Rising rates haunt bond investors

Interest rates are near historic lows and seem bound to rise. Bond investors should heed duration, or sensitivity to rising rates

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From the June 2013 issue of the magazine.

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We recently got “man’s best friend,” a border collie puppy. We attended puppy-training class because we’d heard the nature of training has changed. I’m old school, with punishment being used, albeit judiciously. Today it’s all about positive reinforcement, and it seems to work. Dogs are acutely sensitive and you need to be aware of that. Who knew?

Over the past decade an investor’s “best friend” has been the bond market. Heck, bonds have been on a three-decade roll and investors have benefited from a steady stream of coupon payments, even as bond prices have risen. But all good things must end. We sit at or near historically low yields, and the only place they can go is up. As yield rises, bond prices fall, so the challenge is knowing when rates will move and managing portfolios as they do.

Turns out bonds are also sensitive. The buzzword in the fixed-income world these days is a technical term called duration. Duration is a quantifiable measurement of bond sensitivity to changes in interest rates: if they change by 1%, how much will the price of the underlying bond, or portfolio of bonds, likely change.

The DEX Universe Bond Index holds 1,200 securities, including federal, provincial, municipal and corporate bonds. It has a mix of short- and long-term bonds with an effective term of just under 10 years. Duration is just under 7, so in theory if interest rates rise 1% the index should fall about 7%.

The iShares DEX Universe Bond Index ETF (XBB) is among the biggest ETFs in Canada, and it’s often used to get inexpensive but broad exposure to fixed income. As Aubrey Basdeo at iShares explains it, XBB matches the underlying index it tracks to a “T.” That’s what it’s supposed to do, as it shares the same characteristics as the underlying portfolio and the ETF price is a function of the individual components. As with most bonds, returns are a function of the coupon—or stream of coupons—and movements in interest rates. XBB makes monthly distributions, with yield to maturity projected at 2.3%.

Here’s the problem. Its duration also matches the index, at 7. So if rates rise 1%, XBB will lose 7% of its value. It would take almost three years of monthly distributions just to recover the value lost with the price drop!

Derek Brown is a sub-adviser and portfolio manager for Fiera Capital, one of the primary managers of the Horizons Active Canadian Bond ETF (HAD). Derek believes managing duration is key and says that if we look back in time, in the mid-’90s, yields were at 9% and duration was at 5. As rates fell, duration rose. Makes intuitive sense doesn’t it? A 1% change in interest rates has more impact at lower rates. In the bond world, the relationship between yield and duration is called the risk/reward profile. The 9:5 ratio of percentage yield to years duration meant six months of yield would offset the impact of the 1% change in rates. An investor was ‘risking’ six months of yield against a 1% interest rate increase. That seems a reasonable trade-off. Today the ratio sits near 2:7—almost three years of yield to offset the same 1% uptick. That’s less attractive, and riskier.

That greater risk is why most bond traders believe now may not be the best time to buy bonds, especially if you’re new to it. If you must buy bonds, they suggest buying short-term maturity fixed-income products. Their prices can fluctuate, but even in a worst-case scenario where rates skyrocket, you’ll know the bonds will mature, you’ll eventually get your principal back, and can reinvest at the higher rate. That’s in essence what bond managers do in mutual funds. ETFs are similar except that they track indices that roll over their holdings according to prescribed rules.

What’s interesting about short-term bonds, or portfolios built around them, is that yield and duration are significantly closer than the 9:5 ratio. Brown says the optimal risk/reward ratio is closer to 1:1. To achieve that or even get close to it, two things need to happen: increase yield and shorten duration.

Traditionally, increasing yield has been relatively easy: reduce credit quality and boost yield. But recent years have seen the hunt for income drive yields down to much closer spreads. Corporates are still riskier than government bonds but there’s only so much yield you can pick up.

That’s why the discussion is shifting to the other half of the equation: duration. This is calculated after considering such variables as maturity, coupon, price and yield. It’s easier to find it on ETF provider websites, or try PC Bond Analytics.

I know what’s in store with my puppy because I’ve had two before. It shouldn’t be too hard, as long as I manage his sensitivities. Managing bond portfolios through upticks in rates isn’t easy, but it’s worth it. Pay attention to yield, duration and the relationship between them.

Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitter feed is @patbolland.

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