Here’s a way to play rising interest rates

Floating-rate bonds and floating-rate bond ETFs offer you a way to protect your fixed-income portfolio from rising interest rates.

In view of rising interest rates, we’ve advised you to shorten the average term to maturity of your bond holdings, and more importantly, their duration, by trading into high-coupon, short-term maturities. Another way to limit the damage from rising rates on your fixed-income portfolio is to buy floating-rate bonds.

Floating-rate bonds vary their interest payments to match changes in interest rates. Typically, the interest paid is tied to the rate of a money-market benchmark such as the London Interbank Offered Rate (LIBOR) or the prime rate.

This makes them relatively attractive holdings when interest rates rise. That’s because their increasing interest payments help protect their market value, or their price. Fixed-rate bonds, on the other hand, lose their market value when rates rise because their price must fall to offer buyers a more competitive return on their investment.

But while floating-rate bonds (floaters) are attractive to hold when rates rise, they typically underperform their fixed-rate cousins when rates fall or remain flat.

Another drawback of floaters is credit risk. This is particularly the case when you invest in junk bonds. In the bear market of 2008, the BMO Floating Rate Income Fund lost 48 per cent of its value as high-yield bonds collapsed.

Conservative floating rate bond ETFs

Yet you can find more conservative alternatives. Among exchange-traded funds (ETFs), for example, there is iShares Floating Rate Index ETF (TSX—XFR). This ETF seeks to provide income while limiting rate risk by trying to track the performance of the FTSE TMX Canada FRN (floating-rate notes) Index, less expenses.

The portfolio is conservative. More than 90 per cent of its assets are invested in federal and provincial government bonds. The rest is mostly invested in Canada’s big banks. Credit quality, therefore, is high. Just over 98 per cent of the portfolio has credit ratings of A or higher. Nearly 65 per cent of its assets carry the highest rating—AAA.

The ETF’s weighted average yield to maturity is 1.9 per cent. This is lower than the 2.4-per-cent yield of the Vanguard Short-Term Bond Index ETF (TSX—VSB), which we recommend and regard as a core ETF bond holding in a fixed-income portfolio. Floaters typically have lower yields than fixed-rate bonds.

But despite its lower yield, iShares Floating Rate ETF has outperformed Vanguard Short-Term Bond over the past year, which was a period of rising rates. iShares delivered a total return of 1.7 per cent, while Vanguard’s return was just 0.1 per cent.

The iShares ETF’s management expense ratio (MER) is 0.23 per cent. It’s a relatively conservative buy for income and capital preservation in a rising-interest rate environment.

Investors who are willing to take on more risk might consider Horizons Active Floating Rate Bond ETF (TSX—HFR). This ETF invests in corporate issues and about 99 per cent of its portfolio is rated BBB or higher. Its MER is 0.46 per cent and its yield to maturity is 2.73 per cent. It’s a buy if you can accept higher risk.

Advantages of ETFs

Exchange-traded funds (ETFs), such as the ones recommended above, are investment vehicles constructed like a mutual fund but trade like an individual security on a stock exchange. Usually designed to mimic a certain market index, they can provide you with several benefits over a traditional, managed mutual fund.

First, ETFs offer you greater transparency, as their exact holdings are disclosed on a daily basis. This lets you know precisely what you own and what you’re paying for.

Second, they offer you the flexibility to trade them at any time when the exchange is open. You can even use such fancy trading features as market limit and stop orders. Keep in mind, though, when you buy and sell them, whether through a financial advisor or brokerage account, you’ll have to pay commissions most of the time. Note that some discount brokers waive the commissions on certain ETFs.

Third, ETFs that track an index are usually more tax efficient than managed funds, or managed ETFs for that matter, since they typically have lower portfolio turnover.

Fourth, ETFs also normally have lower management expense ratios than managed funds.

This is an edited version of an article that was originally published for subscribers in the September 14, 2018, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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