Your Complete Guide to Index Investing with Dan Bortolotti

Bond Basics 3: Should You Wait for Higher Yields?

2018-06-21T07:14:45+00:00May 9th, 2017|Categories: Asset Classes|Tags: |39 Comments

In my last podcast, I set out to answer a series of common questions about bonds. Here’s one I’ve been hearing on and off since 2009: “With yields so low now, is it even worth it to invest in bonds? Wouldn’t I be better off waiting until interest rates go up?”

It’s true that interest rates are near historical lows: as of early May, 10-year Government of Canada bonds are yielding just over 1.5%, and a broad-based bond index fund like the ones I recommend in my model portfolios yield a little less than 2%. It’s hard to get excited about that, especially when equity returns have been so strong in recent years.

It’s also hard to tune out the financial media, which is still populated by gurus who warn interest rates have “nowhere to go but up.” Since rising rates will cause the value of bonds to fall, why not just stay out of bonds until yields are higher?

The first thing to discuss is this idea that interest rates are highly likely to go up in the near future. I don’t think we can take people seriously anymore if they continue to beat this drum. We have been hearing this argument almost constantly for at least seven or eight years, and it has been spectacularly wrong. Bond yields have trended steadily downward since the end of the financial crisis of 2008-09, even as the economy has recovered. If nothing else, that should tell you that anyone who thinks they can forecast interest rates is delusional. So if you’re building a portfolio based on the idea that interest rates are certainly going to rise, you’re making a critical decision based on guesswork.

(If you want to read an actuary’s take on why there’s no reason to expect interest rates to rise, see this article by Fred Vettese, who also discusses the idea in his excellent book, The Essential Retirement Guide.)

“You need me on that wall”

If we accept the premise that interest rate forecasts have no value, we can think about bonds in a different way. Why hold bonds in your portfolio when they’re yielding less than 2%? Because most investors just don’t have the stomach to hold an all-equity portfolio. By adding bonds to your portfolio, you make it less volatile and less likely to suffer large losses during a market downturn. When an ugly bear market finally arrives, those bonds may be all that stands between you and the exits.

By their nature, bonds are a lot less volatile in stocks: a traditional bond index fund, for example, is not likely to lose more than 5% or 6% even in a very bad year, whereas that’s a bad day for stocks. So adding 20% to 40% bonds is going to lead to a smoother ride compared with a portfolio of all equities. Moreover, when stock markets fall sharply, interest rates usually go down, which causes bonds to go up in value and reduce the losses in your portfolio.

I can already hear some younger investors pushing back against this advice: they may argue that because they have many years to recover from a market downturn they don’t need to worry about short-term losses. Maybe that’s true, but let’s remember that we have been enjoying a bull market for about eight years now, and many young investors have never experienced a true market crash. Unless you lived through 2008–09, when an all-equity portfolio would have been cut in half in six months, or through the dot-com bust, when an equity portfolio saw three straight years of negative returns from 2000 through 2002, you don’t really know what your risk tolerance is. So don’t be so sure you’re you can get by without any bonds in your portfolio. (I touched on this issue in the Ask The Spud segment of Podcast 3.)

At the other end of the demographic spectrum, if you’re a retiree, you might be depressed about low interest rates and reluctant to invest in bonds, too. And you might reasonably argue that you’ve lived through many market crashes during your lifetime, so you can comfortably handle an all-equity portfolio. But I’d encourage you to rethink this idea as well.

First, if you’re drawing down your portfolio in retirement, you may no longer have the time nor the earning power to recover from a major market crash. You need some bonds in your portfolio simply to reduce your risk of large losses. And second, if you’ve been a good saver and your spending is modest, you probably don’t need to take that much risk with your retirement savings. Most people can meet their retirement income goals with a balanced portfolio that generates a return somewhere between 3% to 5%.

Bottom line: yes, interest rates are low and if they rise, bond index funds will lose value. But for most investors they should still be a permanent part of your portfolio.



