“Henderson has scored for Canada!”

Paul Henderson’s winning goal in the dying moments of Game 8—a defining moment for Canadian hockey, if not the country—is the only thing most people remember about the 1972 series between Team Canada and the Soviets.

Fixed-income strategies suffer from a similar myopia. Bond prices fall when interest rates go up. What more do we need to know? Plenty.

Most advisors spend more time with stocks than bonds, because equities seem more dynamic, more interesting and in most cases, if working on commission, more lucrative. So, forgetting how to use bonds is explainable.

These days, low interest rates pose a threat to capital in two ways:

• not providing enough coupon income to grow it;
• eroding it when rates rise.

Bonds in balanced portfolios traditionally provide a stable component, lowering overall volatility through diversification.

We’ve discussed laddered bond portfolios before and how ETFs give investors the choice of pre-constructed or do-it-yourself ladders using target-maturity ETFs. Ladders mitigate some volatility from both rising and falling interest rates by rolling forward in a stepped fashion.

So, like Henderson’s 1972 goal, if you remember only one thing about bonds in retail clients’ portfolios, use a ladder. It’s not always a perfect solution, but it’s usually sufficient.

Do the research

Sometimes, it pays to do more research.

One of Team Canada’s problems in ’72 was underestimating the Soviets. Before the series, two scouts declared goalie Vladislav Tretiak a pushover after he allowed 8 goals. Problem was, they didn’t bother to find out that Tretiak had been at his stag party the night before. (They were Maple Leafs scouts.)

Buying quality bonds can make us overconfident. If interest rates double from current levels, the DEX Long Term Bond Index can drop 30%. Some bonds offer great credit quality, but you could find yourself in a hole.

Turns out, 86.6% of bond returns are explained by the level of interest rates (the coupon) plus the overall shift in the yield curve according to Frank J. Jones, professor of accounting and finance at San Jose State University.

If you want to protect against a significant upward shift, a money-market fund is your best bet. Currently diminutive short-term rates may justify trying other strategies.

Curve flattening

Central banks raise short-term rates when they feel a strengthening economy will create inflationary pressure. Curiously, the Bank of Canada warns about inflated housing prices and personal debt while sticking to a low-interest-rate policy. They’re concerned about economic fragility and don’t want to crush consumer confidence by raising rates now.

Nevertheless, if short-term (e.g. two-year) interest rates rise faster than long-term interest rates (e.g. 10-year)—something that usually occurs late in economic cycles, rather than earlier—the difference between short- and long-term rates narrows.

This is referred to as a flattening of the yield curve (see “Corporate yield curve,” this page).

Consider a curve-flattening trade. Sell short a two-year, like RBC Target 2014 Corporate Bond ETF (RQB) with a yield to maturity (YTM) of about 1.79%, or a three-year, like RBC Target 2015 Corporate Bond ETF (RQC) or BMO 2015 Corporate Bond Target Maturity ETF (ZXB).

And, buy long a 10-year, such as RBC Target 2021 Corporate Bond ETF (RQI) YTM 3.11% or BMO 2025 Corporate Bond Target Maturity ETF (ZXD) 3.51%. The absolute level of rates matters less than the difference between short and long rates.

Long-only flattening trade

A long-only approach is to use a barbell-like strategy: buy long a two-year and a 10-year-plus bond ETF, or use one of the prepackaged barbells (see “Table 1: Barbell options,” below). The gains at the long end should offset the losses at the short end, but if the entire yield curve shifts upwards, overall gains will be diminished.

Table 1: Barbell Options

Making the team stronger

Barbells are useful but treacherous. A steepening yield curve (when long-term bond rates rise faster than short-term bond rates) can bite you. You need to mitigate your risk.

For instance, scared they might lose to the Soviets, Vic Hadfield, Gilbert Perreault, Richard Martin and Jocelyn Guevremont quit Team Canada rather than risk humiliation.

Luckily, strong performances by previously unheralded players like Ron Ellis, Bobby Clarke, Serge Savard, Paul Henderson and others made up the difference, leading to a Team Canada win.

Similarly, a barbell can be tweaked with long and short bullets if you think the shape of the yield curve will change a certain way. We will explore these issues next month.

Special thanks to Edward Orfao, CFA for his bond expertise and Dr. Jim Sugiyama for his hockey knowledge.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.