Your Complete Guide to Index Investing with Dan Bortolotti

How Will Rising Rates Affect Bonds?

2014-10-25T09:53:54+00:00July 3rd, 2012|Categories: Bonds, Research|95 Comments

Since the 2008–09 financial crisis caused bond yields to plunge to new lows, market forecasters have been predicting a rise in interest rates. And when bond investors think rates will increase, they tend to move to short-term bonds or cash. That has certainly been popular advice over the last three-and-a-half years.

As bond investors now know, the forecasters were spectacularly wrong about the direction of interest rates. Yields have fallen since the crisis, and as I wrote about in a recent feature for Canadian MoneySaver, anyone who moved to to short bonds or cash did far worse than investors who simply held the whole bond market. From 2009 through 2011, the iShares DEX Universe Bond (XBB) delivered an annualized return of 6.9%, compared with 4% for the iShares DEX Short Term Bond (XSB), and about 1.5% for cash.

The next three years

The fear of rising yields is even more palpable today, and the soothsayers may be proven right. But how badly would bond index funds suffer in a rising rate environment?

To get some insight, I ran some hypothetical scenarios to see how things might shake down if rates all along the yield curve climbed 100 basis points (1%) annually for the next three years. Then I asked BlackRock, provider of iShares ETFs, to estimate how that might affect XSB and XBB. The numbers in the table below are based on the following assumptions:

  • During the entire three-year period, the profile of the two bond indexes—their duration and average maturity, for example—remain approximately the same as they are today.
  • Credit spreads—the difference between the yield on government bonds and corporate bonds of the same maturity—remain where they are now.
  • The rate increases occurs at the beginning of the year, resulting in an immediate decline in the value of the fund.
  • Over the next 12 months, cash flows from coupon payments and the sale of bonds are reinvested at the new higher rates.
Estimated returns if rates rise 100 bps annually
Year 1 0.30% -2.80%
Year 2 1.20% -1.50%
Year 3 2.20% -0.30%
Annualized return 1.20% -1.50%
Total three-year return 3.70% -4.50%
Source: BlackRock Asset Management Canada, Inc.

What’s the takeaway message from this simulation? The first is that bonds probably didn’t perform as poorly as you expected. With our simulated rate increase of 1% annually across the yield curve, XBB suffered three straight years of negative returns, but the losses were modest. Rising rates will hurt certainly bond returns, but the talk of bonds getting “killed” is probably overstated. Remember, too, that rate increases like this are likely to happen only if the economy gets red hot, which would probably lead to higher equity returns on the other side of your portfolio.

But there’s something else to consider: the opportunity cost you would have paid if you sat in short-term bonds or cash during the last three years, waiting for the rate hikes that were “certain” to come. As my Canadian MoneySaver article explains in detail, if bond returns over the next three years turn out to be similar to those in our simulation, XBB would still outperform both XSB and cash during the full six-year period beginning in 2009.

Investors should accept that no one can predict interest rate movements, and it is expensive to try. Rather than making tactical shifts that amount to guessing, bondholders are likely do best when they choose a diversified fund with an appropriate duration for their time horizon, and then hang on for the long term.


  1. Gordon July 9, 2012 at 8:07 pm

    RESP is one component of my overall portfolio. Since it is registered account it is the place where I keep part of overall portfolio fixed income portion. RESP is also account where I like to count on investment proceeds on particular draw dates. That is why is structured as bond ETF ladder. I plan to contribute each of next 7 years , before end of high school. Each year contribution value will be added to XSB portion but adhering to defind ratios for each year. For example instead of seling 50%XBB to buy 50% XSB after year one I will say sell 40% of XBB and add contribution to purchase XSB, again maintaining ratio for the year.

  2. dale July 9, 2012 at 9:46 pm

    raffael not sure if it works like that. A long etf will keep replenishing with long bonds as other bonds mature. That said duration is a moot point in the long run. The risk is how long do rates rise for. My understanding is that interest rate increase environments are usually severe but swift. Generally over within 18 months or so. That said your portfolio could experience some equity like volatility and paper losses. Take a look at the permanent portfolio for nice total return and low volatility. We can learn a lot from that asset mix.

