Creating a Diversified REIT Portfolio

It has been a busy month, but some ideas have been fermenting the on the back burner during that time, and one of them is REITs. REITs, or Real Estate Investment Trusts, offer a great vehicle for regular income, and often offer high yields relative to regular equities. A REIT is several things at once, as indicated by its name:

  • It is an investment trust. As a trust, income from REITs is often categorized as interest income1, and as such is treated different for income tax purposes. However, one key advantage to interest income is that when you use it in a TFSA, none of that interest is taxable.
  • As a trust structure, ownership of the REIT is accomplished through trust units, which differs from equity shares of a typical dividend paying firm.
  • REITs invest in some type of real estate, as indicated by its name.

Artis REIT was my first REIT investment, and in terms of an income stream has treated me incredibly well. While the distribution payout has been flat — the actual distribution has been a consistent $0.06/month for the 2+ years that I have owned it — given the yield that it has provided, I cannot complain. However, one key challenge with holding only one REIT is that you are subject to the properties that the REIT itself invests in. Here is a map, which I pulled from Artis’ own website, which shows its current property distribution:

ARTIS Property Map

Map of properties in Canada and the United States within the ARTIS REIT

As you can see from the above, Artis is heavily concentrated in Central Canada. Not that this is a bad thing, but remember that one of the key qualities of a good portfolio is diversification. One of the easiest ways to diversify a REIT portfolio would be to simply invest in a REIT ETF, such as the S&P/TSX Capped REIT Index Fund, XRE.TO, or Bank of Montreal’s Equal Weight REITs Index ETF, ZRE.TO. One minor challenge with this is that you are still victim to the ETF’s investing strategy. However, the bigger challenge is that the relative yields between an ETF and a hand-picked portfolio of REITs is pretty wide. For example, the latest distribution yield (as of December 6, 2012) on XRE.TO was 4.58%. However, if you were to hand-pick an equal-weighted portfolio of four REITs, AX.UN, BTB.UN, CUF.UN, and HR.UN, you could achieve an effective yield of 6.92%!2.

With that thought in mind, I have been doing research lately on the different REITs available in Canada. My goal is to create a small (sub-)portfolio of REITs that will allow me to beat the yields of the major ETFs, while allowing me to customize the focus of the (sub-)portfolio, and diversify away any geographic concentration risk. There are few articles which are specific to Canadian REITs, but here are some useful links to start with:

For my own research, I headed over to my discount brokerage and ran a quick screen on all Income Trusts which are traded on the TSX. From there, I stripped out any trusts that were not REITs, and came up with the following list:

Ticker REIT Sector URL
AAR.UN-T Pure Industrial Real Estate Industrial link
AP.UN-T Allied Properties REIT Office link
AX.UN-T Artis REIT Diversified I (Office/Industrial/Retail) link
BEI.UN-T Boardwalk REIT Residential link
BOX.UN-T Brookfield Canada Office Prop. Office link
BTB.UN-T BTB REIT Diversified I (Office/Industrial/Retail) link
CAR.UN-T CAP REIT Residential link
CRR.UN-T Crombie REIT Diversified II (Office/Retail) link
CSH.UN-T Chartwell Seniors Housing REIT Retirement/Nursing/Healthcare link
CUF.UN-T Cominar REIT Diversified I (Office/Industrial/Retail) link
CWT.UN-T Calloway REIT Retail link
D.UN-T Dundee REIT Office link
DI.UN-T Dundee International REIT Commercial link
DIR.UN-T Dundee Industrial REIT Industrial link
HLP.UN-T HealthLease Properties REIT Retirement/Nursing/Healthcare link
HLR.UN-T Holloway Lodging REIT Hospitality link
HNT-T Huntingdon Capital Diversified I (Office/Industrial/Retail) link
HR.UN-T H&R Real Estate Invest. Trust Diversified I (Office/Industrial/Retail) link
IDR.UN-T REIT INDEXPLUS Income Fund Fund link
IIP.UN-T InterRent REIT Residential link
INN.UN-T InnVest REIT Hospitality link
KRE.UN-T KEYreit Retail link
LRT.UN-T Lanesborough REIT Residential link
MRG.UN-T Morguard North American REIT Residential link
MRT.UN-T Morguard Real Estate Inv Trust Commercial link
MSN.UN-T Morguard Sunstone Real Estate Fund link
NPR.UN-T Northern Property REIT Residential link
NRF.UN-T North American REIT Fund link
NWH.UN-T Northwest Healthcare Prop REIT Retirement/Nursing/Healthcare link
PAR.UN-T Partners REIT Retail link
PMZ.UN-T Primaris Retail REIT Retail link
RCO.UN-T Middlefield Can-Global REIT Fund link
REF.UN-T Cdn. Real Estate Investment Diversified I (Office/Industrial/Retail) link
REI.UN-T RioCan Real Estate Investment Diversified II (Office/Retail) link
RIT.UN-T First Asset Canadian REIT IF Fund link
RIU.UN-T Canadian REIT Income Fund Fund link
RMM.UN-T Retrocom Mid-Market REIT Retail link
RRB.UN-T Connor Clark & Lunn Real Ret Fund link
TGF.UN-T Timbercreek Global Real Estate Fund link
TR.UN-T Temple REIT Hospitality link
USM.UN-T US Agency Mortgage-Backed REIT Fund link

