Archive | Bonds

The Real Problem With Inflation-Protected Bonds

When I announced my stripped-down model portfolios at the beginning of last year, one of the asset classes I dropped was real-return bonds (RRBs). Part of the reason was simplicity: it’s easier to manage a portfolio of three or four funds compared with five or six, and you’re not giving up much diversification. But there was a more important reason for booting real-return bonds from my recommended portfolios.

First, a quick refresher. RRBs are a type of government bond designed to protect investors from the effects of inflation. Both their face value and interest payments are pegged to the Consumer Price Index and adjusted twice a year, which means you’re guaranteed to maintain your purchasing power over the life of the bond. That feature overcomes one of the biggest shortcomings of traditional bonds.

There’s little question that RRBs are useful in theory. Consider a retiree who needs $50,000 annually to meet her expenses today. She could build a 10-year ladder of traditional bonds with a face value of $50,000 each, but by the time that last bond matures $50,000 won’t buy as much as it used to.

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The Curious Case of the BMO Discount Bond ETF

When the BMO Discount Bond Index ETF (ZDB) was launched back in February 2014, it was unique: the first broad-market ETF in Canada made up primarily of bonds trading below their par value. By avoiding premium bonds, ZDB promised to deliver similar returns to traditional bond funds, but with greater tax efficiency, making it ideal for non-registered accounts. With a little more than two years of real-word performance, it’s time for a checkup. Has ZDB delivered on its promises?

Top of the heap

The first question we’ll examine is whether ZDB achieved pre-tax returns similar to other broad-market bond ETFs. The fund was designed to match the popular FTSE TMX Canada Universe Bond Index in credit quality, average term, duration and yield to maturity. But ZDB set out to achieve this profile using bonds with lower coupons to reduce the amount of taxable income.

As it turns out, ZDB outperformed all of its competitors in 2015. Here are the NAV returns for the calendar year:

BMO Discount Bond
ZDB
3.60%

Vanguard Canadian Aggregate Bond
VAB
3.48%

iShares Core High Quality Canadian Bond
XQB
3.38%

BMO Aggregate Bond
ZAG
3.24%

iShares Canadian Universe Bond
XBB
3.15%

Sources:  BMO ETFs,

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The Trouble With Bashing Bond Indexes

In my last post, I looked at a tired criticism of traditional equity index funds. Similar arguments have been made against fixed-income index funds, most recently in a blog post called The Trouble With Bond Indices produced by Mawer Investment Management. And once again, they don’t hold up to scrutiny.

First the background. Bond indexes, like their equity counterparts, are usually weighted by market capitalization. This means governments and companies that issue the most bonds (by dollar value) receive the largest weight in the index. Most index investors in Canada use funds that include only domestic bonds, and typically these are roughly one-third federal government bonds, one-third provincial and municipal bonds, and one-third corporate bonds. Global bond index funds are much less common in Canada (only Vanguard offers an ETF in this asset class), but the principle is the same: countries that issue the most debt receive the greatest weight in the index.

You may have already spotted the potential red flag: the more debt a country or company has on its books, the more of its bonds you’re likely to own if you use an index fund.

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How Changing Interest Rates Affect Fixed Income

It’s been a tough few months for bonds. Since early February, the yield on Government of Canada five-year bonds has climbed from 0.59% to about 1.07%, and 10-year bonds yielding 1.24% have ticked up to 1.82%. The seesaw relationship between yield and price means bond values have fallen sharply: over the same period broad-based index ETFs such as the Vanguard Canadian Aggregate Bond (VAB) have lost well over 3%.

A 3% decline over several months is modest—it’s a bad day for stocks—but bond investors have been so accustomed to steady gains in recent years that it’s caused a lot of anxiety. More worrisome, it’s revealed that many investors have some fundamental misunderstandings about the relationship between bonds and interest rates, which admittedly can be confusing. Inaccurate information leads to poor investment decisions.

If the last five years have taught us anything it’s that forecasting the direction of interest rates is futile, and countless armchair economists have paid the price for trying to do so. A better approach is to get out of the guessing business and simply understand the risks of various fixed income investments.

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Should You Replace Bonds With Cash?

Not many investors are enthusiastic about bonds these days, and it’s hard to blame them. While rates have ticked up in the last few weeks, they’re still so low that even some sophisticated investors have abandoned them altogether. I’ve spoken to some investors who are ready to follow that advice, though they are not prepared to ride the roller coaster of a 100%-equity portfolio. So they’re asking whether they should just swap their bonds for cash.

