With yields on guaranteed investment certificates so low, I am thinking of using the iShares Core Canadian Universe Bond Index ETF (XBB) for my fixed-income exposure. I realize there is some risk with the unit price and there is also the management expense ratio of 0.1 per cent to consider. But with rates likely staying low for at least the next year, I was thinking XBB’s yield of 2.51 per cent would satisfy my income needs. Thoughts?
I feel your pain about GIC rates. At my own discount broker, the highest yield available on a one-year GIC is a paltry 0.74 per cent. If I’m prepared to lock in my principal for five years, I can earn – wait for it – 1.41 per cent.
Better rates are available with niche institutions such as Oaken Financial, Maxa Financial or Accelerate Financial. Oaken, for instance, is currently offering 2.1 per cent on an 18-month GIC. So before you dismiss GICs altogether, you might want to shop around. Comparison websites such as ratehub.ca are a good place to start.
A bond exchange-traded fund such as XBB is a reasonable alternative to GICs, but it’s important to understand what you’re getting into before you take the plunge. About 70 per cent of XBB’s assets consist of high-quality federal and provincial bonds, with the remainder invested in investment-grade corporate issues. So XBB’s credit quality is very high. But that 2.51-per-cent yield you quoted requires some elaboration.
The iShares website calls this the “distribution yield,” and it represents XBB’s most recent monthly distribution multiplied by 12 and divided by the current unit price. But the distribution yield doesn’t tell you the full story. The vast majority of the more than 1,300 bonds in XBB are trading at a premium to their par value, having risen in price as interest rates dropped (recall that bond prices and interest rates move in opposite directions). These bonds are going to gradually fall in price as they approach maturity, when they will be redeemed at par.
But XBB’s posted distribution yield doesn’t include this expected capital loss. A better gauge of XBB’s expected return is the “yield to maturity” (YTM), which includes the coupon payments of the bonds and the expected capital loss if the bonds are held to maturity. According to the iShares website, the weighted average YTM of the bonds in XBB is 1.21 per cent – or less than half of the distribution yield. What’s more, the posted YTM is before fees. After subtracting the MER of 0.1 per cent, XBB’s net YTM falls to about 1.11 per cent.
This shouldn’t come as a huge surprise given how low government bond yields have sunk. Five-year government of Canada bonds, for example, were yielding about 0.33 per cent as of Friday morning, while 10-year bonds were yielding 0.49 per cent on a YTM basis. If it weren’t for higher-yielding corporate issues, XBB’s YTM would be even lower than it is.
Another thing to keep in mind is that the price of XBB – or any other bond fund – won’t be stable. It could move higher if interest rates drop or lower if rates rise.
I don’t mean to steer you away from bond funds. As long as you understand what the distribution yield means – and can accept some modest volatility – they are a fine solution for your fixed-income needs.
However, if you are comfortable taking on more risk, you may also wish to explore dividend-paying stocks, particularly those at the conservative end of the spectrum, such as utilities, power producers and telecoms.
Dividend-paying stocks exhibit more price volatility, but the yields are substantially higher than bonds or GICs. Fortis Inc. (FTS), for example, is widely seen as one of the most secure utility stocks and currently yields about 3.5 per cent. What’s more, Fortis has said it intends to raise its dividend at an annual rate of 6 per cent through 2024. With bonds and GICs, on the other hand, your income is fixed. Another advantage of dividends is that, thanks to the dividend tax credit, they are taxed at lower rates than interest.
Other utilities and power producers with growing dividends include Algonquin Power & Utilities Corp. (AQN; currently yielding about 4.5 per cent), Emera Inc. (EMA; 4.5 per cent), Canadian Utilities Ltd. (CU; 5.4 per cent), Capital Power Corp. (CPX; 7.1 per cent) and Brookfield Renewable Partners LP (BEP.UN; 3.8 per cent). For non-registered accounts, newly created Brookfield Renewable Corp. (BEPC; 3.6 per cent) may be a better choice, as its distributions qualify for the dividend tax credit. (Disclosure: I own all of the stocks mentioned here.)
You’ll find more examples of dividend-growing stocks in my model Yield Hog Dividend Growth Portfolio at tgam.ca/dividendportfolio.
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