# If interest rates are set to rise, which ETF bond fund should I buy?



## jpjuggler (Apr 30, 2012)

HI 
I'm brand new so please bear with me.

I want to buy a bond etf fund. Many people say interest rates are set to rise and I think that's a reasonable assumption. If one buys a bond fund, and interest rates rise, the share price falls.

with this in mind, what is the class of bond fund etf for me to buy where the share price either won't fall or fall the least? I assume it's a short term bond fund, is this right? Would a laddered bond fund be even better? 

Can anyone reccomend a particular bond fund for me?

Thanks
JP


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## Albert (Jan 19, 2012)

I have been looking for same, and in reading came across the following:
Horizons’ Floating Rate Corporate Bond ETF (HFR/TSX). For a management fee of 0.40%, HFR hedges interest rate risk with a fixed-to-floating interest rate swap, which has the effect of providing a current 2.5% annualized yield that will increase along with interest rates while protecting its value at the same time.
here is some reading:
http://business.financialpost.com/2011/06/23/floating-rate-bond-etf-helps-hedge-against-rate-hikes/
Would appreciate comments on this ETF.


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## andrewf (Mar 1, 2010)

XFR is interesting, but I don't see the point in taking the additional risk of non CDIC insured debt for an extra few basis points. You can get high interest savings accounts at 2%.


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## VJ99 (Apr 24, 2012)

*Bond ETF alternatives*

Given that HFR's holdings are for about 6 months maturity, I wonder about the benefit of a fixed/floating swap. 
Sure, the ETF will benefit from the swap once interest rates rise, but the fixed holdings will be need to replaced soon after anyway and then they will catch up with the floating rate. 
That seems like a marginal difference for the extra fees.

I'd prefer a prefer a plain vanilla (ie. no over-the-counter derivatives) ETF.
You also need to consider the duration you want. 
I agree that rates must rise eventually but they won't rise evenly across all durations. 
IMHO, the near to mid terms will rise the most ie. 2 to 5 years. 
Therefore, it would be best, IMHO, to stay out of those and focus instead on shorter and longer ends. 
ie. under 2 years and over, say, 10 yrs. 

The ETFs that readily come to mind are:
XSB ishares short-term bond etf - with a duration of about 2 yrs, its 1yr Total Rtn=3.55% vs 2.19% for HFR.
XLB ishares long term bond etf. - with duration of about 10 yrs. 
ZRR BMO inflation protected - longer duration but inflation protection is like a floater anyway. Great return.

Hope that helps. 
Vikash
www.archerETF.com


Disclosure: I'm long XSB, personally and in client portfolios.


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## andrewf (Mar 1, 2010)

Impact of interest rate changes is in proportion to the duration. So even if short-term rates rise by 2% and long term yields rise by 1%, long duration funds will take a much larger loss in value. So, buying 10 year bonds at 2% yield seems like an excellent way to lose money.


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## VJ99 (Apr 24, 2012)

True, but...
1. the yield pickup is significant and
2. a significant rate increase is likely still some time off since:
- inflation is still low, other than in real estate
- Manufacturing is operating below capacity and weak (see yesterday's print)
- Unemployment is still relatively high
- CAD is at parity with the USD (a rate increase would push up CAD and hurt exports)

Gov. Carney doesn't really have the option of raising rates in this environment. That's why he has been only talking down real estate - there's not much else he can do.


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## fatcat (Nov 11, 2009)

there is no scenario where a bond fund makes sense at this point
i agree with andrew, the best bet if you are talking less than 100K is cdic hisa @ 2%
a recession pushes yields so low, you might as well be in cash
a recovery will start to hit the share price
going sideways means returns about what they are now and XSB can't even yield 2%


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## Belguy (May 24, 2010)

I have a little bit of recent experience looking after a portfolio of four short term bond ETF's in my mother's RIF. Since the first of the year, this portfolio is essentially flat and has gone nowhere. Within just a few dollars, it stands exactly where it was on January 1 and interest rates have not even begun to rise yet. I am considering selling the bond ETF's and putting the full amount into a HISA. At this point, I wouldn't recommend ANY bond ETF's.


