A bull mar­ket for bonds in the ETF world

The Globe and Mail (Alberta Edition) - - GLOBE INVESTOR WEEKEND - rcar­rick@globe­and­mail.com ROB CARRICK Fol­low me on Twit­ter: @rcar­rick

De­spite ris­ing rates, these se­cu­ri­ties are in­creas­ingly be­com­ing the choice for in­vestors over in­di­vid­ual debt is­sues. Here’s why

The out­look for bonds in 2017 started out blah at best and got worse.

Years of spec­u­la­tion about higher in­ter­est rates gave way to a rapid-fire pair of rate in­creases in July and Septem­ber. Higher rates are bad for bonds, but there’s no sign of any con­cern about this in the world of bond ETFs. In fact, ex­change-traded fund sales num­bers for the year through Aug. 31 show bonds have by far been the most in­de­mand cat­e­gory of ex­change­traded fund.

The months and years ahead could in­deed be harsh for bonds. But the re­cent in­ter­est in bond ETFs points a way for­ward for in­vestors. Con­tinue to hold bonds to stay di­ver­si­fied, and con­sider do­ing it by us­ing bond ETFs in­stead of in­di­vid­ual bond is­sues.

The to­tal in­flow of money into TSX-listed ETFs in the first eight months of 2017 was $18.7-bil­lion, enough to put the sec­tor on track for an­other record year of sales. Bond funds at­tracted in­flows of $8.1-bil­lion over this pe­riod, ahead of sec­ond-place in­ter­na­tional stocks at al­most $4-bil­lion, and third-ranked Cana­dian stocks at $2.5-bil­lion.

In­ter­na­tional stocks have out­per­formed the Cana­dian and U.S. mar­kets this year in Cana­dian dol­lars, so you’d ex­pect them to be pop­u­lar. Canada has been a stock-mar­ket slacker lately, so there’s an op­por­tu­nity to buy into a mar­ket that hasn’t risen as much as oth­ers. But bonds? The tone for this as­set class is set by the 1.4-per-cent de­cline in the bench­mark FTSE TMX Canada uni­verse bond in­dex for the 12 months to Aug. 31.

So why, ex­actly, are in­vestors buy­ing bond ETFs? Daniel Straus, head of ETF re­search and strat­egy at Na­tional Bank Fi­nan­cial, puts it down to a “a gen­er­al­ized adop­tion of ETFs for fixed in­come ex­po­sure.”

Mr. Straus says this shift ap­plies to both in­sti­tu­tional in­vestors such as pen­sions, en­dow­ments, foun­da­tions and hedge funds, as well as re­tail in­vestors and in­vest­ment ad­vis­ers. “Some ad­vis­ers have been us­ing bonds for a very long time,” he said. “But when they see the ease of use and the min­i­miza­tion of trans­ac­tion costs that can be had when you switch to ETFs, it be­comes a pretty sim­ple de­ci­sion for them.”

While it’s not al­ways clear when you buy ac­tual bonds, there’s a com­mis­sion built into the price you pay. Think of it as a markup over the price your in­vest­ment dealer paid. Won­der­ing why the yields on the bonds in your in­vest­ment firm’s in­ven­tory are so darn low? Much of the rea­son is to­day’s low in­ter­est rates, but dealer markups also play a role. The higher the price you pay for a bond, the lower the yield.

Bond ETFs, whether they pas­sively track bench­mark bond in­dexes or hold an ac­tively man­aged portfolio, are able to buy bonds at a lower cost than in­di­vid­u­als. The big play­ers in the mar­ket es­sen­tially pay whole­sale prices, while small in­vestors pay re­tail.

For years, a weak spot with bond ETFs was that their ad­van­tage in pay­ing less for bonds was off­set to some ex­tent by the fees they charged in­vestors. When I started The Globe and Mail ETF Buyer’s Guide in 2014, the man­age­ment ex­pense ra­tio (MER) for core bond funds ranged as high as 0.33 per cent. To­day, 0.13 per cent or there­abouts is the cost of own­ing one of the big, di­ver­si­fied bond ETFs listed on the TSX. (Find the lat­est com­plete series of the ETF Buyer’s Guide at tgam.ca/ETFguideseries.)

