# Running my own bond fund, comparing to VAB



## james4beach

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.


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## james4beach

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:


*Month**VAB %**My %**Difference*Sept 20160.23%0.44%+0.21Oct-1.00%-1.29%−0.29Nov-2.19%-2.01%+0.18


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## Eclectic12

Since you posted in the tax section about being able to convert interest to capital gains, is any of this likely to happen in your bond account?


Thanks for the update.


Cheers


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## james4beach

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.


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## agent99

james4beach said:


> 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.


If you earn 2%, what do you have left after tax (whether CG or Int)? And how does that compare with the inflation rate?


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## james4beach

It's a pretty low after tax return. I do it for the bond asset class exposure, not for particularly high returns. If I can get similar to VAB performance but more tax efficient, that's a win


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## agent99

james4beach said:


> It's a pretty low after tax return. I do it for the bond asset class exposure, not for particularly high returns. If I can get similar to VAB performance but more tax efficient, that's a win


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


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## james4beach

To clarify here, I am very much trying to replicate and duplicate VAB, so assume for the sake of this thread that the investor wants bond exposure of the variety in VAB and XBB


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## james4beach

With another month,


*Month**VAB %**My %**Difference*Sept 20160.23%0.44%+0.21Oct-1.00%-1.29%−0.29Nov-2.19%-2.01%+0.18Dec-0.57%-0.59%−0.02


*Year**VAB %**My %**Difference*2016 (partial)-3.50%-3.42%+0.08

So far so good


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## james4beach

Now on to 2017


*Month**VAB %**My %**Difference*Jan 2017-0.21%-0.06%+0.15


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## 0okm9ijn

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.


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## james4beach

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.


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## james4beach

james4beach said:


> 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._


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## 0okm9ijn

james4beach said:


> *VAB is guaranteed to provide higher returns than XSB over the long term.*



http://servowealth.com/resources/articles/simple-lessons-save-your-bonds

Table 2: Interest-Rate Cycles and Stock/Bond Annualized Returns
Bond Maturity/ Stock Index
1964-1981 (interest rates UP*)
1982-2013 (interest rates DOWN*)
1964-2013
Inflation
+6.4%
+2.9%
+4.1%
Cash (1Mo T-bills)
+6.5%
+4.4%
+5.1%
1YR T-Notes
+7.0%
+5.5%
+6.0%
5YR T-Notes
+5.4%
+8.0%
+7.1%
20YR T-Bonds
+2.5%
+10.0%
+7.2%


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## james4beach

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.


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## james4beach

james4beach said:


> 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.


Here was the error in my reasoning: yes the yield curve rewards you with higher yields at longer maturities, but you're also trapped at those yields for a longer time. That's fine when yields aren't changing much. BUT when yields are rapidly rising, you are better off at the short end of the curve because the bonds get flushed out of the portfolio more rapidly and replaced with even higher YTMs.


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## 0okm9ijn

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.


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## james4beach

It sounds like you're 100% in stocks. Are you comfortable with the ~ 50% drawdown situation and the possibility for being negative for a decade or more? Everyone says they're ready for that, until it happens.


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## mordko

0okm9ijn said:


> 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.


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.


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## james4beach

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.


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## Argonaut

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.


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## 0okm9ijn

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.


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## james4beach

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.


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## james4beach

0okm9ijn said:


> 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.


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## mordko

james4beach said:


> 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.


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.


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## mordko

> 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.


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## james4beach

So mordko if I understand you correctly, you're saying you don't see the appeal of bond funds because of the zero real rate of return - is that right?

It sounds like you're leaning towards higher inflation expectation?


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## mordko

james4beach said:


> So mordko if I understand you correctly, you're saying you don't see the appeal of bond funds because of the zero real rate of return - is that right?
> 
> It sounds like you're leaning towards higher inflation expectation?


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?


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## james4beach

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.


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## Argonaut

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.


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## mordko

james4beach said:


> 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?


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## james4beach

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.


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## james4beach

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 !


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## Argonaut

Can you look at a bond with a maturity of around 3 years, and tell me how much it would have to rise in percentage terms for the YTM to equal zero?


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## james4beach

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?


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## mordko

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.


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## james4beach

I think this is where you're missing the point that any given bond's return is guaranteed. It really is upside with a floor on the downside. A bond fund never has to sell a bond at a loss, unless forced to by redemptions.

Say bond prices crash and interest rates soar. When this 10yr bond in the portfolio matures, or approaches maturity and is rolled, it has still returned the original 1.8% -- guaranteed at time of purchase. Conversely if bond prices soar, you might find a couple years down the line that the YTM has already dropped to 0.1%. The bond could be sold here and rolled into something further down the yield curve. If the price goes up, this helps you because you achieve the same total return earlier and redeploy the money.

Thought experiment:

Imagine a perpetual GIC ladder. We can agree that at any point in time, its return is guaranteed because the YTM of each instrument is known at purchase time. Now pretend GIC prices fluctuate on the open market. The prices will fluctuate and you'll freak out along the way, but the returns are identical (plus volatility).

Now consider the fact that those fluctuating GIC prices _only work to your advantage_. If the price of a GIC rises so much that it offers you a superior total return, then you can sell the GIC and buy another. If the price falls, then don't sell it and let it mature naturally.

Blink once, and you're looking at a bond fund.



> If the rates double overnight, a bond maturing in 10 years suffers a huge capital loss


I disagree. What about the GIC example above? Your GIC ladder still returns the same, even if rates double overnight. The price fluctuations are transient and the bond price always converges to 100 at maturity.


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## mordko

I disagree but as a minimum you should be consistent. If you are crediting potential capital gain then you should also consider the risk of capital loss (much larger) but both are short term. 

If you are ignoring short term gains and losses then you are looking at long-term return from a bond fund then you know exactly what it is: it's your 2% minus tax and minus inflation. The latter is variable. Basically you have no upside and potential small loss due to inflation and taxation.


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## james4beach

My understanding of the math on the bond fund is different ... 2% lower bound (over 10 years) but could be higher if the yield curve is steep and/or bonds rally.

Again this is fundamentally for the reason I tried to illustrate with the GICs. If the GICs were liquid, you would have the option (but not the requirement) to realize gains. You don't lose your guaranteed return while doing so.


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## james4beach

Let me show how I calculate the profitability of my bond rollovers... this illustrates the "option" to get a higher total return with actual numbers from a bond I own.

The original bond purchase was on 2011-10-11 for a 2.00% YTM bond maturing 2019-06-01. The original total return is 16.3% (this is just the YTM to power of lifetime), which is a guaranteed profit if I never touch the bond again and let it mature.

Today, 2017-02-09, I look at the liquidation value of the bond. Based on the coupons received to date and today's liquidation value, I can calculate the total return so far: 12.53%. If I were to liquidate and roll the money into a new bond/GIC at 1.97% YTM, I can calculate that the cumulative total return up to the original maturity date: 17.7%

That shows a (mildly) profitable rolling by selling my bond before maturity. Instead of leaving it alone and getting a 16.3% total return with the original bond, by selling it more than two years away from maturity I boost the total return up to 17.7%. Both are over the same time period, 2011-10-11 to 2019-06-01.

That's the "option" to get a higher return. The 16.3% total return was absolutely guaranteed at purchase time. I can boost it to 17.7% if I want.


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## mordko

Now try the same exercise but looking forward and accounting for real return. What could happen to a bond purchased today if inflation were to creep up?

1. account for 1.5% inflation (annual) and 2% YTM 10-year government of Canada bond at the time of purchase on 2017-03-01.

2. assume 3% inflation (annual) and 3.5% YTM bonds are available in 2026, 1 year before maturity. 

3. assume you keep buying more bonds with the interest earned; assume an average coupon of 3% for the new bonds. 

4. assume average inflation of 2.5% per year for the next 10 years.

That's a plausible scenario. What would be your total real return, not accounting for taxes?


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## james4beach

I agree that sounds plausible. I might have to develop some software to calculate scenarios like that one.


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## 0okm9ijn

I'm very far from a bond expert, so I welcome feedback, especially criticisms.

In the long run, the return of high quality bonds has been equal to their interest. Please correct me if I'm wrong. If you want to outperform the bond market, you have to better than the market, when it comes to determining credit risk and/or interest rates. Assessing credit risk is in someways the equivalent of stock picking. There are those who can stock pick, but I"m not among them. About predicting interest rates, please tell me of someone who is the Warren Buffet of predicting interest rates, because I don't know of anyone. 

Kudos to those who can beat the bond market. But for myself, I don't see that as being worth trying. However, I do think it's productive for me to learn about maximizing tax efficiency of fixed income. To maximize such efficiency, I've learned about discount and premium bonds. In this thread, I've learned about selling bonds, when they're near to maturation and have a YTM of around 0. Any other suggestions about increasing tax efficiency of fixed income?


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## andrewf

Basically. what james is doing is increasing his portfolio duration, and for doing so he is being compensated with a somewhat higher return.


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## 0okm9ijn

With increased duration, you get higher return. In other words, you're rewarded for taking on interest rate risk. Historically in the US, the equity risk premium has been better rewarded that the interest rate risk premium. And that's ignoring taxes. Based on historical US data, the Sharpe ratio is best for the interest rate premium in the first 5 years of term.


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## andrewf

Also, james is also just doing what most bond funds do, and rolling out of bonds that are nearing maturity.


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## 0okm9ijn

Rolling bonds that are near maturity makes sense. In other words, bonds maturing within the next 1-2 years. However, there are transaction costs associated with such a strategy. So I assume that one has to use government of Canada bonds, to keep transaction costs down. Please correct me if I'm wrong on that. Right now the yield on a government of Canada 5 year bond is 1.01%. With a cursory internet search, I can get a 5 year noncompounding GIC rate of 2.5% (Canadian Tire Bank). There are no transactions costs. Now you can't use that GIC as loan collateral, unlike a bond. And the return will be taxed as interest, not as cap gains.

But that GIC isn't liquid. However, Oaken has a 1 year cashable GIC with a rate of 1.65%, if you hold it for a minimum of 90 days. And I can find CDIC backed high interest savings accounts (HISAs) with rates of 1.95% and 2.00%. 

Now you're taking on reinvestment risk with the products mentioned in the last paragraph. But I doubt, although I may be wrong, that interest rates will go much lower than this. And with interest rates this low, one can make the case that reinvestment risk is lower with short maturity securities. 

For fixed income with a maturity of 5 years or less, GICs/HISAs may often be better than bonds. The exception would be institutional investors, which are too big for GICs. And even if bonds are better, I think it unlikely that you'll do a lot better than GICs/HISAs.


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## like_to_retire

0okm9ijn said:


> Right now the yield on a government of Canada 5 year bond is 1.01%. With a cursory internet search, the highest rate on a 5 year GIC is 2.35%. There are no transactions costs. Now you can't use that GIC as loan collateral, unlike a bond. And the return will be taxed as interest, not as cap gains.
> 
> Even if the government of Canada bond return is completely cap gains, you'll still come out ahead with GICs.
> 
> For fixed income with a maturity of 5 years or less, GICs seem to be better than bonds.


I suppose the transaction costs are baked into a GIC, but I certainly agree the GIC pays a lot better than low risk bonds. The big downfall of the GIC is liquidity of course, but if you're not too concerned about that (by having liquidity available elsewhere), then GIC's win hands down for 5 years or less. You can cover the longer terms in fixed income with preferred shares.

Certainly purchasing bonds is a costly affair at anything less than $20K. I believe TDDI price break points are at 10K, 20K, 30K, 50K, 75K, 100K, 250K.
Typical spread for a $5K bond may be $1.10 per $100 face, but can drop to $0.45 per $100 at $50K. Costs lower as you purchase larger bonds and will vary with rating. So for example, if the spread is a dollar per $100 face, then you can roughly assume the cost to you at half the spread was 50 cents per $100. If you hold for 5 years until maturity, the cost to you (or your MER) was about 0.10% per year. So I suppose that's in line with bond ETF's.

I use to have all bond ladders, but switched long ago to GIC ladders.

ltr


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## 0okm9ijn

If you're willing to accept Manitoba credit union backing, Outlook Financial offers a 5 year cashable GIC with a rate of 2.35% interest paid annually. If you withdraw early, you'll get 1% on the money you withdraw.

Assume you're an individual investor looking for fixed income with a maturity of no more than 5 years and you're not high net worth. I think that GICs/HISAs, if you shop around, will do you well.


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## andrewf

The only problem with GICs is the illiquidity and the fact that if you have millions of dollars you are essentially defaulting to the credit risk of the bank issuing them rather than the government of Canada, since CDIC only covers 100k per institution.


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## james4beach

As andrewf said, my goal here is to match VAB's performance, not outperform it. Rolling down the yield curve and managing constant maturity are all normal things the bond funds do. Using low coupons for tax efficiency, as andrewf said I end up with higher duration. I just want to see if I can balance out these forces (credit risk / maturity / duration) and I'm benchmarking against VAB


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## like_to_retire

andrewf said:


> The only problem with GICs is the illiquidity and the fact that if you have millions of dollars you are essentially defaulting to the credit risk of the bank issuing them rather than the government of Canada, since CDIC only covers 100k per institution.


I'm sure you know that it's $100K per account and institution. So it's fairly easy to insure a million or more with GIC's. Most of the 5 big banks offer GIC's from a laundry list of institutions, each with a $100K capability. And then there's RRSP/TFSA/Non registered at $100K each.



james4beach said:


> ...Using low coupons for tax efficiency, as andrewf said I end up with higher duration.


Yeah, this may well work out nicely during a rising rate (discount bond) environment that is in the cards right now, but how well could you have come up with any discounts during the last number of years as rates dropped and all choices were inefficient premiums? The double taxation on premiums would be a problem.

ltr


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## james4beach

like_to_retire said:


> Yeah, this may well work out nicely during a rising rate (discount bond) environment that is in the cards right now, but how well could you have come up with any discounts during the last number of years as rates dropped and all choices were inefficient premiums?


Well it's not exactly discount bonds that I need (those are sub-100 prices). My strategy is to go after low coupon bonds and there have been plenty of those available for the last few years. A bond can be a premium bond but still have relatively low coupons.

Here's an example: the 2023 Govt of Canada bond has 1.5% coupon, price 100.88 (premium bond). I would buy this bond due to the low coupon. This gives me much lower average coupons than VAB, which has 3.2% average coupon


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## like_to_retire

james4beach said:


> Well it's not exactly discount bonds that I need (those are sub-100 prices). My strategy is to go after low coupon bonds and there have been plenty of those available for the last few years. A bond can be a premium bond but still have relatively low coupons.
> 
> Here's an example: the 2023 Govt of Canada bond has 1.5% coupon, price 100.88 (premium bond). I would buy this bond due to the low coupon. This gives me much lower average coupons than VAB, which has 3.2% average coupon


Are you buying these premium bonds in a taxable account?

ltr


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## james4beach

Yes, this is a taxable account. Holding VAB would not be appropriate in this taxable account, with its high 3.2% average coupon (or XBB with 3.3% coupon). This is why I'm trying to replicate VAB performance but with low coupon bonds. ZDB uses this same strategy.