  3. Canadian Couch Potato July 9, 2012 at 11:48 pm

    @Dale: Bond ETFs do not hold typically hold bonds until maturity. A fund like iShares XLB, for example, must sell any bond as soon as it is 10 years from maturity, because at that point it is not a long-term bond anymore.

    Duration is not a moot point if it exceeds your investing horizon. If the duration of your bond fund is seven years (as with XBB) and you need the cash in three years, you may find yourself with a loss of capital. So Raffael is right that you should probably have a long horizon if you want to use long-term bonds (XLB’s duration is almost 14 years).

  4. Oldie July 10, 2012 at 3:56 am

    Well, I’ll be…

    I signed off for a few hours and came back to find the old forum beavering away. And I learned yet one more vital fact.

    “Bond ETFs do not hold typically hold bonds until maturity. A fund like iShares XLB, for example, must sell any bond as soon as it is 10 years from maturity, because at that point it is not a long-term bond anymore.”

    Kind of obvious, now you put it that way, but there you go, I needed to be told before I knew! Wow, I have moved from knowing very little about bonds to being at least on passing knowledge with quite arcane bond characteristics, just from reading the little lectures and then carefully following the animated discussions that result!


    In keeping with the spirit of questioning triggering more thoughtful answers, @Gordon, now that you’ve sort of explained why you only have bonds in your RESP…

    “it is the place where I keep part of overall portfolio fixed income portion. RESP is also account where I like to count on investment proceeds on particular draw dates. That is why is structured as bond ETF ladder. ”

    This would make some sort of sense if the anticipated withdrawal of the cash was imminent. But
    I think you explained that the first dollar scheduled to come out was still 6 years down the road. From what I’ve just learned, that seems like a long time to hold bonds or bond equivalents if you accept the general premise that bonds in isolation can be volatile. You may rationalize by thinking that these bonds are not in isolation, because they are only part of your big “Mega-Portfolio” with equity held elsewhere in other holdings outside your RESP. But if the value of your bonds goes down early in the game say, due to an unexpected rise in interest rates, by the time you have sold the bond (as per your planned schedule) for a loss and bought more bond component (also as per plan), the sum compounded total of your losses cannot be offset by your gains in the Equity portion elsewhere, as there is no way to bring these gains from outside into the RESP (any more than the allowable contribution dollar limits) so you end up selling the 75% XSB in year 6 for less education dollars than you planned, or to put it another way, bond ETF’s in isolation can have some volatility whose risk can be mitigated somewhat by adding, say, a 20% equity component, and holding this proportion at least until you get a little closer to winding down the RESP fund. Do you have a worse scenario that is just as likely to occur that you are trying to avoid by holding only bond ETF’s (and later cash) from now on until the closing of the RESP?

  5. Dale July 10, 2012 at 6:57 am

    @ccp, i think we’re saying the same thing, sort of. etf’s are not like buying individual bonds, because there are always bonds going out and coming in.

    if you buy a 7-year average duration bond etf, though, the only thing that matters when you want to ‘cash out’ is which way are interest rates moving when you want to cash out. if they are rising again (there could have been a couple of cycles) you could face a capital loss. because near the end of your period, your time frame is one year and you’re still holding a basket of long bonds.

    that said, you may have suggested to shorten along the way, but at that point you could be taking capital losses to reinvest into shorter bond etf’s.

  6. Dale July 10, 2012 at 7:03 am

    Raffael, you might want to take a look at some US dividend etf’s to sprinkle in, as well as xei for Canada (pays over 5% and holds a great basket). there are utility etf’s for nice income.

    xtr is a very nice high income multi asset class etf. and there are detractors but i really like the bmo zwb covered call writing on canadian banks. 9% yield. i am biased because i have bought low and have capital gains (position) on that as well, but i believe over the years that will prove to be a great investemnt for income and captial gains.

    But again. 20-30% equities can moderate volatility and offer the opportunity to boost income above what bonds will currently pay.

  7. Raffael July 10, 2012 at 10:30 am

    Dale, I am a fan of covered calls because of the increased yields they provide.

    ZWB and ZWU look like great products. I did hold ZWB for a short time but I am moving away from stocks at this time do to the global uncertainty. As I mentioned in my previous posts.

    I think I will sit in Bond ETF’s for a little while and rebalance and adjust my portfolio in 6 months to reflect the global market conditions at that time.

