This story was originally published in October 2012.

This is Part 1 of a series.

As a freshman summer student on the U.S. securities desk of a major insurance company, the bond team amazed me.

Fixed-income portfolio managers traded with sustained aggression. Michael Bloomberg was still on the Salomon Brothers trading floor so having instantaneous quotes at every trading desk on the planet was still a distant dream.

These bond managers instinctively valued quality, term, duration and coupon spreads between sectors and regularly traded between dealers. Global fixed-income markets today, by contrast, are highly integrated. Information is available to everyone, virtually in real time. Opportunities to exploit inefficiencies still exist, but spreads are generally tighter and tradeable mis-pricings more rare.

Institutional investors have long known that adding value to bond indices is difficult. Mercer’s Median Pooled Canadian Fixed Income (Universe) Fund, for the five years ending June 30, 2012 and before fees, returned an annualized total weighted return of 7.23% versus the 5th percentile fund just 49 basis points higher at 7.69%. This advantage narrows further for longer time periods, making passive approaches to fixed income investing attractive. With more fixed income ETF offerings, retail investors can follow this lead.

Comparative costs

Broad-based bond Funds Management expenses
Bond Mutual Fund (Median | Bank funds) 1.98% | 1.15%
iShares DEX Universe Bond Index Fund (XBB) 0.30%
BMO Aggregate Bond Index (ZAG) 0.32%
Vanguard Canadian Aggregate Bond Index (VAB) 0.20%

When considering costs in building better bond portfolios, ETFs make logical choices. Fees for bond-based mutual funds are high (see table). And with Government of Canada long-term benchmark bond yields around 2.32%, owning only physical bonds or ETFs makes sense.

Comparative costs

What if interest rates move higher from today’s central-bank-induced low rate environment? If rates double from current levels — a parallel upward shift in the yield curve of about 2.34% to 4.68% — the DEX Universe Bond Index would fall about 16%. Funds tracking the DEX Long Term Bond Index, for a similar 2.34% rate increase, would lose over 30%. Yield seekers would be happy but keeping their principal whole during this move is the trick.

Product expansion

Not long ago, Canadian ETF investors had few fixed-income choices. iShares DEX Universe Bond Index (XBB) and Short Term Bond Index (XSB) were primary vehicles, and continue to be. But weak global economies, volatile stock markets and low interest rates have created a demand for protection and yield, and ETF sponsors responded with new products. It’s now possible to implement more sophisticated fixed-income strategies, the popularity of passive strategies notwithstanding.

Ladders

Buying bonds with staggered maturities, or laddering, is a straightforward way to manage a fixed-income portfolio. Laddering eliminates guessing about interest rate changes because maturing bonds are rolled forward to capture current rates.

Laddering eliminates guessing

Pre-Constructed Ladder ETFs Management expenses
Bond Mutual Fund (Median | Bank funds) 1.98% | 1.15%
iShares 1-5 year Laddered Corporate Bond Index (CBO) 0.25%
iShares 1-5 year Laddered Government Bond Index (CLF) 0.15%
iShares 1-10 year Laddered Corporate Bond Index (CBH) 0.25%
iShares 1-10 year Laddered Government Bond Index (CLG) 0.15%
Powershares 1-5 year Laddered Investment Grade (PSB) 0.25%

Two ways to ladder with Canadian-traded ETFs are pre-constructed and do-it-yourself. Among the pre-constructed ladders, you may choose between a shorter 1-5 year or longer 1-10 year ladder. If defensive, pick the shorter one. Given the strengthened condition of balance sheets, I currently prefer corporates over governments.

For clients with larger portfolios, consider building a ladder using individual maturity ETFs.

For clients with large portfolios

Do-It-Yourself Ladder ETFs Management fee
BMO 2013 Corporate Bond Target Maturity (ZXA) 0.23%
RBC Target 2013 Corporate Bond (RQA) 0.30%
RBC Target 2014 Corporate Bond (RQB) 0.30%
BMO 2015 Corporate Bond Target Maturity (ZXB) 0.30%
RBC Target 2015 Corporate Bond (RQC) 0.30%
RBC Target 2016 Corporate Bond (RQD) 0.30%
RBC Target 2017 Corporate Bond (RQE) 0.30%
RBC Target 2018 Corporate Bond (RQF) 0.30%
RBC Target 2019 Corporate Bond (RQG) 0.30%
BMO 2020 Corporate Bond Target Maturity (ZXC) 0.30%
RBC Target 2020 Corporate Bond (RQH) 0.30%
BMO 2025 Corporate Bond Target Maturity (ZXD) 0.30%

Bullets, barbells and butterflies

Ladders won’t protect against big changes in interest rates but do provide a systematic way to smooth them out. More active strategies require a specific view about the movement and shape of the yield curve:

Bullets: Target maturity ETFs extend their usefulness beyond components in ladders to bullets. Picking a specific maturity or tight range is useful in matching an investor’s liquidity needs and reducing exposure to yield curve changes around the targeted maturity.

Barbells: Holding short- and long-term maturities like 2-year and 20-year bonds at the same time softens the exposure to sharp changes in long-term rates. First Asset has prepackaged barbells for DEX Government (GXF), DEX Corporate (KXF), and DEX All Canada (AXF) Barbell Indexes that use 1-2 year and 10-20 year bonds.

Butterflies: Used in conjunction with long or short positions in mid-term bond positions, barbells can be used to exploit changes in the curvature of the yield curve. Strategies exploiting these shifts are called butterflies with long-term and short-term bonds being the wings.

Three basic components explain bond returns: the level of interest rates, the slope of the yield curve and its curvature. The level of rates and parallel changes in the yield curve account for about 86.6% of a bond portfolio’s return and should be the focus of managers’ attentions.

The slope (or twists) of the curve accounts for 9.8% of the return, and the curvature (or convexity) accounts for approximately 3.6% of the return (so said Frank J. Jones in 1991).

We’ll explore these strategies and how to construct and use them in various rate structure scenarios using ETFs in future columns.