Do bonds in RRSP/TFSA still make sense?

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adrian2
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Re: Do bonds in RRSP/TFSA still make sense?

Post by adrian2 » 04 Dec 2017 14:55

milton wrote:
04 Dec 2017 12:53
adrian2 wrote:
03 Dec 2017 11:57
On average, VAB should return more than the YTM - MER, due to the "ride-the-yield-curve" effect.
This 'ride-the-yield-curve' effect is really cool, never heard of it before. Is this how it works?--Let's say 30yr bond yields 2.23% and 1 yr bond yields 1.36%. The yield curve is the curve between 1.36 - 2.23. If an investor buys $1000 of the 30yr and sells in year 29, he can sell the $1000 bond for $1639.71, because the 30yr bond is now equivalent to a 1yr bond ($1639.71*2.23%=$13.60). Once the investor cashes in, he can reinvest the $1639.71 in another 30yr, so 'picks up' a little extra versus holding to maturity. This of course assuming the yield curve stays the same. A steeper curve will result in more gain and if the yield curve is flat then there is no gain. If the yield curve is inverted, then the investor would simply hold to maturity.
You are correct.

For my quiz on the same topic, try: Bond investing.
milton wrote:
04 Dec 2017 12:53
Is there a way to calculate how many basis points the 'ride-the-yield-curve' effect adds to VAB? Even back of napkin calculation?
Back of the envelope, it counterbalances the MER and then some...
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“It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong.” [Richard P. Feynman, Nobel prize winner]

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Re: Do bonds in RRSP/TFSA still make sense?

Post by FI40 » 04 Dec 2017 16:37

adrian2 wrote:
04 Dec 2017 14:55
milton wrote:
04 Dec 2017 12:53
adrian2 wrote:
03 Dec 2017 11:57
On average, VAB should return more than the YTM - MER, due to the "ride-the-yield-curve" effect.
This 'ride-the-yield-curve' effect is really cool, never heard of it before. Is this how it works?--Let's say 30yr bond yields 2.23% and 1 yr bond yields 1.36%. The yield curve is the curve between 1.36 - 2.23. If an investor buys $1000 of the 30yr and sells in year 29, he can sell the $1000 bond for $1639.71, because the 30yr bond is now equivalent to a 1yr bond ($1639.71*2.23%=$13.60). Once the investor cashes in, he can reinvest the $1639.71 in another 30yr, so 'picks up' a little extra versus holding to maturity. This of course assuming the yield curve stays the same. A steeper curve will result in more gain and if the yield curve is flat then there is no gain. If the yield curve is inverted, then the investor would simply hold to maturity.
You are correct.

For my quiz on the same topic, try: Bond investing.
milton wrote:
04 Dec 2017 12:53
Is there a way to calculate how many basis points the 'ride-the-yield-curve' effect adds to VAB? Even back of napkin calculation?
Back of the envelope, it counterbalances the MER and then some...
Got it. Yeah the spread between 10y and 2y govis now is about 38bp.

I just did the math and if you bought a 10y, sold it after 8 years at the current 2y rate (assuming 1.9% 10y and 1.52% 2y rates, as per Dec 1st yields on the BoC page) your CAGR including the eight $1.90 coupons, buying for 100 and selling 8 years later for ~100.75, is ~1.986% over 8 years. Compared to 1.9% over 10 years if held to maturity. There is an effect but in the Canadian market it seems negligible...

In a bond ETF though, don't bonds get held to maturity, then a similar maturity bond is repurchased, in general? So this selling early strategy doesn't really apply there? I thought YTM-MER would be fairly accurate (all else being equal) for a bond ETF even with a sloped yield curve.

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Re: Do bonds in RRSP/TFSA still make sense?

Post by fireseeker » 04 Dec 2017 17:50

adrian2 wrote:
04 Dec 2017 14:55
For my quiz on the same topic, try: Bond investing.
I learned something useful and interesting today, Adrian. Thanks!

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Re: Do bonds in RRSP/TFSA still make sense?

Post by adrian2 » 04 Dec 2017 19:12

FI40 wrote:
04 Dec 2017 16:37
adrian2 wrote:
04 Dec 2017 14:55
Back of the envelope, it counterbalances the MER and then some...
Got it. Yeah the spread between 10y and 2y govis now is about 38bp.

I just did the math and if you bought a 10y, sold it after 8 years at the current 2y rate (assuming 1.9% 10y and 1.52% 2y rates, as per Dec 1st yields on the BoC page) your CAGR including the eight $1.90 coupons, buying for 100 and selling 8 years later for ~100.75, is ~1.986% over 8 years. Compared to 1.9% over 10 years if held to maturity. There is an effect but in the Canadian market it seems negligible...

In a bond ETF though, don't bonds get held to maturity, then a similar maturity bond is repurchased, in general? So this selling early strategy doesn't really apply there? I thought YTM-MER would be fairly accurate (all else being equal) for a bond ETF even with a sloped yield curve.
No, in a bond ETF the bonds are not held to maturity, they are held as long as they fit the mandate. When a bond's duration becomes too short, it gets sold and replaced with a longer bond.

As per your calculation, it confirms my hunch that it counterbalances the MER and then some.
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“It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong.” [Richard P. Feynman, Nobel prize winner]

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Re: Do bonds in RRSP/TFSA still make sense?