    I am not an active trader but I do believe that these turbulent times do require more active management of ones assets. I will reconsider those investments at that time. XTR looks very interesting, especially when you look at it’s volatility over the last 3 years.

    ETF’s are a great product, have you ever considered building your own stock portfolio replicating the holdings of an ETF? Bond ETFs and Covered Calls excluded as these funds would require either a much more active approach or not enough diversity in terms of Bond Funds.

  8. Dale July 10, 2012 at 10:39 am

    Hey Raffael, ironically i have moved to etf’s and a conservative model portfolio, but with my canadian equity component I have ‘destroyed’ the index with thi, enb, trp, and cpg along with xre over the last 5 years. i will probably wait until that streak ends and move to canadian and us etf’s. i think i got lucky and have to leave it at that.

  9. Gordon July 10, 2012 at 8:07 pm

    Oldie I acualy hold bonds in RRSP and plan to do the same with TFSA. Equity portion is in non registered accounts. Target split of overall portfolio is 30% bonds, 70% equity.
    You are right first 25% of RESP bond portfolio will be cashed in 6 years.
    You are correct if interest rates unexpectedly rise XBB would take a hit, likely few percentage points. However, the following year I am using annual contribution and proceeds of sale for portion of XBB (together they would add up to 50% of value) to buy short term bond XSB that is now selling with higher coupons as consequence of raised rates. Similar thing but in different ratio would be repited year after and so on until year 6 at which point I am starting to cash in. The way I understand it I am matching bond duration with my time horizon. In theory that would mean I will get my invested capital back plus some. I can not predict which way interest rate will go nor when but I can structure portfolio in such a way that losses are minimal if the rates go up and return predictable if rates stay as they are or even better drop. There is no risk free investment. Risk can be mitigated but not eliminated.

  10. Dale July 13, 2012 at 7:43 am

    Hey Raffael, on a final thought would just add with respect that in your effort to run into the arms of safety after getting hammered. you may have created a portfolio that has all the risk of an all equity portfolio. You just moved to the other side. Bond etf’s are not ‘safe’ at all.

    When we go to a trend of rising rates, your long bond etf’s will get hammered. They could show 60 even 80, 90% capital losses (on paper). Mid range will get smacked as well. Check out some charts on the Bank of Canada site for interest rate history.

    Following the crowd (retail investor) has always been the wrong thing in investing. They always get it wrong due to psychology. They are perhaps the most accurate telltale sign in a biz where predictions are mostly useless. But you can always count on the retail investor to get it wrong. And now they are fleeing equities and going into bonds.

    I am personally happy to add more equities at this point. And will do so meaningfully if we get some nice pullbacks.

  11. Gordon July 13, 2012 at 8:14 am

    Dale, my understanding is that bonds (or bond ETF’s) had double digit losses ( on paper as you say) only two times. I believe 1936 and 2009 ( or around there) and loses were in more like 20% range than 60-90% as you seem to think.

  12. Canadian Couch Potato July 13, 2012 at 9:14 am

    @Dale: With respect, I think statements like that are irresponsible. I’m concerned they can scare inexperienced investors into making poor decisions. As Gordon says, long-term government bonds (using US data going back to 1926) have never experienced anything like the losses you’re imagining. They had a few years of single-digit losses in the 1950s and 1960s, even more modest loss in the 1970s, and then about a 15% or 20% loss in 2009 (depending which index you use). That 2009 loss was sandwiched between enormous gains (30%-plus) in 2008 and 2011.

    Of course, the past is not the future, and unexpected things happen. But for long bonds to suffer the losses you’re talking about, rates would have to rise from about 2.5% to about 7% or 8% in a very short period. It is difficult to imagine what economic conditions would prompt something like that. I would put that in the category of “the US dollar is going to zero” and “gold is going to $10,000.” Possible, sure, but not a foundation for building an investment strategy.

    Investment decisions should be made after careful assessment of the risks, not Armageddon scenarios.

  13. Dale July 13, 2012 at 9:44 am

    Thanks, I know the post is provocative. Just following the bond ‘rules’ that I’ve read in other places and on your site. If a bond etf with 20-yr average duration sees just a 2% increase in rates, that’s a 40% drop minus income?

