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How bond investors can address the interest-rate dilemma

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When it comes to bonds, income investors face a real dilemma.

Almost every financial adviser agrees that fixed-income securities should be an integral part of your portfolio and the older you are, the greater the weighting they should receive.

But what do you do when it appears interest rates are reversing their long downward trend and moving into an upward cycle? Everyone knows rising interest rates are bad for bonds, so why should you hold them and risk a loss?

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The reason may seem counterintuitive: safety. Yes, bond prices may drop if rates rise sharply. But they won't fall as much as equity prices in a stock market crash. A bond portfolio won't lose 30 per cent or 40 per cent of its value in a few months, as stocks did back in 2008.

That said, no one likes to hold losers, even if the downside is limited. So what are the options?

One possibility is to buy individual bonds and hold them to maturity. As long as the issuer doesn't go belly-up, you'll collect regular interest payments and receive your principal back in full when the issue matures.

The problem with that solution is that you need a lot of money to build a diversified bond portfolio. Plus you're at the mercy of your broker when it comes to availability and pricing. Unlike stocks, there is no open, transparent market for bonds. You can find quotes on several websites, but whether you'll be able to buy a specific bond for that amount – or at all – will depend on your broker's inventory and pricing policy.

Mutual funds and ETFs are another way to own bonds but most do not have a maturity date and, therefore, there is no guarantee that your capital will be repaid at a specific time.

The exceptions are target-date bond funds, which are now offered by a few companies. One of the Canadian pioneers in this area is RBC, which currently offers seven of these ETFs, with maturity dates from 2017 to 2023.

These funds invest in a portfolio of high-quality corporate and provincial bonds that all mature in the same year. Taking the RBC Target 2023 Corporate Bond Index ETF as an example (RQK-TSX), all the bonds come due in that year and will be repaid at that time. When that happens, the fund will terminate and investors will receive their principal back (assuming no defaults and excluding fees and expenses).

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All the bonds in the portfolio are rated triple-B (investment grade) or higher and are issued by major corporations or provinces (there are no federal government bonds). Most of the issuers are Canadian but there are a few U.S. companies, such as Wells Fargo.

This ETF currently makes monthly payments of 4.6 cents a unit (55.2 cents a year). If that distribution were to be maintained through 2017 (no guarantee), the yield would be 2.8 per cent based on a recent price of $19.74.

Obviously, you're not going to get rich at that rate. But you'll receive regular cash flow and you don't have to worry about fluctuations in the bond market. You'll receive most, or all, your principal back at maturity. At that point, you can take the cash or roll it over into a new target-date bond ETF.

The management fee for this ETF is 0.25 per cent. It's quite new and only has about $4-million in assets at this stage so it is thinly traded (on some days, no units are traded at all). If you are interested in taking a position, place a limit order and be patient.

The other ETFs in the RBC series are more mature and have a performance history. The 2019 fund (RQG-TSX) has $138-million in assets and usually trades several thousand shares a day (although a limit order is still advised). It had a total return of 3.57 per cent in the year ending Feb. 28.

There is no ideal solution for fixed-income investors in this environment. But these target-maturity ETFs are certainly a decent option to consider.

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Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

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About the Author

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. More

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