Earlier this month, Mackenzie Investments produced this advertisement for the Mackenzie Sentinel Corporate Bond Fund. The banner headline reads “Think high yield means high risk?” The rest of the ad reads, “Think again. High-yield corporate bonds have produced equity-like returns with less risk.”

Two graphs then compare the performance of the fund with the S&P/TSX Composite Index from November 2000 (the fund’s inception date) through October 31 of this year. During that period, the Mackenzie fund delivered annualized returns of 5.7% with a standard deviation of just 5.8%. The Canadian stock market, by comparison, delivered just 4.5% with much more volatility: a standard deviation of 15.5%.

Those are compelling numbers: high returns with lower volatility is what every investor wants. But it’s always important to scrutinize comparisons like this. There’s nothing incorrect in the data here, per se, but one needs to ask whether the fund really did deliver superior risk-adjusted returns, and whether it is likely to do so in the future.

To begin with, the start and end dates examined here are crucial. If you look at the table under the two graphs, you’ll see that the S&P/TSX Composite returned 8.5% annualized during the 10 years beginning in October 2001, outperforming the Mackenzie fund by 2.8% a year. So by moving the start date by just one year, you get a completely different result. It may be true that “high-yield corporate bonds have delivered equity-like returns,” but only during specific periods when equities dramatically underperformed their historical averages.

Were you rewarded for taking more risk?

The ad also argues that “it takes rigorous company and credit analysis to find bonds with long-term growth and income potential. When you do, it adds up to superior returns and a smoother market ride.” In the case of the Mackenzie fund, it also adds up to an MER of 1.7% a year.

There are only two ways that a bond manager can deliver superior returns than a broad-market index. The first is by adjusting maturities—that is, by selecting a portfolio of bonds with shorter or longer terms than the benchmark. The second is by varying credit quality: by selecting bonds of lower quality, and therefore higher yields. With that in mind, did the Mackenzie Sentinel Corporate Bond Fund add value?

Justin Bender, a CFA and portfolio manager at PWL Capital in Toronto, supplied the following analysis. He compared the Mackenzie fund’s performance to a blended benchmark consisting of two indexes of federal government bonds: 60% DEX Mid Term Federal Bond and 40% DEX Short Term Federal Bond. This 60-40 mix creates a benchmark with an average term to maturity of about 5.7 years, which is identical to that of the Mackenzie fund’s portfolio. In this way, we’ve taken maturity out of the equation so we can focus only on credit quality.

Since high-yield bonds have far more credit risk than government bonds of the same maturity, investors should naturally expect higher returns. Would they have achieved them with the Mackenzie fund? Here are the numbers:

Sources:  PC-Bond, BMO Financial Group, Mackenzie Investments, Dimensional Returns 2.0. Returns as of October 31, 2011.

As you can see, since its inception, the Mackenzie fund has not even outperformed government bonds of similar maturities. Over the last 10 years, it managed a mere 10 basis points of outperformance. Over shorter periods, the results are mixed. This hardly a compelling argument for the fund’s “rigorous company and credit analysis.”

And what about volatility? The Mackenzie fund’s standard deviation of 5.8% does indeed look low when compared with the S&P/TSX Composite. Yet our 60-40 benchmark of government bonds not only achieved higher returns since November 2000, but it did so with a much lower standard deviation of just 3.5%, according to Bender’s analysis.

“Finding equity-like returns with less volatility is something many market weary investors are looking for,” the Mackenzie ad says. No argument there. But the data suggest they need to keep looking.

Why the doomsday predictions? Because most people think that after two decades of trending downward, interest rates are due to start edging up. And if they do, bond prices could crash. Since bond index funds simply deliver the returns of the overall market—and there’s no fund manager trying to forecast interest rates—they would crash too. The critics are saying that the passive approach to bond investing that worked wonders during the last 20 years has run its course. They think investors should run, not walk, to the markets to dump their bond index funds. But will Couch Potatoes really face a fixed-income disaster?