    I would guess that 40-60% paper losses are not an Armageddon scenario. Rates rising 3-4% is back to ‘normal’ range.

  14. Dale July 13, 2012 at 12:23 pm

    Things have been calm for a while, but go back into other decades and you can see quick and violent spikes such as from 3% to 12%.

    Wondering how bond etf’s would only lose 20% in this kind of environment thanks.

  15. Canadian Couch Potato July 13, 2012 at 12:55 pm

    @Dale: When did interest rates move quickly from 3% to 12%?

  16. Dale July 13, 2012 at 1:25 pm

    late ’93. some other quick spikes of several percentage points around the period as well.

    chart is listed as Canada Benchmark Rates.

  17. Canadian Couch Potato July 13, 2012 at 1:34 pm

    @Dale: Your data are wrong, or you must be misreading them. Here are the historical rates on long-term Canadian bonds directly from the Bank of Canada:

    The rate hike actually occurred in 1994, and they went from 7.16% that January to 9.40% a year later. The DEX Long Term Bond Index (the same one tracked by XLB) returned -7.4% in 1994.

    There was another hike in 1999, from 5.23% to 6.23%, and the index returned -6%.

    I have Canadian index data going back to 1948 and those are the two worst years.

  18. Dale July 13, 2012 at 1:40 pm

    Thanks. They are listing it as Bank of Canada as well. The spike(s) was over several months. You can adjust the time period on the chart linked

    Thanks, I will do some research on rate and spikes.

  19. Dale July 13, 2012 at 1:48 pm

    Looks like that is the Bank of Canada rate that I found? Guessing Long Bonds don’t react with very much correlation (that is the actual long bond chart that you found). They move together of course, but LB’s are much more muted in response to bank of Canada moves?

    Thanks again.

  20. Canadian Couch Potato July 13, 2012 at 2:11 pm

    @Dale: Happy if this could help. The Bank of Canada website is a great source for historical rates.

    I think the misunderstanding comes down to which specific interest rates people are referring to. People often talk casually about “rates going up,” but it’s not clear which rates they’re talking about. It’s not that uncommon for short rates to go up in the same year long rates go down. Or for short rates to go up a lot, and long rates to go up a little.

    Central banks only have direct control over the shortest of short-term rates (i.e. the overnight rate referenced on the site you linked). Those at the longer end are driven mostly by market conditions: they are likely to rise when the economy heats up and fall during recessions. That’s why it’s so hard to imagine long rates shooting up dramatically in the current climate.

  21. Dale July 13, 2012 at 2:54 pm

    Thanks for that. Does that mean short term bonds would spike more violently (and more immediately) to rapid bank of Canada moves?

    Again, appreciate your time and input/expertise.

  22. Canadian Couch Potato July 13, 2012 at 3:08 pm

    @Dale: Yes, short-term bonds would be affected almost immediately by a spike in the Bank of Canada rate. But there’s no violence. With bonds that are only one or two years to maturity, the loss would be very modest and the silver lining is that you get to quickly reinvest maturing bonds in new higher-coupon bonds. So you recover quickly. If you happen to have your money in a high-interest savings account, you get a bonus, because the rates are likely to go up and you suffer zero loss.

    One other thing you might have noticed is that banks change their rates on lines of credit and variable mortgages instantly when the Bank of Canada changes its overnight rate. But fixed-rate mortgages move in conjunction with five-year bond yields, since they usually have five-year terms. Sometimes these two rates go in opposite directions in the same year, most recently in 2010.

  23. Oldie July 13, 2012 at 5:31 pm


    2 questions: firstly in the Bank of Canada Long Bonds chart you linked to, the rubric made a referral to the duration of the “long bonds” listed, but this was to a different page from the one (p 14) you had linked. What was the actual duration of these “long bonds”?

    Secondly, I’m trying to wrap my head around the risks of various bond structures (apparently not as severe as some posters had feared) and the potential benefits. Given that a 3% TFSA savings account was proposed by one of the posters in this blog (July 12, 2012, “The Long and Short of Barbell Bonds”) as an alternative for bonds in this economic climate in the diversified portfolio, I wonder if this might warrant a side by side analysis and comparison of these two alternatives.

