Fixed Income - Bonds, Real Return Bonds, Laddered?

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Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by eulogy »

Hi everyone,

I'm still on the green side of saving for retirement, but I'm stacking away the money at a pretty fast rate. Currently I have a very simple portfolio held in a TD e-series mutual fund account (Canadian Index, US Index $US, International Index and Canadian bonds). I'll probably end up moving to a brokerage account sometime within a year and I'll be able to move into cheaper ETFs. I'm just doing a little investigating now to try to determine the funds I should go for. A little offtopic from the title, but I really haven't been that impressed with the choices available to me except for the US market since I do hold that in US dollars. VTI provides me a nice option, though Canadian equities, international equities and bonds aren't really catching my eyes.

But my real question is about the different bond funds in general. The TD fund follows the DEX Universe Bond Index, and it's the only choice. But with ETFs there is a lot to look at. We have short term bonds, long term bonds, government bonds, 1-5 year laddered government bonds, 1-5 year laddered corporate bonds, and real return bonds.

I'm really having a hard time picking one. And I guess the keyword is one. I'd prefer to keep my portfolio as simple as possible, so ideally, I'd like to only purchase one ETF for fixed income only. But I have no idea what is a good choice. I know real return bonds give you something to fight against inflation, but it's a government type of bond.

I'm just confused with the amount of choices I have. Can someone shed some light?

Edit: I'm in my late 20s and probably have a good 30+ years of working to do. Hopefully this helps.
Last edited by eulogy on 25 May 2012 20:20, edited 1 time in total.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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eulogy wrote:But my real question is about the different bond funds in general. The TD fund follows the DEX Universe Bond Index, and it's the only choice. But with ETFs there is a lot to look at. We have short term bonds, long term bonds, government bonds, 1-5 year laddered government bonds, 1-5 year laddered corporate bonds, and real return bonds.

I'm really having a hard time picking one. And I guess the keyword is one. I'd prefer to keep my portfolio as simple as possible, so ideally, I'd like to only purchase one ETF for fixed income only. But I have no idea what is a good choice. I know real return bonds give you something to fight against inflation, but it's a government type of bond.
If you are relatively early in your career, i.e not retiring in the next 10 years, I would be tempted to go to a laddered investment grade Corporate bond ETF of 1-5 years or even a bit longer duration (medium term) and stay the course. Rationale: 1) There is enough diversification within the ETF to counter any Black Swans in the lot and corporate bonds give you extra return over gov't bonds (for the additional risk). 2) If you have no plans to access the funds, then the longer term adds a bit more punch to the return. There is some 'common' thinking that the sweet spot for bonds is in the 6-10 year group... or thereabouts though no one has a crystal ball.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

For a single bond ETF only, OTOH, I would stick with a broad index, either XBB Overview - iShares ETFs or VAB -Vanguard Canadian Aggregate Bond Index ETF.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by gsp_ »

eulogy wrote:VTI provides me a nice option, though Canadian equities, international equities and bonds aren't really catching my eyes.

I'd prefer to keep my portfolio as simple as possible
5 or 6 parts VXUS for 4 parts of VTI will have all your non domestic equity needs covered.

VCE/XIC for domestic, pick one.

VAB is the direct e-bond replacement. VSB if you want shorter duration. Not a fan of the corporate ETF suggestion, haven't achieved similar all around portfolio returns as short/all bond alternatives when combined with equities. Higher correlation to equities means the yield advantage disappears during rebalancing and you're left with a higher risk portfolio. In a 2008 scenario when your equities are getting halved it's nice to own an asset that is going up rather than one that is bleeding slower than your stocks.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

One thing the OP hasn't mentioned is if the account is registered. Premium bonds - which a broad index will hold right now - are tax-disadvantaged in non-registered accounts.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by eulogy »

Thanks for the suggestions so far. When I get a little more time I'm going to do a little more research on what is suggested and read into more of what was offered.

