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.”

That way, you can live off the money from your maturing bonds during a market downturn and you won’t end up decimating your portfolio by cashing in stocks when they’re down.

The key is to remember that capital gains and stock dividends enjoy tax breaks, while interest payments from bonds GICs don’t. So keep any bonds or GICs you own in your RRSP.

If you run out of contribution room, your stocks and stock-based mutual funds can remain outside your RRSP without inflicting too much damage.

Momentum investing: A truly wild ride
Want to shoot for the stars? Consider momentum investing, where the drops are stomach-churning, and the possible returns jaw-dropping.

Value investing: A taste for value
Love a good bargain? Check out value investing. It’s not for beginners, but with a little patience this strategy can produce stunning results.

Dividend investing: Yield to growth
Like the idea of stocks for the long run, and getting paid to wait? Take a look at dividend investing, and discover the power of high-yield growth.

Index investing: Easy street
Want a low-cost investing strategy that beats most professional managers? Harness the humble power of the Couch Potato.

Mutual funds: In good hands
You can get great long-term results with mutual funds—you just have to keep it simple and watch the fees.

Fixed income: Safe and sound
No stomach for stocks? A smart fixed-income strategy can help you achieve your financial goals with a minimum of risk.

]]> http://www.moneysense.ca/2010/10/21/six-strategies-to-build-your-wealth/feed/ 50 http://www.moneysense.ca/2010/10/21/fixed-income-safe-and-sound/ http://www.moneysense.ca/2010/10/21/fixed-income-safe-and-sound/#comments Thu, 21 Oct 2010 16:59:06 +0000 Dan Bortolotti http://www.moneysense.ca/?p=8038 What I learned as a fixed-income investor

Bill Bartels, 73
retired entrepreneur; Kitchener, Ont.

My dad worked in a factory, and I grew up in a normal family—I don’t think I’m smarter than anybody else. But I happened to be in the right thing at the right time. A partner and I started an automotive parts manufacturing company and it went way beyond what we ever dreamed. When we sold it I was able to retire at 50. Suddenly I had a pile of money and I didn’t know what the heck to do.

Over the years I had bought and sold a bit of stocks: some good ones, but mostly not good ones, so I wasn’t eager to put money into stocks. I talked to my dad, and he had his money invested in GICs. So I went to see the same guy he used, and I bought a whole whack of GICs: this was the late 1980s, and I got 15.5% for five years! I staggered them the same way you would ladder bonds so I could draw a regular income. But when the five years was up, I thought, now what will I do?

Eventually I connected with Alan Tchabushnig, an adviser who told me about bonds. He helped me build a ladder of government bonds going out as much as 15 years. I got a good income from them, and when interest rates went down we sold some at a profit. Then the yields started to drop, so we switched to corporates. We have them all laddered, so if things change drastically we’ll have time to make adjustments.

……..

Maybe you used to be an equity investor, but you got pummelled and now you’d sooner slide down a cheese grater than buy another stock. Or perhaps you’re a diligent saver who has amassed a comfortable nest egg, and you can get by just fine with risk-free returns of less than 5%. Whatever your profile, you can fund a comfortable retirement without investing in stocks. But you’ll likely have to get away from savings accounts, money market funds and Canada Savings Bonds—those dreary investments can’t even keep up with inflation. Here’s how you can succeed with a super-safe all-fixed-income portfolio:

Get the most from your GICs. There’s a place for GICs, but not if you accept the terrible rates offered by the Big Five banks. At press time, their one-year GICs were offering just a 0.75% annual return, compared with much better rates from the online banks: 1.75% from ING Direct and 2% from Ally. You can also enlist the help of a deposit broker, an independent dealer who will shop around at banks, credit unions and other financial institutions to get you the best deal.

Build a bond ladder. One of the biggest knocks against GICs is that they usually have terms of five years or less. “Anyone who hasn’t invested in fixed-income securities longer than five years has been a loser over time,” says Hank Cunningham, fixed-income strategist at Odlum Brown in Toronto, and the author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market. Since the late 1990s, 10-year Government of Canada bonds have yielded about 1% more than five-year GICs on average. “That’s a lot of compounding left on the table.”

Cunningham’s preferred strategy for fixed-income investors is to build a 10-year bond ladder: you invest 10% of your money in a bond that matures in one year, another 10% in a two-year bond, and so on up to 10 years. Every year one of the bonds will mature, and you reinvest it in another 10-year bond. This strategy smooths out your returns and risks over the long term. “You’re not guessing about interest rates,” Cunningham says.

“You’re buying the best yielding product you can, and yet you won’t get caught with the wrong maturities at the wrong time.” In a taxable account, he suggests using provincial or investment-grade corporate bonds for each rung, since Government of Canada bonds have lower yields. In an RRSP, investors can also use strip bonds.

Use low-fee bond funds or ETFs. Many bond mutual funds in Canada are too expensive— they’re almost guaranteed to trail their index benchmarks. The median MER of a Canadian bond fund is about 1.5%, and while that’s lower than most equity funds, bonds offer fewer opportunities for active managers to add value. “These guys are guessing with your money, because nobody knows where the bond market is going,” says Cunningham. He also dislikes the fact that bond funds never mature, and their annual returns fluctuate with the market, which makes retirement planning difficult.

That said, if you seek out the lowest-fee options, bond mutual funds and exchange-traded funds (ETFs) can be attractive to fixed-income investors (see some suggestions above in Best fixed-income funds). In addition to simplicity and liquidity, they offer instant diversification, and they’re open to investors with portfolios of any size.

How have bonds performed? Amazingly well, over the period we looked at. As you can see in Steady as she goes above, the DEX Universe Bond Index, which includes Canadian government and corporate bonds, had just two negative years in the last three decades (1994 and 1999), while averaging returns of about 9.9% a year. However, it should be noted that this was over a period of steadily declining interest rates—an ideal environment for bonds. Rates are now at historical lows, so a repeat performance is unlikely.

What can go wrong? The price of security is lower returns—if you’re not prepared to accept that, you shouldn’t be a fixed-income investor. “In a low-inflation world, 4% to 6% is what you should expect to get from a bond portfolio,” Cunningham says. The surest way for GIC and bond buyers to blow themselves up is to reach for more.

Junk bonds spinning off yields of more than 8% are very tempting these days, but there is no reward without risk: the default rate on U.S. high-yield bonds was almost 14% in 2009. Cunningham says a high-yield bond ETF may be appropriate for 10% of a portfolio, but proceed with caution. “Fixed-income is supposed to be about peace of mind and safety of principal.”

Best fixed-income funds

If you’re building a fixed-income portfolio with mutual funds, keeping costs down is paramount. These low-fee funds hold high-quality corporate and government bonds and have excellent track records.

Exchange-traded funds (ETFs), which are bought and sold like stocks, offer even lower costs. They also give you the option of using specialized funds to build a custom fixed-income portofolio.

What are your tips for fixed-income investing? We invite you to share one or two with our readers in the comments field below. The person with the best tip will get a copy of MoneySense’s new retirement book, Guide to Retiring Wealthy, when it comes out in mid-October. For the full story on investment strategies, pick up a copy of the September/October 2010 issue of MoneySense, on newsstands now.

In the September/October issue of MoneySense, currently available on newsstands, we have an indepth package on six proven investment strategies–dividend investing, mutual funds, fixed income, index investing, value investing and momentum investing.

If you follow one of these approaches, we’d love to hear from you. Click on the appropriate link (above) and share your ideas and tips. The best tip from each category will receive a copy of MoneySense’s new retirement book, Guide to Retiring Wealthy, when it comes out in mid-October.