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.
Here’s one place Couch Potatoes can learn a lesson from dividend investors. If a company raises its quarterly payout and its stock price falls, dividend investors scramble to buy more shares. And why not? The higher yield means they’re paying less for all future cash flows. Tell a dividend junkie to stop buying shares (or trim his current holding) when the yield goes up and he’ll think you’re taking crazy pills. Yet long-term investors who want to stop buying bonds because rates have risen are using the same loopy logic.
Rising yields mean higher expected returns
Let’s say in July 2012 you put $1,000 into a 10-year Government of Canada bond. The yield at that time was about 1.6%, meaning if you held the bond to maturity that would be your annualized return. If today you have another $1,000 to invest, a 10-year bond would give you a yield of almost 2.8%. Surely that new purchase should make you feel better than the old one: after all, if you hold both bonds to maturity, the newer one will deliver an annual return 120 basis points higher.
Bond funds don’t have a maturity date, so their returns aren’t knowable in advance, but the principle is the same. As recently as this April, the DEX Universe Bond Index had a yield to maturity of about 2.1%, while today it’s over 2.9%. That means every dollar you put into XBB today has a much higher expected return than a dollar contributed six months ago. If you were willing to buy the fund in April, why would you avoid it today?
Make sure you’re in for the duration
There’s one extremely important caveat here. Any time you buy into a bond fund you need to make certain it’s appropriate for your investment goals. As I’ve written before, you should never hold a bond fund whose duration is longer than your time horizon.
Broad-based bond index funds—not only XBB, but its counterparts from Vanguard, BMO and TD—have a duration between 6.6 and 7 years. You should not use them to hold the down payment on the house you plan to buy next year, nor hold them in an RESP if your child is in grade 11. It is quite possible they will lose value over the next few years. (For the record, US Treasury bond data go back to 1928 and the worst period was a –0.4% annualized return from 1955 through 1959.)
But if you have a horizon of 15 or 20 years, or more, why are you worried about what might happen to your bond fund in the next 12 to 36 months? Even if you are gun-shy about short-term losses, shifting from bonds to stocks clearly increases that risk.
If you’re in the accumulation phase of your life, rising interest rates will cause some short-term pain. But in the long run they’re a good thing—as long as you stick to your strategy of buy, hold and rebalance.
Right on. Thanks for the reassurance!
With rates so low, isn’t the only way to go up?
I keep my fixed-income holdings (about 30% of the investment portfolio, I’m in my thirties and don’t plan retiring soon) in high interest savings account rather than in bonds. I’ll reconsider when the bonds rates go higher.
I also think I might want to use that fixed-income portion of my portfolio for the cash-down on a real estate purchase in the next 4 to 7 years.
Is that a sane position ?
@John: “With rates so low, isn’t the only way to go up?” People have been asking that question for four years and rates mostly moved down until this May. And since rates are now higher than they were, why is it impossible to imagine they might return to where they were 6 to 12 months ago? If we have a big correction in the equity markets (another common fear after such a long bull market in the US) which direction will interest rates move?
“I’ll reconsider when the bonds rates go higher.” Again, many people have been doing that since 2009 and they paid a significant opportunity costs as bonds dramatically outperformed cash:
https://canadiancouchpotato.com/wp-content/uploads/2012/07/Opportunity-Cost_Bortolotti.pdf
“I also think I might want to use that fixed-income portion of my portfolio for the cash-down on a real estate purchase in the next 4 to 7 years.” Now that changes everything. If you’re planning to spend the money soon, this money is not a long-term investment, and cash is absolutely appropriate. My advice applies only to people who know they won’t be tapping their investments for a decade or more.
CCP what is your opinion on the floating rate bonds HFR which seem to be gaining in popularity these days. Are they a good substitute for XBB or would you add them to diversified portfolio?
I’m excited about rising yields because of the increased returns. While I did fear the effects of rising interest rates, I acted by selling out of bonds entirely over the last 2 years as yields went lower. Now that they are getting a little more attractive I’m starting to think about getting back in. It may not be long before I can own a bond index fund with a yield greater than the interest rate on my mortgage. This is good news.
