Bond index funds have a place in almost all portfolios, even in a low-rate environment. However, it’s important to match the right bond fund to your investment goals. To do that you need to know two important details. You can usually find both of these numbers on the web page or fact card of any bond mutual fund or ETF.
The first is the weighted average term to maturity of the bonds in the fund. For example, the iShares DEX Universe Bond Index Fund (XBB)—which tracks the most popular fixed-income benchmark in Canada—is about half short-term (one to five years to maturity), one quarter intermediate-term (five to 10 years) and one quarter long-term bonds. The weighted average term to maturity of all the bonds in the fund is 9.3 years.
This number is important, because the fund will behave much like an individual bond of about this same maturity. Sure enough, if you look up the current yield on Government of Canada 10-year bonds you’ll find it is 3.07%, almost identical to XBB’s current yield to maturity (3.03%). Now you know that XBB will be sensitive to the prevailing interest rate on 10-year bonds: if this yield goes up, the fund’s value will fall. Other interest rates—such as the Bank of Canada’s overnight rate that you keep hearing about on the news—are pretty much irrelevant.
The second key figure is your bond fund’s weighted average duration. This tells you the fund’s sensitivity to interest-rate movements: the longer the duration, the more your fund will lose if rates go up.
Duration is a calculated with a complicated formula that considers a bond’s term to maturity and its coupon. The important idea is that the longer the maturity, or the lower the coupon, the longer the duration. This is why short-term bonds are less sensitive to interest rate swings, and why higher-yielding corporates are less vulnerable than government bonds:
| Ticker | Avg. Term | Coupon | Duration | |
|---|---|---|---|---|
| iShares DEX Short Term Bond | XSB | 2.9 years | 3.62% | 2.7 |
| iShares DEX All Corporate Bond | XCB | 8.3 years | 5.21% | 5.5 |
| iShares DEX Universe Bond | XBB | 9.3 years | 4.41% | 6.3 |
| iShares DEX All Government Bond | XGB | 9.5 years | 4.00% | 6.6 |
| iShares DEX Long Term Bond | XLB | 22.8 years | 5.72% | 13.7 |
| iShares DEX Real Return Bond | XRB | 20.9 years | 3.40% | 16.2 |
As you can see in the table, XBB (and similar broad-based funds) have a duration of just over six. That means if the relevant interest rate rises one percentage point—remember, in this case it’s the yield on nine- or 10-year bonds—then the fund can be expected to fall in value by about six percentage points.
And the bond played on
There are a couple of subtleties to be aware of here. First, interest rates at the long end of the yield curve tend to be less volatile than short-term rates: it’s unusual for 10-year bond yields to move more than one or two percentage points in a year. So the chance of a fund like XBB suffering double-digit losses in any given year is remote—at least if history is any guide.
The iShares DEX Long Term Bond Index Fund (XLB) looks even scarier with its duration of almost 14: a 2% jump in the yield on 20-year bonds would theoretically mean the fund’s value would decline by some 27%. But this has never happened. Since 1948, the worst one-year return on the DEX Long-Term Bond Index was –8.9% in 1956, followed by –7.4% in 1994. In the U.S., long-term bonds have seen just one double-digit decline in 85 years (that happened in 2009).
Another often overlooked point is that rising interest rates have a silver lining: new bonds are issued with higher coupons, and this will eventually lead to more income. (Doesn’t it strike you as odd that fixed-income investors complain about low rates while also worrying they might go up?) As bonds in a fund approach maturity and are sold, the proceeds are reinvested in higher-yielding bonds that help offset the price declines. That’s why bonds recover from bear markets much faster than stocks do.
Stay in for the duration
Which leads us to the key message for investors: as long as your time horizon is at least as long as the duration of your bond fund, you won’t lose any capital.
