Wednesday, 3 November 2010

Which Bond ETFs are Most Vulnerable to a Rise in Interest Rates?

Interest rates are still at historic lows but they have only been maintained at such levels due to economic conditions. When interest rates rise, the price of bonds will fall (for a straightforward explanation of why this inverse effect occurs, see Investopedia's article on the question) as investors demand a higher rate of return. Bond ETFs are collections of individual bonds with varying maturities and coupon rates. Thus, a rise interest rates rise will see the value of bond ETFs fall and inevitably the market price of bond ETFs will fall too.

How do we measure the effect? The answer is a metric called Duration, which measures the amount any one bond, or a collection of bonds, will react to interest rate changes.e.g. a duration of 5 means a 1% rise in interest rate / required investment return will cause a 5% fall in price.

Fortunately the ETF providers do the fairly complicated calculation of Duration (see the Gummy bond tutorial II from the Financial Webring to see the math) for us and we only need to look it up on their respective websites. Let's have a gander at the range of Canadian bond ETFs to find out how much interest rate exposure we investors face in buying these funds today. We'll see that there is wide range amongst bond funds.

Durations of Canadian Bond ETFs
(click on image for details)

The lessons of the comparison table follow common sense:
  • Short maturity funds of five years or less have substantially shorter Durations (around 3) and sensitivity to possible interest rate increases while funds with long-dated maturities are the most susceptible (around 12-13).
  • All-inclusive broad market funds have a mid-range Duration of about 6.
  • There is a general pattern of higher yield for higher duration - other things being equal, the more interest rate risk one is prepared to take on, the higher the yield.
  • While Duration may be the same, all sectors are not the same, especially with regard to credit risk (the risk of not getting paid). This risk is reflected in higher yields for corporate over government bonds. The iShares DEX HYBrid Bond Index ETF (symbol: XHB), with its holdings of higher credit risk corporate bonds yields the most of all.
  • A seeming anomaly is the combination of very low yield and very high duration of the two real return bond ETFs, iShares ' XRB and BMO's ZRR, which mainly contain bonds issued and guaranteed by the Canadian government. Are investors in these funds somehow in a very bad deal? Not necessarily ... A major cause and component of higher interest rates is inflation. Real return bonds include an automatic ratcheting mechanism for CPI increases that protects against inflation. Compare ZRR and XRB with ordinary long maturity and long Duration bonds issued by the Canadian government, e.g. in BMO's ZFL fund. They do not contain any ratcheting for inflation, though they do incorporate an inflation expectation roughly equal to the difference in yield with the real return bonds, in this case about 3.3% - 1.1% or 2.1% per year. If inflation spikes up above 2.1%, XRB and ZRR investors are protected but ZFL owners lose (as do all the other bond ETFs). The protection is worth a lower yield.
A few caveats - the Duration formula of x% price change per 1% change in interest rates isn't exactly uniform and linear. At low yields, such as those prevailing nowadays, Duration changes faster than interest rates, so the formula exaggerates a bit. Duration is most accurate for small changes in interest rates, say +/ 1% - beyond, that the effect becomes less and less and pronounced in a way beneficial to the investor - a big rise in interest rates makes a lesser bond price hit and a big fall makes more of a price rise.

Interest Rate Increase Protection Options
  • The obvious tactic is to buy into funds with shorter Duration, though as we observe, there is loss of yield
  • Another strategy is to try to, as the finance textbooks say, immunize your bond holdings by matching Duration with your investment time horizon. See this brief explanation on, the key sentence of which is "When the duration of a bond or a bond portfolio is equal to the investor's expected investment horizon, the investor will be immunized against interest rate risk." In other words, match the Duration of your bond holdings with the time when you will need the money. A key assumption is that the interest is reinvested (ETFs such as those of BMO and Claymore that let you choose to DRIP automatically instead of having to buy new shares on the market are very useful in that regard). If you do not reinvest, the gain on the higher interest rate from new investments will not be there to offset and compensate for the initial loss of capital/share price when interest rates rise and you the investor will be a net loser in the process.
  • Buy actively managed bond mutual funds, whose managers try to figure out the direction and amount of future interest rate changes to change the bond portfolio in advance. You rely on the skill of the manager and as usual, past successful performance may not be repeated; in fact, most active mutual funds do worse than than a passive index and finding the ones who will be successful is hard. To get a list of bond mutual funds, use the fund filter of your discount broker or the free Fund Filter at GlobeInvestor. All of the ETFs in our table are passively managed funds that merely try to reproduce the performance of a representative set of bonds according to sector and market cap.
Interest rates will inevitably rise when conditions improve, the only question being how soon that will happen. Be ready!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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