Buying Bonds? Think Short Term – The Safety of Short Term Bonds

Economic CrisisBond funds have been out of favor these days, especially with the threat of rising interest rates. With dividend stocks paying juicy yields and returning phenomenal capital appreciation, investors have been reluctant to purchase fixed income securities.

Investors forget that when times are good, that all of that can change on a dime! This week the TSX and S&P 500 are already showing signs of a correction, with some dividend stocks off 10% from their highs. This should be a reminder to investors of why asset allocation is important.

That’s where short term bond holdings come into play! Bonds with a duration of 1-5 years are in opposite movement with the stock market – in other words, they are uncorrelated. When markets fall, short term bond funds do very well. And unlike corporate bonds or long-term bonds, short term bonds are less sensitive to interest rate increases.

Claymore 1-5 Year Govt. Laddered Bond ETF (CLF) is a short-term bond ETF, traded on the TSX, and a core holding in my portfolio. This ETF has a very low MER of only 0.17% with a current yield of 4.5%. It provides an excellent hedge against market declines or a great place to park funds while you are waiting to purchase stocks at discount. I feel more than ever investors should take a second look at short-term bonds as a harbor of safety.

The underlying reason for holding short-term government bonds in a balanced portfolio 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 a 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 a 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 a 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 a 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 harbor 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 set up 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.

Buying Bonds? Think Short Term

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 follow.

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 a 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? It’s 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 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).

Favorite Bond Picks

My favorite choice 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 – e fund 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 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 – i fund, which offers the same assets and rate of return, but with a slightly higher MER of 0.7%.

Disclaimer

This is the part of the website where I tell you I am not a financial advisor or an investment dealer. 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.

19 Responses to “Buying Bonds? Think Short Term – The Safety of Short Term Bonds”

  1. My Own Advisor

    Jun 08. 2011

    Great reminder my friend.

    Even us dividend-investors (who have some securities invested passively) need some bonds; at least I feel I do.

    I recently added to my CLF position: want to keep about 5-10% of my RRSP in that 🙂

    How about you?

  2. The Dividend Ninja

    Jun 08. 2011

    My Own Advisor, great minds think alike! 🙂

  3. Kevin

    Jun 10. 2011

    I am new to your website and reside in the US. Although I like to follow your philosophies, it would be nice if you provided NYSE CUSIPs in addition to the TSX CUSIPs. CLF took me to a different stock when I searched via Fidelity or Google. I also think it might help broaden your reader base.
    Thanks

  4. The Dividend Ninja

    Jun 10. 2011

    Hi Kevin,

    Thanks for reading, and thanks for posting! 🙂 What I’ll do in the future is make a point to mention the security is traded on the TSX, to save my US readers the inconvenience. Good point!

    Cheers!

  5. BeatingTheIndex

    Jun 10. 2011

    This would have been a perfect addition right before the markets slide!

    I actually keep a healthy 30% in bonds in my retirement savings.

  6. The Dividend Ninja

    Jun 10. 2011

    Mich, thanx for posting 🙂

  7. Think Dividends

    Jun 11. 2011

    You really think you are getting 4.5% from CLF when a 5 year GoC Bond pays 3%.

    CLF has a Yield-to-Maturity of 1.843% according to the Claymore website. Y-T-M is what matters. They may be paying you a higher rate (4.5%), but your principal will decline as the bonds mature since they are all currently trading above their par value. Your real return from this product will be below 2%. The 4.5% “distribution yield” is just some clever marketing. Yield-To-Maturity is what serious bond investors look at.

  8. The Dividend Ninja

    Jun 12. 2011

    @Think Dividends,

    Claymore CLF is a laddered 1-5 year bond portfolio, which holds 28 short-term bonds ranging in yield from 2.00% to 6.10%. The weighted-yield (coupon rate) of the portfolio is 4.81%. Here are my calculations, from the holdings provided on their website:

    http://www.dividendninja.com/pdf/CLF-FundHoldings-20110612.pdf

    I think you are being very unfair with Claymore, 4.5% is the actual distribution yield the ETF is currently paying in monthly distributions. That information is available on any financial website – there’s no deception by Claymore on that.

