Ask Dave: How Do Bond Indexes Work?

Published by
Dave
2 weeks, 3 days ago in Ask Dave and Bonds/Fixed Income. 1 Comment

A reader named Charles asks a very good question about how bond indexes work?

Quick question for you. I, of course, know how TIPS and bond works but what about a short-term bond indexes (XSB or XRB or TD e-Series) for instance? Does an investor actually gets coupon payment? (I dont think so…). Because the market value of the bond doesn’t change much, so the investor basically gets its return from the quarterly dividends only?

I have a good understanding about how bonds work myself although I don’t know much about the details of how bond indexes work although I sort of just imagine it as a basket of bonds with different dates of maturity, different coupon rates, and different face values, and that buying an index fund is just as if I had bought all the underlying bonds at their current face value. I will also receive all of the interest payments on the bonds in the index, or some of it will be reinvested into purchasing other bonds. That’s just my idea or assumption of how it must work.

Here is a short summary of how bonds work and how bond funds (mutual funds in this case, but an index should be no different in theory) from some website, but it is reprinted from American Century Investment Services, Inc.:

It’s easier to understand how bond funds work after you know how individual bonds work.

An individual bond pays interest at a rate set by the issuer. Usually, the issuer agrees to pay interest on a regular basis such as quarterly or semiannually. The current yield on a bond, which is the amount you earn, is calculated by dividing the amount of annual income by the bond’s price.

For example, if a $1,000 bond provides $80 in income, its current yield is 8% (80 divided by 1,000). Bonds pay interest income regularly and repay the face amount (principal) when the bond matures. Keep in mind that the price of a bond can change after it’s issued, which could change the current yield even though the interest rate stays the same.

With bond funds, the current yield also is referred to as the distribution yield, and it is calculated using the daily dividend per share. This is what is used to distribute income to the funds’ investors.

Another website called Quamut had a pretty good explanation of How Bond ETFs work:

Bond ETFs track indexes that contain individual bonds. Bond ETFs don’t have a face value or a coupon rate, however. Instead, bond ETFs have a share price that’s determined by the prices (face values) of the individual bonds in the index that the ETF tracks—when the prices of those bonds rise, the ETFs share price also rises. In place of a coupon rate, bond ETFs have a yield (interest payment) that equals the average interest rate of the bonds in the index that the ETF tracks. Though the interest payment on an individual bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF shift. Generally, these interest rates change only in small degrees.

If anyone else can find a better explanation out there please pass it on. So far the Wikipedia article on Bond Market Indexes is not great.

Popularity: 14% [?]

CommunityLend Pre-Launch Site Revealed

Published by
Dave
1 month ago in Debt/Credit Cards and Investing. 1 Comment

CommunityLend is now closer to launch, with the unveiling of their new pre-launch website. CommunityLend is the Canadian version of Zopa (from the UK, but has now expaneded to other countries) and Prosper (from the US), which are P2P lending sites. In theory, by reducing the middle-man (the bank), lenders and borrowers alike should get better rates then they would through the bank.

Popularity: 21% [?]

Sigh…Another Report Shows That Mutual Funds Don’t Beat Indexes

Published by
Dave
1 month, 4 weeks ago in Indexes, ETFs and Mutual Funds. 1 Comment

John Chevreau looks at the latest “the SPIVA (Standard & Poor’s Indices Versus Active Funds) scorecard for 2007″ and it doesn’t look good. When will the average Canadian realize that investing in mutual funds is a loser’s game? Check out Andrew Teasdale’s interesting comments below the article. Here’s a snippet:

Mutual funds in general are products whose main objective is to earn returns for financial intermediaries and financial institutions and in many respects pander to the short term whims of the general investing public and the financial community at large. Sadly the mutual fund industry (as a whole) could be considered more of a game with the odds stacked against the investor than a serious attempt to deliver value and discipline. . . Canada however is one of the worst offenders when it comes to the value for money mutual funds offer the investor. When will Canadian investors as a whole start to realize that the odds, based on the current status quo, are more often than not stacked against them?

Popularity: 39% [?]

Garth Turner’s New Book and Blog

Published by
Dave
1 month, 4 weeks ago in Economics and Real Estate/Housing. 2 Comments

Liberal (formerly Conservative) MP Garth Turner has a new book out called “Greater Fool” as reported by Vancouver Condo Info (see “US housing market problems to show up in Canada?). It’s all about the coming crash in housing prices in Canada. He’s also started a blog at http://www.greaterfool.ca. Enjoy.

Popularity: 37% [?]

Ask Dave: What’s the Best ETF Allocation 15 Years Away from Retirement?

Published by
Dave
2 months ago in Ask Dave, ETFs and Asset Allocation. 2 Comments

Our question today comes from Charles who asked me what he should do with his dad’s pension assets, which are currently invested in two mutual funds:

Hey Dave!