Bond ETFs are still more ex­pen­sive to own than the cheap­est eq­uity funds, which have MERs as low as 0.06 per cent. But fall­ing fees have def­i­nitely helped make bond funds more ap­peal­ing to own.

For re­tail in­vestors, there’s one draw­back to bond ETFs that de­mands at­ten­tion. Un­like in­di­vid­ual bonds, the typ­i­cal bond ETF never ma­tures and re­pays in­vestors the prin­ci­pal they in­vested. Bond ETFs just keep rolling along, fall­ing in price when in­ter­est rates rise, gain­ing when rates drop and mov­ing more or less side­ways in sta­ble con­di­tions. In­vestors are also paid in­ter­est from bond ETFs – in­ter­est pay­ments plus price changes pro­duce what’s called a to­tal re­turn.

If in­ter­est rates keep ris­ing and bond prices fall, then peo­ple who own in­di­vid­ual bonds can buck them­selves up with the knowl­edge their hold­ings will even­tu­ally ma­ture. While bond ETF hold­ers don’t have this con­so­la­tion, they’re not at a com­plete dis­ad­van­tage.

As rates rise, bond ETFs can be ex­pected to slowly in­crease the amount of in­ter­est they dis­trib­ute to share­hold­ers.

Pat Chiefalo, head of the iShares ETF business for Black­Rock Canada, said bond ETFs need to do pe­ri­odic portfolio main­te­nance that re­quires the sell­ing of cur­rent hold­ings and the pur­chase of new bonds. “The new bonds in the portfolio will re­flect the new higher in­ter­est rates that are pre­vail­ing at the time, and that’s where you’ll see higher dis­tri­bu­tions.”

This is a slow, grad­ual process, so it could take 12 or more months for the im­pact of higher rates to be re­ally be felt by bond ETF hold­ers. Short-term bond funds will show the im­pact faster than long-term funds.

Fall­ing rates in re­cent years have cer­tainly af­fected the in­ter­est paid out by bond ETFs. A quick ex­am­ple: The Van­guard Cana­dian Ag­gre­gate Bond In­dex ETF (VAB-TSX) dis­trib­uted al­most 77 cents of in­come per unit in 2012, com­pared with just un­der 70 cents in 2016.

As for bond ETF prices, Mr. Chiefalo said they’ll de­pend a lot on whether ac­tual in­ter­est rate changes ahead cor­re­spond to mar­kets ex­pec­ta­tions. “If in­ter­est rates pan out the way the mar­ket ex­pects, prices could be rel­a­tively sta­ble. Sur­prises to the up­side or the down­side will have an im­pact on bond prices.”

NBF’s Mr. Straus has a cou­ple of thoughts for in­vestors seek­ing a con­ser­va­tive op­tion for bond ETF in­vest­ing in the cur­rent en­vi­ron­ment. One is the Hori­zons Ac­tive Float­ing Rate Bond ETF (HFR), which of­fers ex­po­sure to short-term cor­po­rate bonds and is en­gi­neered to pro­vide sta­bil­ity when rates are fluc­tu­at­ing. HFR’s yield to ma­tu­rity, the best gauge of yield if you’re look­ing to buy, is 1.4 per cent af­ter fac­tor­ing in the MER of 0.46 per cent.

The other is the Pur­pose High In­ter­est Sav­ings ETF (PSA), which af­ter fees has been pro­duc­ing a yield of 1.1 per cent lately with min­i­mal risk of los­ing money. This ETF holds high­in­ter­est-rate de­posits at banks and credit unions, which – in the­ory – should rise as the Bank of Canada pushes rates higher. While the fi­nan­cial in­dus­try has in­creased bor­row­ing rates in lock­step with the cen­tral bank, sav­ings rates have barely moved so far.

Some ad­vis­ers have been us­ing bonds for a very long time. But when they see the ease of use and the min­i­miza­tion of trans­ac­tion costs that can be had when you switch to ETFs, it be­comes a pretty sim­ple de­ci­sion for them.

Daniel Straus Head of ETF re­search and strat­egy at Na­tional Bank Fi­nan­cial

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