More than seven years after the extraordinary measures taken by central banks to counter the great recession of 2008-2009, fixed-income investors continue to face a hostile market environment. Oppressive monetary policies have deprived them of any decent yield on their money, a reality which at least in part has been masked by a total-returns picture bolstered by gains on bonds purchased when prevalent yields were higher. This will change.
Worse still, some countries such as Japan and Switzerland have adopted negative interest-rate policies. This has resulted in savers paying for the privilege of making deposits. Mercifully, negative rates haven't taken hold in North America. Even so, real yields after inflation are very much in negative territory along most of the yield curve.
Will central bankers ultimately succeed in bringing about higher rates, while perhaps tolerating first a bout of higher inflation? Your returns under that scenario won't look that hot.
Will central bankers, on the contrary, continue pushing on invisible strings? From this point onward, your returns won't be that impressive either, at least not without tolerating excessive duration risk.
A risky strategy would entail going "long" the longest duration government bonds you can find. Under a continued lower for longer, or even deflationary environment, the long bonds might yet, against all odds, produce higher gains. That trade, however, could be seen as a potentially expensive "option" trade.
For bond-market bears, the paltry yields still on offer could bolster the case for shunning fixed income entirely. This might hold particular appeal for younger investors with medium- to long-term investment horizons, and with the requisite risk tolerance.
However, the more pragmatic approach for investors is to look at what is available in terms of vehicles facilitating navigation across these challenging markets. Among the most widely accessible solutions available are exchange-traded funds.
There are almost 100 bond ETFs on offer in Canada. The choices available have expanded materially in recent years. They now include ETFs offering active management, be it of credit risk, interest-rate risk (duration), or both.
On trading costs, ETFs effectively provide you with access to institutional pricing on bonds. Otherwise, retail investors would be subject to much less favourable trade executions, significantly clipping already puny yields.
However, just because ETFs are an effective delivery mechanism doesn’t mean they are immune from underperformance resulting from either high fees and/or possibly active or even overly active management.
Having said that, when you read that there can be merits in hiring an active manager to navigate instruments that on their own still trade over the counter, often without the kind of liquidity you might like, don't immediately dismiss it.
This is because the balance of risk and reward overall is significantly tilted to the "unfavourable" side. If you are right, you'll win but you won’t make a killing. But if you make a wrong call on credit or duration, you could stand to lose considerably more than the gains you were after.
Amid market uncertainty, and the recognition that fixed income does play a role even during times like these, focus on what you can control:
Costs: In this practically yield-less environment, it goes without saying that you would want to lower the fees for your fixed-income exposure as much as you possibly can, consistent with your investment objectives. For example, if you are looking for broad low-cost exposure to the Canadian market, candidates for your portfolio would include BMO Aggregate Bond Index (ZAG), Horizons CDN Select Universe Bond (HBB), iShares Core High Quality Canadian Bond Index (XQB) and Vanguard Canadian Aggregate Bond Index (VAB).
Interest-rate risk: You can select ETFs whose duration -- their sensitivity to interest rates -- matches your expectations for markets, or your portfolio mandate, time horizon and risk tolerance. If your tolerance to interest-rate risk is low and you are looking for domestic exposure, consider ETFs in the Canadian Short Term Fixed Income category. Another approach is to invest in an ETF that takes a laddered approach, holding equal portions of bonds that have a range of maturities. The largest example of an ETF that manages a laddered portfolio is iShares 1-5 Yr Laddered Corporate Bond (CBO).
Credit risk: If you are seeking higher yields and are willing to assume higher credit risk, consider ETFs in the High Yield Fixed Income category. Investors with little appetite for credit risk should stick to ETFs whose mandates are to hold high-quality investment-grade credits. If you are so inclined, another choice is an actively managed ETF that has the flexibility to opt in and out of the riskier credits.
Currency risk: To avoid foreign-currency exposure, you can invest in pure domestic ETFs, but there are other alternatives. While some foreign-bond ETFs give investors exposure to potential exchange-rate gains or losses, others hedge their foreign-currency exposure back to the Canadian dollar. Some Canadian-listed fixed-income ETFs trade, as well as pay their distributions, in U.S. currency.
Finally, do not overlook the dynamics at play with bonds, whether you buy them individually, or -- indirectly through an ETF -- as a basket.
Specifically, just because an ETF may, on the face of it, have a higher yield than what is on offer in individual bonds currently trading around their par value, don't think you have found a free lunch. The metric you are falling victim to if you do so is to mistake the cash-on-cash yield (which is based on annual distributions), with the yield to maturity. To avoid this pitfall, consider ETFs such as BMO Discount Bond Index (ZDB) and First Asset 1-5 Year Laddered Government Strip Bond Index (BXF).
For investors in non-registered accounts, consider Horizons CDN Select Universe Bond (HBB) for its total-return swap structure, which allows for tax-free compounding, or the recently launched First Asset Short Term Government Bond Index Class (FGB).
What does the latter bring to the table? While the federal government is putting an end, effective in September, to the tax deferral of gains associated with switching funds within a corporate-class structure, this ETF represents a new tax-efficient alternative for investors in non-registered accounts, in that its distributions are expected to be labelled as return of capital. This will provide the benefit of both deferred taxes, as well as, when ultimately disposed of, a capital-gains tax treatment rather than an interest-income one. This will sound arcane to some, but in a yield-deprived world, every bit counts.