You’ve probably heard people say they prefer individual bonds to bond funds, because as long as they hold on until maturity, they won’t lose principal. Well, the same is true if you hold a bond fund for a period equal to its duration. You can be sure that XBB will not have a negative total return over any period longer than 6.3 years: any price decline from rising interest rates will be offset by higher coupons within that time frame. In fact, history suggests the recovery is likely to be more swift than that: even a three-year period of negative bond returns is extremely rare.
So, if you’re saving for a child’s education with a three-year time horizon, steer clear of XBB and choose a fund with a duration less than three—or just put your money in a GIC or high-interest savings account. But if you’re investing for a retirement that’s 10, 20 or 30 years down the road, a broad-based bond index fund should still be a core holding in your portfolio.
Thank you very much for the advice – I wondered as much looking at one of Vanguard’s long-term government bond funds with close to 2000 holdings where the most I could find in a Long-term Canadian bond fund was around 55 – so even if I did hold long-term funds for the duration the risk may not outweigh the reward
Hi there, just wanted to say thank you for sharing your knowledge on your blog. I was a financially ignorant/dependent working housewife 4 years ago and my divorce had force me to educate myself about my own money and become financially independent – and it all began with your blog (life changing) ….Starting with moving all my investments from one of the big banks (and ditching the financial advisor whom had ‘best interest at heart’ to managing my own ETF portfolio using your model portfolio . I feel much more secure about my future so thank you again.
I know the basic concept of re-balancing/buy low & sell high, and when interest rates goes up, bond prices goes down but I am still confuse about when is the best time to buy Bond ETF? Doe the buy low rule still apply with Bond ETF when interest rates goes up? Is there a rule of thumb for Bond ETFs?
@Heidi: Many thanks for the feedback, and I’m happy to hear you have found the blog useful!
When deciding whether to rebalance, simply look at the market value of your bond ETF holding. For example, if your portfolio is $100,000 and your target bond allocation is 40%, than the holding should be about $40,000. But as you note, when interest rates go up, the value of your bond holdings will fall, so this is likely when you will need to add to it. This is a good thing, since you will be adding more money when yields are higher, which is tantamount to “buying low.”
@CCP
Hi,
I really appreciate your website!
I have been using a full service broker with high cost mutual funds for most of my life. I recently sold the equity mutual funds in my TFSA and transferred it to a discount broker.
I am trying to decide which bond ETF to purchase within my TFSA.
I am retired and in my early 70s. I have a good government pension and don’t need to live off the income from my investments. My portfolio is currently 80% equities, 8% fixed income and 12% cash. I am aware that I am heavily overweight equities and want to increase the fixed income part of my portfolio. Most of the equities are in a taxable account so it is difficult to sell too much of it in one year without incurring a large tax consequence. If I sold all my mutual funds in my RRIF and bought fixed income, my portfolio would still be 70% equities.
I am trying to de-risk my portfolio and want to use most of the 12% cash to buy a fixed income ETF. I have read most of your posts on fixed income but I am still unsure whether to purchase ZAG (BMO aggregate Bond Index) or VSB (CAD short term bond index). I want diversification away from stocks, want the bond ETF to rise in value when there is stock market correction or bear market and would ideally like to get a return of at least inflation.
In your CCP model portfolio you use ZAG, however Justin Bender’s model portfolio’s uses either VSB or an Aggregate bond index similar to ZAG. Andrew Hallam has VSB in the fixed income part of his Globe and Mail strategy Lab Portfolio.
You say that one should aim to keep a bond ETF for at least as long as the duration. ZAG has a duration of 7.33 years while VSB has a duration of 2.7 years. Who knows if I’ll be around in 7 years? Would you say that a retiree should have a shorter duration bond fund as opposed to someone who is younger and is in the capital accumulation part of his life? Is it fair to say that ZAG would increase in value more than VSB in the case of a stock market correction? Maybe the correct approach would be to buy both ZAG and VSB in order to have a duration of somewhere between 2.7 and 7.33 years?
