Why your bond funds are bombing

Interest rates are near all time lows, which augers poorly for bond funds.

To get a glimpse of the misery on offer, let’s take a quick look at three popular exchange traded funds (ETFs) from Vanguard Canada. Just be warned, as I walk through a few back-of-the-envelope calculations, the pickings are slim for risk-averse investors.

Vanguard sells three Canadian bond ETFs and it provides a variety of interesting facts and figures on them at www.vanguardcanada.ca. I’m going to focus on yield to maturity because it is a rough indicator of what sort of return each fund is likely to generate. (Do not confuse yield to maturity with distribution yield or trailing 12-month yield.)

The Vanguard Short-Term Bond ETF (TSX:VSB) has a yield to maturity of 1.3%. If you’re willing to take on more credit risk, you can opt for the Vanguard Short-Term Corporate Bond ETF (TSX:VSC), which has a yield to maturity of 2.0%. But it is the longer-term Vanguard Aggregate Bond ETF (TSX:VAB) that forms a core part of many passive portfolios. It also happens to have a yield to maturity of 2.0%. (All of these figures are based on data from the end of April.)

While Vanguard’s ETFs are famous for their low fees (the three in question cost between 0.11% and 0.13% annually), the yield data is presented on a before-fee basis.  As a result, the expected annual returns for the funds (based on each fund’s yield to maturity minus its annual fee) falls to about 1.2%, 1.9%, and 1.9% for VSB, VSC, and VAB respectively.

Compounding matters, some investors hold the ETFs in taxable accounts, which also has to be taken into consideration. If you apply a 50% tax rate (the top marginal rate in Canada is a little higher, or lower, depending on the province), the expected after-tax returns for the three ETFs falls to about 0.6%, 1.0%, and 1.0%. (I’m ignoring a few subtleties here and the situation varies from person to person.)

Unfortunately, I’m not done yet. Investors also have to contend with inflation, which is the propensity for money to lose its purchasing power over time. Currently inflation runs at a rate of about 1.7% per year, based on the latest year-over-year increase in the consumer price index. (That could easily change–up or down–in the future.) As a result the after-tax after-inflation expected returns for the ETFs stands at roughly -1.1%, -0.7%, and -0.7% for VSB, VSC, and VAB respectively.

While the situation for investors in tax-sheltered accounts is a bit better, their returns still come in at only about -0.5%, 0.2%, and 0.2% after the corrosive effects of inflation are taken into account. 

In other words, it seems likely that bonds will barely break even or lose ground on an after-fee, after-tax, and after-inflation basis over the next little while. As a result, risk-averse investors shouldn’t rely on getting big returns from their bond funds.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of May 30. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, May 30, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

Required Reading

Buffett’s Bad News