How to pick the right bond ETFs for rising interest rates

Q. What bond ETFs would be appropriate when interest rates in Canada are likely to rise? – Jennifer

The fear of rising rates has been a persistent theme in investing for close to a decade now. The concern is understandable: when interest rates rise, the value of bonds—including bond funds and ETFs—fall in value. We saw such a slide in bond prices in late 2016, and then again this past summer when the Bank of Canada hiked its key interest rate twice.

Bonds are supposed to provide the stability in a balanced portfolio, so no one likes to see them lose money. And with many commentators continuing to forecast rising rates, investors are looking to sidestep those losses. But the last several years have made it clear that trying to predict rate changes is futile. A better strategy is to simply understand how bond ETFs differ in their risks and then decide on a long-term holding that is appropriate for you, whether interest rates rise, fall, or remain more or less unchanged.

The most important idea is that, all other things being equal, short-term bonds are less sensitive to interest rate movements than bonds with longer maturities. Consider the iShares Core Canadian Universe Bond Index ETF (XBB), which holds a portfolio of bonds with an average maturity of about 10 years. During the 12 months ending September 30, 2017, this ETF lost 3.21%. Compare that to the iShares Core Canadian Short Term Bond Index ETF (XSB), which has an average maturity of less than three years: it lost less than 1% over the same period. Meanwhile, the iShares Core Canadian Long Term Bond Index ETF (XLB) plummeted more than 6%.

Although we’ve only looked at one 12-month period here, the pattern is typical: during any period when interest rates rise, short-term bonds will be much less affected. Long-term bonds will generally fall much more sharply.

Of course, the opposite is also true: when interest rates fall, short-term bonds will get a modest bump, but long-term bonds can soar. When rates fell in 2014, for example, XLB enjoyed a return over 17%.

Over the long-term, you should expect short-term bonds to deliver lower returns, but far more stability. Long-term bonds are likely to outperform but at the cost of much greater volatility.

In my opinion, long-term bonds are too volatile for average investors: they’re more suitable for institutional investors, such as pension funds. If you’re a long-term investor who won’t need to tap your portfolio for 10 years or so, a broad-market bond ETF is usually a better core holding. If you really don’t like volatility in your bond holdings—and that’s perfectly understandable—a short-term bond ETF would be more appropriate.

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