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First Asset Capital Corp.'s ‘barbell' ETFs are designed to balance defensive characteristics with the potential for yield, says Barry Gordon, president and chief executive officer.Michelle Siu/The Globe and Mail

As anyone who follows the markets knows, it's a tough time to be an investor in equities.

But the old safe harbour of bonds is not looking much better. After a 30-year bull run that started when rates began a steady descent from the high teens to today's U.S. Federal Reserve-directed one-per-cent range, rates really have nowhere to go but up. The only question is when. The Fed would like to keep rates ultra-low – or punishingly low for yield-hungry investors – for a couple more years.

The need for yield is pressing and will only grow as the population ages, but at the same time, the risks are much greater today, observes Jaime Purvis, executive vice-president with Horizons Exchange Traded Funds. "If people are obeying the rules of owning your age in bonds, there is a lot more risk appearing than there was even five years ago," he said.

Why is the risk so high? The cost of interest rate increases on the value of existing bond holdings is much higher than it was, say, in the mid-1990s when yields were higher and average bond durations were shorter. "All of a sudden you are risking three years' yield on a one-per-cent interest rate increase," he said. "So managing that duration in the portfolio, or what you call the yield curve, is really important."

Because investors still seek the safety and returns of bonds, the financial services industry has created lower-cost investment vehicles designed to allow people to gain exposure to the category more safely.

Horizons, for example, has created two ETF bond funds in particular designed to allow investors to lessen their risk of losing out when interest rates rise. The first, HFR (Horizons Active Floating Rate Bond ETF), is based on the concept of floating rate notes. Most often associated with utilities and financial firms, their yields are tied to interest rates. That sounds great – if rates rise, their payments go up. The problem, Mr. Purvis explains, is that in times of crisis, they can devalue quickly and prove hard to sell.

Horizons set about creating a synthetic floating rate note ETF, which holds a portfolio of high-investment-grade five-year notes that it put into a forward swap with National Bank. What it does is give investors the five-year fixed rate (2.3 per cent) with a duration of six months at a low cost of 42 basis points.

"So all of a sudden there is a tool that exists that has a much better yield than, say, cash with not a whole lot more duration," says Mr. Purvis.

The HFR fund was launched at the end of 2010 and has grown to more than $100-million in assets. Investors who use it generally fall into two camps: those who want to augment their cash returns, and those who generally want to reduce the duration of their bond holdings.

The closest competitor to the ETF, he said, would be the iShares Floating Rate Note ETF, which does have the liquidity risk when spreads "blow out" during times of crisis.

As well, Horizons last month rolled out the Horizons Active Canadian Bond ETF (HAD), with a cost of 42 basis points, which similarly promises to allow investors to manage their yield and duration of their bond holdings. The new ETF, which has already attracted $25-million from holders, will actively adjust fixed-income holdings in the fund depending on the outlook for rates. When the adviser believes rates will increase, for example, it will increase holdings of securities with shorter terms.

Over the past decade, the universe of fixed income ETFs has grown, from a couple that allowed investors to buy a large basket of Canadian bonds (iShare's XSB and XBB) to Claymore's bond-ladder ETFs. The ladder strategy "essentially looks to capture the yield curve, which is traditionally upward sloping – the longer the term, the higher the yield," said Yves Rebetez, a former fixed income executive on Bay Street and now editor of "If you put reasonable fees on to that strategy, you get a pretty decent alternative that actually positions you for an environment where interest rates rise."

The latest ways to manage duration risk and increase yield include Horizon's actively managed ETFs and First Asset Capital Corp.'s "barbell" trio of fixed income ETFs.

The three – DEX All Canada (AXF), DEX Corporate Bond (KXF) and DEX Government Bond (GXF) – all attempt to manage duration risk for fixed-income investors. How they work is with a barbell strategy of putting half the funds' holdings in short-term securities and the other half in longer-duration securities.

"It gives you those defensive characteristics balanced out by the yield that you get and investors want from the longer end of the curve," says Barry Gordon, president and chief executive officer of First Asset in Toronto. The ETFs were designed to be as low cost as possible, charging management fees of 20 to 25 basis points.

First Asset views its barbell ETFs as a good choice for investors looking to add to their bond portfolios or those just getting started buying in the ETF space.

"What the barbell strategy does," says Mr. Gordon, "is it positions it to benefit from when interest rates rise and mitigates the need to actually make a call from a broad market strategy to a short duration strategy – or vice versa."

Tried-and-true strategies

When it comes to playing the yield curve, investors have relied upon three tried-and-true strategies.

Bond ladder: This is a portfolio of bonds with different maturities. It carries less risk than if all the securities matured at the same time. Laddering allows people to put money back into the bond market if rates look favourable, or invest the money elsewhere if not.

Bullet: The bullet strategy is used by investors who buy bonds that will all mature at the same time in the future when the money is required. This is useful for investors who know they will have to fund a child's graduation or their own retirement.

Barbell: The barbell strategy involves purchasing only short and long-term fixed-income securities. On the short end, investors get maximum flexibility to pull money out if bonds become unattractive, while the long-term holdings provide the highest yield possible.

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