In my previous post, I mentioned that bonds and REITs posted negative returns over the past quarter. While the fixed income portion of the Sleepy Portfolio is devoted to a medium-term bond fund (TSX:XBB - iShares CDN Bond Index Fund), in our personal portfolios, I use short-term bonds (XSB - iShares CDN Short Bond Index Fund) instead. According to The Four Pillars of Investing, investors should keep their bond terms short because long-term bonds offer little extra return for taking on a higher interest-rate risk and long-term bonds have a larger decrease in price in a rising interest rate environment. That is precisely what’s happened in the last quarter: 5-year Government of Canada bond yield has risen from 4.01% to 4.55% and the 10-year bond from 4.11% to 4.55%. Predictably, short-term bonds have not fallen as much as those of longer terms:
![[Chart comparing performance of XSB versus XBB]](http://www.canadiancapitalist.com/images/2007/xsb_vs_xbb.gif)
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8 responses so far ↓
1 Phil S // Jul 4, 2007 at 11:57 am
Well, if you’re investing in bond funds then you’re basically gambling on the marked to market price of the bonds. On that subject I would agree that you would want to stay on the short end of the yield curve.
However, if you’re planning to buy a Government of Canada bond and are satisfied with getting 4.5% yield by holding the bond to maturity, then you can buy it now and hold to maturity without worrying about the loss of your original principal. But in my brokerage account, I can get a better yield than the GoC 10-yr by buying a GIC for the same duration and it’s guaranteed by the CDIC for up to $100K.
Regardless, for me it continues to be nothing but T-Bills and cashable 1-yr GICs for my new money. Although, I admit that I’ve been getting some itchy fingers for some tantalizing picks on the venture exchange! =0)
2 FinancialJungle // Jul 4, 2007 at 12:11 pm
I’m a chicken when it comes to long bonds. Just by holding 0% in bond, I’m already overweighting in this asset class relative to homeowners with $200,000 in mortgages.
Inside non-registered, bond interests trigger taxes on top of inflation. Personally, I wouldn’t lend money to anyone for at 4.5% for 10-years, but possibly in my golden years.
3 FourPillars // Jul 4, 2007 at 1:00 pm
I like the idea of owning only short term bonds as per Bernstein but I also wonder if there isn’t some diversification benefits to owning short, medium and long term bonds since they aren’t always correlated to each other?
On the other hand, my main goal for investing in bonds is to offset volatility in the equities portion so if the short term bonds achieve that goal then that might be good enough.
FJ - I never understood the idea that a mortgage is akin to being invested in bonds, is this what you mean? or the opposite?
It seems to me that with a mortgage, you owe someone else money whereas bonds are the opposite - someone owes you money.
Mike
4 FinancialJungle.com // Jul 4, 2007 at 1:55 pm
Mike - You’re correct. When you hold a $200,000 mortgage, you’re essentially shorting bonds. i.e. minus $200,000 in bonds. Since I don’t have a mortgage and my bond position is $0, I’m holding $200,000 more bonds than a typical homeowner.
It doesn’t make much sense for homeowners to hold long bonds, when they can earn higher and tax-free yields by paying down their mortgages. BTW, inside RRSP, the yields are tax-deferred, not tax-free.
5 Phil S // Jul 4, 2007 at 2:49 pm
I don’t get the analogy between mortgage and bonds either. I am mortgage free as well, but I don’t foresee my condo’s value increasing at 4.5% a year for the next 10 yrs. In fact, conventional wisdom says that home values tend to go in the opposite direction of mortgage interest rates… Interest rates go up, homes become less affordable, fewer people can afford so it becomes a buyer’s market as prices come down?
For long bonds, 25% of my RRSP is already in Real Return Bonds (bought a few years ago), which amazingly mature around the time that I hit retirement age so they worked out perfectly for me (GoC only sold two or three series of Real Return Bonds the last time I checked). But that’s the absolute most that I want to dump in that one single asset class - on ROBTV they recommend not to have more than 5% of your portfolio in a single investment. As my RSP gets bigger with future contributions, I figure that my Real Return Bonds will some day eventually get down to 5%. =0P
6 Canadian Capitalist // Jul 4, 2007 at 2:54 pm
FJ: We look at things from a slightly different perspective. For me, a home and the associated mortgage are not considered part of my investment portfolio. Even if you did, renters have to account for their own negative bond as well, by thinking of their rental payments as negative coupons.
Let’s say that you have a mortgage and an investment portfolio, most or all of which is in RRSPs (I think this is a very common situation). Should you hold bonds then? I would say yes, at least a little bit because you are not giving up too much return and are lowering the overall portfolio volatility. But this is only true if you are able to hold bonds within the RRSP. A good case can be made for being 100% in stocks if an entire portfolio is in taxable accounts.
Mike: I suppose investors who bought 30-year bonds for their fixed income portion in the eighties would be very satisfied with the results. In general though, long bonds may not be worth the extra interest rate risks.
7 FinancialJungle.com // Jul 4, 2007 at 4:23 pm
My comments were more in the context of long bonds, but I like your perspective. Renters’ rent obligations are reminiscent of bond coupons.
As for RRSP, since it’s meant as a retirement account, my preference is to hold equities (and perhaps short-bonds) instead of long bonds.
8 Canadian Capitalist // Jul 4, 2007 at 6:58 pm
Fair enough. In fact, we are talking about the same thing. Instead of taking on interest rate risk for a lower expected return, it is better to take on market risk in equities for a higher expected return. Still, a bit of short bonds adds a bit of stability to a portfolio.
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