At first blush, this looks like a good strategy. As of May 6, the yield to maturity on short-term bond ETFs is barely 1% after fees. Even broad-based bond ETFs (which have average maturities of about 10 years) have a yield to maturity well below 2% after accounting for management fees. Meanwhile, most investment savings accounts (ISAs) are paying at least 1%, and if you hunt around you can find high-interest savings products with much better yields: Equitable Bank offers one at 1.45%, while People’s Choice has a savings account at 1.60% and a TFSA savings account at 2.25%. Why take risk with a bond ETF when you can get a higher yield from cash,

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Ask the Spud: GICs vs. Bond Funds

Q: I would appreciate it if you could write an article contrasting the advantages and disadvantages of holding bond funds versus GICs. – A.R.

All of my model Couch Potato portfolios include bond funds, and I’m frequently asked whether a ladder of GICs would be a good substitute. In many circumstances the answer is yes. Indeed, our clients at PWL Capital often hold a combination of bond funds and GICs in their portfolios, because these two investments each have strengths and weaknesses. Let’s look at the relative advantages of each.

When GICs are preferable to bond funds

Higher yields. As of March 25, the yield on five-year federal bonds was 0.75%, while you can easily find five-year GICs paying over 2%. Normally higher yield means higher risk, but both federal bonds and GICs are backed by the Government of Canada: GICs up to $100,000 are insured against default by the Canadian Deposit Insurance Corporation.

Tax efficiency. These days just about all bond funds are filled with premium bonds, which are notoriously tax inefficient. Premium bonds pay a lot of taxable interest and then suffer capital losses when they mature.

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When Discount Bonds Are Hard to Find

Everyone loves a discount, but if you’re buying bonds these days you may be out of luck.

Just over a year ago, the BMO Discount Bond (ZDB) was launched as a tax-efficient alternative to traditional bond ETFs. ZDB tracks the broad Canadian market, but it selects bonds trading at a discount, or at a very small premium. Discount bonds have a lower coupon than comparable new bonds, and they will mature with a small capital gain. That combination is more tax-efficient than premium bonds, which have higher coupons and mature at a loss.

A discount bond ETF is a great idea for non-registered accounts, but it faced challenges from the beginning. After many years of interest rates trending downward, there simply aren’t many discount bonds in the marketplace. Traditional broad-market bond ETFs hold between 500 and 900 issues, but ZDB holds just 55.

This constraint has become more urgent after the Bank of Canada unexpectedly cut short-term rates in January. Yields on intermediate and longer-term bonds also fell, driving bond prices up sharply. Suddenly bonds that were trading at a discount were priced at or above par.

In my blog post introducing ZDB,

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Which Bond ETF Is Most Tax-Efficient?

Back in September, my colleague Justin Bender and I published a white paper entitled After-Tax Returns: How to estimate the impact of taxes on ETF performance. Justin has now updated his Excel calculator and made it available for free download on his blog.

Recently Justin put his own methodology to work by measuring the 2014 after-tax returns of 10 short-term bond ETFs. As it happens, 2014 was a relatively good year for short-term bonds: as interest rates fell again, ETFs in this asset class delivered returns between 2.3% and 3.5%. But as we have written about before, traditional fixed income ETFs tend to be full of premium bonds, which are notoriously tax-inefficient because of their high coupons. If you held one of these ETFs in a non-registered account, your after-tax return would have been lower.

Launched in 2013, the First Asset 1-5 Year Laddered Government Strip Bond (BXF) was designed to be a tax-friendly alternative. Strip bonds do not make interest payments like traditional bonds do: rather, they are sold at a discount and mature at par value.

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Ask the Spud: Bond ETFs in Taxable Accounts

Q: Can you share your thoughts about the BMO Discount Bond (ZDB) and the Horizons Canadian Select Universe Bond (HBB) as long-term holdings in a taxable account? – D. F.

Earlier this year BMO and Horizons both launched bond ETFs specifically designed for taxable accounts. These two funds have very different structures, and each has its strengths and weaknesses. So let’s dig more deeply into each fund to help you decide which might be right for your portfolio.

Before we discuss these specific funds, let’s review the problem with holding traditional bond ETFs in non-registered accounts. Most bonds these days trade at a premium (higher than their par value), because they were issued when interest rates were higher. Premium bonds are perfectly fine in your RRSP or TFSA, but they are notoriously tax-inefficient and should not be held in non-registered accounts.

 Do you want a discount or a swap?

The BMO Discount Bond (ZDB), launched in February, is similar to traditional broad-market bond ETFs, such as the iShares Canadian Universe Bond (XBB), the Vanguard Canadian Aggregate Bond (VAB) and the BMO Aggregate Bond (ZAG).

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