Reader Case Study: Scoring Big in Toronto

Some time after my last case study on B in Alberta (who now reads friendlier blogs, haha!), I am ready to do a second case study on a different financial situation.

In their early 30s, the A family is starting their investment journey a little later than myself. But I readily admit I am a financial nerd who started early and was determined not to live the cash-strapped lifestyle I was raised in.

Both of the A's are relatively new to Canada. With less than 10 years in this country each, they are absolutely killing it! These are the kind of ambitious migrants that every country should want!

Scoring Big in Toronto: The Goal & Current Situation

The A's are getting ready for their first child, so they are wanting a second opinion on their financial journey as big changes are coming their way.

They have three main goals:

  1. Retire in 25 years with an annual dividend income of $100,000 in today's dollars;
  2. Pay for their children's university education (likely two kids); and
  3. Explore adequate insurance to take care of the family in the worst scenario.

The A's are earning a very solid income, combined at over $190,000 per year. Mr. A is older and more experienced in his profession and earns a little over $100,000 per year. Mrs. A earns somewhat less, but her compensation is growing more rapidly and will meet Mr. A's in the coming years.

One of the concerns the A's have is if they will be able to meet their goals working in Canada. Jobs in their field in the U.S. pay more so they are tempted to move down into Trump-land to reap those financial rewards.

Right now, the A's are worth a bit less than $200,000. Here's the breakdown...

His RRSP (Work Plan):  $55,000
His RRSP (Self-directed):  $61,000
Her RRSP (Work Plan):  $19,000
His Self-directed TFSA:  $24,000
Her Self-directed TFSA:  $34,000
Vehicle:  $6,000
Total Assets:  $199,000

Car Loan:  $6,000 at 2.99 percent
Total Debt:  $6,000

Current Net Worth:  $193,000

Both of the A's benefit from a matching RRSP workplace plan. They contribute 6 percent of their gross salary, the employer puts in 6 percent. Although the workplace plans only offer expensive, crappy life insurance company mutual funds, the dollar-for-dollar match makes it worthwhile to contribute.

In their workplace plans, the plan managers don't like the employees making them work too hard, so tinkering and making changes to asset allocation is frowned on.

The A's have 70 percent of their workplace portfolios in stocks and 30 percent in Canadian bonds, re-balancing about once per year. The stock portion is evenly divided into U.S. stocks, International stocks, and Canadian stocks in a classic Couch Potato approach.

In addition to their workplace plans, the A's try to save $2,500 a month in their personal accounts (TFSAs and RRSP). Most months they are able to hit their savings target.

In Mrs. A's self-directed TFSA, she holds a classic 60-40 portfolio using low-cost ETFs. In both of Mr. A's self-directed accounts, he runs the Dual Momentum strategy.

Broken down into dollars per asset, they invest $108,000 in buy-and-hold strategies and another $85,000 in the Dual Momentum strategy.

That's roughly $24,000 each in U.S. stocks, International stocks, and Canadian stocks with $36,000 in bonds. The DM signal is currently in U.S. stocks, so another $85,000 is sitting there.

The A's are currently renters in super-expensive Toronto. In preparation for the coming kids, they recently moved to a bigger 2 bedroom 1,500 sq.ft. condo in a great neighbourhood that's just 20 minutes from work. The rent on this place is $2,500 monthly.

Renting in Toronto is a great move! At just $2,500 a month, including property tax, condo fees, insurance, and maintenance costs, the A's are getting the place for a steal. Ownership would easily cost an extra $1,000 a month and the downpayment would drain their liquid assets.

If I Was in Their Shoes

The A's are both high earners who have avoided making any big financial mistakes. They wisely did not get sucked into buying an overpriced property during Toronto's real estate boom. They also have no significant debts.

However, there is a big financial squeeze coming and, despite their apparently reasonable path, the A's need a big financial reality check.

Given their gross income of $190,000, the A's have a tax bill of approximately $45,000 each year in Ontario. They also contribute $11,500 in workplace RRSP plans (matched equally by their employers). That leaves them with a net income of $133,500 to work with each year.

One of A's misconceptions is to focus on dividend income as a goal. Dividends are only a portion of total investment returns. Instead, look to total assets and withdrawal rates.

