Why Bond ETFs Fall In Price

 Claymore 1-5 Yr Laddered Corporation Bond Exchange Traded Fund(TSE:CBO). These iShares ETFs are extremely popular, at least in part because they pay unusually high yields: despite holding nothing but short-term government bonds, CLF pays almost 4%. The corporate bonds in CBO pay almost 5%. That can only happen when the underlying holdings were purchased at a steep premium, and that means these ETFs will see their prices decline steadily as the bonds are gradually sold and replaced. If you’ve held these funds in your account for a full three years, they would show a significant capital loss—and yet their total return over that period was actually quite good:

Price on Price on 3-year Total return
June 30, 2010 July 31, 2013 price change (annualized)
CLF $20.30 $19.47 -4.09% 2.75%
CBO $20.42 $19.84 -2.84% 3.53%

An investor who held CLF over the last three years (and reinvested all distributions) would have seen every dollar grow to $1.08, while CBO investors grew each dollar to $1.11. Yet I recently received an email from a reader who was alarmed that CLF “has been losing money for years.”

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One final note: don’t make the mistake of thinking a distribution reinvestment plan (DRIP) will eliminate this confusion. Index mutual funds don’t solve the problem either, even though all distributions are automatically reinvested. In both cases, the dollar amount of your total holding will increase over time if the fund delivers a positive return, but the gain/loss column in your account summary will show the same misleading price decline.

Here’s a simplified example to illustrate the idea:

  • At the beginning of the year you buy 1,000 shares of a fund for $20. Your holding is $20,000.
  • The fund yields 4%, or $0.80 per share annually. All of the distributions are reinvested, so you receive your $800 in the form of 32 new shares.
  • By the end of the year the fund’s price has declined $0.40 per share to $19.60. Since your purchase price for the shares was $20, the gain/loss column in your account summary now shows a capital loss of 2%.
  • However, your holding is now 1,032 shares worth $19.60, which works out to $20,227.20. That’s a total return of about 1.4% on your original investment.

The easiest way to check the total return on your bond fund is to simply visit its web page: published performance numbers always include both price changes and interest payments, which are assumed to be reinvested. To measure your personal rate of return (which factors in the dates of all your purchases and sales), you’ll need to use a calculator like this one from Justin Bender.

By: Dan Bortolotti

This Article was brought to you Courtesy of the “Canadian Couch Potato.”

Canadian Couch Potato is designed for Canadians who want to learn more about investing using index mutual funds and exchange-traded funds (ETFs). In 2011, it was selected by The Globe and Mail as the best investing blog in Canada. The blog’s author is financial journalist Dan Bortolotti, author of The MoneySense Guide to the Perfect Portfolio, a complete guide to index investing in Canada.

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