Your Complete Guide to Index Investing with Dan Bortolotti

Bonds Behaving Badly

2018-07-19T14:44:22+00:00July 19th, 2018|Categories: Asset Classes|Tags: |15 Comments

There are a couple of basic rules bond investors can depend on. The first is that bond prices fall when interest rates rise, and vice-versa. The second is that long-term bonds are vulnerable to larger price swings than short-term bonds—in other words, they are more sensitive to changes in interest rates.

If you understand these principles, the logical next step—at least for active investors—is to move to short-term bond funds if you expect interest rates to rise, since they’re likely to outperform bonds with longer maturities during any period when yields move up.

With this in mind, imagine you could transport back in time to early July 2017, when the Bank of Canada’s overnight rate stood at 0.50%. This key interest rate had been stuck at that level since mid-2015, and many economists and media commentators at the time were predicting rates would start ticking up. That suggested investors should move to short-term bonds (or even cash) to protect themselves from losses.

As it turned out, the forecasts were right on. The Bank of Canada went on to hike the overnight rate four times: in July and September 2017, and in January and July of this year. Today the overnight rate sits at 1.5%.

So, how would investors have fared during the last year had they favoured short-term bonds over those with longer maturities? Here are the 12-month returns for three representative ETFs:

ETFAverage term12-month return
iShares Core Canadian Short-Term Bond ETF (XSB)2.7 years0.63%
iShares Core Canadian Universe Bond ETF (XBB)10.3 years
1.82%
iShares Core Canadian Long-Term Bond ETF (XLB)22.5 years3.66%
Source: Morningstar, as of July 17, 2018

So much for expectations: despite four well-publicized rate increases, the bond ETFs with the longer average maturity significantly outperformed. What’s going on here?

Different fates for different rates

The answer is that not all interest rates have been rising. The Bank of Canada’s policy interest rate (also called the target for the overnight rate) gets all the headlines, but it may have actually have little effect on the bond market. The overnight rate applies to the shortest of short-term loans: it’s what banks charge when they lend each other money for periods as brief as one day. It can affect the interest rate you get on savings accounts (although not necessarily), and what you pay on your line of credit or variable-rate mortgage, too. But if you hold an ETF full of bonds with maturities of three, five, 10 and 20-plus years, the Bank of Canada’s rate policy may not even move the needle.

Indeed, the day before the first rate hike in July 2017, the yield on Government of Canada benchmark long-term bonds (30 years to maturity) was 2.26%. A year later, though the overnight rate has since tripled to 1.5%, long-term rates have actually fallen several basis points—which explains the comparatively handsome return enjoyed by funds such as XLB during the last 12 months.

Remember, too, that traditional bond index funds hold about 20% to 30% in corporate bonds, which adds another variable. The yield on 10-year Government of Canada bonds may not move in lockstep with the yield on 10-year corporates. The difference between these two figures (called the credit spread) can be affected by the mood in the economy, inflation expectations, and the default risk of the companies issuing the bonds. All of this makes it even harder to predict the effect of interest rate changes on the performance of a diversified bond fund.

Keep this in mind next time you hear someone say it doesn’t make sense to buy bonds if the Bank of Canada has indicated it’s likely to increase its key policy rate. First, the increase might not happen: remember the shock when the central bank cut the rate twice in 2015? (“Virtually no economists had been predicting a rate cut,” the CBC reported after the first one.) More important, even if the central bank increases its key rate as expected, that doesn’t necessarily mean your bond fund will fall in value.

When it comes to bonds, then, the advice is the same as it is for equities: stop trying to adjust your portfolio based on forecasts, because it’s counterproductive. Instead, build a portfolio with an asset allocation appropriate for your risk tolerance and your time horizon and tune out the armchair economists.

 

15 Comments

  1. Sharla Carroll July 19, 2018 at 1:04 pm

    Do you believe this all to be the case for those of us who are truly active investors who may hold stocks and mutual funds in their portfolio instead of and/or along with Exchange Traded Funds?

  2. Marko Koskenoja July 19, 2018 at 1:07 pm

    Great article Dan with good advice. I got burned by buying Vanguard VSC (short term corporate) for half my bond ETF’S and Vanguard VAB (aggregate) for the other half several years ago. VSC is down more than 2% over VAB and the yields are about the same. I would have been better off with just VAB.

  3. Hyacinthe July 19, 2018 at 2:37 pm

    It’s funny how the more you hear about index investing and stopping to try timing the market, the more you see proof of it being the right strategy.

  4. Jan Muir July 19, 2018 at 3:04 pm

    Thank you. I hold XSB and XBB, as well as TD Canadian Bond. I have noticed that the returns did not fit the “norm” of the bond market in a rising rate environment. Now I understand why. Sure am glad I did not sell all XBB and put the funds into XSB which was the advice when rates started increasing. You make me a smarter investor. Thank you.