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## 44545 (Feb 14, 2012)

fatcat said:


> there is no scenario where a bond fund makes sense at this point
> i agree with andrew, the best bet if you are talking less than 100K is cdic hisa @ 2%
> a recession pushes yields so low, you might as well be in cash
> a recovery will start to hit the share price
> going sideways means returns about what they are now and XSB can't even yield 2%


Canadian Direct Financial's "KeyReach TFSA Savings Account" paying 3% interest seems like a good place to park cash that was earmarked for a bond fund.


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## buhhy (Nov 23, 2011)

Given the current low rates, and prospect of increased rates, wouldn't owning bond funds be a lose-lose scenario? Would it be prudent to move my TDB909 holdings into a HISA instead?


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## sharbit (Apr 26, 2012)

What about a resetting preferred, for example: TA-F or TA-D?

"Holders of Series A Shares are entitled to receive a cumulative quarterly fixed dividend yielding 4.60% annually for the initial period ending March 31, 2016. Thereafter, the dividend rate will be reset every five years at a rate equal to the 5-year Government of Canada bond yield plus 2.03%. Holders of Series A Shares will have the right, at their option, to convert their shares into Cumulative Rate Reset First Preferred Shares, Series B (the “Series B Shares”), subject to certain conditions, on March 31, 2016 and on March 31 every five years thereafter. Holders of Series B Shares will be entitled to receive cumulative quarterly floating dividends at a rate equal to the three-month Government of Canada Treasury Bill yield plus 2.03%. The Series A Shares are listed on the Toronto Stock Exchange under the ticker symbol TA.PR.D."

The preferred shares I think can be recalled at par (25$) every 5 years. I've been eyeballing these myself; given how transalta isn't cutting the dividend these would be better then commons right now (IMO).


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## VJ99 (Apr 24, 2012)

Bonds are expensive but they may actually get more expensive in the next 6 to 12 months. That's from Albert Edwards, SocGen's accurately grumpy economist. Here's an excerpt from his latest piece:

"We remain overweight long global government bonds, as we have been for the last 15 years.This is despite our belief that they will prove to be a terrible 5-10 year investment. In our view,
10y+ government bonds are expensive in the face of bankrupt governments and the QE policy
response that bankruptcy engenders. But government bonds will become even more
expensive on a 6-12 month view with an evaporation of confidence in the sustainability of
the US recovery and/or a China hard landing (the former could occur with or without the
latter). In the environment of a China hard landing we would expect to see a slide of implied
inflation expectations as we did during the Asian crisis of 1998 (see charts below). Waves of
Chinese deflation will wash up on western shores. We believe this will occur despite the
cranking up of the western and Japanese printing presses into higher and higher gears."

Here's the whole report:
http://www.scribd.com/doc/92216557/Albert-Edwards-May-3

Here are some related articles:
http://business.financialpost.com/2...st-obvious-bubble-in-30-years-says-economist/
http://ftalphaville.ft.com/blog/201...that-a-credit-bubble-this-is-a-credit-bubble/
(you may need to climb over FT's paywall)

Also, I discuss various bond ETFs in my latest National Post column:
http://business.financialpost.com/2012/05/04/bonds-may-be-expensive-but-still-a-portfolio-bulwark/
Best Regards, 
Vikash
www.archerETF.com


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## andrewf (Mar 1, 2010)

Preferred shares are interesting. I'm not quite sure what to make of them. The total return doesn't seem high enough for being just below common stock in the capital structure. The problem is also that preferreds are dominated by banks and insurance companies, making it difficult to properly diversify.


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## Belguy (May 24, 2010)

http://ca.ishares.com/product_info/fund/overview/CPD.htm


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## dubmac (Jan 9, 2011)

archerETF said:


> IMHO, the near to mid terms will rise the most ie. 2 to 5 years.
> Therefore, it would be best, IMHO, to stay out of those and focus instead on shorter and longer ends.
> ie. under 2 years and over, say, 10 yrs.
> .


