Investors in exchange-traded funds could be exposing their portfolios to higher interest-rate risk than intended, as investment dollars pour into Canadian broad bond indexes that track the fixed-income market.
Canadians have more than 30 per cent of their domestic ETF holdings in fixed income, one of the highest percentages in the world, according to a recent report by research firm ETFGI. In the United States, it's just 16 per cent and in Australia 11 per cent.
Along with an aging population, Canadian investors by nature are more risk-averse than their global peers, and tend to flock to income-generating asset classes, explains Mark Noble, senior vice-president and head of sales strategy at Horizons ETFs.
"With an aging population, older investors, regardless of what happens with market conditions, or with interest rates, are going to buy more income," Mr. Noble says. "From a secular trend they are going to be moving towards fixed income and this has caused bond ETFs to have really taken off in Canada."
The fixed-income ETF market in Canada has approximately $40-billion in assets under management – with more than $8-billion in inflows this year, according to National Bank Financial. Approximately $3.3-billion of those assets have gone directly into bond index ETFs that benchmark the FTSE TMX Canada Universe Bond Index. With a duration of 7.5 years, this puts investors at a greater amount of risk than they may anticipate, Mr. Noble says.
Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. As interest rates rise, bond prices fall – and vice versa. Therefore, if interest rates continue to rise, bond investors are at risk of negative returns.
Mr. Noble suggested four alternatives to traditional bond funds to mitigate risks.
Canadian preferred shares
Approximately 70 per cent of the Canadian preferred share market is composed of rate-reset preferred shares, according to data by Fiera Capital, an institutional money manager.
"These types of preferred shares reset their yields every five years. Typically this yield is a set spread above the five-year Government of Canada bond. As interest rates rise, so to do the values of these preferred shares – which is a key reason why we've seen such a big rally in this asset class over the last 12 months."
Preferred shares still tend offer attractive yields – more than 4 per cent – and are taxed at the lower dividend rate.
"This is a confusing asset class because it has many names: senior loans, leveraged loans or sometimes even floating-rate bonds. These are non-investment-grade bonds that earn a floating interest rate. Senior loans can be an attractive way to earn a yield in the 3.0 per cent to 3.5 per cent range with interest-rate protection.
"Remember, this is non-investment-grade quality and these bonds will tend to fare poorly in a widespread sell-off in corporate bonds like we saw in 2008/2009."
Short-duration corporate bonds
Short-duration bonds are investment-grade corporate bond ETFs that have a duration typically in the two-year range.
"By holding corporate bonds they do tend to generate a higher yield than government bonds, these ETFs can be a way to take advantage of strong conditions in the credit market to earn a higher yield, but doing so with a lower duration to offset potential losses from rising interest rates. "
Floating-rate bond ETFs
"These are investment-grade bond ETFs that pay a floating-rate yield that will rise with prevailing interest rates. These ETFs tend to have lower yields than other bond ETFs but are more or less immune to the negative impact of rising interest rates.,
"One strategy is to blend these ETFs with existing fixed-income strategies to lower the overall duration of a fixed-income portfolio."
Don't sell all your investment-grade bonds
"I've personally run into quite a few investors who simply choose not to hold high-investment-grade bonds any more – opting for dividend stocks or other alternative-income strategies which have generated higher returns in the last few years.
"There is more to bonds than yield. Investment-grade bonds are an essential tool for portfolio diversification and historically in the worse types of equity market sell-offs they have been some of the best protection your portfolio could've had. There might be some value in reducing the overall interest rate risk in your portfolio by looking at some of these other fixed-income strategies, but leaving fixed income altogether is a risky strategy in itself!"