I have to admit that I hadn’t researched investing in bonds in any depth before but some of the books I’ve been reading lately have a great deal of information on bonds. Unlike individual bonds, bond funds, which hold a collection of bonds, do not have a maturity date and hence the bond principal is not guaranteed on maturity. Instead investors should look at the fund’s duration to predict its price volatility when interest rates are changing.
The iShares CDN Bond Index Fund (Ticker XBB on the TSX) seeks to track the Scotia Capital Universe Bond Index, which in turn tracks the performance of a collection of short-, mid- and long-term bonds. The MER is 0.30% and the duration of the fund is 6.49 years.
The iShares CDN Short Bond Index Fund (Ticker Symbol XSB) tracks the performance of an index of short-term bonds (1-5 years) and sports a MER of 0.25% and duration of 2.56 years.
The duration of the two bond funds indicate that the XBB will experience a decrease of approx. 6.49% when interest rates rise by 1% and increase by approx. 6.49% when interest rates fall by 1%. The bright side of rising interest rates, of course, is that the yield on reinvested interest payments will increase and eventually compensate the investor for the fall in value. The thumb-rule is that the time it takes for the fund to regain its lost value would approximately equal the duration of 6.49 years.
I’ve learnt recently (thanks to Investing Intelligently and Efficient Market Canada) that bond investors should keep fund duration as short as possible because longer-term bonds offer little extra return for taking a higher interest-rate risk. Even worse, long bonds are highly correlated with equities. I encourage you to read this excellent article for a detailed discussion on long- versus short-bonds.