Weather is always interesting… Here in Edmonton Spring refused to arrive in April and winter hung on strongly. We got a good bit of snow this past Monday and Tuesday and freezing temperatures. Spring then arrived on Thursday and by today we moved straight to Summer (at least temporarily). I used the opportunity to sit outside on the deck and read the Berkshire Hathaway Q1 report. What could be better? I will update the report for Berkshire before long.
A word about Bonds and Bond funds.
As I updated my ETF article I noticed that under bond ETFs the cash yields were significantly higher than the yields to maturity. This could cause investors to think they are getting say 4% when it is really more like 2%. A similar situation would occur if you bought a bond at par some years ago at higher interest rates. You now have a capital gain on that bond because interest rates have declined. It is still paying you a high interest rate but really your yield to maturity is far lower. The capital gain on that bond WILL disappear by the time it matures at par.
Also if you buy such a bond today at a premium it will still give you a cash yield that is higher than the yield to maturity. You have to have higher cash yield now to make up for the fact that it will decline in price by maturity. If you think of that cash yield as being really a return, that is wrong since part of it is in effect a return of the premium over par that you paid.
I had a question from a subscriber and I want to share the response here. This is for those interested in bond ETFs.
Question:
In your article about Bond ETFs, you didn’t mention symbol CBO. This is a five year laddered bond ETF. I think it is a good place to park cash. It pays 4.5 plus interest. I would be interested in hearing what you think. Thank you.
Response:
I think the 4.5% yield is true but is misleading.
All bond funds today hold some bonds that they bought a little (or a lot in the case of long bond funds) earlier when yields were higher. There bonds now trade above par and that tended to push the bond ETF price up as interest rates fell. As these particular above par bonds approach maturity they will fall to par value and be redeemed at par (barring bankruptcy). So, these ETFs will fall a little in price if interest remain stable and fall further if interest rates rise. A five year laddered fund suffers less from this issue than a longer fund.
ishares is showing a yield to maturity of 1.76%. They do show current yield of 4.41%.
http://ca.ishares.com/product_info/fund/overview/CBO.htm
I believe the 1.76% is the best guess at what you would earn over the next few years on this fund. You should expect the trading price of CBO to fall a little, offsetting your 4.5% yield.
The price of CBO has trended very slightly down over the past five years despite declining rates.
I don’t hold any fixed income and so am not a good person to have a view on whether 4.5% with expected capital loss and 1.76% net expected return is attractive. Things will work out a little better than 1.76% over the next few years if interest rates continue to decline.
Looking at their holdings, everything is showing coupons in the 4 to 6% range.
That seems odd to me as interest rates are lower now. But they don’t show yield to maturity for each bond.
For one year bonds or two year they appear to be buying the tail end of bonds that were originally much longer. These bonds boast high interest but they pay a premium above par that quickly withers away as the bonds mature in one or two years or three etc. This is the issue I mentioned above except I did not realize they are sort of manufacturing that issue by buying the tail end of long bonds rather than new one year bonds and two year etc.
http://ca.ishares.com/product_info/fund/holdings/CBO.htm
However, they are following the DEX 1-5 year index so it seems the issue appears to be embedded in the index, it’s not ishares that creates the problem.
At the end of the day I find the 4.4% cash yield to be highly misleading.
End of response, but a few more thoughts…
It is disturbing that people may be buying this 5 year laddered ETF and think they are actually earning 4.4% yield. It’s not true, not unless you count return of your own money (represented by the falling ETF price) as your money.
Personally I see little or nothing to attract me to invest in bonds. I believe you can find Guaranteed Investment certificates from banks that pay more than this laddered 5 year appears to pay (more than the yield to maturity, that is). I had never looked into this but I looked just now and TD Waterhouse offers GICs from a number of banks. Unfortunately the rates are pretty low, but at least the product is very straightforward. You cannot cash these prior to maturity.
Or buy individual bonds. I just don’t see anything of interest (no pun intended) in bond ETFs.