  1. Chris AtLee May 9, 2017 at 8:42 am

    What’s the longest it’s taken for the stock market to return to previous levels after a crash? Let’s say it’s 10 years.

    Something I’ve been wondering about is, why shouldn’t I keep my portfolio in 100% equities until 10 years before retirement, and then start moving into bonds? Wouldn’t that maximize my chances of good returns from the stock market? Is it because holding bonds lets me buy the market at a discount during a downturn as part of rebalancing my portfolio?

  2. Canadian Couch Potato May 9, 2017 at 8:50 am

    @Chris: That seems to make sense in theory. But imagine you have been saving for 30+ years and now you’ve built a nice nest egg. You’re 10 years from retirement and we have crash like 2008-09 and you lose half your life savings in six months. Or we have a period like 2000-02, where equity markets delivered negative returns for three straight years. My guess is your reaction would not be, “No problem, I have several years to recover before I retire.” It is more likely to be despair and panic.

    Never underestimate how difficult it is to lose a large chunk of money.

  3. Brendan May 9, 2017 at 9:06 am

    Chris AtLee, I think I can answer this one. Dan’s line of thinking is generally that new investors (those who’ve gotten serious about it since the 08-09 crash, typically millennials) haven’t ever experienced true volatility, so they don’t know how much they can *actually* handle. Therefore, your asset allocation is really just a guesstimate of your actual risk tolerance (since you’ve never been able to measure it). Guessing the ‘extreme’ is not probably not the best place to start guessing for most of us. A well-laid plan that’s actually followed is better than a great plan that you bail from because it’s just too scary to handle, so guessing the right AA is an important step.

    So, the math might make sense for your plan, but if you haven’t experienced a big crash or a prolonged period without growth, you might not be as ready for it as you think. It’s hard to know, so you hedge your bets. On the other hand, you know you better than anyone.

    Having some bonds also lets you ‘buy low’ after a market crash. This is typically done by just following a re-balancing plan. Personally I’d put 90/10 as my aggressiveness ceiling no matter the circumstances.

  4. Greg May 9, 2017 at 12:26 pm

    While I do agree that most people need bonds in their portfolio, I’m not convinced that bonds are a good substitute for high interest savings accounts that yield 2%, especially for the shorter duration bond funds.

    Also, in Canada, it’s not possible for rates to go much lower without going into negative yield territory, which I don’t see happening.

  5. James MF May 9, 2017 at 12:54 pm

    Great post! I really appreciate the current series on bonds. I’ve started my portfolio with a bond component, for all of the reasons expressed in your archive, which I plan to continue raising over time. I have no doubt that a crash will happen in my lifetime, probably several. I’m convinced by the math that it just makes sense to include the dampening effect of bonds in my portfolio.

  6. Julien May 9, 2017 at 1:37 pm

    @CanadianCouchPotato: Would you ever recommend to “buy low” after a market crash with your bond allocation as stated by Brendan? It is something that I periodically think about. I think that it makes sense provided that you have a stable source of income, can remove the emotional component of the making that decision, and can swallow the volatility. Would it be something you would ever do?

    I can already think of your argument against it: “Why take on more risk than you need?”. Which I agree with… but at the same time markets have always recovered.

  7. Tim May 9, 2017 at 1:50 pm

    What about investing in preferred shares instead of bonds? What kind of affect would a market downturn have on the value of a preferred share? There are preferred shares offering 3-5% yields, but I don’t really understand the risks compared to a bond fund.

  8. Canadian Couch Potato May 9, 2017 at 1:59 pm

    @Julien: The “buy low” aspect is built in to the idea of rebalancing. If stocks plummet and bonds rise in value, the simple act of rebalancing involves selling (bonds) high and buying (stocks) low. I think this is what Brendan meant, though I don’t want to speak for him.

