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.

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This article has 16 comments

  1. Exactly! Bond fund prices are marked to market on a daily basis, which means that indeed, you CAN lose money in a rising interest rate environment. Right now I think cashable GICs provide the best combination of yield and flexibility. For disclosure, I have about 25% of my RRSP portfolio in cashable GICs – mostly because I owned a couple of securities that were bought out plus I had no idea where to invest this year’s contributions.
    In any case, I can pick up a worthwhile yield while I wait for opportunities to arise in the market. The problem is that I have no idea when those opportunities arise, so I have 1-yr GICs cashable after 30 days.

  2. I’ve held XSB and XBB before and I’m not a huge fan of them because they don’t necessarily hold their bonds until maturity (especially the long term fund), so you face realized capital losses when then sell bonds to maintain their duration range.

    I know it can be more expensive for individual investors, but I like holding high quality bonds directly if the yield is there. My company held Ford bonds in the early 2000s and because we held until maturity we achieved our desired return.

  3. Canadian Capitalist

    Investoid: Bonds and bond funds should preferably held within a RRSP. In my own personal portfolios, I hold XSB because as a small investor bond commissions are too steep to justify directly investing in them. Also, I disagree that average investors should invest in any individual corporate bonds.

  4. Sorry for the typo above – meant to say ‘… when they sell bonds …’.

    CC – I agree that commissions can be high (and are often hidden in the ask price which makes assessing the true costs hard), but for me it comes down to expected yield versus risk. High grade corporate bonds with extremely low default risk can be advantageous to later stage investors who are looking for stable returns. Right now the premium on AAA corporate and the like is so low that I wouldn’t recommend picking them up, but when the yield curve eventually becomes a curve again, you can find good risk-adjusted returns in corporate bonds (providing you’re holding to maturity).

  5. Canadian Capitalist

    Investoid: We’ll have to disagree whether average investors (and remember we are all above average) have any capacity for assessing default risk. I am happy with whatever corporate bond component is present in the index. This is not to say you can’t make (or lose) money on them, just that I don’t think it is a game worth playing for average investors.

  6. Re cost of direct bond purchases for small investors…. Just did a small experiment on my discount broker. The min purchase for any individual bond is $5k. For the GTAA 5% 01JUN15 bond, here are the comparable yields on a purchase – quotes taken within a couple of minutes so there may be some change due to price changes during the time I requested the various quotes but it should be pretty close.
    $5k – annual yield 4.647%
    $10k – 4.702%
    $50k – 4.738%
    $100k – 4.753%
    Thus, the maximum yield difference between the smallest investor and a quite large investor is about 0.1%. That compares well with the 0.3% MER one loses in a bond fund such as XBB.

  7. Canadian Capitalist

    True, but iShares will probably get even better pricing due to the size of its bond portfolio. Would it make up for the 0.30% MER? I don’t know because bond pricing is hardly transparent. I do know that just to build a ladder of 5-year Canada’s, I need an outlay of $25K, which means I need a portfolio of $125K (20% is my bond allocation). And that’s for every portfolio I have. I don’t know where the cut-off point is, where investing in individual bonds is better, but it is pretty high. Thoughts?

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  9. Pingback: Short-Term versus Long-Term Bonds

  10. Is there an etf that shorts bonds.An inverse stock such as dxd that is a stock for shorting the dow.

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  14. I think that you have it wrong when you say that “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… “.

    The way I understand duration is that it is more like a time period where you breakeven on the investment through cashflow from coupons and bond maturities. The sensitivity you are talking about would be more like a beta coefficient.

    Anybody know better, please correct me.

    Otherwise, I agree with your conclusions.

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  16. For investing emergency fund money, what is the difference (risk) of investing the cash in GICs vs. a bond ETF like XBB?

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