Many people continue to struggle with the issue of bonds in a portfolio. That’s understandable. For 40 years, with the occasional blip, bonds have provided stability and reasonable income in an investment account. Now, suddenly, the bottom has fallen out of the bond market, leaving investors shell-shocked.
How bad is it? Year-to-date (to May 13), the FTSE Russell Canadian Universe Bond Index is down 10.71 per cent. I cannot recall ever seeing a drop of that magnitude in the space of just over four months. Even the Short-Term Bond Index, which is supposed to be the lowest-risk bond category, has lost 3.75 per cent.
Most people invest in the bond market through mutual funds or ETFs. Recently, a confused young reader wrote to ask if she should be thinking short-term or long-term bond funds.
“I am in my early 30s and investing for the long term (30-plus years for retirement savings),” she wrote. “My short-term bond ETF, XSB, is down about 4 per cent since January. The long-term bond ETF, XLB, is down 20 per cent.
“I understand that for short-term horizons, long-term bond ETFs like XLB are not a good idea currently. But is it perhaps the better choice for a millennial looking to add to their retirement savings portfolio, with a long-term goal? A 20-per-cent discount seems to be a deal.
“So, my question is this: Should a millennial saving for retirement choose a short-term bond ETF or a long-term bond ETF to add to their portfolio now?”
My answer is neither. Short-term bond funds produce low returns at the best of times. XSB has had an average annual return of 1.4 per cent over the past decade (to April 30). You’re not going to build a large retirement nest egg with those results. The only thing XSB will do right now is minimize your bond losses. The shorter the term to maturity, the less vulnerable a bond is to rate movements.
XLB has done a little better over the past 10 years, with an average annual gain of 2.49 per cent. But even that is not very impressive, considering the risk.
The problem is that most ETFs and mutual funds have no maturity date. They just keep rolling along. The exceptions include six Royal Bank ETFs with maturity dates between 2022 and 2027. However, they aren’t doing so well either. The RBC Target 2027 Corporate Bond Index ETF (RQP-T) was down 8 per cent for the year to April 30. The best performer in this group is the 2023 version (RQK-T). It shows a one-year loss of 2.3 per cent to the end of April but has a five-year average annual compound rate of return of 1.7 per cent. That’s not a lot but at least it’s on the plus side.
Although I don’t think this is a good time to buy bond mutual funds or ETFs, short- or long-term, there is an opportunity to invest in individual bonds. These guarantee a specific rate of return and have an end date when the principal is repaid in full. Anyone who wants to invest in bonds for the long term should focus on buying specific issues, not funds.
Government bonds are the safest, but corporate bonds pay higher returns. If you go the corporate route, choose investment-grade bonds – those which have a BBB rating or better. You can find ratings for some bonds by going to the Morningstar Dominion Bond Rating Service website, but you have to register to gain access. Alternatively, ask your broker.
That said, it is very difficult to trade bonds on a do-it-yourself basis. The bond market is confusing and opaque, unlike stocks, which are openly traded and can be tracked from minute to minute. Efforts have been made in recent years to make the bond market more transparent, but the reality is that institutional bond managers have a tremendous advantage over retail investors in terms of access to a wide array of products and in negotiating trade prices.
This means individual investors will need to work with a broker who understands bonds and won’t overcharge on commissions, which are not broken out as a separate expense when you make a purchase. Your broker’s firm should carry an extensive bond inventory that includes government and corporate issues with varying maturities.
Rising interest rates have knocked down bond prices and increased yields, making this a buyer’s market. But prices are likely to drop even lower as rates continue to rise, so don’t commit all your cash immediately.
Look for quality long-term bonds that are trading below par and offer attractive yields. Tuck them away in your retirement plan and watch them. When interest rates turn back down, the price of the bonds will rise, perhaps to above par. At that point you can sell for a capital gain or continue to hold until maturity.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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Gordon Pape