If a retiree wanted to be extremely cautious, they should have 30 times their annual spending in productive investment assets. At the age the A's are targeting for retirement, even 25 times annual spending is prudent. Especially if they live in Canada and expect to benefit from CPP and OAS.

Using this more sound methodology, if we allow for a tax rate of 15 percent, the A's will need $3.0 - $3.5 million in productive assets when they retire to realize a net income of $100,000 a year. However, as I will show later, this amount is way too high considering their total financial timeline.

Given their current assets, the A's will need to save at least $4,000 every month for 25 years to hit their retirement goal. After the combined gross workplace RRSP savings of $1,900 per month, they should be putting another $2,100 in their personal accounts every month to achieve their income objective.

While they appear to be doing well at their current savings rate of $2,500 a month, the problem is coming. Kids reduce income and raise expenses. Chances are Mrs. A may go part-time or even take a few years off when the bambinos are not yet in school.

This means they need to maximize the savings now! Before kids are in the picture reducing family income and increasing family expenses. Don't forget, at their household income levels the A family is not going to see those potentially big Canada Child Benefit cheques.

They will also need to save around $60,000 in 20 years to pay for education costs for both future kids. This means once the first kid comes they will need to save $1,500 per year in a family RESP to pay for their kids education. That number does not include the government's CESG grant.

I believe it's important for kids to have skin in the game for their own education. Plan to cover tuition costs and maybe some extras, but encourage them to work part-time to pay for their fun money. Also, kids education savings should always and only come after your own retirement security.

Step 1: Sell the Rolls-Royce

The vehicle is a real killer in the A family budget. Despite having just one car and driving a mere 10,000 km per year, they spend $100 a month on parking, $480 on insurance, $150 on gas, $300 a month on loan repayments, and at least $100 on other maintenance.

Adding this all up, they spend at least $13,500 a year on this vehicle. That's more than $1.30 per km! If they sold the car and invested the savings, they would be $700,000 richer in 25 years. The A's are not driving a Rolls, but it may as well be one at this cost!

It may be slightly less convenient, but selling the car and buying two decent used commuter bikes is a must. For longer trips there's always Uber or car rentals. Remember, they are living near downtown Toronto.

Even considering some Uber or car rental costs over the year, selling the car should increase their savings by over $1,000 a month in a single step.

Step 2: Cut Down the Daily Spending

Next order of business is to take a hard look at the other daily spending categories. It is way too high and this is very evident by their pitiful savings rate relative to their monthly net income of $11,100.

We know their rent is $2,500 a month. They also pay an extra $100 for hydro and probably $20 for tenant insurance bringing their total housing costs to $2,620 per month. I'm fine with that if it's close to work, avoids the need for a vehicle, and is a comfortable place to live.

But, there should be no reason why the A's would spend more than $2,500 a month on groceries, cell phones, internet, entertainment, clothing, workplace benefits, and vacations.

To get these costs down, dump the cable bill, look at TekSavvy for internet and use Netflix, get data-lite cell phone plans from Public or Freedom Mobile, use older cell phones and electronics, start shopping at Walmart and No-Frills, stop eating and drinking away from home, and shrink the closets and buy clothes only at consignment stores.

Also, examine those workplace extended health/dental benefit plans. It often does not make sense for both spouses to contribute their own plan. Instead, choose the better plan and contribute to one plan only. Have the spouse with the worse plan opt out. This can save $50 to $100 per month in premiums.

With some simple optimization—including the car sale—the A's should be able to save somewhere between $5,000 and $6,000 per month in addition to their workplace RRSP contributions and still enjoy a great lifestyle.

Lets not forget the added benefit of getting in better shape from those bicycle miles!

Step 3: Create an Emergency Plan

With a kid coming in the future, the A's need to put away a cash cushion as soon as they can. If the first child is coming quick, make this a priority and hold off on new personal investment contributions!

I would recommend they maintain a balance around $5,000 in their chequing account and open a High Interest Savings Account, rapidly stashing another $10,000 there.

It will take a few months to get there at an optimized savings rate, but having a cushion that covers several months of expenses is very smart considering a youngster is coming.

Kids mean time away from work for mom (and maybe dad), unexpected expenses, and a little more nerves all around. The last thing the A's should worry about during this stressful time is money in the bank.

Once baby fixtures are provided for, new kid care expenses are reduced, and things are back to normal, they can get rid of or shrink the HISA and maintain a total cash balance of $10,000. This should cover about 2 months of hard expenses.

