Insulate clients from rising rates

While we don’t know when rates will rise, we know they will. And it’s likely that increases won’t be evenly distributed.

Analysts expect Mark Carney and Janet Yellen to be the first to introduce hikes. Stephen Poloz has said he doesn’t feel obligated to raise rates when the U.S. does and, more recently, he indicated the Canadian economy is showing broadening recovery.

For investors, this could mean more uncertainty and increased volatility as divergent interest rate policies drive varied impact on bond prices in each region. The combination of volatility and rising rates could be especially challenging, not just because we’ve become used to historically low yields, but also because current fixed-income portfolios may be highly susceptible to rising rates.

Read: Bank of Canada holds rate steady, for now

To understand why, consider the current relationship between duration and yield in the bond market. Accommodative central bank policies have suppressed yields; meanwhile, duration (a measure of the sensitivity of a bond’s price to rate changes) has been going up. This has been driven by governments issuing bonds with longer-dated maturities in an effort to lock in low interest rates. This has lengthened the duration of Canada’s aggregate bond market.

Duration and yield can be instructive in gauging interest rate risk. If the spread between duration (in years) and yield (in percentage points) is minimal—say, a duration of seven years and yield of 6%—then there’s minimal risk from an interest rate hike. (We’re not accounting for credit risk.) But when durations are far higher than yields, even a small interest rate increase could wipe out a year’s worth of income or more, as Figure 1 illustrates.

Read: Near Fed majority pushes for rate hike

In the Canadian bond universe, average yields are in the 2% to 3% range, while average duration is above seven years. That’s a historically high differential, and presents a significant risk to clients’ wealth when interest rates rise.

In addition, many have been increasing exposure to high-yield securities to balance off some of the lost yield of the past number of years. But, excessive exposure would elevate credit risk.

So, with rate hikes on the horizon, it makes sense for clients to address duration-yield discrepancies in their portfolios. ETFs allow them to respond to market conditions in ways traditional bonds don’t: clients can more easily adjust their exposures, implement tactical allocations and gain exposure to markets that might otherwise be difficult to access.

Read: Bond yields won’t rise much in 2015

Of the $3.2 billion in fixed-income ETF inflows in Canada in 2014, nearly $2 billion went into shorter-duration funds. That’s the largest inflow of any fund class—higher even than U.S. equity ETFs, which had inflows of $1.2 billion as of Nov. 2014. We’ve also seen inflows into high-yield fixed-income ETFs ($407 million, as of Nov. 2014) and outflows of $175 million from long-term fixed income.

In Figure 2, we suggest a model portfolio that could address the duration-yield mismatch while preserving a balanced approach.

From a risk perspective, the key is narrowing the gap between yield and duration to prepare portfolios for what could be significant shocks.

Portfolio Characteristics
Weighted Average Duration (years)			6.31
Weighted Average Yield to Maturity (%)			2.37
Weighted Average Coupon			3.92
Sector Breakdown
Government	29.67%	Corporate	70.33%
Rating Breakdown
AAA	19.76%	BBB	15.94%
AA	31.57%	BB	0.00%
A	30.82%	B	0.00%
		CCC	0.00%

Portfolio Characteristics
Weighted Average Duration (years)			3.09
Weighted Average Yield to Maturity (%)			2.46
Weighted Average Coupon			4.43
Sector Breakdown
Government	46.03%	Corporate	53.98%
Rating Breakdown
AAA	24.04%	BBB	7.83%
AA	24.82%	BB	9.10%
A	22.14%	B	7.89%
		CCC	2.92%

As of Oct. 31, 2014. Data shown is for informational purposes only, does not represent an actual account, and is not the result of any actual trading. This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. This information is subject to change. Actual investment outcomes may vary.

by Pat Chiefalo, managing director and head of iShares Canadian Product at BlackRock.