Bonds and bond ETFs: related but different

Posted on: July 4, 2011 in: Economic Growth, Fixed Income, Inflation with 0 comments

iShares CDN DEX Short Term Bond ( Ticker: XSB )

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A version of this post appeared in the National Post on Saturday, July 2, 2011.

Exchange-traded funds holding bonds offer cheap, efficient access to bond markets that, for individual investors, can be illiquid and expensive to trade. No surprise then that they are among the most favored of all ETFs in Canada. However, bond ETFs are not bonds. They behave differently and that has implications – good and bad – for investors.

Three of Canada’s biggest ETFs – by assets under management – hold bonds. All three are from the iShares family: the DEX Short Term Bond Index Fund (XSB-TO) with nearly $2 billion in assets; the DEX Universe Bond Index Fund (XBB-TO) with about $1.5 billion and the DEX All Corporate Bond Index Fund (XCB-TO) with about $1.3 billion.

The first difference between single bonds and bond ETFs is credit risk, better known these days as “Sino-Forest”. The typical bond ETF has hundreds of holdings. XCB, for example, has 148 individual issuers, with the big five banks accounting for about 25% of its allocation. XBB and XSB, with government bond allocations of more than 60%, offer even better credit quality, though at the expense of yield.

Sino-Forest aside, generally, when you buy a quality bond you can reasonably expect to get your principal back plus interest, as long as you hold it to maturity. While you hold it, the bond gradually ages and, every day, its price moves in response to changing interest rates. But, as an individual investor holding to maturity, you can ignore all that.

Not so on a bond ETF. You cannot hold a bond ETF to maturity because they do not age (I’m envious!). XSB is always about 2½ years from maturity, XCB and XBB are about 5 and 6 years away. The ETF manager regularly refreshes the portfolio by selling bonds as their time to maturity moves out of the target range. As they refresh, the ETF price moves with interest rates, rising as they fall and vice versa.

On the flipside, unlike a bond’s locked in coupon yield, the yield on the bond ETF moves roughly in step with market interest rates. Your expectation of where interest rates are going will determine which bond or bond ETF you buy.

After Wednesday’s 3.7% inflation reading, the chances are a rate hike will come sooner rather than later. However, at archerETF, we believe that a hike will impact prices of mid-term – that is 5 to 8 year – bonds more than it will shorter and much longer dated bonds. In other words, the yield curve will flatten out, with short and mid-term rates rising more than longer-term rates.

Interest rate changes affect bonds with longer term more. Another metric for evaluating bonds is something called duration: it is simply the term adjusted by the present value of the bond’s coupons. A bond with 10 years to maturity paying a 5% coupon would have a duration of about 8 years. An interest rate increase of 1 percentage point would cause the price of that 10-year bond to fall about 7.5%. An equivalent 5-year bond would fall about 4.25% and a 2-year by about 1.86%.

Based on our view, our bias is to hold short-term and long-term maturities so we hold XSB but avoid the mid-term XBB and XCB for now. For the long-term exposure, we use other instruments.

If the short-term rate rises significantly, as we believe, the shorter duration will lessen the price impact on the ETF. As for the longer maturities, though they have a longer duration, we expect their smaller increase in rates will keep prices from falling too much. In the meantime, we will benefit from their higher yield.

XSB is well diversified and highly liquid. The only complaint is its fee: at 0.27%, it seems a tad rich for an indexed bond ETF but still much less than the mutual fund equivalents. Even then, I hope, as more ETF competitors arrive in Canada, we’ll see this price come down.

 

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archerETF Metrix XSB
Category Fixed Income
Benchmark DEX Short Term Bond Index
Total Holdings 256/100 issuers
52 Week High $29.08
Recent Price $28.93
52 Week Low $27.91
Avg Daily Volume 0.07 Million Shrs
Avg Daily Volume ($) $2.02 Million
Total Market Cap $1.99 Billion
ETF Annual Fee 0.27%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 2.6%
Correlation to S&P 500 -48.3%
Return to Risk Ratio 10.09
Use of Leverage No
Use of Futures No
6 month Return 1.94%
1 Year Return 3.28%
2 Year Return 7.23%
3 Year Return 15.40%
Dividend Yield (TTM) 3.32%

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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© 2011 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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