Selecting the Bond ETF(s) and Why Bonds instead of Cash

A reader sent in a couple of excellent questions on the practical aspects of setting up the bond portion of a portfolio:

1. which Canadian bond ETF to buy for a portfolio - the iShares Short-Term Fund (Ticker: XSB), or the iShares Canadian Universe Fund (all issuers and maturities; under ticker: XBB), or possibly other funds
   
2. why buy any bond fund if cash in ETrade is paying a healthy 4.15%?

To start a portfolio, I would favour XBB since it covers the whole Canadian bond market. Buying and holding the market is one of the fundamental principles of passive index investing. If one were to buy only XSB, that cuts out a substantial portion of the bond market.

The attached chart, using data from the iShares Canada website on December 6, illustrates more key differences between XBB and XSB:

• long term, the performance of XBB will be superior - note the five year return of 5.89% vs 4.37% (these figures are for the reference index that the fund attempts to track; the tracking error shows how much the ETF deviates from the index); Since XBB holds some long term bonds, it has a longer duration (see here for an explanation of bond duration as opposed to the term to maturity), which means more sensitivity to interest rate changes and more volatility, but which also provides greater yields in the long term.
• XBB's tracking error is a little more than XSB's, partly a reflection of the 0.05% higher MER on XBB
• currently, the yield difference is much slimmer than the long term averages for different maturity funds
• XBB has some of its distributions in the form of capital gains (cf 2005 and 2004), which benefits from a lower tax rate if held outside an RRSP or other registered account
• XLB has a much higher longer term performance, as shown by the results of the index it tracks
  

Note also that TD CanadaTrust also offers a mutual fund - the TD e-Series Cdn Bond Index - that tracks the same whole of market Scotia Capital Universe Bond Index as XBB. The TD fund has a higher MER of 0.48%, which almost certainly results in lower net returns than XBB. However, being a mutual fund, it charges no commissions, so if regular purchases of small amounts in a building up phase of a portfolio are taking place, it may be a better choice (e.g. the 0.15% extra MER is about the same as a $10 trading commission on a $6666 purchase of an ETF) . The other caveat is that one must have an account with TD to buy that fund.

I would note in passing that other commentators like Efficient Markets Canada and Investor Solutions, seem to be saying that short bonds / XSB are a permanently better choice because of the return to risk/volatility relationship - i.e. that long term bonds are too volatile for the small extra return. Perhaps at a moment in time, or for a specific time period, the relationship may be out of whack, but finance theory and research say that they will get realigned. There are bubbles and anomalies in the markets but they get eliminated.

Another point to consider is that just as the equity portion of a portfolio is better off with holdings beyond the Canadian market, so too is it for bonds. The next stop is likely the addition of a US fund. Major ETFs available to Canadians through US markets include BND, the Vanguard whole of US market bond fund and AGG, the iShares Lehman Aggregate Fund. There don't yet appear to be any international bond index ETFs, which would be good for even wider diversification. The Google spreadsheet at the bottom of my blog shows how I have structured my portfolio - instead of my bond ladder, just substitute XBB.

As of today, the minimal difference between the yields on cash and short, medium or long term bonds suggests that it may be just as well temporarily to hold the cash. Sooner or later larger rising differences for longer maturities will re-establish itself. ETrade's fine print does state that the interest rate can change anytime, which means having to monitor it and the funds to decide when to make the shift into the bonds. Incidentally, the ETrade folks said to me in a phone call that cash balances are protected for up to $1 million by the Canadian Investor Protection Fund.

Bonds and cash can provide a highly beneficial diversification effect in a portfolio with equities; through being un- or sometimes negatively-correlated with equities, they can increase returns and lower volatility at the same time. This surprising result has been documented and explained in such fine books as Roger Gibson's Asset Allocation and Richard Ferri's All About Asset Allocation, which I have reviewed previously.