For the sectors, I borrowed (and slightly expanded) the list found in the Seeking Alpha article listed above. The list above focuses purely on the TSX, and ignores REITs which can be found on the TSX Venture Exchange, some of which were pointed out in a post I put up on the Canadian Money Forum3

Because I already own Artis REIT, I am looking for other REITs to balance the geographic distribution in the Diversified I sector space. The above is just the first cut at the research, and in later blog posts I will document my selection methodology and progress.

Happy investing!


1 As with a dividend paying corporation, occasionally this income may be in the form of Return of Capital.
2 For the 6.92% yield, I used the incredibly scientific method of randomly selected the four highest yield fully diversified REITs.
3 Not that there is anything wrong with the TSX Venture Exchange, however it is not an area that I have ever really looked into.


Stock Indices

ETF investing has become one of the primary vehicles for many individual investors, since it offers a low-cost, low-maintenance approach to investing, with results that match the overall market. The reason for this is that most ETF strategies revolve around investing in market-index ETFs. A great reference for this type of investing can be found at the Canadian Couch Potato blog, or at the original couch potato site at MoneySense Magazine.

When I started off investing on my own, I purchased Canadian Market Index Stocks such as XIC and XIU. At a high level, I understood that an index based ETF basically held the holdings of the index it represented; for example, XIC holds all of the equities in the S&P/TSX Capped Composite Index. But what is an index anyways?

In its broadest sense, an index provides an overview of the performance of the underlying securities, either through a price-weighted or value-weighted average. What constitutes inclusion in that group of securities depends on what the index is trying to achieve. Standard & Poors is one of the primary index publishers, and they have several such as the S&P/TSX 60, S&P/TSX Capped Composite, S&P/TSX SmallCap, etc. Each of these indices is designed to be representative of one dimension of the overall market. The 60 acts as a subset of the S&P/TSX Composite, but caps the total number of equities at 60. The SmallCap attempts to provide an overall barometer on the performance of small cap stocks on the TSX, etc.

Excluding the focus of the index, the other primary factor to take into account is whether or not it is price-weighted or value weighted.

(For the discussions below, a worksheet is available to play with, which can be found here.)

Price-Weighted Indices

The most popular price-weighted index is the Dow Jones Industrial Average (DJIA). There are a number of articles on the Internet which speak to the history of the DJIA, and my interest is in what it means to be price-weighted.

Essentially, a price weighted index is exactly what it sounds like: an index whose value is more influenced by firms which have a higher price. The value of a price-weighted index is the sum of the prices of firms in that index, divided by some divisor. The divisor is the trickier part of the equation.

