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:
ETF | Average term | 12-month return |
---|---|---|
iShares Core Canadian Short-Term Bond ETF (XSB) | 2.7 years | 0.63% |
iShares Core Canadian Universe Bond ETF (XBB) | 10.3 years | 1.82% |
iShares Core Canadian Long-Term Bond ETF (XLB) | 22.5 years | 3.66% |
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 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.
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?
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.
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.
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.
Thanks for the article Dan , personally I’m enjoying having 40% of my portfolio in VAB and I’m enjoying the good monthly payments :)
When you post the returns at 0.63 / 1.82 / 3.66 is that total return (share price + yield)?
How has a 3/5 year ladder of individual GIC’s, bonds or strips performed? Is that not a valid approach?
@rdz: Yes, returns should always be reported this way.
@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.
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?
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?
@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.
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.
@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/
@CCP Thanks for the response, Dan. Agreed that total return is what matters. The tax efficiency change is an interesting effect.
Hi Dan
I do have a question regarding one of your article
https://www.moneysense.ca/save/investing/etfs/one-etf-portfolio-pros-cons/
“If you’re an experienced DIY investor, you can also use individual ETFs to build a more tax-efficient portfolio across multiple accounts. For example, you might want to favour equities in your TFSA and bonds in your RRSP,”
Can you elaborate more on the last sentence regarding equities in TFSA and bonds in RRSP
Thanks
@Ale: Because the TFSA grows tax-free forever, while an RRSP is tax-deferred (you pay taxes upon withdrawal), it generally makes sense to keep high-growth assets in the TFSA to take full advantage. Of course, there is nothing at all wrong with holding equities in an RRSP, but one would normally fill up the TFSA with equities first.
Hello Dan,
I have a quesiton for you and your experienced blog readers ???? it’s regarding gold investing vs stocks.
I had a chat with a coworker regarding investing/rrsp/tfsa and all that , he simply can’t stand the word rrsp as he believes that it’s the government biggest scam to double dip on taxes during your working and retiring years, anyways we were talking about stocks and apparently the only thing that he buys is gold and that is physical gold not etfs or stocks , he told me that he bought an ounce of gold in 2000 for about 400$ and today it’s worth over 1800$ so that’s about 400% plus in increase and that is no match for the s&p500 which is about 180%.
Looking at these charts i really didn’t know what to say unless i’m really missing something here ,please guys enlighten me because i wanted to make a good argument but like i said seeing those charts left me in a shock .
I would really like to know if someone here invest or buys gold and for you Dan what’s your take on gold investment.
Thanks
@Gus: The short answer is that gold outperformed US equities from about 2000 (the bursting of the dot-com bubble) to 2008 (the global financial crisis), which was a terrible decade for stocks. Over longer periods, gold has not been a good investment at all, except perhaps as a diversifier in a balanced portfolio. Even then, I don’t think it’s necessary.
https://www.moneysense.ca/columns/why-investing-some-of-your-portfolio-in-gold-isnt-worth-it/
https://canadiancouchpotato.com/2011/09/06/is-gold-a-hedge-against-inflation/
https://canadiancouchpotato.com/2011/08/22/golden-advice-that-suits-any-investor/
Thank you so much Dan for the reply and links.
I have been holding ZAG in my RRSP since May 2017. No surprise with rising rates this fund has declined some…to date, approximately 5.03%. With (interest) distributions the net loss is approximate -2.01%. What is your view on holding ZAG going forward? I ask because it is a core ETF in one of your model portfolios.
@Mike: Bonds are in the portfolio for diversification, so it should not be surprising when they perform poorly during periods when equities deliver very strong returns. It’s a bit like saying, “I’m tired of carrying around this damn umbrella when it never rains.” Eventfully, of course, it rains.
Remember, too, that the recent rise in interest rates improves the outlook for bonds. This is obvious when you think about it (higher interest rates must be good for fixed income) but often forgotten:
https://canadiancouchpotato.com/2013/09/16/ask-the-spud-should-i-fear-rising-interest-rates/
What’s your thought on bonds and stocks becoming positively correlated (one goes up and the other goes up too) when for years they were negatively correlated. Going forward, how’s does this impact bond Index?
