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Exchange-traded funds (ETFs) are being used increasingly to provide low-cost and diversified exposure to fixed-income assets in diversified portfolios, and are often easier and cheaper to trade than their underlying bond portfolios, according to panellists who spoke at the third annual ETF conference in Toronto on Thursday.

“Almost 40¢ of every dollar going into ETFs in Canada is going into fixed-income ETFs,” said Michael Cooke, senior vice president of ETFs with Toronto-based Mackenzie Financial Corp. at the conference, which was organized by Mindpath Corp., also of Toronto. “Whether you’re a retail or an institutional investor, it’s becoming harder to navigate the bond market by trading individual issues.”

In addition, a growing number of fixed-income ETFs are being introduced that go beyond broad general exposure and target specific areas such as high-yield bonds or shorter-term securities that are less sensitive to interest rate moves. This is expanding the choices available for investors, he added.

Bonds tend to trade in a less liquid, more opaque market than equities, with no central exchange and low visibility on fees, Cooke said. On the other hand, fixed-income ETFs tend to be liquid, they trade openly on a central exchange and the fees and bid/ask spreads are clearly visible. Often, the bid/ask spreads of fixed-income ETFs are superior to the spreads on the underlying securities thanks to healthy liquidity in the ETFs.

Issuer risk on individual bonds can also be lowered by accessing the broadly diversified portfolios available through ETFs, and investors can gain exposure to a much greater array of securities and at lower costs than they could achieve buying bonds on their own. Like stocks, fixed-income ETFs are easy to trade throughout the day.

The cost savings on bonds accessed through ETFs are particularly relevant at a time when interest rates are low and fixed-income investors are struggling to find a decent return.

ETF Guide 2016

Squeezing out more income

“The reduction of trading and execution costs available through fixed-income ETFs can result in huge cost savings to clients, and that is especially important in today’s low interest rate environment,” Jaime Purvis, executive vice president with Toronto-based Horizons Exchange Traded Funds Inc., told the conference. “This matters, especially in today’s low yield environment; it’s a tangible benefit in your pocket.”

The risk of rising interest rates at this point in the cycle and the potential negative impact of a rate increase on outstanding bonds can be mitigated by investing in fixed-income ETFs that employ specific strategies designed to perform better in a rising rate environment, Cooke pointed out.

It’s a “suboptimal time” to enter the bond markets with a passive strategy in fixed-income markets that doesn’t manage the types of securities held but simply duplicates broad bond market indices, he said.

“It makes sense to broaden the scope and look for ways to add value,” Cooke added. “Some strategies are not available through basic bond indices. Fixed-income will always have a place, but you need to pay attention to better ways to build a portfolio.”

An active fixed-income ETF manager can invest with even more precision, for example, deciding whether it makes sense to hold high-yield bonds or floating-rate senior loans, and if so, specifically which issues.

“There’s been a proliferation of ETFs with active or smart beta fixed-income strategies intended to mitigate risk,” Cooke said.

The securities clients don’t own can be as important to returns as the ones you do, he says, and active management can take advantage of “pockets of opportunity.”

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