Strip bonds or Bond ETF

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SjSp
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Strip bonds or Bond ETF

Post by SjSp » 04 Nov 2017 11:59

i have typically held strip bonds inside a TDWH self-directed RRSP account rather than bond ETFs because I don't need the money any time soon, like the idea of holding them to maturity and knowing exactly what they will be worth then, and assumed that a bond ETF would be less efficient because it would be buying and selling bonds all the time to keep it average duration in an appropriate range. Are those assumptions about bond ETFs accurate?

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Re: Strip bonds or Bond ETF

Post by Quebec » 04 Nov 2017 18:25

Welcome to the forum!

For context, my fixed income (F.I.) holding are divided into a ladder of GICs, and two bond ETFs (one for nominal bonds, the other for real return bonds). So I am not strongly for or strongly against directly held F.I.

One thing to keep in mind with regard to 'efficiency' is that the ETF is likely buying and selling the bonds at better prices that you can (see finiki: Buying individual bonds.

The ETF is also way more diversified than any home-made F.I. portfolio.

Previous FWF topics on bond ETFs versus ladders are listed under further reading in the same finiki page.
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Re: Strip bonds or Bond ETF

Post by zeno » 05 Nov 2017 17:08

The third option is plain old GICs.
Like you, I like the certainty of a known value at maturity. I used to hold 100% of my fixed income in Provincial strips, but the yields don't make any sense any more. You can get a 5yr (2022 maturity) GIC with 2.8% interest. To get the same YTM out of provincial strip you have to you out 10yrs (2027), at least according to RBC inventory.

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Re: Strip bonds or Bond ETF

Post by AltaRed » 05 Nov 2017 17:48

If one is willing to stay short term, i.e. 2.5-2.8 year duration, a 5 year GIC ladder has been more attractive for some years now, competitive with BBB+/A- grade corporates. I play with some BBB/BBB+ corporates, unsecured debentures and 5 year GICs in my RRSP to get a bit of an edge over a 5 year GIC ladder weighted average yield, but not sure it is worth the basis points over a plain vanilla 5 year GIC ladder.
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Re: Strip bonds or Bond ETF

Post by longinvest » 05 Nov 2017 20:12

I don't know. When I added bonds to my portfolio, people were having the same worries about tax efficiency, interest rates, and the unpredictability of bond funds/ETFs. Yet, since January 2014, when I added it, VAB has provided an annualized 3.9% total return. Not bad for such a "worrisome investment" (for some people).

It's the return and volatility of stocks which dominate a portfolio with a significant allocation to stocks. This is true of my portfolio, too. Had I invested into a GIC ladder instead of VAB, my portfolio returns would have been pretty similar, if maybe a bit lower. Nothing to make the difference between being able to retire one day or not.

I think that people worry way too much about bonds when their portfolio contains stocks.
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Re: Strip bonds or Bond ETF

Post by ghariton » 05 Nov 2017 20:48

longinvest wrote:
05 Nov 2017 20:12
I think that people worry way too much about bonds when their portfolio contains stocks.
I share your opinion... as long as the bonds are rated A or better. In fact, the extra return for taking on credit risk is just not worth it to me, and I hold only government bonds. After all, I hold them to reduce volatility, not to earn a return I can live on.

As well, I don't worry too much about interest rates on HISAs or similar instruments. I hold those for liquidity, not return.

Return on equities are what allow me to retire.

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Re: Strip bonds or Bond ETF

Post by longinvest » 05 Nov 2017 21:14

ghariton wrote:
05 Nov 2017 20:48
Return on equities are what allow me to retire.
I like the way Taylor Larimore says the same thing, on the Bogleheads forums: "Bonds let us sleep well. Stocks let us eat well."
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Re: Strip bonds or Bond ETF

Post by BRIAN5000 » 05 Nov 2017 23:51

longinvest wrote:
05 Nov 2017 20:12
I don't know. When I added bonds to my portfolio, people were having the same worries about tax efficiency, interest rates, and the unpredictability of bond funds/ETFs. Yet, since January 2014, when I added it, VAB has provided an annualized 3.9% total return. Not bad for such a "worrisome investment" (for some people).

It's the return and volatility of stocks which dominate a portfolio with a significant allocation to stocks. This is true of my portfolio, too. Had I invested into a GIC ladder instead of VAB, my portfolio returns would have been pretty similar, if maybe a bit lower. Nothing to make the difference between being able to retire one day or not.

I think that people worry way too much about bonds when their portfolio contains stocks.

Sorry this may be sort of out of the blue and maybe has been answered before but why don't you use HBB instead of VAB? Counterparty risk?
For those using HBB do you have any maximum amount you may invest in it? I'm using VAB in my RRSP but looking for a simplification from a large GIC ladder*, HBB or ZDB are starting to look better & better in non- registered accounts?