Don’t confuse different rates
To find out, I turned to Norbert Schlenker of Libra Investment Management in Salt Spring Island, B.C. He explained that when you talk about interest rates you have to be specific: there are many different rates, and they don’t all behave the same way.

The media tend to focus on what’s called the overnight rate, which is set by the Bank of Canada. It’s the shortest of short-term rates, and it has a big influence on lenders: banks use it to set their prime rate, so it affects what we pay on variable mortgages and lines of credit. But here’s the important point: the overnight rate doesn’t drive what happens in the bond market.

Central banks have little control over the yields on 5- and 10-year bonds, Schlenker explains, and those rates march to different drummers. “The short end of the yield curve doesn’t act like the middle or the long end,” he says. For example, the Bank of Canada lowered the overnight rate three times in 2009 and raised it three times in 2010. But the yields on 5- and 10-year government bonds trended the other way: they rose in 2009 and declined in 2010.

Know your numbers
So which interest rates will have the greatest effect on a bond index fund? To answer that question, Schlenker explains that you need to know two important numbers, both of which you can learn by looking at the fund’s fact sheet or its website.

The first is the “average term to maturity” of the bonds in your fund. The index mutual funds and exchange-traded funds we recommend in the Couch Potato portfolios track the broad DEX Universe Bond Index, which includes a wide range of maturities, from one year to more than 25 years. The average term, however, is between nine and 10 years. That tells you that your fund will behave much like 10-year bonds, and won’t be affected by short-term rates at all.

The second important measure is the fund’s “duration.” This number indicates a bond fund’s sensitivity to interest rate movements: the longer the duration, the more value your fund will lose if rates rise. Funds tracking the DEX Universe have a duration of about six years. That means if the rate rises by one percentage point—and it has to be the rate that corresponds to the correct average term to maturity—then the fund will fall in value by six percentage points.

Stay in for the duration
The key message for investors is to make sure your time horizon is at least as long as the duration of your bond fund. “If you do that, everything will wash out in the end,” Schlenker explains.

In other words, if you need your money in three years—to pay for a child’s education or a down payment, for example—then you should not be holding a broad-based fund with a duration of six. You should be in a short-term bond fund with a duration less than three—perhaps even a three-year GIC—or you risk losing some of your capital. “But if you have an investing horizon of 10 years, or 20 years, then investing in something that tracks the DEX Universe is perfectly fine,” says Schlenker.

Fixed-income investors often forget that there’s a silver lining in the black cloud of rising rates: new bonds have higher coupons, which means more interest income down the road. In any bond fund, the manager is constantly collecting interest payments and cashing in bonds as they mature. He then invests that money in new bonds with higher yields. “If you can hang on for the whole duration, the increased coupon will bail you out. You will be no worse off than if you invested in T-bills.”

Does that mean Couch Potatoes should expect their bond funds to deliver 8% annualized returns, as the broad-market bond index has done since 1991? Absolutely not. But bond index funds should still be part of any long-term portfolio, even if there is a risk of short-term pain.

“It would be wonderful if everyone could invest in a portfolio where everything only went up in value,” Schlenker says. “But that happens to absolutely nobody. If we own a diversified portfolio of stocks, some of them will be down in a year’s time, but in most cases we’re comfortable that they will come back. That holds true for bonds as well.”

Q: I just read about the launch of RBC’s family of target-maturity corporate bond ETFs. They seem like they would be an attractive option for the fixed-income portion of my RRSP. How do these products compare with more conventional bond ETFs? How do I compare their yields? And can I use them in a laddered fashion? — Karl T.

RBC became Canada’s sixth ETF provider when it launched a family of eight corporate bond funds last week. Unlike traditional fixed-income ETFs, which continually buy new bonds to replace those that mature, these new products have a “target maturity.” That means all the bonds in the fund will come due in the same year, and once they’re redeemed, the fund will be liquidated and all the money returned to investors.

ETFs like these are not exactly new in Canada: BMO launched four similar funds in January, with target dates of 2013, 2015, 2020 and 2025. However, RBC’s offerings fill in the gaps, covering every year from 2013 through 2020. Each ETF will mature on or about November 30 of the target year.

