:15 pm #

    @Scotty,

    “I feel like when a savings account is yielding 1-2% above aggregate bond YTM it’d be worthwhile to switch (even though you lose the negative correlation benefit).”

    I would argue that the negative correlation is the main benefit.

  4. Greg April 26, 2017 at 12:17 pm #

    Good post, Dan. Another reason, other than the dividend yield myth, to focus on total return.

    I have another somewhat related question. I noticed the BXF is called a strip bond ETF, yet pays a quarterly distribution. Where does the money for this distribution come from, given that strip bonds don’t pay periodic interest? Is it due to the limited market for strip bonds in Canada?

  5. Canadian Couch Potato April 26, 2017 at 12:29 pm #

    @Greg: My understanding is that First Asset simply holds a small amount in cash in the fund to pay out this small distribution, presumably to counter the objection many investors have about being taxed on income they don’t actually receive.

  6. Ben April 26, 2017 at 1:16 pm #

    Hey Dan.

    I recently helped a retiree with their investments, and chose to allocate 80% to bonds. Would you say that choosing VSB over VAB is a good choice due to the shorter-term of the bonds? This individual is 80 years old.

    Thanks

  7. John April 26, 2017 at 3:12 pm #

    With “Premium Bonds” you pay a higher price because the bonds pay an above market interest rate. The higher interest is offset by the capital loss of the bond.

    The problem with this is that the interest you receive is taxed at your full marginal rate while the deduction for the capital loss is only for half of the loss (50% inclusion rate). Also the capital loss deduction can only be used to offset a capital gain.

  8. Canadian Couch Potato April 26, 2017 at 3:25 pm #

    @John: Absolutely correct! This is why premium bonds and traditional bond ETFs are a poor choice in taxable accounts:
    http://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/

    @Ben: Every case is different, but for an 80-year-old one would presume that low volatility is important and therefore short-term bonds are likely a better choice.

  9. Roberto April 26, 2017 at 6:21 pm #

    Hey: great podcast. I loved the information density in this one.

    I’m still trying to decide on ZDB vs ZAG (and sorry you weren’t able to get into it a bit more!). Currently holding ZAG in a TFSA and an unregistered account, and I’m not in the highest tax bracket.

    To make matters tricky for me to figure out the advantage, I’ve noticed two things:
    1) ZDB currently lists a coupon (2.12%) greater than the yield to maturity (1.77%) at https://www.bmo.com/gam/ca/advisor/products/etfs?fundUrl=%2FfundProfile%2FZDB%23overview#fundUrl=%2FfundProfile%2FZDB%23overview. So it’s clearly not a discount bond index right now, maybe because of a trend to falling interest rates?
    and
    2) The YTMs are not identical between ZAG (1.91%, https://www.bmo.com/gam/ca/advisor/products/etfs?fundUrl=%2FfundProfile%2FZAG%23overview#fundUrl=%2FfundProfile%2FZAG%23overview ) and ZDB (1.77%).

    So I now have to compare an apple to different flavour of apple (they’re both effectively premium bond indices), with a different tax constraint, to try to figure out which bond has the advantage!

    I think I do this by comparing the difference in taxable coupons (3.35% [ZAG] vs. 2.12% [ZDB]; difference of 1.23%) against the difference in yields to maturity (1.91% [ZAG] vs. 1.77% [ZDB]; difference of 0.14%) in the context of my tax bracket. Does an extra 1.23% of my principal, taxed at my highest marginal rate, exceed (offset) the 0.14% extra yield of that same principal provided by ZAG? If yes, I’m better off with ZDB?

    I’m hoping my approach is reasonable. Any comments you might have would be fantastic! Thanks for the great content.

  10. Canadian Couch Potato April 26, 2017 at 6:30 pm #

    @Roberto: The decision is simple: use ZDB in a taxable account and ZAG in a registered account. This helps explain why ZDB does not hold only discount bonds:
    http://canadiancouchpotato.com/2015/03/09/when-discount-bonds-are-hard-to-find/

  11. Jacqui April 27, 2017 at 8:40 am #

    Thanks so much for these posts explaining bond funds. I have been using the TD fund couch potato plan for many years and I track weekly in a spreadsheet the money in each fund, the number of shares and the price per share. I find the reports by various funds to be confusing so this allows me to see exactly how much growth or loss I have had in actual dollars. The balance in my TD bond e-fund has grown 3% over the last twelve months (after adjusting for balancing transfers) even though the share value is only up by one cent. So yes, my bond fund is certainly making money for me.

    My only regret about following the couch potato plan is that I didn’t start it sooner!

  12. Bruno April 27, 2017 at 8:58 pm #

    Hi Dan,

    I am using TD E-Series Mutual Funds to invest in a taxable account, following your podcast recommendation that you said they are easier to track Average Cost.

