Have you had your bond jab?

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 Morgane Delledonne, ETF Investment Strategist
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Morgane Delledonne, ETF Investment Strategist

Industry Voice: As the liquidity taps are increasingly turned off and policymakers turn to fiscal measures, BMO Global Asset Management's ETF Investment Strategist, Morgane Delledonne, explains why you should consider immunising your bond portfolio.

Although global corporate bonds are likely to benefit from increasing global demand, while US corporates will also benefit from Trump's tax reform, the economic backdrop remains challenging for fixed income investors.

The rising interest rate environment presents difficulties for bond investors, as bond prices move inversely to interest rates. In this context, investors with a short-term investment horizon generally shift toward shorter maturity bonds in order to reduce the interest rate risk, i.e. duration (‘duration' measures a bond or bond portfolio's sensitivity to movements in interest rates; lower duration means lower sensitivity) of their portfolio. Our 1-3 year Global Corporate Bond ETF is one option for conservative short-duration fixed income exposure. While shorter maturity bonds generally have lower sensitivity to an increase in interest rates, they also generally have lower coupon returns than longer-dated bonds and might not fully compensate for inflation.

For longer-term investors, looking for income and diversification, longer-dated bonds generally provide higher coupon rates as well as ‘term premiums' when yield curves are upward sloping. But, they also have greater capital risk along with greater duration. Overall, duration management is about balancing capital risk and reinvestment risk.

Immunising your bond portfolio against interest rate hikes

Alternatively, investors can use an immunisation strategy to minimise the sensitivity of their bond portfolio to a change in interest rates. Such strategies require a matching of the investment horizon to the average duration of the bond portfolio. In the example below, we illustrate how investors can use bond ETFs to implement this strategy. We have built three hypothetical immunised portfolios using our BMO Barclays Global Corporate Bond ETFs.

Our range of bond ETFs all have the same average credit rating (A-) but differ in the following ways:

 

Weighted Average Coupon (%)

Average Maturity (years)

Duration (years)

1-3 Year

2.2

1.8

1.9

3-7 Year

2.8

4.8

4.4

7-10 Year

3.3

8.4

7.3

 Source: BMO Global Asset Management, as of 29 December 2017.

  Bond ETF Portfolio 1 Bond ETF Portfolio 2 Bond ETF Portfolio 3
BMO Barclays 1-3 Year Global Corporate Bond ETF 65% 84% 74%
BMO Barclays 3-7 Year Global Corporate Bond ETF 35% 0% 18%
BMO Barclays 7-10 Year Global Corporate Bond ETF 0% 16% 8%
Weighted Average Duration (yrs) 3 3 3
Weighted Average Coupon rate 2.4% 2.4% 2.4%
Weighted Average Maturity (yrs) 3 3


Source: BMO Global Asset Management, as of 29 December 2017

 

All the bond ETF portfolios have the same average duration of three years, which matches our hypothetical investment horizon as we estimate the current tightening cycle will terminate in three years. We conducted an analysis where interest rates were the only variable to see how these three portfolios would behave in a rising interest rate environment.

The results of the analysis were as follows:

We found that the Bond ETF Portfolio 2, which has a greater weight on the long-dated Bond ETF than Portfolio 1 and 3, gives the best returns as interest rates increase. In other words, a bond portfolio with greater convexity or curvature (i.e. convex relationship between price and yield) is less affected by interest rates than a bond with less convexity. Bond ETFs portfolios that include longer duration bond ETFs can outperform in a rising interest rate environment as coupon reinvestment returns have the potential to overcompensate for capital losses.

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Bond ETFs can provide some simple relief

We believe that this analysis demonstrates that investors can implement an interest rate immunisation strategy with bond ETFs instead of other securities with various characteristics, which often involves a complicated set of calculations. In addition, to be cost-effective, bond ETFs also provide an additional layer of liquidity allowing investors to quickly adapt to the changing environment.

 

Past performance should not be seen as an indication of future performance.

Capital is at risk and investors may not get back the original amount invested.

Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them.


        Read more from our ETF Investment Strategist here

 

 

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