Markets seem to be doing very well this September and October, both the Dow and TSE hitting record highs since January 2009. In fact September and October 2010 have been stellar market months for bulls, an unusual trend. Usually October is the notorious month of market crashes. Investors seem to be complacent however and there is much positivity (though cautious) about the future of the market. But investors have short-term memory when times are good. It was less than three years ago in May 2008, another season of record highs, that the TSE began its decline before the unparalleled 2008 market crash. When markets tumble, bonds do well – bonds are essential in any portfolio.
What about Bonds?
What about bonds? The adage is you should be diversified with your asset allocation in bonds (and fixed income) at your age. So for me that means I need to have at least 40% in bonds, bond funds, or fixed income. I want to enjoy buying stocks, and create my own dividend stream, but I also want to sleep at night if markets turn. And GIC rates are too low to be effective, unless your goal is to preserve capital. So ultimately bonds or bond funds are a necessary part of my portfolio.
Every investor understands the inverse relationship between interest rates and bonds. When interest rates go down bond prices go up, and that is why bonds and bond funds have done so well. Conversely when interest rates go up bond prices go down (and that means Bond Fund NAVPS as well). With interest rates at record 20+ year lows, and China making the move to raise its prime rate this week, it’s only a matter of time before the US and Canada follows. So are bonds still a good buy, or a losing investment with interest rates on the potential rise? The answer is it depends on what kinds of bonds you own (or what your mutual fund invests in).
Right now bonds are trading at premium with low yields, so that basically means they are expensive. If you have the 5K bond minimum, expertise, and plan on holding to maturity then you may be fine. The reality is bonds are very complex instruments. So for most people I’m guessing Bond Funds and Bond ETF’s are where the money is being parked.
Corporate Bond Funds have had stellar returns these last couple of years as have bond funds with 5-10+ year holdings. But once rates start rising, corporate bonds and long term bonds are definitely going to be the most sensitive to interest rate changes – bond prices and bond fund NAVPS will go down. Likewise by not holding bonds in your portfolio, you also run the risk of not providing safety in your portfolio. And if Interest rates stay where they are for another year or two, and markets take a turn, then you have lost out on safety and good income potential.
Regardless high yield bonds with high rates of return should be avoided – junk bonds they are termed. Rob Carrick had an excellent article on this in the Globe and Mail that created a buzz. He warned people not to load-up on high yield bonds to get high returns. But he is right, high yield bonds = large gains and conversely large declines.
Buying Short Term Bonds
That means that if you want to invest in bonds, short term bonds and short term bond funds and ETF’s are the way to go. That way you can diversify into bonds, to protect yourself against stock market declines, and other unforeseen economic events. But unlike corporate or long-term bonds you will be impacted less by rising rates. I think there is room for capital appreciation in short-term bonds over the next year.
Let’s say that you buy into a Short Term Bond Fund or ETF and for the next year you make a 0% gain in share price. What is the yield from distributions you can expect? Well its currently around 3.5% to 4.5%. That’s about the same yield as blue chip dividend stocks. It’s not as spectacular as Corporate Bond Funds, but it’s going to be a lot safer. That also means that you can’t buy any Short Term Bond fund with high commissions, fees, or a Management Expense Ratios (MER) above 1%. Otherwise you are going to be taking a hit those earnings. But bond funds and ETF’s do provide monthly income which is a nice benefit. But also as short term bonds are due, the managers must replace the holdings with new bond issues. So that means that the rate of return on the Fund or ETF will also increase (at least in theory).
Favourite Bond Picks
My favourite choice (thank you Dan at the Couch Potato) is Claymore 1-5 Year Govt. Laddered Bond ETF (CLF). It has a very low MER of only 0.16% and a current dividend yield of 4.4%. It holds mostly Govt. Canada investment grade bonds. But since you have to pay a commission to buy an ETF, then it may not be the right choice. Anything under 3K (unless you have one of those nice 6.99 or 9.99 trade fees) and you are going to lose any benefit of that yield through the fee.
If you have an account at TD Waterhouse or a TD e-funds, account, then you can take advantage of the TD Canadian Bond Index fund – e that replicates the DEX Universe Bond Index. As it’s a no-load fund you don’t pay any commission. With an MER of only 0.48% and a yield of 3.7% it’s not a bad choice either (boring but stable). The fund isn’t completely a short term bond fund however, but it does have about 50% holdings with bonds of 1- 5 year duration.
If you don’t have a TD account, you can still buy the TD Canadian Bond Index Fund – i, which offers the same assets and rate of return, but with a slightly higher MER of 0.7%.
This is the part of the website where I tell you I am not a financial advisor (thank goodness) or an investment dealer (LOL). This website does not offer professional or financial advice, only my personal rants and opinions (hope you enjoy them). I’m also supposed to tell you to consult with a “professional” financial advisor before making any investment decisions. Be prudent and cautious. Do your own research, and only invest in what you understand!
I own Claymore CLF, TD Canadian Bond Index (e-series), as well as other bond mutual funds.