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Soaring interest rates amid spiralling bond prices is creating an opportune time for investors to rebalance their portfolios with effective fixed-income strategies in volatile times.
As a result, laddered-bond exchange-traded funds (ETFs) have seen a jump in fund flows recently as the Bank of Canada and other central banks stretch benchmark rates to multidecade highs.
After experiencing broad outflows through much of the first half of this year, Canadian laddered-bond ETFs reversed the trend in the third quarter, taking in $46-million, according to National Bank Financial, which closely tracks market fund flows. The Invesco 1-3 Year Laddered Floating Rate Note Index ETF PFL-T has proven popular with investors after the fund cut its management fee to zero in July, effective for at least one year.
In the United States, the trend is more apparent. More than US$3-billion has flowed into BlackRock’s iShares family of laddered-bond ETFs since June, with about half going to investment-grade bond funds.
“There’s a lot of interest in these right now,” says Luke Shane, vice-president of corporate communications at BlackRock Inc., in New York.
Their appeal stems from a few reasons aside from steady, low-risk income generation. One factor is the far deeper liquidity the units have compared with direct bond purchasing. Less duration risk is another, while the low fees inherent in ETFs are always attractive.
“These are for your steady Eddie investor,” says William Bluteau, wealth associate at Bluteau Caseley Wealth Management Group with National Bank Financial Wealth Management, in Halifax.
“You don’t really know where interest rates are going – you don’t want to make a call on that – but you need exposure and income.”
Laddered-bond ETFs have the benefits of being simple and transparent. They are typically set to mature or be redeemed at the end of any given year and owning a series of them over a short- or longer-term payout period allows for the remainder of a client’s portfolio to stay invested for the long term.
Advisors and investors can seek out a series of specific bonds to create their own ladder, but ETFs simplify the process at a lower cost. Management fees for the RBC iShares laddered-bond ETFs start at 0.15 per cent, for example, while Invesco’s BulletShares funds have annual fees as low as 0.1 per cent.
Flows from tax loss harvesting
A portion of recent inflows into these funds is coming from investors wiping the slate on underperforming securities and opting to sell them in order to lower their overall tax bill, Mr. Bluteau says.
“It’s likely a lot of rebalancing. This is probably one of the worst markets we’ve seen in decades,” he says. “If an investor’s money is held in a taxable account, they’re going to harvest that tax loss and put those proceeds into a new idea.”
Investors are cutting losses on beaten-up assets, such as longer dated bonds, and moving into shorter duration fixed-income securities – a trend that has quickened as the inversion of the yield curve has steepened.
“Instead of going into eight- or 10-year bonds again, they’re saying, ‘Hey, I’m going to sell and crystallize this loss. I’m going to go shorter into a one-to-five years laddered ETF,’” Mr. Bluteau says.
With the yield curve inverted, investors aren’t getting well compensated for the duration of longer-term ETFs. Even relatively shorter duration securities are feeling the squeeze. For example, RBC iShares 1-5 Year Laddered Corporate Bond ETF RBO-T has a yield-to-maturity of 5.25 per cent, which is not much more than the 4.21-per-cent yield on the BMO Ultra Short-Term Bond ETF ZST-T.
Presumably, as the yield curve eventually returns to a more traditional slope, the bond laddering approach will have a greater payoff, Mr. Bluteau says.
How to play rates nearing a peak
Some demand for laddered-bond ETFs is also based on bets that the current rate-tightening cycle is close to running its course and some investors are positioning themselves for a bond market recovery, according to Per Homer, wealth management adviser at Assante Financial Management Ltd., in Mississauga.
As the bond market recovers, beaten-down bond ETFs will erase declines in short order and see their unit prices rise, he says. “It’s a little bit like a bowling ball on a trampoline – at some point, that trampoline is going to spring back and that ball is going to go with it.”
The TD Select Short Term Corporate Bond Ladder ETF TCSB-T, for example, is down more than 7 per cent this year, and it is far from alone among bond ETFs that have posted declines.
“At some point, you’re going to see the Bank of Canada reverse its course on rates and lower them,” Mr. Homer says. “When they do that, you’re going to get those capital gains. And because you have the liquidity of an ETF, you’re going to be able to cash in on that very easily as opposed to if a client held a random corporate bond.”
Yet Mr. Homer cautions against looking to laddered-bond ETFs to generate outsized returns, a sentiment shared by National Bank’s Mr. Bluteau.
Whether laddered or not, using bond ETFs for above-average gains “is more of an asset allocation decision around interest rates now,” Mr. Bluteau says. The investment objective should remain to use them for steady, reliable income over a multiyear period.
“A traditional bond ladder is about maturity and cash flow,” he explains.
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