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, this short-term benchmark is only one of many interest rates. The yields on two-year, five-year, 10-year and longer-term bonds move independently of the target rate, and these are the rates that affect your bond index fund. They’re rarely reported in the financial media, but you can follow them on the Bank of Canada’s website.
The chart below shows the yield on several benchmark Government of Canada bonds over the last two months:
Notice that all of these rates moved upward in May, and the steepest line belongs to 10-year bonds, which have seen yields jump from 1.68% at the beginning of the month to 2.07% on May 29. As a result the iShares DEX Universe Bond (XBB), the BMO Aggregate Bond (ZAG) and the Vanguard Canadian Aggregate Bond (VAB), all which have an average term of about 10 years, saw their market prices fall significantly during the month:
The price is only half the story
There’s another extremely important point to understand. Whenever you look up bond ETFs using a tool like Google Finance, as I did above, the results are highly misleading. These charts show only the change in market price, not the interest payments paid to investors in cash, so they do not reflect the total return of your bond ETF.
These days, with virtually all bonds trading at a premium, you should expect the market price of your fund to fall even if interest rates hold steady. However, the cash payments from the underlying bonds are in the neighbourhood of 3% to 3.5% for broad-based index funds, which will offset at least some of that price decline. Indeed, the three ETFs above each delivered a total return of more than 1.5% during the 12 months ending in May, even though their market prices fell considerably during that time.
Remember this when you look at your brokerage statement. Say you bought ZAG on May 31, 2012, and paid $15.96 per unit. Exactly one year later its price was $15.70, so your statement would show a loss of –1.63%. However, the fund’s total return over that period was +1.62%, because the interest payments more than offset the price drop. You didn’t lose money, even though I’m sure some investors thought they did.
An individual fund’s total annual return never appears on your statements, so you should periodically visit your bond fund’s website to see how it’s really doing. Click the “Performance” tab to see the total return on the fund including price changes and reinvested interest payments. Here’s what they look like for ZAG:
If yields continue to rise, bond funds can and will deliver negative returns even after accounting for interest payments, so you should be prepared for that. Remember why bonds are in your portfolio: they lower overall volatility and provide a cushion when equities inevitably suffer a downturn. If bonds do have a difficult year, that’s not a reason to abandon them: it’s an opportunity to rebalance.
What would happen to bonds for example if interest rates climb say by 3% over the next 2 or 3 years – which really now may not be out of the realm of posibilty? People who have Bond funds with high mer’s may also have to consider that fee alone may negate any gain or even cause a loss, for the next while as well. (People with work pension plans that have little choice in selection could be affected more with their high fee fund offerings).
Maybe slowly laddering into GIC’s now as interest rates rise within an RRSP with a portion of your money might be something to consider?
@Paul N: There’s no question that fees are much more important in this era of low rates. There are funds with a yield to maturity of 2% that charge more than 1% in fees, which is outrageous.
Regarding the effect on rising rates on bond funds, see this post, where I asked iShares to run some simulations assuming a 1% hike across the yield curve for three years in a row. There would certainly be some negative returns, but my guess this is not nearly as bad as many people expect:
https://canadiancouchpotato.com/2012/07/03/how-will-rising-rates-affect-bonds/
There’s nothing wrong with a GIC ladder (or short-term bonds) if that’s in line with your goals. But be wary of using phrases like “now as interest rates rise.” Interest rates rose (past tense) in May. There is no reason to assume they will continue to rise this month or next. We saw a similar hike in 2012, and it was immediately followed by another rate drop. If we have a correction in the equity markets, rates will almost certainly fall. That’s why it’s important to have a long-term target and stick with it. Otherwise you become a market timer.
Thank you so much for this explantation. I did indeed buy bond ETF’s a year ago and should rebalance now. I am glad that you reminded us how weird it will feel to put money into what feels like a losing proposition, but that is just so that next year or the year after, we feel great about the overall mix.
It looks like there have been particularly big moves in the yields Friday and today. I would welcome higher bond yields since they will provide much better long-term returns regardless of the short-term impact.
