Archive | Bonds

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?

Continue Reading 33

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,

Continue Reading 18

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.

Continue Reading 33

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,

Continue Reading 91

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,

Continue Reading 56

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.

Continue Reading 63

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.

Continue Reading 53

Why Diversification is a Piece of Cake

After almost four years of false alarms, the bond bears are finally able to act smug. Broad-based Canadian bond index funds have fallen in price about 4% or so in since the beginning of May. Meanwhile, real-return bonds have taken it on the chin: they’ve plummeted about 13% and are headed for their worst calendar year since first being issued by the federal government in 1992.

In times like these investors question the whole idea of including these asset classes in a balanced portfolio. So it’s time for a reminder about how diversification is supposed to work.

It’s helpful to think about a portfolio like a cake recipe. You probably wouldn’t eat flour, baking powder or raw eggs on their own, but when you mix them with sugar, butter, vanilla and other ingredients the results are delicious. A baker doesn’t view ingredients in isolation: she considers how each interacts with the others to produce the final result.

In the same way, it’s important not to view individual asset classes in isolation. Real-return bonds are a perfect example. It would be hard to make a compelling argument for holding nothing but RRBs: their yields are low,

Continue Reading 43

What’s Happening to My Bond ETF?

If your portfolio includes a broad-based bond index fund, you’ve probably noticed its value has fallen significantly over the past several weeks. Judging from recent e-mails I’ve received, the reasons for this decline are not always clear, so let’s take a closer look.

Most investors understand that when interest rates rise, bond prices fall. But there are many different interest rates, and they all affect your bond fund in different ways. The shortest of short-term rates is the target for the overnight rate, which is set by the Bank of Canada to control monetary policy—in other words, to keep inflation low. This rate influences the prime rate banks use to price variable-rate mortgages and lines of credit, so it’s the one most widely discussed in the media.

The Bank of Canada has kept the target rate at 1% since September 2010: that’s more than 32 months, the longest period it has ever remained unchanged. Meanwhile, the prime rate has held firm at 3% during this same period. I’ve been asked by some investors why they’ve seen their bond holdings fall when “interest rates haven’t gone up.”

But as I’ve mentioned,

Continue Reading 60