Bond funds and rate risk

You might have noticed that the shorter-term returns of the broader index-tracking bond ETFs, such as the iShares Core Canadian Universe Bond Index ETF (TSX: XBB), have been sliding recently. Is it time to switch out of passive, index-tracking bond funds, and look for something more actively managed?

It’s true that bond prices have been declining over the past year. In fact, the iShares Core Canadian Universe Bond Index ETF, 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.

What rate risk means

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, good, bad, or indifferent.

However, in actively managed bond portfolios, such as those you’ll find in fixed-income mutual funds or private actively-managed pools, 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.

Bond ETFs with an active management component are also being introduced to the market, but these generally have short track records of only a year or two, which most manager don’t consider to be enough to form an informed opinion on about performance. Bond ETFs and mutual funds 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, it’s always best to check in with your advisor first.

Courtesy Fundata Canada Inc. © 2017. Robyn Thompson, CFP, CIM, FCSI, is president of Castlemark Wealth Management. This article is not intended as personalized advice. Securities mentioned are not guaranteed and carry risk of loss. No promise of performance is made or implied.