It’s a testament to the usefulness of bond ETFs that they’re selling briskly in a year when the outlook for fixed income has rarely looked less appealing.
Introduced to the world 20 years ago right here in Canada, bond ETFs simplified life for investors who want to build their own diversified portfolios. They provide cheap, transparent, liquid and infinitely adaptable access to bonds, which otherwise must be purchased through investment dealers who have an excessive amount of power to dictate prices to clients.
If your portfolio needs bonds, then you have to at least consider bond ETFs. Even in a low-rate world, these funds can be shaped to suit almost any investor’s needs.
A quick illustration of low rates can be found in the decline in the yield on the five-year Government of Canada bonds to 0.45 per cent from 1.47 per cent one year ago. Despite near-zero yields, and some momentary drama in the March stock market crash, bond ETFs have taken in a net $11.4-billion in the first 10 months of 2020. That’s one-third of the total amount that went into TSX-listed ETFs.
A total of almost $82-billion was invested in the 251 bond ETFs listed on the TSX as of the third quarter of the year, according to National Bank Financial. All of this flows from the two bond ETFs introduced back in November, 2000, the iG5 (designed as a proxy for a five-year Canada bond) and the iG10 (acting like a 10-year Canada bond).
I might be the only financial journalist writing today who covered the debut of those ETFs (read that column here). . Just a few ETFs were listed on the TSX back then, compared with 977 as of the third quarter. The five-year Canada bond yield in late 2000 was around 5.3 per cent, which seems otherworldly in today’s financial market conditions.
Bond ETFs as we know them today really date back to late 2004, when the iG10 was converted into what’s now called the iShares Core Canadian Universe Bond Index ETF (XBB-TSX). A year later, the iG5 became what is today known as the iShares Core Canadian Short Term Bond Index ETF (XSB). Both new funds offered access to a broadly diversified package of government and corporate bonds in a single purchase.
“These ETFs were really a game-changer,” said Pat Chiefalo, head of the iShares Canada ETF family at BlackRock. “They were launched to provide simple, cost-efficient access to fixed income securities, which are a cornerstone of any portfolio.”
A big debate in investing these days is what low bond yields mean to portfolio-building. Should investors shift the default 60-40 mix of stocks and bonds to 70-30, or should they keep their current portfolio mix and simply change their mix of bonds?
Note that the extent and content of your bond exposure is in question, not whether bonds are necessary. “You have a fixed income allocation for risk mitigation, as ballast to your overall portfolio,” Mr. Chiefalo said. “It serves a vital purpose there.”
It can’t be overstated how important low costs are for bond funds in today’s low-rate world. While not quite as cheap to own as ETFs holding stocks, XBB and competitors like the BMO Aggregate Bond Index ETF (ZAG), the Vanguard Canadian Aggregate Bond Index ETF (VAB) and the Horizons Canadian Select Universe Bond ETF (HBB) have management expense ratios in the 0.08- to 0.1-per-cent range.
ETFs are without doubt the most price-competitive investments in the market today and bond funds offer proof. When they were introduced, the iG5 and iG10 had MERs of about 0.25 per cent, and XBB began with an MER of 0.3 per cent. “As we’ve applied more and more technology, we’ve been able to pass down some of the cost savings that we have in managing our products onto the investor,” Mr. Chiefalo said.
Buying and selling ETFs through an online broker also has become more cost-effective. Most brokers charge a commission to trade ETFs, like they do with stocks. Online brokers charged between $24 and $33 a trade back in the days of the iG5 and iG10, compared with between $5 and $10 today, and sometimes zero.
Bond ETFs offer real value in the context of what they do and how they compare with buying individual bonds. XBB holds 1,359 federal government, provincial and corporate bonds. Further diversification is provided by mixing bonds issued by companies at varying levels of credit quality (all meet the threshold of being investment grade, or financially solid) and bonds maturing in the short, medium and long term.
Someone investing for 10 years or more could buy a broad-based bond ETF like XBB, ZAG or VAB and be confident they have sensibly covered off their portfolio’s bond allocation with a single product.
Or, you could build your own portfolio of bonds through your online broker. Good luck with that. Brokers are notoriously uncompetitive in pricing bonds – they tell you what they’ll charge if you buy and what they’ll pay if you sell. Unlike with stocks, there is no open auction system where investors of all types bid against each other to set market prices.
ETF companies pay wholesale prices for bonds, not marked-up retail prices. The price paid for bonds is crucial because of the effect it has on yield. The more you pay for a bond, the lower your yield.
Investors buying XBB now should expect a yield of 1.2 per cent, which is calculated by taking the weighted average yield to maturity (YTM) and subtracting the MER. After-fee YTM is the best measure of bond ETF yields, not the higher distribution yield you often find when looking up quotes for bond ETFs. YTM is definitive because it factors in both the amount of interest income paid by the ETF and the changing prices of bonds in its portfolio.
One of the big online brokerages offered the following yields on bonds sold at mid-week: 0.04 per cent for a Canada bond maturing in a year, 0.7 per cent for a five-year provincial bond and 1.5 per cent for an investment-grade corporate bond maturing in a little over seven years. You see by this comparison how competitive the yield on a broad market bond ETF can be.
A compensating advantage for individual bonds is that they eventually mature. No matter how much a bond fluctuates in price, you can expect it to be redeemed on a set date at its issue price. Bond ETFs are designed to keep rolling along, never maturing and thus subject to price declines when interest rates rise and price gains when rates fall.
Some investors find that guaranteed investment certificates are actually the best bond ETF alternative thanks to competitive yields when the issuer is an alternative bank or credit union. GICs don’t bounce around in price like bonds and bond ETFs, but they cannot be sold before maturity without severe penalty. Cashable GICs are available, but there’s a cost in the form of a lower yield.
While they’re primarily meant to be a stabilizing force in portfolios, bond ETFs did have a brief moment of drama when financial markets crashed in March. Disruptions in the bond market resulted in the price of bond ETFs temporarily falling below the net value of their assets. This problem worked itself out as central banks took steps to calm the markets.
Don’t overthink bond ETFs if you’re adding them to a portfolio. A simple but sensible approach is to buy a broad-based fund like XBB, VAB or ZAG and be done with it. An alternative is to blend other ETFs into a portfolio to add yield.
Mr. Chiefalo said some higher-yield options include long-term bonds, investment-grade corporate bonds, high-yield corporate bonds and emerging market government bonds. High-yield bond ETFs offer yields around 4.25 per cent, while long-term bond ETFs blending government and corporate debt are in the 1.9-per-cent range.
You’ll need to adjust riskier bond ETF holdings to reflect changing market conditions, but the broad-based funds have proven over the past two decades that they can be hold-forever investments.
“Bond ETFs are an all-weather solution,” Mr. Chiefalo said. “We’ve gone through the ’08-’09 credit crisis and we’ve gone through the March madness of this year.”
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