Friday, 12 October 2007

Bond Index ETF/Funds vs Bond Ladder

A little while back, Mike from QFP asked me to compare my experience using a bond ladder for the fixed income component of my portfolio versus bond funds, which I have just started using this year in the form of ETFs. Good question, here are my thoughts.

Bond Ladder
My holdings look like this:
  • More than ten individual bonds;
  • Different issuers, corporate only, none government, Canadian only, no foreign;
  • Staggered Maturity approximately (at various times throughout the calendar year) one year apart, from 2008 up to 2026
  • Held across two LIRAs and an RRSP
  • No buy-sell, just buy and hold to maturity - when one matures I buy at the long end of 10+ years which gives higher yield - since I've been doing this, the yield curve hasn't gone upside down, where higher yields would be available for shorter term bonds
  • Coupon bonds only, no strips or residuals
  • Investment grade only

Observations:
  1. Credit risk and diversification is merely ok but not great - I have too few bonds in too few categories to be properly diversified. Though I have bought only investment grade bonds, it happened once that one company had its debt rating lowered and the price took a big hit. It didn't actually go into default but that risk isn't negligible. I didn't lose any money because I held to maturity and the bond was repaid at par. A few years back, Telus had a bad patch, it got downgraded, I nervously bought a bit, management got the ship back on track and lo and behold, I made a very nice gain in addition of course to continually receiving the coupon payments. Nowadays, I'm taking the attitude that I won't presume to judge better the credit risks than Standard & Poors or Dominion Bond Rating Service.
  2. Portfolio rebalancing is more difficult - since I have made myself a policy to rebalance my overall investment portfolio back to target percentage allocation (30% in fixed income) if it comes to pass that equities have a crappy year and I am overweight in fixed income, what should I do - which bond to sell and put a hole in the ladder? As well, bond buy-sell minimums might cause an asset allocation overshoot and the buy-sell spread/commission on bonds adds to costs.
  3. Purchases are lumpy - the minimum bond purchase amount is $5,000 so you need a fairly hefty sum to even build a ladder. The smallest I have seen suggested is a ladder of five bonds, i.e. $25,000, though due to the above diversification considerations, I feel $50,000 is more like a proper minimum.
  4. Limited inventory - the discount brokers don't have a huge selection. Yesterday, when I went through my TD Waterhouse account there was not a single corporate bond of more than eight years maturity. BMO Investorline had a much better inventory, but ...
  5. Commissions can vary between discount brokers - I managed to find the same bond for sale at both BMOIL and TDW yesterday and discovered that BMOIL charges a higher commission than TDW. The GE Capital 4.4% 01JUN14 ask price for the min $5k purchase at BMOIL was 96.46 and 96.257 at TDW, a difference in commission of about 1% vs 0.76%. BMOIL = bigger inventory but higher commissions. TDW also supplies, very conveniently, both the bid/buy (94.757 in this case) and ask/sell prices, which is what allowed me to figure out the mid/average price and the commission.
  6. Commissions and therefore costs can be low if bonds are held to maturity - though the commission on an equity trade of $10/5000 = 0.2% is much lower than the above bond example, there is no recurring admin or management cost on the bond and, if held to maturity, the cost averaged over years goes down to very small amounts, which Shakespeare's primer has conveniently calculated and graphed here. On the other hand, if you start actively buying and selling bonds, your commission costs will be quite high, i.e. my recommendation is that a bond ladder is for holding bonds to maturity.
  7. Commissions do drop with larger purchases and your yield/return rises. For example, today on BMOIL, buying $100,000 of GE Capital DD Call 4.65% 11FEB15 gives a yield of 5.238% while the minimum purchase of $5,000 yields 5.117%, a difference of 0.121%. As they say here, every little helps. Do you have $1mill for your bond ladder to get that extra 0.1%? No? Then just buy another bond that yields slightly higher.
  8. Choice of receiving the return as cash or an ultimate lump sum. Most bonds pay out cash as coupon interest payments every six months, though some do so every month, allowing one to tailor a cash flow if desired. In my case, I really should be buying stripped coupons and residuals instead of regular coupon bonds to avoid having the interest payments sitting idly in cash between my rebalancings and to lock in the yield aka avoid the reinvestment problem. (A really good brief explanation of stripped bonds is BMOIL's on their website at https://www1.bmoinvestorline.com/EducationCentre/FixedIncome/Products.html#3.1 or if you cannot access that page, see Shakespeare's explanation at the link above. I am still accumulating and not withdrawing from my registered plans so I don't want cash, but someone else in retirement and needing to withdraw cash might find that handy.
Bond ETFs
  1. Diversification is easy and assured. With one purchase it is possible to acquire a large number of bonds to cover the whole Canadian market, like XBB, or subsets thereof to reduce individual company credit risks to their minimum. One can acquire a subset that apparently acts as a separate un-correlated asset class - real return bonds, like XRB. One can also buy foreign bonds, like the US dollar AGG, which I have done to further diversify my holdings, or even international bonds, though I have not done that yet. Read this GlobeInvestor article for a rundown of various US and international alternatives.
  2. Rebalancing is easy and precise. Since the ETFs are like a stock, an asset allocation can be set almost to the dollar and it takes only one trade.
  3. Management fees are a bit higher. The annual management fee on a fund, even if it is a passive index-tracking fund like the ones named above, takes a bit away from the return every year. MERs: XBB - 0.3%, XRB - 0.35%, AGG - 0.2%
  4. Interest payments on bond ETFs are received in cash, with the same issues as discussed in the case of individual bonds. Bond mutual funds can reinvest the payments but their MERs are higher, which is a worse problem than receiving cash. If you have one giant holding in an ETF and receive a large cash payment, it may be enough to reinvest immediately instead of waiting months while a reasonable amount piles up.
Most of my fixed income portfolio is in the Canadian bond ladder, but I have smaller holdings in some of the bond ETFs mentioned to facilitate my asset allocation and rebalancing. For me, and I would suggest for anyone, tax considerations don't enter into the picture since my holdings are all in tax-deferred registered accounts. It doesn't make sense if one can possibly avoid it, to have any fixed income in a non-registered taxable account - it's always better to pay taxes later.

