Archive | Bonds

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.

Continue Reading 52

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 tomaturity 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,

Continue Reading 50

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.

Continue Reading 14

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,

Continue Reading 22

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.

Continue Reading 42

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).

Continue Reading 73

Ask the Spud: Should I Use Global Bonds?

Q: I was surprised to see a Vanguard infographic pointing out that international [non-US] bonds are the largest asset class in the world. Do you have any thoughts on why Canadians have not embraced international bonds in their portfolios? – A.M.

While stocks grab all the headlines and dominate the conversation among investors, the bond market is vastly larger. Yet while a diversified index portfolio can include 10,000 stocks from over 40 countries, chances are your bond holdings are entirely Canadian.

There are some good reasons for a strong home bias in bonds. The main one is currency risk. Exposure to foreign currencies benefits an equity portfolio by lowering volatility (at least for Canadian investors), but taking currency risk on the bond side is usually a bad idea. Because currencies are generally more volatile than bond prices, you’d be increasing your risk without raising your expected return. That’s a bad combination.

It also gets to the heart of why few Canadians have international bonds in their portfolios: there just aren’t many good products offering global bond exposure without currency risk. iShares and BMO have a number of ETFs covering US corporate and emerging markets bonds.

Continue Reading 44

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,

Continue Reading 38

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,

Continue Reading 78