  24. Canadian Couch Potato July 13, 2012 at 6:09 pm

    @Oldie: On the Bank of Canada site, “long bonds” seems to be mean 30 years. See this page, which says the long bond benchmark has a maturity date of 2041:

    If you can find a savings account that pays 3%, that would certainly be a good alternative to bonds. But the People’s Trust offer seems to be unique in Canada, and there is no guarantee that it will continue. A rate like that is often a teaser, and they can change it at any time. The going rate on cash these days is about half that.

    There’s nothing wrong with holding cash. But one downside is that if rates fall, you just get a lower interest rate going forward: you don’t get a boost in the value of your holding like you would with bonds.

  25. Oldie July 13, 2012 at 6:28 pm


    I get it. A teaser might be withdrawn any time. But as long as you’re in there till they withdraw it, you haven’t lost any opportunity, you get your advertised 3% till the month they yank the rug from under you, and you have to go back to Plan A, buying bonds again. My question was, if it could be assumed to be available, is it a good alternative to bonds, and, notwithstanding the teaser aspect, considering the guaranteed return of 3%, it appears your answer is yes. Bond yields are, what?… 2-3% and the return is plus/minus whatever capital gain/loss occurs. Given there is a downside possibility, and the upside appreciation is limited by the fact that prevailing interest rates are low enough to squeeze the possible declines to unlikeliness, to my unsophisticated eye, 3% guaranteed seems to beat the bonds. I’m just trying to figure out, what’s the catch?

    The major difficulty, as far as I can see, is the fact that it is structured and offered only as a TFSA savings account. But you can still have your $5ooo in this TFSA (I’m talking about 2012 for the time being) and have your $15,000 worth of Equity ETF’s in another TFSA elsewhere, then do your rebalancing in 6 months when your next $5000 of TFSA headroom becomes available. Your rebalancing is only mildly complicated by the fact that it has to be done across 2 separate TFSA accounts. I’m assuming that transferring between different TFSA’s does not trigger all kind of tax difficulties.

  26. Canadian Couch Potato July 13, 2012 at 6:53 pm

    @Oldie: I would agree with pretty much everything you said. Clearly 3% on a savings account is an excellent deal these days. The only quibble I would make is that it is not a “guaranteed 3%” for any specific period. It could change tomorrow. And there is a potential opportunity cost: if you were to put your $5,000 in a bond instead and interest rates fall, your bond will go up in value and you will continue to receive the coupon payment. That’s good. Ihereas your savings account will no longer be paying you 3% and there is no capital gain. That’s bad. Yes, you can get out of the savings account and buy the bond, but now it will be more expensive than it was before.

    I don’t want to belabor this point: these are pretty small risks. And it is very unusual to be comparing cash at 3% to long-term bonds at 2.5%. This discrepancy just comes about because People’s Trust happens to be offering an extraordinarily unusual rate on cash.

  27. Oldie July 13, 2012 at 7:33 pm


    Yes, I think you have given this all the attention it deserves. I see I have spent an inordinate amount of effort trying to parse an unusual, and quite likely in the long run, unhelpful situation. But a useful exercise in the learning situation for me.

  28. dale July 13, 2012 at 9:38 pm

    would add that maybe the 90% loss is a stretch. Given how artificially low rates are, a 30-50% drop may not be an unlikely scenario. We r in uncharted territory.

  29. Canadian Couch Potato July 13, 2012 at 10:01 pm

    Sorry, Oldie, I didn’t mean you were belaboring the point. I meant I was. :)

  30. Oldie July 14, 2012 at 1:32 am

    @ CCP:

    Not at all; no offence was perceived. I think you correctly concentrate on the major points, and, also correctly, try to advise what are lesser, perhaps rather inconsequential considerations that beginners like myself have not yet learned to discern as being any different in importance.

  31. Que August 11, 2012 at 1:16 pm

    Please tell me if I have this table correctly filled out for an example of requiring funds in year 2020. (assuming XBB duration is 7 years, and XSB is 3 years, for this example, just ignore equity amounts)

    XBB XSB Cash Duration Year
    100% 0% 0% 7.00 2013
    75% 25% 0% 6.00 2014
    50% 50% 0% 5.00 2015
    25% 75% 0% 4.00 2016
    0% 100% 0% 3.00 2017
    0% 67% 33% 2.01 2018
    0% 33% 67% 0.99 2019

    The problem I have with understanding this is, remembering the words “stay in for the duration”, so how are you staying in for the duration if you have been contributing to XBB prior to year 2013, and then selling some in year 2014 to buy XSB? Do you think about it as a first in, first out type of scenario?

