The Safety of Short Term Bonds – Part 2

The Safety of Short Term BondsIn a previous post, The Safety of Short Term Bonds, I pointed out  the merits of holding short-term government bonds in a balanced portfolio. The underlying reason for doing so, is short-term bonds are an ideal hedge against stock market volatility. Short term bonds generally move in the opposite direction of the stock market – in other words they are inversely correlated. As investors, we saw this effect over the last three weeks as markets declined, and bond funds and bond ETFs gained value. We also saw this occur during the Japan Earthquake, and also last spring 2010 as markets also temporarily declined. It’s called flight to quality and safety. And there is no doubt that market declines will occur again.

Yield to Maturity

My previous post focused on one specific product, Claymore 1-5 Year Govt. Laddered Bond ETF (CLF-TSX), a short-term bond ETF (Claymore CLF). It holds a 1-5 year ladder of primarily Government of Canada and provincial bonds. This is about as safe as you can get, without holding cash.

One of the issues that surfaced in the comments, and even in a Globe And Mail article, is the distribution yield of 4.5% is not the true yield. It was pointed out that the YTM (yield to maturity) of only 1.85% is the true yield . I felt this was not the case as it was likely Claymore was able to purchase many of their bonds at face-value or at issue price, rather than paying a premium for them.

However, I was incorrect in my assumption. Thank you to Think Dividends, a professional in the financial industry, who first brought this to my attention, and also provided invaluable insight. The bonds for Claymore CLF (TSX), are indeed bought at premium, and not bought at par/face value.

My Own Advisor, verified this directly with Claymore CEO Som Seif, and wrote an excellent and in-depth post on the subject this week: Understanding yield to maturity is important.

Yield to Maturity Does Matter

The bottom line is yield to maturity does matter. The distribution yield of 4.5% will result in a capital loss of the share value over time, since the bonds are bought at premium. In other words the bonds cost more than they are currently worth. The ETF manager for Claymore CLF must continually add to the core holdings as they receive capital from investors. So the bonds in this current interest rate environment are always being purchased at a premium.

This also means there will be a small capital loss triggered as the bonds mature, since they will be worth less than the price paid for them. Although you will receive the distribution yield of 4.5% on a monthly basis, the true return on Claymore CLF is the yield to maturity of 1.85%. Therefore you will notice a small decline in Claymore CLF-TSX over time (see the chart for Claymore CLF).

The Canadian Couch Potato also covered this issue with Claymore CLF in-depth in his post Bonds, GICs and the Yield Illusion back in November 2010.

In reality the capital loss triggered will be quite small, since only 20% of the bonds reach maturity in a given year. Remember this is a 1-5 year laddered bond portfolio, so only a portion of the bonds mature at any given time. However, even a 2% decline can be detrimental to government bonds which already have a low coupon rate to begin with. After all, you pay a premium for safety, and the safety of government bonds is a lower yield than provincial or corporate bonds.

What’s Driving the Price Down?

The current capital loss of Claymore CLF (about 3% since October 2010) is not only due to YTM (yield to maturity), but also to rising stock markets. Since short-term bonds and stocks are negatively correlated, they tend to move in opposite directions. Claymore CLF has seen a decline from a high of around $20.60 per share in October 2010, to a low of $19.90 in April 2010 – or a decline of 3.3%. Claymore CLF is currently trading at $20.02 per share. In my situation I have paid an average of $20.10 per share, so I haven’t noticed the decline at all.

Why Should I Invest in Short-Term Bonds?

So why would you want to invest in a product with a continuous capital loss, and a low yield? The reason is simple – asset allocation of course. Bonds are a hedge in times of financial crisis, and especially short-term bonds in this interest rate environment.

Short-term bonds (1-5 year maturity) are much less sensitive to interest rate increases than long-term bonds (over 5 year duration) and corporate bonds. By investing in short-term bonds, you will have the least amount of capital loss if and when interest rates increase.

The premise against investing in bonds is based on a few ideas. Mainly (1) that you would hold a 100% stock portfolio (dividend or otherwise) and be comfortable with that asset allocation. (2) You believe markets will continue to rise as they have since 2009, and (3) you believe since interest rates are at a record low, they will increase suddenly over a short period of time.

