Dissecting ETFs and ‘Doomsday Calls’

06/15/2011 7:00 am EST


John Heinzl

Reporter and Columnist, GlobeInvestor.com

The final return you will receive from your fixed-income investment depends on a number of variables, writes John Heinzl, reporter and columnist for Globe Investor.

I was just watching your Investor Clinic video on bond ETF yields. One question comes to mind: Is the yield to maturity shown on the iShares Web site before or after deducting the management expense ratio (MER)?

According to Oliver McMahon, director of iShares product management at BlackRock Canada, the yield to maturity it quotes is "before (i.e. excluding) the management-expense ratio (MER).

“Yield to maturity is a portfolio characteristic, and thus shown without an adjustment for MER. This is standard across the industry."

The iShares DEX All Corporate Bond Index Fund (Toronto: XCB), for example, is based on the DEX All Corporate Bond Index, which has a weighted average yield to maturity (YTM) of 3.53%. But because the fund has an MER of 0.42%, the investor's effective yield to maturity is closer to 3.11% (3.53% minus 0.42%).

Competing ETF provider Claymore Canada discloses the YTM in similar fashion, but using slightly different language. For example, Claymore's 1-5 Year Laddered Corporate Bond ETF (Toronto: CBO), based on the DEX 1-5 Year Corporate Bond Index, has an "index yield to maturity" of 2.358% and an MER of 0.27%, for an effective YTM of 2.088% for the ETF.

Not sure what yield to maturity is? A little background is in order.

When people talk about the yield of a bond, they're usually referring to the yield to maturity (YTM). Because the YTM takes into account the bond's current price, coupon interest rate, time to maturity, and any projected capital gains or losses when the bond matures, it is a useful approximation of the annual return an investor can expect by holding the bond until it matures.

It is not exact, however, because it assumes all coupon payments are reinvested at the same interest rate—which doesn't happen in practice.

The yield to maturity of a bond ETF isn't exact, either, because proceeds from maturing bonds are frequently rolled over into new bonds, while the ETF itself never matures.

Just remember that to get a true reflection of an ETF's YTM, you will have to subtract the MER yourself.

What does the term "DD call" mean in a bond quote? Should I steer clear of these bonds?

DD call is short for Doomsday call, but don't let the name scare you. A DD-call provision—also known as a Canada call—actually protects the investor, because it forces the issuer to pay a premium if it decides to redeem the bonds prior to maturity.

Specifically, a DD call stipulates that bonds must be called at a predetermined spread (often a fraction of a percentage point) over the yield on Government of Canada bonds of the same maturity—or at par, whichever is higher.

For example, say you own XYZ corporate bonds that are yielding 6% and mature ten years from now, and that ten-year Government of Canada bonds are yielding 3%. The corporation wants to call its bonds now, but the DD call provision stipulates that the price must equate to a yield of, say, half a percentage point above the ten-year Canada yield.

Clearly—because bond prices and yields move in opposite directions—the issuer is going to have to pay a very steep price for the bonds in order for the effective yield on the bonds to fall to 3.5%. That's why companies seldom redeem these bonds early.

Where the term "Doomsday call" originated is an interesting story. As Harry Koza, senior markets analyst with Thomson Reuters, wrote in The Globe and Mail several years ago, Domtar was the first company to issue bonds with this provision, back in 1987.

"For several years after the issue, this kind of call feature was known as a 'Domtar call.' Then the name morphed into 'Doomsday call' for a while, but that never really caught on. I don't know, maybe the dealers thought it was too negative."

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