    I’m just trying to actually plan how this would work the best, and having a hard time accepting this method.

    Any additional thoughts, or idea would be appreciated.

    Thanks, Que

  32. Canadian Couch Potato August 11, 2012 at 1:44 pm

    @Que: Yes, this is a reasonable way to shorten the duration of a bond portfolio as you approach the date you need the money. (You might also do the same thing by mixing only XBB and cash.) Although it seems complicated, it’s not much different from how your risk exposure would change if you bought a single bond with a duration of 7 and held it until maturity.

    I think the mental stumbling block here is that when you hold XBB for several years, you feel like you’re just “buying and holding.” But inside that fund, the turnover in holdings is quite large. All bonds are sold as soon as they have one year left to maturity, for example. And new bonds are constantly being added at the longer end to track the index and ensure that the duration of the fund remains more or less constant. So it feels like you’re not selling anything, but in reality you are.

    Have a look at the target maturity bond ETFs from BMO. They do exactly what
    you’re doing in your table: they simply mix two other bond ETFs in the right proportion to achieve the desired duration and they adjust the mix as necessary. The RBC target maturity ETFs work differently: they simply buy a number of bonds with the desired term and hold them to maturity. Two different techniques, but they accomplish the same thing.

    Let me know if this helps. It’s a confusing concept, I realize.

  33. Canadian Couch Potato August 11, 2012 at 1:52 pm

    @Que: I think there’s another concept that needs to be clarified.

    You asked “How how are you staying in for the duration if you have been contributing to XBB prior to year 2013, and then selling some in year 2014 to buy XSB.” You’re not. But it depends on what you are trying to achieve.

    Let’s assume that you put $10,000 in XBB today, and the fund has a duration of seven years, and you need the money in seven years. The only assurance you have is that seven years from today (in August 2019), your total return including distributions is not going to less than 0%, no matter what happens to interest rates. (Technically, it’s not a guarantee, since duration is only an estimate, but it’s close enough.) So you will still have at least $10,000.

    If you’re making more contributions along the way, the situation changes. Say the fund returns 5% in the first year so it rises to $10,500 in August 2013. That month you also contribute another $2,000, so the fund is now worth $12,500. The duration of the fund is still seven years, so you can now assume that it will be worth at least $12,500 in August 2020. In August 2019, in theory, the fund could be worth less than $12,500 (though it will be at least $10,000).

    The same is true if you decide to shorten the duration along the way. Every time you make an adjustment, you are resetting the base value and the time period during which you can be sure you’ll suffer no capital loss.

    Does that make sense?

  34. Que September 3, 2012 at 12:45 pm

    Yes Dan, thanks for the addition details and examples.

    As always, please keep on writing, and thanks for helping all of us with understanding.


  35. lofty September 30, 2012 at 7:54 pm


  36. Que October 11, 2012 at 8:03 pm


    Could you touch on some details on how XRB is different from XBB, and maybe get, or add to your Post, the estimated returns if rates rise 100 bps annually for the next 3 years for XRB as well?


  37. Canadian Couch Potato October 11, 2012 at 10:16 pm

    @Que: XRB has a much longer duration than XBB, so it will be more sensitive to interest rate moves. It will also be sensitive to changes in inflation: if inflation is higher than expected, XRB will outperform nominal bonds, and vice-versa.

    The interest rate estimates here were done with the help of BlackRock, so I can’t offer any meaningful analysis of how the situation might play out for XRB, sorry.

  38. Jamie February 23, 2013 at 8:04 pm

    If I am a buy-hold, passive ETF investor with a 30-year time horizon, with no interest in predicting interest rate movements, why would I have the majority of my bond holdings in a short-term bond ETF – as has been recommended to me by a fee-only advisor? Why not simply own an ETF that tracks the DEX Universe Bond index as my entire bond allocation?

    The only rationale I can come up with is that bonds are supposed to be the ‘safe’ component of your portfolio. But if your time horizon is 30 years, doesn’t this obviate the ‘safety’ requirement – ie. the 3 year losses you describe would be a blip on the 30-year radar, given the likely concomitant rise in equities (from a hot market) and the continual purchase of new bonds within the ETF with new interest rates?

