Friday, 2 March 2012

Fixed Income: Which is "best" - GIC, Individual Bonds, Target Maturity ETF or Traditional ETF?

GICs and individual corporate bonds have been around forever. Broad-based corporate bond / fixed income ETFs (we'll call them "traditional" ETFs in this post) have existed for a decade or more too. In the last couple of years, BMO, then RBC, launched a series of target maturity corporate bond ETFs to add to the mix available to online investors. So today we ask ourselves - How do they compare, is there one "best investment" or if not, what does each do best? We'll take real examples to assess the current situation.

The Contenders
As usual we have compiled a comparison table below using current data for the following investments:

"Best" is relative to investment objectives
1) GIC - Looks to be the winner by a slight margin for any kind of near-term spending goals requiring a large lump sum of money at predictable or planned moment for which capital preservation is key. Examples might include funding post-secondary education in an RESP, a house purchase in a TFSA or RRSP. A GIC is a highly predictable and simple investment. If held to maturity, the interest rate is the yield and it never varies. The investor's return is exactly the interest rate and it will not change, no matter whether interest rates in the economy go up or down. The compounding option allows cash to be reinvested at the same rate and not sit idle. The GIC is a winner because the rates on offer now are at least as or better than the other investment options when true net yields are calculated (see Net Yield line highlighted in pale yellow in the table).

Another possible use is to set up a sequence or ladder of GICs staggered at whatever maturity intervals desired to hold cash securely in preparation for annual withdrawals from a RRIF to fund retirement spending.

A practical drawback is that not all issuers are available at all brokers and the highest rates may not be available through your broker. For example, Outlook is not listed at this blogger's broker. The highest available five-year rate is only 2.75%. GICs also lack some flexibility since the cashable variety incur a big interest penalty, more or less negating the value of making the investment at all. They are not a good emergency fund.

Nor do they lend themselves easily to maintaining a target asset allocation within a portfolio. Selling to reduce an allocation occasions the interest penalty. Buying to add to an allocation cannot go through existing GICs; new ones must be bought and one might end up with too many small GICs after some years.

2) Individual Bonds - Bonds lend themselves well to creation of a ladder, usually done with maturities about a year apart. The ladder could be used to similar fixed funding objectives as GICs e.g. annual retirement spending with each bond's cash used as it matures. Once the bond is purchased, just as for GICs, if held to maturity, the YTM/return and cash flows are fixed and precisely known. There is no variation. The certainty can help for planning. As our Bell Canada bond example shows, Net Yields now for middle range investment grade bonds are about the same as the best GIC rates.

The biggest drawback of bonds is the exposure to a much more limited number of companies than in a fund. Ten individual bonds in a ten year ladder is not many. A company that is rated investment grade today may not be so in a few years (readers may wish to read more about such realities in our post on default risk). Another practical challenge of bonds is that different brokers also have more or less bond inventory to sell, so a desired maturity date, credit rating, premium/discount, coupon etc may not be available as required.

Should an investor sell before maturity, the price will be influenced by the change in interest rates since purchase. If rates have gone up, the bond's price will be pushed down, probably the more likely scenario today looking forward given the historically low rates in the market. If rates were to go down, then a bond's price will rise. There is a limit that as bond gets approaches maturity, its price will gradually converge to the par value of $1000, which is the amount the issuing company will pay back e.g. Bell's quoted price today of $1088.05 will give the investor $1000 on March 16, 2018 (along with the final interest payment of course).

Individual bonds are poor for maintaining asset allocation in a portfolio. First, there is a large embedded (in the broker's bid price to buy from you) cost of up to 1%. Second, it will be necessary to pick which of the ladder steps to buy or sell, creating an imbalance.

3) Traditional Bond ETF - The broad-based bond ETFs, such as our example XCB, which maintain a wide variety of bond issuers and maturities, do best for the asset allocation function of portfolio management. Rebalancing is easy, requiring only one trade in any desired dollar amount. When the investment time horizon is unknown or indefinite, the traditional bond fund's indefinite end point makes sense.

The biggest disadvantage is uncertainty, both about eventual returns and distribution cash flows (see explanation below). The big swings in returns that are possible can be seen in the wildly gyrating iShares XCB Performance numbers. The YTM of 3.05% on the iShares website must also be reduced by the annual MER of 0.42% to arrive at the net current YTM of 2.63%. Cash flows also change quite a bit year to year as seen in XCB's distributions.

