There’s nothing sophisticated about the strategies of laddered bond ETFs, which divide their portfolios into equal buckets according to maturity dates. And that’s part of their appeal, ETF executives say. “The ladder is a very simple, easy to understand strategy for an advisor to express and explain to a client,” says Stephen Hoffman, vice president of exchange traded funds with Toronto-based RBC Global Asset Management Inc.
In many cases, advisors who recommend laddered ETFs may have already been using a ladder strategy for clients through direct holdings of bonds or GICs. “So the move from a ladder strategy where you were buying individual bonds for your client to an ETF that uses a ladder strategy is a natural evolution,” Hoffman adds.
Most of the laddered ETFs compete in the Canadian short-term fixed-income category. Typically, these funds have five equally weighted “rungs” in their ladders, ranging from one to five years. The longer-dated ETFs can have up to 10 rungs, ranging from one to 10 years.
The shortest ladder is that of Invesco 1-3 Year Laddered Floating Rate Note Index ETF, making it the fund least subject to interest-rate risk. The one with the longest-dated securities is RBC 6-10 Year Laddered Canadian Corporate Bond ETF. However, this fund would commonly be held in combination with RBC’s one- to five-year laddered ETFs.
Currently, 17 Canadian-listed ETFs employ laddered strategies, and all but two are in domestic fixed-income categories. Their combined assets of about $4 billion, though substantial, are far less than what’s held in conventional index ETFs.
Well over half of the assets of laddered ETFs are held in four funds sponsored by Toronto-based BlackRock Asset Management Canada Ltd., led by the $1.1-billion iShares 1-5 Year Laddered Corporate Bond Index ETF. The next largest player is Invesco Canada Ltd., with the $796-million Invesco 1-5 Year Laddered Investment Grade Corporate Bond Index ETF being the largest of its five offerings.
Fees for laddered ETFs are modest, with management expense ratios typically about 0.28%, and in some cases as low as 0.17%. However, laddered ETFs are slightly more expensive than the cheapest Canadian bond index ETFs, which have MERs at or below 10 basis points.
Over time, the returns of a laddered bond index and that of a market-cap-weighted index are likely to be closely correlated, assuming that their constituent securities are substantially the same. The risk-return profiles of passive indices vs laddered strategies in the same category are similar, says Jasmit Bhandal, vice president and head of ETF product strategy and development with Invesco Canada.
The difference, says Bhandal, is that laddered ETFs address the needs of clients who don’t want to follow interest rate trends when choosing investments, and don’t want to worry about reinvestment risk: when cash from matured bonds cannot be reinvested at current market rates. “With the ladder, whether interest rates go up or down, that portion of the portfolio is always being reinvested at prevailing interest rates,” Bhandal says. “So that’ll help stabilize the annualized returns.” Among the investors for whom laddered ETFs may hold appeal are those already building their own bond ladders or buying individual bonds. “This is a way to help diversify rather than having to build that bond portfolio or bond ladder yourself,” Bhandal says.
One of the less-known characteristics of laddered ETFs is that their duration — a measure of the price sensitivity of the portfolio to changes in interest rates — varies over the year. The portfolio’s duration is highest at the point of rebalancing, when cash flows from maturing bonds are reinvested. It then gradually falls until the next rebalancing.
Steven Leong, head of ETF product with BlackRock Canada, cites as an example the duration of iShares 1-5 Year Laddered Government Bond Index ETF, which is rebalanced annually at the end of June. In July 2018, shortly after last year’s rebalancing, the portfolio’s duration was about 3.3 years, or about half a year longer than the market-cap weighted iShares Core Canadian Short Term Bond Index ETF. But by mid-June of this year, shortly before the annual rebalancing, the duration of the laddered ETF had fallen to 2.5 years, slightly lower than the index ETF. “It’s in the eyes of the beholder, really, whether for most investors that difference in duration is actually meaningful,” says Leong.
As for yields, an apples-to-apples comparison suggests that there are no significant differences between a laddered strategy and its passive market-cap-weighted counterpart. Leong notes that iShares 1-5 Year Laddered Corporate Bond Index ETF currently has a yield to maturity of 2.3%, very close to that of the 2.4% yield of iShares Core Canadian Short Term Corporate + Maple Bond Index ETF. The small spread can be mostly attributed to the cap imposed on the amount of lower-quality triple B securities that the laddered ETF is able to own, Leong says.
The flattening of the yield curve has dampened demand for laddered bond ETFs because there’s scant incentive for investors to hold long-dated bonds. For instance, the 12-month trailing yield of iShares Core Canadian Long Term Bond Index ETF, which holds bonds with maturities of longer than 10 years, was 3.24% in mid-June. By comparison, iShares Core Canadian Short Term Bond Index ETF, holding maturities of one to five years, was 2.36%, a difference of less than a percentage point despite the huge difference in duration risk.
Reinvestment risk still exists for fixed-income investors. But as RBC GAM’s Hoffman, notes, it’s certainly not as prevalent as in the 1990s, when the yield curve was more upward sloping, as it has been historically. “We have seen some flow out of these laddered products, more generally, into the more traditional market-cap index products,” says Hoffman, whose firm is in a strategic marketing alliance with BlackRock. “But they absolutely still serve a purpose in a client’s portfolio. There’s still significant dollars in there.” At some point in the future, there will be greater yield pick-up from investing in longer-dated bonds, Hoffman says, adding: “It’s very difficult to predict when that will happen.”