Bonds, GICs and the Yield Illusion - MoneySense

Bonds, GICs and the Yield Illusion

If you like to keep the fixed-income side of your portfolio as safe as possible, there’s lots to like about the Claymore 1-5 Year Laddered Government Bond ETF (CLF). It carries one of the lowest management fees of any ETF in Canada at a paltry 0.15%. Its default risk is essentially zero, and its short […]

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If you like to keep the fixed-income side of your portfolio as safe as possible, there’s lots to like about the Claymore 1-5 Year Laddered Government Bond ETF (CLF). It carries one of the lowest management fees of any ETF in Canada at a paltry 0.15%. Its default risk is essentially zero, and its short duration means it’s not too vulnerable to rising interest rates. Finally, the ETF uses a laddered structure to spread out interest-rate risk.

However, for many income-hungry investors, the most attractive thing about CLF these days is its 4.5% yield. Indeed, Gordon Pape recommended CLF last month in a Moneyville article, arguing that it was far superior to the “negligible” returns from GICs. Unfortunately, this a classic example of how investors — and commentators who should know better — too often focus on yield while ignoring total return. In fact, CLF is not likely to outperform a comparable ladder of GICs in the foreseeable future. It may well do worse.

Here’s why yield can be an illusion. The bonds held by CLF all have fairly high coupons (ranging from 4.25% to 6.10%), so they throw off a nice stream of income, which gets paid out to the fund’s investors every month. However, all of the bonds in the portfolio were purchased at a premium. Each time one matures — or is sold before maturity — the ETF will suffer a small capital loss. I can attest to this personally: I’ve owned CLF since May 2009, and since that time its value has fallen about 2.8%.

When you invest in a bond or a bond ETF, ignore its current yield and consider its yield to maturity (YTM), which is usually easy to find on the fund’s website. The YTM takes into account both the coupon and the capital loss (or gain) that will occur when the bonds mature. (I explained this idea in detail in a previous post, The Bond Dilemma.) The yield to maturity of CLF is barely 2% — which means that investors who think they’ll be earning 4.5% are fooling themselves.

GICs: What they yield is what you get

Unlike government bonds, which are frequently traded, GICs have no secondary market: you can’t sell yours to someone else. In some cases, you can’t even cash them in before maturity. Their market value never changes, so there is no risk of capital loss, nor any potential for capital gain. The current yield on a GIC, therefore, is the same as its YTM.

With that in mind, here’s what you’d earn from GIC ladders purchased through ING Direct, Ally and Outlook Financial, a Manitoba credit union that’s currently offering the best rates in the country:

ING Direct Ally Outlook
One year 1.75% 1.75% 2.25%
Two years 2.20% 2.40% 2.60%
Three years 2.25% 2.60% 3.10%
Four years 2.30% 2.90% 3.25%
Five years 2.75% 3.30% 3.50%
Weighted YTM 2.25% 2.59% 2.94%

As this table shows, you can get a return close to 3% in the first year from the Outlook GICs. That isn’t “negligible,” as Gordon Pape argues. On the contrary, all three GIC ladders offer rates significantly higher than the yield to maturity of CLF. And unlike the returns of a bond fund, these returns are guaranteed.

Yield is wonderful, but it’s only half the story. The other half is that there’s still no free lunch.

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