@johnny m: Floating-rate bonds are not a substitute for a broad-based bond fund:
https://canadiancouchpotato.com/2013/05/02/understanding-floating-rate-notes/
Thank you for the post.
I have some new money that will come in to my portfolio. Rebalancing means that I will have to add to the bond index fund. However, I have no more contribution room inside RRSPs or TFSAs and would need to invest it in taxable accounts.
I know taxable accounts are not the best place to hold bonds. What options do I have, other than the Claymore tax-advantaged ETFs?
Thank you for your very informative and helpful blog.
@DA: The former Claymore (now iShares) Advantaged ETFs are no longer an option, as they have likely lost their tax-favored status:
https://canadiancouchpotato.com/2013/04/02/how-the-2013-budget-will-affect-etfs/
If you must hold fixed income in taxable accounts (and you may not have to if you pay careful attention to your overall asset location) GICs are much more tax-efficient than bond ETFs:
https://canadiancouchpotato.com/2012/03/12/ask-the-spud-investing-with-multiple-accounts/
https://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/
With GIC rates in the range of 2.60-3% for a 5 year rate, wouldn’t you be better off purchasing one of those to get the same yield to maturity? Heck, even a 2 or 3 GIC pays only 20-30 basis points less than most bonds funds if you are looking for more flexibility
This topic is exactly why I chose to go with a 5 year ladder of GICs instead of bonds in my complete potato. I just find it mich easier to understand how it will behave.
@mark and KJF: There’s nothing wrong with substituting a GIC ladder for bonds. Remember that GICs have some practical limitations (it’s hard to add money each month, they’re less liquid, it’s hard to rebalance) and there is no opportunity for a positive bump if stocks crash and interest rates fall. But as long as you’re not trying to guess where rates are headed, it’s a perfectly good fixed income strategy.
Interest rates and yields could stay low and rangebound for 10-15 years. They did in the early 40’s to mid 50’s. Or they could increase modestly and cause bonds to deliver modest returns over an extended period.
Or they could spike like crazy. That said, equities are usually there to pick up the slack when bond prices suffer. In a period of rising rates from 1950-1964 a U.S. balanced portfolio delivered incredible returns – courtesy of the stock markets that went on one of the greatest runs ever. And then there was the 70’s – we don’t want to go there, when nothing worked.
Now what about Warren Buffett’s recent comments that ‘bonds are a “terrible” investment at the moment and that owners of long-term bonds may see big losses when interest rates eventually rise’.?
Our fixed income portion of our RRSP is in the RBC Canadian Government Bond Index Fund right now because we’re not at the level yet where ETFs at a discount broker are cheaper. However, we will be moving to ETFs within a year when we reach a certain mark. When we move to ETFs, will this affect the outcome of the fixed income portion since we technically will not have held the fund for the duration or is it not significant since it’ll be going from one bond index fund into another bond index ETF?
“Tell a dividend junkie to stop buying shares (or trim his current holding) when the yield goes up and he’ll think you’re taking crazy pills.”
Good one.
I’m buying REITs of late since they tanked Dan and although I don’t need more bonds in my portfolio, staying the course with bonds right now is a good call. In fact, indirectly, I’m buying more bonds every month via DRIP and I don’t intend to shut off that tap.
Another excellent reminder to avoid holding any bond fund that has a duration exceeding your investment time horizon. I think this point cannot be re-emphasized enough.
See you this weekend at CPFC13.
Mark
@Joel: Depending when you started contributing to your current fund, you may end up selling it at a loss, but as you’ve anticipated, this really doesn’t matter, because you’re seemly moving from one bond fund to another. You’re not bailing on the asset class.
@Mark: Looking forward to seeing you and the gang this weekend as well!
Hello CCP,
I understand that with rising interest rates, bonds yield also increases. I happened to check on both ishares and BMO sites to check the cash distribution and I couldn’t see a significant increase since May especially for ZAG. Am I looking at the wrong picture to see an increase in yields?
