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portfolio strategy

The outlook for bonds in 2017 started out blah at best and got worse.

Years of speculation about higher interest rates gave way to a rapid-fire pair of rate increases in July and September. Higher rates are bad for bonds, but there's no sign of any concern about this in the world of bond ETFs. In fact, exchange-traded fund sales numbers for the year through Aug. 31 show bonds have by far been the most in-demand category of exchange-traded fund.

The months and years ahead could indeed be harsh for bonds. But the recent interest in bond ETFs points a way forward for investors. Continue to hold bonds to stay diversified, and consider doing it by using bond ETFs instead of individual bond issues.

The total inflow of money into TSX-listed ETFs in the first eight months of 2017 was $18.7-billion, enough to put the sector on track for another record year of sales. Bond funds attracted inflows of $8.1-billion over this period, ahead of second-place international stocks at almost $4-billion, and third-ranked Canadian stocks at $2.5-billion.

International stocks have outperformed the Canadian and U.S. markets this year in Canadian dollars, so you'd expect them to be popular. Canada has been a stock market slacker lately, so there's an opportunity to buy into a market that hasn't risen as much as others. But bonds? The tone for this asset class is set by the 1.4-per-cent decline in the benchmark FTSE TMX Canada universe bond index for the 12 months to Aug. 31.

So why, exactly, are investors buying bond ETFs? Daniel Straus, head of ETF research and strategy at National Bank Financial, puts it down to a "a generalized adoption of ETFs for fixed income exposure."

Mr. Straus says this shift applies to both institutional investors such as pensions, endowments, foundations and hedge funds, as well as retail investors and investment advisers. "Some advisers have been using bonds for a very long time," he said. "But when they see the ease of use and the minimization of transaction costs that can be had when you switch to ETFs, it becomes a pretty simple decision for them."

While it's not always clear when you buy actual bonds, there's a commission built into the price you pay. Think of it as a markup over the price your investment dealer paid. Wondering why the yields on the bonds in your investment firm's inventory are so darn low? Much of the reason is today's low interest rates, but dealer markups also play a role. The higher the price you pay for a bond, the lower the yield.

Bond ETFs, whether they passively track benchmark bond indexes or hold an actively managed portfolio, are able to buy bonds at a lower cost than individuals. The big players in the market essentially pay wholesale prices, while small investors pay retail.

For years, a weak spot with bond ETFs was that their advantage in paying less for bonds was offset to some extent by the fees they charged investors. When I started the Globe and Mail ETF Buyer's Guide in 2014, (download the latest guide here), the management expense ratio (MER) for core bond funds ranged as high as 0.33 per cent. Today, 0.13 per cent or thereabouts is the cost of owning one of the big, diversified bond ETFs listed on the TSX.

Bond ETFs are still more expensive to own than the cheapest equity funds, which have MERs as low as 0.06 per cent. But falling fees have definitely helped make bond funds more appealing to own.

For retail investors, there's one drawback to bond ETFs that demands attention. Unlike individual bonds, the typical bond ETF never matures and repays investors the principal they invested. Bond ETFs just keep rolling along, falling in price when interest rates rise, gaining when rates drop and moving more or less sideways in stable conditions. Investors are also paid interest from bond ETFs – interest payments plus price changes produce what's called a total return.

If interest rates keep rising and bond prices fall, then people who own individual bonds can buck themselves up with the knowledge their holdings will eventually mature. While bond ETF holders don't have this consolation, they're not at a complete disadvantage.

As rates rise, bond ETFs can be expected to slowly increase the amount of interest they distribute to shareholders.

Pat Chiefalo, head of the iShares ETF business for BlackRock Canada, said bond ETFs need to do periodic portfolio maintenance that requires the selling of current holdings and the purchase of new bonds. "The new bonds in the portfolio will reflect the new higher interest rates that are prevailing at the time, and that's where you'll see higher distributions."

This is a slow, gradual process, so it could take 12 or more months for the impact of higher rates to be really be felt by bond ETF holders. Short-term bond funds will show the impact faster than long-term funds.

Falling rates in recent years have certainly affected the interest paid out by bond ETFs. A quick example: The Vanguard Canadian Aggregate Bond Index ETF (VAB-TSX) distributed almost 77 cents of income per unit in 2012, compared with just under 70 cents in 2016.

As for bond ETF prices, Mr. Chiefalo said they'll depend a lot on whether actual interest rate changes ahead correspond to markets expectations. "If interest rates pan out the way the market expects, prices could be relatively stable. Surprises to the upside or the downside will have an impact on bond prices."

NBF's Mr. Straus has a couple of thoughts for investors seeking a conservative option for bond ETF investing in the current environment. One is the Horizons Active Floating Rate Bond ETF (HFR), which offers exposure to short-term corporate bonds and is engineered to provide stability when rates are fluctuating. HFR's yield to maturity, the best gauge of yield if you're looking to buy, is 1.4 per cent after factoring in the MER of 0.46 per cent.

The other is the Purpose High Interest Savings ETF (PSA), which after fees has been producing a yield of 1.1 per cent lately with minimal risk of losing money. This ETF holds high-interest-rate deposits at banks and credit unions, which – in theory – should rise as the Bank of Canada pushes rates higher. While the financial industry has increased borrowing rates in lockstep with the central bank, savings rates have barely moved so far.