    @Tim: Preferred shares don’t offer anything like the diversification benefit of bonds. During a market crash they typically fall along with stocks. I discuss this question in the podcast. You may also be interested in these:

  9. jb May 9, 2017 at 3:18 pm

    A rheorical question: might a retiree just invest in a Canadian-bank ETF? — The principal value might fluctuate more than a bond fund, but the income should be higher and not likely to decrease.

  10. Peter May 9, 2017 at 6:34 pm

    @CanadianCouchPotato What is the advantage of bonds over a high interest savings account? EQ Bank offers a 2.25% CDIC ensured account and Tangerine frequently has promotions offering 2-3%. Alterna Bank, also CDIC insured, even offers a TFSA savings account with a 1.90% rate. Even if one doesn’t want to take a view on the direction of rates, I think it’s fair to say rates have a lot more room to go up, than room to go down (assuming they don’t enter negative territory in Canada). Given the larger upside potential for rates, and downside for bond prices, doesn’t it make an even stronger case for the high interest savings accounts over bonds as a less volatile investment? Additionally, with the Fed now raising rates in the US, won’t yields follow, albeit at a slower pace?

  11. Oldie May 9, 2017 at 6:50 pm

    The hypothetical questions asked in this post (and in the responses from readers) are a good test of how well one has grasped the CCP idea. Trying to sort out my answers have led to an uncomfortable review of what I truly believe.

    I think in my journey from Newbie Couch Potato to Intermediate I have gone through various stages of thinking. The first was enthusiastically embracing the CCP principles intellectually, while never really letting go of the underlying thought that my “feelings” were reliable, for example, regarding the idea that Equities would be underpriced following a crash. So I would be tempted to use Bond ETF money in that situation to fund “over-purchasing” of depleted equities to a higher allocation than specified in the original formulation, so as to “lock in” a superior profit when the equities subsequently rebounded.

    All this went on while I told myself I was being rational, and as part of my rationalizing, I thought of the periodic rebalancing strategy as a disciplined method of buying low and selling high.

    I realize now that this has been a jumbled mix of theory and a lingering hopeful belief in my ability to predict the future in specific profit making ways. With great difficulty, I think I have moved on to the sober realization that while periodic rebalancing to re-acquire one’s originally formulated asset allocation ratios may indeed sometimes result in a successful “buy low sell high profit” situation, maximizing profit after fluctuations is not the primary intent of re-balancing — it is to regain a situation (i.e. a buffering asset mix) that you can live with despite all possible economic outcomes, come what may, because you truly cannot predict the future. That idea should be simple enough that I hope I don’t lose sight of it.

  12. NKD May 9, 2017 at 6:51 pm

    I don’t have anything further to add to this discussion, but I would just like to thank you Dan (and others who comment here) for the insightful information. Almost every article I read on this great blog has comments following it which ask things that I’m commonly thinking as well. Even if not, it provides a great discussion of alternative views and their merits.

    I truly do not understand why we are not teaching this stuff in school. In High School we had CPP (Career and Personal Planning) classes which were mandatory and taught resume building, job searching, etc but never the importance of simple financial planning. I was lucky because my math teacher was adamant that we understand the power of compound interest. That’s the only reason why I gave financial planning and investing a second look once I was working.

    Anyway, that’s a bit of a tangent. But all I want to say is thanks to all and especially Dan for this amazing resource for Canadians young (especially the young ones) and old.

  13. Canadian Couch Potato May 9, 2017 at 7:10 pm

    @NKD: Many thanks for the kind words of support. It is indeed a lot of work to maintain the blog (and now the podcast) so I genuinely appreciate when people take the time to say it has been helpful. Cheers!

    @Peter: There is certainly a good argument to use a high interest savings account in place of bonds, so long as you stay within CDIC limits and you understand that those rates are not guaranteed (especially at Tangerine, where they are almost always temporary teasers). I discuss this idea here:

  14. François May 10, 2017 at 3:14 am

    Dan, great work as usual. One thing I am struggling is the composition of my bond holding. If the idea is reduced variability I would think that you would be going mainly shorter duration. However to me this sounds like in trying to guess interest rates, within the component- it’s been fine in recent years with an extremely flat rate curve, but this seems anti couch potato.
    One more issue, since I expect significant portion of post retirement spending to not be pegged to the Canadian dollar, does it make sense to start having bond component diversified in currency? I know it will mean variability in return expressed in a base currency, but wouldn’t it reduce variability of my purchasing power, which should be the ultimate goal?

