Bonds ETFs Are Safer Than You Think

07/06/2011 2:30 pm EST


John Heinzl

Reporter and Columnist,

The notion they don't mature and therefore should be avoided is nonsense. Quite the contrary: only millionaires should be mucking about with individual bonds, argues John Heinzl, reporter and columnist for Globe Investor.

There is a topic regarding bond exchange traded funds which I have never seen discussed and seems critical to me, especially if interest rates rise. That is the fact that they have no maturity date. It seems to me that an ETF could be underwater forever. In other words, they are a very dangerous place to be. Am I missing something?—D.J.

I hear this argument all the time, but while you are technically correct that the price of a bond ETF could theoretically be "underwater forever" if rates rise (and stay elevated), this is not a reason to avoid bond ETFs.

Think about what a bond ETF is. It's just a diversified portfolio of individual bonds.

Now imagine that, instead of owning the ETF, you owned all of the bonds directly. Bonds would mature and be rolled into new bonds, but the portfolio itself would never mature. But I don't hear anyone saying that it's therefore a bad idea to own a diversified portfolio of individual bonds.

Similarly, if you set up your own bond ladder with maturities ranging from, say, one to ten years, the ladder itself would never mature, even though the individual bonds would. But again, nobody would argue that a bond ladder therefore exposes you to additional interest-rate risk.

Quite the opposite: The point of a ladder is to avoid a situation where you're rolling over all of your bonds at a time of low interest rates.

The reason people get freaked out about losing money with bond ETFs is that they are focusing only on the capital part of the equation. But the return of a bond is made up of two components: The capital gain or loss, and the coupon payments.

Even if the price of a bond ETF drops when rates rise, you'll continue to collect coupon payments, which will counter the drop in price. And these coupon payments will rise as the ETF rolls into new, higher-yielding bonds.

To go back to the ladder example, if interest rates rise and plateau at the higher level—as long as you maintain the ladder long enough for the longest-dated bond to mature—the theoretical market price of the portfolio would return to its original value. So, in that case, you would not be "underwater forever."

Now, it's true that bond ETFs typically roll over holdings one year before they mature, because at this point these securities are considered money-market instruments. But in an environment of rising interest rates, a bond ETF that follows a sell-before-maturity policy would buy new, higher-coupon bonds sooner than an identical portfolio of bonds that held to maturity.

The higher income would make up for any capital loss incurred as a result of selling early, said James Hymas, a fixed-income expert and president of Hymas Investment Management.

Bond ETFs have several advantages, he points out. Because ETFs buy in volume, they get much better pricing than retail investors could obtain through their broker, and this pricing advantage for most ETFs will outweigh the management expense ratio. Bond ETFs also provide instant diversification.

The notion that bond ETFs don't mature, and should therefore be avoided, makes no sense, he said.

"Anybody investing less than $1 million in bonds should do it through ETFs," Hymas said. "If you have more than $1 million, then you can talk about buying individual issues, but if you have less than $1 million you're either going to have poor diversification or poor pricing, perhaps both."

Why are the distributions from dividend exchange-traded funds so volatile? I own the iShares Dow Jones Canada Select Dividend Index Fund (Toronto: XDV), and from one month to the next the income is all over the map.—P.B.

You're right about the distributions for this particular ETF being volatile.

XDV paid 4.806 cents a unit on June 30, which was slightly higher than the May distribution of 4.628 cents, but less than half of the 10.866 cents it paid in April. In February, the distribution got as low as 3.325 cents, down from 8.737 cents in January.

This sort of volatility is a pain for people who require a predictable income flow, but the ETF is merely reflecting the distributions from the stocks in its portfolio.

"XDV has monthly lumpy distributions because the underlying stocks pay in a lumpy fashion and XDV is just returning this dividend flow to unitholders," said Oliver McMahon, director of iShares product management at BlackRock Canada.

Most dividend stocks pay on a quarterly basis, and the months of January, April, July, and October are especially popular for payments, which is why the ETF's distributions are usually higher during these periods.

Not all dividend ETFs are so volatile month-to-month. The Claymore S&P/TSX Canadian Dividend ETF (Toronto: CDZ) distributed 5.5 cents per unit in each of April, May, June and July, and 6.95 cents in each of the previous nine months.

Unlike iShares, Claymore calculates the ETF's projected yield every quarter, which is essentially the yield of the underlying portfolio minus expenses. It then pays out the cash in equal installments over the following three months, smoothing out the distributions.

"It makes it easier for investors. It's simple. It's clean," said Som Seif, Claymore's CEO.

If the portfolio yield changes when the ETF's holdings are re-weighted (semi-annually) or reconstituted (annually), the monthly distribution is adjusted accordingly, he said.

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