At the risk of sounding like a broken record, I firmly believe that the most important component to my portfolio is my asset allocation. I think it is even more important than owning dividend growth stocks! As I do regularly these days, I made a recent portfolio move in the name of asset allocation. I bought some more of one of my fixed income assets – iShares CDN Real Return Bond Index Fund (xrb.to) in order to bring my fixed income allocation closer to target.[ad#tdg-embedded]
My fixed income asset allocation percentage is determined using a simple formula taught regularly by John C. Bogle, founder of Vanguard (the big index fund company). He explains that the easiest way to determine what an individual’s fixed income percentage should be is to allocate your age equivalent to fixed income assets. For example, I am 35 years only and as such, my fixed income percentage in my portfolio should be 35%. When I turn 45, then the reasoning is that I should then hold 45% in fixed income. I like and use this because it is simple and very easy to apply.
Being a Canadian, I am focused right now on building up a fixed income portfolio with Canadian fixed income instruments. My thinking is that I am underweight in fixed income as it is, so I should bring my fixed income allocation up to target in my home country and then as I get older and need more and more fixed income, then I can spread it out to other country fixed income opportunities.
I use two funds as part of my allocation. The first is a short-term bond fund. I hold short-term bonds simple because they are less volatile. In a bond, there are two main risks: maturity and credit. Maturity refers to the fact that rising interest rates tend to depress the prices of longer term bonds more than shorter-term bonds. As a result, long-term bonds can have much higher swings in price and in my mind are therefore riskier. The short-term bond fund I use is the iShares CDN Short-Term Bond Index Fund (xsb.to).
The second fund is a real-return bond fund. Real-return bond funds are Government of Canada bonds that pay a rate of return that is adjusted for inflation. Unlike regular bonds (like the short-term bond above), this feature assures that your purchasing power is maintained regardless of the future rate of inflation. I think this component is important because bond fund typically have a lower rate of return that stocks and inflation can eat a lot of purchasing power out of fixed income assets. As a result, adding in some additional protection from inflation hopefully will help maintain my future purchasing power in retirement. The kicker is that I need to pay for this protection the form of a higher MER – 0.35% for the real return fund and 0.25 for the short-term fund. The fund I use is the one mentioned above, iShares CDN Real Return Bond Index Fund (xrb.to).
Fixed income assets are an important component of my portfolio. I have devised what I believe is a strong strategy and will continue to bring it up to target allocation over time.
Why have you chosen to go with a short term bond fund vs. a ladder of GICs? I looked at this same issue, and the yields are much higher, with no increase in credit risk. As long as you keep CDIC limits in mind, you are 100% backed by the Canadian government.
For the portion of a fixed income portfolio that matures in less than 5 years, high interest savings accounts and GICs seem to be a free lunch when compared to money market funds and short term marketable bonds.
Good point on GICs. However, my timeframe is longer than 5 years so I wanted to take a little more risk than just the GICs. That being said, I still view my fixed income component as insurance, as a source of funds if I want to take advantage of market crashes, and for volatility control.
I think your use of a bond fund is simply wrong.
If you buy a bond that produces a 3% return and you hold it to maturity then you know your actual return and you get back your principal. If you buy a bond fund, not only do you pay an annual mer, but you will lose part of your capital as interest rates rise.
The purpose of the fixed income eliment of your portfolio is security of capital and consistent income. You want the funds to be there at a certain point in time. The actual bond (I use GIC’s because they are guaranteed and I get a higher rate of interest than a bond) gives you this and the bond mutual fund does not.
Regards
John
Thanks for the comment John. I agree that with bond funds you have the MER issue and are at risk because the unit price can decline. Do you then suggest to just buy a ladder of government bonds or even GICs? At some point I will probably go down that path – building a ladder of bonds. However, in the meantime because I am slowly building up my bond allocation over time the best and easiest way to do this is to use bond funds. It also provides more diversification than buying one or two bond or GICs.
If you have a small amount to invest, can you afford to lose capital?
Ask yourself why you are investing in the fixed income area. My answer always comes up safety of capital and consistent income. If this is why you invest in this area as well, then you must take the word risk out of the equation.
With interest rates so low, I suggest a ladder of GIC’s (higher rates than bonds) over a 3 year period. When rates go higher I would expand my ladder to 5 to 7 years. Even if you have a small amount of money you do not have any risk if you invest in a GIC. As Matt stated, it is fully insured. You can buy a GIC for a $1,000 so all you need is $3,000 for a 3 year ladder ($1,000 in each year).
Regards
John
Point taken John – I will have to investigate this more.
fixed income is a necessary part of you portfolio; however, consider that tax implications of the fixed income you choose. If these investments are outside your RRSP, TFSA, or 401K you may want to consider preferred shares instead. This is because dividends are given a preferrencial tax treatment whereas interest from bonds are not. Preferreds are very similar to bonds and are considered fixed income so do consider them. There are also ETFs for preferreds if you require diversification.