Now would also be a great time to apply for a personal line of credit at a bank. I would aim for a $25,000 unsecured line of credit. The line of credit plus the enlarged chequing account should cover six months of bare-bones expenses.

As with all emergency funds, don't use the line of credit unless it's absolutely necessary! It should only be touched if both of the A's lose their job or a similar big financial shock comes.

The $35,000 cushion will buy time to adjust to a new lifestyle in the wake of new economic realities. This could mean downgrading the house, job hunting, moving for a new job if needed, or similar measures.

Step 4: Obtain a Life Insurance Policy

Considering a little one is coming, now is the time to take a good look at life/AD&D insurance.

The life insurance industry is full of snakes and potholes, so the goal is to keep this very simple.

Life insurance is only a fail-safe to cover modest family expenses if the worst case scenario happens; the goal is not to make sure that if you die your family will live in the Hamptons eating Caspian caviar!

You should also try self-insure as soon as you can. More money in your bank account, less profits for the insurance companies.

That means saving, investing, and buying a shorter duration term policy only. I'll repeat that, buy a shorter duration term life policy only. Do not buy a whole life, universal life, term-to-100, or a similar fancy and expensive plan.

Right now the A's are already self-insured to the tune of $190,000. This level of assets will generate $6,500 a year for life with an extremely low likelihood of depletion.

Both of the A's also have workplace life insurance plans. Each individual plan will provide a $150,000 benefit to the employee in case of death.

Given that an upper middle class Canadian family will spend about $75,000 per year, we should aim to cover about half that number with each adult's policy until the youngest child is 20. The remaining adult can work at least part-time and both of the A's have good earning power.

To generate an income of $40,000 a year for 20 years, they would need to invest about $500,000. Given their current access to $6,500 per year and the $150,000 workplace plan, they should each obtain a life insurance policy for approximately $300,000.

Obtain a 10 year term life policy to keep premiums down. In 10 years time when the policy is up, the A's are likely to have close to $1 million in their investment accounts and will no longer need extra life insurance coverage.

Shop around for the best rates—there are many life insurance companies! A 10 year term life policy of $300,000 for a non-smoker should cost about $20 to $25 per month.

Step 5: Maximize Tax Advantaged Accounts

Although Mrs. A has her TFSA maxed, Mr. A still has contribution room in his TFSA. Both have some room in their RRSPs since their combined employer-employee contribution is just 12 percent of gross income and allowable RRSP amount is 18 percent of gross income.

Given the high income that Mr. and Mrs. A earn, they should both maximize their RRSPs accounts first. Mrs. A can draw on her RRSP a little when she is at home with the kids if there is an opportunity to do that at a low tax rate.

If Mrs. A is planning on staying home for a few years, Mr. A should contribute to a spousal RRSP benefiting Mrs. A. He gets the tax refund at his high tax rates now, she pulls the money out a few years later at her low stay-at-home mom tax rate. Win-win! She can use this money for TFSA contributions or other investment savings.

Of course the TFSAs should be kept topped up as well. With both Mr. and Mrs. A working hard and earning big dollars right now, they should save nearly $6,000 per month in their personal accounts.

Even after building the emergency account, in roughly a year's time they should both have full RRSPs and full TFSAs. Hopefully they can achieve this before the first kid comes into the picture and incomes take a hit.

Step 6: Pry Into the Workplace RRSP Accounts

Given the workplace RRSP plans have very crappy investment options, it is worth Mr. and Mrs. A's time to take a very close look at optimizing these plans.

First of all, make sure the plans are invested in the lowest cost mutual funds available for their target asset classes. Every year ask the plan manager for a complete list of funds including the total management expense ratios (MER) for each fund.

Next, research if you can move money from your workplace RRSP to your personal RRSP/LIRA account. Although the plan managers don't like it and may put up a fuss and talk circles around the question, at the end of the day many plans actually allow you to do this. Read the fine print if necessary!

Usually a transfer fee of $100 to $300 per transfer will be charged by the plan manager. Given the cost, you should only transfer money out of your workplace plan and into your personal RRSP/LIRA once every year or two.

Always try to manage your own money if you can. You can buy ETFs for 10 basis points per year, so don't calmly sit back and let your RRSP plan managers soak you for 150 to 300 basis points per year!