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## like_to_retire

james4beach said:


> Yes, this is a taxable account. Holding VAB would not be appropriate in this taxable account, with its high 3.2% average coupon (or XBB with 3.3% coupon). This is why I'm trying to replicate VAB performance but with low coupon bonds. ZDB uses this same strategy.


OK, I get it, but I suppose by low coupon bond you mean lower than what VAB holds. We both know that there are discount, premium and PAR bonds, and that's it. Low coupon means relative I guess to something? As soon as a bond moves to a premium, it suffers from a tax disadvantage in a non-registered account. But you know this already.

ltr


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## james4beach

Right, I mean low coupon in relative terms, vs the average holding in VAB. Strictly speaking I could hold all premium bonds and still be much more tax efficient than VAB.


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## 0okm9ijn

At present, I'm reading Ramit Sethi's "I Will Teach You To Be Rich". I don't get as much out of these type of books as I used to, but I still find actionable advice. And this book isn't an exception. For money needed within 5 years, he recommends a high interest savings account (HISA).

The highest 5 year GIC rate that I can find is 2.5%. The highest HISA rate that I can find is 2.0%. Now the HISA has higher reinvestment risk than the GIC. At present rates, I'm not too worried about that.  I also lose 0.5% in yield by not going up the yield curve. In a taxable account with a 50% marginal tax rate, that's 0.25% in lost yield. 

However, the greatest risk to fixed income, IMO, is unexpected inflation. The longer the term of nominal fixed income, the greater the risk of unexpected inflation. 

https://personal.vanguard.com/pdf/icruih.pdf

Go to Fig. 5 in the above Vanguard paper. The asset class that best correlates with inflation over one and three year time horizons is cash. Cash is noticeably better than TIPS (American real return bonds). The worst asset class is bonds, which has a noticeable negative correlation with inflation, unlike the other six asset classes. 

At present, long term government of Canada bonds yield 2.35%. Real return government of Canada bonds yield 0.64%. So the market thinks that future inflation will be around 1.7%.

http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

But there is the possibility that inflation will be higher than expected. 

http://inflationcalculator.ca/historical-rates-canada/

The following are Canadian inflation rates: 1971 3.0%, 1974 11.0%, 1950 2.5% 1951 10.4%, 1946 2.2%, 1948 14.6%, 1939 0% 1941 6.3%, 1915 1.6%, 1916 9.0%.

Some of those increases can be blamed on war. But what happened in 1946-48 and 1971-74 isn't easily explained by that. 

To get that extra 0.5% in yield and decreased reinvestment risk, one is taking on inflation risk. If over the span of 5 years, inflation goes up to 9.7%, the return on the 5 year GIC will suffer. The return on the HISA will also suffer, as the rate will likely keep up with inflation better, but you'll be paying tax on inflationary gains. Nevertheless, in such a scenario, the HISA will probably end up being the better choice. 

For money I need within 5 years, safety is important. Other than for matching nominal liabilities within the next 5 years, one can make a good case for using HISAs.


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## james4beach

I agree with what you said above, money needed within 5 years should be in a savings account (cash). And I agree that fixed income and bonds are vulnerable to a sudden pick-up in inflation.



0okm9ijn said:


> But there is the possibility that inflation will be higher than expected.


It's equally possible that inflation will be lower than expected.

The investment industry tries to scare people about inflation. They really want you to believe that the inflation boogeyman is always around the corner. Myself, I think it's about even odds for inflation vs deflation going forward.

Here's a graph of global inflation rates. The last "inflation is imminent!" scare was in 2007, and we know how that turned out after money hurled itself into stocks and commodities. http://www.economicshelp.org/wp-content/uploads/2016/09/global-inflation-rate.png


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## mordko

Inflation could be lower than expected. But it could be higher than expected by a lot more.


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## like_to_retire

james4beach said:


> ......... money needed within 5 years should be in a savings account (cash).


I think a ladder with a couple GIC's per rung would be a better idea. You enjoy a duration of about 2.5, and every 6 months you turn over the maturing GIC at the new rates of the day. It offers cash availability, protection of nominal capital, and I suspect a better total return within 5 years.

ltr


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## 0okm9ijn

james4beach said:


> It's equally possible that inflation will be lower than expected.
> 
> The investment industry tries to scare people about inflation. They really want you to believe that the inflation boogeyman is always around the corner. Myself, I think it's about even odds for inflation vs deflation going forward.
> 
> Here's a graph of global inflation rates. The last "inflation is imminent!" scare was in 2007, and we know how that turned out after money hurled itself into stocks and commodities. http://www.economicshelp.org/wp-content/uploads/2016/09/global-inflation-rate.png


Conventional wisdom is that inflation can be significant for a currency on the gold standard, but less so with a fiat currency. With a fiat currency, the government can print money, and is not limited by its gold reserves.

http://www.inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx

The link above gives US inflation info since 1914. The USA went off the gold standard part way through 1933. And deflation prior to 1934 was relatively common and significant. For example, deflation was minus 10.85% in 1921. Since 1933, the following years have had deflation with the corresponding number in brackets: 1938 (-2.01%), 1939 (-1.30%), 1949 (-0.95%), 1955 (-0.28%) and 2009 (-0.34%). Since 1933, the USA has had six years, where the inflation rate was greater than 10%. 

About the linkage of the gold standard to deflation, the data isn't as good for Canada. Canada was off the gold standard from 1914-1926, and off it permanently from 1929. For the period prior to 1934, Canada had significant inflation at times, despite not being on the gold standard. But you can make the case that that is due to the linkage of the Canadian economy to the much larger US economy. Since 1933, Canada has had one year with deflation (1953 minus 1.4%). Since 1933, Canada has had seven years, where the inflation rate was at least 10%. 

http://inflationcalculator.ca/historical-rates-canada/

It is the policy of the Bank of Canada, and other central banks that I know of, to have a modest inflation rate. In Canada, the target is around 2%. I've read of several reasons for this. Firstly, the cynical reason is that it keeps down the real cost of government debt and increases tax revenues. A second reason is that it gives the central bank room to manoeuvre during a recession. In a recession, inflation decreases. To stimulate the economy, the central bank cuts interest rates. But there has to be room to cut those rates. Otherwise, you'll end up with negative interest rates. Finally, economists seem to be more frightened by deflation than inflation. I'm not an economist, but inflation seems to be easier to correct than deflation.

So that's a long winded way of saying lower inflation is possible. But I'd be more concerned about higher inflation.


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## 0okm9ijn

like_to_retire said:


> I think a ladder with a couple GIC's per rung would be a better idea. You enjoy a duration of about 2.5, and every 6 months you turn over the maturing GIC at the new rates of the day. It offers cash availability, protection of nominal capital, and I suspect a better total return within 5 years.ltr


Liquidity probably won't be quite as good, as with a HISA, although that's not a major reason that I'm considering a HISA. A GIC ladder will preserve nominal capital, as will a HISA. And you should get a higher total return with a GIC ladder, as you're taking on inflation and liquidity risk. 

Is the extra 0.5% in yield worth it? And if taxed at a rate of 50%, that's an extra 0.25%. Are you picking up pennies in front of a steam roller?

I'd like to add that I think a GIC ladder is a reasonable option. But within the last 24 hours, I've come to the conclusion that a good case can be made for a HISA for money needed within the next 5 years.


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## james4beach

As much as I love GIC ladders for long term investments and ongoing fixed income exposure, I have frequently recommended a regular savings account for money needed within 1-5 years


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## like_to_retire

0okm9ijn said:


> .......you should get a higher total return with a GIC ladder, as you're taking on inflation and liquidity risk.
> 
> Is the extra 0.5% in yield worth it? And if taxed at a rate of 50%, that's an extra 0.25%. Are you picking up pennies in front of a steam roller?..
> .


I feel you may be downplaying that the GIC rate is guaranteed and the HISA rate will fluctuate over the 5 years. Yes, that HISA rate may rise, but it may drop also. Have your predictions of interest rates been accurate over the last 5 years - mine haven't - yikes.

The question of the 0.5% difference in yield is only valid the day of purchase. With the GIC's the rate is known, not so much with the HISA. You're gambling that the rates will rise. You're starting out with an HISA that is already behind the GIC rate and hoping that it will meet and surpass the GIC. The inflation and partial liquidity risk is offset by the interest rate risk of the HISA. Remember too that the entire GIC will have turned over, picking up rates of the day, by the end of the 5 years in a ladder.

ltr


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## james4beach

like_to_retire said:


> I feel you may be downplaying that the GIC rate is guaranteed and the HISA rate will fluctuate over the 5 years. Yes, that HISA rate may rise, but it may drop also. Have your predictions of interest rates been accurate over the last 5 years - mine haven't - yikes.


People around here have, for years, constantly thought that rates are about to shoot skyward at any moment. Just check out threads similar to this from 2013 or 2015 -- any time bond prices sag.

For some reason, most investors seem to think that higher inflation and higher interest rates are coming any moment. That's despite a 35 year trend of lower inflation and lower interest rates, plus zero and even negative rates in western countries similar to ours. Not to mention a stagnant global economy and central banks that are unable to spark inflation despite their best efforts. Just look at the Federal Reserve's zero interest rates & QE ... it barely did anything.

There are people around here who have kept money in HISA for years, all because of the fear that rates are going to soar "any moment now". The result is underperforming the GIC ladder, and horribly underperforming the typical bond fund (VAB).


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## 0okm9ijn

like_to_retire said:


> I feel you may be downplaying that the GIC rate is guaranteed and the HISA rate will fluctuate over the 5 years. Yes, that HISA rate may rise, but it may drop also. Have your predictions of interest rates been accurate over the last 5 years - mine haven't - yikes.
> 
> The question of the 0.5% difference in yield is only valid the day of purchase. With the GIC's the rate is known, not so much with the HISA. You're gambling that the rates will rise. You're starting out with an HISA that is already behind the GIC rate and hoping that it will meet and surpass the GIC. The inflation and partial liquidity risk is offset by the interest rate risk of the HISA. Remember too that the entire GIC will have turned over, picking up rates of the day, by the end of the 5 years in a ladder.
> 
> ltr


The GIC ladder should outperform a HISA, as it's taking on more risk (increased liquidity and increased inflation risk). And you correctly point out that the HISA has one risk that is increased compared to a GIC ladder: reinvestment risk. About inflation risk, the GIC ladder will have some protection against it, with its short term nature. 

But my goal with a HISA is not to outperform a GIC ladder. The HISA is for money I need within the next 3-5 years, and I want that money to be safe.

I'm weighing the increased liquidity and inflation risk of a GIC ladder versus the decreased return and increased reinvestment risk of a HISA. I think it's debatable, as to whether the GIC ladder is the better of the two options, when it comes to my goals for those two options.

P.S. Short term Canadian interest rates are significantly influenced by the Bank of Canada overnight lending rate, which is presently 0.5%. About it going higher or lower, which of the two do you think is the higher probability? I've added that in a postscript, because even if the rate was 5%, it wouldn't change my thinking


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## 0okm9ijn

james4beach said:


> People around here have, for years, constantly thought that rates are about to shoot skyward at any moment. Just check out threads similar to this from 2013 or 2015 -- any time bond prices sag.
> 
> For some reason, most investors seem to think that higher inflation and higher interest rates are coming any moment. That's despite a 35 year trend of lower inflation and lower interest rates, plus zero and even negative rates in western countries similar to ours. Not to mention a stagnant global economy and central banks that are unable to spark inflation despite their best efforts. Just look at the Federal Reserve's zero interest rates & QE ... it barely did anything.
> 
> There are people around here who have kept money in HISA for years, all because of the fear that rates are going to soar "any moment now". The result is underperforming the GIC ladder, and horribly underperforming the typical bond fund (VAB).


I'm certainly not advocating a HISA to time the market. I'm advocating the use of a HISA for money you need within the next 3-5 years. I don't consider a HISA or a GIC ladder to be investments, as I think their expected aftertax real return will be negative, at least in my situation. They're risk management tools.


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## james4beach

I absolutely agree with you that HISA is the right option for money you need within the next 3-5 years.

I consider fixed income (GICs & bonds) to be investments, personally.


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## 0okm9ijn

james4beach said:


> I consider fixed income (GICs & bonds) to be investments, personally.


To some extent, it is semantics. Consider the following scenario. 50% marginal tax rate. 5 year GIC with 2.5% rate. HISA 2.0%. Inflation 1.7%. In a taxable account, your GIC return is -0.45%, and your HISA return is -0.7%. I don't consider those investments. In a tax advantaged account, the respective numbers would be 0.8% and 0.3%. Those numbers do meet my definition of an investment, although I think that if you have a time horizon of more than 5 years, you'll likely do better with a diversified stock portfolio in a tax advantaged account. And Vanguard EAFE ETF has a yield of 2.73%. In a tax advantaged account, you'll save more tax by having that ETF than the 5 year GIC. 

As mentioned previously, I consider cash and fixed income as necessary to offset known and unknown liabilities within the next 3-5 years. For known nominal liabilities within the next 3-5 years, fixed income makes sense. Other than that, a HISA is a good option. 

Thanks for all those who contributed to this thread, as I've learned something here. However, everyone's situation differs, and YMMV.


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## Joewho

I have been trying to follow this thread but it may be a little too sophisticated for me. But, i do have a question which may be related. With a certain fear and trepedation I have been feeling the need to have some fixed income. Most of what I have available for that is in U.S. cash in an RRSP. It would be about $200,000. And I have been thinking of a fund such as Ishares AGG. But, I am told that I could lose money on buying that. Not very good for a supposedly safe harbour. But, I am also told that if you hold it long enough the distributions will make up for the loss of capital. I have been thinking of the bond fund because there doesn't seem to be a large inventory of government bonds at BMo and they seem to charge a lot to buy them. Also, an etf is liquid. 

So, will I really and assuredly make up the difference and more with the distributions?

Hope this is not irrelevant to the thread. I tried to get as close as I could to the subject matter.
joe


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## CPA Candidate

I feel the need to remind forum members not to get lost in calculation noise that doesn't matter. Whether you run your own bond fund or not, fixed income interest bearing securities for relatively young people is a poor use of capital. The proper way to refer to bond investments in the current environment is return-free risk. If everything goes great, you earn zero real return. If it goes bad, you can take a significant haircut on a "safe" investment.

The idea that in the end the investor gets their interest and capital back from a bond, and therefore nothing is truly lost, is false. The true loss is the lost opportunity to earn a higher return on another investment.


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## like_to_retire

CPA Candidate said:


> I feel the need to remind forum members not to get lost in calculation noise that doesn't matter. Whether you run your own bond fund or not, fixed income interest bearing securities for relatively young people is a poor use of capital.


