The Long and Short of Barbell Bond ETFs

Chalk up another one for ETF innovation in Canada. This week, First Asset launched three new bond ETFs that are the first of their kind in North America. And unlike some innovations in the ETF world, this one doesn’t involve any exotic, expensive and opaque derivatives. On the contrary, it uses a simple fixed-income strategy that’s been around for decades.

The new First Asset funds use what’s called a barbell strategy, which involves holding equal amounts of short-term and long-term bonds, with no allocation to intermediate maturities. According to the index methodology, the ETFs hold 50% of their assets in bonds with maturities between one and two years, and 50% in bonds that mature in 10 to 20 years. The short-term bucket includes both regular fixed-coupon bonds and floating-rate notes, which have coupons tied to prevailing rates. (The benefit of floating-rate notes is that they have extremely low interest rate risk: if rates rise, their prices remain more or less stable.)

Best of both worlds

So why would you use a barbell rather than simply holding a broad-based bond index fund? The goal of the strategy is to balance offense and defense: the long-term bonds give you higher yield, while the short-term bonds protect you from rising interest rates. To get more technical, the barbell strategy lowers the portfolio’s duration without sacrificing yield. In other words, it attempts to deliver better risk-adjusted returns.

Duration is an approximate measure of a bond fund’s sensitivity to changes in interest rates: the longer the duration, the greater the loss in the fund’s value if interest rates rise (and the greater the increase if yields fall). If you’re concerned that rates will move higher, you may want to keep your duration short, but that usually means accepting lower yield. However, with the barbell strategy that isn’t the case. Look at how the new First Asset ETFs stack up against their iShares counterparts:

As you can see, the barbell ETFs are almost identical in yield to maturity, similar or lower in average term to maturity, and significantly shorter in duration. (If you’re inclined to get geeky, this means the barbell portfolio has higher convexity.)

The shape of things to come

We all know there is no free lunch in investing, so what is the trade-off? The important idea is that the relative performance of a barbell strategy will depend on how the shape of the yield curve changes.

Recall that the yield curve describes the difference between short-term, intermediate, and long term interest rates. Most of the time, the curve slopes upwards, which means that 20-year bonds have higher yields than 10-year bonds, which have higher yields than five-year bonds, and so on. But rates don’t all move in lockstep: sometimes those at the long end rise or fall while the shorter end remains unchanged, or even moves in the opposite direction. The pattern of these changes will determine whether the barbell outperforms or lags a traditional broad-based strategy:

• The best possible scenario for the barbell would see long-term rates fall and short-term rates rise. In other words, the strategy will thrive when the yield curve flattens.

• The worst environment for the barbell is one where the yield curve steepens: that is, long-term rates rise while short-term rates fall.

• If rates rise or fall in parallel (in other words, short and long-term rates move in the same direction by approximately the same amount), then things get a little more complicated. You may be slightly better off with a conventional bond strategy if rate changes are modest—say, no more than one percentage point. However, if yields spike or plummet across the board, then the barbell can be expected to outperform. Remember, however, that if interest rates move sharply higher, then “outperform” simply means “lose a bit less.”

In the end, a barbell strategy is a bet that interest rates will behave in a specific way. But it’s not a particularly large bet: during all but the most extreme periods, the relative performance of the two strategies should not be dramatically different.

If you do decide to use this strategy, the First Asset ETFs are an ideal way to implement it. Sure, you could build your own barbell using existing ETFs, but it makes no sense to do so. The First Asset funds carry fees of just 0.20% to 0.25%, the same or lower than their competitors, and using a single fund means automatic quarterly rebalancing and fewer trading commissions.