  39. Canadian Couch Potato February 23, 2013 at 8:14 pm

    @Jaime: I agree that a broad-market bond is appropriate for an investor with a long-horizon. Chances are the person recommending short-term bonds believes interest rates will rise in the near future, in which case short-term bonds are likely to outperform in the short term. But as you say, if you do not need to touch your savings for 30 years you should not be concerned abut short-term fluctuations. Unfortunately, investors (and advisors) find it very hard to think long-term and prefer to base their decisions on what they think will outperform in the next one to three years or so.

  40. Oldie February 24, 2013 at 5:52 pm

    @Jaime: I would add that as a beginner, your objective analysis of the logic of investing for the long-term (i.e 30 year horizon) is spot on; the only caution is whether or not your steely-eyed determination to hold your course will hold out through periods of sudden bond fund devaluation, which must happen some time or another. We all (couch potato investors) believe we will weather these storms when we set out to sea after allotting our asset categories according to whatever plan we have, but only time, and the first storm will confirm our faith in ourselves. Best wishes on maintaining courage through the years to come — if you do, you surely will reap the rewards you plan for.

    @CCP: the discussion you had with Jaime was whether or not to cling to short term bond funds; and your answer, in the light of his 30 year horizon, was not, (which makes sense).
    His follow-up question was “Why not simply own an ETF that tracks the DEX Universe Bond index as my entire bond allocation?”. I was curious if you had an opinion on whether or not this would be the ideal investment for someone with a 30 year horizon, if a short term bond fund was not. Jaime’s hypothetical candidate XBB has an average term of 9.63 years. How would the risk/benefit of a fund with a longer average term (or some combination thereof) play out?

  41. Jamie February 25, 2013 at 8:24 pm

    Thank you for your reply and also to Oldie for his comments.

    With the above in mind, what are your thoughts on a post comparing Vanguard Aggregate Bond ETF (VAB) vs. XBB? The former has a lower MER, and seems like a reasonable alternative to XBB if looking for a broad Canadian investment-grade bond ETF with a low MER.

    The reason I ask is that it doesn’t seem overly logical to switch from VSB (MER 0.15) to XBB (MER 0.33) with the logic outlined above. Specifically, it only gets you another ~0.70% in yield (to maturity), though it makes sense for a 30-year time horizon of investing, you’ll eat up some of that improved return with a rise in the MER cost. So I wonder if VAB would be a decent alternative to XBB.

    Is this minutiae?
    Thanks again,

  42. Canadian Couch Potato February 25, 2013 at 8:41 pm

    @Jamie: The difference between short-term bonds and a broad-market bond fund is likely to be large over time. As an example, over the last 30 years, broad bonds outperformed by about 1.34% annually.

    The difference between VAB and XBB, on the other hand, is indeed minutiae, because the lower MER of the Vanguard fund does not ensure better performance. They’re both perfectly good funds, and it’s a coin flip. I discuss this idea here:

  43. Jamie April 2, 2013 at 8:03 pm

    Hi Dan,
    Having just finished reading “The only guide to a winning investment strategy you’ll ever need” by Larry Swedroe, I think I’ve figured out why my advisor recommended only short-term bonds for the fixed income portion of my portfolio.
    In the book, he makes the point that long term bonds are more closely correlated with equities, and therefore present a significant risk during periods of rising rates, when equities can also lose value. He also points out the fact that the volatility of a portfolio rises with increasing the maturities of the bonds. Finally, he makes the point that the fixed income portion should be the ‘safe’ portion, and therefore not at significant risk of declining in value. He uses the period of 1964-2002 for these points – the annualized return of a one month T-bill was 6.2%.
    Regardless, the broad-based bond fund still appeals to me. The 30-year time horizon and the 1.34% figure you quote seem to resonate more. I wonder how important our current low interest rate environment changes his arguments, if at all…

  44. […] and a short term duration fund is only 1% right now. (XSB at 1.58% vs XBB 2.50%) As explained on Dan’s blog on bonds and interest rates, if interest rates rise by 1% per year for three years, a short term bond fund will be in the black […]

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