* trying to keep decent rates 1-5 year ladder all CDIC insured, easy renewal, his & hers funds separate etc. At the moment you can get to $600,000 at Oaken with his & hers with two insurers, lose 10bp for monthly payout (maybe Mer equivalent almost)
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Re: Strip bonds or Bond ETF

Post by longinvest » 06 Nov 2017 00:00

BRIAN5000 wrote:
05 Nov 2017 23:51
why don't you use HBB instead of VAB? Counterparty risk?
Synthetic ETFs defeat the whole idea of diversification. I'm not touching any such ETF with a ten-foot pole. (I'm allergic to derivatives; I won't touch currency-hedged ETFs either, because of their use of derivatives for hedging currency).
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Re: Strip bonds or Bond ETF

Post by big easy » 06 Nov 2017 15:58

I think this article sums how things can go wrong but why it is still a good ideal to hold bonds.

http://awealthofcommonsense.com/2015/03 ... ar-market/
A much better comparison, if you want to make one, would be the 1950s. At the start of 1950 the 10 year yielded 2.3%. It rose throughout the decade and finished at 4.7%. Inflation was relatively mild in throughout the 1950s — close to 2% annually. The 10 year currently yields just shy of 2.1%. Inflation also remains subdued for the time being.
The question for investors is how did various fixed income sectors perform in that type of rising rate environment? Here are the stats for long-term treasuries, long-term corporate bonds, 10 year treasuries and cash:
Image
Nominal returns were muted while real returns were negative across the board. The total real returns over this entire period were losses of 19.97%, 10.60%, 12.38% and 1.33%, respectively. It’s interesting that holding cash in short-term t-bills turned out to be the best performing fixed income holding. The fed funds rate was under 1% a couple of times in the 1950s but it was never zero as it is now so I wouldn’t expect the cash returns to outperform like they did back then if rates do rise from here.
So why would an investor choose to hold bonds if this type of market is a possibility from current yields? Although those after-inflation losses sound painful, bonds still served a purpose. The 1950s witnessed a strong bull market in stocks, but when the S&P 500 fell double digits in 1957 bonds held up really well. Here are the returns from that year:
Image
When risk strikes and stocks get hit, investors will almost certainly switch to the perceived safety of high quality bonds. In a risk-off scenario that’s generally how markets work. The worst annual returns for 10 years treasuries was minor compared to the losses in the stock market.
Although bonds could potentially lose purchasing power over the long run from current yields they can still serve a purpose in a well-diversified portfolio. Bond act as both a volatility-minimizer for those investors that can’t stomach a large stock allocation and a source of stability during stock market sell-offs for either spending purposes or liquidity for those that need to rebalance into lower stock prices.
Last edited by big easy on 06 Nov 2017 21:42, edited 1 time in total.
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Re: Strip bonds or Bond ETF

Post by AltaRed » 06 Nov 2017 16:09

Nice find! Always good to find something factual that could be very close to repeating itself going forward, e.g. 240 bp increase over 10 years and a 2% inflation rate.
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Re: Strip bonds or Bond ETF

Post by DanH » 06 Nov 2017 16:51

longinvest wrote:
06 Nov 2017 00:00
BRIAN5000 wrote:
05 Nov 2017 23:51
why don't you use HBB instead of VAB? Counterparty risk?
Synthetic ETFs defeat the whole idea of diversification. I'm not touching any such ETF with a ten-foot pole. (I'm allergic to derivatives; I won't touch currency-hedged ETFs either, because of their use of derivatives for hedging currency).
I don't completely agree with this. True, you want your bonds to be pretty straightforward. But a total return swap (which is what's used in HBB) isn't such a complicated instrument. And it only puts the periodic payments at risk - not the capital. See this old post about HXT (HBB's sibling). In short, HBB introduces some complexity and somewhat higher risk. But it also offers some tangible benefits in exchange - namely the significantly higher after-tax return potential. It may be worth noting that this benefit is a bit lower than it was.

HBB was originally priced at the same level as XBB - i.e. 15bps management fee + 15bps swap fee = 30bps total cost. That was XBB's annual fee until price competition drove it down below 10bps. And in this low yield environment, every bp counts. Still, I think HBB is worth considering for taxable money. We don't use HBB but we do have access to one tax efficient bond solution that we continue to use (though it's a corporate class structure not a synthetic fund/ETF).

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Re: Strip bonds or Bond ETF

Post by BRIAN5000 » 06 Nov 2017 18:16

We don't use HBB but we do have access to one tax efficient bond solution that we continue to use (though it's a corporate class structure not a synthetic fund/ETF).
Yeah that was the other option I was looking for last night couldn't find anything other than First Trusts short term, Mer at @ .25 (FGB)*. Not that I know what I'm talking about but this thing isn't limiting distributions it looks like to me.


Is there a Corporate Class fund which indexes the whole Canadian bond market no active management?


*http://www.firstasset.com/solutions/ove ... +Class+ETF

From HBB PDF
Management Fee:
0.09% (plus applicable sales tax)
Swap Fee:
No more than 0.15%
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Re: Strip bonds or Bond ETF

Post by DanH » 06 Nov 2017 20:12

BRIAN5000 wrote:
06 Nov 2017 18:16
Is there a Corporate Class fund which indexes the whole Canadian bond market no active management?
No. HBB is as close as you're going to get. It's not a corporate class but it's just as good or better in terms of tax efficiency. If the Feds crack down on swaps of this nature (as they did with equity forwards a few years ago) then that will no longer be an option. But I'd enjoy it while I could at this point.