Thank you for that fast reply. My work pension plan has a 1.6% mer on the bond offerings. I have no other bond option. I feel if I will be faced with GWL skimming off that amount for the next few years (coupled with most likely a low return). I don’t have much of a choice. I’m sure I am not the only person in a company pension plan out there that is in this boat.
I won’t get 100% out of bonds. By transferring a portion of what I have into the GIC offering in our plan I feel the risk is minimal. If the Bonds suddenly go up I still have bonds. If they go down further I will have buffered the drop with a few GIC’s to offset some of the loss. ( And I’ll feel better I saved some of my 1.6% fee :) )
@Paul N: At 1.6%, the fund manager is getting three-quarters of the yield to maturity. It’s absurd. Is there a way you can structure your overall situation so you your work plan is 100% equities and the fixed income component is held in a self-directed RRSP where you can take advantage of lower-cost bond options?
Let me see if I have this right… so as interest rates on long-term bonds rise, the demand for the older bonds in the fund (which have today’s lower coupon) will decline, so the demand and thus price for the existing bonds being held will go down. But as these older bonds in the fund reach maturity and are replaced with higher-coupon bonds being issued under the new, higher rates, the fund itself will gradually fill up with new, higher-coupon bonds – so this means that if you’re holding it long enough to get to the point where interest rates start falling again say in ten to fifteen years (none of us know when), then you’ll be holding a fund full of comparatively high-coupon bonds which will be in demand relative to the current offering. Is that right?
I have the same problem as Paul N. I’m glad to hear you are offering suggestions, but my company has a DCP and offers the choice of about 20 mutual funds and that’s it; all of which are loosing money, even though I have balanced to them within 1% of the Couch Potato Portfolio (so how have they catastrophically missed the S&P 500 rise I dunno – but that mutual fund is down 10%!!). Many of the employees are crying out to be able to use self-directed RSP’s, which we are welcome to use, but if we do, the Company won’t contribute to them. But we know we are being screwed by fees and poor returns of the mutual fund company!
I am underwhelmed by the fees on this account, but at the end of the day, all I can do is grit my teeth and say my Company is matching my contribution so I am ‘making’ more than the mutual funds are loosing. How long that will continue, I don’t know. But it is a weak supportive thought as I have watched my entire portfolio loose about 20% over the last year…
Also, since the company will only match a certain percentage of my contributions, I am only contributing the maximum amount that the Company will match. The rest I am putting into a self-directed RSP, which is slowly being bought into alignment and balance with the couch potato portfolio (because being a ‘new’ Canadian, I didn’t start out with a Couch Potato Portfolio and do not have a lot of room to contribute each year…)
How do you think this fits in with floating rate bond ETFs that offer decent yields and much lower duration risk? I’m thinking of XFR as a lower-risk option, and HFR as a higher risk.
@Alex: You pretty much nailed it.
@Cybamuse: It’s hard to imagine how any portfolio could have fallen 20% over last 12 year. If your only choice is high-cost, terribly managed funds, is there a way to do the opposite of what I suggested to Paul—that is, get the maximum company match by using the most conservative fund you can get (maybe a money market fund) and then keep all your equities in self-directed RRSPs and TFSAs? And maybe transfer out as much as you’re allowed each year?
@Andrew F: I wrote about floating rate notes here. As always, there’s a tradeoff you need to consider:
https://canadiancouchpotato.com/2013/05/02/understanding-floating-rate-notes/
Wow as a DIY guy I really never thought of it that way. Just the opposite. I always think of my fallback as my work pension so I kept the “safety” portion in bonds there. I invest in securities outside of it in my TFSA and SD-RRSP. Your idea of course makes sense. Just some of those DC equity funds (you know the ones that they claim are low to medium risk on their website?) took such wild swings of volatility down 55 to 60% in 2008 – 2009 but never really came back up the same way they went down.
