Canadian Money Forum banner

Running my own bond fund, comparing to VAB

92K views 195 replies 25 participants last post by  Covariance 
#1 · (Edited)
Starting September, I began using a dedicated account for my fixed income. I'm trying to see if I can replicate what VAB does, but with direct ownership of bonds. My portfolio is similar, around 10 year maturity with mostly govt bonds plus a few GICs.

I'm comparing to my broker-generated monthly performance report, which includes fees and isn't affected by cashflows. Current results seem to be tracking VAB well, but it will take at least a year of data to know.
 
#2 · (Edited)
Slight modification. The Vanguard web site is probably more accurate, so I'll grab the monthly VAB data from there, using NAV.
https://www.vanguardcanada.ca/individual/mvc/detail/etf/overview?portId=9552##performance

(Regarding VAB: note that quarterly/annual performance in terms of share price chronically falls shy of their ideal NAV performance -- does anyone know why that is?)

My monthly performance is tracking VAB reasonably well so far:

MonthVAB %My %Difference
Sept 20160.23%0.44%+0.21
Oct-1.00%-1.29%−0.29
Nov-2.19%-2.01%+0.18
 
#4 ·
I hope so :) I mostly hold discount bonds so this should be quite tax efficient. While the underlying securities earn around 2% yield, only about 1.6% is taxable interest income coupons. That means that if I left the account alone and let the bonds mature, I'll get a total return breakdown of around 1.6% coupon interest + 0.4% cap gains = 2.0% yield

Compare that to VAB, which contains 3.3% coupon interest (the highly taxed stuff). So I think my "fund" has 1.6 vs 3.3 or half the taxable coupons. If I have the same total return, that makes mine much more tax efficient than VAB.
 
#7 ·
After reading this article about three investing legends predictions of a major market crash, I am interested in how to deploy cash. I would like it to at least keep pace with or beat inflation. Otherwise investing in government bonds is in effect investing at a negative return.

Although we have substantial fixed income holdings, they are all in higher yielding, more risky corporates. No good answers, it seems. Maybe buy some gold bullion. Sell REITs & Utilities? Some advice was offered in this article: http://www.forbes.com/sites/schifri...ke-pre-election-portfolio-moves/#5e465f4331a8
 
#11 · (Edited)
james4beach:

"If you are doing your own bond portfolio, make sure that you roll along the yield curve by selling bonds that are 1-2 years from maturity, and reinvest them. This is part of the magic that lets bond funds post excellent results ... the key is to maintain a constant avg maturity, and roll over bonds once their YTM drops to nil."

This is a rolling down the yield curve strategy, correct me if I'm wrong. However, it's not a shifting maturity strategy, but instead keeps constant average maturity. By selling bonds, you are now exposed to price risk, unlike with a buy and hold strategy. But if bonds are 1-2 years from maturity, that risk is small. Also, there will be transactional costs in selling bonds, which would be avoided with a buy and hold strategy. For this strategy to work, you'd need relatively liquid bonds. An attractive feature of this is that some of the yield will be cap gains, and in a taxable account, that's important.

How does this compare to GICs? One feature of GICs is that if you shop around, you can do well, relative to bonds. A disadvantage is that you're limited to 5 year terms, if you want the government guarantee. But since I don't want to hold fixed income more than 5 years, that's fine with me. A second important disadvantage is the illiquidity of GICs. If you need liquid fixed income, riding the yield curve makes sense. But if liquidity isn't important, would you be better off shopping for GICs?

I'm thinking of how one could implement this strategy. You could set up a 5 year ladder, but sell each ladder when it's 1 year (or possibly 2 years) from maturity. My guess is that it would work best with government of Canada bonds. I don't know about agency or provincial bonds.

One problem with this strategy is that it assumes a positive yield curve, which is usually but not always true. DFA has a somewhat similar strategy, except maturity is not kept constant. Maturity shifts, and will be extended, but only if if the longer maturity has at least 20 bp more per annum. In other words, the yield curve must be sufficiently positive. It is interesting to note that in the last edition of Hank Cunningham's book on bonds, he basically endorses DFA's strategy.

I like this strategy, as it helps deal with the negative expected return of fixed income in a taxable account. I would be interested in articles/research on this strategy.


Edited to include the following. In this strategy, you sell the bond, when the YTM is zero. There is interest remaining on the bond. But there's a capital gain on the bond, which if the bond is held to maturity, will be lost. So you sell the bond and take the capital gain instead of holding and getting the interest. So you'll get taxed on cap gains instead of interest, which cuts the taxation in half. OTOH, you'll have the transactional costs of selling the bond, which will decrease total return.
 
