Questioning Gordon Pape on Bonds

I will admit to some trepidation in writing this blog post. Gordon Pape is one of the grand old men of investing in Canada. He has written a column for the Globe and Mail for more years than I can recall right now. However, like all of us, Mr. Pape has biases, and not all of them are well-founded. His article on bonds from last week (May 17, 2022) is a case in point.

 

The problem with bonds

Bonds are not a controversy-free investment at the best of times. Over the long run, they are virtually guaranteed to return less compared to equity investments. For years, prevailing interest rates have been declining, which means that the fixed income payments that bonds generate for their holders have been decreasing relative to the amount invested.

 

However, it hasn’t been all bad. As a result of the general decline in interest rates, bonds have gained in value. Using XBB, the iShares Core Canadian Universe Bond Index ETF as a representative example, the annual gain in 2020 was 8.57% and in 2019 it was 6.83%.

 

Negative years are not entirely unknown, of course. In 2021, XBB lost 2.65% but before that 2013 was the last losing year, coming in at -1.50%. In 2022, however, year-to-date losses are dramatically negative at -10.27%. Nevertheless, when you compare XBB to the all-stock ETF, XEQT, the iShares Core Equity ETF Portfolio, which has a mix of equities from around the world, you find the latter is performing unfavourably with a year-to-date return of -13.03%.

 

Bonds and your time horizon

The classic rule of thumb has been that the percentage allocation to bonds in your investment portfolio should equal your age. In other words, a 30-year-old should have 30% in bonds with the balance of 70% in equities. A 60-year-old should therefore have 60% in bonds and only 40% in equities. Rules of thumb, though, are seldom a good idea, although they may serve as a useful starting point. More consideration should be given to the willingness to take investment risk, the ability to absorb losses, the emotional or psychological capacity to take risk, and finally the need to take investment risk to meet your goals. One could well argue that the woman in Pape’s column who is in her early 30s could take plenty of risk, given retirement is likely three decades or more into the future, and she may need her assets to last through another 30 or 40 years after she retires. Potentially, she could ditch the bonds and go all-in on equities for the next several years.

 

However, she may be in a commission-based job with a wildly fluctuating income. She may have grown up in a family that was always short of money. She may, therefore, crave a stable income-oriented portfolio. Whether that is the best choice for her from a dispassionately rational perspective, the more important thing is to invest in a portfolio that she can stick with for the long term.

 

I realize a brief column in a newspaper is not the place where Gordon Pape or anybody else can provide useful investment advice, but the suggestion that the person writing in should buy “quality long-term bonds that are trading below par and offer attractive yields” is not at all helpful.

 

Individual bonds versus bond ETFs

What truly bothers me, though, is Pape’s caution against buying bond ETFs in favour of individual long-term bonds that should be held to maturity. “Anyone who wants to invest in bonds for the long term should focus on buying specific issues, not funds.” In my opinion, this is exactly the wrong answer. If you have a 30+ year time horizon with an unclear endpoint, I will argue that a bond ETF or a low-cost mutual fund is the right choice. If you know that you will need exactly $20,000 ten years from now, then yes, you might buy a bond with a maturity in ten years, but otherwise, why would you want to lock yourself in? Yes, you can sell the bond before maturity if you want, but if interest rates go up in subsequent years, you may have to sell that bond for a loss.

 

A bond fund is similar to a bond ladder. It will hold a wide range of bonds of various maturities. XBB has 1,455 holdings, with maturities of some corporate bonds extending out to the 2080s, 60 years from now, while on the short end there are multiple government and corporate bonds that mature as soon as June 2023. The average maturity is a shade over 10 years. This suggests that as long as you plan to hold bonds for about 10 years or more, XBB, or a fund of similar average maturity, may be appropriate for you.

 

However, it is more than just maturity that is involved. There is the diversification factor. With a broad-based bond ETF like XBB, you have a slice of investment-grade corporate and government (federal and provincial) bonds that you could not hope to approach through the purchase of individual bonds. Pape is suggesting that this woman in her early 30s buy long-term bonds. Depending on how much money she has available, she might be able to buy a handful of individual bonds, but the commissions to buy those positions will seriously impact her returns and she will still be undiversified. If people buy bonds in part to reduce risk, favouring individual bonds over bond funds is one way to re-establish risk.

 

Risks of investing in bonds

Interest Rate Risk

When interest rates rise, as they are doing now, bond prices tend to fall. All else being equal, a bond with a longer term to maturity will react more dramatically to an increase in interest rates than will a shorter-term bond. Consider ZGB, the BMO Government Bond Index ETF versus ZFL, the Long Federal Bond Index ETF. ZGB has a weighted average term of just under 10.8 years, while ZFL’s average term is 24.46 years, which can serve as a proxy for Pape’s recommendation of an individual long-term bond.

 

 

The green line represents the year-to-date price change in ZGB while the blue line shows the outcome for ZFL. You can see how the run-up in interest rates has more dramatically affected the longer-term bond.

 

Reinvestment Risk

Some people buy bonds and bond funds for the income they generate. If that’s the case, reinvestment risk is not an issue. But, for those who wish to reinvest their interest payments, if interest rates drop, they will have to settle for a lower rate. In our increasing interest rate environment, however, this can work in our favour as new bond purchases will be at higher rates, or if you care to look at it this way, lower prices.