I have been trying to pressure our people in power at work to do a full review and comparison of our DCP to other companies offering group plans. At least threaten our existing provider that we will leave if they don’t offer other low cost options or a few index funds as option 2. It’s finally met “some” success but unfortunately when the CEO and our accountant do not know the difference between a GIC and a bond and invests 100% only in GIC’s…claiming that’s the only safe thing to do, its a little tough to explain. A discussion about inflation and it’s effects on GIC returns was also lost on them. An on-line MER calculator (wheredoesallmymoneygo.com) was actually one tool I used and it helped make my point – people so resist change. I have worked in one place for quite some time – I have to put it out of my mind regularly of how much I lose (bleed) in fee’s every year.
@Paul N: It’s so disappointing to hear stories like this. One of the benefits of a workplace plan is they usually qualify for much lower pricing than retail funds, if for no other reason than there is no advisor to pay. It’s a shame that’s not the case here. And there’s really no excuse for not offering at least some kind of indexed option. My suggestion assumed that you had some reasonable equity options in the DC plan, but it sounds like that may not be the case either.
Thanks for your support and comments, love your Blog!
I am in the same boat as Cybamuse & Paul N. My employer DC pension plan matches up to 5% of the employee contributions. It is run by one of the biggest players in the Canadian DCPP business. Overall it is a decent plan and very generous on the part of my employer. However, the bad part is that the investment choices consist of about 25 or so mutual funds. The mutual fund MER’s are lower compared to retail, but compared to ETF’s the MER’s are absolutely outrageous.
My only option to get my investments out is to leave the plan and forfeit the 5% matching. Not a great option. In addition, I strongly suspect that behind the scenes, the DCPP carrier is indexing themselves and repacking in a “mutual fund” wrapper which gets marked up with higher MER’s and then sold to the employees.
In my opinion a lot of money in MER’s is being made on the backs of the employees, not only at my company but at all other employers across Canada.
How can we put pressure on these large work DCPP plans to reduce their fees?
Paul, would you be able to put together a comparison that shows how the funds have underperformed their benchmarks? It sounds like you could pretty easily make the case that they are all terrible and there are similar options with much better performance (ideally, from a low-fee provider). If these funds have all been around for a while and you focus on the long-term record, the difference should be pretty clear. Ask the CEO what would happen if the business delivered 60% of the value that competitors do at twice the cost…
My employer is using manulife and we can select our index funds. My MERS are all competitive to TD-series funds. And performance has been well above expectations. I decided to take the option of maxing out my RRSP’s aswell as the pension plan through pay deductions. So fight hard, there are great providers out there. And I hope you’ll end up getting a pension plan that’s a great match.
That was TD e-series funds, which I also hold in my TFSA
I have a questions reagarding this
“If yields continue to rise, bond funds can and will deliver negative returns even after accounting for interest payments, so you should be prepared for that”
I was under the impression that you will get the yield to mataurity of fund if you hold it for the duration regardless of what happens to interest rates?
For example, VAB has a current YTM of 2.1% and duration of 7.2 years, is it possible to lose money if you held it for 7 years?
thanks
@karim: Yield to maturity and duration are not precise, but they are good estimates. You’re correct that you will not lose money if you hold a bond fund for a period equal to its duration. I was only referring to negative returns over shorter periods. It’s certainly possible for a fund like VAB to lose money over three years or so if rates move up steadily. There was a period in the 1960s when bonds suffered negative returns for a few years running. But these losses were small, and new higher-coupon bonds eventually led to a relatively speedy recovery.
Of course, you could try to time the market by selling bonds when you think rates are about to rise, and then buying them back when yields are higher. Ask the gurus how that’s worked out over the last four years. :)
http://www.forbes.com/sites/petercohan/2012/02/25/bill-grosss-bad-call-cost-investors-5-7-trillion/
http://blogs.marketwatch.com/thetell/2013/05/31/pimcos-total-return-fund-headed-for-worst-loss-since-2008/
If you think nominal bond ETFs are having a rough time, take a look at real-return bond ETFs. I assume their poor recent performance is due to their long duration (>15 years). Does anyone know if there are any real-return bond funds with a shorter duration (say less than 10 years)? I’d like an instrument that is less influenced by interest rates and more influenced by inflation.