Don't forget the importance and results of panic for young investors who commit to no fixed income. The loss associated with fixed income as a result of inflation is quite acceptable, compared to an equity market crash and the resulting panic and selling of equities at market bottom.



CPA Candidate said:


> The idea that in the end the investor gets their interest and capital back from a bond, and therefore nothing is truly lost, is false. The true loss is the lost opportunity to earn a higher return on another investment.


Or a complete loss on another investment. You're downplaying it somewhat.

ltr


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## andrewf

I agree that james is over-cautious with his fixed income allocation. I don't raise it any more because we had that conversation already.


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## james4beach

Joewho said:


> With a certain fear and trepedation I have been feeling the need to have some fixed income.


If the bond funds make you nervous, just use a GIC ladder. This will hide the price fluctuations and show value that steadily marches higher. Most people find this very reassuring as it makes it crystal clear that fixed income returns are guaranteed, and can only go up.



> The proper way to refer to bond investments in the current environment is return-free risk. If everything goes great, you earn zero real return.


Maybe at this snapshot, current day, yes you're right. But this isn't always the case, and staying invested in a bond fund lets you capture the longer term story with bonds.

What drives me nuts about all of this is that forum members seem to understand the point of staying invested in stocks long term, because you can't time the market, so you should just maintain your stock allocation. The same thing is true of bonds... which is why I'm running a VAB-like portfolio... but whenever I bring up bonds, forum members come out of the woodwork and give me advice on timing the bond market, saying with confidence that bonds are "sure to" go down from here. (Forum members have also always been wrong about this by the way).

The point I'm getting at is that an investor should persistently maintain their desired asset allocations, because timing stock and bond markets is impossible. You want the long term effect of being in stocks or bonds or both.

Zero real return in bonds? Hardly.

See the Credit Suisse Global Investment Returns Yearbook. This graph shows real returns in Canadian asset classes up to 2016. They use long term government bonds for the "bond" component.









For the full period going back to 1900, real returns in bonds are indeed less than stocks. But they are better than zero real returns.

1966-2015 (the last 50 years!) *the real returns from stocks & bonds are awfully close*. Equities are clearly not the only way to get solid real returns. Real returns from stocks were 4.5% and bonds were 4.1%.

2000-2015 shows *superior* real returns from bonds, vs stocks.

My overall point: don't be so quick to conclude that you sacrifice good returns in bonds. Over the last 50 years, the real returns in stocks & bonds were very similar. It's not a matter of what the exact bond yields are today. You should be staying invested in these asset classes long term.

And that's the point of staying in a bond fund like VAB, or a persistent GIC ladder, as a long term investment.


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## Argonaut

Well, you're looking at the past j4b. Of course bonds have done well in a bond bull market with falling interest rates. There's a difference in timing the market and seeing that an asset class is not attractively valued. Because of that guaranteed return you talk about, fixed income is one of the easier things to assign a value to. Me, I'm not all that excited about a <2% return. I'll even ignore the talking heads who talk about "real" return because I don't think it's all that relevant. But the nominal return of bonds is bad, and I wager that they'll be better interest rates in the future to look at. And if not, then I don't think bonds will ever be an attractive asset again. At least so long as they yield less than a basket of relatively safe dividend stocks.


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## mordko

In general, at any given point in time, there is no good reason to expect with any degree of confidence that total return from bonds over the next 20 years will be lower than from stocks. Therefore the absolute statement that young people shouldn't invest in bonds is wrong, even not accounting for psychology.


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## james4beach

Argonaut said:


> Well, you're looking at the past j4b. Of course bonds have done well in a bond bull market with falling interest rates.


And of course stocks have done well during a stellar, 35 year bull market in stocks.



> There's a difference in timing the market and seeing that an asset class is not attractively valued.


So should a couch potato investor not invest in stocks at all with the CAPE at 29, and global stocks at the high end of their historical valuations? Stocks aren't attractively valued either. They haven't been a good deal since the early 90s.

I don't think anyone around here advises timing the stock market. Why are you trying to time the bond market? When you own a bond fund you're not buying a 2% YTM bond. You're buying ongoing bond exposure.



> and I wager that they'll be better interest rates in the future to look at


Your bond fund gets you exposure to that. It's a portfolio that picks up new bonds at those "better interest rates" you mention. Sure there will be periods it underperforms, but you will benefit from higher interest rates when those happen.

You are advocating timing the bond market and swooping in "at the bottom" to buy bonds at an optimal. Good luck timing that market! It's about as easy as buying the bottom in the stock market.

Or you can do the right thing, and just maintain a steady allocation (whatever that % might be) to bonds.


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## 0okm9ijn

There are those who know a lot about bonds in this board, likes j4b. However, many are learning, like myself, so the following might be useful.

"The Sharpe ratio has been about 0.40 at the one-year maturity but falls to about 0.26 if we extend the maturity to about five years, and it continues to fall as we extend the maturity. Thus holding assets with a maturity of about one to two years is the prudent strategy for those investors wishing to maximize the risk-reward relationship."

Swedroe, Larry E.; Hempen, Joseph H.. The Only Guide to a Winning Bond Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today (pp. 68-69). St. Martin's Press. Kindle Edition. 

Larry Swedroe doesn't give more detail, but the context of the quote would suggest that the data from which the analysis is derived is historical US federal government bonds. Of course, Sharpe ratios are not an ideal measure of risk, but they are worth looking at.

It makes me consider rolling over 1 year GICs or 2 year GICs. 

http://www.financialpost.com/personal-finance/rates/gic-annual.html

From the above link, the best rates for 1 year, 2 year and 5 year GICs are 2.1%, 2.050% and 2.5% respectively.

So a strategy of rolling over 1 or 2 year GICs might be a reasonable option. It would have less reinvestment risk than a HISA. It would have less liquidity risk and less inflation risk than a 5 year GIC ladder. And at least at present, you're not sacrificing much yield by having shorter term exposure.


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## james4beach

^ I understand (and somewhat agree) with all these arguments about targeting the short end of the yield curve.... *right now*. No question, as of Wednesday February 15, the best risk/reward tradeoff is in the short end.

My question though, is when do you adjust to farther down the yield curve? Everyone on these forums is saying basically the same thing: "current conditions make the short end of the curve the best fixed income investment. Some time down the road I will go back to the long end of the curve when it becomes more attractive".

OK, so hum along in cash and the shortest term fixed income, forfeiting performance as you do so. Luckily you timed it so well, bond yields immediately go up, and then Mr. Market rings a bell and tells you that bonds have stopped falling and now you can go far down the yield curve -- really? Does that sound plausible over the span of several decades?

This is bond market timing. _It doesn't sound like_ market timing to people, for some reason. People have been saying this for years, at least back to 2009 when yields first fell quite low. For the last 8 years, people have unsuccessfully timed the bond market. That's a pretty long streak of timing failure.

Here for illustration is the chronic failure to "out-smart" the bond market. Those short term bonds XSB (blue) that were so obviously the best investment, according to everyone, have underperformed XBB (green). Which is exactly what you would expect if you have a neutral rate outlook, or even if you allow for mild rate increases: http://stockcharts.com/h-sc/ui?s=XBB.TO&p=D&st=2009-01-01&en=(today)&id=p76152527729

Again -- why do we all recognize that we can't time the stock market, but we think we can time the bond market? Not only are you timing the bond market, but you're putting a lot of faith in a very specific scenario: rapidly rising interest rates and an end to a 36 year interest rate trend.

You might have better results than me, but I don't believe that I can time the bond market. This is why I stick to a certain reasonable long horizon maturity (VAB and its 10 year average) or the maximum CDIC insured GIC term (5 years).

The simple reason: with a neutral rate outlook, or even if you allow for mild rate increases, VAB/XBB (10 yr maturity) will outperform cash/GIC/XSB (short maturity) over decade-ish periods.

It's the couch potato strategy. You assume that you can't time or outsmart the market, and decide to just take exposure to the asset class.

Even if you are correct that interest rates are about to go higher, that's not enough. You also have to successfully time your entry back into regular (VAB) bonds. Get this timing wrong (e.g. everyone over the last 8 years!) and you dramatically underperform.


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## 0okm9ijn

I think that there is a 69 year span in the USA in the 19th century where bonds outperformed stocks. That's something to think about. 

This is from p.95 of "Stocks for the Long Run". This shows highest and lowest real returns on stocks, bonds and bills over 1, 2 5,10, 20 and 30 years holding periods in the USA between 1802-2012.

Worst 1 year return for stocks is -38.6%, for bonds -21.9%. 2 years -31.7%, -15.9%, 5 years -11.9% -10.1%, 10 years -4.1% -5.4%, 20 years 1.0% -3.1% 30 years 2.8% -2.0%

By 5 years, the worst real returns are similar for stocks and bonds. 

The following is from p.95 of "Stocks for the Long Run". This shows highest and lowest real returns on stocks, bonds and bills over 1, 2 5,10, 20 and 30 years holding periods in the USA between 1802-2012.

Worst 1 year return for stocks is -38.6%, for cash -15.6%. 2 years -31.7% -15.1% , 5 years -11.9% -8.3%, 10 years -4.1% -6.1% , 20 years 1.0% -3.0% , 30 years 2.8% -1.6%

If your time horizon is 1-5 years, cash and bonds are safer than stocks. But if you have a time horizon of 5-10 years or more, stocks are safer than cash or bonds.

That's data from 1802-2012. So one can't be accused of choosing time periods favorable to your conclusion. In fact, the data is biased in favor of bonds. The older data includes the gold standard time period. During that time, deflation was much more severe than it has been in the paper currency era. Government bonds will tend to do better than stocks, in the face of deflation.

Finally, the above returns ignore taxes. In a taxable account with a 50% marginal tax rate, bonds have a handicap that is difficult to over come.


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## 0okm9ijn

0okm9ijn said:


> There are those who know a lot about bonds in this board, likes j4b. However, many are learning, like myself, so the following might be useful.
> 
> "The Sharpe ratio has been about 0.40 at the one-year maturity but falls to about 0.26 if we extend the maturity to about five years, and it continues to fall as we extend the maturity. Thus holding assets with a maturity of about one to two years is the prudent strategy for those investors wishing to maximize the risk-reward relationship."
> 
> Swedroe, Larry E.; Hempen, Joseph H.. The Only Guide to a Winning Bond Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today (pp. 68-69). St. Martin's Press. Kindle Edition.
> 
> Larry Swedroe doesn't give more detail, but the context of the quote would suggest that the data from which the analysis is derived is historical US federal government bonds. Of course, Sharpe ratios are not an ideal measure of risk, but they are worth looking at.
> 
> It makes me consider rolling over 1 year GICs or 2 year GICs.
> 
> http://www.financialpost.com/personal-finance/rates/gic-annual.html
> 
> From the above link, the best rates for 1 year, 2 year and 5 year GICs are 2.1%, 2.050% and 2.5% respectively.
> 
> So a strategy of rolling over 1 or 2 year GICs might be a reasonable option. It would have less reinvestment risk than a HISA. It would have less liquidity risk and less inflation risk than a 5 year GIC ladder. And at least at present, you're not sacrificing much yield by having shorter term exposure.


With the remark "And at least at present", one could accuse me of fixed income market timing. But I doubt that my conclusions would change regardless of the yield curve. Although Larry Swedroe doesn't mention the time period on which the data is drawn, my guess is that it's a long one. And the strategy of rolling 1 or 2 year GICs is for money needed within the next 3-5 years. I have earlier talked about using a HISA for money needed within the next 3-5 years. A strategy is rolling 1 or 2year GICs is just going a little further out on the yield curve.


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## mordko

^ Interesting, but:

1. Not a huge discovery that long-term bonds can be just as volatile as stocks. I don't know what the above statistics actually covers, but the 19th century data are long-term bonds. Assume that TIPS and other inflation-linked instruments are not covered at all.

2. Not sure we can claim the data are biased in favour of bonds. The 20th century was also special; the loss of gold standard and the time it took governments to figure out inflation resulted in major damage to bonds. There is nothing to indicate that 20th century conditions will be repeated. 

All this history is very interesting but in truth... We just can't project the past forward. Diversification is good in the game of "winning by not losing".

Having said all this, I just don't see how the risk is priced within any bonds on offer right now and the delta between government bonds and private/junk bonds does not seem to be anywhere near historic standards. It's probably because I don't understand the instrument but I tend to be cautious about the things I don't understand. The pricing is moving in the right direction though.


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## hboy54

james4beach said:


> What drives me nuts about all of this is that forum members seem to understand the point of staying invested in stocks long term, because you can't time the market, so you should just maintain your stock allocation. The same thing is true of bonds... which is why I'm running a VAB-like portfolio... but whenever I bring up bonds, forum members come out of the woodwork and give me advice on timing the bond market, saying with confidence that bonds are "sure to" go down from here. (Forum members have also always been wrong about this by the way).
> 
> The point I'm getting at is that an investor should persistently maintain their desired asset allocations, because timing stock and bond markets is impossible. You want the long term effect of being in stocks or bonds or both.


As most of you know, I am not in the habit of agreeing with James, but on investing first principles he is correct here. Decide on your asset allocation and stick with it.

On this point, I even do the above, that is maintain my asset allocation which is stock exposure of around 125%, that is all stocks all the time plus leverage.

My next point is what is market timing exactly? Perhaps it is investing in any manner which is not taking your monthly savings and adding to new investments according to your AA. If this is the case, then I market time and am quite successful at it. If however, given that I am always about 125% invested in stocks or "in the market" and don't much waver off that, then perhaps I don't market time.

Given the above paragraph then, what is the scope in investing theory to consider the landscape and selectively approach one thing and selectively avoid another based on what one considers "likely". You still have all your money in something, so you are in the market. Is this market timing or something else?

Personally, I have this past week trimmed stocks winners and paid down margin. Unlike the past 2 years when there were selective opportunities in sectors of the equity market, I see nothing 'likely" to have outsized chances right now. My first thought was to perhaps restore T or BCE etc. to the portfolio, but they look so expensive right now. So I find myself effectively investing in FI at 3% to wait out new opportunities. Market timing or something else?

Personally I see the entire investing landscape as a minefield right now. Putting money into FI at 2 or 3% for the next decade or so looks like a weak idea. Buying stocks at current highs is getting riskier by the day. Real estate in Toronto and Vancouver has not looked sensible in a very long time.

Frankly, I'd consider thinking outside the box for a young person. Maybe now would be a good time to invest in yourself by way of a degree, or second degree. Or run the figures on your 20 year old 80% efficient oil furnace as maybe a higher expected return than 3% exists there. Or house insulation or ... There are likely all sorts of things that could make more sense than 3% FI or watching a 30% haircut on recently purchased stocks develop.

hboy54


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## Argonaut

james4beach said:


> I don't think anyone around here advises timing the stock market. Why are you trying to time the bond market? When you own a bond fund you're not buying a 2% YTM bond. You're buying ongoing bond exposure.