@Serge: You won’t necessarily see the distributions increase. The point is that when the unit price falls, you will pay less for those cash distributions. For example, an ETF trading at $20 and paying a cash distribution of $1 a year has a yield of 5%. If the price falls to $19, the yield would be 5.26%, but the distribution would still be $1.
The number you want to look for is the fund’s “Weighted Average Yield to Maturity.” For ZAG, it’s currently 2.78%.
Ok I get it now. So in fact the yield doesn’t increase unless you buy more cheaper shares. Indeed it makes sense to accumulate those cheaper bonds when you’re young but I guess when you’re retired and you no longer contribute, you just watch the capital loss. Now I don’t understand why if interest rates rise, the borrower doesn’t pay more interests to the lender. There are still a lot of things I don’t understand with bonds, I don’t hold many of them since I’m not 30 yet but I certainly will in the future so I’d like to know them better. Thank you for the quick reply!!
I always think it’s interesting when people complain about low interest rates providing poor returns and then go and freak out when those very same interest rates start to rise. Maybe they just like having something to worry about.
@Serge: Bonds are traded in the market. When current yield goes up, the price of an existing bond, which was issued some times ago at a lower yield, has to go down so that its yield can compete with the new yield.
Hi CPP,
When talking a look at Bond ETFs, I’ve noticed there are Aggregates and Corporate options. In your recommended ETFs, you don’t suggest any corporate bond ETFs, despite these bonds having higher yields. Is there a risk to holding corporate only bond ETFs? ex.
VSB vs VSC.
Thanks,
Hi Dan,
I follow the Global Couch Potato Portfolio utilizing TD e-series for my TFSA. The money in this account is for short-term (3-5 yrs) home renos etc…. Therefore, what alternative to the TD Bond e-series (50% of my portfolio) could I use? The total account is well less than $50,000.
Thanks Brad.
@Matt: Corporate bonds are indeed more risky than government bonds, and during a stock market downturn they provide much less protection than government bonds. For example, in 2008 government bonds (represented by XGB) returned 8.7% while corporate bonds (XCB) returned -0.68%.
Some indexing advocates (including David Swensen and Larry Swedroe) recommend avoiding corporate bonds altogether. I don;t go that far. An “aggregate” bond fund includes a mix of about 70% government and 30% corporate bonds, which is typically a good mix for most investors.
@Brad: The Global Couch Potato is not suitable for a 3 to 5 year time horizon. There’s no e-Series short-term bond fund, either, so the only safe option is really GICs or a savings account. Your goal here should not be maximizing returns: the priority is safety.
The income from bond funds such as CBO and XBB has been falling for a while. I would guess there would be quite a lag on getting the real income per unit to increase in the funds – as a result of new higher yielding bonds being added to the funds? And the longer the average duration (and the greater number of bonds in the fund) the greater that lag?
Thanks Dan.
@Dale: I’m not entirely clear on how these ETFs determine their monthly distribution amounts. The seem to make some effort to keep them fairly consistent (I’m not sure it’s accurate to say they have been “falling for a while”). CBO in particular regularly adds a return of capital component to keep the payouts predictable, like a monthly income fund does.
But you’re right that there will be a significant lag before you see those coupons moving up. Just because rates went up this year does not mean bond funds are buying many new bonds with higher rates. That is especially true in something XRB, where there are no new issues to buy.
@CCP Any chance you’ve researched which bond funds have distributions close (or below) their coupons? E.g. hold bonds at par or at a discount. I have room in my taxable account and I don’t really want to buy GICs and the Advantaged funds are now useless for this purpose.
You would think with all the new ETFs someone would start up a new fund just for this reason.
@Brian: As far as I know, there are no funds that hold only par or discount bonds. It would be impossible to find enough of them, at least for now. It’s easy enough to check by simply comparing the weigted average coupon and the weigted average YTM on any ETF: these numbers appear prominently on the fund’s website. I can’t imaging you’ll find one with a coupon lower than the YTM.
