What's Happening To Canadian Bonds? (XBB)

Last update on July 31, 2014.

Buy National War Bonds

 

A little over a year ago, I published an article where I argued that holding mid to long term bonds were a bad idea. In the article, I also criticized the Canadian Couch Potato for incorporating an ETF that holds such bonds in their portfolio.

In this article, I will give an update on what happened to the bond market since then, as well as what I see going forward.

 

XBB Performance

For those of you who don't know, the Canadian Couch Potato is a popular blog dedicated to index investing. While they generally have good content, I criticized their choice to continue to incorporate the iShares Canadian Universe Bond Index ETF (Ticker: XBB.TO) in their portfolios.

When you buy shares of XBB.TO, you essentially buy a basket of diversified bonds. These bonds have differing maturities, ranging from 1 to 25+ years. In my article, I argued against investing in mid to long term bonds, which make up the majority of XBB.TO, because an increase in interest rates would penalize holders of XBB.TO, and because such an increase was likely. If you want to learn about bonds and ETFs, check out our free book on investments.

On June 1, 2013 when I published the article, XBB.TO was priced at $31.05/share. In the first few months that followed, bond prices seemed to crater. By Sep 6, 2013, the price went down to $29.65, which represented a loss of 3.7% even after interest payments were taken into account.

However, since then, prices of XBB.TO recovered and closed at $30.95/share as of July 30, 2014. This meant that holders of XBB.TO gained 3.5% since June 1, 2013.

 

What Determines Longer Term Interest Rates

You might be tempted to say I was wrong, but before you do, consider the following.

Unlike many other investors, I never said that interest rates will definitely rise (which would cause XBB.TO to fall). However, I did say that interest rates were more likely to rise than to stand still or fall, since I thought it likely that the Canadian economy will recover.

I explained in my previous article that there was a link between the economy and interest rates, but I didn't fully explain just why that is the case. Let me explain this link in fuller detail.

In Canada, the central bank that controls interest rates is the Bank of Canada (BoC for short). However, the BoC doesn't control all interest rates. Rather, they only control the short term interest rates of the Government of Canada bonds. Currently, the BoC has set the short term rate at 1%/year.

With respect to all other interest rates, including longer term government bond interest rates, they let the markets arrive at the 'right' rate. The interest rates of these medium to long term bonds reflect the market's expectation for short term rates in the future.

To understand why, let's take an example. Suppose an investor thinks interest rates on one year bonds will be 1% this year, and 2% next year. Then, the investor will be indifferent between buying a two year bond that yields 1.5% per year, or buying 1 year bonds this year and next year, as both scenarios will generate the same returns for the investor.

However, if two year bonds yield 2% per year, then the investor will buy the two year bonds, since that would generate higher returns for the investor. If many such investors buy two year bonds, the demand for two year bond increases and this pushes the yields down until two year bonds yield 1.5% per year. The opposite would happen if two year bond yields are lower than 1.5%. The lack of buyers and more sellers will push the yield up to 1.5% per year.

In this example, two year bonds will have to yield 1.5% per year because investors expect one year bonds to yield 2% next year. If they expect the one year bond to yield 3% next year instead, then two year bond yields would have to arrive at 2% (i.e. average of 1% and 3%).

In other words, longer term bond yields depend on investors' expectation for future short term bond yields. Since the BoC controls the short term yields, the longer term yields indicate what investors think the BoC will do in the future.

 

What Determines Short Term Interest Rates

To understand movement in medium to long term interest rates, we therefore need to understand what makes the BoC move short term rates.

Officially, the BoC is mandated to keep inflation within a specific range, between 1 and 3%. If inflation goes above this range, the BoC will typically raise rates, and vice versa.

Higher interest rates make it unattractive for people to borrow money, so they take out less mortgages, buy fewer cars on credit, etc. This forces the economy to cool down, and brings inflation down as well. On the other hand, lowers interest rates encourage people to borrow money, which stimulates the economy and brings up inflation.

Therefore, if the economy does well, investors anticipate that the BoC will raise rates. This makes medium to long term interest rates go up. The opposite also happens if the economy doesn't do so well.

One economic indicator that the BoC watches closely is the unemployment rate. This is because there is a direct relationship between inflation and unemployment in the short term

In the latter half of 2013, the Canadian economy appeared to be doing well. The unemployment rate fell from over 7.2% in May 2013, to 6.9% in Oct 2014. This led investors to believe that the BoC will increase rates soon, which raised medium to long term interest rates (i.e. lowered bond prices).

