In a rising interest rate world, should you own bonds or bond funds?

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Interest rates have been falling for so long that many investors have never lived through a rising interest-rate cycle. The uptick in rates in recent weeks suggests that this state of affairs could end soon. Among other impacts, rising interest rates can inflict significant damage on what is supposed to be the safe side of an investment portfolio – bond assets. Invariably, when interest rates rise, the market value of bonds and bond funds falls and the loss could be substantial.

Rising interest rates generally do not impact returns on bonds bought directly and held to maturity, at which time the face value of the bond is paid back. A bondholder should receive the bond yield specified when she purchased the bond, provided the issuer is able to pay. The risk of an issuer defaulting is very low for bonds with top credit ratings such as Government of Canada bonds.

Managing a bond portfolio takes work and is not feasible for smaller accounts. Consequently, many investors buy bond mutual funds or bond exchange-traded funds. These funds pay regular distributions. When interest rates rise, fund net asset values fall to reflect the current value of the bond holdings. Investors may never recover these losses because there is no maturity date when the holder is paid the bond's face value.

Bond fund prices in May illustrate the impact of rising interest rates. The Government of Canada benchmark long-term bond yield rose from 2.37 per cent on April 30 to 2.63 per cent on May 31. Over the same time period, here is what happened to two popular funds which both hold a diversified mix of investment grade government and corporate bonds.

– The net asset value of the BMO Aggregate Bond Index ETF dropped 1.47 per cent.

– The NAV of the RBC Bond Fund, a mutual fund, fell 1.52 per cent.

Some relatively new bond funds can help investors manage bond interest-rate risk.

Target maturity bond ETFs are designed to perform like individual bonds. They pay regular distributions and have fixed maturity dates. The bond holdings are structured to mature by the ETF maturity date. As this date approaches, the fund invests the proceeds from maturing bonds in cash and cash equivalents. At maturity, the net asset value is distributed to investors or rolled into a short-term bond ETF. Bank of Montreal BMO offers a series of corporate bond target maturity ETFs with target dates 2013, 2015, 2020 and 2025. Royal Bank of Canada RBC has nine corporate bond funds with maturities ranging from 2013 through 2021.

A diversified bond portfolio with staggered maturity dates (albeit one lacking any government bonds) is possible with just a few target maturity bond ETFs. Investors can choose the funds which match their risk tolerance. Funds with longer maturity dates drop more in value when rates rise as the May returns in the table demonstrate.

Another relatively new product to Canada, the floating rate note ETF, is designed to limit interest-rate risk. The iShares DEX Floating Rate Note Index Fund (XFR-TSX) invests in short-term, investment-grade government and corporate bonds with coupon rates that float with a benchmark interest rate. The Horizons Active Floating Rate Bond ETF (HFR-TSX) invests in high-quality corporate bonds and uses a derivative to achieve a return rate that should float with prevailing interest rates.

With these bonds ETFs, as with bonds, the shorter the maturity date, the lower the yield. The trick is to find the right balance between risk (NAV loss) and reward (yield) to meet your investing objectives. The fund's duration can help you decide. This statistic indicates how much the fund price will change if interest rates change by 1 per cent. For example, if rates rise 1 per cent, the BMO 2020 Corporate Bond Target Maturity ETF (duration 6.2 years) would fall 6.2 per cent.

A fixed-income alternative to bonds and bond funds is a ladder of five-year Guaranteed Investment Certificates. It can be built with relatively modest sums and is best for longer-term savings as the principal is generally accessible only at maturity. Most GICs are insured by the Canada Deposit Insurance Corporation or a provincial deposit insurance corporation, so your principal should be secure. Currently, five-year GICs pay in the 1.75 to 2.5 per cent range, but higher rates are available with a little searching e.g. ICICI Bank is offering 3.15 per cent at ratesupermarket.ca . These rates are certainly competitive with recent Government of Canada bond yields: five-year, 1.7 per cent; 10-year, 2.3 per cent; 20-year, 2.8 per cent.

Economists are forecasting that interest rates will rise this year and next. The time for determining how this will impact your bond holdings and what actions you need to take is now.

Note: All data in table as of May 31. GIC and bond return rates in body of article as of mid-June. Ms. Bebee does not own any of the funds mentioned in this article.

Ms. Bebee is Canada's independent voice on personal finance and author of No Hype –The Straight Goods on Investing Your Money, a popular book of investing basics for Canadians from a financial industry outsider viewpoint. Through her writing, speaking and teaching, Gail shows people how to take control of their money and achieve their financial goals. Her column will appear monthly on the Financial Road Map site. Her website is www.gailbebee.com