Brace yourself when you open your next account statement if you own bond funds of any type.
The numbers will look bad.
I use a Globeinvestor.com Watchlist to keep a list of the bond exchange-traded funds in the latest ETF Buyer’s Guide. Twelve bond funds are included and all of them were down 2.1 to 4.3 per cent on a trailing 12-month basis as of mid-November.
These numbers are not as bad as they seem. As is often the case when you get a stock quote for an ETF, they reflect simply the share price of the fund and not the total return with bond interest or dividends included. On a total return basis, bond funds are down only a bit on a year-to-date basis.
Examples: The BMO Aggregate Bond Index ETF (ZAG) lost 1.1 per cent in the first 10 months of 2018 on a total return basis, the iShares Core Canadian Universe Bond Index ETF (XBB) fell 1.1 per cent and the Vanguard Canadian Aggregate Bond Index ETF (VAB) lost 1.4 per cent. While these losses are small, they’ll still be bothersome to investors who expect stability from their bond holdings.
ZAG, XBB and VAB are proxies for the broad Canadian bond market, including federal and provincial government bonds and investment-grade corporate bonds. Bond fund results of 2018 suggest this diversified approach has some appeal in today’s complex investing environment, but with a twist. Short-term bond funds have delivered a slightly smoother ride in 2018, with only a negligible cost in terms of yield.
The case for diversified bond ETFs starts with the fact that we now have strong economic growth and rising interest rates, an environment where government bonds get hurt more than corporates. We also have volatile stock markets, where government bonds tend to outperform. With a diversified bond ETF holding government and corporate bonds, you’re covered against both rising rates and falling stocks.
You can get a diversified package of bonds in the likes of ZAG, XBB and VAB, which offer after-fee yields to maturity in the 2.8-per-cent range and duration of seven years. If rates rise by one percentage point, the price of a bond or bond fund with a duration of seven years would fall seven percentage points (and vice versa if rates fell). The higher the duration, the more risk there is if rates rise.
Based on 2018 to date, short-term bond ETFs seem the better bet. Take the Vanguard Canadian Short-Term Bond Index ETF (VSB) as an example. Its duration is 2.8 years, its after-fee yield to maturity comes in around 2.5 per cent and its year-to-date total return was 0.4 per cent. In a tough year for bond funds, that’s a pretty good all-around package.