[Freddie]

Hi all,

I have been following this site for about a year now and have all my retirement funds in ETF's one of which is ishares XBB bond fund. Given the low rate of interest and the impending interest rate rise should one think of switching out of XBB and into some other fixed income vehicle of lower maturity?

Off the top of my head I think the average maturity in the XBB fund is around 6 years give or take. From what I've read, for every 1% increase in interest rates the XBB fund return will be reduced by around 6%. I hope I understand this correctly. Funds with shorter maturities should do better in a rising interest rate environment.

I generally don't try to time the market at all and this is really not that. I'm trying to find out if I need to re-allocate my fixed income portion to some other fund that might work better in a rising interest rate environment.

I'm thinking of maybe XSB instead or maybe keep 1/2 in XBB and move 1/2 to XSB.

thoughts?

thanks,

Freddie

 

[CanadianCapitalist]

I keep my bond maturities short and prefer XSB instead of XBB. I'd recommend reading up Four Pillars on Investing by William Bernstein. The crux of the argument is that investors do not get a commensurate increase in reward for taking on the extra risk that comes from increasing the length of the term.

http://www.canadiancapitalist.com/short-term-versus-long-term-bonds/

 

[Freddie]

Yes when you look at the returns of these funds there is a slight benefit in favour of XBB in the long haul and slight benefit towards XSB over the short haul so really what additional risk are you taking then?

The only additional risk I can see is that XBB fluctuates a lot more than XSB so if you need to cash some fixed income, say if in retirement, then there is a higher risk that you may get caught at a low point in the fund if you are in XBB rather than XSB.

Is that what you are trying to say?

I assume if you are 30 years from retirment then one might as well go with XBB.

 

[OntFA]

Given the low rate of interest and the impending interest rate rise should one think of switching out of XBB and into some other fixed income vehicle of lower maturity?

Remember that bonds really get hurt only if rates rise kind of quickly. If they go up more gradually, XBB will be just fine. And rising rates is associated with a generally healty and growing economy. And with the Canadian dollar having risen strongly again, I think rising rates won't come any time soon, at least not with any real velocity.

Off the top of my head I think the average maturity in the XBB fund is around 6 years give or take. From what I've read, for every 1% increase in interest rates the XBB fund return will be reduced by around 6%. I hope I understand this correctly. Funds with shorter maturities should do better in a rising interest rate environment.

You're thinking of the average DURATION not the average MATURITY, though the two are related.

I generally don't try to time the market at all and this is really not that. I'm trying to find out if I need to re-allocate my fixed income portion to some other fund that might work better in a rising interest rate environment.

Let's call a spade a spade. If you're proposing to lower your bond duration because you expect rising interest rates, that is market timing of some form. Nothing inherently wrong with that but you should recognize what you're doing. And if rates fall at all, you'll miss out on bigger gains available in XBB.

I'm thinking of maybe XSB instead or maybe keep 1/2 in XBB and move 1/2 to XSB.

Personally, I like short term bonds anyway so XSB is a good option regardless of your interest rate expectations. The long term returns of short term bonds have been just mildly less than mid-term bonds but with a fair bit less risk.

 

[Freddie]

Let's call a spade a spade. If you're proposing to lower your bond duration because you expect rising interest rates, that is market timing of some form. Nothing inherently wrong with that but you should recognize what you're doing. And if rates fall at all, you'll miss out on bigger gains available in XBB.

Yeah I get your point it's just that the interest rates are so low that really they only have 1 diretion to go and that's up thus my logic to flip to XSB. I would never think of doing this when say rates dropped from 6% to 4.5% thinking they would go back up. To me that is market timing as they could easily continue down but at the current situation of 0.5% interest rates for the BOC how much lower can they really go?

 

[OntFA]

Yeah I get your point it's just that the interest rates are so low that really they only have 1 diretion to go and that's up thus my logic to flip to XSB. I would never think of doing this when say rates dropped from 6% to 4.5% thinking they would go back up. To me that is market timing as they could easily continue down but at the current situation of 0.5% interest rates for the BOC how much lower can they really go?

I hear you. The thing is, I've been hearing "rates have only one direction to go" for at least ten years. I think Moshe Milevsky wrote about this a few years ago. Again, rising rates is only really damaging if they move quickly. Otherwise, the coupon can cushion the blow of rising rates.

 

[CanadianCapitalist]

Yes when you look at the returns of these funds there is a slight benefit in favour of XBB in the long haul and slight benefit towards XSB over the short haul so really what additional risk are you taking then?

The only additional risk I can see is that XBB fluctuates a lot more than XSB so if you need to cash some fixed income, say if in retirement, then there is a higher risk that you may get caught at a low point in the fund if you are in XBB rather than XSB.

Is that what you are trying to say?

I assume if you are 30 years from retirment then one might as well go with XBB.

Yes, that's my point.

XBB fluctuates a lot more than XSB = XBB has more risk than XSB
XBB's returns are slightly higher than XSB = XBB has slightly higher reward

XBB has higher risk because it is more sensitive than XSB to interest rate fluctuations.