#12 · (Edited)
Yes, I am rolling down the curve and overall maintaining a fixed avg maturity of the portfolio. I consider the fees when I calculate the YTM on the candidate for sale. Because Govt bonds are so incredibly liquid, it makes very little difference. Yes there is price risk exposure but I think there's still a guaranteed return component. Every bond you purchase has a guaranteed YTM -- and rolling them doesn't change that (it can only boost the guaranteed part of the performance).

Here's how I think of it. There are two elements driving the price of the bond portfolio

(1) the guaranteed return, the aggregation of all individual bonds. This part is absolutely analogous to a GIC ladder, with staggered YTMs which collectively produce a guaranteed return

(2) the market price fluctuation of the bonds; the volatility. If GICs were liquid and had pricing, you would see this effect, but GICs hide this.

I think people are overly pessimistic about bond portfolios. The fact you have volatility (2) does not erase the guaranteed portion (1). And in this respect they are very different from stocks. Stocks have the volatility, and do not have any guaranteed portion. Bond funds do have a guaranteed return underpinning them.

Bad years of (2) can make people forget about (1), which is what's been happening since last year. You'll notice on the forums people gravitate towards short term bonds like XSB ... and yet those bond funds still use the same composition!

What are the differences between a GIC ladder, XSB, and VAB ? They are fundamentally the same thing and yet people have very different perceptions of them.

- people don't see the price fluctuations on GICs, element (2) above, and therefore think GICs are much safer
- XSB does have the volatility (2), but it's diminished, therefore people think XSB is much safer

The way I see it, for a long term holder the short term volatility (2) is irrelevant. Either way they will be getting the aggregate YTMs on the bonds, as the bond market offers it. And the whole point of the yield curve is that you are rewarded with higher yields farther down the yield curve. VAB is guaranteed to provide higher returns than XSB over the long term. With more volatility, yes, but its constituent bonds have higher YTMs.

Where I think you do have to be careful is picking the appropriate avg maturity such that (2) does not swamp (1). Personally I am running my portfolio a bit shorter than 10 year avg maturity.
 
#13 · (Edited)
Here's how I think of it. There are two elements driving the price of the bond portfolio

(1) the guaranteed return, the aggregation of all individual bonds. This part is absolutely analogous to a GIC ladder, with staggered YTMs which collectively produce a guaranteed return

(2) the market price fluctuation of the bonds; the volatility. If GICs were liquid and had pricing, you would see this effect, but GICs hide this.
I should add, this is consistent with the rule of thumb that the best estimate you have for the forward return of a bond fund is the YTM of the entire portfolio, what I describe as (1) above.

More accurately stated, historically there has been a very high correlation between the US aggregate bond performance over 10 years and the initial YTM at purchase time (it's 10 years because that's the avg maturity of the portfolio). This is consistent with what I'm calling (1) in my model. The second factor (2) is transient and averages out to zero.
 
#15 ·
OK, it looks like I was wrong about this point. I'm surprised at those results over such a long period, 1964-1981. I agree that it does show that there can be periods where short end of the curve (like XSB) consistently outperforms the longer end of the curve (like VAB).

I can corroborate what you demonstrated from this data source. With that data I can also find a 17 year period where the short end of the curve outperforms... wow. I am surprised it can be such a long period.

Note that this isn't inconsistent with what I wrote about the guaranteed return + volatility. The return is still positive as the bonds are still providing the guaranteed returns as predicted. But I was clearly wrong about the superior returns in the longer end of the curve.

Some observations / Devil's Advocate

* Even in this worst case scenario, the bond returns are still positive across different maturities

* To think that you're better off at shorter maturities, you must believe that interest rates are going to consistently rise, a lot. We're talking about a historical period where rates went up from about 4% to 16%.

* If you think we're entering a period like that, you don't want to be invested in stocks either. The economy has been dependent on low interest rates/consumer borrowing since the 90s, and US govt will default if borrowing costs soar like this. In Canada, it would be nothing short of catastrophic to the housing market, and probably collapse the banks as a result after mass consumer and business defaults. It would end the ~ 25 year credit bubble.

* Since nobody can predict where interest rates are headed, on average you get better performance at longer maturities. Don't rule out Japan-style ultra low rates for 20 years.