The talk about timing the market is just a distraction from the real issue, that bonds yield so poorly. I just refuse to accept a <2% yield while taking on interest rate risk. Someone put it eloquently above, that bonds right now are return-free risk.

This doesn't mean I would advocate everyone do the same, just that it works for a relatively young professional like me. And you can scold others for staying in short-term bonds or cash for the last 8 years, but the return they gave up wasn't anything to write home about. You then reserve the right to be scolded if and when longer term bonds get crushed.


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## agent99

"Decide on your asset allocation and stick with it."

This is something I just don't see. If you were running a business, you wouldn't choose a mix of products to sell and stick with it regardless. If one product was going out of favour, you would use your floor space to display a product that is likely to sell. 

Economies change and it seems to me that we as investors must change too. Early in past century, railroads represented over 60% of the US market. Now only about 0.2%. In 1900 IT did not exist and now it is about 23% of US economy. Banks & Finance share of US markets has doubled. 

So I could see deciding on your asset allocation and sticking with it for at most 12 months. Then reassess.


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## james4beach

Argonaut said:


> The talk about timing the market is just a distraction from the real issue, that bonds yield so poorly. I just refuse to accept a <2% yield while taking on interest rate risk.


What if I said to you: "I just refuse to accept a CAPE (Shiller PE) of 29 which virtually guarantees low stock returns while taking on the risk of a 30% to 80% capital loss"

Factually, that's accurate. That's what you're saying about bonds as well. What's the problem with this statement? OK, so let's say I sit out US stocks due to the current CAPE. Once the ratio gets better, will I get back in? How long will I lapse and delay before getting back in? How long will the current non-optimal situation persist? What if there isn't reversion to the mean within my lifetime?

This is a direct parallel to your bond comments. Realistically, you can't time yourself into & out of stocks like that. Doing so, you would have abandoned stocks in the late 90s and never re-entered. You also realistically can't time yourself into & out of bonds looking at today's yields.

Couch potato approaches with continuous investment in the asset beat this kind of timing. Choose whatever asset allocation you see fit though. I just think the persistent allocation is a better approach than trying to jump in and out based on things like today's CAPE or bond yields.

_agent99_ - I agree that one should reassess their asset allocations. These aren't set in stone, though I think it's best to make small and smooth adjustments as opposed to sharp allocation differences, which look more like market timing to me. I think the reason for the adjustment is also important. If I was making dramatic annual adjustments to my stock % based on CAPE, I'm just market-timing. Similarly if I make dramatic annual adjustments to my bond % based on yields, I'm just market-timing.

_0okm9ijn_ - I think you're quite knowledgeable on this subject. I've been reading some more resources to better grasp your point that bonds can be quite risky even vs stocks. I think I have a better sense of the historical point you're making.

I agree, bonds have had historical periods where they have long stretches of poor returns. From the historical data I can see that these stretches of poor performance can be much longer than I thought. This is a real danger, I agree. Bonds could have multi decade periods of low real returns. Or high real returns.

Maybe this is just personal taste but for me: portfolio management is easiest when I have a number of simple knobs. There's a stock % knob and a bond % knob. For me, the "bond" allocation should be VAB or something a lot like it. Now I have only one setting to worry about: what % bond exposure do I want? If you complicate it by choosing points on the yield curve, now you have all kinds of knobs to manage.

For me, I have that bond knob set to 25% allocation. It wiggles around a bit ... last year I was 23%, and after the price drop I increased it to 25%. For me, no massive changes year to year. It's a consistent theme, with persistent allocations and no sudden market timing.

And to each their own. If you decide that your investment approach only needs 10% bonds, then by all means, keep your allocation low.


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## james4beach

A reference to back up my claim that persistent allocations are a better strategy than "tactical asset allocation"
http://www.etf.com/sections/index-i...are-tactical-asset-allocation.html?nopaging=1

I think that some people in this thread are basically proposing tactical asset allocation, where they are looking at current bond market yields and inflation rates and determining that bonds should be cut out of the portfolio because they are projecting poor returns ahead. As good as this kind of idea sounds in theory, it doesn't work well in practice.


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## mordko

Don't believe there is any serious source recommending that there should be no fixed income at all, but prominent proponents of passive such as William Bernstein do recommend to time your bond purchases. For example in the Four Pillars he is recommending only purchasing government bonds during times like today.


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## Joewho

james4beach said:


> If the bond funds make you nervous, just use a GIC ladder. This will hide the price fluctuations and show value that steadily marches higher. Most people find this very reassuring as it makes it crystal clear that fixed income returns are guaranteed, and can only go up.
> 
> 
> 
> Maybe at this snapshot, current day, yes you're right. But this isn't always the case, and staying invested in a bond fund lets you capture the longer term story with bonds.
> 
> What drives me nuts about all of this is that forum members seem to understand the point of staying invested in stocks long term, because you can't time the market, so you should just maintain your stock allocation. The same thing is true of bonds... which is why I'm running a VAB-like portfolio... but whenever I bring up bonds, forum members come out of the woodwork and give me advice on timing the bond market, saying with confidence that bonds are "sure to" go down from here. (Forum members have also always been wrong about this by the way).
> 
> The point I'm getting at is that an investor should persistently maintain their desired asset allocations, because timing stock and bond markets is impossible. You want the long term effect of being in stocks or bonds or both.
> 
> Zero real return in bonds? Hardly.
> 
> See the Credit Suisse Global Investment Returns Yearbook. This graph shows real returns in Canadian asset classes up to 2016. They use long term government bonds for the "bond" component.
> 
> View attachment 13929
> 
> 
> For the full period going back to 1900, real returns in bonds are indeed less than stocks. But they are better than zero real returns.
> 
> 1966-2015 (the last 50 years!) *the real returns from stocks & bonds are awfully close*. Equities are clearly not the only way to get solid real returns. Real returns from stocks were 4.5% and bonds were 4.1%.
> 
> 2000-2015 shows *superior* real returns from bonds, vs stocks.
> 
> My overall point: don't be so quick to conclude that you sacrifice good returns in bonds. Over the last 50 years, the real returns in stocks & bonds were very similar. It's not a matter of what the exact bond yields are today. You should be staying invested in these asset classes long term.
> 
> And that's the point of staying in a bond fund like VAB, or a persistent GIC ladder, as a long term investment.


As i mentionned, I have U. S. dollars. So no GIC there, or I would buy it. I don't see anything of an equivalent, either. But, the question was really, whether an ETF, in my case, such as AGG in the States, could possibly loose money? I know that for the short term it can loose money. But, I believe, but am not sure, that your point is that with distributions that loss is overcome in the long term. I am not sure why i would invest in something that was going to lose me money when I could just keep it in a High interest savings account.
joe


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## mordko

^ in real terms you can lose money in both HISA and AGG.


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## Joewho

An enigmatic expression! I suppose by that you mean you can lose to inflation?
joe


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## james4beach

Joewho said:


> question was really, whether an ETF, in my case, such as AGG in the States, could possibly loose money? I know that for the short term it can loose money. But, I believe, but am not sure, that your point is that with distributions that loss is overcome in the long term.


Right, in nominal (not real) returns, when you hold AGG on the order of 10-15 years, your total return will be positive, virtually guaranteed. To see this, look at historical bond returns and you'll see that even during the very sharp rise in interest rates in the 70s-80s, bonds had a positive nominal return. Nobody "lost money".

So the real debate we're having is not whether bonds will lose money in nominal terms, but whether they can perform well in real terms.



> I am not sure why i would invest in something that was going to lose me money when I could just keep it in a High interest savings account.


Is your question, why invest in AGG or VAB which may suffer interim losses, when you can just keep it in a high interest savings account?

Answer: because AGG or VAB will likely (on average) have a superior long term performance. The same way that a GIC ladder would have outperformed a savings account. Both GICs and bonds are the same kinds of vehicles.

And in response to this point, people respond to me and say -- well not this time it won't. And I call that an attempt at market timing... people are trying to predict interest rates, the yield curve, and inflation rates.


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## Argonaut

james4beach said:


> What if I said to you: "I just refuse to accept a CAPE (Shiller PE) of 29 which virtually guarantees low stock returns while taking on the risk of a 30% to 80% capital loss".


Shiller PE is just an academic construct, something that may or may not be correlated with market direction, the answer of which we can definitely call an unknown. The 1-3 year Canada bond yield is 0.76%, that is a known. The capital gain upside you calculated on your 3 year bond was a meager 2.69%, that is a known. Negative interest rates is just wacky-town, so I'll ignore them. There's just no reason for myself and others to accept these poor returns, that are completely known.

Capital gain or loss of equities is unknown, but its maximum is unlimited and not capped like bonds. Aggregate dividend yield of a solid Canadian portfolio is about 4%, maybe a bit less nowadays. That is a known. There is always the possibility of a cut or suspension of dividend, but I would put that likelihood and impact (for high quality companies) about the same as bond default and call it a wash.

If you add up all the knowns and unknowns, bonds are just really not attractive right now for many people. There may be a place for bonds in some portfolios but one has to know that they are committing themselves to poor or negative returns, something I'm not willing to do. A bit of cash provides some of the same benefits with less of the risks.


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## like_to_retire

Argonaut said:


> ......Aggregate dividend yield of a solid Canadian portfolio is about 4%, maybe a bit less nowadays. That is a known. There is always the possibility of a cut or suspension of dividend, but I would put that likelihood and impact (for high quality companies) about the same as bond default and call it a wash.
> 
> If you add up all the knowns and unknowns, bonds are just really not attractive right now for many people. There may be a place for bonds in some portfolios but one has to know that they are committing themselves to poor or negative returns, something I'm not willing to do. A bit of cash provides some of the same benefits with less of the risks.


If I look at a balanced Cdn portfolio, it might look like this:

Cdn Equities = 50%
Cdn GIC's = 42%
Cdn Pref Shares = 5%
Cdn Cash = 3%

That's a healthy allocation to fixed income, either GIC's or bonds. Examine the expected low volatility assumptions below.

Cdn Equities =~ 3.5% dividend yield plus 3.5% capital appreciation
Cdn GIC's =~ 2.5%
Cdn Pref Shares =~ 4.5% dividend yield with no capital appreciation
Cdn Cash =~ 1%

Do the math and the total return is a very low risk, low volatility 4.5% per year. 

I would think that this would be a lot better for most people than what you're suggesting. What are your thoughts?

ltr


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## Argonaut

I'm not suggesting anything. Maybe there are real humans behind your usernames, but for all I know I'm talking to a bunch of 1's and 0's in the matrix. I wouldn't give financial advice to someone I know nothing about. Just explaining to j4b why I personally don't see value in bonds at the present.


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## like_to_retire

Argonaut said:


> I'm not suggesting anything. Maybe there are real humans behind your usernames, but for all I know I'm talking to a bunch of 1's and 0's in the matrix. I wouldn't give financial advice to someone I know nothing about. Just explaining to j4b why I personally don't see value in bonds at the present.


Nice response. I'm out.


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## agent99

james4beach said:


> And I call that an attempt at market timing... people are trying to predict interest rates, the yield curve, and inflation rates.


Just like choosing an allocation and not wavering from it, I have trouble with those that talk about market timing as something that should be avoided at all costs! 

Being at the right place at the right time is something to hope/wish/strive for. Needs a certain amount of brainpower, intuition, luck? But as a famous golfer once said "the more I practice, the luckier I get" . 

For example right now markets 'seem' to be overvalued. Trump effect or whatever. Maybe it is a time to try to time the markets and move equities to cash or maybe even bonds? Or would that we unwise because it is an attempt to time the markets?


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## james4beach

I completely understand the argument for why someone doesn't see anything attractive about bonds at present.

Still the point I'd like to stress is that the "tactical asset allocation" kind of approach -- outsmarting the stock & bond markets -- tends to not work well in the long term. Personally I also wish I could tune my allocations such that I'm optimally exposed to stocks & bonds *only* at the right times, but from the studies I've seen, and personal experience, this doesn't work. Interest rates and inflation are no easier to predict than stock or commodity market direction.



agent99 said:


> Being at the right place at the right time is something to hope/wish/strive for. Needs a certain amount of brainpower, intuition, luck? ... Maybe it is a time to try to time the markets and move equities to cash or maybe even bonds? Or would that we unwise because it is an attempt to time the markets?


I'd like to believe it's possible to intelligently adjust exposures like this, but I haven't been able to do it, and neither have the plethora of mutual funds. The studies on "tactical asset allocation" funds have also shown they are failures. Maybe you will be able to do it, but you'll be one of the very few who can.

Basically I'm making the argument for couch potato indexing. The only wiggle room I leave myself for market timing is in the small allocation adjustments, but these are _trimming_ activities and not sweeping changes to my strategy.


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## agent99

James, 
I don't disagree that is hard to get market timing or allocation timing "right". For those who are working or heavily involved with other things, some sort of autopilot investing using some of those often espoused "rules" may be the right thing. But if you have time and do it in a way, that limits or avoids chance of a loss if you are wrong, then I see nothing wrong with trying. I am sure most managed funds and professional investors attempt to get timing/allocation right.


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## james4beach

One anecdote from me: I knew that stocks were overvalued in 2006-2007 and there were financial sector risks, so I (correctly) lightened up on stocks. This was market timing at its finest ... I avoided the 2008 catastrophe.

BUT after the turmoil, I failed to buy back in. Instead if I had been steadily invested in SPY & XIU, that would have done much better.

I similarly have tried to outsmart the bond market. Even in the early 2000s, I was limiting myself to 3 yr instruments thinking that interest rates would rise. I was wrong. Just like with my stock experience, I would have done much better if I just stayed consistently invested in the asset class.


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## 0okm9ijn

https://www.youtube.com/watch?v=_chiIIxMGl0&list=PL24qYBiXaDDsSGgzBFxEe8SsECXiqVFpI

Above is a link to a video by Lars Kroijer. Basically, it's about indexing, which isn't relevant to this thread. But what is relevant is his approach to asset allocation. He advocates what some might call a barbell approach. The equity portion of the portfolio is indexed. But the rest of the portfolio is in cash or government bonds. It's his advocacy of cash for the nonequity portion of the portfolio that I find interesting.

http://www.financialpost.com/personal-finance/rates/gic-annual.html
http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/
http://www.financialpost.com/markets/data/bonds-canadian.html
https://www.highinterestsavings.ca/chart/

From p. 95 of "Stocks For The Long Run", the following are the worst real returns from 1802-2012 for US bonds and bill over 1 ,2 and 5 year holding periods respectively: -21.9% vs. -15.6%, -15.9% vs -15.1% and -10.1% vs. -8.3%. What defines bonds is important, because a 5 year bond behaves quite differently than a 30 year bond. Nevertheless, if capital preservation is important, bills look like a reasonable option. 

The following is only about products with CDIC backing. The top HISA is 2%. The top 1 year, 2 year and 5 year GICs are 1.75%, 1.95% and 2.50% respectively. 

