In a past blog, we discussed the many intricacies of the variable maturity approach to fixed income investing. Recall that the main idea is to extend the maturities of your bond portfolio when yield curves steepen and reduce the maturities when yield curves flatten. In this blog, we will look at how the average investor could implement a similar strategy with their own portfolio, using commonly traded ETFs.
For this example, we will use the iShares DEX Short Term Bond Index Fund (XSB) as our default ETF, and the iShares DEX Universe Bond Index Fund (XBB) as our replacement ETF. Our assumption will be that XSB will be held continuously unless we can receive at least 0.15% of additional expected yield per year for taking on each additional year of term risk (this could always be adjusted, depending on your risk appetite).
Using data that is readily available on the iShares site, we can determine that XBB has an additional 6.85 years of term risk relative to XSB, and this is compensated for with an additional 0.65% of annual expected yield (after MER). Since we require at least 1.03% of additional yield per year (6.85 years × 0.15%), we will continue to hold XSB and no changes will be made to our fixed income portfolio.
Variable Maturity Simulation
Using historical ETF data kindly provided by Rahim Surani and Marie Amilcar of BlackRock Canada, we can create a simulation of this strategy to gain a better understanding of the process.
In our analysis, quarterly yield differences (after MER) and maturity differences between XSB and XBB were examined to determine when a switch from one to the other would have made sense (i.e. would have given us an additional 0.15% of annual expected yield for each additional year of term risk). Interestingly, the only time period when XSB was swapped for XBB was between April 2009 and June 2010.
In the table above, we notice that the variable maturity simulation resulted in higher returns than XSB, as well as higher risk-adjusted returns than both XSB and XBB.
Although there are many other factors to consider when deciding on any investment strategy (your willingness to take risk would be at the top of the list), the variable maturity approach to fixed income investing is based on the sound investment philosophy that investors should take risks that they are expected to be compensated for in the long term.