What are we looking for?
Short-term bond funds that may help fixed-income investors in higher interest-rate environments.
Tuesday’s unexpected jump in U.S. inflation shocked markets around the world. The Dow Jones Industrial Average marked its worst one-day sell-off in more than two years, falling 3.9 per cent, and Canada’s S&P/TSX Composite Index followed, falling almost 1.8 per cent. It is now widely expected that the U.S. Federal Reserve, as well as other central banks, will be forced to raise interest rates even higher as they battle seemingly unyielding inflationary pressures.
Although bonds are traditionally less risky than stocks, they are not immune to sharp moves in interest rates. Bonds are inversely related to interest rates, meaning as interest rates rise, bond prices fall. Longer-dated bonds tend to be more sensitive to rising interest rates as uncertainty regarding future interest rates grows with time. In such an environment, investors could benefit from tilting their fixed-income portfolios toward shorter-term or floating-rate bonds. I used Morningstar Direct to screen more than 100 short-term fixed-income mutual funds and exchange-traded funds to find a selection of top-rated strategies to consider. The criteria include:
- Funds are categorized by the Canadian Investment Funds Standards Committee as Canada short-term fixed income. This indicates the fund must invest at least 90 per cent of its fixed-income holdings in fixed-income securities denominated in Canadian dollars and have an average duration of less than 3.5 years. (Duration measures a bond price’s sensitivity to interest-rate moves; the higher the duration, expressed in years, the higher the bond price’s sensitivity.) The fund must also invest primarily in investment-grade securities, limiting high-yield exposure to no more than 40 per cent. Lastly, up to 30 per cent of the fund’s assets may be held in foreign fixed income but the foreign-currency exposure must be hedged into Canadian dollars.
- A Morningstar Quantitative Rating of bronze, silver or gold indicating a forward-looking view of the fund’s ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over a full market cycle.
- A Morningstar Overall Rating (aka “star rating”) of four stars or better. The star rating is an objective look back at a fund’s after-fee, risk-adjusted returns relative to the category to which the fund belongs. Though the measure is backward-looking, Morningstar’s research shows that over time and on aggregate, five-star funds continue to outperform four-star funds, three-star funds etc., after receiving the rating.
What we found
Since the Bank of Canada began raising interest rates in March, 11 of the 15 funds in the accompanying table have outperformed the FTSE Canada Short Term Bond Index. Furthermore, over the past three months, when interest rates have risen more aggressively, 14 of the 15 funds above outperformed. For investors seeking diversification, the list provides a wide range of options, including funds with exposure to floating rate, mortgage, and laddered securities with duration of less than five years. There are nine ETFs and six mutual funds on the list. Only one fund (Lysander-Canso Bond F) has a higher management expense ratio (MER) than the overall category average of 0.76 per cent, suggesting investors have a variety of cost-effective options to choose from.
Note that the MERs listed here are reflective of the fee-based share classes. In the table, these share classes exclude the cost of advice and are held in fee-based accounts where the adviser charges separately for advice.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Danielle LeClair, MFin, is director of manager research, Canada for Morningstar Research Inc.