A little-known investing fact: The bond ETF originated in Canada 21 years ago.
So when we say the current year is shaping up as the worst ever for exchange-traded funds holding bonds, it means something. Year-to-date declines for these funds are minor league by the standards of the stock market. But if you regard bonds as a safe investment, the events of 2021 have to be unnerving.
Bonds remain the best way for the everyday investor to shield a portfolio from the worst of a stock-market crash. But bonds can bite at times like now, as financial markets worry that interest rates will snap back from their pandemic lows harder and faster than expected.
Let’s take a tour through the bond ETF universe to see how various types of funds have reacted to the recent upset in the bond market. You’ll get an idea of what’s happening with bond ETF performance right now, and find some clues on how to invest in bonds through ETFs in a way that offers some resilience in a rising rate world.
A good starting point is the $4.6-billion iShares Core Canadian Universe Bond Index ETF (XBB-TSX), which was down 5.1 per cent for the first 10 months of 2021 on a total return basis (changes in bond prices plus bond interest). XBB’s management reports on fund performance going back to its inception in November, 2000, show only one previous annual decline – a loss of 1.5 per cent in 2013.
XBB and newer competitors such as the BMO Aggregate Bond Index ETF (ZAG) and the Vanguard Canadian Aggregate Bond Index ETF (VAB), both of which appear in the accompanying table, are proxies for almost the entire Canadian bond market. They hold a blend of bonds issued by federal and provincial governments, as well as financially stable corporations. The bonds are a mix of maturities – some short (one to five years), some medium (five to 10 years) and some long (10 years plus).
The anticipation of rising rates causes some investors to sell the bonds they already own, thereby pushing bond prices lower. Yields move in the opposite direction of bond prices, which explains why yields have moved sharply higher this year. If you put new money into bonds today, you’ll get a better yield than a year ago.
You can measure the influence that changes in interest rates will have on bond prices by looking at the duration of a bond ETF. XBB has a duration of eight years, which means its price would fall by 8 per cent for every one percentage point that rates rise. In falling rate periods, a one-point drop would increase the price by 8 per cent.
Online bond fund profiles from ETF companies almost always include duration. You’ll also find yield to maturity numbers, which are your best measure of the yield you’ll get based on the current price of an ETF. Subtract the management expense ratio from a bond ETF’s published yield to maturity to get the net yield to maturity.
In the Globe and Mail ETF Buyer’s Guide, published earlier this year, ZAG’s net yield to maturity was 1.3 per cent. It’s now up to just less than 2 per cent and could climb higher if this worst year ever for bond ETFs continues into 2022.
Short-term bond ETFs are one way to limit your portfolio’s vulnerability to rising rates. Check out the iShares Core Canadian Short Term Bond Index ETF (XSB) – it was down only 1.6 per cent on a total return basis for the first 10 months of the year.
Corporate bonds are another possibility for the ETF investor looking to tweak a portfolio to address vulnerability to rising rates. In a rising rate world, expect them to fall less in price than government bonds. The performance this year of the Vanguard Canadian Corporate Bond Index ETF (VCB) backs this up – the fund was down 3.1 per cent, about two percentage points less than VAB, with its hefty weighting in government bonds.
Floating rate bond ETFs have eked out tiny gains this year, which is something of a win in present conditions. These funds hold bonds that adjust their interest payments to reflect what’s happening with interest rates. Note the paper-thin yield from these bonds.
Much better results were produced by high-yield bonds, which hold bonds issued by financially weaker companies than those that turn up in conventional corporate bond funds. The NBI High Yield Bond ETF (NHYB) has produced a 4.6-per-cent total return so far this year, according to Morningstar Canada.
Here’s the catch with high-yield bond ETFs – though they do well in a rising rate world, they tend to fall hard when stocks crash. If you want a hedge against the next stock-market decline, they’re no substitute for ETFs holding government and investment-grade corporate bonds.
Real return bonds seem a promising option for investors right now because they adjust their principal value higher to compensate for increases in inflation. Rising prices are a big reason why rates are expected to rise more than expected.
I wrote earlier this week about why some real return bond ETFs are doing better than others. To quickly summarize, real return bonds issued by the federal government tend to have long maturities. Investors treat them more like long-term bonds, which explains why the likes of the iShares Canadian Real Return Bond Index ETF (XRB) was down 6.3 per cent over the first 10 months of the year.
U.S.-issued real return bonds – they’re called Treasury Inflation-Protected Securities, or TIPS – come in a variety of maturities and thus are more appealing to investors right now. You can see this in the 4.3-per-cent rise this year for the Mackenzie US TIPS Index ETF (CAD hedged), which trades under the ticker symbol QTIP.
When rates peak and start heading lower, long-term bonds will hit their stride. They’re down nearly 10 per cent, at worst, so far in 2021, which highlights their extreme vulnerability in a rising rate world.
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