    I am fully aware of YTM issues, which I suspect is irrelevant for Claymore CLF. I would expect they purchase bonds at par when they are issued (or very closely) and hold to maturity. So I think the premiums would be negligible in this case, certainly not a 2% spread. I’ll phone Claymore and confirm that with them on Monday.

    Over the last year my average cost for Claymore CLF is around $20.10 per share, it currently is priced at $20.12. This ETF trades in a very narrow range and is a great hedge against market declines, with its short-term bond holdings. But that’s for investors to decide for themselves – not everyone wants a 100% equity portfolio.

  9. Think Dividends

    Jun 27. 2011

    Timely article: Distribution rate does not equal yield
    http://thewealthsteward.com/2011/06/distribution-rate-does-not-equal-yield/

  10. The Dividend Ninja

    Jun 27. 2011

    Think Dividends,

    Thanx for posting 😉 I know you are a pro and work in the financial industry, so I do value your input.

    The assumption here is that Claymore is purchasing all its bonds at premium, which if it did would certainly result in a continual capital loss when the bonds mature, or if they sell them early. The Canadian Couch Potato covered this issue for CLF.TSX and CBO.TSX as well. My Own Advisor is currently finding out from Claymore if this is indeed the case. If it is then you are completely correct.

    In the meantime my distribution rate is very close to the coupon rate (the 4.5%)and I haven’t noticed any significant captial loss over time in my shares. I really see the short-term bonds as more of a safety-net if/when markets turn sour.

    I know you hold 100% dividend stocks, and I know you have the expertise to determine which are the safest stocks etc. But I just don’t have the stomach for a 100% stock portfolio, or your’e expertise to pick exactly the right companies. SO I feel short-term bonds are a great hedge for me alongside my dividend stocks and index funds 😉

    Thanx for posting, I’d sure like to see you create a blog and share your knowledge with others.

  11. The Dividend Ninja

    Jun 27. 2011

    @Think Dividends, you are correct. YTM does matter, with interest rate increases there will be the potential for capital losses. CLF and CBO bonds are not bought at par/face value.

  12. Think Dividends

    Jun 28. 2011

    You can look up the current prices of the bonds in the portfolio at:

    http://www.pfin.ca/canadianfixedincome/Default.aspx

    A lot of the higher coupon bonds are trading at around $109 (GoC 2016, Ontario 2014, Ontario 2016, Manitoba 2014, BC 2014, MFAofBC 2016). The most expensive one is Quebec 2014 at $111.52.

    As new investors buy into the ETF, the manager must by the bonds at current market prices.

    Bond prices have been stable / moving up (rates haven’t moved and investors are seeking safety/quality) for the past year and only 20% of your portfolio matures every year (given the fact that it is a 5 year ladder).

    Therefore, the declines have not been noticeable thus far (some bonds have been appreciating, offsetting the ones that are maturing, keeping the portfolio’s value stable).

    Right now I am 100% equities, but I am patiently waiting to add some provincial bonds to the portfolio. I am waiting for rates that are more satisfactory, so I may have to wait several years. I owned a lot of fixed income in the 1990s. While I am biased towards dividends, I won’t invest in anything unless it meets a certain return objective and allocate my portfolio accordingly.

    I did run a successful blog in the past, but now have to keep it private due to my current employment contract.

    P.S. I am not trying to bash your blog; I’m just playing devil’s advocate.

    CHEERS

  13. The Dividend Ninja

    Jun 28. 2011

    @Think Dividends

    Thank you for posting and following-up! I do appreciate your feedback and expertise. No problem being a “devil’s advocate” and in this case you are correct. I was incorrect in my assumption. Now I understand why CLF has been stable in price.

    If markets perform poorly this Summer then CLF will be great hedge, and I can also buy some good companies on sale 🙂

    Cheers
    Dividend Ninja

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