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Look to ETFs to hedge against rising rates Add to ...

Look to exchange-traded funds if you need a way to protect the bond side of your portfolio from the threat of rising interest rates.

The first several weeks of 2011 have not been kind to bonds and the trend could well continue if last week's unexpectedly strong unemployment report is any indication. When financial markets sense a risk of inflation from renewed economic growth, it means price declines are ahead for bonds and funds holding portfolios of bonds.

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ETF companies have introduced new products recently that can help you manage the risks posed by rising rates, including a fund that rises in price as bond prices fall. There are also some tried and true ETFs that offer as steady a way as possible to maintain your bond exposure through tough times in the bond market.

The fund that rises while the bond market falls is the Claymore Inverse 10 Year Government Bond ETF , which was introduced last summer. This fund is designed to provide the opposite return of the Government of Canada 10-year bond over a single trading day, which means you lose if the benchmark bond moves up in price and you win if it falls.

Don't mistake CIB for a leveraged ETF, which delivers two times the up or down move of an underlying index or commodity, depending on whether you buy the bull or bear version. Leveraged ETFs are trading tools for sophisticated, active investors and need to be handled with extreme care.

The single inverse Claymore product hasn't been advertised at all, which may explain the tiny daily trading volumes. Also working against it is the fact that Claymore's funds are almost exclusively for long-term investors. CIB is definitely something different. Think of it as a short-term hedging tool for bonds at a time of rising interest rates.

While CIB is technically designed to provide the opposite return of the 10-year Canada bond for a single day, it can be held for longer periods provided you understand a few points. First, the more volatile the price of 10-year Canada bonds is, the more unpredictable CIB's returns become. Fortunately, the 10-year Canada bond is not as prone to sudden price reversals as, say, a stock index or commodity price.

Second, CIB pays no interest. So if the 10-year Canada bond stays flat, you're losing out on the 3.5 per cent yield of the underlying bond (minus CIB's fees of just over 0.5 per cent).

"To play a bearish bet in bonds, it's not bad," Larry Berman, chief investment officer at ETF Capital Management, said of CIB. "It's not something you would buy and hold for long periods of time."

Claymore says that in an investment portfolio equally divided between stocks and bonds, you might consider putting 10 to 15 per cent of the whole in CIB as a hedge against rising rates.

Another new ETF product that deserves attention at a time of rising interest rates is the series of target maturity bond ETFs just introduced by Bank of Montreal. These funds are designed to address the criticism that bond ETFs never mature, like actual bonds do. This is a real concern at a time of rising rates because bonds that fall in price will ultimately mature and repay the amount invested in them. With bond ETFs and bond mutual funds, you have to wait for the next period of falling interest rates to see a rebound in price.

BMO's target maturity funds are basically corporate bond ETFs that have a maturity date. The maturity dates currently available are year-end 2013, 2015, 2020 or 2025.

Each target maturity ETF holds a mix of BMO's individual bond ETFs. As target maturity ETFs get close to their end date, the mix becomes more conservative and ultimately resembles a money market fund. The goal is to return your invested capital to you intact.

The management fee for these ETFs is 0.30 per cent, which is a drag on returns. But it can be offset by the fact that BMO pays a lot less for bonds than you do.

"These ETFs are vastly cheaper than someone trying to buy the bonds themselves," Mr. Berman said. "When retail investors try to create their own bond ladder, bond desks typically burn them."

Two additional similarities between target maturity ETFs and actual bonds is, first, that they both fluctuate in price as interest rates move up and down and, second, that the market price when you buy can be a little higher or lower than the amount you'll get at maturity. Also, target ETFs pay interest as do regular bonds.

In terms of the core bond ETFs they're using for clients, portfolio managers such as Mr. Berman favour very short-term bond funds these days because they offer the most stability at a time of rising rates. He suggests the Claymore 1-5 Year Laddered Corporate Bond ETF , which is designed to replicate a portfolio of bonds evenly divided between terms of one through five years. Each year, the maturing bond is rolled over into a new five-year term.

"Using a short-term corporate ladder is a very defensive strategy," Mr. Berman said. If interest rates are rising, he argues, it means the economy is improving and the risk inherent in corporate bonds over government bonds is minimal. For those who prefer the security of government bonds and are willing to accept a little less yield, Mr. Berman suggested the Claymore 1-5 year Laddered Government Bond ETF .

Vikash Jain, portfolio manager with archerETF Portfolio Management, said one thing he's doing to prepare for rising rates in Canada is buying exposure to longer-term U.S. corporate bonds.

"We believe rate increases will come later in the U.S. than in Canada," he said in an e-mail. "So to postpone the impact of any increase as long as possible, we've shifted some of our long bond exposure to U.S. investment-grade corporate bonds offering decent yields."

Mr. Jain said he believes the U.S. dollar will rise against our Canadian dollar, which raises the possibility of currency-related gains from buying a U.S.-market bond ETF. His ETF of choice for U.S. corporate bond exposure is the iShares iBoxx Investment Grade Corporate Bond ETF .

Oh, and Mr. Jain does not use CIB, the inverse 10-year bond ETF. Reasons include the fact that both inverse and leveraged ETFs can have trouble producing their expected returns, the low trading volumes for CIB and the difficulty in making the right call on when to buy and sell an ETF like this.



Bond ETFs for Challenging Times

Here are some bond exchange-traded funds that can help your portfolio through a period of rising interest rates, which will cause the price of bonds and bond funds to fall.

Fund

Ticker (TSX)

Fee (%)

Quick Description

Short Term Bond ETFs (will fall least in price when rates rise; focusing on bonds maturing in one to five years)

BMO Short Corporate Bond Index

ZCS

0.3

Short-term corporate bonds

BMO Short Federal Bond Index

ZFS

0.2

Short-term federal government bonds

Claymore 1-5 Yr Laddered Corporate Bond

CBO

0.27

Provides an instant ladder of short-term corporate bonds

Claymore 1-5 Yr Laddered Government Bond

CLF

0.16

Lower yield than CBO and a little more protection from the risk of bond default

iShares DEX Short Term Bond Index

XSB

0.25

A mix of short-term government and corporate bonds

Target Maturity Bond ETFs (Mature like actual bonds)

BMO 2013 Corporate Bond Target Maturity

ZXA

0.3

A corporate bond portfolio that matures at the end of Dec. 2013 and returns your upfront investment to you

BMO 2015 Corporate Bond Target Maturity

ZXB

0.3

Same as above, matures in 2015

BMO 2020 Corporate Bond Target Maturity

ZXC

0.3

Matures in 2020

BMO 2025 Corporate Bond Target Maturity

ZXD

0.3

Matures in 2025

Inverse (Moves opposite to bond prices)

Claymore Inverse 10 Year Government Bond

CIB

0.5

Gives you the opposite of the one-day return of the 10-year Government of Canada bond

Horizons BetaPro U.S. 30 Year Bond Bear Plus

HTD

1.15

For sophisticated investors only; provides 2x exposure to the daily inverse move in the 30-year U.S. Treasury Bond

Source: company websites





Craig Porter, portfolio manager at Front Street Capital, will take your questions and offer his insight on investing in the energy sector in this live Globe and Mail discussion. Mr. Porter's CIBC Energy fund is among Lipper's top-ranked Canadian energy funds, with a three-year annualized return of 10.5 per cent. Read more on his selection process here. He also runs the Front Street Resource Fund, which was up 55 per cent in 2010.

Readers using mobile phones should read the discussion by following this link.



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