Saturday, March 11, 2017

Can We Talk Bonds?

Now that you have some Canadian equity ETF planted in your investment garden, the next step is to add some bonds. Bonds serve as a buffer against volatility, since high quality bonds usually go up in value when equity prices go down (and vice versa). We will start by describing how individual bonds work, although for most of us a bond ETF makes more sense.

Those of retirement age probably bought Canada Savings Bonds in the past.  You buy a bond with some money, at some point in the future they give you back that money, along with interest along the way.  Bonds work like that. Unless the government or company defaults, your principal (the initial cost) is guaranteed and is returned on the maturity date.  The interest rate is called the coupon in the world of bonds.

Bonds are sold by the Canadian government, the provinces, municipalities, and companies.  We call bonds from companies corporate bonds, while the others are called government bonds (sometimes municipal are split off into their own category). Compared to stocks (equities), most individual bonds are safer, both from absolute loss of principal, and also from deep losses in value.

That is not to say that buying a bond is absolutely safe. The investing world have developed ratings for bonds as a measure of how secure they are.  The most widely used bond rating system is done by Standard & Poor.  The most secure bonds, generally offered by national governments, are given a rating of AAA.  Still very secure, but slightly less so, are AA and then A, followed by BBB.  We show these in the following table. Different terms are sometimes used for the different letter categories, but there is general agreement that BBB and above are investment grade. Note that Moodys have a slightly different bond rating system.

I don't like the term "junk" bonds for those rated BB and below.  I think that has a more negative connotation than is appropriate.  Yes, there is a higher risk than with government AAA or AA  bonds, but junk bonds these are often offered by large stable companies and the odds of them not defaulting are good. The reason to purchase bonds in the BBB to B rating is that generally they pay a significantly higher coupon rate in return for the higher risk that you are assuming.

Many discount brokerage firms allow you to purchase individual bonds and hold them in your account. I am most familiar with Scotia iTRADE.  They make it easy to find bond listings according to the type (e.g. corporate), duration, coupon rate and credit quality.  In terms of pricing you pay a commission at purchase of $1 per $1000 in face value, but with a minimum of $24.99 (and a maximum of $250).  For example if you buy bonds worth $20,000 you will pay $20 in commissions, while if you buy $100.000 you will pay $24.99.  Of  course these may well change, so be sure and check current rates if you are considering purchase of individual bonds.

I have never purchased an individual bond from my discount brokerage.  It seems to me that the commission is significant, especially if I consider that I would want to buy a number of different bonds to lessen the impact if one of them did default.  I think unless you are a huge institutional investor it is better to buy a bond ETF.

The  Freedom Thirty-Five blog has done a really nice job of looking at Canadian bond ETF choices.  As he points out, while cost is important, so is performance. By the way, while on his site, check out his graphic in About Me regarding what others think he does! He points out that there are more than 60 bond ETFs on the TSX, so my analysis below will be highly selective, looking only at broad holdings of primarily investment grade bonds.  We will look at corporate bonds in a future post.

You can purchase bond ETFs with exclusively corporate or government bonds, with long or short durations, or a ladder of purchase dates. You can purchase bonds that will increase in value if interest rates go up (so called real return bonds in Canada, TIPs in US). But in the rest of this column, I am going to narrow the choice to three widely held bond ETFs with reasonable MER values and which hold a mix of government and corporate bonds, mainly of investment quality.

My three choices are shown in the following table. For each I give the name, fees expressed as a MER, the assets held in the fund (e.g. 385M$ means that $385 million dollars are invested in XQB at the time of writing), the average daily volume at the current time (e.g. 65k means about 65000 units of VAB are traded daily), and the spread between bid and ask prices on open orders.  Note that all of these change over time, so if important to you should be checked through a source such as at the time of investment.
Note that although ZAG has a formal MER of 0.23 based on audited financial statements, its MER currently and going forward will be 0.10. We explain all that here.

I did some searching, both directly from the companies themselves and from third party assessments, and the portfolio holdings reported for the same product seemed slightly inconsistent.  I expect this is due to how bonds with a federal agency that is a crown corporation are reported (is that corporate or government?), and the changes from different reporting periods.  In any case, all three hold a mix of government and corporate, with roughly 60 to 70% government and 40 to 30% corporate.

While any of these are good choices, there are some differences.  As indicated in the table, the effective durations are not quite the same, with XQB slightly shorter duration.  ZAG is a fund of funds, which means that rather than holding a number of individual bonds, as VAB and XQB do, it holds in varying amounts 10 other BMO bond funds.  In this way it is arguably more fully diversified than the other two. While all three are high investment quality, XQB contains nothing below A, while VAB does have just under 10% at BBB.  This helps the investment yield, at only a tiny amount of higher risk.

If you are a Scotia iTRADE account holder, there is an advantage of XQB in that it is on the list of commission free trades.  This means that it is a good choice if you are purchasing your bond ETF in a number of small transactions, which would not be efficient if you needed to pay commissions with each purchase. It is also helpful for annual strategic rebalance, since there is not a commission charged for XQB sale or redemption in an iTRADE account.

There are other broad Canadian ETFs not covered here. iShares XBB has more than $2.3 billion in assets, and has been a mainstay for many years, but with its MER of 0.34% I find it currently uncompetitive. If you desire a swap-based product that does not pay out annual dividends, then HBB (MER of 0.17%) is worthy of consideration.  Many suggest that in the current climate you give up a little bit of return and buy shorter duration ETFs to guard agains interest rate fluctuations. Vanguard VSB would be a good choice (MER 0.11%) as would iShares XSB (although at a higher MER of 0.25%).

My final views?  If your discount brokerage is something other than Scotia iTRADE, I would probably choose ZAG.  I like the stability of the "fund of funds" approach, it has a marginally higher yield, and a marginally lower management fee going forward.  The Canadian Couch Potato have currently selected it for bond holdings.  The differences are not enough to move ETFs if already invested in one of the others, however. If you are a Scotia iTRADE customer, I would use XQB.  You will more than make up for the slightly higher MER through saved commission fees.

As with any financial decision, it is always wise to seek qualified investment counsel prior to purchase. I suspect the 2017 edition of the Globe and Mail Buyer's Guide to ETFs should be out shortly after this is published, and that is a valuable and comprehensive source of information for Canadian bond ETFs.

The fees are now remarkably low for bond ETFs.  With XQB a Scotia iTrade customer can hold $10000 in bonds, spread across high quality federal, provincial and corporate bonds, and pay only $13 a year in fees, and no commission charges for purchase or redemption.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account: VAB and XQB.  I use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.

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