Narrowing Down the Choices
Most bond ETFs have pulled back meaningfully over the last few months. Now is probably a good time to consider buying some bonds in your TFSA. There are over 60 bond ETFs on the TSX to choose from. So which is the best one? Rob Carrick wrote an article about bond ETFs for the Globe & Mail back in 2011. I’ve narrowed the list down to the following 5 exchange traded funds which I think are the most appropriate for Canadian retail investors!
- Vanguard Canadian Aggregate Bond Index ETF (VAB)
A favorite fund among couch potato investors. The default go-to bond ETF. Portfolio manager Justin Bender recommends it in his model ETF portfolio. - Vanguard Canadian Short-Term Bond Index ETF (VSB)
This is similar to VAB, but contains shorter maturing bonds. Very safe and steady. Popular with conservative index investors. - iShares Canadian Universe Bond Index ETF (XBB)
This one has been around for a long time. It’s the largest bond ETF here by net asset value. Great track record overall. - iShares Canadian Corporate Bond Index ETF (XCB)
Holds corporate bonds only. Withstood the great recession very well. Relatively high management fees though. - BMO Mid Corporate Bond Index ETF (ZCM)
Similar to XCB, but more diversified and lower fees.
Honorable mentions: Horizons Active Corp (HAB), iShares Canadian HYBrid Corp (XHB), TD e-Series Bond Mutual Fund (TDB909)
Maybe there’s a bond fund I didn’t include above that is a better fit for you. Check out Rob’s article to see a more complete list of funds. The following table breaks down the five bond ETFs into categories so we can compare them. 🙂 You can read my previous post about what bonds are if you need a refresher. (Bond table below)
Breakdown of the Top Five Bond ETFs
| Comparing Bond ETFs | VAB | VSB | XBB | XCB | ZCM |
|---|---|---|---|---|---|
| Price per unit as of Jan 2016 | $25 | $24 | $31 | $21 | $16 |
| Government / Corporate mix % | 77 / 23 | 71 / 29 | 69 / 31 | 0 / 100 | 0 / 100 |
| Net Assets | $1.1 billion | $0.8 billion | $2.1 billion | $1.7 billion | $1.2 billion |
| MER (annual fees) | 0.13% | 0.11% | 0.34% | 0.45% | 0.34% |
| Average duration | 7.6 years | 2.7 years | 7.4 years | 6.1 years | 6.2 years |
| Annual yield | 2.75% | 2.45% | 2.80% | 3.19% | 3.18% |
| Avg yield to maturity | 2.0% | 1.2% | 2.1% | 2.7% | 2.8% |
| % Credit rating AAA | 45% | 57% | 41% | 4% | 0% |
| % Credit rating AA | 37% | 23% | 27% | 26% | 22% |
| % Credit rating A | 9% | 11% | 21% | 33% | 26% |
| % Credit rating BBB | 8% | 10% | 11% | 38% | 52% |
| 1 year total return | 1.2% | 1.3% | 1.3% | 3.2% | 3.6% |
| 5 year average annual return | 3.0% | 1.9% | 2.9% | 3.7% | 4.8% |
| Morningstar ETF Rating | 4 stars | 4 stars | 4 stars | 5 stars | 5 stars |
| Sector breakdown | Gov’t 77% Financial 12% Industrial 8% Utilities 1% |
Gov’t 71% Financial 19% Industrial 8% Utilities 1% |
Gov’t 69% Financial 12% Infrastructure 4% Energy 5% Industrial 2% Utilities 1% Others 8% |
Financial 42% Energy 18% Infrastructure 16% Communication 10% Industrial 7% Real Estate 6% |
Energy 28% Financial 25% Communication 15% Real Estate 13% Industrial 10% Infrastructure 9% |
How to Decide Which Bond ETF to Buy
Let’s go down the list of categories one at a time, starting with the government/corporate bond mix. Government bonds in Canada are considered very safe investments. Low risk means low reward. The current yield on a 10 year Canadian bond is only 1.7%, which leaves much to be desired.
However, a 10 year corporate bond can go for roughly twice that yield, reaching between 3.0% to 3.6% return. Here are a couple of corporate bonds I’ve found using my broker’s online web interface – Brookfield Asset Management and Bell Canada bonds. 🙂
As we can see, Brookfield and Bell Canada have investment-grade credit ratings of A- and BBB+ respectively. Both companies are very financially sound, and are well known among stock investors as blue-chip, large-cap stocks (BAM.A) and (BCE).