Some actions I will take

You've changed some of my thinking on this. I now see that shorter maturities can outperform longer maturities, even over decades. For now I will continue tracking VAB (10y) but will reduce my portfolio maturity if there are signs interest rates are steadily heading higher. Currently, I am not convinced they are heading higher.

But I will not rule out shifting my portfolio towards XSB / VSB if it looks like we're in a period of steadily rising rates.
 
#17 ·
http://seekingalpha.com/article/1511132-the-risk-of-purchasing-power-loss

Nice article showing aftertax real return in USA from cash, bonds and stocks from 1928-2012. Obviously some assumptions about taxes. In a taxable account, I conclude that bonds and cash are for risk management. In a tax advantaged account, you could have a positive expected return. But since it's a while until I retire, I own stocks in my tax advantaged accounts, to get growth.
 
#19 ·
You can't take 1928-2012 in the US as an indication of what will happen 2017-2080. In the 20th century the American economy was a huge winner and inflation was high. Special circumstances played a major part, like giving up the gold standard and the length of time it took to figure out how to control inflation. The future will not be the same as the past.

What we can glean from the 20th century is that stocks handle inflation well compared to bonds and cash. Oh well, we kinda knew it anyway.
 
#20 ·
mordko, do you foresee (or think there's a reasonably good chance) of a prolonged period of low inflation ahead?

I agree that stocks definitely handle inflation well. Personally I think low inflation or even deflation are possibilities on the horizon -- which is a reason I keep an allocation to cash & bonds.
 
#25 ·
Personally, I struggle to see how we can keep inflation at current levels. Right now it's low primarily thanks to cheap Chinese and Mexican/Indian imports. Costs in these countries will eventually start going up as their rates are increasing and productivity platos. There are other short-term factors which may push up inflation, e.g. protectionism. On top of it all, governments are starting to pressure central banks (we are seeing this not just in Turkey but also in Britain, Europe, Japan and now US).

Having said this, Canadian consensus is infinitely low inflation forever, so who am I to argue? Anything is possible.
 
#21 ·
Yeah, I agree with mordko. The generals are always fighting the last war.

When it comes down to it, investing is really about predicting the future. Because no one can do that with total accuracy, you just have to play your probabilities.

What I would be curious about, and maybe something j4b could do the calcs on, is what is the current ceiling on bonds? How much would your bonds have to rise to reach a YTM of zero? I know bonds in Europe and Japan reached below zero yields, but lets ignore that for now.
 
#22 ·
If there is deflation, nominal bonds, especially nominal government bonds, will do well. With fiat currencies, deflation is less of an issue. If there is significant inflation, inflation indexed bonds will do well. However, the taxation of inflation indexed bonds is worse than that of nominal bonds. And the supply of inflation indexed bonds in Canada isn't high. Over short periods of high inflation, inflation indexed bonds will likely to better than stocks, at least in pretax returns. Over periods of 5 years or more, stocks usually manage to keep up with inflation. They did in the Weimar Republic.

A problem for me is bonds in a taxable account. I knew about the tax advantages of discount bonds and GICs to premium bonds. But I hadn't heard the idea of selling a bond, when the capital gain on the bond equals the remaining interest on it (YTM of zero). If transaction costs are minimal, you've cut your tax bill in half on the remaining interest. Thanks for pointing this out.
 
#24 ·
A problem for me is bonds in a taxable account. I knew about the tax advantages of discount bonds and GICs to premium bonds. But I hadn't heard the idea of selling a bond, when the capital gain on the bond equals the remaining interest on it (YTM of zero). If transaction costs are minimal, you've cut your tax bill in half on the remaining interest. Thanks for pointing this out.
Are you referring to the bond rolling activity? Yes, just check the YTM of a bond about 1-2 years from maturity. It doesn't have to be exactly zero, just low.
 
#23 ·
So Argo, do you maintain a bond allocation as well?

If interest rates hover around current levels (that is, don't make a dramatic move in either direction) then VAB will return slightly better than 2% annual going forward. Maybe much better, if the yield curve is steep. Similar return with GICs.

I can't do the other calculation right now, and I'm not sure it's easy to calculate. It's a very different question of how much a single bond price has to rise, vs the portfolio value of a bond fund.
 
#26 ·
If interest rates hover around current levels (that is, don't make a dramatic move in either direction) then VAB will return slightly better than 2% annual going forward.
Exactly, which is real return of around about zero. Investors are assuming that the risk is exactly nil. Who buys based on the required rate of return of nothing? How do people buying bonds make this math work?

