Higher interest rates on the horizon?

There is a large selection of passively managed, index-tracking fixed-income ETFs on the product shelf, allowing “advisors and their clients [to] pinpoint exactly where they want to be in terms of both duration and credit risk,” says Alfred Lee, vice-president, portfolio manager and investment strategist on the ETF team at BMO Global Asset Management Inc. (All firms are in Toronto unless otherwise noted.)

For example, Lee suggests that in a rising-rate environment clients could have the bulk of their fixed-income holdings in short-term corporate bond ETFs, such as BMO Short Corporate Bond Index ETF. This ETF, which tracks the FTSE TMX Canada short term corporate bond index, invests in bonds with terms to maturity of one to five years.

With actively-managed fixed-income ETFs, portfolio managers can adjust the duration and the mix of holdings as the interest rate environment changes. This can be important at a time when there is no clear picture of the direction —  and speed — of interest rate changes.

“There’s no consensus on how much or even when interest rates will go up or on how Canadian rates will move vs U.S. rates,” says Rohit Mehta, executive vice-president for distribution and strategy at First Asset Investment Management Inc., a wholly-owned subsidiary of CI Financial Corp.

Furthermore, there are more anomalies in pricing in fixed-income markets (compared to equity markets) that portfolio managers can use to enhance income, says Mark Noble, senior vice president, sales strategy, at Horizons ETFs Management (Canada) Inc.: “Fixed-income markets are a lot more inefficient than equity markets.”

One option from First Asset to deal with a low rate environment and rate uncertainty is First Asset Investment Grade ETF, which invests in Canadian, U.S. and European investment grade corporate bonds, with all foreign currency exposure hedged to Canadian dollars except in exceptional circumstances. Mehta notes that this ETF “can capitalize on potentially higher rates in different jurisdictions, while also managing the overall duration of the portfolio to protect against the unwanted downward price pressure on bonds as interest rates rise.”

Another possibility is Horizon Active Floating Rate Bond ETF, says Noble. This ETF invests in high quality investment grade bonds and uses derivatives, including interest rate swaps, to deliver returns that reflect current rates. Noble says that is average duration effectively is zero.

Portfolio managers also favour  ETFs investing in preferred shares with rate resets in this today investment climate because their dividends will increase if rates are higher when the reset date occurs. Mehta thinks this is an area in which active management can make a big difference. “The preferred share market, based on all of the different structures and nuances, is one that really calls for a specialized manager.” 

Noble says that devoting 5%-10% of a portfolio’s assets in preferred share ETFs would be a reasonable allocation.

Once decisions have been made about the core fixed-income holdings, clients can consider adding a bit of spice to their portfolios, in the form of potentially better performing but riskier ETFs that invest in high-yield bonds. The rise in U.S. interest rates is signaling that economic growth is improving, which should mean less risk of defaults by high-yield bond issuers.

There are a number of ETfs that offer exposure to high-yield bonds. One example is the actively-managed iShares Conservative Short term Strategic Fixed Income ETF, sponsored by BlackRock Asset Management Canada Ltd. The portfolio manager of this ETF is permitted to invest up to 25% of the ETF’s assets under management (AUM) in high-yield bonds. It currently has about 12% of AUM in high-yield bonds, says Pat Chiefalo, head of iShares Canadian product at BlackRock Asset Management Canada Ltd. in Toronto

Despite the attractiveness of high-yield bond ETFs, they should not be heavily weighted in client portfolios beause of their potentially higher risk. Mehta suggests that a reasonable allocation is  5%-10% of a portfolio’s assets.

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