A lot of hype on alternative investments adding REITs, infrastructure and/or options to provide better negative correlations.
@Marc: My first question would be, where are the data showing that stocks and bonds are more positively correlated than they have been historically? That has probably been true over the last year or so, but short-term correlations are meaningless. Over the long term, bonds are the only asset class that have reliably provided protection from a severe equity market downturn. It doesn’t work all the time (nothing does), but beware of the “this time it’s different” pitch from people selling alternatives.
Hi I just realized that I was paying 1.5 MER on RBC conservative mutual fund 250k (3% return one MER paid) and my tfsa account was maxed the same way by RBC advisor. 12k later in fees I woke up and did some reading. So I am in the process of moving things out to Questrade for TFSA and RBC DI for RRSP( free trade deal to avoid me transfering). Anyways, I have read that bonds would be best in RRSP versus TfSA. Yet the TFSA 3 etf model couch potato portfolio contains ZAG (I am assuming this is in case someone doesnt have room or cash to put bonds in a RRSP or is it for safety reasons?) So should one consider VCN/XAW in TFSA (2 etfs instead of 3) and put all their bonds like ZAG in a RRSP? I guess I am wondering because of high votality of stocks if its a good idea to keep a portion of bonds in a TFSA to balance things out and avoid my tfsa account from dropping down to much because of yearly limits?
The other thing I wonder is if I should favor holding 13 to 15 stocks from VCN instead of holding VCN and adding a bit of XAW. Would the stocks out perform the VCN at the higher risk of votality…I guess I am wondering if it is worth the risk to hold individual stocks versus an etf when only 50k ish limit. I guess I am looking at maybe 15 Years before I retire and probably be in a high tax bracket. I assume when they say to diversify and when they talk about ratios for example 75/25 it means overall accounts including my taxable, rrsp and tfsa? Or should I favor having 75/25% ratio in taxable, 75/25% in RRSP and 75/25 TFSA? If I understand what I read well, it means I should work on 100% equity in TFSA (VCN/XAW) , and maybe get my %fixed income in RRSP? Like BONDS or GIC?
For my RRSP: I was actually thinking having 50%Vanguard Balanced and 50% VGRO which would put me at 70/30 ratio in RRSP OR use the 3 ETf model of ZAG, VCN, XAW and Adding some VOO, VTI..or even US shares in the mix, and use my 65k extra GICs to compensate from not putting any fixed income in my TFSA. I have read that index funds are something to consider and it is why I was considering adding some to my RrSP.
I am also debating holding individual stocks im RRSP versus etfs. I guess I would rather my RRSP be passive and maybe more active in TfSa for fun. But I have like 10 US stocks that interest me and I am canadian so might be penalized with exchange and RRSPs are best for US stocks from what I have read. Is it bad to add in some indivudual stocks to ETfs models when funds around 250k ish? I have read about the gambit and I would probably not want to get into that..so I am assuming investing directly is Us stocks be kinda pointless with-my canadian funds right?
I understand that you cant give direct advice but any other links to help my learning would be appreciated. Thanks.
Hi! I follow your ETF portfolio suggestions and bought these 3 ETF, except for ZAG that I replaced with XLB. The only reason I did that is that for the last few years, XLB has most often beaten ZAG in terms of return.
Is that a bad idea? Would it be preferable that I sell my XLB and go with ZAG instead?
Thanks a lot for the valuable advices
@P: Long-term bonds (XLB) have outperformed recently because long-term interest rates have declined faster (or increased more slowly) than short-term rates. That’s may not be repeated in future years. Over the very long term, it is reasonable to expect long-term bonds to deliver somewhat higher returns, but at the cost of much more volatility: they can suffer double-digit losses in some years. Overall, a broad-market bond fund (like ZAG, VAB or XBB) is likely to have a better risk-reward trade-off.
Hi Dan,
I have a lot of fixed income and am finding GICs to be rather harder to manage. I want to use ZDB in my CCPC.