Step 7: Open a Non-Registered Investment Account

Although this may be a year away depending on the children situation, when the registered accounts are full the A's will need to open a non-registered investment account to keep saving money.

When this happens, take a very careful look at your family income and expenses. The highest income spouse (probably Mr. A) should pay all of the household expenses, including incomes taxes and registered account contributions for the lower income spouse.

In turn, the lower income spouse should save as much of their gross income as possible and put it into the non-registered investment account. Investment money contributed by the lower income spouse will be taxed at the rate of the lower income spouse.

This is very important since investments in a non-registered account are likely to generate taxable income such as dividends and capital gains. It is much better to pay these taxes at the lower income spouse's level.

Step 8: Evaluate the Investment Strategy

Take a close look at the investment strategy across all of the accounts and make sure the overall picture reflects what you want. Enough bonds and safe things, enough stocks, adequate diversification across markets, and not too much home country bias.

I am a big fan of using two unique investment strategies with a roughly equal amount of money in each strategy. This can help your portfolio experience a different sequence of returns, especially providing benefits in poor stock market conditions.

Many models (CAPE, Tobin's Q, Hussman's MA-CAPE, Research Affiliates, P/S, Market Cap/GDP, etc.) are expecting gross annual returns of 3 percent or less for the next 10 years on buy-and-hold portfolios.

These models could all be wrong, but it is pretty safe to say that the returns for a buy-and-hold portfolio are not going to be very high for some time. While far from guaranteed, a large exposure to an alternative investment strategy could drastically change expected returns for investors.

Right now the A's are fairly balanced across two strategies. This should become more balanced as the remaining room in the registered accounts is filled. My main change would be to reduce the exposure to Canadian stocks to maybe 10 percent of the Couch Potato portfolios.

After the First Child

I don't know exactly how far away from children the A's are, but one thing is clear: their financial situation will probably change drastically.

I expect that children will add at least $500 a month in expenses for the first child and another $250 a month for each additional child. This doesn't include education savings or kids activities.

Diapers and baby wipes, baby clothes and double the laundry, a crib and changing table, stroller and baby carrier, baby food and formula do not fall from heaven.

Baby things are not cheap brand new, but almost everything can be purchased used on Kijiji or Craiglist, at consignment stores, or through mom groups and swaps and other informal things. It's very important not to go crazy with this stuff; kids grow out of things extremely fast!

If daycare is involved, this will cost at least $1,000 a month if Mrs. A works part-time and double that if Mrs. A works full-time. That assumes after-tax numbers since childcare expenses are tax deductible.

Scenario 1: Taking Maximum EI Benefits & A Part-time Job

I think the most likely scenario, one that many couples take with more than one child, is that Mrs. A stays home and collects the maximum EI parental benefits for the first year, returns to work earning at least $55,000 until the second child comes, then collects EI again for a year, and finally changes to less than full-time employment.

In this scenario, their gross household income will drop by around $50,000 per year and they will probably lose one employer RRSP match and maybe the better workplace extended health/dental benefit plan.

On the bright side, taxes will decrease and cushion some of the blow. Using a very rough calculation, the A family gross income will shrink to about $140,000 per year. Their tax bill will drop to about $32,000 per year and the workplace RRSP contributions will fall to $6,500 per year.

This means the net income that the A's will be able to work with drops from $11,100 per month to $8,400 per month.

To be on the cautious side, we'll assume that Mrs. A will continue to earn a lower salary when the kids are in school full-time, but will get a better job with RRSP matching plan. Daycare expenses at this point will not be necessary.

After the kids are in high school or off to college, we will assume Mrs. A will go back to full-time work and earn $80,000 a year with a workplace RRSP matching plan. This salary number assumes Mrs. A keeps her skills adequately fresh in the child-raising years so she is very employable.

Scenario 2: Stay-at-home Mom With No Part-time Job

If Mrs. A doesn't go back to work for the entire time their kids are growing up and in school, things will be quite a bit tighter financially for the A family.

Family income will drop to around $115,000 per year after including moderate CCB payments. Taxes will drop to $26,000 and workplace RRSP contributions will be at $6,500.

The net income for the A family will be around $6,900 per month. Expenses will still increase because of the kids, but daycare expenses will not be a factor.

Given the long period away from work, when Mrs. A returns to work full-time after the kids are finished school we'll assume her gross income will be $40,000 with no workplace RRSP matching plan.

