This is how ETF investors are playing defence in a hostile world for bonds

Interest rates and inflation have been rising, yet bond ETFs are crushing equity funds in attracting new investment.

The exchange-traded fund format can be a smart way to add bonds to a portfolio, but what’s up with the strong preference for bonds at a time when fixed income is under pressure? For answers, consider the bond ETFs that were most popular with investors in July.

The hottest bond ETFs were the ones that take a defensive approach in a rising rate world. For example, the No. 3 ETF as ranked by net new assets in July was the iShares Floating Rate Index ETF (XFR), while the fifth-ranked fund was the BMO Ultra Short-Term Bond ETF (ZST). Other popular funds in July included the Horizons Active Floating Rate Bond ETF (HFR), the Mackenzie Floating Rate Income ETF (MFT) and the BMO Short Corporate Bond Index ETF (ZCS).

Floating rate bonds adjust their interest payments in line with changes in interest rates, which makes them less vulnerable in a rising rate world and less attractive when rates are falling. While the FTSE TMX Canada Universe Bond Index was down 0.1 per cent for the first seven months of the year, the FTSE TMX Canada Floating Rate Note Index gained 0.9 per cent. Income seekers, note the smaller yield from floating rate bonds. XFR has an after-fee yield to maturity of 1.6 per cent, compared with 2.6 per cent to the iShares Core Canadian Universe Bond Index ETF (XBB).

Short-term bonds, generally considered to be those maturing in five years or less, offer somewhat less vulnerability to rising rates than longer-term bonds. BMO’s ultrashort-term bond ETF takes the short-term theme even further by focusing on bonds that mature or have their rates reset in less than a year. The year-to-date return through July 31 was 1 per cent, while the net yield to maturity was about 2.2 per cent.

By comparison, bonds in the BMO Short Federal Bond Index ETF (ZFS), another popular bond fund in July, had an average term of 2.8 years. This ETF had a year-to-date gain of 0.2 per cent and a net yield to maturity of 2 per cent. In today’s world of rising inflation and interest rates, short-term bonds beat long-term bonds and ultrashort beats short.