    Should I be aware of any tax efficiency strategy when using E-series? I just read your comment to use ZDB instead of ZAG in taxable accounts. (Reference: Post Model Portfolio Update for 2017).

    Thank you!

    PS: I am missing ‘Baaaad Investiment Advices’ in your podcast 😀

  13. James April 27, 2017 at 9:42 pm #

    So, this raises a question for me: If I’m running a couch potato strategy, and have X% in bonds, how do I factor this cash value vs. interest into my re-balancing? Do I ignore the interest part, and just re-balance by the cash value? (this is my instinct) Or should I figure out what the ‘net value’ of my bonds are, and balance against that number?

    thanks,
    James

  14. caltran April 28, 2017 at 12:24 am #

    And this is why everybody has to have bonds. Those returns are too good to turn away.

    I miss the old days in the 90s when my bond fund paid me 10% a year. Good times.

  15. Canadian Couch Potato April 28, 2017 at 8:02 am #

    @Bruno: The TD Bond Index Fund is not tax-efficient and should probably be avoided in a non-registered account. If you aren’t able or willing to use an ETF, you might consider a combination of GICs and cash for your fixed income.

  16. Canadian Couch Potato April 28, 2017 at 8:04 am #

    @James: For purposes of rebalancing, you would simply use the market value of the fund. That is the net value of your bonds.

  17. Bruno April 28, 2017 at 11:33 am #

    */ @Bruno: The TD Bond Index Fund is not tax-efficient and should probably be avoided in a non-registered account. If you aren’t able or willing to use an ETF, you might consider a combination of GICs and cash for your fixed income /*

    Dan,

    In a non-reg account my total portfolio is 15k (bonds are 9k) and I will not invest more (specific goal in mind). Should I care about tax-efficiency in this case? I am just remembering here one of your top advice: keep it simple.

  18. Canadian Couch Potato April 28, 2017 at 11:36 am #

    @Bruno: That’s up to you, though I would probably agree that $9K in a tax-efficient fund is not a disaster.

  19. Bruno April 28, 2017 at 11:42 am #

    */ @Bruno: That’s up to you, though I would probably agree that $9K in a tax-efficient fund is not a disaster. /*

    Thanks a million!

  20. Murray April 28, 2017 at 1:43 pm #

    Great explanations again!

    Since I have a taxable account and have no need to use “fixed income” for income, I sold the VAB and bought HBB.

  21. Walter April 29, 2017 at 6:32 am #

    Some high-interest savings accounts are offering 2% or close to 2%, greater than the yield-to-maturity for many bond ETFs currently. Should I just keep my fixed income in cash for now, given these rates?

  22. Canadian Couch Potato April 29, 2017 at 9:41 am #

    @Walter: I address that question in the podcast and here:
    http://canadiancouchpotato.com/2015/05/07/should-you-replace-bonds-with-cash/

  23. Jake May 1, 2017 at 3:15 pm #

    @CCP

    Bit off topic but could you give us a take on the Home Capital situation for GIC holders. I have a Home Trust GIC maturing next year which was purchased through BMO investorline. Some questions me and others likely have would be, if Home Cap goes under would my GIC continue to earn interest till maturity and I would see my principal and interest paid to me on mauturity? A rundown on what to expect for us GIC holders who have not had to deal with a bank bankrupt before

  24. Canadian Couch Potato May 1, 2017 at 4:24 pm #

    @Jake: This could play out in several ways: the crisis could pass and Home Capital could continue making all interest payments as usual; another financial institution could purchase Home Capital and assume its obligations; or the company could default on its GICs and CDIC would step in to make investors whole.

    As long as you are under the CDIC limit of $100K you should expect to receive all of your principal no matter what happens. My understanding is that CDIC protection only covers the period up to a default, so if you still had a couple of years before maturity you might forfeit some future interest.

  25. Daniel May 2, 2017 at 5:50 pm #

    Hi Couch Potato!

    For the next few years, until interest rates are higher, would you still recommend putting money into bond ETFs? Or to keep the bond allocation of one’s portfolio in cash?

  26. Oldie May 3, 2017 at 3:10 pm #

    @CCP:

    I just love the Blog Posts. They are clear and methodical and they have the bonus of being easy to re-read and search later on.

    I have trouble sometimes keeping focus when listening to the Podcasts — maybe it’s a symptom of age. But they make a lot of sense if I can keep from losing focus, so I find them very valuable to listen to — maybe it’s more educational to listen to something you’ve already read and digested because it uses a different part of the brain. But it’s hard to rewind accurately and listen again if I miss a point. I was going to ask if you could supply transcripts of the podcasts, but I know that would be very labour intensive.

    But maybe there is method in your approach that I haven’t quite sorted out yet. Is this current Blog post essentially part of the summary of the gist of the last podcast? If so, can we expect that this written review of previous audio material will follow after podcasts? If this is so, then I won’t worry in future about how to review the material I hear in the podcast but can’t remember the details, and transcripts won’t be important after all.