@Smithson: Yes, RRBs are affected by both interest rate movements and expected inflation. And because of their long maturities and low coupons they have a long duration and they can be quite volatile in the short run.
https://canadiancouchpotato.com/2013/02/28/ask-the-spud-the-role-of-real-return-bonds/
Unfortunately, there are very few Canadian RRBs (there are only six federal government issues) and they all have long maturities. In the US, it’s very different: the federal government issues new TIPS (Treasury Inflation Protected Securities) every year. Not sure why the situation is so different here.
@Dave – I agree with you! I am loosing about 10% in fees each month with the company plan, and most of the mutual funds I am forced to choose from are broadly following indexes. No wonder I am loosing money…
@Dan I like your advice to restructure to put everything into the most conservative funds my company has – although I don’t like the fact they are the ones loosing the most right now. But being in 5 mutual funds (to get that Couch potato ratio right), when is the right time to pull out given ALL of them are down between 5 and 20% right now? For me to restructure conservatively means walking away with a 10-15% loss on the total book value. Is the right thing to do is suck it up and take that, rather than continue to haemorrage money over the next possible 10-15 years of working life with this company? My only consolation being that the money ‘lost’ was contributed by my company not me?!
FYI, , company DCP is with Sunlife and the mutual funds we are being offered seem to be specifically designed for our company as they don’t offer public information about them on their website. It was hard just researching the 20 odd mutual funds to get ANY information on them. There is no doubt employees of my company are being offered an archaic deal, and in an internal survey last year, I can at least note our employees wanted to have more access to ETFs, more transparency and choice and lower fees in their DCP, but our HR department put it on the backburner :-(
@Cybamuse (and Paul): I hope it’s clear the only thing I’m suggesting is a change to your asset location, not your asset allocation. To use a simple example, let’s say your target asset allocation is 50% bonds and 50% stocks, and you currently have that mix in both your company plan and your self-directed accounts. You may be able to lower your overall cost by instead holding 100% of the bonds in your company plan and 100% of the stocks in your self-directed plan. But your overall mix (and therefore your risk level) doesn’t change.
With that in mind, it doesn’t matter when you sell any specific fund, because you’re going to be buying something similar immediately in the other account. You won’t be buying low and selling high, or vice-versa. You’ll be selling low and buying low, or selling high and buying high.
Within a basic couch potato portfolio, my allocation to bonds is currently 30%, all in XBB. Would you see any need to add any other bond diverisification, or simply stick with the plan and rebalance to my chosen percentages?
Smithson:
Cash, as T-bills, can also actually be quite highly correlated with inflation and can in fact outperform stocks and bonds periodically when inflation is high (but not necessarily after tax – not an issue in TFSAs RSPs RDSPs RESPs). See here: http://www.fpanet.org/journal/CurrentIssue/TableofContents/TreasuryBillsandInflation/
HISAs may be a substitute.
It is a controversial subject. I needed to see the Canada inflation/cash historic relationship for myself because the research is so sparse so I ran some numbers using BofC and StatsCan data comparing the year over year % change in the Canadian CPI with the average of the March, June, Sept and Dec, 90 day Canadian TBill rate from 1974 to 2002. I found the average 90 day T-bill rate exceeds the average CPI over this period by 2.49% which is interesting.
I decided to break down the numbers by the periods of high moderate and low inflation:
Between 1974 and 1983 the average year over year change in CPI was 9.43% and the 90 day T-Bill only exceeded this rate by only 0.13% with several years where the CPI exceeded the T-Bill rate (1974,75,77,79). The TBill rate seemed to lag the CPI for 2 years then catch up then lag again for 3 years.
Between 1984 and 1995 the average year over year change in CPI was 3.48% and the T-Bills exceeded this rate by an average of 4.64%. Perhaps the T-Bill rates were so high because of fears of renewed inflation during economic expansion. This is something to consider given present conditions and historically low rates for the past several years.
Between 1996 and 2002 the CPI average year over year was 1.91% and the T-Bills exceeded by 2.17% on average.
To conclude: in Canada during high inflation the T-bills kept up with inflation, as inflat