Archive for the ‘Bonds’ Category

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Under the Hood: BMO Real Return Bond

May 30, 2010

This post is part of a series called Under the Hood, where l take a detailed look at specific Canadian ETFs or index funds.

The fund: BMO Real Return Bond Index ETF (ZRR)

The index: The fund tracks the DEX RRB Non Agency Bond Index, which consists of inflation-linked bonds issued by the Government of Canada. It seems to have been created specifically for this ETF.

The cost: The ETF’s management fee is 0.25%. As with other BMO funds, the actual MER will be higher because it includes GST/HST and some other expenses.

The details: This brand-new ETF (it started trading on Wednesday, May 26) holds five real-return bonds issued by the federal government, each making up about 16% to 23% of the fund’s assets.

Real-return bonds — or Treasury Inflation-Protected Securities (TIPS), as they’re called in the US — are an important asset class, and some financial experts recommend them as a core holding.

Both the principal and the interest payments of real-return bonds are tied to the Consumer Price Index, so they go up with inflation. Here’s an illustration of how this might work, courtesy of Bylo Selhi:

On a $1,000 bond, if the coupon interest rate is 3% and inflation is 1% after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3% by year end, the principal is adjusted to $1,030. You then receive another interest payment of $15.45. Assuming similar inflation over 10 years, you will receive $351.64 in interest payments while the principal will have risen to $1,343.92.

Real-return bonds typically have long durations: the maturity dates of the five in this ETF range from 2021 to 2041. Since real-return bonds were introduced in 1992, the average annual return has been 8.2%, which falls between that of short-term (6.6%) and long-term bonds (9.5%) over the same period.

The alternatives: Real-return bonds are an under-served asset class: until ZRR was launched, the iShares Real Return Bond Index Fund (XRB) was the only ETF of its kind in Canada. There are only two no-load mutual funds devoted to them — TD’s Real Return Bond Fund and Phillips Hager & North’s Inflation-Linked Bond Fund — and both are actively managed.

ZRR has undercut its iShares competitor in price — XRB charges 0.35% — although we’ll have to wait for the first Management Report of Fund Performance to learn what its all-in cost will be. TD’s mutual fund charges an onerous 1.42%; PH&N’s has a super-low fee of 0.53%, but brokers may require a minimum investment of $5,000.

What’s most interesting is that all of these funds have very similar holdings. The reason is simple: there just aren’t many real-return bonds to choose from. The federal government has just five issues, all of which are held by BMO’s fund. These five also also make up 86% of XRB, 60% of TD’s fund, and 80% of Phillips Hager & North’s. The only other significant issuers of real-return bonds are Ontario, Quebec and Manitoba, and provincial governments aren’t included in the index ZRR tracks.

The bottom line: It’s too early to pass judgment on ZRR: it will take at least a year to see if it’s able to keep its expenses down and track its index closely. But if it performs well, it will be an attractive alternative to iShares’ XRB, which currently holds over $594 million in assets. Given the extremely limited inventory of real-return bonds, performance of funds in this asset class really comes down to who can keep their costs lowest.

If you’re considering this new ETF, first look through the prospectus.

Disclosure: I do not own ZRR in my own portfolio. I have a small position in TD’s Real Return Bond Fund (too small to make an ETF cost-effective).

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Bonds v. Bond Funds

March 29, 2010

In my previous post, I looked at the uneasiness many investors have about bonds when interest rates are poised to go up. Some readers of this blog and others (see these discussions on Financial Webring Forum and 50Plus.com) have argued that this discomfort can be alleviated by buying individual bonds rather than index funds or ETFs. Let’s look at whether their arguments hold up.

Individual bonds do offer benefits: you know precisely how much interest you’ll be paid, and how much you’ll receive when the bond matures. The payouts from bond funds, by contrast, aren’t known in advance, and funds never mature. This can make planning difficult for those who rely on their bond portfolio for current income, or those who need a specified amount of money on a certain date in the future. No quibbles with that.

The other main argument in favour of individual bonds is much less convincing. It goes something like this: “If I invest $10,000 in a bond fund, its value will go down when interest rates rise. But if I buy an individual bond, I don’t have to worry about interest rate movements, because as long as I hold the bond to maturity, my principal is guaranteed.”

Behavioural economists love this kind of logic. While it’s true that holding a bond (or a GIC) to maturity allows you to collect the full principal, you’re fooling yourself if you think you’ve avoided a loss. Consider a bond that has two years left to maturity and pays 4% interest when the current rate for comparable bonds is 5%. Over the next two years you’re locked into an investment earning 4% interest, when you could be earning 5% with no additional risk. You may not have lost your capital, but you have forfeited $200 in interest. This opportunity cost may not feel the same as losing capital, but in the long run it affects your investment returns the same as any other kind of loss.

There are several other advantages of using index funds or ETFs rather than individual bonds:

Diversification. Canadian government bonds are highly unlikely to default, but corporate bonds certainly can. Just ask the investors who put their retirement savings in bonds from General Motors. You can dramatically reduce default risk by investing in an ETF like iShares’ Canadian Corporate Bond Index Fund (XCB), which holds 350 different issues. A wide selection of bonds with various maturities can also reduce interest rate risk.