And to answer Shakespeare's question, it will be in a registered account.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by eulogy »

Okay, I finally have some time.
If you are relatively early in your career, i.e not retiring in the next 10 years, I would be tempted to go to a laddered investment grade Corporate bond ETF of 1-5 years or even a bit longer duration (medium term) and stay the course. Rationale: 1) There is enough diversification within the ETF to counter any Black Swans in the lot and corporate bonds give you extra return over gov't bonds (for the additional risk). 2) If you have no plans to access the funds, then the longer term adds a bit more punch to the return.
Interesting. I'm definitely early in my career timeline and have many decades for my fixed income to sit in funds. I know there is more risk with corporate bonds versus a government bond, but the long time line should help out a lot. Have corporate bonds or at least laddered funds shown to have produced decent returns over the long term? I assume with more risk there would be more reward. If I was going to buy one of these funds I would go with the iShares CBO, which has a MER of 0.28% which is on the lower side for Canadian bond funds.
For a single bond ETF only, OTOH, I would stick with a broad index, either XBB Overview - iShares ETFs or VAB -Vanguard Canadian Aggregate Bond Index ETF.
This might be the easiest approach since it has a mix of everything. I really like the Vanguard ETFs, but I get a little concerned with the volume of trading and possible liquidity issues. But I don't think I could beat that MER.
5 or 6 parts VXUS for 4 parts of VTI will have all your non domestic equity needs covered.

VCE/XIC for domestic, pick one.
This is a good point and I've been debating how I should do this. I love the US funds so much better because they're cheap as hell and they have better products I think. The reason I own US equities in $US is that I have a side income of US dollars. So to save exchanging things around, I just hold onto the US dollars and that's the plan with VTI. But I noticed for my international allocation that a lot of the funds available in Canadian dollars aren't cheap. I personally don't want to hedge the currency, so the vast majority are pretty close to the TD International Index-e.

I'm definitely thinking about the picking up VXUS for my international portion. I don't know how confident I am with this move though. I don't have enough US dollars coming in to fund both US equities and international in US dollars. I could do Norbit's Gambit, but I consider myself very green. But at the end of the day this might be my only option since I'm disappointed at what is offered in Canadian dollars for ETFs and international holdings.
Higher correlation to equities means the yield advantage disappears during rebalancing and you're left with a higher risk portfolio.
This is a very good point. I never thought of the risk factor.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by like_to_retire »

eulogy wrote:Currently I have a very simple portfolio held in a TD e-series mutual fund account (Canadian Index, US Index $US, International Index and Canadian bonds). .........................I'll probably end up moving to a brokerage account sometime within a year and I'll be able to move into cheaper ETFs.
Note that the TD e-series funds have very acceptable MER's, and note that there are no fees to purchase them, and they automatically re-invest the cash they throw off.

With ETF's you'll pay brokerage fees with every purchase including the re-investment of their dividends. That can get quite costly every quarter and should be factored into your MER comparisons. I would consider a minimum entry point into an ETF to be in the $50K range.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Peculiar_Investor »

eulogy wrote:But my real question is about the different bond funds in general. The TD fund follows the DEX Universe Bond Index, and it's the only choice. But with ETFs there is a lot to look at. We have short term bonds, long term bonds, government bonds, 1-5 year laddered government bonds, 1-5 year laddered corporate bonds, and real return bonds.

I'm really having a hard time picking one. And I guess the keyword is one. I'd prefer to keep my portfolio as simple as possible, so ideally, I'd like to only purchase one ETF for fixed income only. But I have no idea what is a good choice.
When I was in your situation I approached the problem with the following thought process. My Investment Policy Statement required defined a fixed income asset allocation, but no current need for an income stream. I hadn't spend much time understanding the nuances of how various fixed income choices worked or were analyzed, so felt I had no expertise in the area. As such, the logical conclusion for me was to purchase the broadest based Canadian fixed income index that was available to me, with a nod towards lowest cost.

The broadest index I could find was the DEX Universal Bond index, so my investment choice was XBB Overview - iShares ETFs. Vanguard Canada didn't exist when I was making my choice, but today VAB - Vanguard Canadian Aggregate Bond Index ETF would also seem a worthy consideration.

