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Has there ever been a more uncomfortable time to hold bonds?

It’s not just the fact that the benchmark bond index has lost ground so far this year. Interest rates are widely expected to start to edge higher at some point in the next 12 months, which is negative for bonds. Meantime, the stock market surge of the past 15 months has heightened concerns about an eventual correction. Bonds will help stabilize a portfolio when this pullback happens.

How do you navigate this contradiction-filled outlook? One thought is to hold an exchange-traded fund holding short-term bonds, which mature in five years or less. Short-term bond ETFs are a compromise product. You get less income than you do from broad-based bond ETFs and less upside if stocks plunge. But you’re also less vulnerable to a rise in inflation that sends interest rates higher.

Short-term bond ETFs come in many different versions – some combine government and corporate bonds, while others hold one or the other. Another version replicates the time-tested laddering strategy, where your holdings are evenly divided between bonds or term deposits maturing in one through five years. When a bond matures, it gets reinvested into a new five-year term.

To compare the options, I created a Globe Investor Watchlist of short-term bond ETFs and evaluated returns for the year through early June. To set a baseline, the unit price of broad-based bond ETFs was down a little more than 5 per cent for that period.

Short-term bond ETFs from a variety of companies did much better – unit price declines for the year were typically in the low 1 per cent range for funds that combined short-term government and corporate bonds. Three examples:

  • BMO Short-Term Bond Index ETF (ZSB-T): down 0.8 per cent for the year through early June.
  • iShares Core Canadian Short Term Bond Index ETF (XSB-T): down 1.2 per cent.
  • Vanguard Canadian Short-Term Bond Index ETF (VSB-T): down 1.3 per cent.

Consider funds like these as a sweet spot for investors who want bond exposure that tamps down vulnerability to rising rates while also offering protection against falling stocks.

One big virtue of these diversified short-term bond ETFs is management expense ratios of around 0.1 per cent. Yields are low these days, which means a minimal fee is imperative. The mix of corporate and government bonds is also helpful – government bonds will do better if stocks fall hard, while corporates have more resilience in an inflationary world with rates rising.

The after-fee yield on diversified short-term bond ETFs is currently about 0.7 per cent. You can get about 1.6 per cent from broad-based bond ETFs, but with more downside risk.

At present, broad-based bond ETFs have a duration around eight years, while short-term bond ETF average around 2.5 years. This means that if rates were to rise one percentage point, the broad-based bond ETF would fall by 8 per cent and the short-term fund by 2.5 per cent. If rates fall, you get the opposite effect.

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