Understanding yield to maturity is important
Recently, I wrote about my purchase of the Claymore 1-5 Year Laddered Government Bond ETF (CLF). I choose CLF because it carries one of the lowest costs of any ETF in Canada, at a dirt-cheap fee of 0.17%. I also bought CLF since it is a low-risk product, I now own some government debt. The average bond duration of CLF is about 2.5 years. Meaning, when (if?) interest rates rise (don’t they have to go up?) I won’t lose much value. A rise in interest rates of 1% means I should only lose about 2.5% of my CLF bond value since bond prices and interest rates are inversely related.
I like CLF for many things. I wouldn’t have purchased this product if I didn’t. However, I needed some clarification about this product and more importantly, I wanted to understand from Claymore how important yield to maturity (YTM) really is over distribution yield, to me, maybe to you, a bond investor. The trigger for this clarifcation came from comments on my blogpost and the fact that my site was mentioned by a reader responding to a recent Globe and Mail article. They also mentioned another blog, The Dividend Ninja, who recently wrote about the safety he gets from keeping his bonds short. Low and behold, while the Ninja loves dividend-paying stocks he’s also a fan of indexing and low-cost products as well.
You see, the distribution yield of CLF is about 4.5%. CLF pays investors just under $0.08/unit/month or about $0.91/unit over the course of a year. On the flipside, the yield to maturity for CLF is about 1.8%, quite a bit less. Should I be concerned about this as an investor? Should you?
While the distribution yield is important, that’s income in my pocket or income to reinvest more CLF, my recent conversation with Som Seif, President & CEO of Claymore Investments Inc., said “investors should really be looking at yield to maturity if they want to understand bond returns.”
Som reinforced with me that investors must focus on total return since while the distribution stream derived from bond ETFs are very real and rather nice (whether it is from Claymore, iShares or other financial institutions that are required to pay the coupons on ETF holdings) the distribution yield is only part of the story. “Investors need to understand that distribution yield is not the actual bond yield.” I understand it this way: the ETF doesn’t mature, the ETF holdings do. So, while bond distributions might be higher today (about 4.5%), total return (close to 2%) must account for bond prices, interest rates, holding periods and loses (or gains) incurred over time to maturity. With interest rates near rock bottom, bonds will fall in price between today and maturity as rates rise. This means you and I holding bond ETFs, while we get some fixed-income security we should expect a capital loss in our future. That makes sense – we bought the bond higher than it likely will be in the future. YTM counts both the coupon interest and the price change through to maturity and that’s why we should care about it.
I’m happy Claymore is both committed and obliged to pay the coupons on CLF holdings but investors should not be disillusioned by the posted yield. An article by Dan Bortolotti, our Canadian Couch Potato comes to mind on this. A very knowledgeable reader of my blog, a financial professional and former blogger himself, Think Dividends sent me an article by Dan Hallet on this very topic: “Distribution rate does not equal yield“. I want to thank him for that article, reinforcing my conversation with Som Seif.
Som certainly has no disillusions himself when he made his final point with me: “yield to maturity and transparency of it, should always matter to bond investors.”
Getting back to my transaction, do I have any regrets knowing my true yield for CLF is closer to 2%? You might be surprised if I say no. Why? I wanted some short-term government bonds in my RRSP and I thought this product was great for it. Buy, set and forget. For comparative purposes, here are a couple yields for other widely held short-term bond ETFs in Canada, with and without government debt:
With my CLF purchase, I know I have:
- Institutional pricing
- A ready-made bond ladder that I do not have to self-manage; continuously rebalance
- Some fixed-income that will be reinvested to buy more CLF units every month
- Some price protection against a higher interest rate environment (again, I wonder if rates will ever rise?)
- Some total return certainty
- A low-risk product
- A highly-transparent product
Yes, you can argue interest rates will rise, might not rise soon at all. You can also argue that some bond products could be overvalued right now and existing distribution yields around 4% are not sustainable; they will go down. That could be very well true. Furthermore, interest rates might not rise fast enough to compensate for the loss of maturing ETF holdings. I could go on. However, I stand by my transaction. My CLF entry point was just above the five-year price average and regardless of the marginal price increase I paid, long-term I’m going to get a secure, virtually risk-free income for about 5% of my RRSP portfolio. That’s a diversified improvement over what I had before.
A special thanks goes out to Som Seif, President & CEO of Claymore Investments Inc. who took some time out of his very busy day last week to chat with me about yield to maturity and why it should matter to bond investors.
Readers, what do you think about laddered-bond ETF products?
At current bond or ETF prices, do you see more benefits or drawbacks to diversify your portfolio?
Instead of laddered-bond ETFs, are there other bonds you prefer holding?
Share your thoughts!