Scenario 3: Go Back to Work Full-time

If Mrs. A goes back to work as soon as possible after each child comes into the picture, the family income will be very high. It is likely that the workplace RRSP matches on both incomes will stay.

Taxes and expenses will also be very high. Net daycare costs will be enormous and the overall family expenses are likely to increase because things are that much busier. There will also be after-school care for $1,000 a month when the kids are in school.

The household net income will likely stay around $11,100 a month with two years of reduced income in the EI parental leave periods.

Future Financial Budgets

Scenario 1

Source: TheRichMoose.com

If the A's optimize their spending how I suggest in the above steps, they will be spending a little over $5,000 per month as a couple not including taxes and workplace RRSP contributions.

It is conceivable to estimate their monthly household spending will jump to $7,000 in this scenario including part-time daycare cost while their net monthly income will be around $8,400.

They will be able to save just $1,400 a month minus $125 for RESP contributions. Not only is that less than the required $2,100 goal, they are also going to miss the second RRSP matching program.

Once the kids are in school and daycare expenses are eliminated, their income would allow for around $2,400 per month in personal savings, less $125 for the RESP.

Plugging that into our handy calculator and assuming the first child comes in a year, the A's financial situation will be as follows if they follow my steps and keep their spending in line:

End of Year 1 (baby comes):  $290,000
End of Year 7 (kids in school):  $625,000 + $17,000 RESP
End of Year 18 (college starts):  $1,800,000 + $65,000 RESP
End of Year 25 (retirement):  $3,500,000

The rough projection of $3.5 million in investable assets at retirement age will generate an annual withdrawal capacity of $120,000 to $140,000 per year.

This will be much higher than my recommended budget of $60,000 to $65,000 per year as a couple, allowing room for sabbaticals, an earlier retirement, or a more luxurious retirement.

Scenario 2

Source: TheRichMoose.com

If the A's optimize their spending how I suggest in the above steps, they will be spending a little over $5,000 per month as a couple not including taxes and workplace RRSP contributions.

It is conceivable to estimate their monthly spending will increase to $6,000 in this scenario as no daycare will be required.

Their available monthly income will be around $6,900. This means they will be able to save $900 a month in addition to the workplace RRSP, less $125 for RESP contributions.

Plugging that into our handy calculator and assuming the first child comes in a year, the A's financial situation will be as follows if they follow my steps and keep their spending in line:

End of Year 1 (baby comes):  $290,000
End of Year 7 (kids in school):  $590,000 + $17,000 RESP
End of Year 18 (college starts):  $1,400,000 + $65,000 RESP
End of Year 25 (retirement):  $2,600,000

The rough projection of $2.6 million in investable assets at retirement age will generate an annual withdrawal capacity of $90,000 to $100,000 per year.

This again is quite a bit higher than my recommended budget of $60,000 to $65,000 per year as a couple.

Scenario 3

Source: TheRichMoose.com

If the A's optimize their spending how I suggest in the above steps, they will be spending a little over $5,000 per month as a couple not including taxes and workplace RRSP contributions.

Once the kids enter the picture, it is conceivable to estimate their monthly spending will jump to $8,500 in this scenario including daycare costs. Their available monthly income will be around $11,100 except for the first years of children during parental leave time.

On the personal side, they will be able to save $2,600 a month minus $125 for RESP contributions.

Once the kids are in school and reduced after-school care costs come in, their income would allow for around $3,600 per month in personal savings, less $125 for the RESP.

Plugging that into our handy calculator and assuming the first child comes in a year, the A's financial situation will be as follows if they follow my steps and keep their spending in line:

End of Year 1 (baby comes):  $290,000
End of Year 7 (kids in school):  $750,000 + $17,000 RESP
End of Year 18 (college starts):  $2,400,000 + $65,000 RESP
End of Year 25 (retirement):  $4,400,000

The rough projection of $4.4 million in investable assets at retirement age will generate an annual withdrawal capacity of $150,000 to $175,000 per year.

This will be effectively double my recommended budget of $60,000 to $65,000 per year as a couple on an after-tax basis. This means their lifestyle in retirement would be much more luxurious than their former lifestyle, which obviously doesn't make a whole lot of sense.

