With interest rates due to rise, it’s a good time to buy bonds
Several providers are launching new funds, but research which ones are a safe bet
Interest rates are rising. When that happens, bond prices drop. It’s one of the basic rules of investing. But how is that playing out in today’s investment climate? You may be surprised.
The Bank of Canada has raised interest rates three times this year, with another quarter-point move possible in December. You would normally expect that such aggressive action would significantly knock down bond prices.
However, the FTSE Russell Canadian Universe Bond Index was down only 0.12 per cent year to date as of the Nov. 16 close. In other words, only a tad below break-even. Government bonds took the biggest hit, off 0.22 per cent as a group. Corporate bonds were ahead 0.16 per cent. Not big either way.
What about stocks? To that point, the S&P/TSX Composite Index was down 6.5 per cent for 2018. Where would you have rather had your money?
Mutual fund returns reflect a similar pattern. To Nov. 16, the average Canadian fixed income fund was down 0.68 per cent for the year. The average Canadian equity fund was off 5.19 per cent.
The reality is that a bear market in bonds is never as severe as a bear market in stocks. Even in the worst years, a bond portfolio will probably only loss a few percentage points. Stock market losses could reach 50 per cent or more in a real crash — think 2008.
That’s why bonds and similar fixed income securities are a cushion for your portfolio. When things get really bad, the bonds will protect your downside. In fact, they might even post gains to offset the decline in stocks. Some exchange-traded fund providers think investors will turn back to fixed income products if stocks continue to slide and are launching new funds to grab some of that market share.
That’s what happened in 2008-09, when bond prices surged after central banks cut interest rates to attempt to boost a sinking economy.
Investors don’t seem to have caught on to this, however. According to the Investment Funds Institute of Canada (IFIC), fixed income mutual funds experienced redemptions of slightly more than a billion dollars in September (the last month for which figures have been posted). Equity funds, by contrast, lost only $277 million. Based on those numbers, people are more worried about bond losses than stock declines. Perhaps a rethink is order. Some exchange-traded fund (ETF) providers think investors will turn back to fixed income products if stocks continue to slide and they are launching new funds to grab some of that market share.
CIBC, which until now has been the only major bank without a suite of ETF products, entered the field last week by filing prospectuses for four new funds. Two of them are actively managed fixed-income ETFs: CIBC Active Investment Grade Corporate Bond ETF and CIBC Active Investment Grade Floating Rate ETF. We don’t have many details about them yet, beyond the fact both funds will have a “low” risk rating and will aim to generate steady income.
We know a little more about another new entry, the Evolve Active Global Fixed Income ETF. It began trading in Toronto last week with an initial price of $50.
London-based David Newman of Allianz Global Investors will manage the fund. He said in a telephone interview that he will rely on a combination of quality, investment grade bonds (average credit rating of BBB) and relatively short duration (three years) to create a portfolio that will protect capital while generating decent cash flow.
The initial target payout is $0.12 a month ($1.44 annually) for a yield of 2.9 per cent based on the opening price.
He points out that interest rates are not going up at the same rate in all countries, with Europe and Japan lagging behind North America. He intends to use those differentials to create what he terms a “sleep at night” fund for investors.
“The global bond market has had a tough year,” Evolve CEO Raj Lala says. “But perhaps we have a near-term ceiling in bond yields making it worthwhile to include bonds in a diversified portfolio. Global bonds are typically more difficult for Canadian investors and advisers to access.”
He says his fund offers several advantages over others in the field, including active management and Allianz’s “ability to invest in fixed income instruments where they deem the best risk-reward ratio lies — and where they see them in the credit cycle.”
CIBC and Evolve face a lot of competition. According to Morningstar, there are more than 2,300 fixed income mutual funds and over 300 ETFs available in Canada. BMO has 34 bond ETFs on offer, including several that are actively managed (meaning they don’t just passively track a bond index). The top performer so far this year is the BMO High Yield U.S. Corporate Bond Index ETF, which is up 4.58 per cent in 2018. But a word of caution: this fund has only been in existence for about a year and it invests in a portfolio of high-yield bonds (sometimes called junk bonds), which adds to the risk level.
BlackRock’s iShares Canada offers 25 fixed income funds, of which 10 are in positive territory year-to-date. The best performer so far this year is the iShares Floating Rate Index ETF, which showed a total return of 1.31 per cent to Nov. 15. It is currently paying out $0.031 per month for a yield of 1.8 per cent. The return is not high, but this is a very conservative fund.
Many other ETF providers such as Vanguard, RBC, Mackenzie, and First Asset also offer fixed income products.
Here are some guidelines to follow when selecting:
Look at the history. Past results are no guarantee of future returns but in the case of fixed income funds they can provide a good idea of what to expect. A long track record will tell you how they did in times of both rising and falling rates.
Focus on safety. These funds are not going to make you rich. The goal is to protect yourself from being impoverished if stocks plummet.
Look abroad. Unhedged U.S. bond funds have been among the best performers recently, boosted in part by currency gains.
Check out distributions. If you need cash flow from your investments, look at the payout record of any fund that interests you. That information should be available on the company website.
Finally, don’t be concerned about a small drop in fund prices due to interest rate increases. Just remember why you invested in fixed income in the first place: Bond funds as an insurance policy against a stock market crash, pure and simple. If they provide some small gains and cash flow, so much the better.