I did some research into the effects of interest rates on bond funds, and some fund managers avoid buying bonds with mid-term length maturity dates in their collection of bonds. They call the process "bar-belling" if I'm not mistaken, wherein the "weighting" of the fund is distributed in short term and long term maturity dates.


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## Belguy (May 24, 2010)

In the short term at least, my bond component is still serving it's purpose. While equities just had a bad week, my bond fund was up nicely. Hence, my portfolio which includes a 40 per cent bond component and a 10 per cent cash component (HIS) does not experience the same volatility as most portfolios with a heavier equity allocation would experience.

In fact, over the years, the majority of my gains were through my bond investments but how likely can we depend on that going forward?


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## Financial Cents (Jul 22, 2010)

XSB or XBB. Stay away from long bonds, unless it's a small position in your portfolio. JMO.


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## Financial Cents (Jul 22, 2010)

andrewf said:


> Preferred shares are interesting. I'm not quite sure what to make of them. The total return doesn't seem high enough for being just below common stock in the capital structure. The problem is also that preferreds are dominated by banks and insurance companies, making it difficult to properly diversify.


I feel exactly the same andrew. I keep common stocks and bond ETFs.


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## PMREdmonton (Apr 6, 2009)

It depends on your investment objectives versus your risk tolerance.

If you want to avoid capital losses when interest rates rise, short government bonds like XSB or real-return bonds XRB are best.

If you want something that will move less with government interest rates you could try corporate bonds like XCB.

If you want something that will give higher yield you could try junk bonds like XHY which is Cdn dollar hedged. I actually prefer to just directly buy JNK off a US stock exchange. However, these bond funds won't do well in a risk-off environment like a recession. So even though they are bond they are much more equity like in the risks of capital losses. If you can survive a dip without selling you will do okay so long as the business default rate is not high through the crisis. This is a risky asset class but you won't be penalized much in the event that government interest rates increase as they are trading at quite a high yield spread presently.

If you want alternate sources of yield you can consider mortgage REITs in the US but these will be penalized if T-bill rates go up.

You can do very conservative dividend stocks - stick to non-cyclical consumer staples and you'll do better with less risk although many of these will go down 20-30% in a major market event so there is still risk of capital loss.

Canadian REITs are another area for yield although they can go down significantly when interest rates to up too as their interest rates will rise which will squeeze their AFFO (adjusted funds from operations).

The best advice I would give you is not to reach too much for yield in this enviornment. You may be better off just putting the bond part of your portfolio in cash if you are risk adverse. You will not lose much to inflation these days over the next couple of years. A high interest savings account through some of the internet type banks would be another conservative choice. Preferred stock in very high quality companies is also another possibility if you are willing to enter the equity market.


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## johnlewisgrant (Apr 1, 2011)

I'm assuming that 1) inflation and interest rates will remain low longer than we think and 2) equities are at this point exceptionally expensive on a longer term, secular basis .... 

The strategy therefore for me would be to stay out of common shares altogether, stick to preferreds WITH a par value guarantee down the road (as suggested in a previous post), or short-term corporate/or government bond ladders, or for the super conservatives... GIC bond ladders.

I have 25 per cent in some private reits that focus on the apartment sector for yield. Again, I'm assuming, here, that 1) rate increases and what, inevitably, will be the increased cost of carrying large rental units as real estate values drop, can be absorbed by the Reit through commensurate rent increases.

But I consider the Reit thing the "risk on" component of the equation, because it is less liquid than a bond fund. 

Therefore, the final underlying assumption that applies to anything that is riskier than a GIC, is to be prepared to sell or liquidate riskier components of the "portfolio" as conditions warrant. When interest rates DO finally start to rise, all investors will need to change direction and to do so quickly. If you are in a bond fund, you don't want to end up part of that herd.

JG


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