Scenario 3 could be an "over-saving" situation, but again it allows for earlier retirement, sabbaticals, job loss situations, etc.

Some Notes on These Scenarios

These are just rough calculations using an assumed long term investment return net of inflation. Within periods the returns will of course be very different.

I shared these three scenarios as they are related to common options that families choose when they start raising children. The facts show household income often takes a dip—usually because mom makes less—and household expenses increase.

I also assume that current salaries will keep pace with inflation and there are no periods of job loss.

If Spending Stays the Way It Currently Is

Although the A family looks like they are doing fine on paper right now and might be tempted not to change a darn thing about their lifestyle, here is the big wake up call.

Right now, the A's are spending more than a whopping $8,600 per month as a couple! Once kids come into the picture, if they don't change their lifestyle, the household expenses will jump to $11,500 or more when both children are in daycare.

They won't earn even a net income of $9,500 a month when Mrs. A is on parental leave, resulting in net spending which is higher than income.

This means they will be forced to deplete savings in the years Mrs. A can't work full-time and they will be stretched to the absolute maximum when Mrs. A does go back to work full-time.

Near absentee parenting will be the routine. Both parents working full-time, both kids in daycare, then after-school care, then after-school activities.

Welcome to a lifestyle of two vehicles, more consumer crap than a condo can handle, whirlwind weekends of insanity, excess take-out and restaurant eating, flabby "dad-bod" and "mom-bod", and fat kids who are spoiled and entitled. Insufferable North American suburbia...

Source: TheRichMoose.com

I'll say that this chart is optimistic. The financial picture could even be worse when they are forced to move to the suburbs, own two vehicles, and I've barely scratched the surface on potential spoiled kid expenses.

If they don't make the necessary spending corrections, during the entire time they are raising their future children the A family will be treading financial water, maybe going into debt, they won't be able to retire early (if ever at their current lifestyle!), and they will certainly be stressed out.

If this bad news isn't enough, the data tells us this financial tightrope lifestyle drastically increases the potential of a very nasty event: divorce. Not only does divorce have the potential to destroy their family and their relationship with the kids, it will also sink them both financially.

Summary

While both Mr. A and Mrs. A are earning very healthy salaries, they are spending way too much money with their current lifestyle. It's not sustainable. The real problems will begin to surface when kids enter the picture.

The easiest spending reduction is getting rid of their vehicle. It's an unnecessary luxury that is costing them an enormous amount of future wealth.

Their discretionary spending is also way too high, I don't know where the money goes (and the A's might not either), but the numbers say they are burning around $5,000 a month on groceries, clothes, entertainment, electronics, phone plans, vacations, and other lifestyle items.

The A's should immediately start building an emergency plan. This means funding a savings account and establishing a personal line of credit plan. The plan should be in place before the first child comes.

After the emergency plan is in place, the focus should return to filling their registered accounts. Be tax smart and use Spousal RRSPs, finishing topping those TFSAs, and invest in a balanced approach across two unique investment strategies.

Rethink the goal of $100,000 in spending money each year in retirement. This is much higher than it needs to be. The only way to achieve this level of spending sustainably is if the A family salaries get quite a bit higher than their current level. Trying to get there could mean significant family sacrifices.

Spending in retirement will realistically land somewhere between $60,000 and $70,000 for a relatively luxurious lifestyle. That requires $1.5 to $2.1 million in investment assets backstopped by CPP and OAS.

If they can get their spending down to a reasonable level, the A's have the flexibility to achieve a fantastic, family friendly lifestyle. They could have a full-time stay-at-home parent, save enough for retirement, help their kids with their education, and live very stress-free.

Reader thoughts on these case studies are always welcome in the comment section!

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Dual Momentum: Evaluating the Bonds Component

This is the final post in a three post series of evaluating each signal within the Dual Momentum model: "U.S Stocks", "International Stocks", and now finally "Bonds".

In the Dual Momentum strategy, which I share each month with the blog readers, I use a customized 3-month Treasury bill rollover index to analyze 12-month performance of cash (the absolute momentum hurdle).

To calculate the past 12-month return of T-bills, I mimic what an investor would have achieved for a gross return if they had purchased a 3-month T-bill a year ago and rolled it into a new 3-month T-bill each time the T-bill expired, creating a compound return.