Extreme couponing

Whenever you buy an individual bond or a bond ETF, you’ll be quoted both its coupon and its yield to maturity (YTM). It’s crucial that you understand the difference between these two figures, or you’ll fall victim to the yield illusion that plagues so many investors.

The coupon tells you how much you’ll receive in interest payments each year, but that’s not the whole story. The YTM is a much more important number. When the coupon is higher than the YTM, it means the bonds were purchased at a premium, and they will suffer small capital losses when they mature. These losses will cause the fund’s price to fall, offsetting some of the interest payments and lowering your total return.

That’s where the YTM comes in: it factors in both the coupon payments and the expected capital loss and tells you what your total return will be if you hold the bond (or the ETF) until its maturity date. Have a look at the dramatic differences between the coupon and the yield to maturity in the new RBC funds:

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The RBC Target 2018 fund’s distributions will be a whopping 6.39% a year, but these will be offset by capital losses, so your total annual return will be less than half that: just 3.21%. Don’t be misled by those tempting coupons. You’re not going to earn 5% or 6% annually with any of these ETFs.

Target maturity v. traditional

How do these yields stack up against those of traditional bond funds? Actually, there’s no meaningful difference in risk or return if you make a fair comparison. To do that, you need to look at corporate bond funds with a similar duration, which is a measure of sensitivity to interest rate risk. (The longer the duration, the more the fund’s price will drop if interest rates rise.) I’ve included the duration of the RBC funds in the table above.

Now let’s compare these with other corporate bond ETFs. You can visit the website for Claymore’s 1–5 Year Laddered Corporate Bond ETF (CBO) and learn that it has a duration of 3.07, which makes it comparable to the RBC Target 2014 ETF. You’ll also see that he yield to maturity of CBO is almost identical at 2.29%. Meanwhile, the iShares DEX All Corporate Bond Index Fund (XCB) has a duration of 5.78, which is very close to that of the RBC Target 2018 ETF. Again, the yield to maturity of XCB is virtually the same as the comparable RBC fund: in this case, 3.25% versus 3.21%.

The only difference here is that CBO and XCB will always have approximately the same duration. The durations of the RBC funds, however, will get shorter every year as the fund approaches the target maturity date.

How to put these ETFs to work

So how might a target maturity bond ETF fit into your portfolio? You might use them to fund a future obligation on a specific date: if you know that you will need your money in 2015 for a down payment, you could buy the RBC Target 2015 ETF instead of putting it in a savings account or buying a four-year bond or GIC. You’ll receive interest payments for the next four years, and then have your money returned to you at the end of that period.

Target maturity ETFs do have some advantages over individual bonds. The first is diversification: each RBC fund holds 20 to 50 issues. Another advantage is that you can invest small amounts, which is difficult to do with individual corporate bonds. You can also add new money to your investment whenever you want—although you’ll incur a trading commission each time.

The RBC funds carry a management fee of 0.30%, which you would not pay if you bought individual bonds. However, the retail spread on individual bonds can be very high (and hidden), especially if you’re buying from a discount brokerage. In many cases, the ETF will be a better deal in the end.

RBC’s new ETF website suggests that you can also use these products to build a bond ladder. Presumably they will launch a new ETF every year beginning in 2013, to replace the one that gets liquidated, allowing investors to maintain an eight-year bond ladder indefinitely.

However, for long-term investors who do not have a specific time horizon, a traditional bond ETF is almost surely a better choice. First, the fixed income side of a portfolio should include government bonds as well as corporates. And second, if you do hold corporate bonds, a single fund such as CBO or XCB will be more manageable and less expensive in the long run than building a ladder with these ETFs.

Got a question about index investing? Send it to mail@canadiancouchpotato.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.

Bond index funds have a place in almost all portfolios, even in a low-rate environment. However, it’s important to match the right bond fund to your investment goals. To do that you need to know two important details. You can usually find both of these numbers on the web page or fact card of any bond mutual fund or ETF.