Over time, I've educated myself on Canadian fixed income as I retirement (and income generation) appeared on my radar screen. This has implications on our Investment Policy Statement and has changed our fixed income choices, we've now built a 10-year fixed income ladder so that we've got more control of the income stream going forward.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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Peculiar_Investor wrote:we've now built a 10-year fixed income ladder so that we've got more control of the income stream going forward.
That's a very important point for anyone who is in withdrawal phase.

FWIW I was burned badly by long nominal bonds in the 1970s and now I never go near them. I do hold GICs and very short term government bonds, usually 90-day, but currently 8 months, which I roll over. I've been doing this for three years now. Coincidentally, very recently I read a book by Antti Ilmanen which argues that the best fixed income instruments, in terms of risk-reward ratio, are (a) "stub" government bonds with less than a year left to maturity (b) corporate BB grade bonds. The latter is because a lot of institutional investors cannot go below BBB and that leaves a gap in demand for BB bonds, hence a lower price when adjusted for risk. I found the book pretty convincing, although I have yet to buy any corporate BB.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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James Hymas has argued that the difference between a ladder and the corresponding ETF or fund of the same duration is largely mental accounting. You withdraw 100 cents on the dollar but you reinvest at the longest duration, so there is little net benefit.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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like_to_retire wrote: Note that the TD e-series funds have very acceptable MER's, and note that there are no fees to purchase them, and they automatically re-invest the cash they throw off.

With ETF's you'll pay brokerage fees with every purchase including the re-investment of their dividends. That can get quite costly every quarter and should be factored into your MER comparisons. I would consider a minimum entry point into an ETF to be in the $50K range.

ltr
Yeah I like TD e-series and I plan to continue using them. The plan right now is very simple and that is passing the $50,000 threshold. Once I do that I plan to upgrade my RRSP (might do my TFSA, but not necessary) to Waterhouse. I hold all my US dollar investments in my RRSP. The plan on one transaction for VTI. I only deposit US dollars once a year and buy US, so I will stick with that plan. The other items (bonds, international, canadian equity) will sit in e-series until I have enough to warrant a purchase. From there, I'll most likely put new contributions back into the e-series funds I hold them until I build up enough again (most likely 1 purchase a year). That's at least the plan I'm going with as of now.
Peculiar_Investor wrote:When I was in your situation I approached the problem with the following thought process. My Investment Policy Statement required defined a fixed income asset allocation, but no current need for an income stream. I hadn't spend much time understanding the nuances of how various fixed income choices worked or were analyzed, so felt I had no expertise in the area. As such, the logical conclusion for me was to purchase the broadest based Canadian fixed income index that was available to me, with a nod towards lowest cost.

The broadest index I could find was the DEX Universal Bond index, so my investment choice was XBB Overview - iShares ETFs. Vanguard Canada didn't exist when I was making my choice, but today VAB - Vanguard Canadian Aggregate Bond Index ETF would also seem a worthy consideration.
This is my exact thinking. A broad index seems the safest and easiest. I might go with VAB, I just don't like the low volume.
Peculiar_Investor wrote:Over time, I've educated myself on Canadian fixed income as I retirement (and income generation) appeared on my radar screen. This has implications on our Investment Policy Statement and has changed our fixed income choices, we've now built a 10-year fixed income ladder so that we've got more control of the income stream going forward.
Retirement is a long way off for me, so income generation isn't on my radar, but I realize my needs will probably change as I get closer to that day. When you say you've built a 10 year fixed income ladder, does that mean you went out and bought your own bonds for this?
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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The other items (bonds, international, canadian equity) will sit in e-series until I have enough to warrant a purchase. From there, I'll most likely put new contributions back into the e-series funds I hold them until I build up enough again (most likely 1 purchase a year). That's at least the plan I'm going with as of now.
Yeah, smart. It's a good plan. I use $50K as a rough indicator, such that if you buy four ETF's at $50K ($200K total), and you approximate a 2% overall cash throw-off, you'll have $4000 a year to re-invest. That's $1000 a quarter to pump back into the system. Even with a single ETF re-investment costing $10, it's an MER of 1%. Putting that into e-funds until it becomes significant in relation to broker fees is a smart way to go.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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like_to_retire wrote:Yeah, smart. It's a good plan. I use $50K as a rough indicator, such that if you buy four ETF's at $50K ($200K total), and you approximate a 2% overall cash throw-off, you'll have $4000 a year to re-invest. That's $1000 a quarter to pump back into the system. Even with a single ETF re-investment costing $10, it's an MER of 1%. Putting that into e-funds until it becomes significant in relation to broker fees is a smart way to go.
WADR, your 1% calculation is a red herring. If you're accumulating, just lump the distributions with the rest of investable cash; you don't need to make separate purchases with the dividends alone.