  15. Canadian Couch Potato May 10, 2017 at 7:29 am

    @Francois: Thanks for the comment. The decision to use short-term bonds rather than a broad-market fund is not about forecasts or active management. It’s just a decision about how much risk you’re willing to tolerate. If your goal is to minimize volatility, then choosing short-term bonds is a perfectly reasonable decision. This is quite different from, “We know interest rates will rise, so I’m going to use short-term bonds now, and then when they go up I’m going to switch,” which is a much more active approach.

    As for holding USD-denominated bonds, I do not recommend this: just get your currency exposure on the equity side of the portfolio:

  16. Patrice Leblanc May 10, 2017 at 2:39 pm

    @Chris AtLee:

    What’s the longest it’s taken for the stock market to return to previous levels after a crash?

    – I believe that the question is wrong. The previous level is due to a bubble. So its level is quite high. Ex: between 1924 to 1929, S&P500 picked up a stagerring return of about 400%. I’m on the opinion that a better approach is required than only looking at the Fund level. Perhaps the average of expected pension at retirement since contribution start date?

    – However, if we compare the peak of 1929, it would take more than a decade before breaking to the peak.

    – Feel free to look at
    for my analysis of the market crash.

    – Yet worse, history is no guarantee that a worse crash is not up next. It could be worse.

    Something I’ve been wondering about is, why shouldn’t I keep my portfolio in 100% equities until 10 years before retirement, and then start moving into bonds?

    – Why consider retirement date as an end all be all date? I tend to agree with Vanguard opinion on this. Whatever level of risk you are confortable prior to retirement should be the same as after retirement. Life cycle strategy tries just what you are suggesting. in the end the level of confort you have is what determine this. (Need/Ability/Time)

    Wouldn’t that maximize my chances of good returns from the stock market?

    – Technically, it doesn’t maximize the chance of good return from the stock market. However, Stock market have greater return than bonds. Maximizing exposure to them over long term, maximize your return. Life cycle strategy will help you deal with your bad behavior (Need/Ability/Time) that you might take once the market sunk. You may sell when it’s low and buy when it’s high and miss out on the recovery.

    Is it because holding bonds lets me buy the market at a discount during a downturn as part of rebalancing my portfolio?

    – If you “believe that you can predict that you are in a downturn”, then you are an active investor. Rebalancing is a tool that can be use regardless of if you believe you are in a downturn or upturn. It does produce a few point basis increase versus not doing it.

  17. Brian May 10, 2017 at 4:32 pm

    When you rebalance after a market crash, or even a surge, would it payoff to oversteer the rebalancing? For example, say you have a 50/50 portfolio and after a market crash it drops to 30% equity, 70% bonds, instead of rebalancing back to 50/50, what if you increased your equity allocation by an additional 5-10%?

    Has a similar strategy been backtested?

  18. Paul G May 10, 2017 at 5:03 pm

    @CCP: I don’t always have something to add, but I can tell you your blog largely defines how I invest and I’ve advocated the passive investing approach to a lot of people.

    I don’t get all that many converts though, most people are sure they’re making boatloads of profit over and above market returns. I tell them to check the numbers and yet I never hear from them again. ( I suspect they don’t even check… *sigh* )

    All that was a long-winded way of saying thanks for all the hard work.

  19. Canadian Couch Potato May 10, 2017 at 11:27 pm

    @Paul G: Many thanks for the comment, much appreciated! Passive investing, like so many other things, is a decision one has to arrive at on one’s own. It’s almost impossible to convince someone who is not ready.