1 month Canadian treasury bills, 1 year Canadian Treasury bills, 2 year government of Canada bonds and 5 year government of Canada bonds are paying 0.44%, 0.60%, 0.79% and 1.18% respectively. 

A province of Ontario bond maturing on March 8/2018 has a yield of 0.78%. Province of Quebec bonds maturing on December 1/17 and December 1/18 have yields of 0.70% and 1.00% respectively.

Enbridge Pipelines has a bond maturing on Nov 19/18 with a yield of 1.37%. Rogers Communications has a bond maturing on March 22/21 with a yield of 2.06%. 

As mentioned previously, I see the role of cash/fixed income as a way to offset known and unknown liabilities for the next 3-5 years. A bond/GIC approach is a good way to meet that goal. But I'm becoming increasingly convinced that a HISA is a reasonable alternative to a bond/GIC strategy.

What strikes me is how simple it is. To become a fixed income expert takes a lot of time, and even if I wanted to spend the time, I'm not certain that I would succeed. But I think I can become an expert about Canadian HISAs, and it won't take that much time. And I doubt that I will significantly underperform strategies that are much more sophisticated.


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## james4beach

0okm9ijn said:


> But I think I can become an expert about Canadian HISAs, and it won't take that much time. And I doubt that I will significantly underperform strategies that are much more sophisticated.


Let's look at a period where interest rates have actually gone up. On 2012-07-24 the govt 10yr was 1.58% and today it's 1.74%.

According to your thinking, the period from 2012-07-24 to 2017-02-17 should be a period where cash/HISA outperforms bonds. XBB annualized performance in this period was 2.51%.

Even at the sketchiest mortgage trust high interest savings accounts you could have found over that period, I don't think you would have outperformed in HISAs. Some of the very high rates we see today are promotional and from new subsidiaries of places that didn't even exist before. A place like Outlook Financial *has* been a long established top HISA yield. Over this period the average Outlook Financial HISA rate was 1.85%

*So here is a period where interest rates went up -- just as you are fearing -- and XBB/VAB returned 2.51% vs about 1.85% in HISA*. Personally I would be happier with the 2.51% from a static "set it and forget it" investment, vs constantly shuffling money between different sketchy mortgage lenders, opening endless new accounts, and catching promo rates.

I don't see how HISAs are less work, and they actually underperformed during this period where interest rates went up!


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## james4beach

You might say, well the 1.85% in HISA during that period wasn't too much worse than 2.51% in XBB -- and I agree, they both round to 2 more or less.

As far as predicting what's in store for the future,

1. bond yields go up gently -> VAB outperforms
2. bond yields go up sharply -> HISA outperforms
3. bond yields go down -> VAB outperforms
4. bond yields stay flat -> VAB outperforms

Personally when I look at that matrix of forecasts, I say to myself: the average case is that VAB outperforms. And holding VAB or XBB is much easier than jumping around between HISAs to get the best rates.


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## 0okm9ijn

The purpose of a HISA is to offset cash flow liabilities over the next 5 years. XBB has an average effective duration of 7.16 years; 10.75% of the fund is in BBB bonds. I wouldn't use XBB to offset cash flow liabilities over the next 5 years. With XBB, you're taking on interest rate risk and some credit risk. You should outperform a HISA. I'd prefer to take my risk in equities, rather than bonds, where it historically has been better rewarded. And that's ignoring posttax returns. 

http://quote.morningstar.ca/QuickTakes/ETF/etf_Portfolionew.aspx?t=XBB&region=CAN&culture=en-CA


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## james4beach

I agree, if your goal is to have cash available over 5 years, HISA is the correct option -- not XBB/VAB. My time horizon is 10+ years so I feel VAB is appropriate for my fixed income. Separate from this, I also maintain a full 25% allocation to HISA & GICs.


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## james4beach

Performance update


*Month**VAB %**My %**Difference*Jan 2017-0.23%-0.06%+0.17February0.99%0.86%−0.13


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## james4beach

My portfolio's weighted average maturity/term is 7 years. This is shorter than VAB at 10 years and explains why my portfolio of individual bonds is less volatile than VAB.

This has been good for me during this soft period in bonds, but it also means that I will underperform VAB when bonds strengthen (e.g. February).

Currently I am debating whether to immediately boost my maturity upward to match VAB, or to attempt some market timing [*] and keep my avg term a bit lower until bonds weaken more.



_[*] I doubt that I can time the bond market, every though most CMF participants seem to be sure they can time bonds_


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## james4beach

I found a better way to track my portfolio's performance vs VAB. This chart is built using monthly performance from both Vanguard and my brokerage; total returns. Curious to see if I can keep up with the professionals at Vanguard.

After six months I'm tracking VAB perfectly so far


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## goldman

*Fund duration risk*



james4beach said:


> My portfolio's weighted average maturity/term is 7 years. This is shorter than VAB at 10 years and explains why my portfolio of individual bonds is less volatile than VAB.


Great thread, and your work at running your own private bond fund is inspiring James! Unfortunate that rates are so low and we face the risk of rising rates. I've yet to complete reading the entire thread, but I'm curious about duration risk and the impact of rising rates ahead.

With a fund like your fund, ZAG, VAB, or XBB ... a growing concern is duration risk that the fund value will drop as rates rise. ZAG has a duration of 7 similar to yours. The US Fed is expected to raise rates about 3 or 4 times during 2017 for approximately an increase of .75 - 1%. Even though its US rates, it obviously effects rates in Canada when you study the charts. 


example: www . tradingview . com/x/B6jky3uL/

With the frist 1/4% rate hike in Dec 2015 the ZAG pulled back 2.6% and recovered. But with a series of 1/4% hikes in the Fed funds rate approximately every three months from Dec 2016, should these 7 year duration funds not be expected to drop about 7% in fund value by the end of the year?


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## james4beach

goldman said:


> Great thread, and your work at running your own private bond fund is inspiring James! Unfortunate that rates are so low and we *face the risk of rising rates*.


Bond yields can either go higher or lower. Nobody knows. Even if the Fed raises rates, the bond market may have already priced this in, so it's a total unknown what will happen to the bond yields.



> With a fund like your fund, ZAG, VAB, or XBB ... a growing concern is duration risk that the fund value will drop as rates rise. ZAG has a duration of 7 similar to yours.


Clarifying, 7 is my avg maturity, not the duration. My avg maturity is lower than ZAG, VAB, XBB. My duration is probably a bit lower than theirs as well.



> The US Fed is expected to raise rates about 3 or 4 times during 2017 for approximately an increase of .75 - 1%. Even though its US rates, it obviously effects rates in Canada when you study the charts.


Right, the Canadian bond market moves very similarly to the US bond market.



> should these 7 year duration funds not be expected to drop about 7% in fund value by the end of the year?


You're echoing some common misconceptions

(1) The central bank is raising the overnight rate, but this is not the same as the bond yield, especially not at 10 year maturity on the yield curve. Here's a web site that shows the US yield curve.

The Federal Reserve, or Bank of Canada, etc only directly changes the short end of the curve: *the cash rate*. They do not change the other rates on the yield curve; that's determined by the bond market. Let's say the Federal Reserve does raise rates a total of 1.0%. What will happen to the 10 year point on the yield curve? Who knows -- it could go down, up, or stay the same.

This is one of the key misinterpretations about the Fed "raising rates" and its impact on bond funds. Even if we think it's 100% certain that the Fed will raise rates by one percent, we don't know what will happen to the yield at 10 years on the yield curve. For example: the bond market might have already priced this in. That means that by the time the Fed raises rates, it's old news to the bond market and perhaps the *10 year yield* does not react at all.

Between Jan 2004 and Jan 2007, the Federal Reserve increased the fed funds rate a whopping +4.25% and the 10 year yield increased just +0.3%. This was a far more aggressive rate tightening regime than today, and yet bond funds (like AGG exposed to the 10 year yield) did very well. AGG returned +3.42% per year. I should add that early in this time line it did decline, temporarily, 5%.

(2) That calculation where duration translates to % move is applicable to an individual bond. If you have a specific govt bond with duration=7 and if the yield of that bond increases by 1% then yes, the price is expected to drop 7%.

For the rest of this discussion I will assume we're talking about a 1% increase in the yield of the 10 year, which as I described in (1) is not necessarily what happens when the Fed raises rates by 1%

With the bond fund, yes if the rates *suddenly* increase by 1%, then the fund with duration=7 will decline by 7%. However once you start spacing it out over time, you're also getting interest earned on bonds, and new bonds that bring in higher levels of interest due to the increase in rates.

So yes it's true that a sharp increase in rates can cause that 7% price decline as you mention. However, gradual increases in rates won't cause that effect.


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## james4beach

james4beach said:


> Between Jan 2004 and Jan 2007, the Federal Reserve increased the fed funds rate a whopping +4.25% and the 10 year yield increased just +0.3%. This was a far more aggressive rate tightening regime than today, and yet bond funds (like AGG exposed to the 10 year yield) did very well. AGG returned +3.42% per year.


I realize I've made another long winded bond post, but I want to highlight this important point.

Why did AGG (exposed to the 10 year yield) have such a great return even though the Federal Reserve increased interest rates by 4.25% ?

(1) Central banks don't set the yield of the 10 year bond, which is the key factor for VAB, XBB, ZAG or AGG in the US. The central bank can raise _cash rates_ but the 10 year yield may or may not increase. It does tend to follow, but not in lock step. e.g. 2004-2007, the Fed increased the fed funds rate +4.25% and the 10 year yield increased just +0.3%.

(2) Even if the 10 year yield does increase, a relatively slow increase in yields does not hurt a bond fund.


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## james4beach

Another example. Between Jan 1994 and May 1995, the Fed increased rates +3.0%. The 10 year treasury bond yield increased +1.3% ... http://stockcharts.com/h-sc/ui?s=$TNX&p=D&st=1994-01-01&en=1995-05-01&id=p35931391770

Bond funds similar to VAB saw a temporary 6% decline but ended positive 3%, as shown here ... http://stockcharts.com/h-sc/ui?s=VBMFX&p=D&st=1994-01-01&en=1995-05-01&id=p94689011619

Notice that the temporary losses in bond funds were nowhere near as severe as someone may have predicted by saying 3.0 rate hike x duration of 6.0 = 18% decline. And after this 15 month series of Fed rate hikes, the bond fund was ultimately higher by 3%


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## GreatLaker

james4beach said:


> (2) That calculation where duration translates to % move is applicable to an individual bond. If you have a specific govt bond with duration=7 and if the yield of that bond increases by 1% then yes, the price is expected to drop 7%.
> 
> For the rest of this discussion I will assume we're talking about a 1% increase in the yield of the 10 year, which as I described in (1) is not necessarily what happens when the Fed raises rates by 1%
> 
> With the bond fund, yes if the rates *suddenly* increase by 1%, then the fund with duration=7 will decline by 7%. However once you start spacing it out over time, you're also getting interest earned on bonds, and new bonds that bring in higher levels of interest due to the increase in rates.
> 
> So yes it's true that a sharp increase in rates can cause that 7% price decline as you mention. However, gradual increases in rates won't cause that effect.


Well said James. No one knows what is in store for long-term interest rates, even in response to Fed rate changes. Investors forget that bond total returns are the combination of price changes and interest payments. And as older bonds mature or are sold off, newer bonds with higher rates are purchased, driving fund returns back up. 

I hold VAB and have no plans to sell any of it for at least 5 years and hopefully 10 years.

One minor point, and it's probably just semantics of how you wrote it, but you said "a specific govt bond with duration=7 and if the yield of that bond increases by 1% then yes, the price is expected to drop 7%". The cause and effect are actually the opposite. The price of a bond will drop until its yield increases to that of newly issued bonds (with similar risk and duration characteristics). Sorry but I could not resist pointing that out. :boxing:


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## 0okm9ijn

http://www.sensibleinvesting.tv/doc...8efe-79ee5a4055f2/acuity issue16 sensible.pdf

The above link is from the website sensibleinvesting.tv. For a novice investor, it's a good website.

The following isn't directly relevant to this thread, but it is to novice bond investors.

UK BBB bonds, from Nov 2007 to Feb 2009, declined 15% in value. I knew that junk bonds did poorly at that time. And I knew that high quality bonds increased in value during that time. But I didn't know what happened to bonds in between the two categories. BBB bonds are considered investment grade. It would be interesting to see what happened to A bonds during this time period. If BBB bonds were down 15%, my guess is that A bond might very well have had a modest loss during this time. If you're using bonds to diversify equity risk, then perhaps the minimum credit quality should be AA.

Edited to include the following. During the same time period, UK high yield went down 24% and UK stocks went down 41%. Were BBB bonds greatly different than junk bonds?


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## 0okm9ijn

http://www.servowealth.com/blog/be-careful-with-your-bonds

This is a followup on my last post. It seems that it's been too long to edit my last post, so I have to start a new post.

This is about what bonds went up in 2008 and what went down.

The link above shows US intermediate bond returns in 2008. High yield was down around -26%. Baa around -8%. A around -5%. Aa around +2%. Aaa around +8%. US Government (I assume Treasuries) around +10%.

There's a clear message here. In a flight to quality, the bonds that will diversify stocks are likely to be bonds with credit ratings of at least Aa. And you can make a case that Aa bonds didn't diversify stocks in 2008, although they did dilute them, just as cash would have done.


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## Pluto

CPA Candidate said:


> I feel the need to remind forum members not to get lost in calculation noise that doesn't matter. Whether you run your own bond fund or not, fixed income interest bearing securities for relatively young people is a poor use of capital. The proper way to refer to bond investments in the current environment is return-free risk. If everything goes great, you earn zero real return. If it goes bad, you can take a significant haircut on a "safe" investment.
> 
> The idea that in the end the investor gets their interest and capital back from a bond, and therefore nothing is truly lost, is false. The true loss is the lost opportunity to earn a higher return on another investment.


This is one of the smartest posts in the thread. 

If one is a bond holder, one is a loaner. It is better to be an owner. (Remember the Wealthy Barber? - be an owner, not a loaner.) Buy assets that produce income and hold for as long as possible.


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## Pluto

Argonaut said:


> Shiller PE is just an academic construct, something that may or may not be correlated with market direction, the answer of which we can definitely call an unknown. The 1-3 year Canada bond yield is 0.76%, that is a known. The capital gain upside you calculated on your 3 year bond was a meager 2.69%, that is a known. Negative interest rates is just wacky-town, so I'll ignore them. There's just no reason for myself and others to accept these poor returns, that are completely known.
> 
> Capital gain or loss of equities is unknown, but its maximum is unlimited and not capped like bonds. Aggregate dividend yield of a solid Canadian portfolio is about 4%, maybe a bit less nowadays. That is a known. There is always the possibility of a cut or suspension of dividend, but I would put that likelihood and impact (for high quality companies) about the same as bond default and call it a wash.
> 
> If you add up all the knowns and unknowns, bonds are just really not attractive right now for many people. There may be a place for bonds in some portfolios but one has to know that they are committing themselves to poor or negative returns, something I'm not willing to do. A bit of cash provides some of the same benefits with less of the risks.