GICs are ideal if you need to hold fixed income in a taxable account. But you may also want to consider strip bonds. More info in these links. Just understand that this ETF is very new and no one really knows what the distributions or tax implications will be:
https://canadiancouchpotato.com/2013/06/05/a-new-etf-of-strip-bonds/
https://canadiancouchpotato.com/2013/06/07/why-use-a-strip-bond-etf/
@CCP Thanks for the ideas, I had never seen that strip bond ETF before. Food for thought but it might be a little too new for me.
One other question, what do you think of buying individual AAA Canadian government bonds in a ladder with the intent of holding each to maturity? Right now, I see that you can find some at or below par. Is there really more risk doing this than buying something like CLF or XGB?
Buying corporate etfs are attractive because of yield. Nonetheless, I think they should be considered more an equity type purchase then fixed income and that is what makes it problematic. One’s asset diversification is the only investing free lunch available because of the asset correlation factor. Federal bond etfs are negatively correlated to equity etfs and there’s the free lunch. Corporate bond etfs move more like equities and should therefore not be included with the bond diversification mix of one’s portfolio. Diluting the bond mix with corporates I think changes your strategic asset mix increasing volatility. You may not want that since bond purchases are supposed to reduce volatility? I guess 30% corporates as in XBB may be less significant, but if you are a purist then even that is bad :).
@JohnZ
Thank you, I used to think bonds were like a variable rate mortgage. Whenever the rate increases, the bond issuer had to pay more interests. I see now how I’ve been misled by this idea. Thanks again!
@Brian: Buying individual government bonds is not more risky than buying them via an ETF, and using a bond ladder can be an excellent strategy, especially if you can get them at par or at a discount.
Dan – my horizon to retirement is shortening. I expect to be retired from full-time work in 4 to 5 years, then work maybe 40% time for 2-3 years after that, and then shut down the employment completely. I have a reasonable amount of money invested, a lot of it in the “Complete Couch Potato” portfolio (non-RRSP), and for the fixed income portion, 35% in XBB and 10% in XRB. Should I be changing my strategy regarding the type of fixed income ETFs I am using, as my time horizon shortens, and if so, to what?
Thanks…..GeoEng51 (John)
@GeoEng51: It’s impossible to be too specific without knowing your whole situation, but in general you’re probably fine for now. But you will want to start thinking about a strategy for drawing down your portfolio after you stop earning an income. Any money you will need within 4 or 5 years should not be in bond funds with a long duration (or stocks, for that matter). You will likely find it makes sense to keep a couple of years’ worth of income in GICs, cash or short-term bonds.
I find it useful to see the portfolio as buckets: open, registered, TFSA, RESP, time horizons short, medium and long, asset classes: cash, non equity correlated, equity correlated, absolute return, overall asset allocation based primarily on capital at risk with a nod to tax efficiency, maximizing compounding time. Rebalancing based on rules. The permutations are complex but pretty easy to understand with a spreadsheet like Dan provide on this site.
A ladder of GICs in open accounts instead of bonds (corporate like yields, government insurance through CDIC) and ETFs like CBO, XBB and XRB fit the registered neatly.
Its interesting to see the money weighted return of an ETF like XBB can become high due to a long holding time, while the simple return can be negligible.
Dan how do you draw down complete couch potato portfolio ones you stop working? My thinking was just to maintain portfolio asset allocation (in my case 60/40) indefinitely (well not quite indefinitely…. you know what I mean) and peal off max 3% of portfolio value annually. These 3% would be mix of dividends, interest payments and sliver of capital gains. Does this make sense??
@Gordon: You have the general idea: in most cases it makes sense to have a couple of years’ worth of income in cash or short-term bonds so you have a buffer when the rest of the portfolio suffers losses. But the details about how to draw down the portfolio in retirement are very complicated, especially if you have a mix of registered and non-registered accounts, other sources of income, etc. It is the one place where it’s really difficult to be a DIYer.