 

[CanadianCapitalist]

Yeah I get your point it's just that the interest rates are so low that really they only have 1 diretion to go and that's up thus my logic to flip to XSB. I would never think of doing this when say rates dropped from 6% to 4.5% thinking they would go back up. To me that is market timing as they could easily continue down but at the current situation of 0.5% interest rates for the BOC how much lower can they really go?

First of all BOC sets interest rates on the low end. Both XSB and XBB hold bonds and the yields are set by the market. When the BOC does raise rates, yields on bonds may or may not move. When you say bond yields have only one direction to do, you are saying that the market is pricing bonds incorrectly today. It may be so but I doubt average investors can consistently guess the direction of bond yields.

 

[leslie]

Everyone owning debt need to understand "duration". Discussion. I believe it is quoted on the ETF's websites. It is often quite different from what you would think.

 

[SRQinvestor]

Protection of Income versus Principle

I recently read a publication of Mr. James Hymas which makes some interesting points on fixed income investing. This article talks specfically about GIC's versus preferred shares but the concepts can be more broadly applied to other forms of short versus long term instruments. Mr. Hymas explores some of the "claims" and "facts" surrounding the investment horizon topic. I found this helpful.

http://www.himivest.com/media/PrefsAndGICs_090814A.pdf

 

[leslie]

I started reading that link and stopped in complete disgust. The real problem for people learning investing from the web is distinguishing what is true from false.

Principal protection:
* The title of the article is GICs vs Prefs, yet his argument compares GICs to bonds.
* His point is a strawman argument that no one makes. No one ever argues that bonds have a variable value AT MATURITY. The argument that IS made is "perpetual preferred have not point in time when the investor can get back a specified $$, and there is no guarantee they will recover the face value value".

Impact of interest rate changes:
* Again he argues GICs vx bonds instead of vs Prefs.
* Another strawman argument. The point people DO make, that he does not address is that a fixed maturity/value GIC will be rolled over at the up-to-date interest rate periodically, therefor limited the effect of a rate change to the period of time before maturity. But a perpetual pref cannot be rolled over because it must first be sold at the variable market value that will impact the amount you reinvest in the subsequent purchase. So effectively, the rate of return you get calculated on the principal you invested at the very beginning will never be the current market rate.

Etc .

 

[OntFA]

I started reading that link and stopped in complete disgust. The real problem for people learning investing from the web is distinguishing what is true from false.

Principal protection:
* The title of the article is GICs vs Prefs, yet his argument compares GICs to bonds.
* His point is a strawman argument that no one makes. No one ever argues that bonds have a variable value AT MATURITY. The argument that IS made is "perpetual preferred have not point in time when the investor can get back a specified $$, and there is no guarantee they will recover the face value value".

Leslie, with all due respect, the article is very much a GIC vs preferreds essay. But he uses the bond market to help bust the myths that GICs never lose their value. Of course they do but nobody sees it because GICs cannot be sold before maturity. Check out cashable GICs, which have a "market value adjustment". Why would a MVA be needed if the market value never changes? Cashable GICs with no MVA simply get a much lower interest rate, from what I've seen. So bonds only appear to enter Hymas' discussion to illustrate a few points about GICs.

I know his article is long and on the technical side, but this guy seems like a serious fixed income dude.

Impact of interest rate changes:
* Again he argues GICs vx bonds instead of vs Prefs.

Again, he isn't making the argument for bonds over GICs as much as he is using bond illustrations to bust common GIC myths.

* Another strawman argument. The point people DO make, that he does not address is that a fixed maturity/value GIC will be rolled over at the up-to-date interest rate periodically, therefor limited the effect of a rate change to the period of time before maturity.

What?! Wait a minute. Are you saying that a BENEFIT of a GIC is that it can be instantly and automatically reinvested at the prevailing rate at maturity? IF SO, I view that more as a disadvantage than a benefit. The investor has no change to shop the market for other GICs or other fixed income alternatives. And while the investor may have wanted that three years ago, maybe rates are so low now that the investor doesn't want to lock in for another three years. I may be misunderstanding you but I've read this over a few times and that's how I interpreted this point. Please correct me if I'm misread your post.

But a perpetual pref cannot be rolled over because it must first be sold at the variable market value that will impact the amount you reinvest in the subsequent purchase. So effectively, the rate of return you get calculated on the principal you invested at the very beginning will never be the current market rate.

Etc .

The first part is right but the second part is wrong. You're right that prefs must be sold in order to be reinvested and they can surely be difficult to sell, unless you want to get ripped off on the bid-ask spread. However, if you simply buy another pref, you are certainly going to get the prevailing rate. Let me try to illustrate. Prefs can be bought back by the issuing company if rates fall sufficiently, they'll do that. And yes, the convexity of the price curve could limit your upside.

But what you have to reinvest is always at the prevailing price/yield. Either you're not understanding fixed income or I'm not understanding you.