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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.”

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:

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!

Filed in: Bonds, Index Investing, RRSP

17 Responses to "Understanding yield to maturity is important"

  1. Thanks for getting the clarification from Claymore on CLF.TSX I would like to mention for the record I was incorrect in my assumption. Therefore YTM does matter, with interest rate increases there will be the potential for capital losses. CLF and CBO bonds are not bought at par value, and therefore they are bought at premium.

    Having said that, I feel very strongly in a balanced portfolio with a good percentage of bonds. I myself just can’t do a 100% stock portfolio (dividends or otherwise) – I just sleep better at night knowing I have diversification. And with the potential of interest rate increases, short-term bonds (govt. bonds and not corporate bonds) are the place to be. CLF does indeed give you the ability to build a 1-5 year bond ladder without the expense of doing it yourself :) I still feel CLF.TSX is an excellent product for Canadian Investors looking for shor-term bond holdings.

    Thanx for the great post MOA! and thanx for the mention ;)

  2. My Own Advisor says:

    I know I couldn’t sleep at night with an all-in stock portfolio either. I love dividend-paying stocks, I simply don’t have enough to keep my pillow soft. Maybe someday, that will change. Until that day comes, I need bonds in my portfolio and specifically, in my RRSP. Bonds, short-ones, will keep a portion of my registered savings protected from higher inflation and down markets. That approach works for me.

    Thanks for your detailed comments Ninja!

  3. SophieW says:

    Thanks for the clarification, it makes total sense now!

    Here’s a question though… I have been seriously considering getting rid of my bond holdings lately because I have a government pension coming my way (indexed defined benefit) which would replace approximately 1/2 of my current income, in today’s dollars. I am looking at my pension as a form of fixed income, which would mean I have an excess fixed income allocation once my bonds are taken into account.

    I have not done anything yet, but after reading your article and Ninja’s too, I think now could be a good time to sell, before interest rates rise and my bond holdings fall.

    Am I being naive, or does it make sense to consider a DB pension as fixed income in my asset allocation? I really appreciate your opinion on this.

    • My Own Advisor says:

      @Sophie,

      Tough question to answer! I can only tell you where my headspace is at, instead of offering some advice for you since I’m definitely not a financial planner, tax expert, estate planner, etc., etc. That said, I too have a government defined benefit pension and I also see my DB plan as fixed-income; at least it will be. While I can’t answer your question, sell or keep your bonds, I can only say for me that I feel safer and more secure that part of my RRSP is in bonds, about 30% allocation overall. I might argue that I feel safer with bonds because I only have 10 years into my DB plan. If I had 30 years or so vested in my DB, that’s much more income security in the bank and maybe I’d feel differently with a lower bond allocation. Being honest here, I won’t know my finanical situation until I “get there” so until that time, I’m keeping my bond allocation closer to my age, give or take 30% for the next 5-10 years. This doesn’t mean this bond-age-allocation-strategy needs to work for everyone.

      Have you done any detailed planning, how much income is going to be coming in from your DB plan? How much of income is essential for living expenses? What income “buffer” you have from your DB plan is you never had any bonds outside your DB plan at all? Is it possible for you to revisit why you invested in bonds in the first place? Maybe there was a really good reason?

      No doubt as rates rise, bond prices will fall but this won’t happen overnight and even when that happens, good bond products will continue to yield some income for you.

      I hope these thoughts helped. ? :)

  4. Think Dividends says:

    Great article MOA. Thanks for the mention. Happy to help!

    • My Own Advisor says:

      Thanks Think Dividends, I appreciate your expertise and the article. Keep them coming :)

  5. SophieW says:

    @ MOA

    Thanks for your input, I truly appreciate your opinion. I have done the calculations and know exactly how much I will be receiving and having 20+ years in the military my pension starts immediately upon my retirement, regardless of my age – one of the perks of serving Queen and Country. I am already planning my second career seeing as I will only be 43 when I retire, and with a teenager and a mortgage, I know I will still need extra income.

    My biggest problem is for the first 18 or so years in the Navy I kept looking at my pension as ‘enough’ so I wasn’t saving any other money towards retirement (and racking up debt too). Now that I have run the numbers and know that I can’t continue doing this job forever, I have paid off my debt and started saving RRSPs and TFSAs pretty aggressively.

    I realise I already have a relatively high equity allocation with only 20% bonds, and to be honest, the only reason I bought bonds was because you’re ‘supposed to’ – not a great reason eh? ;) but what keeps me awake at night is wondering if the bond allocation is too high, not whether my securities are… I think that mostly is because I have the guaranteed income of my pension which will be enough to cover the basic necessities once I fully retire in another 20-25 years.

    I know I am capable of doing most things myself but I’m thinking I might find a fee based financial planner to help me here. I want to make sure I’ve taken everything into consideration before I go any further and some money invested in planning my financial future now, would be well spent I think.

    • My Own Advisor says:

      @Sophie,

      Glad you’re finding the blog insightful. That’s an excellent benefit for sure – military pension starts immediately upon your retirement!!

      Also, huge kudos to you for having your debt paid off and saved in your RRSPs and TFSAs! Well done. My wife and I are working on our house with lump-sum payments every month. We hope to have the mortgage done in another 12 years (close to 50) while maximizing TFSAs along the way.

      A fee based financial advisor must give you some great things to think about. If nothing more, they can validate what you’re thinking re: bond allocation is too high or maybe give you some other perspectives as well. It might be money well spent to do so. If you’re fixed, guaranteed income will cover the basics of life in another 20-25 years when you fully retire, that sounds very ‘bond-like’ to me but a fee based advisor would certainly be able to look at all your finanical information en mass and help you make some decisions.

      I guess the luxury of this issue is, you’re in a good place if this is the only worry you have ;)

  6. @SophieW
    Sophie, I suggest you seek the opinion of a fee based financial advisor who would be able to give you an unbiased professional opinion and take it from there.

  7. “At current bond or ETF prices, do you see more benefits or drawbacks to diversify your portfolio?”

    I think it’s always important to have significant exposure to bonds. With current interest rates so low, however, I have reduced my exposure to bonds, and will increase my exposure once again whenever interest rates rise a bit. Rather than try to time the market, I’m just looking for values, which currently I find in stocks rather than bonds. I wouldn’t ever advocate reducing the bond component of a portfolio to zero, though. Even dividend stocks are no substitute for bonds, which are an entirely different asset class.

    • My Own Advisor says:

      @Dividend Monk,

      Thanks for your comment! We’re aligned, exposure to bonds is important. My plan long-term is to keep a bond allocation that matches my age in my RRSP. I’m just under that allocation level now, around 30% bonds, the rest U.S. dividend-paying stocks and broad-market ETFs. In my TFSA, I probably won’t hold any bonds, I’ll only hold Canadian dividend-paying stocks and receive those dividends completely tax-free.

      When is your tipping point to increase your holdings to bonds? What types do you hold, government debt, corporate debt or both?

  8. SophieW says:

    Thanks guys, I guess I already knew what I need to do, just needed a little confirmation that I’m not nuts… :)

    Once I’m finished this sailing sting – which will be in a couple of weeks – I’ll be shore based in Halifax once again and can look into finding the right advisor.

    Hey, if you watch CBC tonight or Sunday morning, you’ll get to see my ship (and maybe even me) taking the Prince and Kate on a cruise from Montreal to Quebec city! Exciting stuff :)

    • My Own Advisor says:

      @SophieW,

      You’re not nuts, :) and I wish you well with the fee-based advisor. I would be interested in what he/she says about your pension being very bond-like. WOW, you were on that ship? Amazing and very exciting!

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