However, in January 2014, the unemployment rate unexpectedly shot back up to 7.2%. This sudden surge in unemployment rate jolted interest rates back down. If you look at historical XBB.TO prices, you can see the price surge in January.

In June 2013, the unemployment rate stood at 7.1%. As of June 2014, the unemployment rate remained at the same 7.1%. Other key economic indicators that the BoC pays attention have similarly shown very little improvement over the last year.

This is a disappointing result, particularly as our neighbours south of the border have done much better. In June 2013, the U.S. had an unemployment rate of 7.6%. By June 2014, the rate went down to 6.1%. As a result, their long term bond yields went from 2.15%/year on June 1, 2013 to 2.58%/year on July 30, 2014.

As a result, the the U.S. bond ETF named iShares 7-10 Year Treasury Bond ETF (Ticker: IEF), which has a similar average duration to XBB.TO, recorded a gain of just 0.2% between June 1, 2013 and July 30, 2014. U.S. investors would have been better off buying short term bonds instead.

 

What The Future Holds

I had assumed that there was a high chance that the Canadian economy would follow a similar trajectory to the U.S. Was I wrong to assume so? I'll let you decide.

So far, I've only talked about what happened in the past. But what can we expect in the future?

As before, the prices of Canadian bonds will continue to depend on economic factors like the unemployment rate. If the unemployment rate remains high, then we can expect to see bond prices to stay where they are. If the unemployment rate goes up, we can even expect bond prices to go up from here.

While I can easily think of such a scenario (a crash in housing prices will do that, for instance), I'm not sure if such a scenario is likely. If history is any guide, the Canadian economy should follow the U.S. economy up, even though that hasn't happened yet. In that scenario, I expect bond prices to go down again from here.

According to Warren Buffett, the number 1 rule of investing is "Never lose money". The number 2 rule of investing is "Never forget rule number 1". This is what I try to keep in mind as I construct MoneyGeek's portfolios. For that reason, I will continue to incorporate XSB.TO, the short term bond ETF, instead of the riskier XBB.TO.

If you enjoyed this article, you might be interested in our free newsletter. Enter your email to get free updates.

Next entry

Previous entry

Similar entries

Comments

  1. I G - 07/31/2014 1 p.m. #

    With Average Duration of 7.10 years isn't XBB an intermediate-term bond ETF? Also, I've read an article from Rick Ferri recently that seems to argue that those US investors who switched to short-term bond funds in the past few years didn't do so well.

    http://www.rickferri.com/blog/investments/the-risk-of-short-term-bond-funds/

  2. Jin Won Choi - 07/31/2014 1:50 p.m. #

    @I G, XBB is more of a diversified bond ETF. When you buy XBB, you're really buying bonds of vastly different maturities. Some of them have maturities extending to 25 years, so by buying XBB, you own fractions of bonds that mature in 25 years. IET is an example of a true intermediate bond ETF, since it invests solely in bonds with 7-10 year maturity.

    As for Rick Ferri's article, it all depends on when you measure the performance from. He tracked performances from 2011, whereas I made the call on Jun 1, 2013. BSV, the short term U.S. bond ETF, returned 1% between Jun 1, 2013 and Jul 30, 2014. So if you're a U.S. investor, investing in short term bonds paid off vs owning longer term bonds since Jun 1, 2013.

  3. I G - 08/01/2014 11:40 a.m. #

    >When you buy XBB, you're really buying bonds of vastly different maturities.

    Right. And its Weighted Average Term is 10.07 so it'll behave much like an individual bond of this maturity (10 yrs), will it not?

    >... investing in short term bonds paid off vs owning longer term bonds since Jun 1, 2013.

    That's like slightly over a year ago... And I still have at least 25 years to go until retirement... 8-)

  4. Jin Won Choi - 08/01/2014 3:05 p.m. #

    >And its Weighted Average Term is 10.07 so it'll behave much like an individual bond of this maturity (10 yrs), will it not?

    Sort of, but not quite. Investing in a 10 year bond will only expose you to the 10 year interest rate, whereas investing in XBB will expose you to 25 year interest rates as well. Therefore, if the 25 year interest rate moves up and 10 year rate stays constant, XBB will go down whereas the 10 year bond won't.

