Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846
Interest rates have dipped in the wake of the government shutdown in the U.S. If you invest in bond ETFs, then, now may be a good time to do some repositioning in anticipation of an eventual rise in interest rates.
Interest rates may remain low for a while yet. The interest rate on a Government of Canada 10-year bond peaked at about 2.8 per cent in early September, thanks to the U.S. Federal Reserve’s earlier announcement that it intended to taper down its quantitative easing program.
But the subsequent U.S. government shut-down has hurt the U.S. economy. Consequently, the Fed is now expected to delay quantitative easing until next spring. And this, in turn, has caused bond yields to retreat. Thus, the yield on the GOC 10-year bond is now about 2.5 per cent.
In Canada, further evidence that interest rates will remain low for a while yet was recently provided by Bank of Canada Governor Stephen Poloz in his first Monetary Policy Report. In it, the Bank abandoned the “tightening bias” that it has followed since early 2012.
What to do when interest rates rise
Any upward movement in interest rates, then, seems to be put on hold for the time being. But the easy monetary policies of the U.S. Fed and the Bank of Canada are inflationary and should eventually result in rising interest rates. Then too, interest rates will have to naturally rise if economic growth picks up.
Investors should keep this in mind when investing in bond funds or bond exchange-traded funds. In a rising rate environment, high-yield junk bonds are expected to under perform higher quality corporate bonds. And the more you aim for higher returns as rates rise, the more you risk losing money.
That’s why we’ve replaced iSHARES U.S. HIGH YIELD BOND INDEX ETF (TSX-XHY) with the higher-quality VANGUARD CANADIAN SHORT-TERM CORPORATE BOND INDEX ETF (TSX-VSC). The Vanguard ETF has a lower yield to maturity than the iShares ETF — 2.3 per cent versus 5.1 per cent. But it has a lower average duration of 2.8 years versus 4.2 per cent for the high-yield ETF. Remember, for each one-per-cent rise in interest rates, you would expect your bond ETF’s value to decline by a percentage figure that is roughly equal to its average duration.
Keep in mind, too, that when you invest in a managed bond fund, you can always hope that its manager will adjust its portfolio duration in anticipation of rising rates. But as an ETF investor, you don’t have that luxury. It’s up to you to do the adjusting. So try to use dips in yields as opportunities to reposition your bond ETFs.
Recommendation:
Use dips in bond yields to reposition your bond ETFs for an eventual rise in interest rates by buying higher-quality, shorter-duration ETFs such as the one we recommend on this page.
Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846
Canadian Mutual Fund Adviser •11/5/13 •