Archive | Bonds

Bond Bears: Admit You Were Wrong

One of the most common excuses made by forecasters is, “I wasn’t wrong, I was just off with the timing.” But that fails to acknowledge that timing is an integral part of any forecast. Imagine a weather reporter predicting rain on Monday and claiming he was still right when the downpour doesn’t arrive until Thursday.

We need to demand the same accountability from the commentators who have been predicting rising interest rates for about five years now. Even if rates do rise significantly in the next year or two—which would cause bond prices to fall—they won’t be able to claim their predictions were accurate but merely late. The only honest thing to do is admit they were dead wrong—and to stop making forecasts that encourage investors to abandon their long-term plans.

The bond bears had already been growling for a couple years when I wrote a column on this topic for a 2011 issue of MoneySense. The article quoted an advisor who had arrogantly told me “the bond index funds you recommend in your Couch Potato portfolios will soon be a disaster.” Like just about every other commentator at the time,

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A Tax-Friendly Bond ETF on the Horizon

Bonds should be part of just about every portfolio, but if you have to hold them in a non-registered account the tax consequences can be onerous. Fortunately, Canada’s ETF providers are taking steps to ease that burden with some innovative new products, including an ETF of strip bonds and another that holds only low-coupon discount bonds. The latest entry is the Horizons Canadian Select Universe Bond (HBB), which is set to begin trading this week. HBB is unique: it’s the only bond ETF in North America—and maybe anywhere—that uses a total return swap, which should dramatically improve its tax-efficiency.

The swap structure is the same one used by the Horizons S&P/TSX 60 (HXT) and the Horizons S&P 500 (HXS), which are now more than three years old. Here’s the basic idea: the ETF provider has an agreement with National Bank (called the counterparty) to “swap” the returns of two different portfolios. When you buy units in HBB, Horizons places your money in a cash account and pays the interest to the counterparty. In return, National Bank agrees to pay Horizons an amount equal to the total return of the fund’s index—that means any price change,

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Ask the Spud: Is My Pension Like a Bond?

Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? – Brian

This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets?

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How Pension Funds Think About Bonds

With the bond market up about 3% year-to-date, the bears have been growling less than usual. But I still get a steady stream of email from readers who think bonds “make no sense anymore” because they have low yields and will fall in value if interest rates rise. However, if you’re a pension fund manager your opinion of bonds is probably different.

Before we go further, let’s acknowledge that a pension fund isn’t the same as your RRSP. Institutional investors have an indefinite time horizon, as well as access to far more investment options than you and me. Yet retail investors can learn a lot from the smart money like the managers of the Healthcare of Ontario Pension Plan. (Hat tip to Raymond Kerzérho, director of research at PWL Capital, for pointing me to the HOOPP strategy.)

It’s not about the income

HOOPP uses what it calls a “liability driven” investment approach, which involves constructing two separate portfolios with different goals. The first is the Return Seeking Portfolio, and it includes primarily Canadian and international equities, as well as a number of active strategies. The second is called the Liability Hedge Portfolio,

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iShares Advantaged ETFs: Where Are They Now?

Before being bought by BlackRock early in 2012, Claymore Investments pioneered many new services and unconventional products. One of these was its so-called Advantaged ETFs, which used a complicated structure to convert fully taxable bond interest and foreign income into tax-favoured return of capital and capital gains.

Barely a year after these funds joined the iShares family, the 2013 federal budget took aim at this sleight of hand. While the government is grandfathering contracts already in force, it won’t allow new ones, which means the eventual end of the tax break promised by the Advantaged ETFs. A couple of weeks after the budget, iShares stopped accepting new subscriptions for these funds until they decided how to handle the situation.

The ETFs are open for business again, but several have new names and all have new strategies. Here’s a summary:

The iShares Global Monthly Advantaged Dividend has become the Global Monthly Dividend Index ETF (CYH). The tax-favoured structure is gone, but the investment strategy is largely the same: the fund is about half US and half international dividend stocks. However, the older version used two US-listed Guggenheim ETFs as its underlying holdings.

