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.
  

IIROC Request for Comments on Proposed OTC Rules

The IIROC has published its proposed rules for over-the-counter securities, including bonds. Straight from the document, the proposed amendments will:

• Require Dealer Members to fairly and reasonably price securities traded in OTC markets;
• Require Dealer Members to disclose yield to maturity on trade confirmations for fixed-income securities and notations for callable and variable rate securities; and
• Require Dealer Members to include on trade confirmations sent to retail clients in respect of OTC transactions a statement indicating that they have earned remuneration on those transactions unless the amount of any mark-up or mark-down, commissions and other service charges is disclosed on the confirmation.

The full document can be found here. Instructions on how to send your comments in are included in the document. Comments must be received by July 16, 2009.

Disclosure Rules for Bond Trading

The Globe and Mail reports that the Investment Industry Regulatory Organization of Canada will publish a proposal for regulations this Friday governing bond trading with the intent to bring more transparency into the pricing and commissions charged by brokerages.

This sounds like a great idea (although we'll have to wait and see what the rules actually are). In the US, the FINRA TRACE system can be used to get the prices on recent bond trades, but here in Canada it's much more difficult to know if you are getting a fair price.

Even if (and it's a big "if") we are currently always getting fair prices from our brokers, being able to see what commissions are being charged will hopefully keep our brokers honest and help the retail investor decide how to spend his/her money.

Other highlights from the article are:

• "better disclosure of the bond's yield" (we'll have to see what this really means)
• "a 'fair pricing rule' to enable regulators to punish dealers who trade bonds at prices far from the true market price"

I hope we'll eventually see a TRACE-like system so that we will be able to see near-real time trading information for bonds like we do with stocks.