The first is the weighted average term to maturity of the bonds in the fund. For example, the iShares DEX Universe Bond Index Fund (XBB)—which tracks the most popular fixed-income benchmark in Canada—is about half short-term (one to five years to maturity), one quarter intermediate-term (five to 10 years) and one quarter long-term bonds. The weighted average term to maturity of all the bonds in the fund is 9.3 years.

This number is important, because the fund will behave much like an individual bond of about this same maturity. Sure enough, if you look up the current yield on Government of Canada 10-year bonds you’ll find it is 3.07%, almost identical to XBB’s current yield to maturity (3.03%). Now you know that XBB will be sensitive to the prevailing interest rate on 10-year bonds: if this yield goes up, the fund’s value will fall. Other interest rates—such as the Bank of Canada’s overnight rate that you keep hearing about on the news—are pretty much irrelevant.

The second key figure is your bond fund’s weighted average duration. This tells you the fund’s sensitivity to interest-rate movements: the longer the duration, the more your fund will lose if rates go up.

Duration is a calculated with a complicated formula that considers a bond’s term to maturity and its coupon. The important idea is that the longer the maturity, or the lower the coupon, the longer the duration. This is why short-term bonds are less sensitive to interest rate swings, and why higher-yielding corporates are less vulnerable than government bonds:

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As you can see in the table, XBB (and similar broad-based funds) have a duration of just over six. That means if the relevant interest rate rises one percentage point—remember, in this case it’s the yield on nine- or 10-year bonds—then the fund can be expected to fall in value by about six percentage points.

And the bond played on

There are a couple of subtleties to be aware of here. First, interest rates at the long end of the yield curve tend to be less volatile than short-term rates: it’s unusual for 10-year bond yields to move more than one or two percentage points in a year. So the chance of a fund like XBB suffering double-digit losses in any given year is remote—at least if history is any guide.

The iShares DEX Long Term Bond Index Fund (XLB) looks even scarier with its duration of almost 14: a 2% jump in the yield on 20-year bonds would theoretically mean the fund’s value would decline by some 27%. But this has never happened. Since 1948, the worst one-year return on the DEX Long-Term Bond Index was –8.9% in 1956, followed by –7.4% in 1994. In the U.S., long-term bonds have seen just one double-digit decline in 85 years (that happened in 2009).

Another often overlooked point is that rising interest rates have a silver lining: new bonds are issued with higher coupons, and this will eventually lead to more income. (Doesn’t it strike you as odd that fixed-income investors complain about low rates while also worrying they might go up?) As bonds in a fund mature, the proceeds are reinvested in higher-yielding bonds that help offset the price declines. That’s why bonds recover from bear markets much faster than stocks do.

Stay in for the duration

Which leads us to the key message for investors: as long as your time horizon is at least as long as the duration of your bond fund, you won’t lose any capital.

You’ve probably heard people say they prefer individual bonds to bond funds, because as long as they hold on until maturity, they won’t lose principal. Well, the same is true if you hold a bond fund for a period equal to its duration. You can be sure that XBB will not lose value over any period longer than 6.3 years: any price decline from rising interest rates will be offset by higher coupons within that time frame. In fact, history suggests the recovery is likely to be more swift than that: even a three-year period of negative bond returns is extremely rare.

So, if you’re saving for a child’s education with a three-year time horizon, steer clear of XBB and choose a fund with a duration less than three—or just put your money in a GIC or high-interest savings account. But if you’re investing for a retirement that’s 10, 20 or 30 years down the road, a broad-based bond index fund should still be a core holding in your portfolio.

Investors are worrying about a lot of things these days, but the fear of rising interest rates remains near the top of the list. Not only are savings accounts and GICs yielding peanuts, but bond investors are worried that a spike in rates will send the value of their bond funds and ETFs plummeting.

The concern is certainly warranted. Remember that bond prices and interest rates are on opposite ends of a seesaw: whenever one goes up, the other goes down. But before you make drastic changes to the fixed-income side of your portfolio, make sure you understand the subtleties of interest rates and their effect on bond prices.

