|Contributed by: martingale |
Barclays has announced changes in its line-up of bond exchange traded Canadian iShares (formerly iUnits) funds, in addition to many other recent changes. Unlike the changes to XSP and XIN Canadian iShares ETFs, the changes to the bond ETFs are across the board good news for Canadian investors. XSB is what the former XGV has become: The 5 year govt. bond Canadian iShares ETF is changing into a general short-bond index. Canadians have needed an efficient way to invest in short-bonds for some time. The other new bond fund, XRB, will be some sort of real-return bond index ETF. While the details remain to be seen, adding some real return bonds to your portfolio is probably a good idea.This is the second article in a series of reviews of the new Canadian iShares ETF's.
In general you want to hold bonds with a duration under five years. The "duration" of a bond is roughly the number of years it will take for you to recover your investment from the coupon payments and the ultimate return of capital. A bond can have a short duration either by paying a high monthly coupon, or by having a maturity date that is just a few short years away. Either way, if a bond has a duration of 2 years, you know you will get your capital back in roughly two years time.
Duration is also a measure of how much interest rate risk there is inherent in a bond. Consider a bond with a 10 year duration: If interest rates go up, you will suffer along with your lower interest rates for a full ten years before you get the opportunity to re-invest at the new, high rates. Because of the way bonds are valued (as the present value of future payments) a long-duration bond can lose a lot of money on an interest rate hike. Since bonds are supposed to be the conservative portion of your portfolio this is a Very Bad Thing.
One of the problems for Canadian investors has been finding a good way to invest in bonds. There were several bond funds available, including the XBB Canadian iShares ETF, but as I noted in previous articles the duration on these funds was too high. This left investors either having to invest via bond mutual funds (where you had to invest tens of thousands to get anywhere near a good MER), or buying bonds directly, which is painful and inefficient. Another option I sometimes recommended was to combine the XBB Canadian iShares ETF with cash in a high-interest savings account. While that worked well enough, it was never ideal.
Good news! With the conversion of the Canadian iShares XGV 5-year govt. bond ETF into the new XSB short-term bond fund we now have an Canadian bond ETF that I can recommend to Canadian investors. The XSB has a duration of around 2.75 years and holds a variety of fairly conservative bonds, mostly government and municipal, with a few high quality corporate bonds thrown into the mix (around 1/3rd). It presently yields in the neighbourhood of 4% with a MER capped at 0.25%.
Note the principle here: If you want to earn a higher return, you have to take a higher risk. Some investors try and earn the higher return by buying longer duration bonds, and taking on a higher interest rate risk. I think this is a bad idea: If you want to take on a higher risk, instead buy more equities and take on more market risk. Whatever risk/return ratio you achieved by buying longer duration bonds, you could achieve by holding fewer bonds and more equities. In general I think the equities have the better risk/return ratio. That could always change--but at least historically, it's been the case that equities have been a better investment than long-term bonds.
I do want to remind you that there is also an excellent bond ETF available in the United States: Lehman Bros' AGG ETF holds an aggregate index of the entire US bond market. It has a duration around four years and it offers Canadian investors the opportunity to diversify away from the Canadian dollar if they want to. I do generally recommend diversifying your equities into the U.S. market, but holding the bond portion of your portfolio in Canadian is often the right balance for many investors; it's more important to diversify the equities, so if you must hold a large portion of your money in Canadian dollars it's better to do that with your bonds.
The other interesting addition is the proposed XRB Canadian iShares ETF, which will be an index of "real return bonds". The details of this ETF are not clear yet, but it does look interesting. A real return bond is one where the interest rate adjusts with inflation. If the RRB has a yield of 2%, then that means it pays interest of 2% plus whatever inflation was. If inflation is presently 3% then the RRB yields 5% in actual dollars. Real return bonds are a fairly new concept and how well they will do in the long-run is not yet entirely clear.
RRBs do promise to have a very different risk profile than ordinary bonds do. As a result, it makes some sense to mix them into your portfolio: They'll do well at times when other bonds are doing poorly, and vice versa. I would not go over-board, but holding a fraction of your bonds in RRBs should be a good idea. Since they're relatively new it's hard to establish a correct percentage, but I'd not put more than 1/3rd of your bonds into RBB's. We'll have to wait and see how the XRB ETF actually works when it is formally released for me to say more about it now.
In summary, the new XSB Canadian iShares ETF is an excellent vehicle for anyone wanting exposure to the Canadian short-term bond market. Make sure when you purchase it to purchase $2500 or more at a time, in order to avoid paying too much commission to your discount stock broker (assuming you pay something like $25-29 per trade). The announced XRB is also promising, since it gives Canadian investors access to a class of bonds with a very different risk profile than conventional bonds.