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Continuing on our little mini-series on how we build our Yield Shield (Read up on Preferred Shares and REITs if you missed it), today I’d like to talk about bonds.
I’ve been lumping bonds together into one asset-class tracked by a broad ETF like VAB or BND, but the truth is the bond market is a bit more complicated than that.
Usually, when people talk about bonds, they’re talking about those issued by the government. These are seen as ultra-safe and unlikely to default, since the government can always raise taxes to pay off bondholder’s interest payments. These are also the assets that tend to go in opposite directions of stocks. When the stock market rampages ahead, money flows out of bonds and into stocks to capture the gains, and when stock markets tumble money flees back into the safety of government bonds.
However, those aren’t the only bonds out there.
But before we get into those, let’s talk about how each bond’s risk level is determined.
What Is a Bond Risk Rating?
When people walk into a bank to get a line of credit, the bank takes a look at the person’s job situation, their savings, and their credit score to determine how financially healthy they are. A guy with a good credit score and a full-time job is going to be more attractive than someone who’s unemployed and living in their parent’s basement. Their credit-worthiness then determines how much money they can get, as well as what interest rate they will pay. A good credit rating means you’ll qualify to borrow more at a lower interest rate. A sucky one means you can borrow less (or not at all) and if you do, you’ll have to pay through the nose to get it.
Same thing happens with a bond. When a bond gets issued, independent rating agencies like Standard & Poor, Moody’s, and Fitch evaluate a company’s financials and determines how likely that company will be able to pay the interest to future bondholders. They then assign a rating to that bond, which then determines how attractive that bond will be to investors.
A bond issued by the US government would be rated AAA (though I think that got downgraded to AA+ after that whole fiscal cliff debacle in 2011). A bond issued by Morgan Stanley currently has an A+ rating. United Airlines has a BB-.
Think of a bond’s risk rating as the company’s credit score. And just like a person’s credit score affects the interest rate you can get from a bank, a company’s bond rating affects the interest rate they can get on the open bond market. A company with a high bond rating can borrow with a lower interest rate, so their bonds will have relatively lower yields. A company with a crappier bond rating needs to pay a higher interest rate to attract buyers, so their bonds will have relatively higher yields.
Corporate Bonds
You’ve probably noticed a recurring theme in our articles about Preferred Shares and REITs. The key to increasing your yield is to pivot into riskier assets, and bonds is no different.
You can check what the credit quality of a bond ETF by looking at the ETF’s website. For an ultra-safe Vanguard Treasury bond ETF like VGIT, for example, you can click over to Vanguard’s site, open up the “Portfolio & Management” tab and scroll down to find their bond breakdown.
We can see here that this ETF is almost 100% US government, which would make sense since the ETF is called the Vanguard Intermediate-Term Treasury ETF. This fund also has a bond yield of 2.6% as of the time of this writing.
If we wanted to up this yield, we need to up the risk level. To do that, we need to look in Corporate bonds.
Corporate bonds are basically just bonds issued by companies like Apple or Morgan Stanley rather than governments. These are by definition more risky than governments since it’s more likely for a company to go bankrupt than the entire US government, so we can expect their bond yields to be higher. For an example of an ETF that invests in this space, we just need to click around Vanguard’s site until we find a Corporate Bond ETF. Here’s one called the “Vanguard Total Corporate Bond”, VTC.
Clicking into it, we can find this ETF’s bond rating breakdown.
This ETF holds almost no government bonds, but has mostly bonds rated A or BAA. As a result, its bond yield is 3.3% vs the government bond ETF’s yield of 2.6%.
The actual ETF I own in this space is the Canadian equivalent iShares Canadian Corporate Bond ETF, XCB.
| Fund Name | Ticker | Yield | MER |
|---|---|---|---|
| Vanguard Total Corporate Bond ETF | VTC | 3.3% | 0.07% |
| iShares Canadian Corporate Bond ETF | XCB | 3.1% | 0.4% |
As usual, I’m not recommending either of these funds for your personal situation, these are just the ETFs I used to illustrate how corporate bonds work.
Though that being said, I’m surprised by how low the fees are on Vanguard’s Corporate Bond ETF. Mine is 0.4%! Yeesh. If I was American, I’d consider switching over.
High-Yield Bonds
Despite the fact that Corporate Bonds are riskier than government bonds, this asset class still puts a limit on how risky they’re willing to go. Standard & Poor’s risk scale considers everything from AAA down to BBB- “Investment Grade.” Everything below that (BB+ downwards) is considered speculative.
So Morgan Stanley (A+) would be considered a Investment Grade while United Airlines (BB-) would be considered Speculative.
That’s where High-Yield Bond ETFs come into play. These ETFs actively invest in speculative and really risky bonds in the hopes that the company can actually, you know, pay the interest they promised and not default.
However, I’d be really careful with these ones. The less polite name for High Yield Bonds is Junk Bonds. In fact, one of the biggest ETFs in this space, the SPDR Bloomberg Barclays High Yield Bond literally has the ticker symbol JNK.
