Thursday 28 October 2010

Bond ETF Comparison: Canadian Broad Market Funds

Bonds are popular these days so let's have a look at three ETFs containing a broad range of corporate and government holdings. Bond funds are typically included in a portfolio to provide diversification for equities and other asset classes, to preserve capital by virtue of being more stable and secure than equities, or to generate income for spending from the interest they pay out on a regular basis. There are also many narrowly focused bond funds, such as high yield & risk, international bonds, short or long term maturities, corporate or government holdings, but broad ETFs provide a basic starting point and core holding for a portfolio.

The ETFs
Key Comparison Factors:
(for details click on the table image below)

Management Expense Ratio - ZAG is lowest overall by a hair at 0.28% over XBB. CAB's ratio is double that figure but its unique features may be worth it for certain investors with specific needs, as explained below.

Net Assets and Trading Costs - The winner here is XBB whose sheer size ensures a very active market for its shares. That keeps the spread between bid and ask prices very tight, which in turn minimizes investor trading costs (i.e. you can buy - the ask price - at a slightly lower price and sell - the bid - at a slightly higher price).

Diversification and Credit Risk - It's hard to conclude which is best on this dimension. On the one hand, XBB dominates on the number of holdings, which means the impact on the ETF of trouble at any single bond issuer is lessened. And it does have a higher percentage of its holdings in possibly safer government bonds than CAB. However, ZAG with the fewest number of holdings has the most in government bonds. CAB's strong suit is that, unlike ZAG and XBB, it holds none of the BBB or lower credit quality bonds that are most likely to run into trouble. Take your pick!

Interest Rate Risk aka Duration - Interest rates are as low as they have ever been right now but sooner or later they are likely to rise. Duration measures the sensitivity of the portfolio's bonds to changes in interest rates - the lower the duration, the lower the sensitivity (see Shakespeare's brief explanation here and a detailed mathematical explanation here on gummy's stuff of the Financial Webring). CAB is the least exposed with its lowest duration, but not by very much.

When interest rates do begin to rise, that will put downward pressure on the prices of bonds within the ETFs and the share price of the ETFs will fall as well. A mini preview of this effect occurred in April of this year when interest rates briefly spiked up about 0.5% only to fall back down 1% by today. The Google Finance chart below shows the price dip of our three ETFs followed by the upswing.

Yield to Maturity vs Distribution / Coupon Yield - Some investors mislead themselves by looking at the cash distributions (termed either the Distribution Yield or the Weighted Average Coupon percentage) paid out by the ETF as the investment return they will get. But that neglects the fact that the return of a bond or a collection of bonds is made up of the interest coupon (the cash part) and the difference between the price paid for the bond and the eventual payback of the principal of the bond upon its maturity (again, see the above Shakespeare link for a good explanation). The real economic return, which takes account of both factors, the one that we investors need to look at, is the Yield to Maturity. Note from our comparison table that the yield to maturity is much lower than the cash yield from the payout of interest coupons - about 2% less for ZAG and XBB and about 0.5% less for CAB. Don't be fooled - the 2.7% or so that the three ETFs give off is the real return you will be getting at today's ETF price and current interest rates. The low yield reflects the low interest rates in the economy.

There is very little difference between the three ETFs in yield to maturity, only 0.06% between the lowest ZAG and the highest CAB. That's not enough to call a winner.

After-Tax Cash Flow - For investors who buy bonds to receive cash income to spend, the cash distribution amount is a factor to examine. Here is where there is significant difference between CAB and the other two ETFs. ZAG and XBB simply hold bonds and pay out whatever coupon interest is received as they are obliged to do. ZAG and XBB have very similar payout rates of 4.6% and 4.7% respectively.

CAB has a unique structure, deliberately created by Claymore to fill a niche for a bond fund to be held in a taxable account. Most investors do not want or need that, having heeded the oft-repeated advice (e.g. at to hold bond funds inside registered accounts where interest income does not get taxed until withdrawn. Some investors, perhaps having maxed out their RRSP, may want the stability and steady income of bonds outside a registered account. CAB uses a clever forward contract arrangement with TD Bank that allows it to distribute its income as a Return of Capital (ROC) for tax reporting. The cost of doing this - apparently TD receives a fee of 0.3 to 0.4% for its efforts - reduces the gross income but the after-tax net income is very competitive with the coupon yield of XBB and ZAG, especially for taxpayers in higher brackets e.g. the equivalent pre-tax distribution of CAB for a 40% tax rate is 5.34% versus only 4.7% for XBB.

That's because ROC is not taxed at all. Instead the ETF owner / taxpayer must reduce the Adjusted Cost Base of his/her ETF holding. The investor will eventually pay tax on the income as a capital gain instead of income at the time when he/she eventually sells the ETF holding (see our previous post on Calculating Capital Gains in ETFs and Mutual Funds). Claymore says it intends and feels it can achieve to only ever pay out ROC, and not income or capital gains from CAB. This is believable if the arrangement with TD or some other bank in its place is maintained indefinitely since then the returns (both income and price gains if any) will never get realized in tax terms. It's the same principle we outlined in our previous post Return of Capital: Separating the Good from the Bad as "good ROC" in the point about unrealized capital gains in mutual funds. At no point is CAB's income taxed at the higher marginal rate of interest - it achieves the minor miracle of turning the "water" of interest into the "wine" of deferred capital gains! The method used is totally legitimate and well established (the new TSX 60 index tracker from Horizons BetaPro which we reviewed here uses a very similar technique).

