We see little appeal in bond exchange-traded funds, or ETFs, right now. That’s because even shorter-term bond ETFs are vulnerable to the potential of rising interest rates over the next year or so.
In its latest quarterly forecast, RBC Economics foresees the Bank of Canada’s target overnight interest rate rising from its current 1.00 per cent to 1.75 per cent by the fourth quarter of 2015. That’s a rise of 75 basis points.
Under these circumstances, even short-term bond ETFs may suffer a loss, albeit maybe a modest one. Take Vanguard Canadian Short-Term Bond Index ETF (TSX-VSB), for example. This ETF tries to track the performance of the Barclays Capital Global Aggregate Canadian Government/Credit 1-5 year Float Adjusted Bond Index. The Index is made up of investment-grade securities — including government, government-related and corporate bonds — all with maturities between one and five years.
Use duration to assess risk
One measure that lets you asses the risk of a bond, or a bond portfolio, is its duration. Simply put, duration is the price sensitivity of a bond to a change in interest rates. It works like this: for every one-per cent rise in interest rates, you would expect a bond to decline by the same percentage as its duration.
In the case of Vanguard Canadian Short-Term Bond Index, the average duration of its bond portfolio is 2.7 years. (Note duration should not be confused with term to maturity, which in this ETF’s case is 3.1 years.) So, with an increase in interest rates of 75 basis points, you would expect the value of the bond’s portfolio to decline by about two per cent.
But the fund’s income should help offset the declining value of the portfolio. With a yield to maturity of 1.6 per cent, minus a management expense ratio of 0.17 per cent, the fund’s total return in this scenario may amount to about minus half a per cent.
The foregoing analysis, of course, is a simplified one, as other factors such as geopolitical and economic events will play a role in influencing bond prices too. But if you don’t want to risk a capital loss from bonds, even a minor one, over the next year or so, your best bet may be GICs. With them you know exactly what interest rate you’ll get, and you know your principal investment will not be eroded by the time they mature. Their drawback, of course, is a lack of liquidity.
Canadian Mutual Fund Adviser, MPL Communications Inc.
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