Bonds are essential for clients in, or approaching, retirement who seek yield and portfolio balance. Yet, in today’s low interest environment, with yields to maturity in the low single digits, buying into bond mutual funds has become much more challenging given their high management fees that cut into clients’ returns.
That’s why it’s worth looking at fixed-income exchange-traded funds (ETFs) as they offer packaged diversification, liquidity, cost control, geographical diversification and even duration and term management — all at much more palatable fees than those charged my most mutual funds.
Not surprising, fixed-income ETFs are growing rapidly in Canada, as assets under management (AUM) in these investments grew by 18.4% year-over-year to $22.4 billion as of Sept. 30, 2014. In fact, they now account for about 7% of all fixed-income retail-accessible funds, says Mark Noble, head of sales strategy for Horizons ETFs Management (Canada) Inc. in Toronto: “Fixed-income ETFs are gaining traction in the larger market for bond and related products because they are cheaper and, therefore, can give a higher return to their investors. They are due to become the vehicles of choice for fixed-income investors who want low cost and diversification.”
All fixed-income ETFs — regardless of whether they’re broad market index replicas, such as iShares Canadian Bond Universe Index ETF, or more narrowly-focused — share certain attributes. They tend to be cost efficient in operation because they tend to track indices closely or adjust their holdings by rules that refine the indices, says Michael Cooke, head of distribution for ETF manager PowerShares Canada: “Turnover for index-following ETFs tends to be lower than for fixed-income mutual funds that tend to do more trading.”
In the ETF world, fixed-income products are sold with whatever the investment dealer charges and not with massive cuts in fees for big investors, says Trevor Cummings, head of business development with RBC Global Asset Management Inc. (RBCGAM) in Toronto: “ETFs provide democratic exposure. With individual bonds, the more you buy the better the price you pay and, therefore, the better the yield you get. This does not help if an investor has a smaller amount to invest. With ETFs, whether you buy $1,000, $100,000, or $1 million, the price is the same price.”
The foundation of the fixed-income ETF market in Canada is BlackRock Asset Management Canada Ltd.’s iShares Canadian Universe Bond Index ETF, which has $1.6 billion in AUM and a return of 5.52% for the 12 months ended Oct. 31, 2014. This ETF is a replica of the FTSE/TMX Canada universe bond index, formerly known as the DEX universe bond index, which has 1,200 bond issues, of which 60% are government issues and 40% are corporate bonds. If your clients want to focus on the government bonds in the index, there’s iShares Canadian Government Bond Index ETF; iShares Canadian Corporate Bond Index ETF invests in just the corporate bonds in the index.
The virtue of these funds is their low management fees: 0.33% for iShares Canadian Universe Bond Index ETF; 0.39% for iShares Canadian Government Bond Index ETF; and 0.44% for iShares Canadian Corporate Bond Index ETF. In addition, the instant liquidity that these ETFs provide, as they can be traded anytime the Toronto Stock Exchange (TSX) is open for business, and the transparency of their portfolios make these ETFs more useful than mutual funds, which are priced only at the end of the day and don’t necessarily post of all their holdings. The disadvantage of these big funds is that they are both moving targets for the losses that can be caused by rising interest rates and, in the case of corporate bonds, defaults should credit quality deteriorate, Noble notes.
As a result, newer fixed-income ETF entrants seek to mitigate the risk of the broad fixed-income market by using rules-based management or active management at fees that are a good deal below the average, non-weighted 1.5% management expense ratio (MER) of their mutual fund class.
For example, Montreal-based Fiera Capital Corp., the subadvisor for the $505.5-million Horizons Active Corporate Bond ETF, monitors the credit quality of the corporate bonds in the FTSE/TMX Canada universe bond index. The fund charges an MER of 0.50% for its advisor class, which is more than the MER for iShares Canadian Corporate Bond Index ETF, but which has provided a 25.71% return since inception in 2010 compared with the 23.93% return for its iShares counterpart in the same period.
By selecting subindices or term strategies, your clients can obtain higher returns. For example, First Asset Management Inc.’s ETFs offer such fixed-income products as barbells with a choice of all bonds in the FTSE/TMX Canada universe bond index, or just government bonds, or just corporate bonds. Barbells combine short bonds with long bonds. All of First Asset’s barbells ETFs are 50% bonds with terms 10 years and over, 25% bonds of two years term and under and 25% floating-rate bonds. The effect is to swap a few points of yield that would be available with the long bonds with the ability of maturing short bonds to provide money for reinvestment.
There are also fixed-income ETFs that specialize in bond strips. For example, First Asset 1-5 Year Laddered Government Bond Strip Index ETF, with total AUM of $5.6 million and a 3.17% return for the 12 months ended Sept. 30, 2014, has a low MER of 0.20%. It combines the characteristic of strips to add value as they approach maturity, unlike conventional bonds, which lose time value as they approach maturity and turn into short-term notes.
Fixed-income ETFs have also made formerly exotic portfolios more available to Canadian retail investors and even to many financial advisors. For example, BMO Emerging Markets Bond Hedged to CAD Index ETF has a 0.57% annual MER; it has government holdings from Latin America to the Russian Federation and the Kingdom of Bahrain. It produced a 12.3% return for the 12 months ended Sept. 30, 2014, which is far more than the 5.5% of the broad iShares Canadian Bond Universe Index ETF for the same period. The foreign fund gives the investor a position in economic cycles other than Canada’s and non-senior market risks.
For investors who want bond exposure with limited term and duration risk, RBCGAM offers target-maturity corporate bond ETFs, which have management fees of 0.29%. There are ETFs for periods ending from 2014 to 2021. As an example, the target-date portfolio for 2016 returned 2.18% on its net asset value for the 12 months ended Nov. 4, 2014. For that, clients get risks defined by industry in which the bonds are issued, a certain maturity date, diversification and liquidity prior to maturity. “If the investor needs to sell before the maturity date, it’s easy. The sale is via the TSX with no need to price a bond desk at a brokerage,” Cummings says.
The bottom line is that with that lower management costs in today’s penny-pinched fixed-income market, the expanding choices of fixed-income ETFs increase potential returns in comparison with fully managed and relatively high-fee fixed-income mutual funds.
This web-exclusive article is part of an Investment Executive special feature, The challenges of retirement.