My name is Charles, and I am a Finance student at the John Molson School of Business in Montreal. Lately, I decided to take over my dad’s pension fund. His company provides my dad with $15,000/year to be invested with Desjardins Financial Security (I don’t think you have this Quebec bank in BC but it is popular here and in Ontario). His plan is a defined contribution plan and not a benefit plan. When I look at my dad’s assets, he had 2 funds: 1) Jarislowsky Fraser Balanced Fund 2) Jarislowsky Fraser Canadian Equity Fund — These funds are not beating the market (benchmark) often and if they do…well these funds MER are expensive so they perform worse than the market.

Therefore, I wanted to take over his asset allocations but I have no choice but to deal with Desjardins since his company deals with them but of course I or my dad can choose its asset allocations.

I am a strong believer of index funds and ETFs. Desjardins offers great Barclay’s (iShares) ETFs: 1) Active Canadian Equity fund, 2) EAFE Equity Index, 3) Universe Bond Index Fund, and 4) S&P/TSX Composite Index Fund.

My dad is currently 48yrs old and wants to take its retirement when he his 63 - 65 years old. Therefore, a good 15 years of investment.

Here’s my question…what should be my weights in each asset class?

I was thinking 70% equity; 25% bonds and 5% T-Bills. Is having all of the 25% bonds in the Universe Bond Index Fund good? As for the equities, is 60% in S&P/TSX Composite Index Fund and active Canadian Equity fund and 40% for EAFE Equity Index any good? If I have the S&P/TSX index..is Active Canadian Equity relevant?

You can find all the info for each fund on Desjardins‘ website:

Again, thanks for your help and thanks for your great website!

First of all, it’s too bad that Desjardins does not publish the MER of those funds, although it is pretty much a given that they are going to be higher than any Barclays (iShares) ETF.

Although Charles says that “these funds MER are expensive so they perform worse than the market” it seems that over the last 10 years the Jarislowsky Fraser Canadian Equity Fund has outperformed the S&P Composite Index (16.3% to 9.5%). Although that probably says more about your dad’s reasons for choosing this fund over the others and this fund’s longevity, than it does about the fund’s prospects of “beating the index.”

Currently Charles’ dad is invested in 77.5% equities (50% from JF Canadian Equity Fund and 27.5% from JF Canadian Balanced Fund) assuming that he is invested equally in both of these two funds. My first recommendation would be not to deviate too much from what his dad was invested in before. This isn’t Charles’ portfolio, and if things turn ugly (or uglier?) for either stocks or bonds he doesn’t want to be the one to blame for shifting him more or less into either category. So I don’t see anything wrong with going with 70% equities in his new ETF based portfolio. I really don’t have a precise answer on what allocation of bonds/equities is right for your dad. I would try to stick with a balanced approach, and by that I mean that he should be invested 25-75% in equities and 25-75% in bonds (neither all bonds or all stocks). Risk assessments on banks’ websites (like TD Canada Trust’s Retirement Strategy Tool) are somewhat useful, not to come up with a precise answer, but to give you something that is in the ballpark. If anything, psychologically they can give Charles and his dad some comfort.

The Bond Universe fund is a good way to capture the bond market.

I don’t see anything wrong with his allocations within the equity class. I would not bother with the Active Canadian Equity as he will just get poorer performance (on average) than the index itself (after MERs). The only other thing that I noticed is that there is no exposure to the US market here as it looks like Desjardins does not offer Barclays’ (iShares) S&P 500 Index. I assume his dad has other investments besides this pension? If so, then I hope Charles will look at his entire portfolio (pension + RRSP + spouse?) as one, rather than each individually and hold a US index outside of his pension.

Popularity: 47% [?]

RRSPs versus TFSAs

Published by
Dave
2 months, 1 week ago in RRSP. 0 Comments

Here is a great little summary of how the RRSP and the TFSA differ: “RRSPs versus TFSAs: The Math”

In summary:

So, while it appears that the two plans produce the same results, that only holds true if your upfront tax rate is the same as your tax rate later on.

RRSPs will make more sense when the tax rate upon withdrawal is expected to be lower than the tax rate upon original contribution. Conversely, TFSAs will work out better if your tax rate (including the effect of RRSP withdrawals on benefits such as the Guaranteed Income Supplement or the Old Age Security, which are clawed back based on income) will be higher upon withdrawal than it was when you contributed.

Popularity: 38% [?]

Site Moved to New Server

Published by
Dave
2 months, 2 weeks ago in Miscellaneous. 0 Comments

Well I got the site moved over to a new server and sorted out the kinks. If anyone notices anything weird let me know.

Popularity: 40% [?]

Google Ads No More

Published by
Dave
2 months, 2 weeks ago in Blogs and Miscellaneous. 0 Comments

I’m proud to announce that I am getting rid of all the Google Ads from my site. They just don’t make enough money to be worth it. A second factor is that I have always written on this blog for fun, as a hobby, and not because I want to make money. I want to make sure people know that when they read my posts. I find that some blogs tend to pump out articles just to increase ad revenue.

I may think about phasing out my link ads as well. As some of you might already know, Google frowns upon links ads these days and some sites have had their page rank reduced due to unrelated paid link ads. The link ads on my sites are mostly debt-related and not very related to what I blog about so this has worried me a little. Most of them don’t expire until later this year so I’m not worrying about those yet.

