Archive | Bonds

Under the Hood: BMO Real Return Bond

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: BMO Real Return Bond Index ETF (ZRR)

The index: The fund tracks the DEX RRB Non Agency Bond Index, which consists of inflation-linked bonds issued by the Government of Canada. It seems to have been created specifically for this ETF.

The cost: The ETF’s management fee is 0.25%. As with other BMO funds, the actual MER will be higher because it includes GST/HST and some other expenses.

The details: This brand-new ETF (it started trading on Wednesday, May 26) holds five real-return bonds issued by the federal government, each making up about 16% to 23% of the fund’s assets.

Real-return bonds — or Treasury Inflation-Protected Securities (TIPS), as they’re called in the US — are an important asset class, and some financial experts recommend them as a core holding.

Both the principal and the interest payments of real-return bonds are tied to the Consumer Price Index, so they go up with inflation.

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Bonds v. Bond Funds

In my previous post, I looked at the uneasiness many investors have about bonds when interest rates are poised to go up. Some readers have argued that this discomfort can be alleviated by buying individual bonds rather than index funds or ETFs. Let’s look at whether their arguments hold up.

Individual bonds do offer benefits: you know precisely how much interest you’ll be paid, and how much you’ll receive when the bond matures. The payouts from bond funds, by contrast, aren’t known in advance, and funds never mature. This can make planning difficult for those who rely on their bond portfolio for current income, or those who need a specified amount of money on a certain date in the future. No quibbles with that.

The other main argument in favour of individual bonds is much less convincing. It goes something like this: “If I invest $10,000 in a bond fund, its value will go down when interest rates rise. But if I buy an individual bond, I don’t have to worry about interest rate movements, because as long as I hold the bond to maturity, my principal is guaranteed.”

Behavioural economists love this kind of logic.

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The Bond Dilemma

With interest rates poised to rise later this year, I’m getting a lot of emails and comments from readers who are wary about investing in bonds. There seem to be a lot of myths and misunderstandings about bonds, which isn’t surprising: fixed-income investments can be difficult to get your head around.

Let’s start with the most relevant issue: when interest rates rise, the value of bonds goes down. To understand why, imagine buying a five-year bond with a face value of $1,000 that pays 5% interest annually. Now imagine that 12 months later interest rates have risen one percentage point. Your bond now has four years left to maturity and it’s still paying $50 a year in interest, while new four-year bonds are paying 6%, or $60 a year. If you decide to sell your bond now, you won’t get $1,000 for it. Why would anyone buy your bond with its 5% yield when they can get one that pays 6%?

Of course, your bond isn’t worthless: you just need to drop the price to make it more attractive. If you sell it for $965, the buyer would still earn $50 annually in interest, plus he’d make a $35 capital gain when he collects the full $1,000 at maturity.

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