Short-term bond ETFs provide yield for conservative investors

While acknowledging that bond ETFs lack the principal guarantees of GICs or other cash deposits, Mathews said short-term bonds can help diversify a fixed income portfolio while limiting duration risk.

By definition, funds in the Canadian short-term fixed-income category invest primarily in investment-grade securities with an average duration of less than 3.5 years.

Bond prices move in the opposite direction of interest rates. If interest rates were to soar a full percentage point, for example, that would imply a capital loss of 8% for a broad-market Canadian bond ETF with an average duration of eight years. The longer-dated the bond portfolio, the greater the losses.

Conversely, shorter-term bonds are less risky. “Where yields can be found in the short end of the curve today,” said Mathews, “can outweigh a lot of the risks that an investor can take on in terms of the rising rate environment.”

For advisors, a Canadian short-term bond ETF can be a liquidity tool or a tactical tool, said Jonathan Needham, vice-president, ETF distribution, with TD Asset Management Inc.

They’re potentially a ready source of cash, or they can serve to express the views of advisors who want to decide where their clients should be along the yield curve. If outsourcing that asset-mix decision, Needham added, a more suitable choice would be a broader strategy such as that of the TD Income Builder ETF.

The short-term fixed-income category of ETFs, with assets totalling about $17 billion, is dominated by index strategies. Led by the $3.3-billion iShares Core Canadian Short Term Bond Index ETF, the five largest funds, each with assets exceeding $1 billion, have management expense ratios (MERs) of no more than 11 basis points. That’s an important advantage in this low-yielding category.

Another characteristic of the historically best performing ETFs is a focus on corporate bonds. BMO Short Corporate Bond Index ETF, Desjardins 1-5 Year Laddered Canadian Corporate Bond Index ETF, Invesco 1-5 Year Laddered Investment Grade Corporate Bond Index ETF, iShares Core Canadian Short Term Corporate Bond Index ETF and Vanguard Canadian Short-Term Corporate Bond Index ETF all have five-star Morningstar ratings for risk-adjusted returns.

Illustrating the yield advantage is the iShares corporate ETF, whose 12-month trailing yield of 2.88% is more than half a percentage point higher than that of its more broadly positioned iShares counterpart, the iShares Core Canadian Short Term Bond Index ETF.

Active managers, albeit at a higher cost, can attempt to add value through company selection as well as through duration management. “There are different drivers for why an investor may choose a low-cost index exposure versus a more higher-cost active exposure,” said Mathews.

The actively managed Mackenzie Canadian Short Term Fixed Income ETF recently had a 2.2% trailing 12-month yield, similar to its passive counterpart, while holding more corporate issues and taking far less duration risk. “That is the type of behaviour that is differentiating an eight-basis-points product from a 35-basis-points product,” said Mathews, referring to the management fees of the two Mackenzie ETFs.

Over at TDAM, the only offering in the category is the actively managed TD Select Short Term Corporate Bond Ladder ETF, with a 0.28% MER. As of the end of October, it was just short of the three years of history required to qualify for a Morningstar rating. The ETF has outperformed its passive benchmark, overcoming its higher fee hurdle.

Elsewhere in the category are a couple of ETFs — BMO Ultra Short Term Bond ETF and Horizons Active Ultra-Short Term Investment Grade Bond ETF — whose durations are at the short end, even within their peer group.

The BMO ETF, for example, has a duration of only about half a year. Less risk has also meant lower returns. For the three years ended Sept. 30, the ETF has a well below-average annualized return of 1.7%.

Taking the least duration risk of all in the Canadian short-term category are several ETFs that specialize in floating-rate securities: CIBC Active Investment Grade Floating Rate Bond ETF, Dynamic Active Investment Grade Floating Rate ETF, Invesco 1-3 Year Laddered Floating Rate Note Index ETF and iShares Floating Rate Index ETF.

The generally high credit quality of these ETFs sets them apart from funds in the floating-rate loan category, which are higher yielding but whose holdings are largely below investment grade.

The yields on short-term bond ETFs that hold floating-rate securities are lower than others in the category, but so is their duration risk. In fact, since interest payouts on floating-rate securities rise when market rates go up, these ETFs can do well in a rising rate environment.

With a weighted-average duration of just 0.15 years, the sensitivity of the Invesco ETF (TSE: PFL) to rising rates is “quite minimal,” said Pat Chiefalo, Canadian head of ETFs and indexed strategies with Atlanta-based Invesco Ltd. “PFL is well positioned to potentially offer higher yields than savings accounts, while at the same time benefiting from the prospects of a rising rate environment due to its low duration profile.”