\text{DJIA}=\frac{\sum_{i=1}^{30} P_{i}}{divisor}

Where Pi is the price of firm i. When the DJIA was initially started, the divisor was 30, because there were 30 firms in the average. However, over time the divisor has had to be adjusted due to stock (reverse-)splits. I.e., when a stock splits, the total number of shares goes up, but the price of the stock goes down. However, the before and after values of the DJIA should be the same. With a little algebra, we can calculate the divisor after a (reverse-)split as:

\text{divisor}_{\text{new}}=\frac{(\sum_{i=1}^{30}P'_{i})\times divisor_{old}}{\sum_{i=1}^{30}P_{i}}

In the above, Pi are the prices before the (reverse-)split, and P’i are the prices after the split.

Over time, the divisor for the DJIA has become incredibly small, and the divisor as of 2010/07/02 was 0.132129493 (from 0.132319125). The reason for this is that, using the formula for divisornew above, over the years successive splits have made the divisor smaller and smaller.

The other thing to consider with a price weighted index is the weighting of the price itself, and how it affects the overall value of the index. That is, an equal percentage change for a stock will mean more (or less) if the stock price was large (small) relative to the index to begin with. For example, both IBM and Bank of America are stocks in the DJIA. However, they are incredibly different in terms of pricing. At one point during the week of October 29, 2012, IBM was trading at $193.27 a share, and Bank of America was trading at $9.12 a share. But why does this matter? It matters because a 5% shift in either stock will have a different overall effect on the index as a whole. A 5% shift in IBM results in a 77.289 point shift in the DJIA, but an identical shift of 5% for Bank of America only shifts the DJIA 3.6471 points!

This means that one should pay particular attention to what it means when news reports say that the Dow has moved – the context of the movement has to be taken into account to ensure that the movement isn’t being skewed by a heavy hitter such as IBM.

Value-Weighted Indices

On the other end of the spectrum are value-weighted indices.

Looking at the sample spreadsheet, when we enter values for the split multiple, the sum of the market caps does not change. This is because (reverse-)splits automatically account for changes in the number of shares outstanding, and share price. This simplifies computation of the index because there is no denominator which must be continuously adjusted.

The other thing to notice is that changes in share price in a value weighted index are scaled appropriately to the weight of the firm in the index, measured by market cap. This means that the bigger the firm by market cap, the more weight it has. This also demonstrates that movements of the share price will be properly reflected in the index, and that the percentage move of a given security in the index will be properly reflected in the change of the index itself. But why does this matter?

Consider two hypothetical stocks, each with a market cap of $1,000,000,000. Further, assume that stock #1 has a share price of $5.23, and stock #2 has share price of $198.53. This is summarized below:

Stock Share Price Shares Outstanding Market Cap
Stock 1 $5.23 191,204,588.91 $1,000,000,000
Stock 2 $198.53 5,037,022.11 $1,000,000,000

As discussed above for the DJIA, if both stocks change by 5%, this will not have an identical change on the stock. However, based on market cap alone, a movement of 5% in either stock will have the same effect on the inded. For this reason, a value-weighted index is often a better indicator of the performance of the cross-section of the market that the index is monitoring.


Analysis: High Liner Foods (HLF.TO)

High Liner Foods holds a special place in my investing heart, because it was the first stock that I ever performed my own analysis on. Since purchasing it in 2010, it has soared over 50%, making it an incredibly valuable part of my portfolio. High Liner’s success is what really pushed me into the value investing sector, whereas before I was always trying to time the markets as a day/swing trader. High Liner’s share price growth has been impressive, showing an 8.57% compound annual rate of return from 2002-2011.

High Liner Foods Share Price Growth, 2002-2011

Fast forward two years, and things are even better. On September 20, 2012, High Liner Foods announced that they had been added to the S&P/TSX Small Cap Index, which was a major accomplishment. This addition brought about added exposure and liquidity to the stock as it is now traded in some of the S&P/TSX Small Cap ETFs such as iShares XCS.

Given all of these changes, I felt that High Liner warranted a refresh of my initial analysis. While I discussed my initial evaluation methodology previously, reviewing my original analysis reminded me of some of the fundamentals I should be looking for. That said, I’ll be expanding my initial evaluation methodology, starting with High liner. So, what do we have at first glance?

