My Own Advisor

Maybe it’s because the market is up and down all over the place and I’m thinking about them more.

Maybe it’s because bonds are one of the first things I learned about when I opened my RRSP account almost 12 years ago.

Maybe it’s because they saved my hide, like my friend ”Bond, James Bond” does with his girl in the movies.  Bonds saved my behind when the TSX plummeted to the mid-7000′s and equities were on fire (as in, burning down to you know where) in 2008-2009.

I like my bond ETFs.

Here are some of my favourite reasons why I like my bond ETFs, why and where I own them, in particular my Canadian bond ETFs.

•  Government bonds, are pretty much risk-free; the government can raise taxes or create additional currency in order to redeem the bond at maturity and cover its IOU.  Sure, there are some examples where a government has defaulted on its debt (Russia, 1998) but this is rare.  Don’t worry folks, I don’t think the U.S. is going to default on its debt – the U.S. just has a heckuva lot of debt to pay back and needs to get going on it!  Here is nifty little gadget that shows how fast the U.S. debt is growing.  Look at the top left of all the calculators you see to find ”US National Debt”.  Kinda cool, then again, kinda scary.   Alas, we are talking about Canadian government debt - almost as risk-free as it gets.
• Government bonds have a similar yield to big bank GICs.  Personally, I’m a fan of CLF, CBO, XBB and XSB, which are all exchange traded funds (ETFs).   You can find CLF and CBO at Claymore’s site and XBB and XSB at iShares site.  I’ll have a post in the coming weeks to explain why these bond ETFs in particular are my favourites, but for this post and this bullet point, you should know you get a dependable yield from any of these ETFs.  I do.  XBB, for example, is yielding about 2.5% if all the coupons that XBB holds are held to maturity.  Last month, for my account in particular, I got paid $0.09 for every share owned of XBB.  After accumulating a bunch of XBB shares over the years, I’m now getting enough income from XBB distributions every month to buy one more XBB share – commission free.  That’s right, just like John Heinzl’s dividend-paying stocks (and my own for that matter), now my bond compounding machine is running full steam ahead.  Click here to learn more about XBB, its holding, distributions and more.
• Government bonds, particularly bond ETFs like all the ones I mentioned above are very easy to buy.   I can buy my CLF which is my favourite Claymore bond ETF (or any other bond ETF) directly through my discount brokerage account.  I do have to be careful though, I don’t want to be buying bonds all the time since it costs me transaction fees.  Fees and the impacts they have on your portfolio are forever.   Also, and more importantly, I don’t want to be buying bonds when markets are falling.  That just wouldn’t make sense.  You buy stocks and bonds when they are low(er) in price – right?
• My bond ETFs are very transparent.  I know exactly what each bond ETF holds.  Don’t believe me?  Click any of the links above to CLF or XBB.  They have nothing to hide.
• Taxes can get a bit tricky if you buy bonds individually.  That’s why, I don’t even bother with individual bonds.  I use bond ETFs instead (which have low management fees by the way) and I put them in my RRSP.  This way, I don’t have to worry about the tax-math in a non-registered account.  I suppose you could put your bond ETFs in your TFSA.  The coupons (meaning interest) is provided tax-free and the shares can compound over time, like I wrote above.  Furthermore, I don’t have to worry about a capital gain or a loss.
• I like dull and boring investments.   Bonds have a deserved reputation for this, which is fine by me because frankly, I’d rather have some security in my portfolio than fret about what Mr. Market is doing any given day.  It really doesn’t matter to me with my bond ETFs.   Like my friend Dividend Ninja recently said on his blog:  “One thing I do know for sure is I have a nice income generating and balanced portfolio which is priceless when stock prices go down. I could have easily gone with a 100% dividend portfolio in 2009, but I didn’t, I saw how bonds gave me a cushion and income through the decade.”  Ninja – I couldn’t have written this better myself.

I think 98% of investors should have bonds in their portfolio.  Canadian Couch Potato thinks it’s a good idea, my friend who is a Millionaire Teacher in Sinapore owns them, another friend who is a Wealthy Canadian who invests mainly with dividend-paying stocks is considering some for his portfolio and countless other bloggers listed on my Blogroll who are very savvy DIY investors own them.  The other 2%?  Well, those investors are either VERY diversified via stocks (I’m talking 50+ here at least) or they have plenty of income from other means to simply not need the capital protection and fixed income that bonds offer.  I’m definitely not in that camp and I’m betting you’re not either if you’re reading this blog.