Although it’s impossible to predict where interest rates will go (look at the last 4 years), the FED has already began tightening and the market is predicting 2 or 3 more hikes this year. Maybe it’s best to buy VSB and then sell it and buy ZAG if and when rates are a little higher?
I am new to do it yourself Index investing and any thoughts or suggestions would be greatly appreciated.
Thank you,
Theodore
@Theodore: This is a relatively small decision and I would not let it distract you from moving ahead with your plan. It comes down to whether you are willing to accept the higher volatility of ZAG/VAB in exchange for a higher yield or whether you would rather accept low volatility in exchange for a lower yield. GICs may also be an option. This might help:
https://canadiancouchpotato.com/2015/05/18/how-changing-interest-rates-affect-fixed-income/
@CCP
You wrote:
You can be sure that XBB will not have a negative total return over any period longer than 6.3 years:
I just want to make sure I’m comparing apples to apples. Let’ say I buy bonds and keep them to their maturity. So I will be be getting par value + interest. Then in your XBB example, not only I would be interested to not have my principal depreciate but also get interest. Is that what you meant by total return not being negative? In other words should the total return be equal to par value + interest?
@Bibi: The ideas are similar. But with a bond fund there is no maturity date, so what happens is that if interest rates rise, the value of the fund will fall, but new bonds will be purchased with higher yields, and eventually these higher yields will offset the initial loss. The duration is an estimate of the “breakeven point.”
@CCP
Thanks for the quick reply.
Sorry I didn’t phrase my question clearly. I am comparing buying bonds and keeping them to maturity with buying a bond ETF and keeping it for duration. It seems your point was that if I bought the bond ETF I would not lose money, but what I’m trying to say is that it’s not enough. I want to get my principle back + interest as I would had I bought the bonds directly.
hello cpp, i need some wisdom, i a new to investing, i bought a bunch of etfs recently, my holdings look like this approximately: 5.75% in REITs, 33.46% in stocks (with 40% of it being XAW, 59% of it XIC), 60.78% in bonds with (62.65% of it being in bond etfs of XBB and ZAG; and 37.34% of being in a 2-year GIC)
this is my first time investing; the money has been sitting in this structure for several months; i have read many many many blogs, by you, moneysense; jason zweig’s book on defensive investing for people who do not have the time to research; andrew hallam’s book etc.
and i know i am not suppose to look at my investments; i also know i am suppose to keep them in there for many years; however none of it (except for maybe zweig’s book) prepared me for the shaking and overwhelming fear in my body that i felt when i did look at it recently and saw numbers like Unrealized gains (losses) ($1,656.16) (CAD) one day on the top of my questrade account page and then another number of Unrealized gains (losses) ($672.39) (CAD) two weeks later; and then getting the statement; looking at it and seeing that in the past few months, my value of investments have declined by $1179.53 …
all to say that i am scared; i know i am to hold this out; however – each time i look online – which is not often, i mean after investing; i have looked maybe once or twice each month; i keep seeing the negative numbers in brackets – particularly in the zag, xbb side of things … like i have yet to see a positive gain in the past 4-5 months
in the stocks side; i saw some incremental gains; then it went negative and i got scared again
i guess my question is – do you have any wisdom on this? is what i am experiencing ‘normal’? will there be a time in which i won’t feel like each time i log on, it is always a number in brackets for my bonds side? i think xbb and zag are fairly mainstream common bonds to invest in …
i’m just wondering and curious (and scared very much so)
@Jill: Thanks for the comment, and sorry to hear that your early investing experience has been so stressful. It is certainly true that the last few months have been difficult, with both stocks and bonds declining in value. I recently reflected on this in the Globe:
https://beta.theglobeandmail.com/globe-investor/investment-ideas/is-diversification-as-we-know-it-broken/article36161580
Here’s a similar story from an investor who also started investing during an unfortunate time:
https://canadiancouchpotato.com/2010/07/29/does-this-thing-work/
That said, it does appear you were unprepared for the normal volatility of an investment portfolio. You “have yet to see a positive gain in the past 4-5 months,” but stocks regularly decline in value over short periods like this. Indeed, they can lose value over two or three years (as they did in 2000-02), and sometimes much longer.
