Disappointment In Store For The Canadian Couch Potato?

Last update on June 1, 2013.

"The dumbest investment you know, in my view, is a long-term government bond" - Warren Buffett, March 4, 2013

 

In the last month's newsletter, I made a bold claim. I said that our portfolios will significantly outperform the The Canadian Couch Potato's in the long run. I also promised to explain why, and in this blog post, I will do just that.

 

 

Transcript:

Hello and welcome to MoneyGeek's podcast. My name is Jin Choi, and today, I'll talk about why I think there's disappointment in store for the followers of the Canadian Couch Potato.

For those of you who don't know, the Canadian Couch Potato is a well known Canadian financial blog. It's run by Dan Bortolotti, a journalist at MoneySense magazine. I intially supported his work because he's a big advocate of index investing, which I agree is a great way to invest, and I still support that part of his mission.

But recently, he's started to advocate something I disagree with. Something I think his readers will suffer for. So what's the point of disagreement?

He wants you to hold long term bonds. I don't.

Facts About Bonds You Should Know

First, let me explain some facts around bonds. 

Fact #1: When interest rates go up, bond prices go down, and vice versa. Explaining exactly why takes a few minutes to explain, so I'll refer you to my free book instead. You can find the explanation in the chapter on bonds. For now, just understand that this is a widely accepted fact.

Fact #2: Longer term bonds are more sensitive to interest rate movements, than shorter term bonds. Let me quote you an example from my book. If interest rates rise by 1%, bonds with 30 years to maturity will lose about 15% of its value. But for the same 1% interest rate movement, bonds with 2 years to maturity will only lose 2% of its value. Again, this is an undisputed fact.

Fact #3: There are two components to your bond's returns: income and capital appreciation. Income is the interest you receive by holding the bond. You'll receive this amount no matter what. Capital appreciation is the difference between the price you paid for the bond, and the price you can sell it at today. Like we said, as interest rates move, the value of your bonds will also move. If interest rates go down, you make money through capital gains because bond prices go up. If not, you lose money.

Fact #4: Interest rates are at historical lows. For instance, if you take a look at XBB.TO (A longer term bond ETF) that Bortolotti recommends, you'll see that it yields just 2.35%/year. If you look at this chart that shows long term interest rates in the U.S., you'll see that they're the lowest they've  been since the great depression. Canadian yields are at similar lows.

3 Future Scenarios

Now that we have all the facts, let's examine what could happen, and see how long term bond holders will fare in these different scenarios.

Scenario #1: Interest rates go down. Usually, this happens when there's a recession. People get scared, so they put money into safe assets like bonds. But how much will interest rates move? There's a theoretical floor of 0% interest rates, which long term bonds will never get to, and that's not too far from the current 2.35%/year for XBB.TO. At best, we can see a drop of interest rates of maybe 1%.

Let's say we have a 1% drop in interest rates 3 years from now. XBB.TO will gain almost 7% in capital appreciation, and it will have earned 2.35%/year. In the next 3 years, XBB.TO will have earned an average of about 4.5%/year combined between income and capital appreciation.

Scenario #2: Interest rates stay still. This will happn if there's no improvement in economic outlook, and if central banks around the world keep interest rates down. In this environment, 3 years from now, the investor will have earned just 2.35%/year in income, and none from capital gains.

Scenario #3: Interest rates go up. This usually happens when the economy improves. How much can interest rates go up by? If history is any guide, it can move up by a 1% or bit more in 3 years. A 1% move in interest rates will push down XBB.TO by 7%. In 3 years time, you'll have gotten 0%/year rate of return on XBB.TO. If interest rates rose by more than that, XBB.TO holders will have lost money.

What Does The Future Hold?

Among these scenarios, which one is the most likely?

There's something you should understand that's unique for our time. When the financial crisis hit in 2008, interest rates went to rock bottom. Since the economy has improved both in the U.S. and in Canada. Usually, this leads to higher interest rates. However, the Federal Reserve, which is the central bank in the U.S., has taken unprecendented action to keep interest rates down. For reasons I don't want to explain right now, Canada follows U.S.'s lead, so our interest rates have also stayed down.

This means interest rates are still at the low levels that you normally expect from a recession. It's an articificially low rate. It will take another major financial crisis to make scenario #1 happen. While it's possible, it's not very likely. If the economy falls back into a milder recession, I can see rates holding where they are, hence scenario #2. But if the economy continues to improve, as it has done in in the last few years? You'll see scenario #3.

That's why savvy investors are worried about potential damage from interest rates moving upwards. For instance, John Stumpf, the CEO of Wells Fargo said on May 30th 2013:

"One of the biggest risks today in our industry is not credit risk (i.e. people not paying back their debts), its interest-rate risk"

So there you have it. At best, in an unlikely scenario, XBB.TO will return 4.5%/year for the next 3 years. But more likely, it will earn just 2.35%/year or earn nothing, or worse. Contrast this with stocks, which have historically generated 9%/year for the past 100 years, and for good reason. This is why Buffett says Americans should hold cash and stocks, and skip the bonds.

Our Prediction

Despite this, Bortolotti continues to feature long term bonds prominently in his portfolios. In this recent blog post, he affirms the 60% stocks, 40% bond mix. If you look at his recommended portfolios, you'll see that these are long term bonds. He's also sent out a tweets in support of his decision to stick to a high long term bond mix.

That's why we'll leave you with a prediction. I think that if you observe the next 3 years, our Portfolios 4 and 5 (the more aggressive portfolios), will significantly outperform the Canadian Couch Potato portfolios. Our portfolio 5 has a mix of 90% stocks and 10% short term bonds, which are far less sensitive to interest rate movements. At the same time, our Portfolio 3 will deliver similar returns to that of the Canadian Couch Potato's but at a lower risk, because our portfolios hold short term bonds. 

You can check the daily performance of both our portfolios and the Canadian Couch Potato's on our membership page. If you have any questions or comments, please let us know by using the comment box below. In the meanwhile, if you want to understand the facts around bonds, don't forget to check out our free book.

Have a great day.

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