A few weeks ago, I wrote about creating an income portfolio. Of course, after getting ready to write this post, I realized a couple of mathematical errors in the spreadsheet (jumped the gun in producing my post and rounded off the wrong areas) and that I should probably put some assumptions around what we’ll track or not track. So, first off, the portfolio (including today’s addition):
Inaccuracies of the original portfolio: Book values were different from market values even though prices were the same – was trying to simulate investing 10K in each security but in whole number. New chart says we invested ~10K (to whatever to nearest whole number of shares were) – this leaves us with $22.25 in cash.
In case people started to knit-pick as updates happened, here’s what we’re NOT tracking:
- Commissions: We’re not looking to trade in and out of this portfolio (although ideally you need to aim for <2% overall).
- Currency Fluctuations: I’m trying to keep this all Canadian; but there are some great US dividend stocks. Not going to track currency rates on date of purchase or dividends, etc. We’re assuming 1:1 to make my tracking easier – although today the USD:CAD is around 1.06. Tomorrow, probably going to be 1.0602 – there are probably better things to spend the effort on.
- Withholding taxes (for US securities): 30% of dividends are automatically withheld for taxes; to be returned back (or kept) when you complete year end taxes. Let’s assume we keep all dividends – this is a portfolio to supplement income, which we would pay taxes on anyways.
- Taxes – Same goes with taxes on dividends at year-end. We would have had to pay tax on the income we are replacing – although I will probably put some commentary around savings gained from dividends (via dividend tax credit); and any lack of savings from REIT return of capital or bond interest
- No DRIP-ing: Dividend Re-Investment Plans are a great way to take the dividends and re-invest it in the stock (without paying commissions). Definitely something to do if the purpose is solely for investment – in this case, we need the income to pay bills (and taxes)
My Hopefully Correct Understanding of Bonds 101
Before we talk about the new addition to the income portfolio – let’s hope my understanding of bonds is correct. Bonds have a face value (i.e. $10,000) which is the amount the bond holder will get back once the bond matures. The coupon rate is the amount of interest paid in a year relative to the face value (i..e. if my $10K bond paid out $500/year, the coupon is 5%).
To add to the confusion, the price of a bond (which is not the same as face value) is the price at which it trades on the bond market. Bonds selling above face value are selling at a premium; while bonds selling below face value sell at a discount. Bond prices affect the yield – if the 10K bond is now selling at $9K (a discount), the yield jumps to 5.56% (500/9000). Similarly, a premium price of $11000 would drop the yield to 4.54% (500/11000). So the simple rule is price goes up, yield goes down and vice versa. The simple rule for investing in bonds is you want to buy at a discount (in order to get a high yield); and as a bond holder, you want the price to go up (have a set yield, and now can cash out by selling at a higher price).
So, why do the bond prices move up and down? One big reason is the risk tied to the issuer of the bond. Let’s say my little company ABC Corp wanted to issue a bond and we’re going with the $10K, 5% coupon and an investor pays face value. Let’s say (hypothetically) that the US Government decides to offer a $10K bond with a 5% coupon as well. That means there’s no incentive for someone to buy ABC Corp’s bond when a much safer bond is available from a more secure issuer. In order for ABC Corp’s bond to be attractive, the yield has to be worth the additional risk an investor takes above and beyond the US Government bond. So, let’s say the market deems that ABC Corp needs to have a yield of 10% – so now the price drops to $5000 – so the poor guy who bought the bond at face value is now facing a potential 50% loss. Of course, this example is meant to prove the relationship between bonds – but chances are an investor would never have had to pay full face value for the bond and the US Government suddenly having rates from near 0% to jump 5% overnight.
It’s a good illustration though of why the fear of, and of course the actual, rising rates cause some bonds / bond funds & ETFs to drop by significant percentages. This is especially the case for long term bonds (>15+ years) – if you invest in them now in a low interest rate environment, there could be some serious capital losses if rates were to rise – even a 1% rise in rates would mean the price would probably have to drop 15% on a 15 year bond to make up for the lost yield (again, interest rates probably not going to go up 1% overnight in today’s world).
Why we’re buying ZCS
So, today we’re adding the BMO Short (Term) Corporate Bond ETF. Recognizing that I should probably have some bond component in my portfolio (but given my lack of real knowledge in fixed income), I went to the trusted model portfolios of the Canadian Couch Potato. Out of the Uber Tuber portfolio, I picked out the BMO Short Corporate Bond ETF – which focuses on corporate bonds with a maturity in 1 to 5 years. Of course, a look at its holdings shows the two largest holdings maturing in 2020 and 2021 (but with each contributing <2.5% to the ETF, that’s probably ok).
All eyes are on the on the Federal Reserve (and to a lesser extent the Bank of Canada) as to the direction of rates – as was just announced the tapering of quantitative easing. I’m not sure if I would say trimming bond purchases from $80B/month to $70B/month is really significant – especially if you compare it to the rumours circulating earlier in the year that the trimming would be much more drastic. From the sounds of it, it looks as if this low rate environment will continue well into 2015 (both in Canada and the United States). Even still, investment in short term bonds means I still get the income, but any rise in rates should be gradual and more manageable in the 1-5 year timeframe resulting in little or no loss in capital. However, any investment in medium and longer term fixed income investments (hence my hesitation around XPF in my income portfolio) would seem to be a risky proposition to me – we don’t really know how fast rates will rise if and when they do – but from my limited knowledge, I’m not really willing to take a capital hit for my 5-6% yield. Long term bonds and fixed income instruments dropped more than 15% on just the thought that rates were going to rise earlier this year. A 15% drop wipes out 3 years of yield.
Alternatives to ZCS (besides another short term fund/ETF) would have been to purchase individual bonds – in which case medium and longer term could bonds and/or preferred shares would be looked at. By buying individual bonds/preferred shares, you can decide to hold them to maturity and actually calculate the Yield to Maturity (or Yield to Call as we found from my earlier dividend mistake) and determine if that yield is acceptable over the lifetime of the bond/PS. The same cannot be said for ETFs and funds as investing in them now means you don’t know what price was paid, the yield, or even the strategy around holding till maturity.
So, that in a long nutshell, is why we’re in ZCS – still on my list is the discussion on diversifying (and the problems I have with it) – which tie into these fixed income investments I’m making.
Disclaimer: The author owns shares of ZCS and XPF. A full list of holdings can be found here.