An inhospitable environment for bond ETFs



Regardless of their low yields, bonds offer diversification and a source of liquidity when equity markets turn bearish. Financial advisers and their clients need to think about how to structure their fixed income allocations in today’s harsh environment.

“Certain segments of the fixed income market and different strategies may still work and produce positive returns in fixed income,” said Paul Sandhu, President and CEO of Toronto-based Marret Asset Management Inc. , which manages around $ 5.5 billion in mutuals. funds and ETFs for CI Investments Inc. “For example, some fixed income strategies do not take interest rate risk. Some bond strategies focus more on yield with a very limited duration. “

Even so, the returns will not come easily. Overall, corporate bonds only earn around 100 basis points more than government bonds. “Quality corporate credit is not too attractive given current spreads,” said Sandhu, referring to the average recovery in yield over Government of Canada or US government issues. “If you look at the Canadian market, we’re only five or 10 basis points away from historic credit spread tightening. “

In addition, corporate balance sheets currently tend to be heavily leveraged, with a higher proportion than in the past of BBB-rated credits, the bottom of the investment category. “We have almost the highest levels of corporate debt in history and we are paid very little,” said Sandhu, whose largest ETF under management is the 880 million CI Investment Grade Bond ETF. dollars. “So from a fundamental credit standpoint, your risk-return here isn’t great.”

That said, Sandhu believes that investing in business issues for extra return still makes sense, given an economic environment where businesses will reopen as the Covid-19 pandemic abates and flows of corporate cash flow will improve. But he doesn’t expect much in terms of capital gains – excess returns greater than returns – from further spread tightening.

When investing in corporate bonds, security selection is important, said Tom O’Gorman, director of fixed income at Franklin Bissett Investment Management, part of Franklin Templeton Investments Corp. kind of research, ”said O’Gorman, who heads a team in Calgary that manages more than $ 5 billion. “The easy money just by allocating to corporate bonds has been made. Now it becomes a very relative value.

The same reasoning applies to high yield corporate bonds. As O’Gorman said, the high yield is no longer high, as some issues have coupon yields of 4% or less. On the positive side, these bonds offer diversification to Canadian investors due to their lack of correlation with the broader Canadian market, he said.

Floating rate bank loans are another source of higher fixed income returns, and Franklin Bissett’s team added to the holdings for modest amounts. In addition to being positively correlated with economic growth, loans can perform well in a rising rate environment, O’Gorman said. Due to their floating rates, their prices move in the same direction as interest rates.

Real return bonds also offer protection against rising rates because their payments are tied to inflation. They have outperformed the Canadian market as a whole over the past 12 months, but not more recently, as evidenced by the annual cumulative losses of the BMO Real Return Bond Index ETF and the iShares Canadian Real Return Bond Index ETF.

Marret holds real return bonds in almost all of his mandates. Almost all of these holdings are in inflation-protected US Treasury securities, known as TIPS, which Sandhu prefers because they are much more liquid than Canadian government real return bonds. Investors in ETFs can gain exposure to TIPS through the BMO Short Term US TIPS Index ETF, launched in January.

Sandhu said that since real return bonds had already performed well last year while providing protection against inflation, the time to buy is likely over. “You would have to have a very hawkish view of inflation to buy more inflation-protected bonds from here,” he said. “In fact, you might be looking for a place to start selling them. “

Among the more exotic fixed income investments are emerging market bonds. “That hasn’t been a big part of what we do,” said O’Gorman, who favors issues in US dollars over those denominated in local currencies. “But again, this is another one of those areas that can offer some diversification.”

Sandhu said Marret generally avoids such securities due to the higher risk of default, volatile local currencies and difficulties in assessing the creditworthiness of sovereign or private issuers. “We are not emerging market experts and we do not pretend to be.

Led by IA Clarington Emerging Markets Bond Fund, Canadian-listed fixed income ETFs specializing in emerging markets have outperformed their Canadian counterparts over the past 12 months. But Sandhu said the risk factors associated with these stocks “are larger exposures than what we really want to take for our clients.”

What Sandhu enthusiastically supports is global diversification into developed markets. In government bonds, diversification allows Marret to take advantage of different monetary policy regimes and relative value differences between different countries. On the corporate side, issuers in the United States and elsewhere provide exposure to fixed income securities in sectors and industries that are not available in Canada.

With multinational companies issuing bonds in various currencies, Marret seeks to exploit price anomalies between countries. “You may be able to find bonds from one issuer that are cheaper in one market compared to another,” Sandhu said.

But Marret generally avoids foreign currency exposure by hedging entirely in the Canadian dollar. “The currency is in our opinion one of the most volatile asset classes,” said Sandhu. “Having unhedged currencies in your fixed income portfolio usually gives you more volatility. What we’re trying to do is sell you fixed income products that reduce the volatility of your overall asset allocation.

O’Gorman takes a contrasting point of view. While the Franklin Bissett team’s scope of foreign currency exposure is limited in its Canada-focused mandates, such as the Franklin Liberty Core Plus Bond ETF, it currently has approximately 7% US dollar exposure in his wallets.

“We consider the Canadian dollar to be extremely overvalued,” said O’Gorman, citing a national economy driven by consumer borrowing and government stimulus measures, and where the real estate boom is crowding out capital investment.

“We’ve seen these overshoots before where the pendulum gets way too bearish on the Canadian dollar and far too bullish,” he said. “And we think [the market is] in the far too bullish camp right now.



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