  27. Owen May 4, 2017 at 8:01 am #

    Nice explanation Dan. I remember being quite confused when first buying bond funds, especially between the three different yield numbers, coupon, distribution and weighted average to maturity.

    Bonds are a tricky thing to understand, in many ways more complicated than equity ETFs.

  28. Marcel May 4, 2017 at 7:29 pm #

    Hello Dan. I have a quick question on bonds, and maybe from an angle that you don’t intend on covering in your series. What are the tax implications of holding a USD traded bond ETF in a non-registered account for a Canadian investor? From my perspective, I wouldn’t mind a bit more USD income, and already have significant USD holdings (VGK/VWO/VTI/VPL/VT) from when I first setup my ETF portfolio in 2009 and the Canadian options were limited, so my accountant already has to worry about the extra form come tax time. Along with that, I’m also at the point where my RRSP/TFSA are about a fifth of my total holdings, meaning that even at 25-30% for bonds I’m having to hold a fair amount of them in non-registered accounts. I also already have USD savings account, Visa, etc. I have no intent of living in the US, but it’s always handy having some US cash around for trips, Amazon, etc.

    So if I were to purchase an American bond fund that is the equivalent of VAB/XBB, are the tax implications essentially the same? Or are there complications from a tax efficiency perspective to be aware of? If it’s more or less the same as holding a Canadian bond fund, then are there American equivalents to BXF or ZDB that may be a better holding?

    Thanks as always for your efforts to educate us Canucks!

  29. Canadian Couch Potato May 4, 2017 at 7:38 pm #

    @Oldie: I don’t really have a consistent process regarding the blog and the podcast. I knew the bond podcast was complicated, so I thought it made sense to reinforce it with a couple of blog posts, but I don’t think I will be doing that every time.

  30. Canadian Couch Potato May 5, 2017 at 8:10 am #

    @Marcel: Thanks for the comment. I do not recommend using US bond ETFs:
    http://canadiancouchpotato.com/2012/03/01/ask-the-spud-should-i-hold-us-bonds/

    The role of bonds in a portfolio shouldn’t be to generate spending money: they’re primarily there to reduce volatility. But bonds denominated in foreign currency will likely increase volatility. They will also be very tax-inefficient in a non-registered account.

  31. Oldie May 5, 2017 at 10:49 am #

    @CCP: OK, ad hoc approach (yes it was rather complicated), I got it — no problem. The podcasts are still a new feature, and I’m sure the support structure around them, or documentation, will evolve over time as needed. Will follow with interest.

  32. Chris May 7, 2017 at 7:34 pm #

    It’s interesting. I invest in the TD E-Series Bond index fund (I have a couch potato portfolio) and I listened to your podcast very intently as I find bonds very confusing. It was very helpful and I feel that I now have a better understanding how bonds work, so many thanks!. In thinking about it after the fact though, I feel I am now becoming more confused! Individual bonds……yeah, makes total sense now with how you broke it down. However, how does a bond index fund work? The TD E-series Bond index fund tracks some mysterious index which confuses me to no end. All I see is the number of shares I have and its current price which equals my funds book value. I think that this would be an excellent idea for another podcast.

  33. Canadian Couch Potato May 8, 2017 at 8:24 am #

    @Chris: Thanks for the comment, and the great suggestion. There is indeed a lot of confusion about how bond funds differ from individual bonds, so I will see what I’m able to put together.

  34. Jon May 16, 2017 at 8:17 am #

    Dan, thanks for all the info you’ve provided and shared over the years. It’s been terribly helpful.

    Given that the premise of this post is that many people just look at market value vs. total return and that I suspect the reason for this is because brokerages and online tools like Google Finance don’t calculate or display total return very well, I thought I would share one free online resource that does. I only learned of it a few months ago and it has changed the way I view my portfolio’s performance.

    The website is https://www.sharesight.com/ca/.

    It allows you to import your trade history straight from your statements and updates with issued dividends etc. It takes a touch of getting used to, but I believe fellow readers will find its breakdown of total return very helpful. There is a paid version, but for those with CCP type portfolios (under 10 funds) the service is free.

    I have no affiliation with the website. I just find it very helpful and thought I would share.

  35. Greg June 9, 2017 at 4:05 pm #

    With the Canadian Foreign Affairs Minister calling the USA no longer able to being a world leader, would this change your prospective on the TD Eseries or Tangerine CP method? Typically I would follow your advise and portfolio ideas but I have never seen the USA fall into a category like this before. How do you think this will reflect the USA portion of the portfolio. Thank you.

  36. Canadian Couch Potato June 11, 2017 at 10:07 am #

    @Greg: Once you go down this road it’s a very slippery slope. Changing your long-term investment strategy based news headlines and current events is one of the best ways to sabotage yourself.

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