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BOND FUNDS AND RATE RISK
9/22/2017 7:38:54 AM
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Fund Library Q&A
Your questions about financial planning, investments, and portfolio management answered by an industry expert



By Robyn K. Thompson  | Friday, August 18, 2017




Q – I notice that shorter-term returns of the iShares Core Canadian Universe Bond Index ETF (TSX: XBB) have been sliding recently. I’m not sure I understand why, but I’ve been told it has something to do with rising interest rates. Are there some actively-managed bond fund alternatives that might do better? – Alan T., Barrie, Ontario

A – It’s true that bond prices have been declining over the past year. In fact, the iShares Core Canadian Universe Bond Index ETF you mention, which represents a broad spectrum of investment-grade Canadian corporate and government bonds, has dropped -3.0% in the past 12 months to July 31. And this is due to the general trend of rising interest rates globally.

With relatively good economic growth in the developed nations, and inflation showing some signs of inching up along with wages, central banks are becoming more hawkish in their outlook. That means they are more willing to raise their policy interest rates and generally remove monetary accommodation to begin returning their balance sheets to normal, after nearly a decade of so-called “quantitative easing” (whereby central banks would purchase vast amounts of Treasury bonds, thus creating and sustaining market liquidity).

All this, of course, has a direct impact on bond prices and yields.

Where interest rate risk comes into play is in the pricing of bonds. Once issued, bonds are traded in an informal (albeit very large) market. And because of the inverse relationship of a bond’s price to interest rates, a bond’s price will fall if general interest rates rise. Conversely, bond prices rise when rates fall. (It’s a complicated mathematical relationship that essentially keeps a bond’s yield competitive in the marketplace.)

Those high-quality government bonds will always pay the stated coupon rate, which is based on the face, or par, value of the bond. What you actually receive is the “yield” of the bond based on the price you pay. So if you paid the face value (usually stated as “$100”) on a bond that carries a 2% coupon rate, your yield will be 2%, or $2 per $100 of face value. But if you paid something other than face value, your “yield” will be either higher or lower than the coupon rate.

When analysts talk about interest rate risk, they’re not referring to whether or not the bond will pay its interest. They’re referring to the bond’s price. If rates rise, the price of your bond may fall below your purchase price, resulting in a capital loss if you sell your bond before maturity.

The bigger bond ETFs track some fixed bond index. For example, the iShares Core Canadian Universe Bond Index ETF passively tracks the FTSE TMX Canada Universe Bond Index. In such indices there is no leeway for offsetting rate or credit risk, and so the ETF will simply track the performance of the index.

However, in actively managed bond portfolios, such as those you’ll find in fixed-income mutual funds, managers will monitor holdings continually, and adjust them as necessary in an effort to mitigate various types of risk. They do this in a variety of ways, including tilting bond holdings to longer or shorter maturities, or investing in bonds with different risk ratings, in different regions or countries, or attempting to anticipate interest rate moves – all depending on the mandate of the fund as set out in its prospectus. Some funds can be quite successful at this, as seen in the Fundata Canada’s list of Canadian fixed Income funds receiving a monthly FundGrade A Grade. For example, at the top of the A Grade list for 12-month performance through July is Arrow Capital’s Exemplar Investment Grade Fund Series FL, with a 6.8% return.

Bond ETFs with an active management component are also being introduced to the market, for example, Purpose Tactical Investment Grade Bond ETF (TSX: BND) or the First Asset Long Duration Fixed Income ETF (TSX: FLB). The funds I’ve mentioned are simply examples of what’s available, and are definitely not recommendations to buy. Bond ETFs come in many configurations, including those that track short- and long-term indices as well as indexes of government bonds, corporate bonds, all bonds, laddered maturities, and so on. It can get complicated.

In general, investing in fixed-income assets can be just as complex as investing in equities, sometimes even more so. If you’re looking for the best type of fixed-income investment to include in your portfolio, or whether or not to switch from passive to active management styles, I’d suggest consulting a qualified financial advisor. – Robyn

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

Notes and Disclaimer

© 2017 by the Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.

 
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