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New Tax-Efficient ETFs from BMO

Bonds are one of the least tax-friendly asset classes: most of their return comes from interest payments, which are taxed at the highest rate. They’re even less tax-efficient when their market price is higher than their par value: these premium bonds are taxed so unfavorably they can actually deliver a negative after-tax return. Unfortunately, because interest rates have trended down for three decades, virtually every bond index fund and ETF is filled with premium bonds. Enter the BMO Discount Bond ETF (ZDB), which begins trading tomorrow. This unique new ETF promises to eliminate the problem that has long plagued bond funds in non-registered accounts.

Let’s take a step back and review the important idea underpinning this new ETF. Consider a premium bond with a coupon of 5% and a yield to maturity of 3%. The bond will pay you 5% interest annually and then suffer a capital loss of 2% at maturity, for a total pre-tax return of 3%. Now consider a discount bond that pays a coupon of 2% and has the same yield to maturity of 3%: now, in addition to the interest payments,

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How Not to Prepare for a Bear Market in Bonds

The risk of rising interest rates has become an obsession in the financial media. Those risks are undeniably real: it’s quite possible that broad-based bond funds will see multiple years with negative returns. (As I illustrated in a previous post, that would likely occur if rates across the yield curve rose 1% annually for three years. This article by Dan Hallett also includes some possible scenarios.) But these risks need to be kept in perspective: if you hold a bond fund with a duration shorter than your time horizon, your capital is not at risk. And if you’re a decade or two from tapping your portfolio, rising rates should even be welcomed.

And yet the bond bears just keep on roaring. The latest example is an advisor featured in a Globe and Mail article this weekend. “For the first time in my entire career,” he says, “bonds are in my opinion riskier than stocks.” He’s recommending his clients abandon the asset class altogether. Whenever articles like this are widely read, I get contacted by worried readers who are ready to follow suit. So here’s my preemptive response to what I believe is dreadful,

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Ask the Spud: Should I Fear Rising Interest Rates?

Q: Recently the bond market—and 40% of my Global Couch Potato portfolio—has dipped significantly. I understand swings like this occur from time to time, but with interest rates moving higher would it be wise to decrease the percentage in bonds to say, 20%? Or maybe temporarily stop my monthly contribution to bonds and instead put it in equities? — C.P.

I’ve received some variation of this question almost every day since interest rates began to spike in May. The unit price of the iShares DEX Universe Bond (XBB), which tracks the most widely followed bond index in Canada, is down about 5.5% on the year, and it could fall further if rates continue to tick upward.

It’s easy to understand the discomfort investors are feeling. After all, Canada has not had a year with negative bond returns since 1999. We’re accustomed to bonds delivering steady returns year after year, and we don’t know how to respond to a sharp decline in price. Our instincts seem to be to stop buying them, and maybe even to sell the ones we already own. But if you’re a long-term investor, that’s getting things exactly backwards.

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Is Your Bond Fund Really Losing Money?

When the yield on 10-year federal bonds spiked earlier this year—from 1.88% on May 16 all the way to 2.55% on July 5—the value of broad-based bond ETFs plummeted sharply. But I’ll wager that many investors think their bond ETFs are performing worse than they really are.

There’s a common misunderstanding about how fixed-income ETF returns are calculated. That’s understandable, because your brokerage’s account summary is highly misleading: it indicates only an ETF’s price change while ignoring all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you understand that, you might think your ETF has lost money when it’s actually logged a nice gain.

Why bond ETFs fall in price

Most investors understand that bond prices fall when yields rise. What’s less well known is that bond ETF prices will decline steadily even if interest rates don’t change. That’s because virtually all the bonds in a broad-based ETF today were purchased at a premium—in other words, for more than face value. As these bonds mature or get sold, the fund will incur a steady trickle of small capital losses.

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