Al­ter­na­tives to tra­di­tional bond funds that mit­i­gate risk

The Globe and Mail (Ottawa/Quebec Edition) - - GLOBE INVESTOR - CLARE O’HARA

In­vestors in ex­change-traded funds could be ex­pos­ing their port­fo­lios to higher in­ter­est-rate risk than in­tended, as in­vest­ment dol­lars pour into Cana­dian broad bond in­dexes that track the fixed-in­come mar­ket.

Cana­di­ans have more than 30 per cent of their do­mes­tic ETF hold­ings in fixed in­come, one of the high­est per­cent­ages in the world, ac­cord­ing to a re­cent re­port by re­search firm ETFGI. In the United States, it’s just 16 per cent and in Aus­tralia 11 per cent.

Along with an ag­ing pop­u­la­tion, Cana­dian in­vestors by na­ture are more risk-averse than their global peers and tend to flock to in­come-gen­er­at­ing as­set classes, ex­plains Mark Noble, se­nior vice-pres­i­dent and head of sales strat­egy at Hori­zons ETFs.

“With an ag­ing pop­u­la­tion, older in­vestors, re­gard­less of what hap­pens with mar­ket con­di­tions, or with in­ter­est rates, are go­ing to buy more in­come,” Mr. Noble says. “From a sec­u­lar trend they are go­ing to be mov­ing to­wards fixed in­come and this has caused bond ETFs to have re­ally taken off in Canada.”

The fixed-in­come ETF mar­ket in Canada has ap­prox­i­mately $40-bil­lion in as­sets un­der man­age­ment – with more than $8-bil­lion in in­flows this year, ac­cord­ing to Na­tional Bank Fi­nan­cial. Ap­prox­i­mately $3.3bil­lion of those as­sets have gone di­rectly into bond in­dex ETFs that bench­mark the FTSE TMX Canada Uni­verse Bond In­dex. With a du­ra­tion of 7.5 years, this puts in­vestors at a greater amount of risk than they may an­tic­i­pate, Mr. Noble says.

Du­ra­tion is an ap­prox­i­mate mea­sure of a bond’s price sen­si­tiv­ity to changes in in­ter­est rates. As in­ter­est rates rise, bond prices fall – and vice versa. There­fore, if in­ter­est rates con­tinue to rise, bond in­vestors are at risk of neg­a­tive re­turns.

Mr. Noble sug­gested four al­ter­na­tives to tra­di­tional bond funds to mit­i­gate risks.

Cana­dian pre­ferred shares

Ap­prox­i­mately 70 per cent of the Cana­dian pre­ferred share mar­ket is com­posed of ratere­set pre­ferred shares, ac­cord­ing to data by Fiera Cap­i­tal, an in­sti­tu­tional money man­ager.

“These types of pre­ferred shares re­set their yields every five years. Typ­i­cally this yield is a set spread above the five-year Gov­ern­ment of Canada bond. As in­ter­est rates rise, so to do the val­ues of these pre­ferred shares – which is a key rea­son why we’ve seen such a big rally in this as­set class over the last 12 months.”

Pre­ferred shares still tend of­fer at­trac­tive yields – more than 4 per cent – and are taxed at the lower div­i­dend rate.

Se­nior loans

“This is a con­fus­ing as­set class be­cause it has many names: se­nior loans, lever­aged loans or some­times even float­ing-rate bonds. These are non-in­vest­ment-grade bonds that earn a float­ing in­ter­est rate. Se­nior loans can be an at­trac­tive way to earn a yield in the 3.0 per cent to 3.5 per cent range with in­ter­est-rate pro­tec­tion.

“Re­mem­ber, this is non-in­vest­ment-grade qual­ity and these bonds will tend to fare poorly in a wide­spread sell-off in cor­po­rate bonds like we saw in 2008/ 2009.”

Short-du­ra­tion cor­po­rate bonds

Short-du­ra­tion bonds are in­vest­ment-grade cor­po­rate bond ETFs that have a du­ra­tion typ­i­cally in the two-year range.

“By hold­ing cor­po­rate bonds they do tend to gen­er­ate a higher yield than gov­ern­ment bonds, these ETFs can be a way to take ad­van­tage of strong con­di­tions in the credit mar­ket to earn a higher yield, but do­ing so with a lower du­ra­tion to off­set po­ten­tial losses from ris­ing in­ter­est rates.”

Float­ing-rate bond ETFs

“These are in­vest­ment-grade bond ETFs that pay a float­in­grate yield that will rise with pre­vail­ing in­ter­est rates. These ETFs tend to have lower yields than other bond ETFs but are more or less im­mune to the neg­a­tive im­pact of ris­ing in­ter­est rates.,

“One strat­egy is to blend these ETFs with ex­ist­ing fixed-in­come strate­gies to lower the over­all du­ra­tion of a fixed-in­come port­fo­lio.”

Don’t sell all your in­vest­ment­grade bonds

“I’ve per­son­ally run into quite a few in­vestors who sim­ply choose not to hold high-in­vest­ment-grade bonds any more – opt­ing for div­i­dend stocks or other al­ter­na­tive-in­come strate­gies which have gen­er­ated higher re­turns in the last few years.

“There is more to bonds than yield. In­vest­ment-grade bonds are an es­sen­tial tool for port­fo­lio di­ver­si­fi­ca­tion and his­tor­i­cally in the worse types of eq­uity mar­ket sell-offs they have been some of the best pro­tec­tion your port­fo­lio could’ve had. There might be some value in re­duc­ing the over­all in­ter­est rate risk in your port­fo­lio by look­ing at some of these other fixed­in­come strate­gies, but leav­ing fixed in­come al­to­gether is a risky strat­egy in it­self!”

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