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etf strategy

Bond-based exchange-traded funds (ETF) have been in the news lately because of predicted increases in interest rates. What is a stability-seeking investor to do?

The conventional wisdom is that if you expect interest rates to rise, you should invest in short-term bond funds. Bond prices tend to fall when interest rates go up, and short-term bonds, and their related ETFs, will probably outperform funds with bonds based on longer maturities.

So what to do now, when it is still predicted that interest rates will rise, but it’s not sure that they will? On Sept. 5, the Bank of Canada maintained its key overnight lending rate at 1.5 per cent, saying “recent data reinforce [the bank’s] assessment that higher interest rates will be warranted” to keep inflation in check.

But when? And under what circumstances? The bank has raised rates four times since July of 2017, the last time in July of 2018.

“We will continue to take a gradual approach” to rate hikes, the bank says. “In particular, the bank continues to gauge the economy’s reaction to higher interest rates.”

Investors might need to adjust their ETF portfolios as interest rates rise.Henrik5000

With rate hikes likely coming sooner or later, “we are vigilant about the risk coming from [this] rate environment, which can affect the value of bond ETFs,” says Neville Joanes, chief investment officer of WealthBar, a B.C.-based robo-advisory.

“Our investment philosophy focuses on diversification and cash flow to reduce volatility. We selected Vanguard Canadian Short Term Corporate Bond ETF [TSX: VSC] for our portfolios,” Mr. Joanes says.

“It is short-duration, so it is less impacted by rising rates. It holds investment-grade corporate bonds, which are higher-credit-quality investments. Even better, it delivers stable cash flow with a current distribution yield of 3.02 per cent.”

In addition, “in this type of environment, we have seen examples where a high-interest-savings ETF such as the Purpose High Interest Savings ETF [PSA-T] can fit. It provides a lot of the benefits of a bond ETF without the risk,” Mr. Joanes adds.

It’s important for investors to understand how bond ETFs respond to interest rate changes, says Sandra Foster, financial author and president of Toronto-based Headspring Consulting Inc.

“When rates fall, the market values of your Canadian bonds, bond funds and bond EFTs are attractive, showing a combination of interest and capital gains," she says. "Rising interest rates are not good for bonds, bond funds or bond ETFs because their market values are discounted – that’s because their future return is now less attractive when compared to new bonds being issued at higher interest rates.”

Investors who hold bond ETFs in non-registered accounts might consider selling them if rates go up. “You could trigger a capital loss in a non-registered account,” Ms. Foster says.

Whether you buy bond investments might also depend on stock-market trends.

“We have been adding to bonds in our asset allocation due to where we are in the equity cycle,” says Robert Mark, investment strategist at Raymond James Ltd. in Toronto. “We know we’re in later innings, but are we in the seventh, eighth, ninth? It’s hard to say.”

“We definitely know we’re later on, and rates are going to move up. The rate increases may be greater in the United States and more restrained in Canada. But we want to be a bit careful with bonds,” adds Mr. Mark, who sits on his firm’s asset-allocation committee.

“So right now we’re underweight in bonds compared with historic levels in our holdings. We prefer keeping bond holdings that are at lower durations as we expect rates to continue to move higher.”

Until recently, Mr. Mark says his firm allocated far larger percentages of investments to equities, which have soared in value, and to cash, to maximize liquidity. As the bull market approaches maturity, “we’re tending to even out” the percentages, though the changes they’re making are still relatively moderate – they are still underweight in bonds, but increasing the percentage of bond-based holdings to 38 per cent from 36 per cent.

There’s not much on the horizon that would cause Mr. Mark to change his outlook, as equity markets remain strong. “There are no big red flags in the economic cycle,” he says.

Admittedly, trade disputes between the U.S. and China are raising concerns, but once that and other issues are resolved the economy could grow even more, putting additional pressure on central banks to raise interest rates.

Investors looking at bonds might then consider short-term bond ETFs.

Ms. Foster offers three suggestions for coping with the inevitability of rising rates.

“First, shorten the duration of your bonds. Longer-term durations have more volatility. Some ETFs cope with rising rates by laddering their holdings,” she says.

“Secondly, review why you are holding bond ETFs at all. If you are holding them for safety and security, consider your risk tolerance and their future returns or losses – not past returns."

If you plan to hold the bonds to maturity rather than trade them, she says, perhaps add some guaranteed investment certificates (GICs) to the fixed income portion of your portfolio.

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