Wednesday, October 28, 2009

BMO’s New Bond ETFs

As Canadian Capitalist reported, BMO has come out with several new exchange-traded funds, including some bond ETFs. Any investor considering these bond ETFs should check whether it is cheaper to buy a bond directly.

The safest of the new bond ETFs are ZFS (0.2% MER) which invests in Canadian 1-5 year bonds, and ZPS (0.25% MER) which invests in provincial 1-5 year bonds. These MERs are a huge improvement over the typical bond mutual fund MERs, but they can still be high for large investments.

An alternative to these ETFs is to simply buy a bond directly. Discount brokers allow investors to buy bonds that make periodic payments, or buy another type of bond called a coupon that just pays a fixed amount at a given end date. The safest of these bonds are backed by the Canadian government or provincial governments.

Let’s suppose that you want to invest $20,000 in Canadian bonds for 5 years. You could buy ZFS and pay 0.2% each year for a total of about 1% after 5 years. The total fee would be around $200 plus the trading commissions. Or you could buy a bond directly.

Discount brokers don’t make it obvious what commissions you pay on a bond trade. You need to figure out how many bond units you can buy with your $20,000 and look at the gap between the buy and sell price for that number of units. The total cost of buying and then selling the bond will be equal to this gap. Of course, if you keep the bond to maturity, you won’t have to pay the selling half of the commission. With this information you can compare costs and decide on the cheaper approach.

Many investors are unaware that they can buy bonds directly. An advantage of this approach is that the final bond value is guaranteed. With a bond fund or ETF, you get no guaranteed future value.

7 comments:

  1. Thanks for the link Michael. It is not clear to me that buying bonds directly will be cheaper than buying ETFs. ETFs get institutional pricing whereas bond investors pay the retail rate. This could easily eat up the MER savings.

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  2. CC: I agree. That's why investors should check the buy-sell spread on bond purchases and sales through their brokerage before making a decision on which way to go.

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  3. The selection from discount brokerage is pretty poor (at least at TD Waterhouse).

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  4. Thomas: Is that the selection of bonds that is poor at TD Waterhouse? I've only checked at BMO Investorline and found that I could always find a bond that matures around the time I was looking for. I always go for either Canadian bonds or provincial bonds from one of the "big" provinces.

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  5. Yes, Investorline has a decent selection of bonds available, but the prices -- based on the low effective yields -- seem high. For long-term investors, bond ETF's or laddered GIC's are better alternatives.

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  6. Anonymous: I can see why GICs would give better returns -- their locked-in nature makes them a different investment. But there is no reason why bond ETFs should be significantly different from buying the same type of bond directly. For a fair comparison, the bonds should be the same duration and type of issuer. For small investments, the commission on buying a bond directly is likely to be more than the MER on a bond ETF, but for larger investments, the ETF MER is likely to be more than the commission on buying a bond. If this isn't true, then there is a arbitrage opportunity to buy bonds in one place and sell them in another.

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  7. Keep posting stuff like this i really like it

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