But I am worried about using one ETF for all my fixed Income. It will be in 7 figures.
Would you advise using a portion of VAB as well even with the less tax efficiency in my CCPC?
@Emily: I don’t think adding VAB or another similar ETF would provide you with substantially more diversification. Remember that 70% of ZDB is in Canadian federal and provincial government bonds. If these were to experience some sort of credit crisis, it would not help to own a different bond ETF that was also full of government bond holdings. ZDB does have fewer individual corporate bonds than traditional bond ETFs (because fewer discount bonds are available in the marketplace), but the additional credit risk is probably minimal.
In terms of diversifying across more than one ETF provider (BMO and Vanguard), this is not necessary, as these fund providers are highly unlikely to become insolvent, and even if they did the risk to investors is trivial:
https://canadiancouchpotato.com/2014/06/02/ask-the-spud-how-are-investors-protected/
With the decreasing frequency of new articles on your blog (this is not a criticism — it is a natural consequence of having already adequately covered all the core concepts of passive index investing that we need to understand!) I have taken the opportunity to re-read the old articles in greater depth to catch insights that I might have missed first time around. This article is a good example of explaining logical outcomes arising out of seemingly unrelated (at least to the uninitiated) events. This all makes a lot of sense, so much so that one then risks drifting to the quasi-obvious conclusions that when one can sort-of predict what’s going to happen (interest rates are bound to rise, and the likelihood increases with time) therefore one should switch to short term bonds, which is precisely what the Financial Pages Gurus all seem to be advising, and again, this is what you’d expect them to do, because this feeds into our worst lizard-brain fears.
Fortunately, you have drilled it into our (Couch Potato) brains over and over again using numerous other prior examples — you can’t predict the future, no matter how good and convincing your story seems to be.
That being fully understood, we can write off the retrospective self-proclaimed cleverness of the gold purchasers in 2000, and other retrospective experts including bond ETF switchers (of course anyone could map out a retrospective bond strategy that would have made money over the past few years) into the same category as Casino winners who swore by the strategy of putting all their money on Number 21 (or whatever) and happened to win big time.
Thank you again, Canadian Couch Potato. With every further insight you give us, you shore up the same old boring and unspectacular concept — don’t try to predict the future, or at least don’t try to make money on your prediction. Boring is good. It is very very reassuring.
PS: I thought I’d read and re-read everything of note in this blog, but on checking with your reference
https://canadiancouchpotato.com/2011/08/22/golden-advice-that-suits-any-investor/
I found that I’d somehow missed this gem before. A real thigh-slapper, with your usual hard truth underlying the humorous take on things! I’d urge other readers to go back into the archives for buried wisdom; you won’t be disappointed.
“one can sort-of predict what’s going to happen (interest rates are bound to rise, and the likelihood increases with time) ”
This has not aged well :)
I’m using the 50% XAW, 30% VCN, 20% ZDB portfolio strategy. I have been letting the bond portion slip down to 10% and have been putting more funds into equities in the past 6 months. Is it better to try to get my bonds back to 20% or continue putting more funds into equities since interest rates are very low now and for the near term? I guess the big question is when should I start putting more funds into bonds? Just wanted to get some of your inputs.
Thank you.
Hi Dan, could there be an advantage to owning both VAB and VSB?
@Arielle: I wouldn’t call it an advantage, but by holding VAB and VSB in different proportions you can control the overall duration of your bond holdings. For example, VAB has a duration of about 8.1 years, while VSB is about 2.7. If you held equal amounts of each your duration would be about 5.4 (the average of the two). But this is probably splitting hairs. Most investors should just pick one or the other.
Hi Dan,
The more I read on bonds, the more I think I understand…but when comes time to put this in practice, I’m finding out that I haven’t got it right yet…I’ll start with one question related to the Vanguard Asset allocation ETFs…
Can you please explain me why while the ratio of equity to fixed-income changes from VGRO (80-20%) to VBAL (60-40%) to VCNS (40-60%), the quarterly total distribution per unit is very similar for all of these according ti the Vanguard web site. My intuitive thinking would have been that the distribution is proportional to fixed-income ration/percentage….but it doesn’t seem to be the case….which seems odd to me…what is it that I’m not getting? From an equity perspective, if you own a higher percentage, you would expect a higher proportional gain, right?