Overnight sensation

When people talk about interest rates, they’re usually vague about which ones. The media tend to focus on the overnight rate, which is set by the Bank of Canada in an effort to control inflation.

That rate was 0.25% in April 2009, and in 2010 it ticked upward three times to 1%, where it stands now. If you follow the mortgage markets, you saw that the banks’ prime rates (currently 3%) went up immediately following each of these three hikes in the overnight rate. That’s why variable mortgages and lines of credit got more expensive last year.

However, you may also have noticed that fixed-rate mortgages got cheaper in 2010. That’s because fixed-rate mortgages, which usually have a term of five years, are tied to the yield on five-year government bonds, not the overnight rate. And during 2010, five-year bond yields declined slightly. They fell further this past May, prompting the banks to lower fixed mortgage rates again.

Whenever there’s talk of rising interest rates, someone points out that long-term bonds are the most vulnerable. This is true, but again, it depends which rates you’re talking about. While short-term rates went up three times in 2010, the yield on 10-year bonds fell. As a result, the iShares DEX Long Term Bond Index Fund (XLB) returned a whopping 12.1% last year. The broad-based iShares DEX Universe Bond Index Fund (XBB) earned well over 6.4%, its best showing since 2004.

The lesson here is that the different parts of the yield curve do not move in lockstep, and various lending markets can behave differently over any given period. If you believe the Bank of Canada is going to raise short-term rates in the near future, then you should be worried about your variable-rate mortgage. But if you’re a long-term investor, you shouldn’t be dumping your bond index funds.

Rising rates aren’t new

Investors have faced similar scenarios before. In May 2004, Americans were filled with fear about rising rates. Typical of the media reports at the time, Kiplinger’s Personal Finance magazine warned investors to “Protect your bonds from the coming storm” as the Federal Reserve raised rates to tame inflation. Some pundits were even recommending inverse bond funds, which go up when bond prices go down.

It turns out that the forecasters were absolutely right about the central bank’s actions: Alan Greenspan hiked short-term rates 16 consecutive times until the they reached 5.25% in July 2006. So did bond investors get slaughtered? Not at all: bond prices fell modestly, but the declines were more than offset by the interest payments. The total return on the Vanguard Total Bond Market Index Fund was about 3.5% annually from 2004 through 2006. Long-term bonds—which the magazine specifically warned against—did even better.

It’s happened in Canada, too. From 1987 to the middle of 1990, Canadians watched short-term rates soar from 7.7% to over 14% in 41 months. But the yields on five- and 10-year bonds crept up more modestly during this period, with several dips along the way. As a result, the overall bond market returned almost 4% a year from 1987 through 1990 after inflation.

There’s no arguing that bonds could see trouble ahead, but the dangers are often overstated, or at least misunderstood.

On Monday, I took issue with the argument that cap-weighted bond indexes are fatally flawed. Rob Arnott, the creator of fundamental indexing, has argued that the classic model is “patently ridiculous.” The Research Affiliates website frames the problem like this: “Traditional bond indices give their greatest weights to the biggest debtors. Should investors buy more of a company or nation’s debt solely because it increases its issuance?”

My previous post looked at this idea as it applies to government bonds. However, there are currently five RAFI fixed-income indexes, and all of them cover corporate debt—three for investment-grade bonds, and two for high-yield bonds. And right now there’s just a single ETF tracking one of these indexes: the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). This fund has been around since 2007, though it didn’t start tracking the RAFI High Yield Bond Index until last August.

The other side of the argument

In a recent conversation with Steven Leong and Oliver McMahon, who handle product management for iShares, I brought up the idea that traditional bond indexes overweight companies with the most debt. “On the surface that is true, but it totally ignores the size of the company relative to the size of the debt,” Leong said. “It should surprise nobody that a company like Royal Bank has issued more debt than a company like Shoppers Drug Mart, for example. Nor should it be something that anyone is afraid of.”