 

Inflation Risk

This is what we are experiencing right now. When inflation increases dramatically, bonds can have a negative rate of return. This is unavoidable but can be mitigated by having a part of your fixed-income investments in shorter-term bonds. For example, consider these three ETFs from Vanguard. VSB, the Canadian Short-Term Bond Index ETF (green, -4.42%), VAB, the Canadian Aggregate Bond Index ETF (blue, -11.14%), and VLB (purple, -19.55%), the Canadian Long-Term Bond Index ETF. All three are in losing positions since the beginning of 2022, but the shorter the average maturity, the better the relative outcome.

 

 

You may be asking about real return bonds offered by the federal government. In ETF form, iShares offers XRB while BMO has ZRR. They are designed to hedge against inflation. Yes, they will do relatively better in cases of unexpected inflation, but they are long-term bonds, so they may still perform poorly compared to bonds with shorter maturities.

 

Credit/Default Risk

Government bonds have the power of taxation available to them which generally makes them more creditworthy. This is not always true, as national governments do default. Examples are Mexico in 1994, Russia in 1998, Iceland in 2008, Greece in 2012, and Argentina multiple times. However, corporations are subject to this risk. If a company that has issued bonds has business problems, it may default on its interest or principal payments. Bondholders could potentially force the company into bankruptcy, resulting in a liquidation of assets, and potentially receiving only a few pennies for each dollar invested. If there is any comfort there, anybody who held the common shares of that company is likely to receive nothing at all.

 

Rating Downgrade Risk

A company doesn’t have to go bankrupt to cause bondholders financial harm. Even if a company maintains its scheduled payments, it can still undergo a downgrade from the bond rating agencies because of circumstances they deem to increase the risk of holding a particular company’s bonds. As a result, potential bondholders will demand a higher interest rate to compensate for that risk. Existing issues of bonds will decrease in value. If for some reason you want to sell a bond issued by a company that has received such a downgrade, you are likely to face a loss.

 

Liquidity Risk

Many bonds do not trade frequently. As a result, there may not be a market if you are trying to sell your bond or there may be so few interested buyers that you will have to sell the bond for a big discount. Conversely, if you are trying to buy a bond, you may have to pay a high price to get what you want, which will negatively affect the yield you receive.

 

How Bond Funds Can Address these Risks

Interest Rate Risk

Increasing interest rates will inevitably cause a decline in bond prices but buying bonds while interest rates are high means you are buying at higher rates that will benefit you over time. Imagine a typical bond fund that tracks the universe of Canadian bonds. Two examples that have been cited earlier are XBB and VAB. As the bonds in these funds’ portfolios fall below one year, they are sold and immediately replaced by bonds at the long end of the spectrum. As long-term bonds typically offer a higher yield than short-term bonds, you are locking in purchases of new bonds at higher yields, while disposing of low-yield short-term bonds. This all happens automatically inside a bond fund. If you hold only a few individual long-term bonds you have to make some judicious decisions that are probably going to be quite costly in terms of both commissions and the bid price when you sell and the ask price when you buy.

 

Reinvestment Risk

Fluctuating interest rates affect bond funds as well as individual bonds. The benefit with funds, though, is that you can reinvest your interest payments (almost) automatically. In the mutual fund world, interest and principal payments are typically reinvested within the fund down to the penny, so you don’t need to worry about this at all. In the case of ETFs, reinvestment is a little less handy in that most brokerages will only invest in whole shares or units so there will inevitably be some dollars left over. This doesn’t eliminate the risk of investing at lower yields, but it makes the process of reinvestment seamless or nearly so.

 

Inflation Risk

As previous paragraphs have shown, bond funds will decrease in the face of inflation, just like individual bonds. However, and this is particularly the case when you buy bond index funds, you will have bonds with the full range of maturities inside the fund so not all of your holdings will be subject to the same degree of volatility.

 

Credit/Default Risk

This is where I think bond funds shine. When you have over 1,000 bonds in your fund, the impact of any one bond defaulting on its scheduled payments is much smaller than if you buy a handful of individual bonds. This would be especially the case if you are comparing the purchase of individual corporate bonds to a corporate bond fund as government bonds would have little chance of default.

 

Ratings Downgrade Risk

Once again, bond funds are superior. A mutual fund or ETF that holds hundreds of bonds from government and investment-grade issuers is highly unlikely to suffer a meaningful decline in value from the downgrading of any one or two bonds.

 

Liquidity Risk

At the risk of repeating myself, funds do a better job here. Bond mutual funds are typically redeemable every business day. ETFs trade throughout the day with steady bids and asks being posted throughout market hours. In fact, as the news of COVID-19 panicked investors in March 2020, “there were reports of ‘no liquidity’ in the fixed income market.” What happened to ETFs? Perhaps surprisingly, ETFs remained continuously quoted and traded.

 

Source: TD Webbroker

 

As you can see above, when bonds were bottoming out, they nevertheless continued to trade. This is the daily chart for XBB from mid-February to mid-April 2020.

 

The bottom line: buying individual bonds is a mistake for the average retail investor. Often, the simpler approach – buying bond funds or ETFs, in this case – is the better one.

 

This is the 149th blog post for Russ Writes, first published on 2022-05-23.

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.

 

Photo by PiggyBank on Unsplash