Stock Market: Bonds Are Struggling, But Is There a Smart Way to Include Them in Your Portfolio?

This was supposed to be the year bonds made a breakout. We’re still waiting. 

After 40 years of decent returns, bond indexes plunged in 2022 as central banks ratcheted up interest rates in a bid to stifle inflation. The benchmark iShares Core Canadian Universe Bond Index ETF (XBB-T), which tracks the full spectrum of Canadian bonds, fell a record 11.78 per cent that year.

The ETF staged a modest recovery in 2023, gaining 6.61 per cent. But it’s back to its losing ways so far this year, down 1.24 per cent (to March 28). The three-year average annual compound rate of return to Feb. 29 was -2.26 per cent. 

Long-term bonds, which carry the most risk, showed a similar but more exaggerated pattern. The iShares Core Canadian Long Term Bond Index ETF (XLB-T) was down 21.9 per cent in 2022, up 9.34 per cent in 2023, and down 3.66 per cent so far in 2024. Its three-year average annual compound rate of return is -5.59 per cent and the five-year number is -0.84 per cent. 

Short term bonds are supposed to be a safe haven in times like these. But the returns have been choppy. The iShares Core Canadian Short Term Bond Index ETF (XSB-T) was down 4.13 per cent in 2022, gained 4.94 per cent in 2023, and is up 0.32 per cent so far this year. The three-year average annual compound rate of return to the end of February was 0.03 per cent, slightly ahead of break-even.

So, if you want to hold some bonds in your portfolio, where should you look? The iShares Floating Rate Index ETF (XFR-T) is worth considering on a short-term basis.

The fund invests in a portfolio of floating rate bonds, whose payments are adjusted to reflect changes in interest rates. So, when interest rates are rising, the payout increases. Conversely, when rates start to fall, as we expect later this year, the distributions from this ETF will decline. 

Those portfolio characteristics enabled the fund to buck the trend and post a positive return of 1.8 per cent in 2022. That was followed by a gain of 5.24 per cent in 2023 and 1.28 per cent year-to-date. 

Right now, the monthly distribution is $0.086 per unit, or $1.032 annually if it were maintained at that level. That’s unlikely. The Bank of Canada and the Federal Reserve Board have both indicated rate cuts are coming later this year, unless…

The “unless” is why this ETF may be of interest to some investors. If we see a resurgence in inflation, the central banks may be forced to change course and push rates higher, which would benefit XFR. The latest inflation numbers from the U.S. suggest this scenario is still on the table.

This fund is never going to generate big gains. It’s average annual compound rate of return since it was launched in December 2011 is 1.62 per cent. But it’s a low-risk choice at this time if you need a fixed income fund.

For longer-term growth, with higher risk, I still like the prospects for XLB. It closed on March 15 at $19.10. The current monthly distribution is $0.062 ($0.744 a year) for a forward yield of 3.9 per cent annually.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca/subscribe 

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