    The last time 10 year interest rates went below 2% was around 1945. Interest rates proceeded to march up for the next 35 years until around 1980. Interest rates came back down for the next 35 years, bottoming around 2013. I'm not saying history will definitely repeat itself, but if it does, then holding bonds for the next 25 years could be painful.

    http://www.ritholtz.com/blog/wp-content/uploads/2012/09/equity-vs-bond.png

  5. Grant - 08/02/2014 10:21 a.m. #

    Jin, the research shows that for the typical investor (equity allocation of 50-80%) the most efficient portfolio holds bonds with terms averaging 4-5 years, in other words intermediate bond funds. There is thing wrong with holding short term bonds, but you are giving up some term premium, so long term investors are better off holding intermediate term bond funds. Remember that if interest rates go up, although the price drops initially, it recovers with new bonds being purchased at higher interest rates, so you do not lose money if you hold the fund for it's duration. Future interest rates are already priced into the yield curve, so if you hold short term bonds, you will only do better if interest rates rise more than expected. In other words you are saying you know better than the market. Going down that road usually ends badly.

    There is a lot of evidence that shows trying to predict the direction of interest rates is a mugs game. You article from a year ago demonstrates that. The one year return of XBB is 5.0%, and for XSB it is 2.93%. (BTW, the one year return for IEF is 3.12%, not 0.2, better than BSV of 1.72%.).

    XBB has somewhat of a barbell structure, and convexity does play a role in price changes, but by far the most important factor is duration. Although it's average term is 10 years, it's duration is only 7.1 years, placing it firmly in the category of an intermediate term bond fund.

    One might prefer a pure intermediate bond fund like XFM, but that is splitting hairs somewhat. Investors with an investing horizon of 7 years or longer will have better portfolio returns with an intermediate bond fund like XBB, than with a short term bond fund like XSB.

  6. Jin Won Choi - 08/02/2014 11:16 a.m. #

    Grant, your calculations are wrong. For example, on July 30 2014, IEF was priced at $102.99. On May 31 2013, it was priced at $105.32. During that time, it paid out 2.5. Combine this altogether, and investors in IEF only gained $0.17, which is just 0.2%.

    I couldn't disagree more regarding your comment about the market. Did the markets really know better during the internet bubble? Did they really know how to price subprime mortgage backed securities in 2007? There are many, many other examples of market failure to price assets rationally.

  7. I G - 08/02/2014 9:05 p.m. #

    Hm, ishares seem to confirm Grant's number of 3.12% one year total return for IEF:

    http://www.ishares.com/us/products/239456/ishares-710-year-treasury-bond-etf

    Or is this a different 1 year period?

  8. Jin Won Choi - 08/02/2014 9:19 p.m. #

    It's a different period. Check the dates.

  9. Grant - 08/03/2014 6:58 a.m. #

    Jin, returns are conventionally reported YTD, 1 year, 3 year etc. choosing a 13 month period is data mining, You can prove just about anything by picking specific points on a graph. But that's not the point of my comment. The point was that if you look at the evidence, investors with an investing horizon of longer than the duration of an intermediate bond fund (about 4-8 years) will have better returns no matter what interest rates do, investing in intermediate rather that short term bond funds.

    With regard to your comment about market failures. Of course, there are many market failures. But that's not the point. The point is that the market is fairly efficient, not totally efficient, such that it is extremely difficult to beat the market after costs, especially if you paying someone to try to do it. The evidence is overwhelming on this point, well reviewed in "The Quest for Alpha" by Larry Swedroe.

  10. Jin Won Choi - 08/03/2014 8:13 a.m. #

    Grant, I didn't arbitrarily choose a date. June 1 2013 when I published my article when I warned people against longer term bonds.

    Also, this is not about beating a particular market. It's about asset allocation, which is about choosing which markets to enter in the first place. I would appreciate it if you argue against a straw man.

  11. Grant - 08/03/2014 5:15 p.m. #

    Jin, sorry, but I took the article to be about the merits of short term bonds versus XBB. Looking at a short period time, whether it be 13 months or one year, is hardly relevant when considering that question.

  12. Jin Won Choi - 08/04/2014 10:36 a.m. #

    Yes, it's about XSB vs XBB.

    All the research you point to about "efficient market hypothesis" only applies to actively managed funds vs. passively managed funds. They indicate that because of expenses and because of management changes, active funds tend to lag behind passively managed funds.

    This article is NOT about that.

    Both XSB and XBB are passively managed, and have very similar expense ratios (XSB's is slightly lower, but who's counting?).