BTW, there are many ETF's paying less often than quarterly, IMHO, the seldom the better. Outside North America, many if not most companies pay 1 or 2 dividends a year (and report annually) -- to me, that would be fine. Just imagine filing your personal income taxes quarterly... :twisted:
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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Shakespeare wrote:James Hymas has argued that the difference between a ladder and the corresponding ETF or fund of the same duration is largely mental accounting. You withdraw 100 cents on the dollar but you reinvest at the longest duration, so there is little net benefit.
True in theory. But in practice there are transaction costs.

So for example I may not like the duration of the ETFs on offer. If I nevertheless buy units of the ETF, I have to buy some individual bonds of appropriate duration to reach my target. If I am buying small amounts, as is probable, the bid-ask spreads can be large. On the other hand, if I buy a portfolio of individual bonds, I can get the desired duration directly, my pufrchases will be bigger, and perhaps the bid-ask spreads will be smaller. And I will be able to control the duration more precisely, because I will not have to keep constant tabs on what the ETF management does, with impact on the ETF's duration.

On the other hand, if I were to invest in corporate bonds, it would be much harder to diversify credit risk with individual bonds than with an ETF.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

You can easily vary your duration by blending bond ETFs.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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Shakespeare wrote:You can easily vary your duration by blending bond ETFs.
True, as long as you have one short (ultra-short?) and one long (ultra-long?). As you may have guessed, I was thinking of XRB.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by gsp_ »

eulogy wrote: This is my exact thinking. A broad index seems the safest and easiest. I might go with VAB, I just don't like the low volume.
I wouldn't worry about the volume as long as the bid/ask spread is reasonable. They employ market makers who put up offers of 10k to 25k shares on both sides and further offers of the same size for one cent less/more on and on several levels down. Buying a million $ or three of these VG CAD ETFs seems easy enough.

Spreads seem to have come down from when they were first launched but are still wider than high volume Ishares products since you are mostly just trading with the market maker rather than other investors.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

XRB is too expensive. XBB/XSB or the Vanguard funds are better.
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Principal risk

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One of the major benefits of buying bonds directly is that your principal is guaranteed, but not so with bond ETFs. So unless one believes that interest rates will stay at the current historic low levels, are bond ETFs worth the risk?
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Re: Principal risk

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Benchwarmer wrote:One of the major benefits of buying bonds directly is that your principal is guaranteed, but not so with bond ETFs. So unless one believes that interest rates will stay at the current historic low levels, are bond ETFs worth the risk?
As I see it, the key to interest rate risk is the duration of an ETF or of a bond ladder. Duration tells you, approximately, the percentage change in the price of a bond that will result from a one per cent change in the yield (i.e. the relevant interest rate). That tells you how much cheaper (or more expensive) you bonds have become, and how much more (or less) you will pay to roll them over. Of course, the longer the duration, the more volatile the bond, and so the more risky. (Recall that volatility is only one aspect of risk, at least in my opinion.)

As a bond comes closer and closer to maturity, the duration gets shorter and shorter, until it reaches zero. (Except, it seems, on Globe Investor. :roll:) But if you are working a bond ladder and replacing bonds as they mature, the duration should stay more or less the same -- shortening a bit as the year progresses, but then getting longer again when you roll over. Remember, you should pick your bond ladder to have the duration you feel comfortable with. You shouldn't allow the duration to change through inertia, by simply leaving your bond ladder gradually mature without replacement. Rather, if you decide to shorten duration as you get older (and many do, as risk aversion usually increases), that should be an affirmative choice.