Bell is literally the largest telecommunications company in the country, worth over $50 billion, and is a full fledged dividend aristocrat. So although there’s a chance BCE could go bankrupt in the next 10 years, the risk of that happening is really low. Government bonds are the safer variety. But after adjusting for risk, I still prefer corporate bonds like Bell that yields 3.2%, over Canadian government bonds that only pay a disappointing 1.7%. Seriously – even GICs offer higher yields than 1.7% right now. 😄
Since I’m comfortable with a 100% corporate bond portfolio, my bond ETF choice is between XCB and ZCM. This is not to say all government bonds are bad. I just think there are better alternatives at this time, given my personal risk tolerance.
The next variable is net assets, or how much bonds the funds are holding. All 5 bond funds are large enough to provide ample liquidity and volume. 🙂
The next thing to consider are management fees. The 2 Vanguard ETFs, VAB and VSB, are the clear winners here. But they are also the 2 lowest returning funds out of the 5. Fees are important, but they’re not everything. I would much rather earn a 5% return and pay 1% in fees, than earn 2% and pay no fees, if that makes sense.
Average duration refers to how sensitive the ETF is to changing interest rates. Longer duration bonds offer higher yields, but are also more sensitive to interest rate movements. All the bond ETFs in the list above, except for VSB have appropriate average durations for my taste.
The annual yield is the current yield on the ETF itself. The higher the better of course. Not surprisingly XCB and ZCM offer the highest yields because they are full of corporate bonds that typically have higher coupon rates than government bonds.
The weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.
Credit ratings tell investors how risky a bond is. The lower the rating, the more likely the company is to default on its debt obligations. As we’ve seen earlier, Brookfield is around “A”. Bell Canada is around “BBB”. Large Canadian banks are usually rated “AA” or higher. I prefer to own bonds rated AA to BBB, which are still investment-grades, but offer higher yields than AAA rated bonds.
In terms of annual returns, the best performing ETF appears to be ZCM.
All 5 ETFs received high Morningstar scores. But only XCB and ZCM can claim to have the full 5 stars rating. 🙂
Finally we have sector breakdown. Just like buying a stock ETF it’s a good idea to be diversified. It appears ZCM is slightly more diversified than XCB. All the other ETFs are too concentrated on the public (government) sector.
That’s pretty much it. Based on my personal investment style I have decided that BMO Mid Corporate Bond (ZCM) is the best bond ETF for me. For full disclosure I purchased 175 units of ZCM for $2,846 earlier this week.
By choosing to buy ZCM instead of a more popular ETF like VAB, I should be able to earn meaningfully higher fixed income returns compared to most index investors over time. Past performance doesn’t always translate to future gains. But as we have seen, ZCM has historically returned 4.8%, which is 60% more than VAB’s historical return of 3.0%. Keep in mind that ZCM is made from lower grade bonds so it’s more risky than VAB. However, the trade-off is worth it to me. The difference in performance between these bond ETFs will become more apparent the longer they are held.
I hope I didn’t trigger anyone from r/PersonalFinanceCanada. 😄 I’m not suggesting the ETF model portfolio featuring VAB on the Canadian Couch Potato website is wrong. Many investors buy VAB for the low management fees and the safety of sovereign debts. I can see the appeal. The couch potato method is still a valid strategy! I’m just pointing out that in a prolonged, low-interest rate environment, it might be difficult to make money with VAB when 77% of its holdings are low yielding government debt. So perhaps it would be appropriate for some investors to buy alternative bond ETFs other than the commonly suggested VAB or XBB. 😉
But whatever. Hardly anyone reads this blog, so I doubt my message will change anyone’s mind.😕
When it comes down to it, bonds and stocks are just different sides of the same coin. Both asset classes are impacted by the health of the underlying company, which in turn is affected by unpredictable market forces and trends. Just like stocks, some bonds are riskier and provide higher potential returns than other bonds. Some people hold only one bond ETF, while others may decide to split their fixed income portfolio between two or three different ETFs. By understanding your own risk tolerance and investment preference you can create a customized bond ETF plan for yourself. Good luck! 😀
__________________________________
Random Useless Fact:
The United Kingdom has more coastline than New Zealand
Great well laid out article. Quite helpful as I can compare my current small VAB holding with others available.
One thing I am confused about though is the impact of changes to interest rates on the overall return of the bond. For the case of an individual bond, if you plan to hold it until maturity, the return would be based on the coupon/interest paid but would it also be based on the market value of the bond price as well? So if interest rates rise then the bond would be less valuable and hence its price may fall. So if the bond cost you $10,000 at purchase, is it possible than at maturity you may not get all of the $10K back or perhaps more if it market price went up?