    Instead, the question is whether a longer term bonds, as an asset class, is worth the risk. This is an asset allocation problem.

    I hope you see the difference.

  13. Grant - 08/04/2014 10:09 p.m. #

    Exactly. And if you look at the research, as I commented earlier, for investors with a 50-80% equity allocation, intermediate term bond funds result in higher portfolio returns than do short term bond funds, assuming a time horizon longer than the duration of the bond fund. This is reviewed in Swedroe's book "The only guide to a winning bond strategy you'll ever need".

  14. HeKyLl - 08/22/2014 11:32 a.m. #

    Hello, I'm not a regular reader of this blog and I have yet to make up my mind whether I will (see below). I consider myself a novice when it comes to personal finance and I have little inclination or time to either become an expert or devote more than a few hours a month to my portfolio. Full disclosure: I'm a couch potato and follow the CCP's website.

    Grant raised an issue which you did not address in your post or your subsequent replies -- the returns of XSB vs. XBB. You stated your reasons in your blog posting and, while I find them plausible, the fact remains that if people had followed your advice 1 year ago and dumped XBB in favour of XSB (or, more generally, shortened the duration of their bond holdings) they would have reduced their bond returns for the past year. I don't want to put words in your mouth but would I be correct in assuming your message here is "I'll be right eventually"?

    FYI the CCP recently called out all the bond bears for their inaccurate predictions.

    http://canadiancouchpotato.com/2014/07/04/bond-bears-admit-you-were-wrong/

    This article isn't directly relevant to your post but I raise it because as you know the media is saturated with experts and pundits who love to make recommendations and predictions which don't always pan out.

    Ironically, your posting has reaffirmed my commitment to the couch potato strategy - if someone with a PhD/financial certification/TV show can't predict when to change their bond duration or asset allocation what hope does a novice like me have? As Grant said, I understand that I won't lose money if I keep a bond etf/fund for the duration. I'm in it for the long haul and the bond allocation isn't there solely to generate returns.

    Dr. Choi you've issued a few challenges to the CCP strategy in your blog and I think a little competition is healthy which is why I'm curious about your blog. In addition, I recognize you have 2 more years in which to prove that your portfolios will outperform CCP's portfolio. Time will tell.

    Nonetheless, and I know I'm stating the obvious, your challenges won't elicit much of a reaction from CCP adherents. I'm happy with earning the market less a reasonable ETF fee in exchange for not making a 20+hr/week hobby out of my portfolio -- I don't have to parse through predictions and recommendations and sweat over whether to buy or sell X or Y or when to do it. I recognize that there are people out there who are doing much better than I am. Yet, I'm OK with that because, as one CCP convert once related, it is a very liberating strategy. I read financial news and blogs for personal interest and not to plan my next major decision with my portfolio. Perhaps most importantly, it's a strategy I can understand, stick to, and have confidence in with respect to my goals.

  15. Jin Won Choi - 08/22/2014 12:53 p.m. #

    Hi HeKyLl,

    You've written a lot, so I'll just respond to a couple of points.

    Regarding "I'll be right eventually", yes I'm saying that but it depends on what it means to be 'right'. When held to maturity, XBB will probably return more than XSB. But then again, when held for the long term, stocks will probably return more than XBB. The question in each case is whether the additional risks justify higher returns. I think risk adjusted, XBB is a poor choice compared to XSB.

    Like I've said in this article, I've never said interest rates will definitely do anything. I just laid out the probabilities and the consequences of such outcomes. I've used the probabilities and consequences to judge the riskiness of investing in XBB though. This is different from a rate forecaster who uses his forecast to dump bonds to boost returns. I hope you see the difference.

    I don't know where your 20+hr/week comment is coming from. Making the decision to buy XSB instead of XBB doesn't take hours. MoneyGeek's regular portfolios change about once a year to adjust for market circumstances, and rebalancing the portfolio takes minutes, not hours.

    I sincerely hope that many others don't have such misconceptions.

  16. Jamie - 08/23/2014 8:36 a.m. #

    CCP has made it clear that holding bonds in a portfolio isn't about generating returns, a you've described, but rather as a risk mitigation strategy. See his recent post on pension fund approaches to fixed income. He's also clearly explained that predicting interest rate moves, and basing your bond choices on such, is prone to error. See the post on 'bond bears' getting it completely wrong.

    The recent performance of XSB vs XBB is completely irrelevant to medium-longterm investors (most of us).