Yep. 

It is pretty obvious bonds are doomed to loserville. Quality stocks with increasing earnings will outperform bonds.


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## james4beach

This thread was intended for me to track my bond portfolio, but you guys keep dragging me into bond debates.

Long term, Canadian bonds have shown solid real returns and certainly provide a role in portfolio diversification even at times (like the current instant) where their real returns are low.

You cannot predict bond prices. The consensus around here is to "avoid bonds and wait until rates are better" -- which is just a market timing attempt.

A bond fund, as opposed to an individual bond, provides ongoing exposure to bonds and the returns they generate. If interest rates go up, you benefit from an increase in returns over the long time. Many people misunderstand what a bond fund is, and confuse it with the issue of an individual bond, which certainly does plummet when rates rise. The key difference is that a bond fund maintains a constant maturity.


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## like_to_retire

Pluto said:


> If one is a bond holder, one is a loaner. It is better to be an owner. (Remember the Wealthy Barber? - be an owner, not a loaner.) Buy assets that produce income and hold for as long as possible.


There's always too much of a good thing. Asset allocation is important. There's a place for equities and there's a place for bonds in a portfolio. The percentages allocated to each is determined by many factors. Bonds have their place for security of capital and income that equities can't match during tough times.

ltr


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## john.cray

James,

I hope this isn't considered another diversion of the topic of this thread.

I was wondering what software (or otherwise methods) you use to keep track of your custom bond "ETF" and more importantly how do you compare it to VAB?
I am running my own REIT basket and wanted to use ZRE as a benchmark so I thought you might share some of your experience in this regard. In particular how do you compare beta, volatility, etc.

Cheers,
JC


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## james4beach

Hi John, the iTrade performance calculator gives me the monthly % change. I then just use a spreadsheet where I list my monthly % gains vs the Vanguard monthly % gains, which you can find in the first posts of my thread.

The most recent graphs I posted are just the cumulative gains by calculating, in a spreadsheet, the total return of the cumulative months together


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## john.cray

Thanks James,

That makes sense for comparing the total returns, which is probably the most important metric.

I was curious about other technicals like beta, correlation coefficient to markets and other funds and such. I guess you could use http://portfoliovisualizer.com for this to some extend. It seems to lack some historical data in certain cases but going forward should be fine.

Let me know if anything else comes to mind.

Cheers,
JC


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## james4beach

I haven't run those kinds of analyses. I'm starting by seeing if I can track VAB over a reasonably long period. If I am tracking it, then that means I have the same stats as VAB 

By the way, Scotia iTrade's Performance calculators look a lot nicer to me than TD's. I would love it if TD enhanced their tracking, being able to give numbers like monthly or quarterly returns (iTrade can do all this)

The primary reason I'm doing all this is, due to international tax issues, I can't hold VAB. Same story with XIU.

If I could, I would hold both XIU and VAB as my primary investments. Currently I think I've found alternatives to both that are actually a bit better.


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## john.cray

james4beach said:


> The primary reason I'm doing all this is, due to international tax issues, I can't hold VAB. Same story with XIU.


That's interesting. Now I am curious what those tax issues are? I've seen from previous posts of yours that you live in the US but how does that complicate the matter of holding Canadian listed ETFs? I know a lot of people hold US listed ETFs.


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## james4beach

john.cray said:


> That's interesting. Now I am curious what those tax issues are? I've seen from previous posts of yours that you live in the US but how does that complicate the matter of holding Canadian listed ETFs? I know a lot of people hold US listed ETFs.


I have become a "US Person" to use their term. US Persons should not hold foreign mutual funds or ETFs because these are called PFICs by the IRS and have burdensome reporting requirements. Plus, they confuse the IRS and are more likely to lead to lengthy and expensive follow-ups about your tax return. The only way to avoid this is to put the ETF inside your RRSP, which I do as much as I can.

Canadian bonds: I'd normally hold VAB or ZDB, but instead I hold a portfolio of individual bonds. Which isn't so bad as long as I can match VAB's performance. I like that I can control my credit quality and optimize it for taxes. My portfolio is probably more like ZDB than VAB, due to my focus on low coupon bonds.

Canadian stocks: I'd normally hold XIU (and I do hold some in the RRSP). But instead, I am replicating XIU by using its largest constituents as described in this thread. Theoretically, according to my back tests, this is a reasonably good way to do it. Others around here like Argonaut follow similar 5-pack and 6-pack approaches, so at least I'm in good company.


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## james4beach

Monthly performance update for my attempt to replicate VAB with individual bond holdings (as total return). My portfolio continues to track VAB very nicely. However, my average maturity at about 7 years is still less than VAB at 10 years. If the bond market strengthens now, I will likely underperform.


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## Eclectic12

james4beach said:


> ... Canadian stocks: I'd normally hold XIU (and I do hold some in the RRSP). But instead, I am replicating XIU by using its largest constituents as described in this thread.
> 
> Theoretically, according to my back tests, this is a reasonably good way to do it. Others around here like Argonaut follow similar 5-pack and 6-pack approaches, so at least I'm in good company.


If you care to dig up old copies of Canadian Money Saver in your library, there's been "10 stocks to beat the TSX" articles tracking progress going back to the '80's. There's lots more company for this approach, AFAICT.


Cheers


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## james4beach

I've got a problem here with my bond portfolio. My average maturity is about 7 years, versus VAB/XBB's 10 year point.

At times like this -- with bonds rallying strongly -- I'm underperforming. This is the same danger I've commented to many of you about, of the downside to "hiding out" in short term bonds. Sure it is safer if interest rates move sharply higher, *but under normal or typical circumstances*, you will forfeit performance in short term bonds. As VAB is my benchmark, my 7 year exposure is currently quite different than their 10 year exposure.

For example many people hide out in XSB or VSB out of fear of rising interest rates, and (perpetually) underperform VAB.


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## like_to_retire

james4beach said:


> I've got a problem here with my bond portfolio. My average maturity is about 7 years, versus VAB/XBB's 10 year point.


I would stay the course. I feel you are at the sweet spot. 

You're high if you believe the continual pundits who predict that rates are about to rise any minute. This prediction has perpetuated for years and years.

You're low if you believe rates are stagnant, and it's inevitable that the rates of the day will stand or even drop for many, many years to come. 

I'm a believer that 5-7 years is a sweet spot right now. 10 years, a bit long.

ltr


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## james4beach

like_to_retire said:


> I would stay the course. I feel you are at the sweet spot. . . .
> I'm a believer that 5-7 years is a sweet spot right now. 10 years, a bit long.


Thanks for the thoughts!


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## james4beach

I'm still underperforming VAB by a bit. However, my portfolio's tax efficiency is excellent. My current holdings have an average coupon (which is taxable interest income) of 1.7%. This is lower than both VAB (3.2%) and even BMO's tax optimized ZDB (2.1% avg coupon).

My taxable interest income is 47% lower than VAB and 19% lower than ZDB !!

This means that my after-tax returns are very good. Basically my performance is about as good as VAB, but with a much lower tax bill, so my after tax returns are much better overall.

Monthly performance tracking is below. This is before taxes.


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## james4beach

My individual bond portfolio (consisting of government bonds + CDIC eligible GICs) continues to track VAB reasonably well, but I'm still underperforming. I'm a bit perplexed by this. My average duration is less than VAB, so in the June & July period where interest rates went up, I thought I would outperform VAB. The opposite happened.

One possible explanation is that VAB's corporates are doing very well. Anyway, difference since inception isn't too different; I'm underperforming by 0.3%. I wish I had a better understanding of why I'm underperforming Vanguard.

Here is updated pre-tax performance:


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## james4beach

My performance kept slipping in 2017. According to the brokerage's rate of return calculation (which is probably correct since there were no options, in-kind transfers, or journals) my bond portfolio returned 0.68% for 2017 vs something like 2.1%-2.3% for VAB.

That's unfortunate, but I know why this happened. It was mainly due to cash drag and failing to consistently stay invested at the average 10 year maturity spot. The bond funds (like VAB and XBB) maintain a constant average maturity at 10Y. What I had not anticipated is that my bond coupon payments, a few hundred dollars each, create significant cash but _not enough to purchase new bonds_. In the early part of the year I had new money coming in, which let me buy the bonds I needed -- resulting in better VAB tracking. My under performance started when I no longer had the fresh cash being added, and therefore could not buy new bonds to maintain the portfolio target average maturity.

My average maturity (not duration) was only 6.1 versus XBB/VAB at 10 years. This was particularly painful actually because the bond market performed worse at these shorter maturities than the long ones!

As I look at this more I am appreciating just how amazing the funds like XBB are.

Unfortunately I can't currently hold XBB or VAB due to some international tax reasons. My two options at the moment are to keep running my own bond portfolio, learning from these mistakes, or to use a 5 year GIC ladder. (This is another way to maintain constant maturity by the way).

I'd still prefer to go with bonds due to their liquidity. I'm just not sure how to handle this cash drag issue. One step is to withdraw cash from the portfolio instead of letting it accumulate, and only add it back in when it's enough to purchase a new bond.


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## james4beach

In short, my advice for a fixed income investor is to buy XBB or VAB if at all possible  Or ZDB for non registered.

Beware cash drag. This is the exact same issue that hurt my performance in a large portfolio I had set up.


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## hlpme

What is the target duration of your bond fund?


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## james4beach

hlpme said:


> What is the target duration of your bond fund?


My target average maturity is 10 years (I'm using maturity not duration). That's the same average maturity as XBB, VAB and most generic bond funds.


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## hlpme

james4beach said:


> My target average maturity is 10 years (I'm using maturity not duration). That's the same average maturity as XBB, VAB and most generic bond funds.


May I ask what is the rationale behind using 10 years? I see a preference towards shorter-term nowadays, thanks to the 30yr bond bull market in U.S. It will be interesting to hear your reasons since you have gone the other way.


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## james4beach

hlpme said:


> May I ask what is the rationale behind using 10 years? I see a preference towards shorter-term nowadays, thanks to the 30yr bond bull market in U.S. It will be interesting to hear your reasons since you have gone the other way.


Targeting the 10 year part of the curve is pretty common, it's what every balanced fund does including the top ones in Canada (Mawer Balanced Fund, etc). I don't anticipate needing the money in less than 10 years. This is just about matching my needs and time horizon to the investment.

Someone who might need the money in a year or two for major purchases should go with short term bonds, though.


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## james4beach

An update of my bond portfolio, vs VAB. I think this experience is teaching me that it's hard to compete with a professionally run, big bond fund (specific reasons below). There are many tangible reasons to go with a big, diverse bond ETF like VAB/XBB. Furthermore, my 2017 total performance was +0.69% vs +2.31% for VAB. Ouch.









I've identified a few reasons I've been underperforming. Hopefully sharing this will help others who manage their own fixed income portfolios:

1. *Cash drag*. Unfortunately, I let a few thousand $ of cash accumulate from coupon payments and sit dormant. I smartened up and got rid of the excess cash in January. Interestingly the tracking got worse as the cash accumulated, and the tracking improved immediately after I eliminated cash. Because of this I suspect that the cash drag had a significant effect. Also interestingly, this isn't the first time cash drag has hurt my performance in a portfolio. The 10-year critique of my largest stock ETF portfolio also showed that my performance suffered due to cash drag and failing to immediately redeploy funds.

2. *Fund activity and management*. In the first few months of running this portfolio, a lot of cash started moving into the account. This gave me the flexibility to regularly buy new bonds and also to use other tricks like rolling down the yield curve. Notice how strong the tracking was, initially. However once the portfolio filled up, it became totally static and I was no longer buying new bonds. That's around when tracking became worse. A real bond fund/ETF is constantly adjusting its holdings and *due to its big size*, generates so much coupon cashflow that it can always buy new bonds. A retail investor probably can't unless the portfolio is close to 1M.

3. *Corporates outperformed in 2017*. One theme last year was the strong performance of corporate bonds. While VAB returned +2.31%, a pure govt fund like XGB returned only +1.71%. I only hold government bonds (due to their liquidity), so it's natural that I'd underperform in a year that govt bonds underperformed.


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## OnlyMyOpinion

James,
You deserve a tip of the hat from all of us for your willingness to experiment and to report your reults to the readers of CMF.
I'm not aware of anyone else who is as inquisitive a financial DIY'er, one who builds 'test' porfolios and then diligently tracks and report their results. KUDOS. :applause::applause:

Cash drag - bingo. That is why in spite of having to track ACB in non-registered accounts (not really a big deal), I am a proponent of synthetic DRIPs. Having cash dribble in through the year and sit there until it is sufficient and I am prepared to reinvest it is just too inefficient for us.


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## james4beach

Thanks OnlyMyOpinion. I really would have just used ETFs if I could, but these international tax complications push me towards individual securities instead.

Normally in a non-reg account, I would hold GICs and ZDB (the BMO Discount Bond ETF) which are both tax efficient. I still really like that my small coupon, individually held bonds are more tax efficient in non registered, but I'd probably be better off in ZDB. Inside a tax shelter, obviously XBB or VAB.


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## JohnZ7

Very good information, james4beach. I often think of investing more in VAB or XXB but haven't pulled the trigger. My portfolio is currently about 28% cash and only 7% in diverse bond funds. One reason I can't have all my fixed income go into bonds is that I have significant cash outside of registered accounts. I don't think it makes sense to invest in bonds funds outside of a registered account due to the taxes. I do have some bonds in a non-registered account (ZDB), which is more suitable for non-registered accounts. In the few years I've had it, my return in ZDB has been higher than what I've got in GICs and HISAs, so it may be worth buying more. You've certainly given me something to think about!

John


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## james4beach

Hi John, GICs are a good option too in non-registered.


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## CPA Candidate

JohnZ7 said:


> I don't think it makes sense to invest in bonds funds outside of a registered account due to the taxes.
> 
> John


Well actually, it can. An issue is people focus on rates of taxation rather than the actual amounts payable. Bonds are tax inefficient, but offer small returns and therefore, small taxable amounts. Using space in registered accounts for low yielding investments displaces potentially higher returning assets. Wouldn't you rather shelter the investments with the highest potential return? Nearly everyone has this backwards, and you even find professionals, giving this poor advice.


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## like_to_retire

CPA Candidate said:


> Using space in registered accounts for low yielding investments displaces potentially higher returning assets. Wouldn't you rather shelter the investments with the highest potential return? Nearly everyone has this backwards, and you even find professionals, giving this poor advice.


But don't we have to also consider the inability to claim a capital loss of those potentially higher returning assets that's exclusive to the taxable account? Not an issue if things are going well, but when they aren't it's a different matter.

ltr


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## OnlyMyOpinion

CPA Candidate said:


> ... Bonds are tax inefficient, but offer small returns and therefore, small taxable amounts. Using space in registered accounts for low yielding investments displaces potentially higher returning assets. Wouldn't you rather shelter the investments with the highest potential return? Nearly everyone has this backwards, and you even find professionals, giving this poor advice.