  20. Oldie May 11, 2017 at 9:38 am

    @Paul G: I have a similar experience ever since after my conversion in the Spring of 2012 and my subsequent furthering of theory and testing of resolve following this blog religiously. One of my almost converts is my running buddy, recipient of my weekly detailed lectures (usually a useful practice review for me of the contents of some recent CPP blog while running round the reservoir). But, while he says he “gets” the principle of CP, and he’s all set to pull the trigger and fire his stockbroker and rejig his RRSP portfolio, he says he “can’t do it yet” until his portfolio recovers because, due to the energy crash, his energy intensive portfolio tanked from $400k to 300k!! No matter how I tell him he’s already lost that $100,000 and he’s just gambling on the future with what real capital he’s got left, he’s convinced that the $100,000 is somehow magically still hidden in the energy stocks that he is clinging on too, like the rest of his stockbroker six-pack. *Sigh*. It’s so sad.

    On the other hand, a happier story is another running buddy, a young tax accountant who was/still is an experienced detailed analyser of company balance sheets (a skill she thought she knew intimately) and she only invested in individual companies that were financially sound and “bound to do well”. Due to her deep technical expertise and her initial confidence in its predictive powers she was a tough nut to crack, but I finally won her over, and part of her RRSP has been in Couch Potato for over a year, and I’m working on her to convert the rest. I hope I can convince her that the great equity gains we’ve made this past year were not a slam dunk (i.e. that she would/should have made much more by tactical re-allocation when everyone could see that equities, especially US were going to really take off…NOT)

  21. Oldie May 11, 2017 at 9:50 am

    @CCP I hope my comments to Paul G reflect what I may not have specifically expressed before — How much I too appreciate the deep expertise and clear-thinking analysis, appropriately geared down for the level of sophistication of your audience that you have put into your blog over the years. It really is a jewel of a resource, readable at all levels of depth, and initially surprising to me, capable of revealing further nuggets when mined repeatedly by reviewing again after further reflection and experience. Thank you, and please keep on educating Canadian investors.

  22. Canadian Couch Potato May 11, 2017 at 10:11 am

    @Oldie: Thanks for the comment. And I do appreciate all the civil and constructive reader comments the blog has generated over the years as well!

  23. Jeremy May 11, 2017 at 1:53 pm

    Dan, forgive me if this isn’t the appropriate post to pose this question. I’m in the withdrawal stage of investing, and I don’t see much material on rebalancing during this phase. My plan is to keep 2 years worth of withdrawals in cash and 5 years in cash/bonds.

    Would rebalancing during the withdrawal phase differ from the accumulation phase? My plan is to use the 5%/25% rebalancing methodology and when my cash from withdrawals sinks below 5%/25%, I would just sell an overweighted equity position to replenish the cash? In other words, rebalance as normal? Thanks in advance.

  24. Potato Salad May 11, 2017 at 8:27 pm

    Like some of the commenters above, I would also like to thank you Dan for your work on this blog and all the great advice I’ve received from you over the years. This blog is probably the only reason I could become a DIY investor. I had read John Bogle’s Little Book of Common Sense Investing back in 2009, but it was after finding this blog in 2010 that I learned what I needed to make it happen and to get good results. I was able to confidently open a discount brokerage account in 2011, and have continued following your blog and learning more since then.

  25. Nick de Peyster May 12, 2017 at 7:43 am

    “If we accept the premise that interest rate forecasts have no value, we can think about bonds in a different way.” Perhaps in terms of valuation: are bonds overvalued or undervalued?

    Nick de Peyster

  26. aslam May 12, 2017 at 8:58 am

    Any response to Brian’s question?

    “When you rebalance after a market crash…….

  27. Canadian Couch Potato May 12, 2017 at 9:54 am

    @aslam and Brian: I don’t recommend any tactical shifts like this. Sure, you would have done very well had you overweighted equities following every crash, but almost no one does this with discipline. Simply sticking to a long-term target and rebalancing occasionally is hard enough. As soon as you deviate from a simple long-term plan you risk falling down the rabbit hole.