So…at least they’re owning it, right?
Anyway this asset class I do own myself but I don’t think it’s for everybody. Back when I first bought into this space, it was paying around 7% yield. But in Canada a lot of the the junk bonds were issued by oil companies, so when the oil crash hit in 2015 and oil fields were closing down left and right, my Junk Bonds really started living up to their less polite name. They got crazy volatile, and as companies starting going under my yield got cut to around 5%. Nothing else cut their yields, so I’m not sure I’d be in this space again if I had to do it over.
Fortunately, I limited my exposure to High Yield to around 5% of my total portfolio, so it didn’t blow me up too badly, but over time I’m planning to gradually sell off this allocation and move it into regular corporate bonds. At 7% they seemed pretty attractive, but at 5% not so much especially since preferreds are paying close to that anyway.
So that’s Corporate Bonds and High Yield Bonds for you. Does anyone own either of these? Any interesting experiences with Junk bonds? Let us here it in the comments!
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I am really digging these ‘Yield Shield’ posts. It’s intriguing, all the myriad ways to rejigger assets into a more stable glide path when FIRE is on the horizon. Thanks for sharing a peek behind the curtain!
It’s a lot of fun. All this finance crap becomes super intuitive once you understand the basics.
I get the idea of reaching for yield, but personally I wouldn’t be comfortable taking on yet more risk on what’s meant to be the defensive side of the portfolio.
All of investing is trading off short term gains and long term gains. When you’re accumulating, you don’t need the short term gains much. But when you’re retired, you don’t need the long term gains as much.
“Fortunately, I limited my exposure to High Yield to around 5% of my total portfolio, so it didn’t blow me up too badly, but over time I’m planning to gradually sell off this allocation and move it into regular corporate bonds. At 7% they seemed pretty attractive, but at 5% not so much especially since preferreds are paying close to that anyway.”
If Preferreds are paying about the same why would you not stick with the bonds. When a company files for bankruptcy bondholders are required to be paid first, then Preferreds, then Common Shareholders.
1. Preferreds are mostly in more credit worthy names. In the junk category there are many that are going concerns and you still may not get your money back no matter how senior you are.
2. In a taxable account Preferreds have much better tax treatment.
3. Most Canadian Preferreds will do better in a rising rate environment, while junk will do very poorly in that same environment, because of the normal interest rate sensitivity and increased interest payment pressure on the poor credit companies.
Because the companies in the preferred space are higher quality than the ones in the junk bond space.
Also, what Tazi Bnu said.
the ETF is called the Vanguard Intermediate-Term Treasury ETF. This fund also has a bond yield of 2.6%
++++
What exactly does a yield of 2.6% mean for VGIT, as its dividend rate is only 1.75%? For VTC, the yield is comparable to dividend rate at 3.2-3.3%. Sorry i am confused.
Not sure what you’re referring to. https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=3143
Standard & Poor, Moody’s, and Fitch are all in bed with the companies they’re rating…
If Standard & Poor doesn’t give my corporate bond a AAA rating, I’m bringing my business to Moody’s. Remember the AAA rated Lehman Mortgage Backed Securities from 2007?
For US Investors, look into the US Government backed Series I savings bonds – current yield 2.58% with zero market risk and inflation indexed.
Series EE savings bonds guarantees you 100% of your investment in 20 years, or an implied 3.5% rate.
Oh, they screwed up big time in the credit crisis. These are the same guys who rated subprime mortgages AAA+. I’m not defending them. I’m just saying this is how the system works.
Very nice. Still looking forward to read about CEFs and CDs (specially that FED raised the rates today).
Well don’t hold your breath. Closed End Funds are just a poor man’s version of ETFs, an CDs are just a shitty savings account. I don’t plan on writing about either of them.
Hmmm…. I have not had any experience with junk bonds as I tend to be conservative. Until a few years ago I didn’t own ANY bonds as I thought my retirement date was so far away. I now have a good amount of holdings and I’m wondering when exactly they are going to yield me any gains….
That sounds like an excellent question to ask your financial advisor…
In NZ our government bonds are around 4% yield. Which is pretty cool given the low-interest rates around the rest of the world right now. NZ doesn’t have quite as much dept as some other countries as well so hopefully, that means they can afford it.
Ooh, cool! I may have to invest in some Kiwis (or whatever the heck you guys use for money).
what was your opinion on the new simple Vanguard funds ?
such as VBAL ….
the bonds inside there seem varied and some international
then one can also buy Preferreds and Reits on top
and i believe it gets rebalanced periodically to keep the weightings
the only thing .. not sure if i want 30 % Canadian equities …
thanks
Learn how to invest, then do it yourself. No one-fund-solution can fit you perfectly, so build your own!
These yield shield articles are great. I’ve got some questions about bonds as I think about constructing my own yield shield. Specifically I’m trying to wrap my head around the relative pro’s & con’s of buying a bond fund ETF (or mutual fund) as opposed to constructing a bond ladder.
The risk sets seem similar, but with a few little twists if I’m reading my research right.