However as many investors learned the hard way in 2008 and 2009 markets do not go up forever, and stock prices can drop quickly. Some companies cut their dividends, and bonds did perform well during that time and throughout the following year. If you gave up on bonds back in 2008 because you felt that interest rates were at a record low, you would have missed out on the safety of bonds and the income they provided during the market meltdown. In times of financial crisis, bonds provide you a soft landing. They did so after the 1987 crash, the early 2000’s recession, the financial crisis of 2008-2009, and they will again.

Remember, the main reason you are investing in short-term bonds (and not corporate or long-term bonds) is because they are the least sensitive to interest rate increases. As with the financial crisis in 2008 and 2009 bonds provided a harbour of safety amidst massive global stock-market declines. If you believe as I do in keeping a well diversified portfolio between assets (stocks and bonds), then short-term bonds should be part of your current portfolio.  Claymore 1-5 Year Govt. Laddered Bond ETF (CLF-TSX) is an excellent product for short-term bond investors. It can also be setup under a DRIP (Dividend Reinvestment Plan) so you can reinvest your distributions. However as My Own Advisor, and many others have pointed out – yield to maturity does matter.

PS – If you are a 100% dividend stock investor, then you can skip the rest of this article – thanks or reading this far ;)

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7 Responses to “The Safety of Short Term Bonds – Part 2”

  1. MoneyCone

    Jul 01. 2011

    The inverse co-relation of Bonds play a important part in a diversified portfolio – anyone who remained invested during the lost decade will appreciate that better!

    A very thorough coverage DN!

  2. The Dividend Ninja

    Jul 02. 2011

    MoneyCone, Cheers and thanx :)

  3. My Own Advisor

    Jul 03. 2011

    Great, detailed post. Thanks for the mention as well.

    I loved your “PS” at the end! ;)

  4. Andrew Hallam

    Jul 07. 2011

    A wise post Ninja!

    I especially like this:

    “As with the financial crisis in 2008 and 2009 bonds provided a harbour of safety amidst massive global stock-market declines.”

    Not only did they provide safety, but a huge opportunity as well. For someone rebalancing their portfolios, they would have had to sell their short term government bonds to buy equities a few times during the crash. And then when equities rose….

  5. The Dividend Ninja

    Jul 07. 2011

    Andrew, exactly :) Well said!

  6. Selling Theta

    Jul 07. 2011

    It’s important to focus on the YTM as you pointed out. Depending on how low the YTM is (and the maturity/duration of the bond) will directly impact how much you can make with the negative correlation to the stock market during a sell off / drawdown. With yields as low as they are today, I like to swap out my fixed income exposure with either MLPs or Utilities (and take it on the chin with a riskier portfolio).

    Best,
    Selling Theta

  7. The Dividend Ninja

    Jul 08. 2011

    Selling Theta, thanx for dropping by and posting :) I had a peruse through your site this morning – very interesting approach, I will check back and study some more. Now I can see why you would sell your fixed-income and take on more risk. I think you are expereinced enough to make that decision.

    For the majority of investors however, I would strongly urge them not to sell their fixed-income and remain the course for two fundamental reasons: First, Bonds provide you a cushion and income in times of declining and/or crashing markets. Second, as Andrew Hallam just pointed out, you can acutally reposition your bonds and buy stocks at a lower price when markets are down ;)

    In 2007 and 2008 many investors gave up on bonds becuase of the perceived low returns, and funnelled their fixed-income into equities. They became complacent that markets always move higher. Many retirees ended up with asset allocations of 80% to 100% stocks before the crash. Obviously they would have been better off keeping their asset allocation in check. I cover this in a post on risk assesment:

    http://www.dividendninja.com/risk-assessment

    I’m always concerned during bull-markets when I hear of investors dumping their allocation model and going aggressive on equities. When in reality it is probably the wrong time to do so. It would essentially be selling bonds low, regardless of interest rates, and buying stocks high – the exact opposite of what one really should be doing. For the majority of investors I would strongly urge them to keep their asset allocation in check, and stay in bonds for the long haul. The Canadian Couch Potato just covered this point very nicely:

    http://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/