Bonds still have a place in your portfolio

Posted on: May 7, 2012 in: Bond ETF with 0 comments

BMO Long Corporate Bond ETF Ticker: ZLC / TSX

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More investors are shunning bonds and focussing on equities. Bonds are too expensive, they argue. We don’t disagree with them entirely. But for most investors, bonds offer a solid bulwark during times of tentative economic growth and volatile equity markets.

Bond prices have enjoyed a 30 year bull run, ever since the double-digit rates of the early 1980s. Now interest rates are at rock bottom. They will eventually rise, but first, we need to see better growth not just at home but also amongst our trading partners.

For that reason, at archerETF, we believe that any interest rate increase is still some time off, say late this year or early next. The U.S. Federal Reserve has committed to low rates for the next 18 to 24 months. Europe is verging on recession. China is cutting rates to spur growth.

In Canada, economic growth is still tentative. Unemployment is higher than it should be. Canadian manufacturing output is still stop-and-go, hurt by lower demand and a strong dollar. Any rate increase by the Bank of Canada would push the Loonie even higher, hitting manufacturers with a swift one-two punch. For all these reasons, we think Governor Carney will find it difficult to materially raise rates any time soon. That may explain why, as concerned as he is about the ebullient real estate market, he has only barked and not bitten.

Currently in our portfolios, our bond allocation resembles a barbell: half in maturities of two years and less and half in maturities of around ten years, with negligible exposure to mid-term maturities.  Why a barbell and not, say a ladder, with bonds spread evenly across all maturities?

Several reasons: First, when rates do rise, we think the mid-term bonds will be impacted the most. Second, we like yield and with rates as low as they are, one way to get yield is to move further out in maturity to the ten-year mark. This carries a risk with it though. The longer the “duration”, the more the bond price will fall when interest rates rise. (Note that by “duration”, I mean the time to maturity adjusted by the present value of the bond’s coupons.) Our allocation to shorter-term bonds partly offsets that risk.

Another way is to boost yield is to relax credit quality a little by opting for investment grade corporate bonds instead of triple-A government treasuries. Though with most governments heavily indebted and corporations boasting healthy balance sheets, we question whether the relative ratings reflect reality.

To implement our long maturity exposure, we use the iShares iBoxx Investment Grade Corporate Bond ETF (LQD/NY) because we also wanted exposure to the U.S. dollar. It has had an outstanding run, up 12.6% in Canadian dollar terms since we bought it at the start of 2011, with half that coming from yield.

However, for Canadian bond exposure, there are two other ETFs we have also used: the iShares DEX Long Term Bond Index Fund  (XLB /TO) and the BMO Long Corporate Bond ETF (ZLC/TO). For the short end, we use the iShares DEX Short Term Bond Index Fund (XSB/TO)

Over 70% of XLB’s allocation is in federal and provincial government bonds. It has a duration of 13.5 years and a current yield of 3.9%. Its return over the last year has been nearly 18%. However, its heavy government weighting has moved us to the more corporate-friendly ZLC.

ZLC offers better yield by dipping down in credit quality from the triple-A governments. Most of its 55 investment grade issuers are single-A  or triple-B credits. As a result, its current yield is also higher at about 4.7% despite its slightly shorter duration of 12.8. It has returned 16.1% over the last year.

The other advantage of corporate bond ETFs is that they will not rise as much as Canada treasuries, at least in the early phase of rate hikes. As things improve, investors will accept less of a premium for the lower credit issuers.

ZLC should not be a long term hold. It is really about picking up nearly 2 percentage points more of yield while waiting for Mr. Carney to act on rates, at which time, it would be best to switch to shorter duration holdings.

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Chart courtesy of Bloomberg L.P. Click on Chart for Larger Image

archerETF Metrix 07 May 2012
Ticker/Exchange ZLC / TSX
Name BMO Long Corp Bond Index ETF
Categories Debt / Canada / Investment Grade / Long Term (>10 yr)
Total Holdings 55 Issuers
52 Week High 17.61
Recent Price 17.52
52 Week Low 15.69
Avg Daily Volume 17,001 shares
Avg Daily Volume ($) $ 297,863
Total ETF Assets $ 71.8 Million
Allocation to 10 Largest Holdings 45.30%
ETF Annual Fee .34%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 9.15%
Correlation to S&P TSX Comp. -34.34%
Return to Risk Ratio 2.51
Beta to S&P TSX Comp. 0.21
Weighted Avg Duration 12.80
Use of Leverage No
Use of Futures No
6 month Return 6.66%
1 Year Return 16.07%
3 Year Return n/a
Dividend Yield (TTM) 4.66%
SECTOR ALLOCATION
Infrastructure 43.0%
Energy 26.0%
Financials 14.0%
CREDIT ALLOCATION 6.66%
AA 3.7%
A 65.0%
BBB 31.0%

The archerETF Global Tactical Portfolio

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archerETF offers Global Tactical Portfolio Management.

Our outlook is Global: we invest across countries, sectors, commodities and other asset classes to improve returns. Our management is Tactical: we strive to select the right opportunities at the right times in response to changing market conditions to manage and minimize portfolio risk.

Please call us for more information.

 

 

 

 

 

 

 

 

 

 

 

 

 

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© 2012 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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