Criteria Value Threshold Pass?
Strong financial condition Current Ratio 2.05 1.50 YES
Earnings Stability Positive EPS over last 3 years 8.00 3.00 YES
Earnings Stability Less than 2 consecutive negative years 0 2 YES
Dividend Growth Dividend Growth 30.75%
(from 2003-2009)
2.00% YES
Share Price Growth Minimum 3.00% compound growth over the past 10 years 9.82% 3.00% YES
Moderate P/E Ratio P/E 8.61 15.00 YES
Moderate P/BV Ratio P/BV 1.09 1.50
Moderate P/E*P/BV Ratio P/E * P/BV 9.38 22.50

In the above, the one that needs a real explanation is the P/E, P/BV, and P/E×P/BV section. I consider a firm to be overpriced if its P/E is greater than 15, its P/BV is greater than 1.5, or if the combined value of both is greater than 22.5. This combination factor allows for some flexibility.

If the above looks familiar, it probably is. For the most part, this is a screen taken from Benjamin Graham’s The Intelligent Investor. The above values are based on the 2009 fiscal year, which is the data I originally used for selecting the stock. However, looking at 2011 data, we have a drastically different story:

Criteria Value Threshold Pass?
Strong financial condition Current Ratio 1.31 1.50 NO
Earnings Stability Positive EPS over last 3 years 10.00 3.00 YES
Earnings Stability Less than 2 consecutive negative years 0 2 YES
Dividend Growth Dividend Growth 28.03 2.00% YES
Share Price Growth Minimum 3.00% compound growth over the past 10 years 5.37% 3.00% YES
Moderate P/E Ratio P/E 13.59 15.00 YES
Moderate P/BV Ratio P/BV 1.53 1.50
Moderate P/E*P/BV Ratio P/E * P/BV 20.78 22.50

While all of the initial tests passed, the price of HLF.TO is now incredibly high; the 2011 chart is based off of a $16.35 share price, but the stock is now trading at $23.94, which yields a P/E of 19.90, P/BV of 2.24, and P/E×P/BV of 44.55! (This is assuming we use the EPS of the fiscal year, with the October 1, 2012 share price). The stock would definitely not be on my radar at the moment because it is incredibly overpriced.

Initial screen aside, the other fundamentals look solid.

HLF.TO Dividends and Dividend Payout Ratio

EPS vs. Dividend Payout Ratio

Observing the above, there has been consistent growth in the dividend over the past five years, and the dividend payout ratio has — except for 2005 — remained consistently below 50%. In adition to this, EPS has been inching slowly upwards since 2005. One may be a little wary of the huge EPS in 2003 which suddenly dropped by 2004, but the 2003 blip was a one time event “realized on [High Liner’s] exit from the harvesting and primary processing businesses,” as discussed in the 2003 annual statement.

ROE, P/E and FCF all show simila rpositive trends, once one ignores the 2003 event:

High Liner Foods ROE 2002-2011

High Liner Foods P/E Ratio, 2002-2011

High Liner Foods Free Cash Flow per Share, 2002-2011

While FCF has been a little week, overall High Liner has been a solid performer. Good management has seen the company shedding businesses that it no longer needs (such as food processing in 2003 and the Italian Village line in 2005), and making good acquisitions such as their purchase of Icelandic Group in 2011. All in all, the firm has strong fundamentals, a good management team which is focused on increasing the value of the business, and a solid (but well managed) history of increasing dividends.

Depending on what the fiscal 2012 results are, I would consider picking up HLF.TO on dips in 2013, provided the combined P/E×P/BV ratio was less than 25 (higher than my regular threshold, but I woudl be willing to give a little on an excellent company).


Fixed Income Part 4: Wrapping It All Up

In this short series I’ve talked about three types of “fixed income”: Bonds, Bond ETFs, and Preferreds. Of the three, bonds are the only true fixed income securities. But, which is best, and why? The following table summarizes the results:

Bonds Bond ETFs Preferreds
Pro
  • The only true “fixed-income” vehicle
  • Preserves capital (if held to maturity)
  • Regular, predictable interest payments
  • Easily accessible; traded on most major exchanges, and carried by virtually all brokers
  • Offers incredible diversification
  • Wide range of vehicles (corporate, government, long, medium short-term, etc.)
  • Easily accessible
  • Regular, predictable interest payments
  • Typically trade near their par value
  • Ranks above common share holders
Con
  • May have covenants attached which are not good for the bond holder
  • Typically high cost of entry ($1,000 or $5,000 is the typical minimum purchase)
  • Not all brokers carry bonds, or a full inventory of bonds
  • If traded before maturity, value of the bond may fall (or rise) with rising (dropping) interest rates
  • No preservation of capital
  • Share price of the bond ETF will fall (rise) with rising (dropping) interest rates
  • Interest payments may not be consistent
  • May have covenants attached which are not good for the preferred holder
  • Sometimes thinly traded; bid-ask spread may be huge
  • Technically, does not preserve capital

So, where does this leave us?

For a long-term investment strategy, given the choice, and provided I the capital were available, I would recommend bonds.  The key point about buying bonds however, is that they are best if held to maturity.  If you start trading bonds on a daily basis, you are subject to interest rate risk; one “bad” announcement from the Bank of Canada about increasing interest rates, and the market value of your bond could drop by a large percentage. This means that you would have to pay careful attention on a daily basis to changes in interest rates, which is counter to a buy-and-hold strategy.

In the interim, if you do not have access to considerable amounts of capital, I would lean towards preferreds.  While they are not bonds per se, I believe that they will preserve their value in a market with changing interest rates.  However, as I type this, I wonder if this is truly the case.  For the time being, I’ll stick by my belief, but this warrants further research.  The key thing is that with the bond ETF, your investment capital will definitely change as interest rates change, and that is due to the underlying securities which make up the ETF.  Whether the value of the investment capital rises or falls, depends on the movement of interest rates.

Full Disclosure: Long XBB.TO


Fixed Income Part 3: Preferred Shares

Insofar as fixed income goes, I have already discussed two types of “fixed” income: Bonds, and Bond ETFs. There is one more category of security that I’d like to discuss, that being preferred shares.

Overview

Unlike a bond, a preferred share is not a true form of fixed income. It is, essentially, equity. However, unlike a common share, preferred shares have many similar characteristics with a bond: they pay a fixed dividend (equivalent to a bond’s coupon payment), can have several options attached to them (such as being callable or convertible), and they rank higher than common shares with regards to a claim on a firms assets. Essentially, a preferred share (sometimes called a preferred) is a class of equity that a firm issues which has a predetermined dividend payment associated with it, which is a percentage of the preferred’s original issue price. The Bank of Montreal has several classes of preferred shares which can be reviewed here, and we’ll take a look at the Preferred Class Series 5 shares for this discussion; a copy of the prospectus can be found here.

Taking a look at the prospectus, the full name of this preferred is Non-Cumulative Class B Preferred Shares Series 5, and the preferred was originally issued with a price of $25.00, and a 5.30% yield. The 5.30% is the yield relative to the original issue price, and this equates to a $1.325 annual dividend, or $0.331250 a quarter. The preferred is also non-cumulative, which means that in the unlikely event that the BMO Board of Directors elects not to issue the dividend for a given quarter, that dividend is lost forever (explained on Page 4 of the prospectus, under the Dividends section). Reading further, the preferred share is also callable on or after February 25, 2012, at a price of $25.00/share.

Not all preferred shares are callable, or non-cumulative. For example, PartnerRe Ltd. on the New York stock exchange has Cumulative Redeemable Preferred Shares, which means that if a dividend payment is missed, the missed payments accumulate until a later date at which all dividends can be paid out to the respective shareholders. Similarly, not all preferreds are callable by their respective issuers; (non-)cumulative, redeemable, callable, etc., are all covenants placed on dividends to protect the issuer. However, not paying a dividend on a preferred share sends a very negative signal to the market. At the very least, bond holders and preferred holders should be paid out of the regular earnings of the firm, and typically common shares are the first shares to be cut.

Pros

The biggest two pros of a preferred share are their regular dividend cashflow, and their ranking on the claim of the firms assets.

For cash flow, when you purchase a preferred you are “guaranteed” the dividend payout for as long as you hold the preferred, or until the firm calls and/or converts it as outlined in the prospectus. This is what places preferreds in the category of fixed income: they provide a steady, predictable stream of income much like a bond.