7 comments:

dj said...

I think there are index mutual funds that deserve to be included in this debate, particularly for people just starting out (TD eFund, 0.48% MER), but also for those with >$150,000 in assets (CIBC, 0.32% MER after rebate)

Jean said...

Good suggestion. With mutual funds, it is possible to make small regular donations at no extra fees. The only drawback I know of for the TD fund at least, is that you can only buy it within a TD account. I could not buy it for instance through my BMOIL. Do you know if that is the same for the CIBC fund?

FourPillars said...

Good info.

One small point - I own some ETFs in a Questrade account and apparently I can do a DRIP plan so the divs get automatically reinvested.

I own XSB (short term bond) but I think I will just set up the drip on US$ ETFs so they don't get converted back to Cdn$.

Mike

dj said...

TD eFunds are only through TD.
CIBC seems to be available, with rebate, anywhere. I have held them in an MD management account and a TD Waterhouse account.

Y HAT said...

Great post on bonds. What's your opinion on buying short term vs. long term bond ETFs?

CanadianInvestor said...

Re short term vs long term bond ETFs... I accept the argument that the ideal is to have the whole mix of bonds from short to long so that means I don't look at it as an either/or choice. Given my prime objective is diversification across all issuers (Government, corporate) and geographies (Canada, the US, Europe etc), I go for the simple universe bond ETFs like XBB in Canada, AGG or BND in the USA. So far, there seems to be only one international bond ETF, the SPDR Lehman International Treasury (i.e. government) Bond ETF, launched only a few weeks ago. Its symbol is BWX and trades in the US.

I've read that real return bonds are un-correlated with other types of assets and so can be a useful diversifier too, so I would take that over a short vs long addition to my ETF bond holdings.

Getting into more than a small handful of bond ETFs will also make rebalancing more complex and costly.

mak said...
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