In the market for income

Here are several types of ETFs to consider in a scenario of rising interest rates:

– Short term-to-maturity bond ETFs generally have lower duration than one- to 10-year laddered bond ETFs, but higher than floating-rate bond ETFs, says Tyler Mordy, president and co-chief investment officer with HAHN Investment Stewards & Co. Inc. in Toronto: “Their performance would likely fall in between the two strategies if rates were to rise.”

A short term-to-maturity bond ETF, he adds, could be used: to lower the overall duration of a client’s fixed-income holdings; to represent the short-term component of a “barbell” strategy; or as a stand-alone position.

– Barbell bond index ETFs invest in bonds of different maturities. For example, 50% of the assets under management in First Asset All Canada Bond Barbell Index ETF is made up of bonds with maturities of 10 years or longer, 25% is in maturities of less than two years and 25% is in floating-rate bonds, says Barry Gordon, president and CEO of First Asset Investment Management Inc.: “[This ETF] gets the benefit of having 50% of the portfolio at the short end of the yield curve and 50% earning higher yields. The 50% in the long end is particularly attractive in a flattening yield curve environment.”

– Floating-rate bond ETFs “generate a floating yield that rises and falls with prevailing interest rates,” says Jaime Purvis, executive vice president, national accounts, with Horizons ETFs Management (Canada) Inc. in Toronto. “Floating-rate bond ETFs have virtually no duration and are largely immune to any rise in interest rates.”

Similar to short term-to-maturity ETFs, Mordy adds, a floating-rate ETF can be employed to lower the overall duration of a client’s fixed-income holdings or as a stand-alone position.

Webster cautions that floating-rate ETFs usually hold bonds that are not investment-grade, which have attractive yields but higher credit risk than investment-grade corporate bonds.

– Laddered bond ETFs hold bonds of different maturities. These ETFs don’t offer as much interest rate protection as some investors assume because about 40% of a typical portfolio has a duration greater than four years, Purvis cautions. That is a relatively long period in a rising interest rate environment. “In a declining interest rate environment,” he adds, “the ETF purchases bonds, often at a premium, which reduces the yield to maturity and drastically increases the impact of after-tax returns for investors.”

Laddered bond ETFs – especially those with one- to 10-year maturities – generally have the highest duration among short-term bond strategies and “would likely perform the worst should rates increase,” Mordy says.

Still, these ETFs have a lower duration than the overall Canadian bond market.

– High-yield bond ETFs. As Pat Chiefalo, managing director and head of iShares with BlackRock Asset Management Canada Ltd., says, “High-yield bonds can also be an interesting play – especially if interest rates are rising because economic conditions are improving – as the higher interest payments made by these bonds can help to offset any fall in prices triggered by rising interest rates.”

– Rate-reset preferred-share ETFs also provide an appealing alternative for clients concerned about interest rate increases. “Preferred shares currently pay a high yield relative to investment-grade Canadian bond products, which helps to compensate for [preferreds’] equity risk,” says Mordy.

However, Chiefalo cautions, although a stock portfolio has much greater potential for capital gains than a bond ETF does, the trade-off is more volatility and downside risk.

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