For example, if I was evaluating the cash return on November 30, 2018, I would simulate the following:

  1. Buys 3-month T-bill on December 1, 2017 and holds until maturity; then
  2. Buys 3-month T-bill on March 1, 2018 and holds until maturity; then
  3. Buys 3-month T-bill on June 1, 2018 and holds until maturity; and finally
  4. Buys 3-month T-bill on September 1, 2018 and holds until maturity.

At each T-bill rollover, the investor would invest their original investment and the interest they earned from the prior T-bills to generate a compound return of the four T-bills. The purpose is to mimic the 12-month return of holding the safest asset currently possible.

While I use the 3-month Treasury bill rollover index to generate the signal, each investor must choose a fund they will actually invest in when the signal is in "Bonds".

I do not recommend buying T-bills as you may need to hold them for less than 90 days, although you could buy a money market fund or cashable GIC if you don't want to use bond ETFs.

When it comes to bonds, there are almost countless choices for investors to implement this signal their portfolios.

Some of the most common bond fund types which are available in a low-cost ETF format include:

  • Aggregate bond funds—invests in all investment grade bonds of all maturities in a market weighted format
  • Short-term bond funds—invests in investment grade bonds up to 5 year maturities in a market weighted format
  • Government bond funds—invests in only government issued bonds
  • Corporate bond funds—invests in only corporate investment grade bonds

There are endless variants of the above, including corporate junk bonds, short-term government bonds, short-term corporate bonds, intermediate-term government bonds, intermediate-term corporate bonds, government TIPS bonds, international bonds, green bonds, etc.

Given all these options available, most at a relatively low cost, what should investors choose when the signal is in "Bonds"?

Aggregate Bond Funds

Gary Antonacci is very clear that he prefers using a low-cost aggregate bond index fund when the signal is in "Bonds".

Gary argues that aggregate bonds represent a safety asset that benefits from investors' shift from stocks to bonds during a stock bear market. As well, they benefit from loosening monetary conditions as central banks attempt to revive the business cycle.

Aggregate bond funds are highly liquid and available at extremely low management fees of 0.05 percent. They consist 70 percent AAA rated bonds, including government Treasury bonds, with the remainder from large corporate issuers.

Their average duration is approximately 6 years, pulled down mostly by the tilt to generally shorter duration on corporate bonds.

Given the inclusion of corporate bonds and long-term Treasury bonds, aggregate bond funds will see somewhat more volatility than a pure short duration bond fund.

Short-term Bond Funds

Short-term bond funds are much more stable than aggregate bond funds as they do not suffer from duration risks. These funds will not hold bonds with maturities longer than 5 years while the average duration is just 2.5 years.

The short-term bond funds typically have somewhat fewer government bonds as a percentage of total holdings than the aggregate bond funds. This is because many corporations issue short-term bonds.

Just 60 percent of bonds in short-term bond index funds are AAA rated bonds.

Short-term bond funds are available at extremely low management fees of approximately 0.06 percent. Like aggregate bond funds, they are very common from several low-cost providers and often highly liquid.

Given their short average duration, short-term bond funds are normally more stable and benefit less from loosening monetary conditions when compared with aggregate bond funds.

Government Bonds

Government bonds, in the context of U.S. Treasury bonds or even Canadian government bonds, are the most stable and secure form of credit investment.

Governments also issue the most investment grade bonds on the market. Funds holding government bonds are often highly liquid and available at a low cost as it is easy manage a fund with only one credit issuer.

Government bonds are issued across the entire duration curve, ranging from 1 month bills to 50 year bonds (Canada). Most commonly, the U.S. treasury issues 3-month Treasury bills through 30-year Treasury bonds.

Although there is inflation risk due to a floating fiat currency system, a bond holder of U.S. government debt is certainly going to be repaid. It would not make sense for the government to declare bankruptcy on their debt when they can just print more dollars to pay it off.

Corporate Bonds

Corporate debt securities range from AAA rated bonds through to unmarketable junk bonds. Investment grade credit, rated above BBB (Standard & Poors), is the most common corporate bonds for index ETF investors.

Corporate bonds suffer from inflation risk like government bonds, but they also suffer from default risk. If the government prints dollars and stokes inflation, corporations will benefit as their debt value decreases compared to asset value.

At the same time, if the corporation runs out of money, they will declare bankruptcy. This could be a near total default, or a partial restructuring where bond holders often take large losses.