  5. Gus July 19, 2018 at 10:49 pm

    Thanks for the article Dan , personally I’m enjoying having 40% of my portfolio in VAB and I’m enjoying the good monthly payments :)

  6. rgz July 20, 2018 at 1:16 am

    When you post the returns at 0.63 / 1.82 / 3.66 is that total return (share price + yield)?

  7. ROBERT COPE July 20, 2018 at 5:50 am

    How has a 3/5 year ladder of individual GIC’s, bonds or strips performed? Is that not a valid approach?

  8. Canadian Couch Potato July 20, 2018 at 8:11 am

    @rdz: Yes, returns should always be reported this way.

  9. Canadian Couch Potato July 20, 2018 at 8:17 am

    @ROBERT: Sure, a GIC or bond ladder is very valid approach, as long as you’re not constantly adjusting the ladder based on your guesses about where interest rates will move.

  10. aslam July 25, 2018 at 2:16 pm

    As interest rates are going up that would bring the bond value down. Which ETF is advisable in this situation. Currently 25% of my investment is in VAB, ZAG. and TD bond index mutual fund. Should I change it to some other ETFs? If yes, which ETF?

  11. Ron July 25, 2018 at 4:08 pm

    CLF never talked about as a good short term ETF during this period of rising rates. Is it a poor ETF investment compared to the other ETF’s and GIC strategy discussed?

  12. Canadian Couch Potato July 25, 2018 at 9:10 pm

    @Ron: Remember that it is specifically short-term interest rates that have recently gone up, which means that short-term bonds were the hardest hit. This was one of the main points of my last two blog posts. The conventional advice to move short-term bonds if you expect interest rates to rise doesn’t always pan out. If the yield curve flattens, that advice actually backfires.

  13. Tim July 27, 2018 at 2:17 pm

    Another interesting thing with broad bond funds (like ZAG or VAB) is that these bond funds are full of premium bonds where the average coupon of bonds held is higher than the weighted average yield to maturity. For example, ZAG’s current average coupon is 3.20% and YTM is 2.68% (as of what is posted on the ZAG page today). This is expected as these funds hold a lot of bonds purchased in years past at higher coupons than are now available.

    However, these funds are always selling held bonds when they hit one year left in their durations and buying new bonds at current rates. And current yields have been generally going up over the last year, especially at the shorter ends of the curve as Dan mentions. This is reducing the overall premium weighting of holdings and moving them closer to neutral.

    This trend also affects the distribution yield of these funds. As the funds sell generally higher coupon holdings as they get close to maturity, the new bonds coming in don’t have the same coupons in absolute terms and distributions have been dropping over time (in absolute dollar terms) as a result.

    Here is the ZAG history:

    2016 Q4 dist. yield 3.0%, YTM 2.1%, cash dist. for quarter per unit $0.120
    2017 Q4 dist. yield 2.95%, YTM 2.5%, cash dist. for quarter per unit $0.114
    2018 Q1 dist. yield 2.91%, don’t have YTM available, cash dist. for quarter per unit $0.113
    2018 Q2 dist. yield 2.89%, YTM 2.7%, cash dist. for quarter per unit $0.111

    As a bond fund holder who will be depending more on distributions in years ahead, the steady gradual decline in distributions over the last several years is not a welcome trend.

    But, with interest rates no longer generally declining, one can now see the plots of average coupon (which is been descending) and YTM rate (which is now ascending) getting close to meeting. As a few more quarters pass, and if interest rates stay generally where they are or go up, bond fund distributions are going to stop going down, stabilize and maybe start climbing.

  14. Canadian Couch Potato July 30, 2018 at 8:31 am

    @Tim: This is a great point, and thanks for compiling the numbers to illustrate it. However, I am not sure I agree with the idea that this is “not a welcome trend.” The only thing that matters in the end is total return after taxes, not the size of the distribution. Rising rates mean higher expected returns for bonds over the long term. That must be a good thing for fixed income investors.

    As the coupons and YTMs move closer together, there will be a couple of other positive effects. One is that the ETFs will fall less in price over time, which will make them much less confusing for investors who feel like they’re losing money even when they are not:
    https://canadiancouchpotato.com/2017/04/26/bond-basics-2-why-your-etf-isnt-losing-money/

    A second benefit is that the inherent tax-inefficiency of premium bonds will become less of an issue in these ETFs. If the coupon and YTM of an ETF are the same, then the fund will be no less tax-efficient than a GIC, and the problem described here will become much less important:
    https://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/

  15. Tim August 2, 2018 at 9:37 pm

    @CCP Thanks for the response, Dan. Agreed that total return is what matters. The tax efficiency change is an interesting effect.

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