Squeezing the most out of your bonds

Let's knock bond ETFs off their pedestal.

Exchange-traded funds that hold bonds annihilated the competition in the definitive guide to bond investing that appeared in this space two weeks ago (read it online at tgam.ca/Dq6V). Buying bonds directly ranked a distant second and bond mutual funds took third spot. Now for some further investigation into the benefits of using ETFs for the bond side of your portfolio.

We'll key in on yield, which is scarce in this low-interest-rate world. A five-year Government of Canada bond yields about 1.4 per cent these days. Are you better off trying to capture this thin income stream by using bond ETFs or by holding individual bonds?

The surprise winner: Individual bonds. In a comparison of some popular bond ETFs against mini-portfolios of actual bonds, the bonds won three out of three times, with additional yield ranging from a few one-hundredths of a percentage point (basis points, in other words) to roughly half a percentage point (50 basis points).

Bond ETFs still have a lot going for them: a blessedly high level of transparency about what they own, precise investing mandates, low fees and excellent liquidity, which means buying and selling them couldn't be easier. But judged purely as generators of investment income, bond ETFs cannot claim supremacy.

And yet, the book on bond ETFs is that they do offer a yield advantage. When ETF companies buy bonds for their funds, they pay a low wholesale price that is much lower than the one charged to individual investors. Bond prices and yields move inversely, which means paying less for bonds gives you more yield.

So where's that bond ETF yield advantage in the real world? Let's just say it's mostly or fully offset by fees. The management-expense ratio for bond ETFs – that's the cost of running these funds expressed as a percentage of the total assets they hold – is quite low in comparison to bond mutual funds. Problem is, even tiny fees matter in today's low-rate world.

"When you're in an environment like this, every five or 10 basis points in fees are meaningful in a way," said Dan Hallett, director of asset management for HighView Financial Group.

To compare the yield of ETFs and actual bonds (see below), I took three mainstream bond ETFs and built a comparable portfolio of individual bonds from the inventory of TD Direct Investing, the country's largest online broker.

The first comparison of a bond ETF versus some individual bonds was done using the Vanguard Canadian Aggregate Bond Index ETF (VAB), chosen because it's a low-cost option among widely diversified bond ETFs with an MER of 0.26 per cent. The best yield indicator for any bond ETF is yield to maturity, which factors in both the interest payments the bonds in the portfolio will make plus capital gains or losses on these bonds when they mature. VAB's yield to maturity with fees deducted is 1.84 per cent.

Facing off against VAB were three bonds chosen to replicate the mix of government and corporate bonds in this ETF. One was a Government of Canada bond maturing in 2018, another an Ontario bond maturing that same year and the third was a Sun Life Financial corporate bond maturing in 2019. Average the yield on these three bonds – as per the price TD Direct Investing was offering them at mid-week – and you get 1.90 per cent, or six basis points more than VAB.

Dean Allen, head of product management for Vanguard Investments Canada, conceded that it's possible to squeeze a little extra yield out of a portfolio of actual bonds. "But you're highly concentrated in particular bonds, you're subject to credit risk and anything could happen to one of your bonds."

He also said that while bond prices are opaque and outside the investor's control, "our MER is stable, predictable and comparatively low."

Also matched against a portfolio of bonds was the iShares 1-5 Year Laddered Government Bond Index Fund (CLF), which is designed to replicate a traditional bond ladder. That's where you divide your money into bonds with terms of one through five years and re-invest maturing bonds into a new five-year term. With a ladder, you always have money coming available to exploit higher interest rates.

Up against CLF was a selection of five bonds either issued or backed by the federal or provincial governments. The average yield for the bonds was 1.29 per cent, which compares with 1.20 per cent for CLF.

Next up was the iShares 1-5 Year Laddered Corporate Bond Index Fund (CBO), which was matched against five corporate bonds with credit rating of BBB or higher. That means they're considered investment grade, or of at least middling quality and better than so-called junk bonds. The average yield for the five individual corporate bonds was 1.82 per cent, compared to 1.59 per cent for CBO.

To be fair to CBO, it's a bit less risky than the five corporate bonds it's compared to here. All of CBO's bonds are rated A to AAA, which means lower default risk and thus lower yields. Furthermore, CBO gives you much more diversification.

"It's really not that important for provincial and federal government bonds, but diversification has a real benefit for corporates," HighView's Mr. Hallett said. He suggests investors consider two types of risk with corporate bonds – default risk and liquidity risk, which refers to the potential for investors to be unable to sell a bond in very difficult market conditions. That happened with some lower-grade corporate bonds in the 2008-09 financial crisis.

With their diversification and other benefits, bond ETFs are still a great portfolio building block. But if you're trying to maximize yield and don't mind some extra risk, then holding individual bonds can get you a higher yield. That's no small advantage in today's low-rate world.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

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Who has the yield?

When you buy a bond as a retail investor, you typically pay a price that includes an invisible but substantial markup. One of the attractions of bond ETFs is that their holdings are bought at wholesale prices, which in theory should mean higher yields. Remember, the less you pay for a bond, the higher your yield, and vice versa. How competitive are bond ETF yields after fees? Let's compare a few of these ETFs against bonds selected from the inventory of the online brokerage firm TD Direct Investing.