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Bond Index Funds in Rising-Rate Environments | Common Sense Investing with Ben Felix - YouTube
Channel: Ben Felix
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One of the favourite arguments of active managers
and financial advisors selling actively managed
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mutual funds is that active management will
protect you in a down market. Let’s think
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about this in the context of bond funds. When
interest rates go up, bonds will generally
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fall in price. With interest rates as low
as they are now, wouldn’t you be a fool
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to buy a bond index fund as opposed to an
actively managed bond fund?
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In fact, you would not be a fool. The performance
of actively managed bond funds has been just
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as dismal as that of actively managed stock
funds compared to their benchmark indexes.
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Over the 15 years ending in 2016, less than
⅓ of U.S. bond funds were able to beat their
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benchmark index.
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If active management isn’t the answer, and
interest rates really do have nowhere to go
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but up, should you still expect positive returns
from your bonds?
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I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common
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Sense Investing, I’m going to tell you why
you don’t need to be afraid of bond index funds.
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When it comes to bond performance and interest
rates, the factors that matter most are the
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magnitude of any interest rate increase, and
the average duration of your bond portfolio.
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Duration is a measure of price sensitivity
for bonds, where higher duration indicates
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greater price sensitivity to changes in interest
rates. If interest rates were to increase
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by 1%, a bond fund with an average duration
of 5 years would be expected to drop by 5%.
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Bonds with longer durations are increasingly
sensitive to interest rates, but they also
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have higher expected returns.
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Increases in interest rates will likely result
in negative short-term performance for bonds.
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These negative effects become more pronounced
as the duration of the bond portfolio increases.
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This is a fairly standard risk/return tradeoff.
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With interest rates as low as they are now,
a common thought process for investors is
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that future bond returns must be low or negative
going forward, this is because interest rates are
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either going to stay low, resulting in low
yields, or rise, causing bond prices to fall.
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This thinking ignores an important aspect
of the situation. As interest rates go up,
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new bonds are issued at the now higher rates.
Think about a a bond index fund. It is a fund
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that owns a bunch of bonds, based on an index.
A bond index includes bonds based on a set
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of criteria. For example, the Barclays Capital
US Aggregate Bond Index only includes bonds
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that have at least one year remaining until
maturity.
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The index usually rebalances monthly, meaning
that bonds in a bond index fund that no longer
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meet the criteria of the index are sold, and
new bonds are purchased. While it is true
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that bonds in the fund are likely being sold
at a loss during a period of rising interest
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rates, the new bonds being purchased will
have higher yields such that the index fund
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will eventually recover from any losses.
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Bond index fund prices may decline with rising
interest rates, but over time it is expected
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that as the index rebalances into new bonds
with higher coupons there will be positive
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long-term performance. Long-term expected
bond returns are independent of future interest
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rate scenarios, but realizing any expected
return will almost always come with periods
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of volatility.
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If you are thinking about ditching bonds altogether,
remember that they are there to help you in
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bad markets. A really bad year for bonds is
not nearly as bad as a really bad year for
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stocks. The worst 12 months in recent history
for the FTSE TMX Canada Universe bond index,
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an index representing Canadian bonds, was
between July 1982 and June 1983 when it posted
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a negative 7.90% return. Over that same period,
the S&P/TSX composite index, an index representing
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Canadian stocks, dropped by almost 40%.
Similarly, Canadian stocks dropped by 33%
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in 2008, while Canadian bonds posted a positive
6.4% return.
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If you are concerned about low or negative
returns in the bond portion of your portfolio
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due to low interest rates, an active manager
is not the solution. It is expected that bond
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index funds will outperform actively managed
bond funds over the long-term. One option
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might be to reduce the duration of your bonds,
decreasing their sensitivity to interest rates,
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but doing so will also decrease your expected
returns.
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Even if interest rates are expected to rise,
bond index funds continue to have positive
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long-term expected returns. You might see
a short-term decline in bond prices, but that
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does not mean that the bonds are no longer
doing their job. Investing is a long-term
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game. If nothing else, bonds act as your buffer
against down markets, so unless you have a
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stomach of steel, it’s probably worth keeping
them around.
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Join me in my next video where I will tell
you why you should not be using your TFSA
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as a day trading account.
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My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking
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about a lot more common sense investing topics
in this series, so subscribe and click the
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bell for updates. I want these videos to help
you to make smarter investment decisions,
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so feel free to send me any topics that you
would like me to cover.
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