  28. financialthoughts May 13, 2017 at 12:39 am

    I want to chime in with my thanks for this blog. I can’t say that I’m the perfect couch potato investor (I tend towards indolence and inertia) but without it, I probably would just be sitting on cash. I found it at the perfect time – I’d just finished paying off the house.

    I sometimes struggle with whether I’ve decided to be too conservative (unregistered cash and pension) or too aggressive (registered is all in equities), but I’m unlikely to change it. I generally feel like I could lose all the equities and be fine. And I do manage to get around 2-3% with the cash by chasing interest rates. Any mistakes are my own :)

  29. Weekend Reading: Kids Birthday Edition May 13, 2017 at 12:01 pm

    […] Bortolotti continues answering your questions about bonds. This week’s podcast looks at whether you should even hold bonds at all, or wait for higher […]

  30. john grant May 18, 2017 at 10:43 am

    “Market timing” may be the most ambiguous term in the investment industry. Some people use the term to mean “day trading”, or various (suicidal) equivalents thereof. Others use the term super-conservatively to mean “informed, careful portfolio re-balancing”. Hussman and Grantham, to cite 2 examples, use the term in the latter sense, and they would seem to believe that market timing, in that sense, is quite rational. Do you think that sort of basic investment philosophy has merit? Or is it mistaken.

    I ask, because I think the answer informs how folks (esp folks near retirement) approach the weighting of fixed income investments in their portfolios.

  31. Canadian Couch Potato May 19, 2017 at 1:52 pm

    @john grant: Personally I would not use the term “market timing” to describe either of these activities. The term generally refers to alternating between being fully invested and fully in cash based on certain indicators, such as past price movements (technical analysis) or valuations (fundamental analysis). Rebalancing is not market timing: it’s risk management. The decision to rebalance depends only on your specific goals and your target asset mix: it has nothing to do with current market conditions.

  32. Patrick May 20, 2017 at 6:42 pm

    I saw a recent article that was recommending interest rate hedged bond funds (for example iShares Interest Rate Hedged Corporate Bond ETF). While the expense ratios look to be higher than the bond ETF in your model portfolio – I thought it might be worth it to protect against the downside of rising interest rates (even if this is only a theoretical risk). I was wondering what your take on it is?

  33. […] Dan’s response here, and while you’re at it, listen to the podcast episode he released on the same topic […]

  34. Greg July 1, 2017 at 2:40 pm

    Hi, Dan. I saw recently that XBB has dropped their management fee to 9bp. This is the same as ZAG. And while they both hold approximately 30% in corporates, the YTM for XBB is 2.18% while ZAG’s is only 1.95%. Would you recommend XBB over ZAG for someone just buying a bond ETF? Thanks in advance.

  35. Canadian Couch Potato July 3, 2017 at 9:06 pm

    @Greg: The two funds are likely to have very similar characteristics. Yields can be measured in different ways, so comparing two funds from different providers can be misleading.

  36. Greg July 5, 2017 at 2:41 pm

    Thanks, Dan. Also, I noticed the MER for ZAG on your recommended portfolio page is wrong. It’s 14bps, 1bp higher than VAB.

  37. Canadian Couch Potato July 5, 2017 at 3:58 pm

    @Greg: The 0.14% MER on ZAG was for calendar year 2016. The fund lowered its management fee from 0.20% to 0.09% last year, so going forward its MER will be lower. A good assumption is that the MER will be 10% higher than the management fee because it includes taxes as well, so for ZAG I would expect it to be about 0.10%.

  38. Oldie February 28, 2018 at 6:41 pm

    Update for those reviewing their Bond Fund education by going back in time — at long last Vanguard has dropped their management fee on VAB to 0.08%, giving a projected MER of about 0.09% as of February 1, 2018, regaining their traditional position as the least expensive of all the intermediate maturity Bond ETF competitors.

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