Bond Investing

For the bond portion of my portfolio, I prefer to use short term bonds and the DEX Short Term Bond Index is probably the closest index to my bond strategy. In Canada, iShares' XSB is the best single ETF tracking the DEX Short Term Bond Index.

However, it still irks me to pay ongoing MERs on bonds when I could buy them individually and just hold them. I also don't like that bond funds' NAVs fluctuate such that it is quite possible to lose money holding bonds through a fund. Bond funds do, however provide the kind of diversification that is not really possible for anyone with less than $500,000 (or some big number like that) to invest.

Lately I've been thinking about how to solve this little problem, and I think I'll try it this way: Government bonds do not really require the diversification that corporate bond holdings do. There is only one issuer of Canada bonds, and only a handful of Provincial issuers. So for government bonds, it is easier to buy individual bonds without worrying so much about diversification.

Thus, appeal of something like iShares' XSB (MER 0.25%) is the diversified holding of corporate bonds. Looking at the iShares offerings, there isn't anything especially appealing for corporate bonds. XCB (MER 0.40%) has a duration that is a bit too long for my liking. Looking over at the Claymore offerings, though, we find the 1-5 Yr Laddered Corporate Bond ETF, CBO (MER 0.25%). CBO is fairly new, but trading volume is not bad for a Claymore fund. I do like that Claymore is offering DRIPs on all their funds now, so that is another plus for CBO.

CBO seems to hold about 70% A-rated bonds, and 30% AA bonds. The number of holdings is somewhat low, at 25, but 25 is also more than I would be able to buy on my own. The duration of the fund is 2.65, which I like. On the down side, there is no getting away from the possibility of losing money in the fund since its value fluctuates, but I think the diversification makes up for it as a corporate bond fund.

So in effect, my short term bonds will be split into government and corporate holdings. Asset allocators will probably like the opportunities to rebalance that this will allow for. There is only one ETF involved, so only one set of transaction fees are incurred when buying or selling. On the down side, when buying bonds from a brokerage, you don't really have a good idea what commissions are being charged. However, in Hank Cunningham's 2nd edition of In Your Best Interest, he investigated the bigger discount brokerages and found that TDW and BMO Investorline were the best for prices and in general found that discount brokerages were charging reasonable commissions on bonds.

The pros and cons of this approach:
Pros:

• Lower overall MER paid.
• Government bond component can be held to maturity.
• More control over allocations to government vs corporate bonds.
  

Cons:

• Overall less diversification than XSB.
• CBO has less diversification than XCB for the corporate component.
• A bit of a hassle to maintain the ladder of government bonds.
  

How Often Should You Rebalance Your Portfolio?

It is often suggested that you should rebalance your portfolio every year. But you might ask yourself, "why every year"?

I think it makes sense to think about why you rebalance and what is happening to your portfolio when you do or do not rebalance. I believe that the top 2 reasons for rebalancing are:

• Control the risk profile of your portfolio
• Capture reasonable gains when they occur (buy low, and/or sell high)
  

How does rebalancing on a timed schedule (quarterly, yearly, etc) help with either of these goals? For example in a volatile market, with wild swings up and down in short time frames, we optimally want to rebalance frequently at market tops and bottoms. This would achieve both goals. In a stagnant market, we might not need to rebalance for many years. This would also achieve both goals.

However, if we agree that we cannot time the market, then we have no way of knowing where those tops and bottoms are, so most of us need some rules of thumb so that we don't forget to rebalance altogether (or rebalance too often--think about transaction costs and taxes on capital gains).

The rule of thumb that is easiest to remember is a timed schedule. This is also probably why it is the most frequently suggested rebalancing strategy. Maybe it's on your birthday, or after you receive your notice of assessment from the CRA. If you will forget to rebalance without a timed schedule, it makes sense to use calendar dates for rebalancing, whether you decide it is every quarter, every year, every 2 years, or whatever is convenient for you. The once-a-year suggestion appears to be historically sound and also keeps transaction costs within reason.

If you have more discipline and follow your portfolio more closely, a more direct approach to achieving the goals of rebalancing is to set limits on how much an asset is allowed to deviate from your target allocation. For instance if you have a 60/40 portfolio and you decide that a 10% deviation is when you are out of your comfort zone, you would rebalance if your portfolio became 70/30 or 50/50. The number you choose as your deviation limit depends on your risk tolerance and what you think are fair gains to cash out on. Using this method, you would be rebalancing whenever it is necessary according to your rules for achieving the rebalancing goals.

While I think that the timed schedule is a fine rebalancing strategy, it does seem to me to be an indirect way to achieving the ultimate goals of rebalancing. If you have the discipline and energy, setting deviation limits is probably a more direct approach.

Consider All Sources of Income When Forming a Portfolio

When you think about your portfolio, take into consideration more than just the assets sitting in your brokerage or mutual fund account. For instance if both you and your spouse work in the high tech industry, maybe you don't need to have so many high tech stocks. Or if you work in real estate and have a couple of investment properties, it might not make sense to invest in REITs since a real estate crash would affect your job, as well as your investments.

Similarly, although you may really like your employer, holding substantial assets in company stock is dangerous. The classic example of this is the Enron case, where employees not only lost their jobs, but many also lost their retirement savings. Either one of these would be terrible on its own. Having both happen is devastating.

Consider your entire financial situation when creating your portfolio so you won't have any unexpected surprises.