Bond yields have dropped recently, and as a result, bond values have risen significantly. For example, the passive iShares Canadian Universe Bond Index ETF has risen 3.3% since the beginning of the year, and is up 4.9% over the past 12 months. Some investors have become concerned about what might happen if and when rates start rising again. To mitigate interest rate risk, is now the time to switch to an actively-managed bond mutual fund?
The key principle of bond pricing is that bond prices rise and fall in order to keep a bond’s yield (which is different from the coupon rate) competitive with current rates.
Bond yields plunge to new lows
Unit values of bond funds fluctuate to some degree with the level of prevailing rates. Yields have been falling in recent weeks following the Brexit vote in the U.K., as traders shift large pools of money away from equities into the perceived safety of government Treasury bonds. The sudden heavy demand raises bond prices, but pushes down yields. This has been most noticeable in Europe, where yields on the German government 10-year bond have turned negative. Some Japanese government bonds have traded with a negative yield for quite some time. Canadian and U.S. government bond yields have fallen considerably as well, though not to negative levels.
Most exchange-traded bond funds are not actively managed, and will track an underlying index. In the case of the iShares Canadian Universe Bond Index ETF (TSX: XBB), the underlying index is the FTSE/TMX Canada Universe Bond Index. The index itself is rebalanced daily and constituents are added or deleted as they reach maturity or fall below the mandated investment-grade rating. So in a way, even the index is “actively managed,” but not in the way bond mutual funds are.
Bond mutual funds actively managed
Most bond mutual funds are actively managed. Fund managers attempt to adjust the fund’s portfolio holdings to mitigate interest rate risk in an effort to maintain the fund’s mandated objective as stated in its prospectus.
Depending on the type of fund and the degree to which assets may be allocated, managers will adjust the portfolio by, among other things, asset type (e.g., government bonds, including federal, provincial, municipal, and corporate bonds), by quality or credit risk (ranging from investment-grade to junk), by term (e.g., bonds with longer terms to maturity tend to be more price-volatile than shorter-term bonds), and by duration (note that “duration” is not the same as “term” – it is a measure of the sensitivity of a bond’s price to the level of interest rates, and is a complex calculation using yield, coupon, present value, maturity, and any call features). In this way, managers aim to smooth out excessive fluctuations in unit values resulting from interest rate risk.
Allocation is more important
As to whether now is a good time or not a good time to switch to a bond mutual fund from your ETF is really the wrong question to be asking. Rather, you should be looking at your overall asset allocation profile and the degree to which fixed-income-type of securities are represented in your portfolio. A conservative balanced portfolio, for example, typically is weighted slightly more heavily to “safety/income” assets, which may or may not include a bond or bond fund component.
If you’re concerned about the outlook, talk to your financial advisor. Remember, too, that when you make changes to your investment fund holdings, you may also be changing your cost structure, as the MERs on ETFs are generally lower than those on actively-managed mutual funds.