Remember, companies don’t necessarily borrow for the same reasons that consumers do. When we get a loan to buy a house or a car, it’s because we’re simply not able to pay cash. Yet just this month Google issued $3 billion in bonds despite having some $35 billion in cash reserves.

“If a company’s internal rate of return is higher than the interest they pay on their bonds, it’s smart for them to issue more debt,” McMahon explained. “They’re creating value for their shareholders. An alternative might be for them to issue more stock, and that’s not always a sensible thing to do, because you’re going to dilute the value of the existing stock. You definitely can get to a stage where you issue too much debt. But the simple fact that a company has a large amount, in and of itself, is not indicative of a problem.”

No regard to fundamentals?

The RAFI website states that “traditional bond indices weight issuers solely by the market value of each firm’s outstanding debt with no regard to underlying firm fundamentals.” As I argued in my earlier post about sovereign debt, this isn’t quite true. Bond indexes funds always screen for credit risk. So if a company is drowning in debt and has little capacity to pay it back, its bonds will get a junk rating and they won’t make into indexes that hold only investment-grade issues.

If you want to avoid companies with bad fundamentals, all you need to do is buy an ETF such as the iShares DEX All Corporate Bond Index Fund (XCB), the Claymore 1-5 Year Laddered Corporate Bond ETF (CBO), or one of BMO’s corporate bond ETFs that hold nothing rated lower than A by Standard & Poor’s. The likelihood of a bond defaulting in any one of these bond funds is very low.

Using a fundamental index for a high-yield bond fund seems to make more sense, since the likelihood of default is much greater. The RAFI High Yield Bond Index includes nothing less than BBB, whereas more than 14% of the iShares U.S. High Yield Bond Index Fund (XHY) is rated CCC+ or lower. “RAFI corporate bond strategies will tend to have higher credit ratings than their market-weighted counterparts,” the website confirms. Of course, lower credit risk may also mean lower returns. Both PHB and XHY have similar durations, but PHB’s yield to maturity is almost a full percentage point lower.

During his recent talk in Toronto, Rob Arnott said, “I think fundamental indexing in bonds is going to be bigger than it is in stocks.” I’m not at all convinced of that—the RAFI strategies seem to offer far more potential in equities. US investors, however, do seem to be receptive: PHB has more than doubled its assets from $202 million before the index change to about $480 million today. (Although for some perspective, its iShares counterpart holds $9 billion.) PowerShares also has an ETF in the works that will track a RAFI index of investment-grade corporate bonds.

Canadians will get a chance to vote with their money soon enough: last month, Invesco announced that it plans to launch a version of PHB on the Toronto Stock Exchange, this one hedged to Canadian dollars.

When Rob Arnott, the creator of fundamental indexing, spoke in Toronto last week, his presentation focused exclusively on equities. When he took questions at the end of his presentation, I asked him a question about the lesser-known RAFI fundamental bond indexes.

Recall that the goal of fundamental indexing is to address the flaws in capitalization-weighted indexes, which give the most influence to stocks that may be overpriced. Traditional bond indexes are cap-weighted, too: the more bonds a country or corporation issues, the greater their weight in the index. Arnott and others have criticized this methodology, so I asked him to comment. Here’s what he said:

“If you’re bond investor, you’re a lender. If you’re cap-weighted, then you’re lending the most to whomever has the most debt. What is the rationale behind that? If you’re investing in a global sovereign bond fund and Greece decides it wants to double its debt, as an index investor you would have to own twice as much. What’s the sense of that?

“Cap-weighting in bonds is patently ridiculous. Cap-weighting in stocks has a lot of theoretical justification, but when you use the same theories and apply them to bonds, it just becomes more obvious that the rationale is stupid.”

Ridiculous, stupid — these are strong words. But before you rush to dump your bond index fund, let’s take a closer look at Arnott’s argument.

