What to do with your bond ETFs?

Broad, investment-grade bond ETFs have been hugely popular in Canada, and they are the ones that stand to lose the most from interest rate hikes, says Horizons' Mark Noble.

Christian Charest 24 July, 2017 | 5:00PM
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Christian Charest: For Morningstar, I'm Christian Charest. The Bank of Canada raised its key interest rate by a quarter of a percent on July 12. This was widely expected, but still the reaction on the bond market was severe. To talk about this and what investors can do about it, I'm joined today by Mark Noble, head of sales strategy at Horizons ETFs.

Mark, thanks for joining us today.

Mark Noble: Great to be here, Christian.

Charest: So, to start, can you give us an idea of how the markets reacted to the news and how some of the biggest ETFs were affected?

Noble: Canadians on average have probably the largest proportion of fixed income ETF assets of any developed market, about 30% on average. The global average is about 16%. But within that, it was what we called the aggregate bond asset class. This is a huge asset class; for instance, this year alone about $2.2 billion went into these ETFs. Unfortunately, these are the ETFs that are really being hurt right now because these are investment-grade bonds, which are very sensitive to interest rate rises.

So, if I take the Universe Bond Index, that's about a 7.5-year duration. It's gone wider as the years have gone on. And so, we would expect it loses almost 2% per quarter-point interest rate rise on the underlying interest rates. So, lo and behold, we've seen those ETFs lose about 2% over the last six weeks, which is very significant on a total-return basis because that universe of bonds only yields about 3%.

Charest: And there are more rate hikes expected?

Noble: Our subadvisor, which is Fiera Capital, one of the largest fixed income managers in Canada, they actually -- from a macro analysis standpoint, they've built in two more interest rate hikes after this one. So, they see the overnight rate probably tip over 1%. And as a result, that would probably put an unfunded liability on this aggregate bond space of about 6%. You could lose an additional 6% if we see two more interest rate rises come in. And of course, that's well over a year's worth of yield.

So, definitely, as the Canadian economy starts to inflate -- [GDP growth] was well over 3% for the first half of this year -- we see probably the strong likelihood that the BOC is going to continue to do at least one, maybe as much as two. That's part of the economic reasons.

There's also the other very key reason that interest rates in the United States are potentially capped out, but if you're someone like Justin Trudeau, who needs to fund all kinds of infrastructure and public projects that he was elected on to do, it requires international funding of bonds. Having a huge discount on the rate that Canadian bonds are paying versus U.S. bonds is not something that can last for a long period of time. Those rates on average and historically sort of need to be near each other. So, for this reason, even if economically Canada starts to plateau, you may see those rates continue to increase anyways.

Charest: So, you mentioned that there's an unfunded loss in the neighborhood of 6% and that's equivalent to about a year's worth of yield. Isn't this really just a loss on paper? Because we're talking about a capital loss, the income is still there and most investors who invest in bonds or bond funds are there mostly for the income and for the risk reduction effect to their portfolio? Wouldn't it be more prudent then for them to simply stay the course?

Noble: That's a great point, Christian, and this is one thing I really want to highlight here. I'm not telling you sell your bond ETFs. What concerns me about the bond ETF market is that the duration on these aggregate bond ETFs has really started to widen over last three years. So, if we're having this interview two years ago, we're probably about five years. Now we have drifted to 7.5 years and that's because corporate bonds, for example, that are part of the high investment grade area there, they're allowing the duration to go out because it's very attractive rates for them to lock in their debt.

And while you make a good point that over the long term, is it really going to affect your total return, the problem is on a go forward basis, if we are on an interest rate rising market, it means most of your return is coming from the income. So, you're not getting the padding of the capital going up. And so, while your yield maybe goes from 3% to 3.5%, you could be losing more on the capital side. So, from a total return basis, you could actually find yourself in a negative market condition. In fact, if you look at some of these aggregate bond ETFs, some of them actually do have negative returns now on a one-year basis, and that’s something that many fixed income investors haven't seen probably for eight or nine years. Certainly, it's a rarity even over the last 30 years.

Charest: Can you recommend some alternatives then to the standard cap-weighted mid-duration bonds that a lot of people have?

Noble: That's a nice thing about the Canadian ETF market is there are some really interesting alternatives right now that you can look at to pad your yield. Generally speaking, I usually call the quest for 4%. Most retail and investors are looking sort of for a 4% drawdown on their portfolio. And so, there are some very interesting solutions you can look at.

What I want to highlight is that with bonds, the biggest risk right now is interest rates. What's not a big risk is credit risk. So, credit risk is sort of the other key risk we look at with bonds. Well, if we're in an inflationary economic growth environment, people aren't as worried about the balance sheets, especially of high-quality companies. So, you can look to generate additional yield by either corporate bonds or the one really attractive area is Canadian preferred shares.

So Canadian preferred shares have seen a big rally actually in the last three months in anticipation of rate rises because they are actually positively correlated to interest rates. And the reason for that is 70% of the preferred shares in Canada are called rate-reset preferred shares, and they use the underlying five-year Canadian bond as their benchmark.

So, they pay a spread above the five-year bond. While interest rates rise, so does the yield that those preferred shares pay. And so, for example, we have 100% rate-reset preferred share ETF, the Horizons floating rate rate-reset preferred share ETF, that's up about 10% over the last year. And not only that, but you're still yielding about 4% tax-efficient. So, that's a really interesting way for you to maybe look at transitioning your portfolio.

Another really interesting alternative are senior loans. Now senior loans are actually high-yield debt. So it's non-investment grade debt, but they have no duration. So, again, when we're talking about senior loans, we are looking at sort of the most common senior loan debt that people are familiar with will be the debt of sort of Tim Hortons from its takeover with 3G Capital, but that debt has a yield of about 3.5%, except there's no duration risk, there is no interest rate risk. And if we are not worried again about the ability for these companies to pay their debt, this is an interesting way for us to start building more of that yield into your portfolio.

Charest: Thank you very much for sharing your insights on this topic with us, Mark.

Noble: Always a pleasure, Christian. Good luck.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.

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Christian Charest

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