Understanding yield to maturity is important
Recently, I purchased (for now) some Claymore 1-5 Year Laddered Government Bond ETF (CLF).
I chose this fund at this time, because it carries one of the lowest costs of any ETF in Canada, at a dirt-cheap fee of 0.17%.
What does this have to do with understanding yield to maturity?
Understanding yield to maturity is important
I bought this fund for a temporary period of time until I figure out my equity options inside my RRSP.
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. Here are some good reasons to own bonds:
- Bonds can help your investing behaviour – riding out stock market volatility.
- Bonds can be used to rebalance your portfolio; keep your portfolio aligned to your investing risk tolerance, and help you adjust it back to its target asset allocation (i.e., keeping a balanced mix of stocks and bonds).
- Bonds can be used for spending purposes – where some fixed income is “king” for major, upcoming expenses or spending.
- Finally, bonds can help protect against deflation – since inflation is a killer for bonds long-term.
For now, I’m using bonds for #2.
However, before I purchased this product I needed some clarification about this fund 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 clarification came from one of the comments on my site and when reading a recent Globe and Mail article.
“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.”
While the distribution yield is important, that’s income in my pocket or income to reinvest in 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.
*Claymore has since been long acquired by iShares.
Som told me:
“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 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 the YTM important.
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. So, the punchline is with bonds: the distribution rate does not equal yield.
Som certainly has no disillusions himself when he made this 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? Not at this time.
I wanted some short-term government bonds in my RRSP and I thought this product was great for it as I weight my options.
With my CLF purchase, I know I have:
- A ready-made bond ladder that I do not have to self-manage.
- Some price protection against a higher interest rate environment (again, I wonder if rates will ever rise?)
- Some total return certainty for the short-term.
- A low-risk product.
Understanding yield to maturity is important – summary
Yes, you can argue interest rates will rise, might not rise soon at all.
I bought CLF for now to get a secure, virtually risk-free short-term income for about 5% of my RRSP portfolio. We’ll see what I buy in the future as I adjust my portfolio!
A special thanks goes out to Som Seif, (then) 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!