Bond ETF Pro’s:
1) lots of diversification – you hold a ton of bonds in the ETF
2) total market bond fund won’t go to zero (just like stock index funds): diversification spreads out default risk
3) easy to buy/sell
Bond ETF Con’s
1) interest rate risk: share value decreases in a rising interest rate environment
2) at type of call risk – the fund manager has to sell fund bond assets if there is a run/panic on the ETF, locking in low returns. My understanding is this would be difficult for the fund to recover from.
3) Variable income as bond price & interest rates fluctuate.
Bond Ladder Pro’s
1) Construct a ladder to build the overall yield you want, out of whatever underlying bonds you want. (lock in your yield)
2) The interest rate risk is of the ETF is mitigated by not selling the bonds in the ladder & holding to maturity. You’re only subject to this if you need to sell a bond. We’re all on the path to FI, so the emergency fund should basically make this extremely unlikely.
3) Regular, predictable, income as bonds on the ladder mature.
Bond Ladder Con’s
1) Less diversification than an ETF/mutual fund
2) Default risk – one bond rung on the ladder could default and set you back by losing principle
3) More work to set a ladder up.
4) Rebalancing would sometimes take more time, or have lag, since you have to wait for a bond to mature to rebalance it into stocks. Again, you could sell a bond to get the cash to buy a stock when you wanted it.
Am I missing anything? Anyone have experience setting up a bond (or even a CD) ladder? Are there fees I’m missing? After writing this out, I noticed fees didn’t show up in my analysis.
We currently hold Bond funds in our asset allocation and have no experience setting up a ladder. If we expect interest rates to continue going up, maybe a I might take a small amount we have in cash and set one up to see how it goes.
The biggest risk in setting up your own bond ladder would be diversification! I worked with an adviser who help me purchase some individual bonds and even with ratings the risks are high. You did mention this but I wanted to share it does happen and the value of the bonds can plummet, even though you plan to hold them to maturity it sucks looking at a bond 30% of face value.
And then the bonds are not providing you the stability to even out fluctuations. Yield is only one reason to own bonds and maybe not the prime one.
I agree with Peter. Building a bond ladder is way less risky than building your own stock portfolio, but that’s still a risk.
That being said, a bond ladder and a bond ETF serve two different roles in a portfolio. A bond ladder provide low, but steady income without price fluctuations. A bond ETF provides anti-correlated volatility reduction for your portfolio. What do you need? That will tell you which one to buy.
Nice article! For what it’s worth, Vanguard actually recommends the use of corporate bonds as well. I signed up for their “Personal Advisor Service” (PAS) for a few months when I first got involved with investing, and they recommended about 25% of our bond allocation in higher-grade corporate bonds, as a way to goose yield a bit. (No junk bonds, though!).
Once I got my stuff together and left PAS, I ended up just dropping it and instead going with VBTLX for all of our bond allocation ‘cuz it was easier for rebalancing. I’m more along the lines of JL Collins investing, at least as it involves laziness (don’t have the stomach for 100% stocks). But in any event, thought you’d want to know that when it comes to your use of corporate rather than just govt bonds, you’ve got good company!
So are you going towards corporates, or government? VBTLX is 2/3 government.
Wanderer if you use XCB for corporate what do you do for government bonds? Do you also hold XBB which would create some overlap as that is 30% corporate bond already?
If not then what have you found that is a good broad CND government only ETF?
XSB for govt – might work.
I used to hold XGB, but now I hold XSB, for reasons I will write about in a future article.
What type of bond is VAB?
All of them. VAB is an aggregate bond fund, weighted by market cap.
Vanguard Canada do offer VCB for corporates bonds. Any reason why you prefer the iShares One?
At the time I built my portfolio, VCB didn’t exist. Now that I know about it, I will research and let you know my answer.
The Yield Shield is important for certain 40-50 year cycles as tested by Andrew Hallam in his recent article … folks who did 100% equities would have run out of money who started in 1973 ….. “The Biggest Risks Of The 4 Percent Retirement Rule
Mar 22, 2018 Article By: Andrew Hallam” AssetBuilder
Risk management is important …. I don’t do bonds yet … but then I work overseas still … and am mostly invested in real estate etc etc …. I have a question … in Canada you need to pay 15 years into the tax system to qualify for government pensions and I believe 10 years for the States? …. for early retirees then this becomes an issue? …. more so for overseas non resident expats who don’t pay into the system … who are there own and will receive zero government pensions …. have you read up much on that and what are your thoughts … CPO
Hmm… just stumbled on the Yield Shield from your binge read post about changing you asset allocation in Early Retirement. I liked that post because it was “so conservative” by FIRE standards. I also like the point of views… I think i’m more of a winnie and FIREcracker myself! I heard an economist talk once about one way to motivate people is to remind them of money they lost but could have not… (they do that in the US a bit by showing you what your neighbors are spending on their energy bills)…so it’s nice to see some people approaching investing from a more cautious standpoint until they get where they desire to be.
Is it just me, or is the article failing to display? I just see the headline picture.