Or is impact of interest rates more of an issue for bond funds/ETFs where the price of these funds would be partly made up of the price of the underlying bonds (in addition to the interest paid) and hence more impacted by market changes and buying/selling in the fund?
Sorry long winded for sure 🙂
Hey David. If you hold an individual bond to maturity you don’t have to worry about interest rate changes. When the bond matures you get your principal investment back. This is assuming the company honors its debt obligations, which is usually the case when you’re dealing with AAA to BBB rated entities. If the cost to buy the bond was $10,000 at face value, then you would get $10,000 back in the end. The value of your bond can move up or down during its life depending on interest rates. For example, if rates decreased then the existing bond would be worth more since it’s paying a higher coupon than newly issued bonds. Even so, the value should return back to par as the bond approaches the maturity date since there’s no advantage to a higher coupon when there’s no more time to collect anymore payments. So you only have to consider the bond price if you plan to sell it before it matures. The impact of changing interest rates will effect bond funds and ETFs proportionally to their “average duration.” For example, XCB has a duration of 6.1 years, which means an increase of 1% in interest rates would… Read more »
this is the reason I have a hard time wrapping my head around using bond ETFs as a “low risk” component of a portfolio.
you could make no money.
you could lose a lot of money.
these are not bonds.
I think perhaps the long slow downward trend in interest rates has lulled people into a false sense of security about these securities.
I would think that bond ETFs with a target maturity date would provide the liquidity and diversity benefits without the interest rate risk and volatility.
I guess it doesn’t matter if you’re 20 years away from making a withdrawal. but you have to sell some day… so, I hope you can time that market exit well…
I’d love to hear people’s comments on this issue
I do appreciate that target-date bond etfs and even bonds themselves still have interest rate risk. but it is “opportunity cost” risk, whereas never-maturing bond etfs turn that into capital preservation risk.
I’m not clear on what the great advantage of these etfs is that offsets that cost.
How do you feel about an actively managed bond fund such as – PIMPCO Monthly Income with a return of ~7% in 2016 or CI Investments Signature High Yield bond with a return of ~10% in 2016.
I like the case for active management in the fixed income space. What are your opinions on this topic – namely active vs passive for the fixed income sleeve of your portfolio?
Hey Tom. That’s a good point. I like actively managed fixed income funds if they have a solid track record for performance like PIMCO’s monthly income fund. I want to make sure there is enough positive Alpha being added by the active fund managers to justify the higher MER. So I look at their historical returns and if it’s higher than the best passive fund alternative then I would consider investing in them. Both the mutual funds you mentioned seem to outperform all the bond ETFs I’ve listed in the post above, so I think they are worth considering for the fixed income part of someone’s portfolio. But there is also more risk when foreign bonds and high yield bonds are part of the mix so I would keep that in mind, and only recommend those mutual funds to more sophisticated investors. Depending on your age and risk tolerance I would reserve, at most 50%, of my fixed income allocation towards funds such as the PIMPCO or CI mutual funds. The rest I would put into conventional, BBB or higher bonds. One of the honorable mentions I’ve mentioned, iShares Canadian HYBrid Corp (XHB), is kind of a good middle ground.… Read more »
Very interesting analysis here. Vanguard has shown, time after time that they are worth investing in.
Yes, I suppose that’s why they are so popular around the world.
Newbie question- How long am I supposed to hold 9when is it maturing)ZCB and what will be annual return?
Assuming BMO does not bankrupt will my pricipal be protected at time of maturity ?
Good questions. You can buy targeted maturity funds which is a separate topic but the 5 bond funds mentioned in this post don’t mature. Think of each fund as a basket of 100 or more bonds. As existing bonds in the basket mature, the principal is returned and the money is used to add newly issued bonds to the basket. The best estimate we have for the annual return if everything else stays constant is the fund’s “Yield to maturity.” It means if no new bonds were added to a fund, this would be the annual return if all the existing bonds were to mature.
Your principal in the bond fund is not guaranteed because the value of the fund is determined by the individual bonds it holds. Individual bonds fluctuate in value when interest rates change. The “average duration” of a bond fund is a measurement of how sensitive to interest rates the fund is. Similar to stock ETFs, the longer you stay invested in a bond ETF the more likely you are to make a profit.
Thanks for compiling this. Definitely a great resource 🙂
R2R
[…] Freedom 35 Blog has a great guide comparing Canada’s major bond ETFs. Y’know, if you’re one of those people who actually owns bonds in their […]