The closing message here is blunt:  bonds should be part of almost anyone’s portfolio.  They’re a part of mine and they’re not going anywhere soon.  They help me sleep through anything Mr. Market serves up.

Give them some notice and respect, just like James Bond.

What about you?  Do you own bond ETFs in your portfolio?  What do you own and why do you own them?

Thanks for reading and sharing this article.

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.” 

Why?

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:

• Yield of Claymore 1-5 Yr Laddered Corporate Bond ETF (CBO) = 2.3% (MER = 0.27%)

• Yield of iShares DEX Short Term Bond Index Fund (XSB) = 1.8% (MER = 0.26%)

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!

Thanks for reading and sharing this article.

For some time now, I’ve been thinking about bonds in my portfolio.  For me, given the financial environment we seem to be trending towards, I think making my bonds shorter is the right thing to do.  I’ll tell you why.

Over the last year, I’ve only had the iShares DEX Universe Bond Index Fund (XBB) in my RRSP which constituted  about 30% of my portfolio.  (I follow a bond allocation close to your age approach.)  That’s not a bad thing.  I believe in XBB.  It’s a great product.  I know I sound biased but I think these facts speak for themselves:

• XBB tracks the widely followed DEX Universe Bond Index.
• XBB has excellent diversity.
• XBB has almost 500 holdings.
• It holds mostly AAA bonds.
• Almost 50% of XBB holdings are short-term (1-5 years) and the weighted
  average maturity is just over 6 years.
• XBB Management Expense Ratio (MER) is low, just over 0.3%.
• XBB yield is just under 4% (yield to maturity is about 3%).
• XBB pays about $0.09/unit per month.

For most investors, including me, I think XBB offers a lot so I’m not totally giving up on it.  I have however recently sold some XBB near $30/unit to get a few units of my newest bond friend, CLF, Claymore’s 1-5 Year Govt. Laddered Bond ETF. Why?  CLF keeps Mr. Craig, rather its bonds on a much, much shorter leash.   Short bonds are better in higher interest rate environments. Since interest rates are expected to rise later year, the next year and beyond (rates cannot get much lower folks; they have only one direction to go…), I’m thinking some short bonds in my RRSP are a prudent move.

CLF tracks the DEX 1-5 year Laddered Government Bond Index.   It has a dirt-cheap MER of about 0.17%.  The average duration of CLF bond holdings is about 2.5 years.   CLF holds 28 securities, not many, but certainly enough federal and provincial government debt to keep things safe.    This ETF also has a cash yield of over 4.5% (yield to maturity is about 1.8%) issuing over $0.07/unit per month.  This is a laddered product, my first one, meaning the money has been divided into equal portions that go into terms, in this case, 1-5 years.  Each year, a maturing bond rolls into a new five-year term.

This ensures I’m getting continuous rebalancing, mitigating loses on my principle when interest rates rise (which they will) and I’m not overexposed (like a Bond Girl) in tough-to-figure-out financial climates.  In fact, I don’t see loses coming my way, even in a higher interest rate environment.  Like my XBB investment, I now own enough CLF in my RRSP to have it DRIP synthetically.  This means I’m earning at least one full share of CLF every month.   New CLF units will pay more distributions every month and over time, more distributions will buy more CLF units.  My CLF passive income machine is full of fuel and ready to go.

If you want more reading about CLF, short-bonds vs. long-bonds and other bloggers who believe in this approach as well, check out just a few of the links below on this subject:

Claymore ETFs – product list.

iShares – fixed income product list.

Canadian Capitalist – XBB and XSB.

Canadian Couch Potato – chosing a Canadian bond index fund.

Canadian Couch Potato - the cheapstakes portfolio.

The Dividend Ninja – think short term when buying bonds.

What do you think of my move?   Are you a fan of bond ETFs?  Short-bonds or long-bonds or just Bond Girls?

Thanks for reading and sharing this article.