    My time horizon is about 25-30 years till retirement and ideally another 30 after that for lifespan. Short term interest rates and the returns of XSB are irrelevant for me for the many reasons that CCP has outlined on his website. These are the reasons why I hold XBB and don't care about the last year's performance.

  17. Jin Won Choi - 08/23/2014 9:48 a.m. #

    Jamie, if you truly want safety, it makes sense to go with XSB or a savings account because they don't have much exposure to interest rate risk.

    If, on the other hand, you don't care about what happens to prices in the next few years, go buy stocks. It'll most likely get you better returns in the long run.. Stocks have outperformed bonds on a rolling 30-year basis every year for the past 100 years except once.

    Buying XBB is kind of like buying a 10 year bond that yields 2%.. If (I don't mean definitely, but IF) inflation stays at the current 2% for the rest of the 10 years, then, once you adjust for inflation, you will have earned nothing (zilch!) on your XBB for 10 years once you account for inflation. Of course, if inflation rises to the historical average of 3%, then you will lose money once you account for inflation.

    On the other hand, buying XSB is like buying a 3 year bond that yields 1.3% so right now, XSB holders are taking a small hit after inflation. But historically, interest rates have tended to go back above inflation. If it does, XSB holders will be able to purchase new bonds that yield substantially higher. If inflation moves higher, then XSB probably will too, so XSB is safer.

    If you follow the CCP model portfolio, 40% of your portfolio should be in XBB. Good luck with that.

  18. HeKyLl - 08/26/2014 9:11 p.m. #

    Thanks for replying to my post. I'll try to ramble less and stick to my main point.

    My 20+ hr/wk. comment is, admittedly, more a reference to my micromanging personality than a generalization. Yes it won't take that long to decide if you want XSB or XBB but if I want to gain the expertise to truly understand that decision (and others like it) I would need to make personal finance a full fledged hobby - particularly if I wanted to get fancy and invest in individual stocks, make predictions, etc. This isn't my day job and I want to be careful with my retirement egg.

    I take issue with your "Was I wrong to assume so? I'll let you decide" statement even if I do agree with your rationale (all good points). Now, I respect the fact that you chose to stick your neck out and make a prediction but is that what you would really say to a reader who followed your advice last year? I don't expect my expert advisers to be perfect but I do expect contrition and an acknowledgement that things aren't working out as planned.

    Sorry, I'm not sure just yet if you are different from the other financial forecasters out there. I'll have to lurk around your blog some more.

  19. Jin Won Choi - 08/26/2014 9:43 p.m. #

    Hi HeKyLl,

    You're right - it does take a lot of expertise to decide between XBB and XSB. But at the same time, I will admit that making the wrong decision in this instance won't be the biggest deal in the world. It's nothing compared to, say, investing in tech stocks in the late 90s, where you could realistically see your whole portfolio wiped out.

    If you choose XBB, the worst that could happen is that you probably lose a few percentages after inflation, which isn't terrible. Instead, I argue for XSB on here because I see no reason why people should risk those few percentages.

    If you read other articles on this blog, you'll notice that I have no problem admitting my errors. I've talked about stocks that I lost money on, as well as times when I gave into fear, and about unrealistic expectations I had held regarding this business.

    However, on the subject of medium to long term bonds, I won't admit any "error" because enough time hasn't passed to make that judgement yet. I had held stocks that I had been losing money on for over a year, only to end up making large profits on. On the flip side, market bubbles have known to last multiple years.

    For example, would you say someone who predicted a US real estate crash was wrong, if he predicted it in 2005 (2 years before real estate prices really started crashing)? Of course not. She would have simply needed more time to be proven right.

    It'll be another couple of years before we really know who's right. Personally, I think Bartolotti jumped the gun with his article. We'll see who's ultimately right.

  20. Martin - 10/08/2014 8:16 a.m. #

    Why not invest in a 15 month 2.45% GIC from people trust instead of XSB? Does that make a better risk to ROI?

    Thanks

  21. Jin Won Choi - 10/08/2014 8:30 a.m. #

    Hi Martin,

    The main purpose of holding XSB is so that if stocks crash, you can sell XSB to buy stocks at cheap prices. If you hold money in GICs however, you won't be able to cash them out without paying heavy penalties.

    Hope that makes sense,
    Jin

  22. Martin - 10/08/2014 12:34 p.m. #

    Totally! Thanks

Post your comment
Web Analytics