Let’s also consider the magnitude of the decline. You do not say how large your portfolio is, so I don’t know what your losses are in percentage terms. But if the portfolio started at $50K, a loss of $1,179 is about 2.4%. The last few months have been frustrating, but the losses are very modest. If you plan to invest for the long-term you will see many, many more similar losses, as well as many that are much larger. Never lose sight of the fact that a garden-variety bear market is a 20% decline in stocks, and in a major crisis a 40% decline (or more) is possible.
This has certainly been an unusually difficult few months for bonds because of the recent hikes in interest rates. That won’t last forever, but to answer your question about whether you will always see a negative number beside your bond holdings, the answer might be yes, though that doesn’t necessarily mean you will have lost money. (In recent months you would definitely have lost money, but this will not always be the case a bond ETF is showing an unrealized loss.)
https://canadiancouchpotato.com/2017/04/26/bond-basics-2-why-your-etf-isnt-losing-money/
My suggestion would be to stop checking your accounts frequently and try to ride this out for a year or two. if you eventually decide you have overestimated your risk tolerance, then you may have to make your portfolio more conservative. Because bonds can be very hard for new (and even experienced) investors to understand, using GICs and cash for your fixed income may not be a bad idea if it makes you more comfortable.
Hang in there!
@Theodore: Your comment just caught my eye, and I thought I’d share my situation. I’m 69 now, but only just learned about Couch Potato Investing 5 years ago when I retired. I had no idea how little I knew till I delved into this CPP website. But once I grasped the idea I was immediately hooked, in principle at least. Getting familiar with the details of management took a little longer.
So we are similar in age, and in my case I don’t have any need for income, as that is taken care of by my RRSP which has been converted to an RRIF and is actively managed by a 3rd party manager, and sadly, my wife has no trust in my CCP knowledge and will not let me take it over and manage it with index funds. Her RRSP is in the same situation. I have a large non-registered portion, which seems to match your situation. Because I/we don’t need any further income, particularly any that would attract taxation, I have opted to hold a larger amount in equities, about 68-70% than normally might be prudent for a 70 year old.
However the heavy preponderance of bonds in my RRIF and my wife’s RRIF does mitigate this apparent equity heavy situation. But the 28-30% bond portion is tricky in a large non-registered investment account — I don’t know how familiar you are with the information given in this CCP website about this (do search it; it is very thorough), but the short story is that bonds and bond ETFs are terribly tax inefficient outside of registered accounts.
My solution to this was to cover this component by purchasing HBB, a total return swap ETF from Horizons that essentially tracks intermediate term bonds (about 65% Government 35% high grade commercial) but never distributes the interest portion. Instead, in a transaction with a 3rd party, issues a swap based ETF that matches the interest portion with an increase in share value of the ETF. So there never is any income generated, only an increase in value, which suits me fine, because I pay no tax until I sell the shares, and then the tax is only paid as a capital gain tax. The annual cost of owning the ETF is 0.09% management, and 0.15% swap fee, which is less than the yearly tax burden would be. But it provides the same buffering effect that a regular intermediate term Bond ETF (XBB, VAB, ZAG etc) in a registered account would. I need to be ok with the slightly more volatile nature of an intermediate term bond fund equivalent than a short term bond fund equivalent, and I am. Unfortunately, Horizon does not provide a short term bond swap based ETF in case that’s what you might prefer.
Judging from your comments and doing some mental calculation, I’m guessing that your non-registered account is large enough that purchasing any significant bond portion as plain bond ETFs would generate a significant tax load, so this might help.
(Oh, although this post was about bonds, I should also mention that I used a similar vehicle from Horizon, the HXS ETF to represent the US equity portion, and it also distributes no dividend but swaps it for an increase in value of the ETF, so no dividend, and thus no annual US withholding foreign tax and Canadian tax. There is also a very low cost Canadian equivalent, HXT).
