Adding XSB to your fixed income quiver

The choice of ETF’s in the fixed income arena is continually expanding as we face uncertainty about markets, the economy and interest rates. One thing for sure is that if interest rates rise, bond prices will fall and your fixed income portfolio will drop. The question is how will you manage this supposedly secure portion of your portfolio? There are a number of choices - you can adjust duration, shift sectors, ladder your portfolio or trade it. Let’s explore XSB.

The iShares CDN short bond index (XSB) replicates the performance of the DEX Short Term Bond Index and consists of a range of investment grade federal, provincial, municipal and corporate bonds with a term to maturity between one and five years. There are 182 holdings with a weighted average term to maturity of 2.89 years, duration of 2.7 years, a weighted average coupon of 4.25% and a weighted average yield to maturity of 2.24%. This is as of March 12, 2010.

Over the last year XSB has traded anywhere from about $29 (support) to $29.58 (resistance). Although 2% volatility is not a lot to work with, there appears to be a range it is trading within and something to work with from a technical perspective as we move into a changing interest rate and economic environment. Over the last year, the current price has traded as many times below the 50-day moving average as above. Today, the current price is $29.21which is below the 50-day moving average ($29.28). Both MACD and relative strength indicators are bearish.

Looking forward, we have some arguments that may warrant a closer look at using XSB as a vehicle to trade. The summer is typically a period of seasonal strength for bondholders, as investors sometimes sell in May and go away for the summer. So far XSB has shown some signs of negative correlation to the TSX. Secondly, there is talk of interest rates increasing as early as June or July. You will want to hold shorter-term bonds. XSB has duration of 2.7 years, which means if interest rates rise by 1%, the price of the bond pool will fall by 2.7%. Thirdly, fixed income will be difficult to make money in as interest rates rise. Pimco, the world’s largest bond-fund manager argues that you need to be active. They filed with the Securities and Exchange Commission to roll out six new bond ETF’s. This is an indication to me that they want to offer investors more choice and flexibility in fixed income to address the challenges of managing fixed income portfolios in a rising interest rate environment.

Using XSB can be a double-edged sword. It is an open-ended fund with no fixed maturity like an individual bond so the price can go down for an extended period when interest rates rise. When an individual bond matures you receive your principal plus you have received the coupon while you owned the bond. The positive side of owning XSB is that it is liquid so you will have no problem buying or selling it.