Popularity: 44% [?]

Ask Dave: US Dollar ETFs

Published by
Dave
2 months, 3 weeks ago in Ask Dave, ETFs and Economics. 0 Comments

Another question (or should I say several questions) from a reader about US dollar ETFs. Paul wrote:

Thanks for the great blog - as a relatively new investor interested in building an ETF portfolio, I have found a great deal of useful information on your site - its much appreciated. I wanted to ask you a few questions regarding the use of the Vanguard ETF’s especially in light of the soaring loonie which is nudging US$1.06 these days.

Do you think that the strong loonie should be an extra incentive for Canadians to buy the Vanguard ETF’s to diversify their portfolios? I feel that the strong loonie offers us an opportunity to buy these US$ based shares at a discount given that historically the CAD has been weaker than the US$. But I have read some blogs that warn that that may all be changing and that with increasing global demand for Canadian resources and with the problems in the US economy, we may see our dollar at least on a par with the US$ for a while to come.

No, I don’t think that the fact that the Loonie is extra strong (relative to the past) should be any extra incentive to buy Vanguard ETFs (read: US dollar ETFs). You are right, with pending problems in the US economy and increasing demand for Canadian resources the Canadian dollar may go even higher, or the Canadian dollar may fall back (or the US dollar may rise) to it’s historical norm relative to the US dollar. It is difficult to predict. It is good to own Canadian dollars if you plan on spending the proceeds of you investments in Canada. On the other hand if inflation ever became very bad in Canada and the Canadian dollar fell against the US dollar it would be nice to have US dollars. Also, if the Canadian dollar fell against all other currencies and you planned to spend your retirement savings travelling, then it would be nice if some of those investments were in something other than Canadian dollars. I think it’s important to have a balance and to not put all your eggs into one basket. He continued,

Also, I read your post about the exchange rate spread issue when buying US based ETFs and how if you do not plan to keep these ETF’s for a long time, the MER is essentially boosted by the costs associated with converting CAD to US$ and then eventually back again. Would this issue not lend more argument to buying ETF’s like XIN or XSP which have higher MER’s but at least you do not have to pay a chunk of change when you convert back to CAD?

Of course you would have to do some calculations yourself to see which is better (or see my post about foreign exchange costs). There are a bunch of variables involved: the foreign exchange rate spread, the MERs of XIN/XSP, the MERs of the Vanguard US$ equivalents, and the length of the time the investments were held. In general you’ll probably see that as the length of time increases, the lower MER investment will become more attractive. As the length of time decreases, the investment without the foreign exchange fees will become more attractive.

Lastly, I have read a lot about the exchange rate risk Canadians face buying ETF’s like VWO, VEA, VPL or VGK. How much of an issue is this? Surely as long as the ETF grows and we are buying these ETF’s now with a strong loonie, the risk must be fairly small and one could do well when the CAD eventually returns to a more realistic level with the US$.

I try not to worry about it too much because if you look at the long term historical trend, the Canadian dollar and the US dollar have not diverged substantially, although they do encounter some pretty big swings, as we have recently witnessed.

Right now I am inclined to overweight my portfolio with VTI, VWO, VPL and VGK to take advantage of the buying power of the loonie and then rebalance it with more XIC later when the CAD weakens a bit. Would this make sense right now or is there serious risk to assuming the CAD will weaken in the next few years?

Personally I wouldn’t assume the CAD will rise of fall in the next few years. Plan for a probability of either situation happening. Stick with an allocation of CAD and an allocation of USD that you are comfortable with, no matter what the current state of the loonie/dollar is, and the stick to that allocation. If you want to speculat, that’s up to you, however, but if you’re talking about a retirement portfolio I would just pick an allocation and go with it. If one currency rises substantially above the other you’ll find yourself buying the cheaper currency just to keep the portfolio balanced.

Anyway, thanks for you help and I look forward to reading your thoughts on these issues.

Thanks for your question Paul, and sorry for the delay in responding to it.

Popularity: 52% [?]

Ohio High Schools to Include Personal Finance Courses

Published by
Dave
2 months, 3 weeks ago in Personal Finance. 1 Comment

According to this article, Ohio high schools to include personal finance courses as of 2010. The article says:

Last year alone, BGSU students borrowed $129 million to attend school. Their debt worries don’t end here. Many are piling up bills they can’t pay on credit cards. The solution: mandatory personal finance classes in high school. That’s going to happen in 2010, the result of a bill sponsored by Ohio Treasurer Richard Cordray.

When I was in high school in BC we had a Business Education class in Grade 12. That included some personal finance topics such as preparing tax returns and investing in the stock market (those are the two I remember anyways). I had heard that the program was scrapped the year after I graduated and sure enough, the most recent google hit I can find is from 1997 or 1998 so they must have gotten rid of it. It’s too bad, as it was a good course. I know that I am definitely going to teach my kids about personal finance and investing even if they aren’t taught it in school. But I feel bad for all the kids out there who learn about some of the basics because it is not included in most school curricula.

Popularity: 45% [?]

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