I don't think you can say unequivocally that having FI in registered accounts is "backwards" and "poor advice". The magnitude, makeup and current income needs of everyone is different. Particularly so for those busy accumulating versus those living off their income. 

For example, holding a large FI component outside of a registered acc means a large taxable amount that is payable each year on accrued interest. As LTR notes, holding equities inside a registered account means a loss of the dividend tax credit and ability to claim any losses. 

Disclosure: I have FI and equities in both registered and unregistered accounts.


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## Jimmy

CPA Candidate said:


> Well actually, it can. An issue is people focus on rates of taxation rather than the actual amounts payable. Bonds are tax inefficient, but offer small returns and therefore, small taxable amounts. Using space in registered accounts for low yielding investments displaces potentially higher returning assets. Wouldn't you rather shelter the investments with the highest potential return? Nearly everyone has this backwards, and you even find professionals, giving this poor advice.


Actually if you have room in your RRSP and TFSA, you are better off to put the lowest yielding assets in your RRSP and the highest (stocks, ETFs) in your TFSA. This will reduce the amount of tax on the gains when withdrawn from either. 

TFSA's will pay no tax on the gains. RRSP income from withdrawals is taxed at your marginal tax rate ( in ON min 20% combined). So you want assets w the highest gains in the TFSA.


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## james4beach

After the BoC decision, I bought 2028 Government of Canada bonds (10 years to maturity) at 2.26% yield. These have a 2% coupon and will produce 2% interest income per year even though they guarantee a 2.26% return.


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## AltaRed

james4beach said:


> After the BoC decision, I bought 2028 Government of Canada bonds (10 years to maturity) at 2.26% yield. These have a 2% coupon and will produce 2% interest income per year even though they guarantee a 2.26% return.


Meaning you bought at a discount to $100.


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## james4beach

AltaRed said:


> Meaning you bought at a discount to $100.


Yes, a discount bond that will give me a capital gain. This is the same trick used by ZDB to get the bond exposure while staying tax efficient. This bond is taxed more lightly than an equivalent GIC, for example. And it's taxed much more lightly than the bonds in XBB.

(A complication is that GICs offer higher yields, but there are other factors at play such as liquidity, credit quality and ability to roll down the yield curve)


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## JohnZ7

CPA Candidate said:


> Well actually, it can. An issue is people focus on rates of taxation rather than the actual amounts payable. Bonds are tax inefficient, but offer small returns and therefore, small taxable amounts. Using space in registered accounts for low yielding investments displaces potentially higher returning assets. Wouldn't you rather shelter the investments with the highest potential return? Nearly everyone has this backwards, and you even find professionals, giving this poor advice.


If you have no more room in your registered accounts and assuming that you've hit your asset allocation target of equities within such accounts, I can see the logic of putting the lower yielding assets in a taxable account; this being said, in such a case, I still think it'd be better to put your money into HISAs or GICs than in bond funds in non-registered accounts. The exception would be discount bonds (e.g., ZDB ETF), which would be more tax-efficient in a non-registered account.

John


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## james4beach

Portfolio update... average maturity of my bond portfolio is now up to 8.4 years and there is no cash. Hopefully this will give better tracking of VAB/XBB.

I must keep reminding myself to look back at these reasons I'm underperforming XBB.


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## james4beach

Update: for the first half of 2018, my portfolio made up of individual bonds + GICs is _exactly_ tracking VAB's total return. So far, it looks like the cash drag was my big problem, but I resolved that in January.

If you're interested, see this post for my illustration of how a bond fund price moves in the long term. I've gotten these insights through running this bond portfolio and seeing these effects first hand.


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## james4beach

Checking up on performance/tracking.Year-to-date total returns to end of July are


Code:


VAB (NAV)    -0.23%
My portfolio -0.13%

So I'm still precisely matching VAB.


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## james4beach

I took a look at my fixed income portfolio to see how the ladder looks. The numbers below are the years to maturity, and the goal is to fill the ladder out over 10 or more years.



Code:


Type	Years
----	-----
gic	0.8
gic	1.9
gic	2.2
bond	4.6
bond	7.2
bond	7.6
bond	8.6
bond	9.6

It's looking a bit thin in the upcoming years. Ideally, I want to fill this out so that something is maturing regularly. In the coming weeks, I'm going to buy a 3 year and 5 year GIC.

Any other ideas for next steps?


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## james4beach

I've filled in the ladder a bit more (below is a graphic of the maturity schedule in years). Every few months, I'll buy a new 5 year GIC, and this will fill in the gap seen between 5-7 years. I'll also occasionally buy bonds, which are needed for liquidity.


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## james4beach

My 2018 performance so far to end of November is +0.65%, compared to -0.07% for VAB (based on NAV reported by Vanguard)

It hasn't been a great year for bonds, but I'm happy that I'm now outperforming VAB. Looking forward to seeing the full year result.


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## Pluto

This is interesting. Beating the etf's. A worthy goal.


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## james4beach

My 2018 fixed income portfolio performance was 2.62% as a money-weighted rate of return, and 1.82% as (approx) time weighted rate of return using Justin Bender's calculator. The 1.82% figure is more useful for benchmarking.

I don't think the official numbers are out yet, but Morningstar says VAB returned 0.96% in 2018. iShares says XBB returned 1.28%

It seems that 2018 was a good year for my fixed income portfolio, slightly outperforming VAB/XBB.


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## scorpion_ca

Have you compared the return against ZAG?


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## james4beach

scorpion_ca said:


> Have you compared the return against ZAG?


I haven't. I figured that XBB, VAB, ZAG were all pretty similar.


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## scorpion_ca

james4beach said:


> I haven't. I figured that XBB, VAB, ZAG were all pretty similar.


I think CCP mentioned that ZAG has around 10% more corporate bonds than other two ETFs.


----------



## goldman

I think this is great James what you're doing here in this thread to document what you're doing with buying individual bonds so the rest of us can learn. 
I'm just catching up on this thread so my appologies if you've already said before what broker you recommend for buying individual bonds . 
I recall you saying earlier that you trade with IB. Have you been using IB for trading bonds? If not what broker do you recommend? 
I'm currently looking at IB as a broker and considering buying a bunch of individual bonds like you've been doing here. 

I find it amazing in this day and age of technology that retail bond trading is so far behind. It lacks transparency and the mark ups are absurd. 
I can buy 1000 or 100,000 in stock for $7 instantly with just a few pennies wide on the bid/ask spread with live quotes.
Options may have less volume but the US fees are $5 and some have pennies wide on the spread with live quotes.
The bond market is larger capitalization than stocks but bonds at most of the big banks are still OTC markets, not live quotes, charge large markups of nearly 1% etc
Paying a broker $85 commission in the spread for a 10,000 bond investment seems ridiculous. 
Its odd that the retail trader experience for this lower risk investment class remains so far behind.


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## AltaRed

Pick a brokerage with transparency, e.g. one that specifically provides the bid/ask spread and charges, for example, $1/$1000k of face value with a $24.99 minimum like I do.

P.S. I always buy in $20-30k increments.....


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## goldman

AltaRed said:


> Pick a brokerage with transparency, e.g. one that specifically provides the bid/ask spread and charges, for example, $1/$1000k of face value with a $24.99 minimum like I do.
> 
> P.S. I always buy in $20-30k increments.....


Any specific recommendations of which brokers? I'm guessing Scotia iTrade or Qtrade? 
Also, its worth comparing the brokers Bid /Ask spread quotes to IB, Candeal, and PFIN/CBID to to see how fair or competitive their prices are compared to the live spot price at the exchanges.


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## james4beach

I'm using Scotia iTrade for all my individual bonds. Over the years I have compared their inventory and pricing (considering total free structures of both) with TD and found iTrade was better for the government bonds I buy, typically in units of 20K and up. The iTrade fee structure is transparent at $1 per 1K face, with $25 minimum.

From what I can tell, their quotes are based on PFIN/CBID. For example, iTrade's quote for the 2028 benchmark government bond is ask=100.403 which is the same as the public quotes on the PFIN page... rather, it's actually a hair less at iTrade than the PFIN page shows.

I have not compared to Interactive Brokers.



goldman said:


> I think this is great James what you're doing here in this thread to document what you're doing with buying individual bonds so the rest of us can learn.


Thanks. Going through this exercise has more or less eliminated my fear of fluctuations and volatility in bond prices (this is a common fear as you know). Since I hold the securities to maturity, I won't be forced to ever have a loss. I see the prices fluctuate but it doesn't matter. The yield for each security is locked in and guaranteed at the moment I buy it, plus liquidity and the option to redeploy or ride the yield curve, if it's steep enough.

Here's a chart of my current ladder. I would like to fill in more 10+ year bonds but currently, GICs have significantly better yields. I treat this as one big ladder with bonds and GICs sprinkled throughout it (where bonds provide liquidity).


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## AltaRed

Yes, it is Scotia iTrade. As James alluded too, market prices change continuously so any comparisons on the same issue, or virtually identical issue, has to be done quickly, e.g. same day. That is understandable since the yield curve changes daily. Like James, I don't care since I lock in the yield to maturity and let the bond mature. For a retail investor, that is all that really matters.


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## longinvest

Interesting thread.



james4beach said:


> Going through this exercise has more or less eliminated my fear of fluctuations and volatility in bond prices (this is a common fear as you know). Since I hold the securities to maturity, I won't be forced to ever have a loss. I see the prices fluctuate but it doesn't matter. The yield for each security is locked in and guaranteed at the moment I buy it, plus liquidity and the option to redeploy or ride the yield curve, if it's steep enough.


James, given your experience, what do you think is the main advantage of maintaining such a bond fund instead of just buying a bond ETF like XBB, ZAG, or VAB? Any drawbacks?


----------



## james4beach

longinvest said:


> Interesting thread.


Thanks. Performance continues to be similar to XBB or VAB though I think I'm now a bit behind with this recent big increase in XBB.



> James, given your experience, what do you think is the main advantage of maintaining such a bond fund instead of just buying a bond ETF like XBB, ZAG, or VAB? Any drawbacks?


Here are the pros and cons I see of my DIY approach with individual bonds

*Pros*:
+ total control over each instrument I buy (credit risk, quality, etc)
+ tax optimization, since I can buy low coupons non-reg. _But ZDB does this too._
+ avoiding PFIC tax concerns for US Persons, which was a big factor for me
+ ability to sell only bonds close to maturity, instead of selling XBB which sells everything
+ (psychological) assurance of guaranteed yields, eliminates fear of rising interest rates

For the last one I says it's "psychological" because the net result is the same as a bond fund. Everything a bond ETF holds also provides a guranteed yield, but people usually don't think of that. It becomes obvious when you hold the underlying bonds yourself, and their prices also fluctuate. For me it has been helpful holding them individually because it's showed me what actually goes on inside a bond fund. This has almost entirely eliminated my fear of rising interest rates.

It's also given me a new perspective, seeing how great bond funds are. Even in a rising interest rate scenario, they are guaranteed to provide positive returns over the long term. Any price drops are guaranteed to be temporary. This was a hard thing to wrap my head around, but bond funds are an excellent structure.

*Cons*:
- there's extra work involved; it's _much_ easier buying XBB, ZAG, VAB, ZDB
- it's hard to maintain average maturity for the portfolio. You have to be vigilant.
- I've experienced lower performance because of mistakes I made managing duration
- liquidity is worse than the bond ETF, especially when including GICs in the mix

If I didn't have the US tax (PFIC) concern when I started this, I might have been just as well off using ZDB. When I started I thought I'd be able to get a higher return because of the 5 year GICs in the portfolio. But it turns out that other advantages the bond funds have -- rolling down the yield curve, wider range of higher yielding bonds, professional management -- makes up for the difference, and I tend to do worse than the real bond funds.


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## Park

james4beach said:


> But it turns out that other advantages the bond funds have -- rolling down the yield curve, wider range of higher yielding bonds, professional management -- makes up for the difference, and I tend to do worse than the real bond funds.


Could you go into more detail about a wider range of high yielding bonds?


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## AltaRed

Park said:


> Could you go into more detail about a wider range of high yielding bonds?


Diversification. Bond funds can afford to have a greater percentage of BBB and even BB bonds because of the diminishing effect of any one high yield bond going 'teats up'. An individual retail investor cannot afford the risk of holding individual junk bonds... Remember that 'high yield' is just a fancy way of saying 'junk'.


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## james4beach

Yes the bond funds can afford to have some higher yielding junky or risky stuff. Look at XBB for example, which I consider one of the best bond funds: https://www.blackrock.com/ca/individual/en/products/239493/ishares-canadian-universe-bond-index-etf

No need to guess at the holdings... click to download the full spreadsheet. Let's take a look inside:

If you scroll down column O (the yield to maturity), you'll see them. You've got some Newfoundland 2046 bonds at 2.51% yield. How about Health Montreal Collective 2049 at 3.66%. Or how about Shaw Communications 2039 (those are 20 year bonds!) at 3.99% yield. They even hold some Enbridge 2078 .... note that is *59 years* to maturity ... at 5.98% yield. It's probably some fancy corporate bond that is not standard fixed all the way to 2078, something a bit tricky.

If I had a 500K bond portfolio of my own, these would be some pretty insane things to buy. The 30 year Quebec financing bond? 59 year Enbridge bond? No way.

But in XBB's $3 billion portfolio, they can afford to take those risks. They are tiny weights in the portfolio. 75% of XBB is rated AAA & AA, the best stuff. And I've monitored XBB over nearly 20 years and they have consistently managed their risk pretty well, holding mostly the best quality bonds and limiting their corporate & low grade holdings.

Big bond funds have a huge diversification advantage. In my own individual bond portfolio I only hold government bonds (for liquidity) plus 5 year GICs for a yield boost. I don't venture into corporate bonds.


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## AltaRed

I do differently. I mix in a few corporate bonds of BBB and BBB+ into my 5 year GIC mix. The likes of Enbridge and Fairfax Financial for example. Government bonds can't offer what GICs do so I have not bought any for about 20 years.


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## james4beach

AltaRed, do you find the corporates are liquid enough if you need to withdraw money? The reason I have government bonds is that they are perfectly liquid, virtually no spread to sell. I thought I saw much larger spreads on corporates.


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## AltaRed

I don't sell them. I let them mature. Longest duration I have bought is 7 years but mostly 5 years to fit in my 5 year ladder.

Added: Meaning 5-7 years left in the bond's term. For example, I hold an old BC Tel bond right now with about a 9.6% coupon. I obviously bought it at a premium but I don't care in my RRSP. My YTM when purchased a few years ago is in the 3% range. Darn good for a Telus bond at that time of low interest rates.


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## Park

I'm basically a taxable investor, so low coupon bonds get my attention. Is it possible for the individual investor to do better than ZDB with low coupon bonds? Can you have greater tax efficiency with a DIY low coupon bond portfolio, as opposed to ZDB?

