Bonds will help reverse that sinking feeling

ROB CARRICK
October 4, 2008

The hidden headline following almost every bad day for the stock market: Bonds rally.

Ah, bonds. Such a comfort in market downturns. You really ought to have some in your portfolio and, if you already do, you really ought to see if you're getting all you can from your holdings.

Most investors are familiar with the idea of diversifying their exposure to the stock market so they own the shares of big and small companies located not only in Canada, but around the world. You can bring a similar level of diversification to bonds, and get the same benefit of limiting risk and enhancing returns.

"This is something that large pension plans do," said Doug Newton, an investment adviser who builds client portfolios using exchange-traded funds that track various bond indexes. "They slice and dice bonds in the same way as stocks."

Mr. Newton starts with Canadian ETFs tracking short-term, corporate and real-return bonds, then adds exposure to global bonds as well. A more streamlined approach to building a bond portfolio is used at PUR Investing, an investment counselling firm where clients might hold just two or three bond ETFs.

And then there's the approach used by Jim Steel, an adviser who avoids bond funds of any type and instead uses individual bonds and guaranteed investment certificates.

These three approaches to bonds may differ, but they do have one thing in common. They bring the same level of care and attention to bonds that investors usually reserve for more glamorous stocks and equity funds.

And now for a quick proviso. Bonds have actually been choppy lately and most bond funds lost a little ground in September. But don't worry. Bonds held up far, far better than stocks last month, they can still be relied upon to pay interest twice a year (provided you have good-quality bonds) and the expectation of lower interest rates ahead can only help. Remember, falling rates are positive for bonds, while rising rates are bad.

Mr. Newton, an adviser with Assante Wealth Management in Canmore, Alta., said his average client would be in his or her 50s and have a 60:40 split between stocks and bonds. Seventy per cent of the bond portion of the portfolio would be directed into the Canadian market and the other 30 per cent into global bonds. The anchor of the Canadian bond position would be the Claymore 1-5 Year Laddered Government Bond ETF.

Laddering is a basic bond strategy whereby you divide your money evenly into bonds maturing in one through five years and then reinvest maturing bonds into new five-year terms. The idea is to free up money every year to capitalize on any increases in interest rates, while also protecting you from having to reinvest a lot of money amid falling rates.

Mr. Newton finds the Claymore laddered ETF to be an efficient substitute for managing individual bonds thanks to a management expense ratio of just 0.16 per cent. "It's really not worth going out and trying to construct a bond ladder on your own and then rebalancing it," he said.

For corporate bonds, Mr. Newton uses the iShares Cdn Corporate Bond Index Fund, which offers exposure to bonds issued by companies with credit ratings that are considered investment grade, or good enough for pension funds. Corporate bonds are somewhat more risky than government bonds, but they also offer higher yields.

Real-return bonds are another category that Mr. Newton likes to include in his clients' portfolios. A real-return bond is a defence against inflation - interest payments ratchet higher if the cost of living increases, and so does the amount that investors get when the bond matures.

For global bonds, Mr. Newton primarily uses a global bond mutual fund from a company called Dimensional Fund Advisors. DFA funds are only sold through a limited number of investment advisers, which means investors and advisers may need to seek alternatives among global bond mutual funds.

There are a couple of specialized bond ETFs listed on U.S. stock exchanges that Mr. Newton uses, the SPDR Lehman International Treasury Bond ETF and the SPDR DB International Government Inflation-Protected Bond ETF. He also uses the iShares iBoxx Investment Grade Corporate Bond Fund.

At PUR Investing, they use a portfolio-building strategy that typically involves just two or maybe three ETFs. The heart of a client's bond position would be the iShares Cdn Corporate Bond Index Fund and the iShares Cdn Real Return Bond Index Fund. Someone who was getting close to retirement would also have some of the iShares Cdn Short Term Bond Index Fund.

The unique thing about the PUR approach is that it uses corporate bonds for core bond exposure rather than a more diversified package like XBB that includes mostly government bonds. Ioulia Tretiakova, portfolio manager at PUR Investing, said the firm's research shows corporate bonds add value without undue extra risk.

On the equity side of its portfolios, PUR Investing uses exposure to commodity stocks as a hedge against inflation. On the bond side, this requires the use of real-return bonds through the corresponding iShares ETF.

Global bonds are not part of the mix at PUR Investing, and the reason is the risk that currency swings will undermine the already small returns from bonds. "With the currency risk, bonds are not the same low-volatility instrument any more," Ms. Tretiakova said. "Risk has increased significantly, and it's not worth it in terms of the risk-reward ratio."

Mr. Steel, an adviser in Ottawa with Watson, said he avoids bond funds, even low-fee bond ETFs, because of the fees. "I don't really see the rationale of paying fees on fixed-income products," he said.

It can be argued that bond ETF fees are reasonable, given that the companies behind these products can buy bonds at wholesale prices that are significantly lower than retail prices. Bond prices and yields move in opposite directions, which means you can improve your yields by paying less for a bond.

But Mr. Steel said he's found that he can get better yields from GICs right now than he can from bond ETFs. Example: He recently got a three-year trust company GIC at 3.77 per cent. The comparable yield at the time on the Claymore laddered bond ETF was an estimated 3.55 per cent after fees, while the competing iShares Cdn Short Bond Index Fund's after-fee yield was about 3.43.

Mr. Steel's bond portfolios are constructed using the laddering approach, with five-year GICs or bonds being the longest maturity he'll use. Like many people right now, he doesn't think the extra yield of longer-term bonds is worth the volatility they bring to investor portfolios.

Portfolio building with bonds

Here are some bond exchange-traded funds that can be used to diversify the fixed income part of a portfolio.

				Year-to-date
ETF	Ticker	MER	Yield	price change*
Claymore 1-5 Year Laddered Government Bond ETF	CLF-T	0.16%	3.5%	n/a
iShares Cdn. Short Bond Index Fund	XSB-T	0.25%	3.7%	0.6%
iShares Cdn. Bond Index Fund	XBB-T	0.30%	4.2%	- 1.5%
iShares Cdn. Corporate Bond Index Fund	XCB-T	0.40%	5.4%	- 4.7%
iShares Cdn. Real Return Bond Index Fund	XRB-T	0.35%	1.9%	- 1.0%

COMPLEMENTARY FOREIGN BOND ETFs