Advisors concerned with positioning client portfolios for a potential rise in interest rates have a range of options in the world of income-producing exchange-traded funds (ETFs).
With interest rates at historically low levels, the past few years have been a challenging time for investors to earn a healthy income stream. But if interest rates rise, as some believe they will in the wake of any tapering of U.S. government economic stimulation programs, income-bearing securities issued at previous low rates will become less attractive and their market values could fall. That leaves investors looking for protection from capital erosion in the area of fixed-income.
A variety of strategies are available through ETFs, including actively managed ETFs that focus on income-paying securities such as bonds, real estate investment trusts (REITs), preferred shares and dividend-paying stocks, but allow managers to deviate from standard market indices.
Other solutions include floating-rate bond ETFs, laddered bond and preferred share strategies and “target date” ETFs that have a predetermined maturity date, much like an actual bond. Also available are ETFs that invest in diversified portfolios of senior loans whose interest rates float in line with leading benchmark rates.
“There are a number of options for investors concerned about rising interest rates,” says Mary Anne Wiley, managing director and head of iShares Canada, a division of BlackRock Asset Management Canada Ltd. and the largest player in the Canadian ETF market. “ETFs provide a variety of choices to protect investors who see rising rates as imminent, but at the same time they offer liquidity, so investors can adjust if something changes on the horizon.”
For example, the iShares DEX Short Term Bond Index ETF and iShares DEX Short Term Corporate Universe + Maple Bond Index ETF will be less damaged by any rise in interest rates than a regular bond portfolio due to the shorter duration of the bonds, and the ability to replace maturing bonds sooner with new bonds paying higher rates. Likewise, the iShares DEX Floating Rate Note Index ETF will ride the direction of interest rates.
Some investors are turning to products that are higher risk but pay higher than average rates, including ETFs backed by REITs, corporate bonds, high-yield bonds and emerging market bonds.
“ETFs allow investors to take different slices of various parts of the fixed income market and fine tune them into a diversified portfolios,” Wiley says. “Investors are moving away from holding individual bonds, and with ETFs they get access to a diversified portfolio and better pricing.”
Craig Stanford, managing director at Trivest Wealth Counsel Ltd. in Calgary is using Horizons Active Floating Rate Bond ETF sponsored by Horizons Exchange Traded Funds Inc. of Toronto, to manage interest rate risk in client portfolios.
“The floating rate ETF offers a way to lower exposure to rising rates and still generate a decent yield,” Stanford says. “We expect interest rates to rise in the future – not necessarily quickly – but have tilted our bond portfolios to a lower duration and a higher weight in corporate bonds. Corporates have have a fatter cushion of yield and are therefore less sensitive to interest rate increases.”
Although ETFs rose to popularity as a way to access equity indices, fixed-income is gaining market share. Currently, 33.3% of the $60 billion in Canadian ETF assets under management is made up of fixed-income products, while 62.2% is in equities, 2.2% is in commodities and the remainder is in a mix of balanced, currency multi-asset class, inverse and leveraged ETFs. Four years ago, fixed-income made up just 20% of the overall ETF market in Canada, which was half the size of today’s with $32 billion in AUM.
“There have recently been big inflows on the fixed-income side into shorter-duration and lower-credit product,” says Pat Chiefalo, director of ETF Research and Strategy at National Bank Financial in Toronto. “People are moving out of the traditional government bonds.”
He says one of the fastest growing ETFs is BMO S&P/TSX Laddered Preferred Share Index ETF, which provides a steady stream of income with rate re-sets that allow it to adjust to market interest rates. Launched in November, the ETF has more than $800 million in AUM.
On Wednesday: Understanding low volatility ETFs.