That’s puzzling me as I’m not sure anymore that the ratio equity to fixed-income is such a great protection against market volatility, although this may sound counterintuitive as a statement…doesnt look like the correlation is as strong as I thought…meaning that an increase from 20%(VGRO) to 60% (VCNS) in fixed income holdings doesn’t seem to protect the investors substantially more…
any thought on this or a good reading reference would be appreciated..
merci
@Benoit: First off, with funds such as VGRO, VBAL and VCNS, the track record is very short, and the performance over the last two years or so doesn’t tell us very much. In 2020, for example, the return on Canadian bonds was higher than that of Canadian stocks and international stocks (developed markets). That will happen over some periods, and this is the value of diversification, but no one is expecting that it will persist over the long term.
You also mention distributions specifically (as opposed to total return). Based on current bond coupons (not yield to maturity) of just under 3% and a dividend yield of about 1.44 on VEQT (a proxy for the equity portfolio in the Vanguard asset allocation ETFs), you should expect the yield to decline as the portfolios get more stock-heavy. That’s what’s happening now with VCNS at about 1.95%, VBAL at 1.85% and VGRO at 1.75% or so.
Am i the only one buying bond index ETFs at current levels compared to others who are freaking out? a lot of people i talk to have TINA and FOMO and are racing to equities, naturally increasing their risk. my worry is that if we get another correction, these people who are typically conservative will be shocked and not in a good way. thoughts?
@marc: If my inbox is any indication, yes, you are the only one who seems happy to buy bonds after a period of rising interest rates. :) I do understand the concern, of course, but I try to frame the question like this: if interest rates are higher and bonds are cheaper than they were a few months ago, isn’t that an argument in favor of buying bonds now? The expected return on a bond today is considerably higher than it was at the end of 2020.
Hi Dan,
Firstly, I loved reading your new book Reboot Your Portfolio. As with all your MoneySense articles, it was well written and easy to understand. I’ve been using the couch potato strategy for a few years now and reading that book really to keep me on track.
As far as bonds go though, I am concerned about the speculation of future interest rate hikes. I feel like I’ve done the responsible thing and moved my child’s RESP fund to be much more conservative the closer post secondary school approaches. As such, I am much more heavily invested in bonds in this RESP because I will need to draw on this account within the next few years (approx. 70% bonds and 30% equities). Over the past few months I have seen the value of the RESP account take a 6-8% haircut, however, worry that my bond exposure will make these losses even larger.
Do you have any advice for those of us who are concerned about continuing to hold bonds under circumstances like these? I feel like I am one of the only ones investing in bonds these days…but may be thanking myself if there is a major market correction. Any suggestions you have are greatly appreciated.
Thanks,
Chris
@Chris: Many thanks for the comment, and very glad that you enjoyed the book!
It certainly has been a challenging year-and-a-half for bond investors. One of the lessons has been that broad-market bond funds are not short-term investments, even though they are often thought of in that way. These funds (which include VAB, XBB, ZAG and TDB909) hold bonds with an average maturity of about 10 years and a duration of about 8 years. If you will need the funds in less than five years, they’re not ideal. And they can certainly lose value over periods of two or three years.
If your kids are less than five years from needing their RESP funds, it’s probably time to start setting aside some money in GICs. If, for example, you expect to withdraw $10,000 per academic year, you could put $10,000 in GICs with maturities of two, three, four and five years. This guarantees that you will have those funds available when needed, with no chance of loss.
Just make sure you plan things carefully, ensuring that the GICs mature well before you will need the money. If tuition is due in the summer, don’t have the GICs maturing in October! Always make sure you have some liquidity in the account, and don’t be afraid to hold some cash. At this stage of the game, after many years of saving, collecting grants and investing, your main goal has become a short-term one: making sure that you have the funds to pay for your children’s schooling. It’s no longer about trying to squeeze out a little more return on the investments.
Hope this helps, and good luck!