In the case of callable preferreds, the preferreds also preserve much of your capital. While the BMO Preferred Share sells for slightly above its original $25.00 sell price (as of this writing, the price is $25.84, the potential of losing all of your initial investment is minimal: if the price skyrockets, the issuer will pay $25.00 if they decide to call; a 3.25% loss, but if the preferred is held for at least a year your total holding period return is still net positive (e.g. if you purchased for $25.84, after one year your total income would be $1.325; even if you sell for $25.00 your return for the entire holding period is still 1.88%). And unless the company declines to pay a dividend, the price is unlikely to fall below $25.00 a share; doing so would equate to a higher yield (as the price of the preferred falls, the yield rises); supply and demand would keep the share price at or around $25.00.

Ranking on a firms assets means that in the unlikely event of bankruptcy, preferred share holders rank below bond holders, but ahead of common share holders. In terms of paying out the shareholders who own the companies equity, after bond holders are paid, preferred share holders are next in line. This is another element of protecting your capital. Within the world of preferreds, there are still rankings (e.g., for our BMO Class B Series 5, the Class B ranks only below bonds, and covenants of the preferred dictate that the bank cannot issue another series of preferred share that ranks above the Class B), but overall there are typically less preferred shares outstanding than common shares, so you are more likely to receive a piece of the pie owning a preferred share than a common.

A final pro to a preferred is that it is more accessible to the average shareholder than a bond. One of my criticisms of bonds was that they had a high initial buy-in, typically in the $1,000 or $5,000 range. Preferreds span the gamut of accessibility and can be had for as little as $25.00 a share, definitely within range of the average investor.

Cons

Due to the covenants available for preferred shares (callable, non-cumulative, etc.), one has to be careful to read the full prospectus to understand what they are getting into when they purchase a share. For example, if you purchased a BMO Class B Series 5 in January 2013, by the time February 25, 2013 rolls around, BMO may decide to start calling the shares on the common market; your fixed income vehicle may be reclaimed by the firm before you’ve even had a chance to enjoy the dividend! Likewise, if the firm declines to pay a dividend for a non-cumulative preferred for one quarter, you have effectively lost 25% of your annual income from that preferred!

Covenants aside, one of the biggest downsides to a preferred when compared to their common counterparts are the fixed payments, which was touted as a strength above. Fixed payments essentially mean that the yield dividend of the preferred is fixed for the life of the equity, which contrasts to a common share where the dividend may rise (or fall) if EPS rises (or falls). However, it isn’t fair to compare a preferred share to a common share; while they are both forms of equity, they are completely different beasts. When analyzing the capital structure of a firm, it preferreds are often lumped in with the fixed income portion, not the equity portion. For this reason, comparing a preferred to a common isn’t a true apple-to-apples comparison.

Wrapping It All Up

Preferreds over an attractive alternative for fixed income. Their biggest advantage in my eyes is the ability to act as a fixed income stream, with relatively low initial investment. In my final post, I’ll compare preferreds to bonds and bond ETFs to see how they all stack up against each other.


Fixed Income Part 2: Bond ETFs

In my last post I discussed the pros and cons of bonds. One limitation to bonds is that the usually require an investment of over $1,000, and sometimes over $5,000, to purchase, which may not be a viable option for the casual investor. One alternative to purchasing de-facto bonds is bond ETFs.

Pros

There are several bond ETFs on the market from the major ETF players such as iShares and Bank of Montreal, covering a wide range of requirements, such as government bonds, corporate bonds, real return bonds, etc. In terms of accessibility, ETFs trade on most major exchanges, and as such they are easily accessible to anyone with a trading account. Bond ETFs are also attractively priced, which puts them within grasp of those with minimal funds to invest; a small position can be created with as little as $100, a far cry from the $1,000 minimum investment for most bonds. Yields are comparable to the bonds that underlie the security, so even a small position would have a net positive payout over time.