XBB and ZAG will produce interest income almost exclusively, though with a minor amount of good ROC - XBB gave off under 5% of its income as ROC in 2009 (see its Distribution History here). This is due to the growth of the ETF assets as investors buy in and more shares are created whose operation we described in our previous post on ROC under the heading Index Mimicking in ETFs.

Bottom line on this measure: XBB and ZAG are both fine and about equal for registered accounts while CAB is clearly best for a non-registered taxable account.

Automatic & Commission-Free Purchases and Withdrawals - For investors not wanting to receive and spend / withdraw the income, e.g. while in the portfolio buildup saving years, a DRIP that reinvests the income into the purchase of extra ETF shares automatically and without trading commissions is a big convenience and cost saver. ZAG and CAB both have the valuable DRIP feature while XBB does not. Two further valuable convenience features that only CAB offers are free and automatic pre-authorized chequing purchases of additional shares or systematic withdrawals by selling shares.

Which is best overall?
CAB is clearly superior for an investor who wants to hold bonds outside a registered account, especially those in higher tax brackets. Within registered accounts, ZAG and XBB are very similar whose slight differences offset each other. For someone building up a portfolio, ZAG is a hair ahead of XBB, due primarily to the DRIP.

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.

Monday 18 October 2010

Online Education for the Canadian DIY Investor

The Internet is a wonderful cornucopia of information at our fingertips but the flood of data and the huge number of websites, blogs and forums can be overwhelming. Today, we run through a few favorite independent neutral non-vendor websites that offer the Canadian DIY investor, in a manner akin to online books, broad, structured educational content on key investment areas.

Investing 101 and Beyond
  • Shakespeare's Investment Primer - a good place to start, always practical in describing the range of investments available to the ordinary person and showing how to put it all together; covers basic components like stocks, bonds, ETFs, preferred shares, REITs, options, foreign content, gold and explains how to manage risk, diversify and allocate assets in a portfolio and withdraw funds in retirement
  • - advanced material oriented to stocks, especially how to assess their value; seems to enjoy knocking down myths; meticulous and thorough with lots of detail, calculations shown and useful spreadsheets to download for one's own use;
  • Independent - (free registration required but they don't sell anything) describes the gamut of common investments equities, fixed income, alternative investments, ETFs, mutual funds; focus on how to protect yourself - advice on dealing with brokers, articles on scams, regulation, costs and industry malpractices; also discusses registered accounts (RRSPs etc) and taxes
  • ByloSelhi - not so much original content itself, but has a large collection of discerning links to high-quality articles on key subjects - ETFs, retirement, real return bonds, financial/investing education
  • - covers taxes on investments (dividends, capital gains, foreign currency etc) within personal taxation; deals with registered vs unregistered accounts; includes calculators and many tips; best of all, it's understandable
  • RetirementAction - serves up assessments of pensions and often-complex investment products oriented to retired people like annuities, GMWBs, structured products, segregated funds; discusses ETFs, asset allocation, inflation/deflation, lifecycle investing and many other topics of import to retirees
Discussion Forums - though not really highly structured content we think one of the best ways to learn is to be able to ask questions and you can ask away in these online forums:
  • Financial Webring - long-lived and active, it tends to be dominated by knowledgeable individuals who reveal many of the fine and sometimes critical points of investing in their quest to outdo each other; there is a separate area called the Finiki that aims to be an encyclopedia of the combined wisdom of the forum
  • CanadianBusiness - tends to be a bit more oriented to the newer investor, lots of active threads in categories such as stocks, mutual funds, investing for beginners, taxes
The list is just a start. Many other useful sites are out there. If you have any to suggest, by all means drop a comment onto this post.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above information is not an investment recommendation. The websites may not provide correct information or advice in every case or subject. Their 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.

Wednesday 6 October 2010

P/E and PEG Ratios - Remember the Effect of Interest Rates

Value investors constantly search for under-valued companies and two of the most common metrics to identify such stocks are the Price to Earnings (P/E) ratio and the ratio of P/E to expected future growth rate of earnings (PEG). P/E and PEG are also used to judge whether the stock market as a whole is under-valued.

Wrong Generalizations: One often sees these kinds of statements made about P/E and PEG:
  • low P/E stocks are under-valued, or a lower P/E stock is a better value than a higher P/E stock; a corollary is that when the stock market is above its long-term historical average P/E of 15, it is over-priced.
  • the P/E ratio of a correctly priced stock is equal to its growth rate and therefore when the PEG ratio <>1 the stock is likely over-priced and should be avoided
Beware! Such statements are too simplistic, misconceptions that arise under the assumption of "all other things being equal", which they rarely are. One particular key variable that can substantially affect appropriate values of P/E and PEG (and which seems to receive scant mention in popular media) is the level of interest rates. Let's see how this works.

