Play defence with short-term bonds

Protect yourself from a market pullback—and rising interest rates – by investing in short duration bonds.

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If, like numerous investment experts, you believe a stock market correction is on the horizon, now’s the time to start protecting your portfolio from a downturn. In the June 13 issue of Canadian Business, I wrote about how investors can play defense with their equity allocation. But it’s not just stocks you need to think about.

In a defensive market you’ll also want to own bonds. Despite all the negative chatter about low-paying fixed income these days, bonds are still safer than stocks and it pays an income, a key part of a defensive portfolio. “Bonds still make sense,” says Paul Taylor chief investment officer with BMO Harris Private Banking.

The trick is holding the right bonds in this environment. Taylor suggests keeping them short term, between three to five years, and buy high-quality corporates. Short-term bonds protect against long-term rising interest rates, while highly rated securities—AA or higher—have less risk of default.

Consider buying a laddered bond mutual fund or ETF, says Taylor, which holds fixed income instruments with durations between one and five years. Every year some of the bonds come due and that money is reinvested into new five-year bonds. “It’s a way of ensuring that one is not overly exposed to investment risk,” says Taylor. “You always have money coming due and redeployed.”

One investment choice is the Claymore 1- to 5-Year Laddered Corporate Bond ETF (TSX: CBO). Dan Bortolotti, an ETF expert who writes MoneySense.ca’s Canadian Couch Potato blog, owns this fund in his own portfolio. It’s a favourite, he says, because it spreads around interest rate risk. It also has a cash yield of 4.6%.

The ETF, and others like it, holds 25 bonds, five of which mature every year. The majority of CBO’s holdings are banks—TD is its largest holding at 4.63%. The average duration of the fund is 2.48 years, and management fees are 0.25%.

If you’d rather buy bonds yourself, Taylor says to follow the same game plan as you would with equities. Look for large, stable companies in sectors such as health care or consumer staples that sell goods people need regardless of economic conditions. “Seek out well-capitalized companies in non-cyclical sectors,” he says.

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