Investors, this will sting.
Doctors and dentists sometimes try to keep patients calm by telling them half-truths like, "this may pinch a bit," or "you may feel some discomfort." But I'm going to give it to you straight: When interest rates rise, it's going to hurt your bond holdings.
People I've corresponded with recently seem to have an impressive level of awareness about the risks posed to bonds by rising rates. They understand the need to keep holding bonds as rates rise because they're essential to proper diversification, but they're still worried about how much pain there will be.
The measure for sensitivity to interest rate changes is called duration. Use it to get an indication of how much your bond holdings might decline in price when rates move higher.
Yes, this is mildly complex stuff. But if you stick with me here, you'll have a way to stress test your bond holdings and thereby make yourself a more prepared investor.
Duration refers to the number of years it takes for a bond to repay its cost through twice-a-year interest payments and return of your investment at maturity. A bond's duration is shorter than its term to maturity, which means how much time is left until it's redeemed by the issuer. But an important rule applies to both term and duration: Shorter is safer when interest rates are rising.
Now, let's analyze your portfolio. If you own:
Individual bonds: Check out the duration calculators listed in the sidebar to this column.
Bond funds: You may be able to find the average duration for the portfolio in the monthly or quarterly profiles that fund companies make available on their websites; if not, follow the instructions in the sidebar.
Bond ETFs: Check the online fund profiles or fact sheets available on exchange-traded fund company websites.
However many years of duration a portfolio of bonds has on average, that's how many percentage points it will fall in price if rates climb by a single percentage point (the opposite applies, too). The $7.3-billion RBC Bond Fund publishes a duration number in its monthly fund profiles, so let's use it as a real-life example of how to measure a fund's sensitivity to changing interest rates. As of the end of February, the duration for the portfolio was 6.2 years. This means that if rates - we're talking bond yields here - rise by one percentage point, the fund as it stands now would lose 6.2 points. That's a $620 loss on $10,000, which would sting.
Note: We're talking hypotheticals here. Fund managers who believe rates are going to move steadily higher can adjust their holdings to shorten the duration and thereby make the portfolio more conservative.
Fund managers have to juggle priorities in a mainstream bond fund, though. While clients expect a degree of safety from a bond fund, they also want a decent yield. Unfortunately, yields improve in only two ways. Longer durations, and poorer quality bonds.
The lowest level of vulnerability to rising rates comes from short-term bond funds. Check out the BMO Short Federal Bond Index ETF (ZFS-TSX), which holds Government of Canada bonds maturing in no more than five years. Its duration is 2.4 years, which indicates a loss of 2.4 percentage points if rates rise by a point.
The yield on this ETF is a puny 1.9 per cent, much less than the 3.5 per cent you could get from the BMO Long Federal Bond Index ETF (ZFL). But the duration for the long bond ETF is 12.7 years, which suggests a nasty hit if rates shoot higher.
Between the short- and long-term bond funds is a middle range of diversified bond mutual funds such as RBC Bond and ETFs like BMO Aggregate Bond Index ETF (ZAG). The duration for ZAG is 6.1 years, while the yield is about 3 per cent.
Once you know and understand the duration of your bond holdings, you have some decisions to make:
Should you get more conservative - shorten your duration - to prevent price declines in your bond holdings?
Should you consider guaranteed investment certificates as a bond substitute, on the understanding that GICs can offer higher yields and never fluctuate in price like bonds?
Should you do nothing, on the understanding that you're a long-term investor who realizes bonds keep paying interest with no regard to the rate environment (bond income may offset declines in bond prices), and also that bonds will rise in price when interest rates eventually start to decline?
Whatever you do with your bonds, knowing about duration will make it a more informed decision.
HOW TO CHECK UP ON YOUR BOND FUNDS
Here are some resources for checking the duration of bond funds and ETFs (duration is a measure of sensitivity to interest rate changes).
If you own individual bonds, try these online duration calculators:
If you own bond mutual funds, try:
the latest fund profiles on your fund company's website
the fund comparison tool on the Morningstar.ca website at http://bit.ly/2LtHdV
If you own bond ETFs, try the fund profiles on your ETF company's website.
Here's how durations of some popular bond funds and ETFs stack up:
Cdn. Fixed Income Mutual Funds
|Fund||Duration in Years|
|TD Canadian Bond||5.6|
|Investors Government Bond C||6.1|
Canadian Bond ETFs
|Fund||Duration in Years|
|iShares DEX Universe Bond Index||6.1|
|iShares DEX All Corp. Bond Index||5.5|
|iShares DEX All Gov. Bond Index||6.3|
Short-Term Bond Funds
|TD Short-Term Bond||2.3|
|RBC Cdn Short-Term Income||2.5|
|CIBC Cdn Short Term Bond Index||2.5|
Short-Term Bond ETFs
|Fund||Duration in Years|
|iShares DEX Short Trm Bnd Index||2.6|
|Claymore 1-5 Yr. Laddered Corp.||2.6|
|Claymore 1-5 Yr. Laddered Gov.||2.6|
© 2007 The Globe and Mail. All rights reserved.
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