Another advantage to bond ETFs is that they offer a good degree of diversification. A bond ETF is composed of a number of underlying bonds, the exact bonds being dictated by the investment objectives of the ETF. For example, as of August 26, the BMO Long Federal Bond Index ETF holds 11 different bonds:

Security %
Cda Govt 5.00 01Jun37 0.1893
Cda Govt 4.00 01Jun41 0.1885
Cda Govt 5.75 01Jun29 0.1847
Cda Govt 5.75 01Jun33 0.178
Cda Govt 3.50 01Dec45 0.0602
Canada Post 4.08 16Jul25 0.0549
Cda Govt 8.00 01Jun27 0.0508
Cda Govt 8.00 01Jun23 0.0333
Cda Govt 9.00 01Jun25 0.0276
Cda Govt 1.5 1Jun23 0.0238
Canada Post 4.36 16Jul40 0.0108

By purchasing a single ETF, you now hold portions of 11 bonds, greatly diversifying the risk of holding a single bond.

Cons

The biggest challenge with bond ETFs doesn’t come from the bond ETF per se, but from the structure of ETFs in general. In its simplest form, an ETF, or exchange traded fund, is a collection of underlying securities which are wrapped up as an ETF, and traded on the open market. ETFs are similar to their mutual fund brethren, two of the key differences being that ETFs trade on major exchanges, and that the key fees inherent in mutual funds (such as front load or back-end load) are represented by standard brokerage fees for trading on the exchange.

Bond ETFs being composed of the underlying bonds is the major challenge. Bonds are directly impacted by interest rates: as interest rates rise, bond prices fall, and vice-versa. Because an ETF is made up of a collection of underlying bonds, as the value of the underlying bonds rises (or falls), the ETF itself rises (or) falls in value. In a period of falling interest rates this means that the underlying bonds rise in value, with a corresponding rise in the value of the bond ETF. Interest rates are currently at historical lows, which means that over time interest rates have nowhere to go but up. As interest rates rise, the underlying value of the bonds will fall, which means bond ETF prices will fall as well.

Why does this matter? Ignoring the obvious fact that your initial investment will fall as interest rates rise, you also suffer from a loss of capital. If you buy a $1,000 par bond today, which matures in 5 years, you are guaranteed two things:

  • The coupon payments of the bond over the next five years
  • The $1,000 principal in the fifth year

However, with a bond ETF, you are not guaranteed your principal since the bond ETF never matures. If you take the identical $1,000 investment for the $1,000 bond and purchase $1,000 worth of shares of a bond ETF, if the rates fall and you sell your ETF shares, you will receive less than your initial investment.

One final drawback to a bond ETF is with regards to the “coupon” payments. Any distributions from the underlying bonds, after paying management fees (defined as the MER) should be distributed to the shareholders. However, because the ETF is composed of a number of underlying bonds, those distributions may change over time. In terms of predictable cash flow, a bond ETF may not be the best option. Looking back to the $1,000 bond example above, if the bond pays a 5% coupon on a $1,000 semi-annually, I am guaranteed $25.00 every six months. This relationship may not hold for an ETF since the underlying bonds of the ETF may change over time.

Wrapping it all up

In terms of accessibility, bond ETFs cannot be beat. They offer low initial investment costs, and offer great diversification. However, since they do not have maturity dates as with a typical bond, you risk losing portions of your initial investment as interest rates rise. Of course, the opposite is also true: if interest rates fall, your initial investment will appreciate. As also mentioned, the cash flows may not be consistent while you hold the ETF (although they may fall or rise, depending on the underlying bonds). However, given that interest rates are already fairly depressed, the likely direction of interest rates in the future is up, not down.


Fixed Income Part 1: Bonds

One of the key elements to proper portfolio diversification is to ensure that you have a healthy balance of equities and fixed income, depending on your risk tolerance. for the most part, there are three types of fixed income that one may add to their portfolio:

  • Bonds
  • Bond ETFs
  • Preferred Shares

To date, my preference has been for bond ETFs, but I am starting to take an interest in preferred shares as well. This is the first of a short series of posts on my views on fixed income investing, and for this post I’ll be discussing bonds.