All corporate class products of which I'm aware are all actively managed. They key - from my perspective - isn't whether it's active or passive but the level of fees and the merit of the strategy. Nor is the existence of a corporate class product a guarantee of tax efficiency for bonds. It has the potential to be but it's not a guarantee. And if there is too much income generated within the corporation as a whole, that will add to the corporation's total cost (via taxes on so-called 'trapped income'). The problem with retail corporate class products is that the pricing doesn't make sense for bond products in this low-rate environment.

In other words, tax benefits are a function of the pre-tax return potential. When return potential is low, tax benefits are low. And fees have long trumped tax benefits in general. But the reality is that there aren't any tax efficient corporate class bond funds that are still open.

You could also look at Purpose Investments, which has a corporate class structure. And while its mutual fund corporation is relatively young (which will limit its tax efficiency) one aspect of the structure might help boost its tax efficiency. But I'm guessing that you won't like the bond strategies offered by Purpose based on your description above.

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Re: Strip bonds or Bond ETF

Post by longinvest » 06 Nov 2017 20:22

Dan,
DanH wrote:
06 Nov 2017 16:51
longinvest wrote:
06 Nov 2017 00:00
BRIAN5000 wrote:
05 Nov 2017 23:51
why don't you use HBB instead of VAB? Counterparty risk?
Synthetic ETFs defeat the whole idea of diversification. I'm not touching any such ETF with a ten-foot pole. (I'm allergic to derivatives; I won't touch currency-hedged ETFs either, because of their use of derivatives for hedging currency).
I don't completely agree with this. True, you want your bonds to be pretty straightforward. But a total return swap (which is what's used in HBB) isn't such a complicated instrument.
I didn't say that it was a complicated instrument; I said that it defeated the idea of diversification.

Instead of investing into 843 distinct bonds (that's the number of bonds in VAB's index), the synthetic ETF invests into some obscure collateral and gets a promise (through a swap derivative) to match some selected index return (minus, possibly, a predetermined fee). If something completely unexpected happened, nothing guarantees that the "high-quality" collateral wouldn't be affected. Also, the return match promise is dependent on the success of a counterparty to fulfill it.

The thing is that the most likely time for the counterparty to fail its obligations is the exact time when one wants his bond holdings to fulfill their promises, during a bad crisis*. Let's not even think about what could happen to the "high-quality" collateral. Maybe this collateral is short-term government bonds or cash which simply hold their value, while the total bond market is jumping up in value thanks to intermediate and long-term yields dropping badly. Or, maybe this "high-quality" collateral happens to be mis-graded stuff, like what happened to commercial paper in 2008.

* That's a recurring theme with derivatives. The most likely time for them to fail is in really-bad times, exactly when their success is most needed!

I just don't want any of that uncertainty. I don't want my bond ETF to behave differently from its index. I want it to hold the securities of its index, as closely as possible. I know that it can't be perfect, but VAB's 807 bonds vs its index's 843 seems close enough to me.

I try to keep my bonds into registered accounts, but I get very little annual RRSP contribution room, because of workplace DB pension contributions. So, my bonds spill into my non-registered account. I'll pay the taxes I have to pay. So be it. More importantly, I'll continue to sleep soundly.

Call me weird, if you like. I'm not trying to maximize returns; I'm trying to reasonably minimize the risk of failing badly to achieve my financial goals. HBB would defeat my objectives.
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Re: Strip bonds or Bond ETF

Post by DanH » 06 Nov 2017 20:56

longinvest wrote:
06 Nov 2017 20:22
The thing is that the most likely time for the counterparty to fail its obligations is the exact time when one wants his bond holdings to fulfill their promises, during a bad crisis*. Let's not even think about what could happen to the "high-quality" collateral. Maybe this collateral is short-term government bonds or cash which simply hold their value, while the total bond market is jumping up in value thanks to intermediate and long-term yields dropping badly. Or, maybe this "high-quality" collateral happens to be mis-graded stuff, like what happened to commercial paper in 2008.
Equity forwards were widely used by Canadian investment funds before, during and after the Financial Crisis. No counterparty to my knowledge failed to make a payment under a swap or forward. It's no guarantee that the next crisis will have the same outcome but that's a pretty good test as far as I'm concerned.

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Re: Strip bonds or Bond ETF

Post by longinvest » 06 Nov 2017 21:02

DanH wrote:
06 Nov 2017 20:56
Equity forwards were widely used by Canadian investment funds before, during and after the Financial Crisis. No counterparty to my knowledge failed to make a payment under a swap or forward. It's no guarantee that the next crisis will have the same outcome but that's a pretty good test as far as I'm concerned.
National Bank didn't go bankrupt in the financial crisis. Had it gone so, it would have been a good test of synthetic ETFs it acts as counterparty for. ;)
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