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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

One of the major benefits of buying bonds directly is that your principal is guaranteed, but not so with bond ETFs. So unless one believes that interest rates will stay at the current historic low levels, are bond ETFs worth the risk?
As I said above, James has pointed out that although you get 100 cents on the dollar on the maturing bond, you reinvest at the longest maturity. This means that if you withdraw money on a bond ladder as it matures you are getting the same loss of income as you would if you sold some of an ETF of similar duration. So that difference between a ladder and an ETF or bond fund of the same duration basically cancels out.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

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Shakespeare wrote:
Benchwarmer wrote:One of the major benefits of buying bonds directly is that your principal is guaranteed, but not so with bond ETFs. So unless one believes that interest rates will stay at the current historic low levels, are bond ETFs worth the risk?
As I said above, James has pointed out that although you get 100 cents on the dollar on the maturing bond, you reinvest at the longest maturity. This means that if you withdraw money on a bond ladder as it matures you are getting the same loss of income as you would if you sold some of an ETF of similar duration. So that difference between a ladder and an ETF or bond fund of the same duration basically cancels out.
In other words, the guarantees in Benchwarmer's statement is an exercise in mental accounting, similar to "I've bought 5 year GIC's @ 3% 2 years ago, now similar ones pay 6% but I have not lost any money because my broker's statement displays them at par".

It's the paper numbers giving you a fuzzy feeling, just as the bond maturing gives you a warm one.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Peculiar_Investor »

eulogy wrote:When you say you've built a 10 year fixed income ladder, does that mean you went out and bought your own bonds for this?
Yes. Part of my education was reading through many posts here regarding purchasing and holding individual bonds. If you haven't already, you can use the forum's search functions to turn up topics such as Bond Ladders vs Bond ETF's and Buying Bonds. There is also a wealth of information in our wiki, see Conventional Bonds - finiki. I would also recommend you read "In Your Best Interest", W. H. Cunningham. I borrowed the 1st edition from the library and read it, then purchased the 2nd edition. See the author's website In Your Best Interest - Canada's Definitive Guide to Fixed Income Investing with W.H. Hank Cunningham. He indicates that starting in Nov 2010 he's working on a 3rd edition.

A couple of key points that I've learned from building my own bond ladder. Like all investing, costs (and pricing) matter. Unlike investing in individual stocks, when buying bonds the size of the order impacts the pricing, the bigger the order, the better the price you are quoted. As the finiki article states, each purchased needs to be at least $10,000 to get decent pricing. This has implications on the size of your fixed income portfolio required to build a diversified bond ladder. ETFs have an advantage here. Bond prices are not quoted on an exchange, so what you'll be offered depends on your brokerage's inventory and pricing decisions. For a specific example of a problem that I encountered trying to fill the 2018 rung, see here.

Some sage advice has been offered here from Norbert,
Norbert Schlenker wrote:I'm repeating myself from long ago but, if a cost conscious DIY investor in Canada has an account that is and always will be stuffed completely full of Canadian bonds (e.g. an RRSP), then a discount broker is not necessarily your best choice. You will get no break on spreads, i.e. the "discounter" saves you nothing, and you almost certainly have less inventory to choose from when you want to buy something. Consider opening an account at a :shock: full service broker.
I haven't gone this route, but might contemplate it as we get closer to retirement and more active in maintaining bond ladder.
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Re: Fixed Income - Bonds, Real Return Bonds, Laddered?

Post by Shakespeare »

You need a pretty decent-sized portfolio to make a corporate ladder with good diversification cheaper than an ETF like BMO Mid Corporate Bond Index ETF - Fixed Income - BMO Exchange Traded Funds (ETFs).
(Which, btw, I hold at about 4% of my portfolio).

Added: order of magitude - 10 bonds at $25k needing $250K; 25% of portfolio suggests million-dollar portfolio.
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