What is the Alternative? Earnings Yield Compared to Risk-Free Bonds
Turn the P/E ratio upside down into E/P. The E(arnings) can then be seen as simply the profit divided by the P(rice) to pay per share - it gives a percentage return, called the earnings yield, for the stock e.g. a P/E of 20 (which happens to be approximately the current figure for the TSX Composite Index, i.e. the average of all the stocks in the index) is saying that the earnings yield is 1/20 = 5%. If the earnings never change that's what an investment in that stock will provide the investor. A P/E of 15 is thus an earnings yield of 1/15 or 6.7%.

Now, let's bring in interest rates. An investor contemplating buying a stock or a market index ETF (e.g. the TSX index-tracker iShares S&P/TSX Capped Composite Index Fund, symbol: XIC) looks at alternatives. What else is available and what is the yield? The usual reference benchmark alternative is a risk-free long term government bond like a Government of Canada bond maturing in 20 years. If interest rates are low, the investor is satisfied with a lower return on stocks, which means that a higher P/E is acceptable.

Interest rates today are lower than they have been since the 1950s (see this table of Government of Canada long-term bond yields from the Presitigious Properties website). A 20-year Canada bond currently yields about 3.3% per Canadian Fixed Back only ten years ago when such bond rates ranged between 5 and 6%, an investor would have required a higher return from stocks at that time. Since interest rates are currently very low, higher P/E ratios should be expected and acceptable.

Adjusting for Risk
The current bond rate of 3.3% is less than the stock earnings return of about 5%. The question is whether there is enough difference to compensate for the extra risk, of stocks in general, or of a particular stock. For stocks in general, the usual method to get a return is to add a so-called Equity Risk Premium to the risk-less rate. How much should we add? We could take the long term actual historical average of 3.7% for Canada (per the Credit Suisse Global Investment Returns Yearbook 2010). For other countries or the world equity market, historically riskier than Canada, we might take the 4.5 - 5% estimated by Dimson, Marsh and Staunton in The Worldwide Equity Premium: a Smaller Puzzle from the SSRN website). For riskier emerging market countries, it should be higher still. For individual stocks, their relative riskiness would require an upward or downward adjustment.

Inflation is inter-twined with interest rates and risk, having the effect of increasing both. Thus, higher inflation creates lower P/E values. Since inflation is currently low - indeed some feel the bigger concern at the moment is deflation (see our August 24th post on the inflation vs deflation debate) - and the low expectations for inflation implied by the 2.1% difference per Bank of Canada rates between nominal and real return bonds (see Bank of Canada's Inflation Expectations and Real Return Bonds), we can say that the inflation picture reinforces the idea that current P/E values can be acceptably higher.

Growth Adds to Price and Pushes Up P/E
The final factor to consider is the growth rate G. Using the current earnings yield assumes a steady state with no growth in earnings. It is normal that companies grow, that's what creates economic growth. Intuitively, higher future earnings are worth something to the investor so it is worth paying a higher price today. The more growth, the more future earnings will be generated, so P(rice) is justifiably higher. P is higher compared to today's earnings and so P/E is higher too.

Earnings growth is driven by the combination of the profitability of a company and the proportion of earnings reinvested (instead of being given out as dividends). The higher the profitability and the more that is reinvested, the faster the growth.

NYU professor of Finance Aswath Damodaran has produced a graph that shows how dramatically high the P/E of fast-growth companies can justifiably be. A high P/E stock may reflect a higher potential growth rate and not be a poor value compared to a lower P/E stock with lower growth. Conversely, a low P/E stock may reflect no growth or even expectations of earnings decline and may not be worth buying at all.

Low Interest Rates = Higher P/E and Higher PEG
The net effect of all factors combined shows up in the following table, calculated with standard finance formulas:
  • P/E values are highest for lowest interest rates, no matter what absolute return the investor seeks
  • PEG ratios are also highest for lowest interest rates, where they greatly exceed 1
  • PEG ratios for correctly valued stocks are above 1 in most interest rate scenarios
  • PEG ratios of 1 or less for under-valued stocks only occurs: primarily, when interest rates are quite high (Government bonds at 10% or more) and secondarily, when investors require higher rates of return (5% or more over the Government bond rate)

TSX Over-Valued at P/E 20?
Since the above table shows no P/E above 18 at the lowest possible interest rate and the lowest required return, does that mean the current TSX P/E of 20 indicates an over-valued Canadian stock market?

Not necessarily. If the required Equity Risk Premium lies at 2.0%, below the historical 3.7% TSX rate, the justifiable P/E rises to around 20. Or, if the future profitability (ROE) of companies in the TSX rises fast and is higher than the required investor return by 3%, a P/E of 20 makes sense at current interest rates (see table below).

Bottom Line - Making the judgement of over- vs under-valued is quite difficult because it requires estimating what the future will bring. But we should not trip ourselves up by ignoring current low interest rates that have the effect of raising justifiable levels of both P/E and PEG.

Further reading: Burton Malkiel, author of the investment classic book A Random Walk Down Wall Street, said about the US market in September 2001, Don't Sell Out

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.