Ask MoneySense: Bond ETFs

What is going to happen to bond ETFs like the iShares DEX Universe Bond Index Fund (XBB) when interest rates rise?

—André Paré, Rimouski, Que.

When interest rates rise, bond ETFs will be hit the same way a bond would. The longer the duration (a measure of the bond’s sensitivity to interest rates, measured in years) the larger the potential risk. “XBB is really going to get hit hard if interest rates rise,” says Fred Kirby, a certified financial planner in Armstrong, B.C. But how big will that hit be? If all rates went up by 100 basis points annually, it would be reasonable to expect a broad-based bond index fund (with a duration of about seven years) to lose about 3% over one year and about 5% over three years. Remember, the interest payments will offset some of the price declines. And rising interest rates usually reflect a booming economy, so bond losses could be offset by gains on the equity side of the portfolio.

Kirby is a believer in keeping duration under five years, and he says it makes even more sense in this market. “I’d be looking to move into shorter-duration bonds,” he says, pointing to ETFs like the iShares 1-5 Year Laddered Corporate Bond (CBO) or the iShares 1-5 Year Laddered Government Bond (CLF). Their duration is about 2.5 years, which means they’ll suffer less if rates rise.

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