ETF News

A Bad Time for Bonds

The bond bull market is over. After more than a decade of falling interest rates, rate hikes are on the horizon again, with the Bank of Canada planning numerous 50-basis point increases over the remainder of 2022. As a result, bond yields have skyrocketed, sending bond prices plummeting. Year-to-date, long-duration fixed income assets have suffered greatly, with the benchmark BMO Federal Long Bong Index ETF (ZFL) down over -19%. 

Even worse, the traditionally negative correlation between bonds and stocks that investors have enjoyed has faded. In 2022, a 60/40 portfolio of stocks and bonds like the Vanguard Balanced ETF Portfolio (VBAL) has drawn down nearly as much as a 100% stock portfolio like the Vanguard All-Equity ETF Portfolio (VEQT), with the former down -12.21% vs the latter at -13.23%.

Still, a healthy allocation to bonds remains a prudent choice for all but the youngest and risk-tolerant investors. I used NEO ETF Market's ETF Screener to find a list of short-duration, investment grade bond ETFs suitable for the current rising rate environment.

A Brief Primer on Bonds

As noted earlier, bonds are usually uncorrelated (or have a lower correlation) to stocks. To put it simply, when stocks fall, bonds tend to rise, especially government bonds. This is called the “flight to quality,” caused by investors panic selling stocks and buying bonds en masse. Savvy investors can use this phenomenon to rebalance their portfolios during crashes.

Bonds also exhibit lower volatility and drawdowns compared to stocks, making them great for reducing the fluctuations in a portfolio. They also pay a coupon, which translates to the fund's yield in a bond ETF. Both these facts are extremely important for retirees who depend on the safety of principal and income to sustain a safe perpetual withdrawal rate. 

The type of bond also matters. When we select bonds for a rising rate environment, we want to focus on bonds with high credit quality and short effective duration. 

Credit risk is the possibility that the issuer of the bond will not pay back the interest or principal amount. For example, if a company issues a bond (corporate bonds) and goes bankrupt, there's a chance that bondholders will lose their investment there (called default risk). 

With government bonds, default risk is not a concern. The Canadian government will virtually always pay their debts. Therefore, we don’t want to use corporate bonds as a hedge (despite their higher yield) because they tend to drop with equities during times of crisis. Government bonds are our safety net.

Effective duration measures the sensitivity of bond prices to interest rate movements. For example, if a bond has a duration of 2.0, its price will fall about 2% if interest rates rise 1%, and vice versa if rates fall. A mechanic called bond convexity makes long-term bonds more sensitive to interest rates and much more volatile. 

For instance, long-term U.S. Treasury bonds spiked upwards during the 2008 Great Financial Crisis and the 2020 COVID-19 crash – the Fed dropped rates, and investors flocked to Treasurys. This is also why, as rates were anticipated to (and did) rise this year, long-term bonds did poorly. 

Generally, investors should match effective duration to their investment time horizon to balance interest rate risk, yield, and crash protection. For example, an investor with 20 years until retirement could hold long-term bonds. An investor who has retired should consider short-duration bonds. A good "jack of all trades" are intermediate duration bonds.  

What Are Some Good Canadian Bond ETFs?

For maximum safety and portfolio protection during a rising interest rate environment, we'll want Canadian bond ETFs with a low effective duration and a high proportion of AAA-rated government (Federal or Provincial) debt. The following ETFs fit this criterion:

1. Vanguard Canadian Short-Term Bond Index ETF (VSB)

• Expense ratio: 0.11%
• Yield to maturity: 3.2%
• Effective duration: 2.6 years
• % of AAA-rated debt: 46.8% 

2. BMO Short Federal Bond Index ETF (ZFS)

• Expense ratio: 0.22%
• Yield to maturity: 2.73%
• Effective duration: 2.56 years
• % of AAA-rated debt: 100%

3. iShares Canadian Short Term Bond Index ETF (XSB)

• Expense ratio: 0.10%
• Yield to maturity: 3.16%
• Effective Duration: 2.63 years
• % of AAA-rated debt: 47.58%. 
  

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.