Income-paying products are the fastest growing category within the already booming world of exchange-traded funds (ETFs) as investors search for healthy returns and stability in a volatile financial environment.
As of July 31, assets under management (AUM) in Canadian-listed fixed-income ETFs totaled $30.3 billion, about 35% of total ETF AUM of $85.7 billion, according to Toronto-based research firm ETF Insight. Five years earlier, fixed-income ETFs totaled $7.9 billion in AUM, a lesser 23% of the $33.9 billion total ETF market.
“Investors are finding that ETFs are an elegant and effective way for getting diversified bond exposure,” says Yves Rebetez, managing director of ETF Insight.
Fixed-income ETFs appeal to both retail clients and institutional investors. For small clients, a fixed-income ETF provides access to a broader choice of securities and at a lower trading cost than they could achieve on their own.
For institutional investors, ETFs offer a highly liquid form of diversified fixed-income exposure. Through ETFs they can increase or decrease exposures across the entire fixed-income asset class, or narrow segments within it, through a single trade – without trying to source and trade bonds individually in a market that can often be opaque and illiquid.
“If the ETFs are liquid they can be easily traded between large investors without the underlying portfolio of bonds being bought and sold,” Rebetez says. “This adds a convenient liquidity sleeve to an institutional portfolio, and can be combined with other bonds that may be bought individually and tucked away to match future obligations.”
A variety of income products are available through ETFs, including traditional government bonds, higher yielding corporate and emerging market bonds, laddered and target date bond portfolios, dividend-paying common and preferred shares and real estate investment trusts (REITs).
Fund of fund products are also available, which offer a predetermined mix of fixed-income asset classes through a single ETF. Additionally, there are sector-focused products, such as those offering a selection of dividend-paying stocks in a specific industry such as banks or utilities. Some employ the use of call options to enhance income.
For the year to July 31, 2015, fixed-income ETFs experienced healthy inflows of $4.3 billion, compared to $2.7 billion for international equity ETFs , $2.2 billion for U.S. equity ETFs , and actual outflows of $1 billion for Canadian equity ETfs, according to the Canadian Exchange Traded Funds Association. Within the fixed-income category, flows were positive across short- and long-term maturities.
The largest flows went to: BMO Mid Federal Bond Index ETF and BMO High Yield U.S. Corporate Hedged to CAD Index ETF, both sponsored by BMO Global Asset Management Inc. of Toronto; iShares Short Term Strategic Fixed Income ETF, sponsored by BlackRock Asset Management Canada Ltd.; and Vanguard Canadian Aggregate Bond Index ETF, sponsored by Toronto-based Vanguard Investments Canada Inc.
Product providers have begun introducing income products that go beyond exposure to the popular broad market bond indices, and the selection includes active as well as passively managed products.
Toronto-based Horizons ETFs Management (Canada) Inc., for example, recently introduced Horizons Active Canadian Municipal Bond ETF, which tracks a portfolio of Canadian municipal bonds. Municipal bonds, issued by cities, municipalities or counties to finance local infrastructure projects, offer yields that are higher than federal and provincial bonds, and in some cases, higher than corporate bonds as well.
Fixed-income ETFs are not without risks, and like the individual securities within their portfolios, they are affected by market interest rate movements and credit quality.
“There is a lot of uncertainty in terms of where interest rates are going,” says Alfred Lee, vice president at BMO ETFs. “If you stick to short duration in the expectation that rates will rise soon, and you’re wrong, you’ve given up opportunity. If you’re long and wrong, that could lead to loss of capital.”
In addition, passively managed ETFs, which track a bond index, must buy and sell the underlying bond securities to match demand for the ETF, whether the markets for those securities are liquid or not, and this can sometimes result in unfavorable trading spreads, particularly in less liquid categories such as high yield or corporate bonds.
Active fixed-income portfolio managers have more discretion than index-followers over which securities they want to trade, when, and at what price.
This is the second article in a three-part series on fixed-income investing.
Up next: Emerging markets and global bonds.