The risk for corporate bond funds is higher than government bonds, but bond funds are well diversified so isolated bankruptcies are not likely to cause significant losses for corporate bond fund investors.

Due to the default risk on corporate debt, investors should avoid investing in long-term corporate bonds.

Junk bond ETFs do exist and are widely available; however, they are much more correlated to stock market performance than they are to bonds, especially in crisis periods. For this reason, you should avoid junk bonds in Dual Momentum!

Comparing Bond Options in Dual Momentum

Before we recommend any one option over another, we will evaluate the historical performance of several major bond fund categories when used in the Dual Momentum model.

Government Bonds

Due to a data issue, I will start with a comparison of short-term government bonds, intermediate-term government bonds, and long-term government bonds since 1978.

For these backtests, I maintained the exact same signals using the MSCI indices which I use for all my Dual Momentum analysis.

When the base signal was in "Bonds", I put the portfolio either into short-term, intermediate-term, or long-term government bonds for each time period. This in effect isolates the performance of each option so you can see how it works in the Dual Momentum model.

The backtest runs from January 1978 until October 2018.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis, Vanguard Funds

In this backtest, long-term treasuries very clearly outperformed. The short-term bond option generated a 16.51 percent compounded annual return over the 40 year test period while the long-term bond option generated a 18.04 percent compounded annual return.

Clearly the intermediate bond option (average duration of 5 years) and the 10-year bond option were in the middle. You can see the month-to-month volatility on the 10-year line and it is a good reflection—amplified or reduced—of the monthly changes of the long-term, intermediate, and short-term bonds.

In my backtest, the long-term bonds were the best holding in nearly every single period where the signal was in "Bonds". Although long-term Treasury bonds were more volatile within the holding periods, the end result was repeatedly better.

Corporate Bonds and Gold

In this next backtest, I will compare short-term corporate bonds, aggregate bonds, and gold (often cited as a crisis asset) from 1987. The time period is shorter, again due to limited available data.

For these backtests, I maintained the exact same signals using the MSCI indices which I use for all my Dual Momentum analysis.

When the base signal was in "Bonds", I put the portfolio either into short-term corporate bonds, aggregate bonds, or gold for each time period. This in effect isolates the performance of each option so you can see how it works in the Dual Momentum model.

The backtest runs from January 1987 until October 2018.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis, Vanguard, London Bullion Exchange

In this comparison, the results for 10-Year Treasury bonds (the standard in my model), short-term corporate bonds, and aggregate bonds were very similar.

Gold underperformed significantly over most of the period, but made for lost ground in the 2000-2003 and 2008-2009 holding periods.

The top performer, 10-Year Treasury bonds, returned 14.62 percent compounded annually in this backtest while the bottom performer, short-term corporate bonds returned 14.24 percent compounded annually.

Although Gary Antonacci shares his preference for holding a low-cost aggregate bond fund when the signal is in "Bonds", 10-year Treasury bonds performed slightly better in nearly every holding period.

This may be a reflection of Treasury's preferred safety during crisis events and the slightly longer average bond duration.

Summary

At the end of the day, the asset of choice for the end investor when the signal is in "Bonds" is largely meaningless when comparing the major options: U.S. Aggregate Bond funds, Intermediate Treasury Bond funds, 10-Year Treasury Bond funds, or Long-term Treasury Bond funds.

If the Dual Momentum investor wanted to pursue the highest possible returns with the increased risk, Long-term Treasury Bond funds would be the better choice.

I believe U.S. Aggregate Bond funds, 10-Year Treasury Bond funds, or Intermediate Treasury Bond funds are all good choices for the typical Dual Momentum investor. Short-term bond funds are probably unnecessarily safe for most investors.

As always, choose a low cost option that is highly liquid to minimize drags in returns caused by management fees and bid-ask spreads.

In Canada, this leaves us with three viable options to invest when the Dual Momentum signal is in "Bonds":

  1. We could choose XBB.TO/VAB.TO/ZAG.TO which invest in the aggregate Canadian bond market at 0.08 MER; or
  2. We could choose ZDB.TO or HBB.TO which are more tax efficient choices of the above at 0.09 MER; or
  3. We could convert our accounts to U.S. dollars and invest in a number of ETFs that hold aggregate bonds, long-term Treasury bonds, or intermediate Treasury bonds all for under 0.07 MER.

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