Low minimum investment. Many bond issues require $10,000 or more, so building a customized bond ladder is out of the reach of many small investors. By contrast, Claymore’s 1–5 Year Laddered Government Bond ETF (CLF) includes a ready-made ladder of 25 bonds, and small investors can buy in for any amount. Bond index funds also have very low minimums ($100 to $1,000) and you can take advantage of dollar-cost averaging by adding money each month, something you can’t do with individual bonds.

Liquidity. You can redeem all or part of a bond fund at any time if you need the cash, typically with no fee (except perhaps the small trading commission on an ETF). While you can always sell individual bonds on the secondary market, many corporate, provincial and municipal bonds are not highly liquid and may have high bid-ask spreads.

Simplicity. Index funds and ETFs eliminate the need to choose individual bond issues, some of which include embedded options that are difficult to understand. Funds also conveniently reinvest all interest payments so you can take full advantage of compounding. (This is harder with ETFs, but Claymore and BMO do offer dividend reinvestment plans.)

Cost. Some investors say they prefer to avoid fund fees, seemingly unaware that buying individual bonds also carries costs. It’s difficult to know just how much mark-up you’re paying, as the bond market is far less transparent that than the stock market, since bonds trade over-the-counter rather than on an exchange. In his book In Your Best Interest, Hank Cunningham says the average mark-up on bonds is 1%, and points out that this fee is payable only once, while bond funds may carry fees of 1.5% or 2% every year. But Couch Potatoes know better than to pay those ridiculous MERs. Bond index funds and ETFs are among the cheapest in any asset class: Claymore’s CLF charges just 0.17%, while the iShares Canadian Bond Index Fund (XBB) gives you access to the entire Canadian market for just 0.30%. With fees this low, any cost benefit of buying individual bonds shrinks dramatically, and many investors will accept the small fee in exchange for the benefits outlined above.

Like all investment decisions, there’s no one right answer here. Building a ladder of individual bonds is a perfectly good strategy, particularly for income-oriented investors with a six-figure sum to invest, a good knowledge of bond features and access to a low-cost broker. But for Couch Potato investors who are in the “accumulation phase” of their lives, a low-cost bond index fund or ETF can deliver market returns far more easily.

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The Bond Dilemma

March 25, 2010

With interest rates poised to rise later this year, I’m getting a lot of emails and comments from readers who are wary about investing in bonds. There seem to be a lot of myths and misunderstandings about bonds, which isn’t surprising: fixed-income investments can be difficult to get your head around.

Let’s start with the most relevant issue: when interest rates rise, the value of bonds goes down. To understand why, imagine buying a five-year bond with a face value of $1,000 that pays 5% interest annually. Now imagine that 12 months later interest rates have risen one percentage point. Your bond now has four years left to maturity and it’s still paying $50 a year in interest, while new four-year bonds are paying 6%, or $60 a year. If you decide to sell your bond now, you won’t get $1,000 for it. Why would anyone buy your bond with its 5% yield when they can get one that pays 6%?

Of course, your bond isn’t worthless: you just need to drop the price to make it more attractive. If you sell it for $965, the buyer would still earn $50 annually in interest, plus he’d make a $35 capital gain when he collects the full $1,000 at maturity. His total return over the four years would be $235 (4 × $50 +$35) on a $965 investment, or 6% annually—the same as new four-year bonds selling at par. (You can check my math with this handy yield-to-maturity calculator.)

This example illustrates why bonds lose value when interest rates rise: their market prices decline in order to bring their yield in line with those of newer bonds. The longer the term of the bond (that is, the greater the number of years until maturity), the bigger the loss in value when interest rates go up.

If you own a bond mutual fund or ETF, virtually all of its holdings will lose some value when rates move higher. That’s why so many investors are reluctant to put money in a bond fund today: the Bank of Canada has all but assured us that rates will move up in the second half of this year. Isn’t buying a bond fund now guaranteed to lose you money?

Not necessarily. Remember that the vast majority of a bond fund’s return comes from interest payments, not from changes in its net asset value (NAV). If the fund’s market price drops 2% one year, but the bonds inside the fund pay 4% in interest, the investor’s total return is still 2%. Notice what happened to the first investor in our example above: he bought a bond for $1,000 and sold it a year later at a $35 loss. In the meantime, however, he collected $50 in interest. That’s a net gain of $15, or 1.5%. Sure, he’s disappointed, because he was expecting 5%. But he didn’t lose money.

It’s not surprising that many investors don’t appreciate this. When you check your account holdings, all you see is your funds’ net asset value, not the distributions you’ve received. In my own account, I have a bond ETF that’s showing a 2.5% loss since I bought it 10 months ago. I had to use a spreadsheet to figure out that my total return, including interest received in cash, is actually slightly positive.

One reader recently noted that the NAV of the iShares Canadian Bond Index Fund (XBB) was about $27 in late 2001, and is about $29.50 today, which looks like an anemic return of barely 1% annually. But when you include the quarterly interest distributions, XBB’s annualized return over the last nine years is 4.8% — almost five times higher. No wonder people are so pessimistic about bonds.

So, is it smart to buy a bond fund or ETF now? Who knows. You may well be able to get in more cheaply if you wait just a few months. But if the interest rate hike is smaller or later than you planned for, you may pay in opportunity cost.

In the next post, I’ll look at the difference between buying individual bonds and investing in bond funds and ETFs.