Post by FI40 » 04 Dec 2017 23:00

adrian2 wrote:
04 Dec 2017 19:12
No, in a bond ETF the bonds are not held to maturity, they are held as long as they fit the mandate. When a bond's duration becomes too short, it gets sold and replaced with a longer bond.
Of course you are right, what about broad index bond ETFs though? Hmm now that I look at XBB for example (largest bond ETF in Canada) there is a provision in the FTSE methodology document that states "A bond is removed from the index on the day its remaining effective term to maturity declines to one calendar year". So assuming the ETFs follow that closely it should happen there, that's interesting.
adrian2 wrote:
04 Dec 2017 19:12
As per your calculation, it confirms my hunch that it counterbalances the MER and then some.
It made an 8.5 bp difference in my calculation...I think the cheapest bond ETFs are still higher than that in MER. Maybe in a more extreme example where there is a steeper bit of the curve being taken advantage of, it would work out better though.

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Re: Do bonds in RRSP/TFSA still make sense?

Post by snowback96 » 05 Dec 2017 02:19

As per your calculation, it confirms my hunch that it counterbalances the MER and then some.
When I look at a broad based ETF like VAB, the performance typically lags the benchmark by about 0.2% per year. I always assumed that the lag was a combination of the MER (currently 0.13%) plus about 0.07% of bid/ask spreads that don't make it into the MER calculation.

It seems to me that the performance boost from "riding the yield curve" must be in both the benchmark and the ETF itself. So really, is it fair to say this "counterbalances the MER and then some"? The fund is just doing its best to track the benchmark (which presumably also rides the yield curve), so it's still missing the bench mark by the 0.13% MER and 0.07% of bid/ask spreads (or whatever other noise is negatively impacting performance). The MER is still a direct hit to performance, right?

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Re: Do bonds in RRSP/TFSA still make sense?

Post by adrian2 » 05 Dec 2017 06:41

FI40 wrote:
04 Dec 2017 23:00
It made an 8.5 bp difference in my calculation...I think the cheapest bond ETFs are still higher than that in MER. Maybe in a more extreme example where there is a steeper bit of the curve being taken advantage of, it would work out better though.
I have some doubts to the accuracy of your calculation, I think you did it for one year only, when it should have applied over many years. Conceptually, it's similar to setting up and running a GIC ladder: initially, you may buy GIC's for 1, 2, 3, 4 and 5 years; after a few years, as each rung gets replaced, every GIC will bear the 5 year rate from the time of the purchase, and none will be at the shorter rates. Looking at current rates for 1 to 5 year GIC's it's apparent to me that the effect is greater than 8 bps.
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“It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong.” [Richard P. Feynman, Nobel prize winner]

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Re: Do bonds in RRSP/TFSA still make sense?

Post by adrian2 » 05 Dec 2017 06:43

snowback96 wrote:
05 Dec 2017 02:19
It seems to me that the performance boost from "riding the yield curve" must be in both the benchmark and the ETF itself.
No, the benchmark does not include the boost from it.
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Re: Do bonds in RRSP/TFSA still make sense?

Post by FI40 » 05 Dec 2017 09:41

adrian2 wrote:
05 Dec 2017 06:41
FI40 wrote:
04 Dec 2017 23:00
It made an 8.5 bp difference in my calculation...I think the cheapest bond ETFs are still higher than that in MER. Maybe in a more extreme example where there is a steeper bit of the curve being taken advantage of, it would work out better though.
I have some doubts to the accuracy of your calculation, I think you did it for one year only, when it should have applied over many years. Conceptually, it's similar to setting up and running a GIC ladder: initially, you may buy GIC's for 1, 2, 3, 4 and 5 years; after a few years, as each rung gets replaced, every GIC will bear the 5 year rate from the time of the purchase, and none will be at the shorter rates. Looking at current rates for 1 to 5 year GIC's it's apparent to me that the effect is greater than 8 bps.
I built a cash flow table and used XIRR, which is an annualized rate. As for the 100.75 number, I got that from pricing a 2y bond with a 1.9% coupon and YTM of 1.52. I used a library function for that. In year 0 you pay 100, you get the coupons at each interval, at the 8y interval you get the coupon plus the 100.75. I don't think there's anything else to it with the assumptions we've made here.

I redid the calculation with semiannual coupons rather than approximating annual ones to see if that makes a difference. That added 1bp, so 1.995%.

Yeah with a GIC ladder as you describe, I guess beyond the 4 year mark you'd just be earning the average of the 5y rates.

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Re: Do bonds in RRSP/TFSA still make sense?

Post by FI40 » 05 Dec 2017 09:51

adrian2 wrote:
05 Dec 2017 06:43
snowback96 wrote:
05 Dec 2017 02:19
It seems to me that the performance boost from "riding the yield curve" must be in both the benchmark and the ETF itself.
No, the benchmark does not include the boost from it.
Wait, why not? As per the XBB documentation mentioned in my previous post, the benchmark removes bonds from the index once they reach 1y maturity. And it seems like it would contribute: "For example, on 1 December 2012, the index sells a bond maturing in one year, 1 December 2013, at the 4:00pm mark-to-market price. This bond therefore contributes to the return on the index from 30 November to 1 December 2012."

EDIT: I think they meant to say 2013 in that last sentence, otherwise it doesn't make sense. Anyway you see my point, it should be counted.

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Re: Do bonds in RRSP/TFSA still make sense?

Post by milton » 05 Dec 2017 10:51

Here's a chart from Vanguard VAB breaking down annual returns. Would the tailwind from riding the yield curve be in the 'Capital Return by NAV' column?
Screen Shot 2017-12-05 at 07.45.46.png

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Re: Do bonds in RRSP/TFSA still make sense?

Post by FI40 » 05 Dec 2017 16:23

milton wrote:
05 Dec 2017 10:51
Here's a chart from Vanguard VAB breaking down annual returns. Would the tailwind from riding the yield curve be in the 'Capital Return by NAV' column?

Screen Shot 2017-12-05 at 07.45.46.png
I think the effect we're talking about here would be a component of the numbers in that column. Can't find any documentation on it though.

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