Bond ETFs to suit every need

As well, for the first eight months of 2024, fixed-income ETFs accounted for 35% of year-to-date net creations, versus 54% for equity ETFs, National Bank Financial reported. Despite the sector’s remarkable product diversity, investors appear to be erring on the side of caution as central banks contemplate a rate-cut cycle.

In 2023, net creations of fixed-income ETFs were barbell shaped. According to National Bank Financial, in total, 44% were in very short-term funds, such as money-market funds (and high-interest savings account ETFs), although demand for this fund type appears to be faltering, and 40% in aggregate bond funds.

A 17% share was in long-term bond ETFs, which is fairly high for 2022’s hardest-hit fund class during the rate hike cycle. National Bank Financial attributed this renewed popularity to the end of the Bank of Canada’s rate hikes, with some investors keen on lengthening bond portfolio durations.

In 2023, short-term bond ETFs logged $2.8 billion in net redemptions. National Bank Financial suggested there is no reason to interpret this rebound as a downbeat sign, as some “outflows may have been strategic, especially as some institutions have been pursuing higher-yielding options.”

Target-date bond ETFs appear to be top performers, touted as “rising stars” by TD Securities. Launched in 2011, this type of ETF doubled in size in 2023 alone. According to National Bank Financial, demand for this ETF type has continued unabated in 2024, with total assets surging from $2.3 billion at the end of December 2023 to $3.8 billion at the end of August 2024.

Change of course

For the first eight months of 2024, market forces, and specifically the BoC’s first rate cut, changed these dynamics.

Net creations of money-market ETFs remained positive, albeit shy of 2022 and 2023 levels. An “interesting dichotomy” affected this ETF type in 2024, with high-interest savings account ETFs seeing low net creations, as money-market ETFs enjoyed steady net creations month after month. “This trend has been in place since the start of this year, possibly because of the yield differentials that arose between the two categories following OSFI’s review of bank liquidity treatment for deposits underlying ‘cash’ ETFs,” National Bank Financial said.

In addition, for the first eight months of 2024, Canadian corporate bond ETFs and aggregate market bond ETFs were leaders in net creations.

Let’s look back at the rise of target-maturity ETFs. Underlying these funds is a basket of fixed-income securities with the same maturity. According to an April 2024 report from TD Securities, investors who hold these ETFs to maturity can expect to receive payments near the par value of the underlying bonds, ensuring predictable performance for these ETFs.

These ETFs also allow, TD Securities continued, “to build a laddered bond ETF portfolio using a few ETFs of varying maturities instead of trading the individual bonds. … In today’s environment, investors also view target maturity bond ETFs as an efficient way to protect themselves from rising rates, as their durations gradually decrease to zero with time.”

Target-maturity bond ETFs “stand out in times of heightened volatility and drawdowns,” TD Securities explained, which appropriately describes the current environment.

According to National Bank Financial, these funds are popular with advisors because they potentially reduce interest rate risk, while replicating the behaviour of a single bond.

By 2023, inflows already totalled $1.7 billion, TD Securities reported. “There are now 45 ETFs of this type from four issuers,” said Tiffany Zhang, vice-president of ETFs and financial products research with National Bank Financial.

April 2024 saw TD and RBC iShares launch multiple target-maturity bond ETFs in the U.S. and Canadian corporate sectors, with target maturities for each year from 2025 to 2029. July also ushered in a flurry of target-maturity ETFs from CIBC, which had yet to enter the sector, with nine investment-grade ETFs with target maturities ranging from 2025 to 2030, including three U.S. issues.

Maturities from 2025 to 2028 inclusively record the most AUM. Note that the lion’s share of these ETFs favour Canadian corporate bonds. As investors in these ETFs hold them to maturity, funds with longer maturities “are not as attractive,” TD Securities emphasized, “as most investors may not want to lock in a lower yield for a very long period.”

These target-maturity ETFs are not for everyone. “We don’t use them,” said Stéphane Martineau, portfolio manager with Desjardins Securities. “In discretionary management,” he added, “you don’t necessarily want to have a large block of securities maturing in three or five years. We don’t need it to achieve our goals of managing duration, credit risk and taxation. But I fully understand that they can be used.”

These fixed-maturity ETFs are definitely attractive, said Laurent Boukobza, vice-president and ETF strategist with Mackenzie Investments. “The approach is popular,” he acknowledged, “when considering that building a broad and diversified bond portfolio is not convenient for an advisor — and virtually impossible for an individual investor.”

On the other hand, Boukobza said, the entire bond universe is currently attractive from the fundamental standpoint of a bond portfolio’s three goals: diversification, capital preservation and income production. “Bonds have attractive yields to maturity, while the underlying securities trade at a discount for the most part,” he explained.

Martineau pointed out the presence of discount bond ETFs, “which we did not see three years ago” and which benefit from the fast-moving overall rate trends. “There are ETFs that seek such bonds exclusively,” he said. Of course, these ETFs are actively managed, he noted.

ETFs that hold a basket of bonds trading at subpar-value prices enjoy a tax benefit. When held in non-registered accounts, the funds’ return at maturity consists of capital gains and lower interest, which may reduce the tax payable in the immediate future.

Geoff Castle, portfolio manager of the Pender Corporate Bond Fund, highlights some fixed-income securities that are currently offering unexpected discounts, although such opportunities are still rare. Bonds issued at par by Desktop Metal a few years ago, for instance, fell to $0.50, while issues from Lucid Group and Emergent BioSolutions slipped to $0.30. Such discounts can clearly be red flags, “but despite the very low prices of these bonds, we deemed there was significant credit support in their structures,” the manager noted.

Three other types of bond ETFs have also been a hit with advisors and their clients, Boukobza acknowledged: broad market (aggregate), short-duration and long-duration ETFs, with the last classes employing a barbell strategy. In fact, aggregate bond ETFs “are considered the core allocation in a balanced portfolio,” he stressed.

The barbell approach clearly demonstrates the changes underway in the bond market, Zhang noted. First, after the 2022 correction, she said, investors are risk-averse and prefer short durations. “If rates didn’t go down, or even rose, investors would lose out.”

Second, central banks’ signals of rate cuts are prompting many investors to adopt positions over longer horizons. An issue like the iShares 20+ Year Treasury Bond ETF (Nasdaq: TLT) is a fine example of the interest longer maturities can rekindle, she said, as this ETF has yielded a total return of 25% since the bond market began to recover from its October 2023 low.

“The yield curve is still inverted, which means that shorter-term securities generate higher yields with less duration risk,” Boukobza noted.

With persistent uncertainty surrounding the timing and magnitude of rate cuts, many investors have hedged against an economic slowdown with longer bonds, while retaining sound short- and very short-term allocations.

“We can expect to see a reallocation to longer durations when investors feel more confident about central banks’ monetary policy and their downside expectations,” Boukobza added.