A red herring

On the surface, the criticism of cap-weighted bond indexes seems to make sense. If you’re a mortgage lender, do you want you lend more money to people who already have the largest home loans? If you’re credit card company, do you look for customers who owe the most on their existing cards? Of course not. You look for borrowers with good “fundamentals”: a reliable job, a low debt-to-income ratio, a good credit history and the like.

But this has no relevance to the vast majority of index funds and ETFs that hold government bonds.

For starters, most investors hold all of their bonds in their own country—as they should. Unlike with equities, there are sound reasons for keeping your fixed income in your home country and currency. Some investment gurus, such as David Swensen and Larry Swedroe, even argue that you should avoid corporate bonds and stick to bonds issued by your own government. In other words, global sovereign bond index funds are few and far between, and I have never seen anyone recommend them as a core holding.

Even if you did decide to add foreign bonds in your index portfolio, the reference to Greece (or any other country at high risk of default) is a red herring. Cap-weighted bond index funds screen for credit risk, so no investor is in danger of being unwittingly saddled with a bunch of fiscal basket cases.

For example, the CIBC Global Bond Index Fund, the only one of its kind in Canada, tracks the cap-weighted J.P. Morgan Global Government Bond Index, which includes only investment-grade bonds. Most of the fund is in Japan, the United States, France, the UK, Germany, the Netherlands and Germany. (There are small allocations to Italy and Spain, which may concern you, but this is a criticism of bond-rating agencies, not cap-weighted indexes.)

The SPDR Barclays Capital International Treasury Bond ETF (BWX), listed in the US, is a perfect example of the methodology in action. This ETF used to have an allocation to Greece (according to this February 2010 article), but it doesn’t anymore, because the country’s credit rating has since been lowered and it’s no longer eligible for the index.

Other safeguards

Other sovereign bond ETFs use different methods to make sure deeply indebted countries are not overrepresented. The US-listed iShares S&P/Citigroup International Treasury Bond Fund (IGOV) starts with a cap-weighted index but makes adjustments “designed to distribute the weights of each country within the index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding.”

If you’re an investor who wants high-risk bonds issued by emerging countries, you’re still not likely to run into any problems with index ETFs. BMO’s Emerging Markets Bond ETF tracks an index “weighted by gross domestic product as a measure of economy size.” The recently launched iShares J.P. Morgan USD Emerging Markets Bond Index Fund (XEB) uses the same safeguard as IGOV.

Designing a bond index fund that systematically overweights countries in danger of defaulting would indeed be “ridiculous” and “stupid.” Which explains why no bond index fund seems to be doing it.

The table below shows the tracking error of Canadian bond and commodity ETFs in 2010.

To make sure you understand these numbers in their proper context, see my earlier post on tracking errors for Canadian equity ETFs.

Notes:

1. The 3.3% return of CLF is based on the fund’s net asset value (NAV). The return on market price was just 2.8% — a significant difference. With bonds so unpopular these days, the forces of supply and demand may have driven down the price of this fund.

2. Several of BMO’s bond ETFs launched in 2010, so these returns do not cover a full year.

3. CGL’s return based on market price was 29.12%, two and a half percentage points higher than its return based on NAV, and only eight basis points off the spot price of gold. Just as an aversion to bonds seems to have lowered CLF’s price, the continuing gold mania helped this ETF trade at a premium in 2010.

4. Silver was the big winner of 2010 and investors in the Horizons BetaPro COMEX Silver ETF would have been dancing in the streets with their 77% return. But the large tracking error here shows that precious metals ETFs using futures contracts (as opposed to those that hold gold or silver bullion) can carry significant frictional costs. They may not closely track the spot price of the commodity.

Postscript. Horizons ETFs sent me this response regarding HUZ: “The tracking error is primarily due to the fact that the silver futures contracts are priced in U.S. dollars and HUZ doesn’t hedge intraday currency fluctuations; HUZ rebalances the FX hedge at the end of the day. We believe this accounts for most of the 4% difference in the performance of the ETF versus the performance of its index. Please keep in mind that any ETF, whether it is physically backed or futures-backed, will likely be subject to this currency differentiation.”