P.S. I've come to the conclusion that the best bond exposure I can get is CPP. This assumes that at approximately age 65, my expected lifespan isn't significantly below my peers.


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## AltaRed

CPP (or any guaranteed and even partially COLA'd annuity) is the best fixed income one can have.

In a taxable account, it is indeed better to use something like ZLB but yields by definition will be low.


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## james4beach

Park said:


> I'm basically a taxable investor, so low coupon bonds get my attention. Is it possible for the individual investor to do better than ZDB with low coupon bonds? Can you have greater tax efficiency with a DIY low coupon bond portfolio, as opposed to ZDB?


ZDB does a pretty good job at it. My bond & GIC portfolio: scaling down to $100 value, the taxable interest for this year will is $1.92.

ZDB: scaling up to $100 value, taxable interest for the year is estimated at $2.10 based on the average coupon rate and monthly distributions. This is just an estimate though. Sometimes ZDB has return of capital, which would reduce taxable interest below the $2.10.

Those numbers are pretty similar. Based on this I think I'd recommend someone go with ZDB for tax reasons unless there are other important reasons they want to bother with individual bonds. I described my various reasons, the benefits in this post.


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## james4beach

After a few years of getting up to speed with this, I think I finally have my own "bond fund" working as I want it. The performance is pretty close to XBB and VAB which means that it's been providing a nice cushion (gains) during this recent turmoil.

My bond portfolio is also reasonably tax efficient as I hold mostly discount bonds, or at least bonds with low coupons.

The big lesson I learned with individual bonds is that you have to manage the *weighted average maturity* of your portfolio. XBB and VAB are at 10 to 11 years, but my bond portfolio is 7 years. I'm going to keep it at 7 years for a while and see how that goes. Note that this means I have to keep buying longer term bonds as bonds/GICs mature.

This is actually pretty challenging to pull off. The shorter maturities in my bond portfolio are mostly GICs (0 to 5 years) but to get the average up to 7 years, that means you have to buy some really long term bonds too!

For example, I hold government bonds maturing in 2028, 2029, 2030, and 2051. As you can guess, these were not easy to buy. It just feels wrong to buy a 30 year bond, but it's necessary in my case to get my average maturity up to 7 years.

Also interesting... that 2051 bond I bought at 1.6% yield is now the most profitable position in my portfolio. The price is up 17% since I bought it, a powerful response to the recent interest rate declines.

I still like managing my individual bonds, but it's a lot of work and there are many psychological hurdles to get through. I don't think I would recommend this to others unless they are bond enthusiasts. It's pretty hard to maintain a constant average maturity and it's also a lot of work to evenly spread out maturities over many years.

Much easier to just buy VAB, XBB or ZDB (tax efficient)

Basically though, my approach is an extension of the GIC ladder and I find that this is the easiest way to think of it. With a 5 year GIC ladder, you space out your GICs evenly, continually roll over the GICs, and maintain the average maturity at 3 years.

Similarly, with my bond portfolio, I maintain a 10 year ladder, evenly space out the instruments, continually roll over maturing amounts and maintain average maturity at 7 years.

It's really the same process but somehow it feels very different. There's actually a GIC ladder inside my broader 10 year ladder.


----------



## like_to_retire

james4beach said:


> The big lesson I learned with individual bonds is that you have to manage the *weighted average maturity* of your portfolio. XBB and VAB are at 10 to 11 years, but my bond portfolio is 7 years. I'm going to keep it at 7 years for a while and see how that goes. Note that this means I have to keep buying longer term bonds as bonds/GICs mature.
> 
> This is actually pretty challenging to pull off. The shorter maturities in my bond portfolio are mostly GICs (0 to 5 years) but to get the average up to 7 years, that means you have to buy some really long term bonds too!


Yeah, I can see how you would have to go fairly long with the bonds to get a 5 year GIC ladder's weighted average maturity up to 7 years. My ladder's spreadsheet calculates all sorts of stuff such as weighted average maturity and duration as it use to involve mostly bonds, but I have gravitated to GICs over the years as they have become the best choice in the 0-5 year's ladder construction.

With ladders exclusive to GIC's I have a weighted average maturity of 3.32 years today as I just renewed a couple rungs last month. That means if I wanted to increase the weighted average maturity to 7 years by purchasing bonds, I would need some fairly long maturity dates. I see why you're buying 30 year bonds.

ltr


----------



## james4beach

like_to_retire said:


> With ladders exclusive to GIC's I have a weighted average maturity of 3.32 years today as I just renewed a couple rungs last month. That means if I wanted to increase the weighted average maturity to 7 years by purchasing bonds, I would need some fairly long maturity dates. I see why you're buying 30 year bonds.


Yup, it would take a lot to increase yours to 7 years. And I initially hated the idea of buying something as far out as 10 or 30 years. It just doesn't feel like a good idea... but really it's the same problem as buying a 5 year GIC. It doesn't always feel great buying 5 year GICs because of the inverted yield curve, etc.

You could try a smaller step and try increasing your weighted average maturity to 5 years, which would involve buying some longer dated bonds without having to go too far out on the yield curve.

Really, these are passive strategies. It took me about 3 years to understand and digest the idea that these are passive approaches to fixed income. There is no attempt to time the bond market.

I like the individual bond approach from the standpoint of the "threat" of rising interest rates. If rates increased dramatically, the price of VAB would plummet. The value of my bond portfolio would plummet as well, but soon enough, some bonds/GICs would mature and have to be reinvested. I then get to buy the now far superior yields at 5 years, 10 years, 20 years, whatever is needed to maintain the ladder.

And even though my existing bonds would have plummeted in value, I also have the peace of mind knowing that each one of them matures with guaranteed return of capital.


----------



## james4beach

Boy did this conservative method work out well. And to think that I was about to give up on it!

For quite a while, I was frustrated by how I was underperforming standard bond ETFs. I think it had to do with some amazing performance from corporate bonds, during their bubble (until they blew up spectacularly recently). I wasn't underperforming by too much, but it was still enough to frustrate me ... until recently!

I had been picking individual AAA rated government bonds, mixed in with GICs, for ultimate safety. All this time I had been worried about interest rates, when it turns out that the storm coming was in fact a corporate bond catastrophe. So far, this portfolio of individual bonds & GICs has escaped all of that unscathed.

Additionally I want to mention how well Scotia iTrade's platform has held up during this turmoil. I did not place any bond trades during this crash, but the fixed income platform seemed to still work as normal including showing quotes that seemed about right. I was very carefully checking the pricing that iTrade was showing me.

To show you how well the pricing of these bonds held up, here's a table of some daily portfolio values during the catastrophe. I've normalized the starting value to 100k to hide my actual value.



Code:


2020-02-25    100,000
2020-02-26    99,932
2020-02-28    100,323
2020-03-02    100,893
2020-03-03    101,320
2020-03-04    101,443
2020-03-05    101,918
2020-03-06    102,959
2020-03-17    101,340
2020-03-18    100,586
2020-03-19    100,830
2020-03-20    101,360
2020-03-23    101,822
2020-03-24    101,584
2020-03-26    101,519
2020-03-27    102,016

That's a 2% increase since Feb 25. In comparison, most bond ETFs are down 3% to 5% since then.

It's possible that in the long term, the bond ETFs will still outperform my method, but what I saw during COVID-19 is that the added peace of mind and price stability of these AAA's is worth it. I am happy to forfeit some long term performance.

I will add that managing a bond portfolio is not exactly easy, which is why I have not recommended it to others. Inside both my RRSP and TFSA, I hold XBB. Obviously those were (and still are) getting hit hard by the corporate bond crash but I still think XBB is a pretty well diversified portfolio with reasonably good credit quality. I am very surprised it has gotten hit so hard, but I think it shows just how severe the corporate bond crash is.


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## Money172375

There is a theory that active management tends to do better in downturns, while passive tends to outperform in rising markets. Many fund companies promote this.......”we won’t knock your socks off all the time, but we’ll save your backs when it gets ugly.“. Research I’ve seen shows consumers would rather take a fairly certain 5% return, than a less certain 8-10% return.


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## james4beach

Money172375 said:


> There is a theory that active management tends to do better in downturns, while passive tends to outperform in rising markets. Many fund companies promote this.......”we won’t knock your socks off all the time, but we’ll save your backs when it gets ugly.“. Research I’ve seen shows consumers would rather take a fairly certain 5% return, than a less certain 8-10% return.


Interesting. My own experience confirms this. All of these strategies I consider somewhat experimental (for example, this individual bond portfolio & 5-pack) seemed kind of pointless during the bull market. But now they have all been outperforming indexes during the bear market. Suddenly all my non-indexing effort appears to be worth it.

But I think the problem remains: can one consistently implement these active strategies long term? We know this is difficult. Indexing (holding a bunch of ETFs) still offers a major long term advantage. Perhaps that still outweighs the greater volatility and drawdowns in the shorter term?


----------



## andrewf

james4beach said:


> Boy did this conservative method work out well. And to think that I was about to give up on it!
> 
> For quite a while, I was frustrated by how I was underperforming standard bond ETFs. I think it had to do with some amazing performance from corporate bonds, during their bubble (until they blew up spectacularly recently). I wasn't underperforming by too much, but it was still enough to frustrate me ... until recently!
> 
> I had been picking individual AAA rated government bonds, mixed in with GICs, for ultimate safety. All this time I had been worried about interest rates, when it turns out that the storm coming was in fact a corporate bond catastrophe. So far, this portfolio of individual bonds & GICs has escaped all of that unscathed.
> 
> Additionally I want to mention how well Scotia iTrade's platform has held up during this turmoil. I did not place any bond trades during this crash, but the fixed income platform seemed to still work as normal including showing quotes that seemed about right. I was very carefully checking the pricing that iTrade was showing me.
> 
> To show you how well the pricing of these bonds held up, here's a table of some daily portfolio values during the catastrophe. I've normalized the starting value to 100k to hide my actual value.
> 
> 
> 
> Code:
> 
> 
> 2020-02-25    100,000
> 2020-02-26    99,932
> 2020-02-28    100,323
> 2020-03-02    100,893
> 2020-03-03    101,320
> 2020-03-04    101,443
> 2020-03-05    101,918
> 2020-03-06    102,959
> 2020-03-17    101,340
> 2020-03-18    100,586
> 2020-03-19    100,830
> 2020-03-20    101,360
> 2020-03-23    101,822
> 2020-03-24    101,584
> 2020-03-26    101,519
> 2020-03-27    102,016
> 
> That's a 2% increase since Feb 25. In comparison, most bond ETFs are down 3% to 5% since then.
> 
> It's possible that in the long term, the bond ETFs will still outperform my method, but what I saw during COVID-19 is that the added peace of mind and price stability of these AAA's is worth it. I am happy to forfeit some long term performance.
> 
> I will add that managing a bond portfolio is not exactly easy, which is why I have not recommended it to others. Inside both my RRSP and TFSA, I hold XBB. Obviously those were (and still are) getting hit hard by the corporate bond crash but I still think XBB is a pretty well diversified portfolio with reasonably good credit quality. I am very surprised it has gotten hit so hard, but I think it shows just how severe the corporate bond crash is.


Is the long-run performance penalty worth a slightly better (less bad) drawdown?


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## james4beach

andrewf said:


> Is the long-run performance penalty worth a slightly better (less bad) drawdown?


Good question


----------



## james4beach

Another way to look at this could be, the significant choice I made was holding government-only and holding no corporates. A passive indexer can still do the same. They could have used XGB instead of XBB. Morningstar shows the performance as

XGB, 2.30% over 5 years, 3.87% over 10 years
XBB, 1.77% over 5 years, 3.69% over 10 years

Until recently, XGB was the underperformer (due to that bubble in corporate bonds) which is basically the same thing I was experiencing


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## Money172375

andrewf said:


> Is the long-run performance penalty worth a slightly better (less bad) drawdown?


problem is, the average retail investor loves to sell in down markets. They crave consistency more than beating the market.


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## james4beach

I looked at performance numbers year-to-date of my fixed income portfolio. I was curious to see what the net result was, after the bond ETFs rebounded in April, recovering from their crash.

YTD total returns (as of April 30)
Me: 7.0%
VAB: 5.3%
XBB: 5.3%

I'm still beating the bond ETFs this year. Here's a chart of my maturities, excluding a 30 year bond. I think the spacing is pretty good right now and there's lots of liquidity thanks to the bonds. Below 5 years, it's nearly all GICs. Above 5 years, all federal government bonds.


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## james4beach

I checked the performance again, now that the bond ETFs have recovered fully and the corporates crash is over.

YTD total returns at June 30
Me: 7.7%
VAB: 7.5%
XBB: 7.3%

Good to see that performance is similar for the year. No complaints here, it's a good year for my fixed income portfolio.


----------



## james4beach

This has been a good year for my fixed income portfolio (mix of bonds & GICs). You can see in the chart that I am meeting my goal of tracking VAB.

My portfolio is concentrated in government bonds, so it did not crash the way VAB/XBB did. The bond crash was much worse than pictured below because these are just monthly changes, and in March, corporate bonds fell even harder -- which isn't captured in this graph.

Overall I continue to like the strategy a lot, especially because I've never been a fan of corporate bonds and this lets me avoid them and substitute GICs.


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## james4beach

I continue to replicate VAB (the generic bond fund) using individual Government bonds and GICs. In 2021 so far, I'm outperforming VAB. Going back to the start of 2020, shown below, I'm slightly underperforming... but these are very close overall.

One advantage of this method is that I can withdraw from the short maturity bonds and GICs in my portfolio. If I held VAB, my only choice would be to sell all bonds at once, which wouldn't be great if bond prices were currently down.

It's kind of like holding VAB or XBB as a long term bond holding, but also having access to a virtual XSB in there, with the freedom to sell just that. Plus this is more tax efficient than VAB because I use discount bonds, and I got some juicy discount bonds in recent months.

@AltaRed @like_to_retire @agent99


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## Covariance

Your GICs don't benefit/suffer from price return whereas a bond does. Thus the ETF (which holds bonds) gave it up as rates rose but got it back when rates dropped because fo the price return.


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## james4beach

Covariance said:


> Your GICs don't benefit/suffer from price return whereas a bond does. Thus the ETF (which holds bonds) gave it up as rates rose but got it back when rates dropped because fo the price return.


Yes I think that's right. The GIC "prices" don't react. This could also work against me. Let's say interest rates plummet in the next few years. A bond fund would rise sharply in value, whereas my GICs don't change... so my portfolio would see only some of the gain of a bond fund.

It seems to me that adding GICs into my bond mix just reduce the volatility of my portfolio.


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## Covariance

james4beach said:


> Yes I think that's right. The GIC "prices" don't react. This could also work against me. Let's say interest rates plummet in the next few years. A bond fund would rise sharply in value, whereas my GICs don't change... so my portfolio would see only some of the gain of a bond fund.
> 
> It seems to me that adding GICs into my bond mix just reduce the volatility of my portfolio.


Agreed.


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