Fixed income needs a fix

The recent Ant-Man movie featured a shrinking hero. Unfortunately, interest rates have also been shrinking and are now at historically low levels.

That’s why it’s high time to take a second look at the iShares Canadian Universe Bond Index ETF, which forms the core part of many fixed income portfolios. The exchange traded fund trades on the Toronto stock exchange under the ticker symbol XBB, is offered by BlackRock, and provides exposure to a broadly diversified selection of Canadian investment grade bonds. It’s a one-stop option for bond investors.

The fund’s annual fee (or MER) is relatively low at 0.33% when compared to actively managed bond funds. While it’s not the cheapest core Canadian bond ETF in the market these days, the fund remains wildly popular.

BlackRock reported that the fund’s weighted average yield to maturity was 1.78%, on a before-fee basis, on July 26, 2016. Take out the annual fee and the yield falls to about 1.45%.

Ways to rethink fixed income

That also happens to be a reasonable estimate of what investors should expect to earn from the fund over the course of the next 10.44 years (the fund’s weighted average maturity) before inflation and taxes.

Problem is, inflation clocked in at 1.49% over the last year according to the latest figures from the Bank of Canada (June 2015 to June 2016). Should inflation persist at the same level over the long term, the bond ETF could lose about 4 basis points a year versus inflation. Matters get worse when you add in taxes.

But the bond ETF might do better in some scenarios. For instance, if interest rates continue to fall and inflation declines over the long term then bond investors could be a happy bunch.

You can check a bond fund’s sensitivity to interest rates by looking up its effective duration, which can be used to estimate how much the fund would gain (or fall) should interest rates decline (or rise) by 1 percentage point. (Just be aware that I’m breezing through some of the finer details here.)

The iShares ETF has an effective duration of 7.66 years. That means, if interest rates suddenly fall by 1 percentage point, the fund would gain about 7.66%. But the opposite is also true. If rates jump up by 1 percentage point, the fund would decline by about 7.66%.

With interest rates already at very low levels, the math doesn’t seem to favour bond investors at this point and the iShares fund is far from unique. Indeed, the situation is very similar for other conservative Canadian bond ETFs.

I hate to be the bearer of bad news, but bond investors should prepare themselves for tiny—one might even say ant-like—long-term returns and the possibility of nasty losses should the market turn against them.

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 July 25. 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, July 25, 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.)