Bond duration is a useful investment metric that can tell you a lot about the interest-rate sensitivity (volatility) of a fixed-income investment. (See my recent article on this.) But duration is more than just another pretty number. It’s actually a very useful tool to help you manage your fixed-income portfolio and optimize performance. Here’s how.
Managing duration has become particularly important given the outlook for interest rates. While there may be some short-term easing in rates, the medium- to long-term expectation is for rates to rise. If so, most investors will want to shorten the duration of their investment portfolios.
Here are a few key strategies you can use to shorten duration.
Invest in short-term bonds
Because of their abbreviated timeline, some short-term bond exposure in your portfolio is a natural way to help reduce the duration of your fixed-income portfolio.
In my opinion, the best options for this are the iShares Canadian Short Term Bond Index ETF (TSX: XSB). About half the portfolio is invested in government bonds, with the rest in corporates. It currently has a duration of 2.8 years. Another ETF option is the iShares 1-5 Year Laddered Corporate Bond Index ETF (TSX: CBO), which invests in a laddered portfolio of corporate bonds.
In the mutual fund space, the PH&N Short Term Bond & Mortgage Fund (RBF1250) invests in a mix of mortgages and short-term bonds. About half the fund is invested in corporate bonds, 20% in government bonds, and 15% in mortgages. The duration at the end of February was listed at 2.7 years. Another one of my favourites is the TD Short Term Bond Fund (TDB967). It is very similar to the PH&N offering, except it does not hold any mortgages. At the end of February, it held 64% corporate bonds, with the rest invested in governments. The duration was listed at 2.8 years.
Invest in high yield bonds
Because of the higher coupon payments they offer, high yield bonds can be another great way to lower the overall duration of your portfolio. However, I would approach this strategy with caution, particularly now.
Within the high yield space, I would suggest you take a look at the iShares U.S. High Yield Bond Index ETF (CAD-Hedged) (TSX: XHY). It invests in diversified portfolio of U.S. based high yield bonds, and has a duration of 3.9 years.
For mutual funds, one of my picks would be the TD High Yield Bond Fund (TDB626). More than 70% is invested in the U.S., 20% in Canada, and the rest spread around the world. It was hit very hard in 2008, but has rebounded nicely. Today, its duration sits at 3.9 years.
Invest in floating-rate notes
Because the interest payments on floating-rate notes change with the prevailing rate of interest, there is very little duration risk. For example, at the end of February, the duration of the FTSE/TMX Universe Bond Index was listed at 7.6 years, yet the duration for the S&P/LTSA U.S. Leveraged Loan 100 Index had a duration of between 45 and 90 days.
While this looks attractive for a rising rate environment, it should be approached with caution. The majority of these loans are unrated, meaning that that credit risk could be rather high. Another concern is that if we see any signs of trouble, liquidity in the loan market may become an issue. As a result, investors should use these types of investments only as part of a well-diversified portfolio.
I like the PowerShares Senior Loan (CAD-Hedged) Index ETF (TSX: BKL), which provides exposure to the 100 largest loans in the U.S. Its duration is very low, matching the Index at 45 to 90 days. Most of the floating-rate mutual funds are relatively new, so there isn’t a sufficient track record on which to do an analysis. There are three that have been around for a few years, but I’m not fully comfortable with any of them in the current environment.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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