Bond ETFs are popular and it’s important to understand why.
While you may not need or want bonds in your portfolio today, one day you will consider it and it’s important to understand what is available and what will fit in your strategy.
What Are Bonds?
Bonds represent a fixed income vehicle for investors. It’s a promise from an entity (corporate, government, municipal, …) to pay you interest for a certain time of time for a certain amount of money.
In short, it’s a loan with fixed parameters. As it happens, there is also a secondary market for bonds when it trades and is usually priced according to interest rates.
With that said, bonds don’t lose money when you keep them to maturity. The dilema investors have to assess is if their money is better with a GIC or a bond.
What Is A Bond ETF?
A bond ETF is an equity investment (the ETF) that focuses on investing in bonds as the underlying investment. The ETF could also invest in other bond ETFs.
Take the Vanguard Global Aggregate Bond Index ETF (VGAB ETF), it invests in 2 Bond ETFs (VBU ETF and VBG ETF). In turn, being that VBU is a CAD-Hedged fund for currency, it directly invest in BND. That’s 3 layers of ETFs before you actually invest in bonds.
ETFs trade like stock on the stock market. Investors bid on the ETF at a specific price and that’s what drives the price of the ETF during the day. Read this to understand the pricing of an ETF as opposed to the NAV (Net Asset Value).
During the trading day, there can be a variation in price vs NAV. Here is another explanation on how the price of an ETF and NAV can be adjusted to avoid a divergence between the ETF price and the NAV.
Investors can end up making an ETF overvalued or undervalued temporarily during trading hours as you are at the mercy of the market pricing. During the Covid-19 pandemic, most bond ETFs were negatively impacted even as bond ETFs were seen as safe havens.
Going back to what a bond is, bond ETFs are not as safe as the actual bonds for your capital. It’s easier to access bond ETFs and have a fixed-income representation but the value is still bouncing around as per the secondary bond market.
The Best Bond ETFs
Instead of making it simple to select a bond ETF, we now have many options to chose from … In fact, too many options that can cause confusion on what bond ETF to buy. Let me simplify the selection for you.
The principle, as an investor when looking for fixed-income representation, is to have the least amount of fluctuation. It’s not about building wealth but protecting it.
- The return should be equal to the income receive. Growth is not important with bonds.
- Have the least amount of fees.
- Invest directly in the bond coupons as much as possible.
- Invest in Canadian bonds only and avoid any currency impact.
The table is sorted by returns since inception. As pointed out, we want the least amount of variance over time so we want a low performance which is counter-intuitive.
Based on the data identified, the best Bond ETF is the one with a near 3% return since inception and an appropriate yield based on the holdings.
My pick is VGV – Vanguard Canadian Government Bond Index ETF.
- It focuses on high quality bonds from the government.
- Has little fluctuations in performance.
- Pays a decent yield compared to GICs and interest rates.
- Only down side is the trade volume as it is relatively small with a lower trade volume than others.
The iShares CBO ETF and iShares CLF ETF are close second and third.
Mark from My Own Advisor picks VAB – Canadian Aggregate Bond Index ETF and it is also a good choice and has higher trading volume and higher net asset if that’s important.
What’s the pattern? Those are the least perfmorming Bond ETFs.
|wdt_ID||Ticker||ETF Name||# Bonds||M. Fees||MER||Yield||Return|
|14||VLB||Vanguard Canadian Long-Term Bond Index ETF||336||0.15||0.17||3.08||5.23|
|15||VGV||Vanguard Canadian Government Bond Index ETF||371||0.15||0.20||2.40||3.13|
|16||VCB||Vanguard Canadian Corporate Bond Index ETF||659||0.15||0.19||2.76||3.63|
|17||VAB||Vanguard Canadian Aggregate Bond Index ETF||1,075||0.08||0.09||2.58||3.26|
|18||XBB||iShares Core Canadian Universe Bond Index ETF||1,404||0.09||0.10||2.62||4.94|
|19||XSB||iShares Core Canadian Short Term Bond Index ETF||488||0.09||0.10||2.13||3.83|
|20||XCB||iShares Core Canadian Corporate Bond Index ETF||956||0.15||0.44||3.08||4.43|
|21||XGB||iShares Core Canadian Government Bond Index ETF||387||0.12||0.39||2.21||3.78|
|22||XQB||iShares High Quality Canadian Bond Index ETF||448||0.12||0.13||2.39||3.30|
Why Not Choose The Best Performing Bond ETF?
Simple, bonds are a fixed income investment with no fluctuation in value. Yes, there is a secondary market but the purpose of a bond is to earn interest, just like a GIC but with different guarantees.
When you buy a bond ETF, you swap the interests for distribution and the guaranteed value at maturity is gone. It’s the same as investing in real estate vs REITs. Both have real estate as underlying assets but the generated income changes.
As such, the best performing ETF is also the riskiest ETF, and that is not what an investor should be focused on when investing in bond ETFs since you are looking for stability.
Interest rates will also have an impact on the following:
- REIT ETFs will be impacted as they are for income
- Bond ETFs will be impacted as they are for safety and need to keep up with interest
- Bonds on the secondary market will be impacted the same way as bond ETFs
- Bonds held to maturity will not be impacted.
The reason for the secondary market and the adjustment in value is if interest rates rise faster than what the bonds can pay, the investor has to make a decision on losing value on the bond and recovering it with higher interest rate investments.
If you still think that returns are important with bonds, than it means you believe in the strategy to predict interest rate movement and where governments will go with their interest rates. Interest rate prediction is very complicated and not a strategy I want to learn.
Last but not least, if you want performance, a Bond ETF is the last place to look …
How Bonds Fit In Your Portfolio
Why do you invest in bonds? It’s not to get rich.
You buy bonds for 1 of 2 reasons.
- You want to balance risk which means you want to minimize the swing in your portfolio when stocks move negatively. Just know that the more bonds you hold, the safer you feel but the less your portfolio grows. The financial industry tries to have a rule around matching your bonds holding with your age but that’s too much in my opinion but you do what you need to sleep at night.
- You want a cash equivalent as part of your withdrawal strategy. It’s like a retirement bucket strategy. From stocks, to bonds, to cash. For example, you might want 5% of your portfolio in bonds while you have 2 years of cash. It gives you a very safe cushion to withdraw from your portfolio when the market drops. It means you avoid selling stocks at the wrong time.
How To Buy Bond ETFs
It’s a lot easier to buy bond ETFs than buying bonds separately which is why they are much more popular.
To buy a bond ETF, you need a discount broker as ETFs trade like stocks on a stock exchange for ETFs. You specify the number of shares you want to buy from the selected ETF and whether you want to pay the market price or you enter the price you want to pay.
I usually put a limit order using the market price just to avoid any blip from trading algorithm.
As it happens, there are many discount brokers that offer access to free ETFs and you should use a discount broker with free ETFs if you can. Questrade is one of those discount brokers with free ETFs.