4) Target Maturity ETF - RQF and its sister ETFs with the range of maturities from one to eight years provide a good compromise product for the objective of lump sum spending at specific time intervals. The promised YTM and return at time of purchase will be very close to the eventual actual return. The hard maturity date for the ETF ensures this for the investor despite small variations due to additions or deletions to the list of bonds in the index it aims to track. One thing that does not change the investor's YTM, very unlike the traditional bond ETF, is interest rate changes. Why this is so is explained in this Seeking Alpha article by Matthew J. Patterson. The mix of interest payments and capital gain/loss may change but the total return does not.

The diversity of issuers - 25 in total in RQF - reduces the risk of individual bond holdings mentioned above, a big plus over individual bonds. Interestingly, that diversity includes provincial government bonds.

Maintaining an asset allocation is easier than with GICs and individual bonds since the ETF can be traded in any amount, though not as easy as the single broad ETF since there would be multiple ETFs in a ladder.

Coupon Yield is not Yield to Maturity nor Ultimate Return
It is important to note, since it often is misunderstood, that the cash interest that gets paid out, the coupon yield, is not necessarily the return that the investor can anticipate achieving. Canadian Couch Potato explains well this crucial difference here. These days with many bonds Premium-priced, the usual reality is that coupon yield is much greater than yield to maturity. Our table shows the expected capital decline, if any, for each investment.

The second reality is that the yield to maturity does not necessarily correspond to what the investor will actually receive as a return in the case of traditional ETFs. The fund never matures - it is perpetually selling bonds when their maturity date approaches to under a year and buying other bonds to maintain something called duration. As the ETF manager alters the portfolio make up to achieve their target duration, there will be an impact on the YTM. What that impact will be is hard to determine, as it depends on the direction and magnitude of the shift, slope of the yield curve and the level of prevailing interest rates.

Translated, this is what it means for our example investments:
  • GIC: Coupon 3.2% = YTM 3.2% = Return 3.2%
  • Individual Bell Canada bond: Coupon 4.4% > YTM 2.8% = Return 2.8%
  • Traditional XCB ETF: Coupon 4.6% > Current YTM 2.63% ? Return ?%
  • Target Maturity RQF ETF: Coupon 5.39% > YTM 2.77% approx.= Return 2.77%
Other ETFs - The ETFs we have picked for our examples are not the only ones in those categories.

Target Maturity ETFs
  • BMO Financial Group - 4 target maturity dates - 2013, 2015, 2020, 2025
  • RBC Global Asset Management - 8 target maturity dates - 2013 to 2020
Traditional Corporate Bond ETFs
  • Claymore Canada - 1-5 Year and 1-10 Year
  • BMO Financial Group - Short, Mid, Long
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

Would the BMO Target 2025 ETF be a good choice for the fixed income portion of an RESP when the child is graduating high school around that time? Keep in mind this would not be a one-time investment (money is added each year), and would be rebalanced each year, slowly creeping from the current 70/30 equity/bond split to something far more conservative.

CanadianInvestor said...

Anon, yes I believe the 2025 ETF generally fits with the requirement to provide a lump sum for education at a fixed future date with a known return / yield to maturity. The big advantage of the 2025 ETF is you know what you will get.

Adding money each year means each new contribution will earn a different return depending on what interest rates do (check BMO's website for the current YTM), but the past contributions will continue to earn the YTM of purchase date. With the large number of bonds inside the ETF, default risk of any particular company is low impact. Also, BMO offers a DRIP plan so the cash distributions can be reinvested at no cost / transaction fee. Being inside an RESP, there is no tax on earnings while inside the account and any withdrawals of the income for education get taxed in the student's hands, which most often is a low/no tax rate.

Around year 2020, I would also be looking at GICs as an alternative. As I found in my post in September comparing fixed income rates - - GICs can provide the highest ultra secure return for near maturity dates.

Best success to your child in his/her education!

Dinesh said...

I am considering a RESP for my 6 year old child and found your post quite useful. I am looking at the BMO Target Education 2025 Portfolio, started on Nov 13, 2014. Does your 27 October 2013 explanation about how it works apply in entirety to this fund too.

CanadianInvestor said...

Dinesh, No, the fund you have found is not at all similar to the ones in the post. Here is one that is the same - It is a BMO ETF 2025 target maturity invested in corporate bonds.

The fund you found is a mutual fund with higher fees of 1.5% - vs 0.3% for the corp bond ETF - and an asset mix with more than half equities at first, which will decline with time as the years roll by towards 2025.