Dan, I read many questions in this post on portolio alloacation and withdrawl strategies in retirement. I have asked you about this in the past as well and you said maybe you will write about it in a future post, any luck with that? :) I know it is easy as each situations will be different but a general post would be greatly appreciated.
Thanks
@karim: I guess I’ve come to appreciate that it’s not a blog post, it’s a book. Drawing down a retirement portfolio in the most tax-efficient way possible is one of the most difficult tasks even for a professional. And I’m not an expert in this area by any means!
You might be interested in Your Retirement Income Blueprint by Daryl Diamond, which looks at the issue in detail.
In fact my portfolio is spread across registered and non registered accounts. Fixed income portion (XBB, XRB) is in registered and everything else in non registered accounts. I agree about having enough cash for couple of years. I don’t understand why is drawing down portfolio difficult to do? 3% rule supposed to insure that I don’t outlast portfolio. If 3% drawn is not enough to cover annual expenses additional funds are need to be obtained from other sources (par time work, investment property, etc.). Am I oversimplifying seemingly complex matter?
What happens if you own Claymore advantaged funds now and once the advantage expires. Are they dead money? What kind of market exists and who would buy them at this time?
@Al: I think that’s a question for iShares. I don’t know whether they will just close the funds and return the assets to the unitholders or whether they’ll roll them into other funds in the same asset class.
HI
Thanks for confirming my strategy of adding to my bond position in our RRSPs with the recent “correction”. With the longer timeline, I am less worried about further downward pressure. I did end up feeling uncertain with various opinions and divided my position into corporate, broad based, and short term (1-5 year ishares), and I added a bit of emerging markets for more yield. Not sure what you think of using international bonds in the mix. I know Vanguard (USA that is) has an international bond option.
I am curious about your comments about RESPs. As my kids are getting older I am shifting away from equity to reduce risk and intended to move it over to bonds but now I feel a bit stuck. You wrote about this in an older column, with suggested weights according to age of children. FYI I don’t have an e-series account so I have been preferring to use ETFs. In this environment what would be the best options for shifting away from equity to fixed income?
@Chris: For fixed income in RESPs, I would just use an investment savings account (these trade like mutual funds and are available from any discount brokerage) or GICs. Just make sure the GICs mature a few months before you need the money so they want be locked in when the tuition bill arrives. Trying to scratch out a few extra basis points of yield on a relatively small amount of money is unnecessary in my opinion.
If you’re not familiar with ISAs:
http://www.canadiancapitalist.com/high-interest-savings-accounts-at-discount-brokers/
If my time of horizon to draw money is 20 years or more should we look to buy long term bond fund instead of medium one like you often recommend?
@Francis: Long-term bonds are very volatile, and they don’t necessarily provide better risk-adjusted returns. For most investors, a broad-based fund is a better choice.
Investing in fixed income products seems so complex… :(
Hi: I look at my portfolio as a series of 5 year plans, approximately to build my portfolio value. Given all that has been written in these posts, I don’t get WHY it is necessary to have any bonds at this time. Why not just invest in equities? I look forward to all your comments.
CCP – look forward to each new article from you – in this one you talk of re-balancing and I have a situation many may have. Currently retired and went DIY about 5 years ago – 60-70 % fixed income ( consider re-set preferred as F/I ). As part of my equity bought some big winners – picked up IPL at below $ 9 and it is currently trading in mid 20’s with a 5.1% yield. Is this a case not to re-balance. F/I is still north of 50%. Do you place any credence to yield calculations on cost price – getting 15% on cost. Is this an equity situation where us dividend guys would be crazy to sell with a gain ( as opposed to a loss )
@Helen: An all-equity portfolio is suitable for someone who has both the stomach and the time horizon to be able to endure a loss of 50% or more. Many people have the latter, but few have the former.
@Pickering: I’ll be honest and say I don’t think I’m the right person to ask about rebalancing a portfolio of individual stocks and pref shares. Here are my thoughts about measuring yield on cost:
https://canadiancouchpotato.com/2011/02/02/debnking-dividend-myths-part-6/