Psychologically, the financial world has never fully recovered from the global financial crisis that six years ago was in full eruption mode.
There's a lingering sense – quite justified – that forewarnings of distress and opportunities to act preventively were missed. Determined to avoid future catastrophes, the world's regulators, central banks, investment strategists and money managers are asking questions and raising concerns about all kinds of investment trends and products. One of the latest to be scrutinized is a useful and seemingly innocuous category of exchange-traded fund that holds corporate bonds.
The concern starts with a lack of liquidity in the corporate bond market today. A liquid asset can be easily traded, without concern that you'll have to pay a premium to acquire it or accept a discount when selling. Corporate bond liquidity has been negatively affected by a combination of a changing regulatory environment for the banks that dominate trading of these securities, and strong demand for these bonds from investors.
Today, the lack of liquidity means investors have to pay up to buy corporate bonds. When interest rates rise, it could mean they'll take a hit if they sell. ETFs, which hold baskets of corporate bonds, complicate things. If investors dumped corporate bonds en masse, would these ETFs be able to efficiently sell their holdings as needed?
ETF industry people insist the answer is yes. But if you're still unnerved by what happened in the financial crisis and have minimal tolerance for more surprises, take a moment to consider your corporate bond ETF holdings. "If you buy into these concerns, look at trimming your exposure somewhat," said Yves Rebetez, a chartered financial analyst (CFA) and managing director of the ETF Insight website etfinsight.ca.
Data from BlackRock Canada, which runs the iShares ETF business, show there's $25-billion invested in bond ETFs in Canada, 40 per cent of which is in corporate bond ETFs. The popularity of corporate bond ETFs is easy to understand – they offer cheap exposure to bonds issued in large part by banks and other blue-chip companies.
Yields are modest, reflecting the fact investor demand has been very strong (as bond prices rise, their yields fall). Still, a widely held corporate bond ETF like the iShares 1-5 Year Laddered Corporate Bond Index ETF (CBO) has an after-fee yield to maturity of 1.9 per cent. The yield for a similar government bond ETF (CLF) would be 1.4 per cent. The gap between government bonds and corporates is much larger when you include the high-yield bonds issued by companies that lack blue-chip financials. The after-fee yield to maturity on the iShares U.S. High Yield Bond Index ETF CAD-Hedged (XHY) is about 5.2 per cent.
An issue investors need to consider in evaluating corporate bond ETFs is the likelihood of interest rates rising enough to truly rattle the bond markets (remember, bond prices move in the opposite direction to rates). U.S. interest rates are expected to start edging up from today's record lows in 2015. Economists expect the Bank of Canada to also move next year, but possibly lagging the Fed because our economy has been lukewarm. Bottom line: A surge in rates is unlikely for now.
Another question is what yield-producing investments people will shift to if they drop corporate bonds. Preferred shares are riskier in terms of losing money, and dividend-paying common shares are more so. High-yield bonds have risk levels comparable to stocks, but investment-grade corporate bonds are comparatively safe.
A flight from corporate bonds doesn't make much sense, then. But don't expect investors to act rationally if there's a jarring change in market conditions. In case that happens, it's important to understand how today's liquidity problems might play out for corporate bond ETFs.
To start with, liquidity would only be a potential issue for investors who tried to sell in a panic. If you hold your corporate bond ETFs through any upsets to come, things will eventually settle down.
If you did submit a sell order for your corporate bond ETF, it would be matched with a buy order from another investor. Even if corporate bonds turn toxic, there are investment dealers designated to maintain an orderly market in ETF trading. They're supposed to put in a bid for the ETF units you're selling, even if the price would reflect prevailing market conditions.
These dealers would have the option of exchanging the ETF units they've accumulated for the underlying securities. At BlackRock Canada, they say that's not a problem. "You can't make an ETF if you don't have liquid underlying [investments]," said Noel Archard, the company's head and managing director.
Alfred Lee, vice-president and portfolio manager at BMO Mutual Funds, said corporate bond ETFs give investors more liquidity than if they tried to sell an individual bond. "Given a liquidity event, liquidity is not going to be as good as in a normal environment. But we're going to be owning the most liquid bonds out there."
To sum up, problems in the corporate bond market will be reflected in the price of bond ETFs. However, ETF industry people say their funds will not exacerbate things.
There is still an issue in the structure of bond ETFs that investors need to know about. An individual bond of any type matures eventually and pays back the money people have invested in it. Bond ETFs never mature – they're perpetual investments that will rise in price when interest rates fall and decline when rates rise.
Investors who think they might need to sell a bond ETF in the next couple of years should be aware of this. A better choice for them might be a ladder of guaranteed investment certificates from alternative banks that are part of Canada Deposit Insurance Corp.
GICs don't fluctuate in value and, if you find the right bank or trust company, you can get rates in the mid 2-per-cent range. You can get close to 3 per cent with credit unions, which have their own deposit insurance plan.
For building long-term portfolios, corporate bond ETFs are no more or less attractive today than corporate bonds themselves. "You've got the risk of the asset class, whether you own the corporate bonds directly, through mutual funds or an ETF," BlackRock's Mr. Archard said. "But as far as the structure of the ETF giving you what it's supposed to, which is exposure to corporate bonds at the level of the index, I don't lose sleep over that."
Globe app users click here for a table showing the corporate bond ETF alternative
Rob Carrick