The consensus among economists and market pundits is that interest rates will rise in the near future, but there's no agreement about when or by how much. This puts financial advisors and their income-seeking clients in a difficult position when looking for a strategy to invest in exchange-traded funds (ETFs) that will be positive for their portfolios.
So, if you assume that rising interest rates are in the cards, the key is to focus on managing the duration - the sensitivity of the ETF's price to a change in interest rates - of your client's ETF investments, says Mark Webster, vice president with BMO Asset Management Inc. in Vancouver.
Here are several types of ETFs to consider in a scenario of rising interest rates:
- Short term-to-maturity bond ETFs generally have lower duration than one- to 10-year laddered bond ETFs, but higher than floating-rate bond ETFs, says Tyler Mordy, president and co-chief investment officer with HAHN Investment Stewards & Co. Inc. in Toronto: "Their performance would likely fall in between the two strategies if rates were to rise."
A short term-to-maturity bond ETF, he adds, could be used: to lower the overall duration of a client's fixed-income holdings; to represent the short-term component of a "barbell" strategy; or as a stand-alone position.
- Barbell bond index ETFs invest in bonds of different maturities. For example, 50% of the assets under management in First Asset All Canada Bond Barbell Index ETF is made up of bonds with maturities of 10 years or longer, 25% is in maturities of less than two years and 25% is in floating-rate bonds, says Barry Gordon, president and CEO of First Asset Investment Management Inc.: "[This ETF] gets the benefit of having 50% of the portfolio at the short end of the yield curve and 50% earning higher yields. The 50% in the long end is particularly attractive in a flattening yield curve environment."
- Floating-rate bond ETFs "generate a floating yield that rises and falls with prevailing interest rates," says Jaime Purvis, executive vice president, national accounts, with Horizons ETFs Management (Canada) Inc. in Toronto. "Floating-rate bond ETFs have virtually no duration and are largely immune to any rise in interest rates."
Similar to short term-to-maturity ETFs, Mordy adds, a floating-rate ETF can be employed to lower the overall duration of a client's fixed-income holdings or as a stand-alone position.
Webster cautions that floating-rate ETFs usually hold bonds that are not investment-grade, which have attractive yields but higher credit risk than investment-grade corporate bonds.
- Laddered bond ETFs hold bonds of different maturities. These ETFs don't offer as much interest rate protection as some investors assume because about 40% of a typical portfolio has a duration greater than four years, Purvis cautions. That is a relatively long period in a rising interest rate environment. "In a declining interest rate environment," he adds, "the ETF purchases bonds, often at a premium, which reduces the yield to maturity and drastically increases the impact of after-tax returns for investors."
Laddered bond ETFs - especially those with one- to 10-year maturities - generally have the highest duration among short-term bond strategies and "would likely perform the worst should rates increase," Mordy says.
Still, these ETFs have a lower duration than the overall Canadian bond market.
- High-yield bond ETFs. As Pat Chiefalo, managing director and head of iShares with BlackRock Asset Management Canada Ltd., says, "High-yield bonds can also be an interesting play - especially if interest rates are rising because economic conditions are improving - as the higher interest payments made by these bonds can help to offset any fall in prices triggered by rising interest rates."
- Rate-reset preferred-share ETFs also provide an appealing alternative for clients concerned about interest rate increases. "Preferred shares currently pay a high yield relative to investment-grade Canadian bond products, which helps to compensate for [preferreds'] equity risk," says Mordy.
However, Chiefalo cautions, although a stock portfolio has much greater potential for capital gains than a bond ETF does, the trade-off is more volatility and downside risk.
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