I mean, I would like to buy bonds but don't understand the math; there is something I am missing.
 
#28 · (Edited)
I am guessing higher inflation in 12 months time and beyond but I would like to have a hedge in case I am wrong. Normally it would be bonds.

The part I don't get with bonds is how they are priced. If their real rate of return is zero + you carry risk then what is the logic of buying them??? Basically you are taking on some risk for free and then you pay tax for the pleasure. Why?
 
#29 ·
I feel like the core aspect of bonds is that you are guaranteed the return at the moment you buy it. That's totally unlike stocks, real estate, commodities.

There were times when bonds paid a premium over inflation. Unfortunately this is not one of those times. What's still worth something is the fact they offer return of capital, and you can't lose money unless they default.

I understand the real return aspect but there's a huge difference still between something like a bond that guarantees a 2% notional return, vs a stock that could return anywhere from -50% to +100% over the next couple of years.
 
#31 ·
I feel like the core aspect of bonds is that you are guaranteed the return at the moment you buy it. That's totally unlike stocks, real estate, commodities.

There were times when bonds paid a premium over inflation. Unfortunately this is not one of those times. What's still worth something is the fact they offer return of capital, and you can't lose money unless they default.

.
Yes, but it's very much like cash. HISA pays 2 percent, which goes up with inflation and no risk of the principle losing value. Why would any private investor aquire risk for no benefit? And given there bonds have been going up in price forever and the governments have been buying them, could they be mispriced?
 
#30 ·
j4b: I don't maintain a bond allocation now, although I could in theory in the future. Right now I see them as something approaching high risk and low reward. Makes no logical sense. Depends what interest rates do in the future but I plan on having an allocation when I get older and have more wealth to protect. Right now cash is OK for me for safety.

I know that calculation wouldn't be easy, but I would love to see it. Probably could do a sample of a few individual bonds and average them out. Just curious to know how much upside is really left besides the coupon.
 
#32 · (Edited)
I don't disagree with your points. These days I have more cash and GICs than bonds. But I really think the core of this argument is "where on the yield curve do I want to go". Everything we're discussing is just at different points on the yield curve. Cash is at the extreme short end (m=0). XSB and GICs are (m=3). VAB is (m=10).

It's all basically the same thing but we're debating about what point on the curve appeals to us. Argo and mordko, you two are tending towards m=0. I have so far, in my bond portfolio, been around m=9. If you take into account all the other cash & GICs I have, I'm probably closer to m=5 overall.

Given that m=3 is very low risk, I don't feel that my positioning is too far off. In this thread I focused on the VAB-mimicking construction to see if my bond management practices actually accomplishes the same thing VAB does. This tracking thread is more of a test of my ability to manage bonds and roll down the yield curve, then it is an endorsement of the yield curve at m=10.
 
#33 ·
I ran a calculation of my overall fixed income maturity, encompassing not just this VAB-like portfolio but also cash, HISAs and GICs. The result surprised me. Overall, my fixed income exposure is at m=3.8 on the yield curve or about the same as XSB/VSB.

So don't consider me too much of a bond bull. And whee, post # 7000 !
 
#35 ·
Sure, but in practice there's the question how fast the price changes. I'll do the simple calculation with a single bond - not a portfolio - assuming a very rapid change in price, so we're pretending time doesn't tick by.

3 year bond, using Govt of Canada 2020-Mar-01
Today's price = 101.84 with YTM 0.89%
Price at zero YTM = 104.58
Upside in price = 2.69%

10 year bond, using Govt of Canada 2027-Jun-01
Today's price = 92.518 with YTM 1.80%
Price at zero YTM = 110.30
Upside in price = 19.2%

When you look at that 10 year bond, one might say, the downside is the guaranteed +1.8% and upside could be as high as +19%. Is that really so bad?
 
#36 ·
You can't claim capital gain from a 10 year bond when interest rates drop and zero capital loss if the rates rise. If the rates double overnight, a bond maturing in 10 years suffers a huge capital loss. You may choose not to sell, play the yield curve, etc, but the loss is just as real. Obviously, HISA does not have this risk.

And if you do wait till maturity after an interest rate rise, you will suffer a loss in real terms on this specific bond, even accounting for the yield curve and buying more bonds with your interest.
 
This is an older thread, you may not receive a response, and could be reviving an old thread. Please consider creating a new thread.
Top