Bonds

There are four basic elements to a bond

  • The bond face — or par — value, which is the amount of cash that the bond is exchanged for at maturity
  • The maturity date: this is the date at which the bond matures. In other words, on this date, the bond is exchanged for its par value with the issuer.
  • The coupon of the bond: this is the rate at which the bond pays interest, relative to its par value. E.g., a $1000.00 bond with an 8% yield would give you $80.00 per year in interest payments.
  • The yield — or yield to maturity — of the bond: this is the relative return of the bond, based on what you paid for it, what its coupon is, and when it matures.

There are other components that define a bond, but these are the four key elements. For example, a bond may be annual, or semi-annual, meaning it pays interest once a year or twice a year. In the case of a semi-annual bond, our 8% yield bond above would provide two $40 payments throughout the course of the year. Another feature may be a callable bond, where the issuer of the bond reserves the right to call the bond prior to the maturity date, and exchange it for cash. Entire textbooks have been written up on bonds, but the purposes of this post the four elements above are the ones I am concerned with.

As a dividend investor, I lean towards a buy and hold strategy. For that reason, my primary concern with a bond is the yield of the bond. The yield tells me what my return will be relative to my investment at the end of the day. One key thing to note is that yield and coupon are not the same. A bond which carries a 5% semi-annual coupon (so two $50 payments per year) may a yield that is higher or lower than 5%. In its simplest form, a yield which is higher than the coupon rate indicates that the bond is selling for less than its par value; e.g. a $1,000 bond may be selling for $990. Likewise, a yield lower than the coupon rate indicates that the bond is selling at a premium; e.g. a $1,000 bond may be selling for $1,050. However, if you are holding the bond to maturity, what matters is that you hold a bond which has the required yield for your portfolio. So if, for my portfolio, I am looking for a fixed income component that pays a 5% yield (so $50 every $1,000 of investment on an annualized basis), then I will search for a bond with a yield to maturity of at least 5%.

So, say I purchase a $1,000 bond which has a yield to maturity of 5.10%, but its coupon is 8.00%; this tells me that even though the bond is paying me $80/year in interest payments, relative to what I paid for the bond, I am only receiving $50.00/year in interest payments, because I paid more than $1,000 for the bond in the first place. To demonstrate this, I’ve put a little spreadsheet up, where you can punch in bond par and selling values, to see the effect on yield to maturity. You can find the spreadsheet here.

Pros

As I see it, the strongest selling points of a bond are:

  • Bondholders hold a higher right to claim on an organization’s assets. In the unlikely event that an organization goes bankrupt or gets itself into serious financial trouble, bond holders rank above shareholders in terms of being paid back for what is due to them.
  • Bonds pay a fixed amount for the life of the bond. Once you have purchased the bond, you know exactly what you are getting, and exactly how long you are getting it for. This stability is like gold for financial planning.
  • The market for bonds is fairly liquid. If you have to sell your bond to free up some capital, you should not have much of a challenge.

Cons

As good as bonds are, there are a few cons:

  • The biggest challenge with bonds is the up-front capital investment. Bonds typically sell for at least $1,000, which is a big chunk of change for personal investors such as myself.
  • Bonds are highly (negatively) correlated to interest rates. In other words, as interest rates rise, bond prices fall. As of this writing (August, 2012), interest rates are relatively low, which means that bond prices are relatively high. But, if you buy a bond today as part of long-term buy and hold strategy, and go to sell it later when (if) interest rates go up, then the value of your bond will decrease, and you’ll be stuck with a capital loss. Investopedia has a short explanaition on this topic at this link.
  • Bond payments are fixed. While I said that bonds paying a fixed amount were a pro, above, this also means that there is no potential for the payment to increase, unlike a dividend paying stock where the organization may elect to increase the dividend payments over time.

Wrapping it all up

Bonds provide an attractive vehicle for fixed income, provided one has the cash to purchase them. You could purchase a bond on margin or take out a loan, and theoretically as long as the yield to maturity of the bond is higher than the interest rate on the loan, you would still come out ahead; I’m curious to the tax implications in doing this, since bond interest is not the same as dividend income, so there is not as much as a tax incentive to borrow to invest in them (as I discussed in my last post.) In future posts on this mini-series, I’ll compare bonds to two other fixed income instruments, bond ETFs, and preferred shares.