Tuesday, April 5, 2011

Bonds not always "safe"

When I first started managing my own retirement portfolio at the urging of a consultant at TD Canada Trust, I trundled off to the library and for a stack of books on investing. I quickly read them all and the ones I really liked I bought. One piece of advice was in every book --- keep a portion of your portfolio reserved for bonds.

In my original allocation model I had about 40 percent of my money in bonds in the form of XSB, the iShares short term bond ETF.

Unfortunately, when interest rates nudged upward the value of my bond-based investments nudged lower. I made the error of deciding that  interest-wise I'd do better holding stocks and I dumped all my XSB and moved into equities. This has proven to have been a lucky move. I say lucky because I made out like the proverbial bandit but I hardly think such luck should ever be mistaken for wisdom.

And I must confess when interest rates crashed, the bond ETFs I had held regained their value, climbing back on their old perch. But the bond climb did not come close to the amazing return of my stocks over the same period and so I consider myself lucky.

Well equities, especially many of the ones that I am now holding, have recovered quite nicely and I'm beginning to think about bonds again. But, I am only thinking about bonds; I am not rushing into buying them.

Why? As interest rates climb, bond funds and bond ETFs fall in value. My understanding has been that the longer the average term of the bonds held by a fund, or ETF, the steeper and deeper the fall. According to an article in The Globe and Mail, Bond lovers: Prepare to feel some pain, it is a little more complicated than that but calculating the potential loss is easy if not totally accurate.

Rob Carrick, of the Globe, writes that to determine the potential change in value of a bond fund one must first determine the average duration of the bond fund or ETF. Find that number and you know how many percentage points the fund or ETF will fall if rates climb by one percentage point (the opposite applies, too). To find the average duration he says:

"Bond funds: You may be able to find the average duration for the portfolio in the monthly or quarterly profiles that fund companies make available on their websites.

Bond ETFs: Check the online fund profiles or fact sheets available on exchange-traded fund company websites."

The weighted average duration in years for XSB is 2.61.
I took Carrick's advice and went to the iShares overview of XSB. I discovered that the weighted average duration in years for this ETF was 2.61.

So, if interest rates rise one percent, this fund could be expected to lose 2.61 percent. Ouch! (On the other hand, equities don't even feel they are in a correction until they suffer losses four times that amount.)

Out of curiousity I checked the distributions for this ETF. It didn't even pay a dollar. This accounts for the current yield of only 3.1 percent. I noticed that this was much higher than the weighted average yield to maturity of 2.37 percent quote on the iShares website.

According to the globe, the current yield is not the best yield number for investors to be use. John Heinzl of the Globe has a video, Don't be fooled by bond ETF yields, and he will walk you through the bond yield maze. When Heinzl is done, he seems to come down firmly on the side of yield to maturity rather than current yield. Watch the video and see what you think.

All I know for sure is that when it comes to XSB neither current yield nor yield to maturity is paying enough to attract me. I need more yield. I have bills to pay. I'll take my chances in the equities arena for a while longer with hopes interest rates will climb and the entry cost to get into the bond fund/ETF game will drop.

Maybe I'll get lucky again.

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