Why your bond ETF isn’t losing money

I frequently get asked questions about bonds. One reader named Andrew recently asked me: “I have been investing using your Couch Potato strategy for just over three years now,” he wrote. “However, does it still make sense to invest in bonds when they are continually losing money?”

As it happens, bond ETFs have not been “continually losing money” at all. Indeed, over the three years ending March 31, broad-based funds such as the BMO Aggregate Bond Index ETF (ZAG) and the Vanguard Canadian Aggregate Bond Index ETF (VAB) returned close to 4% annually, with positive returns in each calendar year. A $1,000 investment in either ETF would have grown to about $1,120 over that period. So why would an investor think he had lost money?

I don’t blame Andrew for being confused, as this one trips up a lot of investors. The problem lies in the way brokerages display the holdings in your account. Rather than calculating the total return on your investments—which would include both price changes and all interest payments and dividends—your list of holdings reflects only the change in market price. This makes sense for calculating capital gains and losses, but it can be highly misleading for investors who want to measure performance.

Let’s break this down to understand what’s happening.

Half the story

Say you bought 500 shares of ZAG about two years ago, on March 31, 2015. On that date the ETF was trading at $16.37 per share, so your shares cost you $8,185. Two years later, on March 31, 2017, ZAG was trading at $15.70, so your 500 shares were now worth $7,850, a decline of about 4%. When you log into your account, your holdings will look something like this:

At this point you’re cursing your decision to buy bonds, as this supposedly safe part of your portfolio has lost you $335. Right?

Wrong. The problem here is you’re ignoring all of the interest payments ZAG made over the last two years. It turns out those cash distributions amounted to about $0.93 per share, which more than offset the decline of $0.67 per share. That made the difference between a loss and a gain on your investment. You started with $8,185, and after two years you had 500 shares worth $7,850 plus $465 in interest, for a total of $8,315. That modest gain is hardly cause for celebration, but it’s certainly not a 4% loss.

Unfortunately, you may not have noticed this because the interest payments are paid into the cash balance of the account. At some point you probably reinvested that cash when buying new shares of some other ETF. But if you calculate your rate of return properly, using the total value of your account at the beginning and the end of the period, you’ll see a positive return.

Why this happens

As discussed in the previous post in this series, bond prices fall when interest rates rise. But even during periods when rates stay more or less the same, you will still see the price of most ETFs decline gradually, even over long periods.

This happens because most bonds today are premium bonds, which means they trade at more than their face value. This situation has come about because interest rates have trended downward for many years now, so most bonds issued in the past have coupons higher than prevailing rates. Investors pay more than face value to get those higher rates, but premium bonds will eventually mature at face value, resulting in a capital loss.

If your ETF is filled with premium bonds—at it almost certainly is—it will experience a series of small losses like this as the bonds approach maturity. That translates into a gradual drop in the ETF’s price during any period where interest rates do not fall significantly.

One way to anticipate this price decline is to look at two characteristics of your bond ETF, which you can find on its web page: the fund’s average coupon and its yield to maturity. The former tells you roughly how much you can expect in interest payments, while the latter estimates your total return, including interest payments and any price change.

If the coupon is higher than the yield to maturity—and again, these days it almost always is—then the fund is dominated by premium bonds. Today the average coupon on ZAG is about 3.35%, while its yield to maturity is 1.91%:

That means if interest rates don’t change, you should expect the price of this fund to decline by roughly 1.44% (that’s 3.35% minus 1.91%) a year. It will never be that tidy because interest rates change constantly, but the key point is that any bond ETF filled with high-coupon premium bonds should be expected to fall in price over time.

Where to get accurate numbers

If you want to know how your bond fund has performed in the past, the best method is to look it up on the ETF provider’s website. ZAG’s webpage, for example, reports the following total returns for the period ending March 31, 2017:

One important note: whenever ETFs report their returns, they assume all cash distributions are reinvested immediately. With an ETF this is impossible, even if you are using a dividend reinvested plan, because some portion of the interest or dividends will always end up as part of your cash balance. So your personal rate of return will never be precisely what’s reported on the provider’s website. But it will be close enough. And at the very least, you will no longer believe you’re losing money with your bond ETF during years when you’re actually netting a gain.

This first appeared on CanadianCouchPotato.com