Hi Dan
Just to be clear if you buy a bond etf with a yield to maturity of say 2.0% and the duration of the etf is say 10 years. The worse you can do is get your original investment back in 10 years with a 2% coupon every year..
Can you do better than this and how does that work?
@John r: This is not quite accurate. It is generally true that if you hold a bond ETF for a period equal to its duration, you have negligible risk of losing the original amount invested. You would also receive a contact stream of coupon payments (i.e. interest from the bonds, paid to you in the form of monthly distributions from the ETF). But don’t confuse “coupon” with “yield to maturity,” as they mean very different things.
For example, if you look at iShares XBB, the average coupon is 3.19%, but the yield to maturity is 2.68%. The duration of the fund is 7.36 years. So in very basic terms, if you were to buy XBB today and hold it for at least 7.36 years, you have very little risk of losing your original principal. If rates rise, the value of the ETF will fall, but maturing bonds will be reinvested at those higher rates, so future coupon payments will be higher.
One of the challenges here is that the math is very elegant for individual bonds, but in an ETF there are so many moving parts that one cannot be too precise. The coupon, yield to maturity and duration of a bond ETF will evolve over time as rates change and holdings are replaced. The key idea here is that if you are a long-term investor, you should not be too concerned with short-term movements in interest rates. And if you have a shorter time horizon, you should look for a bond fund with a shorter duration (i.e. don’t buy a fund like XBB if your time horizon is three to five years).
Hope this helps.
Sorry to be so late to this party. This is the best article out there on Bond ETFs, a financial product that still holds many mysteries for me. One of the things I still don’t understand is why iShares TLT for example (LT bonds, effective duration of 18 years), went up a couple of years after the interest rates were changed between December of 2015 and 2018. You can see he takes a big hit, but shouldn’t he have remained down for a long-time, given the duration of the bonds? in 2019 he soared back up. There’s something I’m obviously missing. Some all-weather portfolio’s like Dalio’s use LT-bond ETFs. I couldn’t wrap my head around that given that rates may go up in the next couple of years. If you’re then stuck with an ETF with a low value for 18 years… but the history of the TLT proves it may not go that way even if rates would go up 1-2% as they did in 2015-18. Can you perhaps elaborate on this please?
@Geert: Thanks for the comment. The volatility of bond ETF prices goes in both directions. If TLT goes up in price when interest rates decline, it will also fall when rates rise. The value of a long-term bond can change significantly between now and its maturity date. So if rates rise in the near term, prices will fall, but they might recover in the next couple of years if rates go down again.
But I think the other issue here is that people often talk about interest rates as if they were all the same. In fact, short-term rates and long-term rates are affected by different factors, and they can sometimes move in opposite directions. This is usually the source of confusion when people notice their bond ETF is not behaving like they expect. This may help:
https://canadiancouchpotato.com/2018/07/19/bonds-behaving-badly/
Thank you Dan for taking the time to respond. I indeed hadn’t thought of that. So as I understand it now, since TLT has an effective duration of 18 years, had the long term Fed rates (affecting the bonds held by the fund) been increased and they would have remained fixed at the higher level, then TLT would have remained down for many years until all the older bonds that matured had been swapped by new ones with the higher rates, or until something else would have lowered the rates in the mean time making the current bonds in the ETF more attractive again.
“Which leads us to the key message for investors: as long as your time horizon is at least as long as the duration of your bond fund, you won’t lose any capital.”
Are you sure?
It does not make any sense to me, it would mean that if I bought a 5 years duration bond ETF and a negative 4 years total return I could be sure that I’ll make a gain in 1 year because the guy who bought the same ETF 4 years ago will get back is principal within 1 year.
On Bogleheads we discussed this if you are interested https://www.bogleheads.org/forum/viewtopic.php?t=373194