Our reader invested almost a million dollars in two short-term ETFs, the
iShares Core Canadian Short Term Bond Index ETF (TSX: XSB) and the
BMO Short Corporate Bond Index ETF (TSX: ZCS). Now he’s in the red and is not happy about it.
“My research indicated that in a rising rate environment, I could expect to
see the funds take a market loss equal to any Bank of Canada interest rate
increase multiplied by the ETF’s duration,” he wrote. “So for every 1 per
cent rise in interest rates, I expected a market loss of 1 per cent times
2.8 (duration), which would equal a market loss of 2.8 per cent.
“Given rate increases of 0.5 per cent so far this year, I would have
expected a market loss of something close to 1.4 per cent (interest rate
increase x duration, or 0.5 x 2.8 = 1.4). In reality, the market loss is
closer 2.2 per cent as I write. The distributions are not keeping up with
market loss in value.
“I understand that the above is a rule of thumb, and the market price
reflects many other assumptions, like future rate increases as well as the
market’s relative confidence levels with respect to risk.
“Furthermore, I also understood that individual bonds would be immune to a
capital loss if I held those bonds until maturity and the issuer didn’t
default. I didn’t purchase individual bonds, as it was so much simpler to
“What I would like to understand is how often do the ETFs hold the bonds
until maturity? If they held the individual bonds until maturity, would the
NAV eventually correct itself and the market price move back up as those
bonds mature, thus clawing back the market loss?
“My research noted that ‘authorized participants’ (APs) will likely remove
any price discrepancies between the ETFs net asset value and market price
by creating or destroying shares of the ETF at any time. Does this
arbitrage effectively lock in the market loss of the ETF?
“In general, I am trying to assess whether to sell the bond funds and lock
in a loss or ride it out hoping the distributions would eventually outstrip
the market loss.”
These questions involve the inner workings of these ETFs,
so I asked both BlackRock, sponsor of XSB, and BMO Global Asset Management,
sponsor of ZCS, to respond.
Mark Raes, head of ETF business development at BMO Global Asset Management,
disputed our reader’s return estimate, saying that as of Sept. 18, the fund
had a total return of 0.2% for 2017. As for holding bonds to maturity, he
commented, “Typically, individual bonds trade above par as a reflection of
current market yields compared to when the bonds were issued. Purchasers of
individual bonds would be subject to a capital loss at maturity if they
purchase at a price over $100.
“ZCS holds bonds between 1 to 5 years maturity. Bonds are sold out of the
portfolio once they fall below one year to maturity. This enhances the
liquidity, and yield of the portfolio, as bonds that are less than a year
to maturity can be considered short-term investments.
“The investor is correct that the APs remove the arbitrage opportunity on
the ETF, which means the value of the ETF will generally move with the
value of the underlying bonds. The NAV and the market price of the ETF are
then subject to market movement.”
I received a similar response from BlackRock, which pointed out that most
of the bonds in the XSB portfolio were bought at a premium to par. “As a
result, the market price of these bonds (trading at premiums) will decline
over time towards their par values. If held to maturity, a bond purchased
today will result in coupon income over time, but a loss on the price of
the bond, which when aggregated will lead to a total return equal to the
yield-to-maturity of the bond when purchased.
“For example, if one purchases a bond at 105, the investor will earn coupon
income over the life of the bond, but the price of the bond will approach
100 (par value) as maturity draws closer and closer. It will not, as the
investor is suggesting, jump back up to 105 at maturity, but instead will
be redeemed at 100. This is true whether the bond is held through an ETF, a
mutual fund, or directly.
“What does happen, though, when holding a bond to maturity, is that the
investor locks in a yield-to-maturity (assuming no default). Most bond
index ETFs in Canada track indices which remove bonds at the one year to
maturity mark, and expose the investor to a periodically rebalanced
diversified portfolio of bonds that reflect the current yield, coupon,
duration, credit quality, sector, and maturity profile of the portion of
the market tracked by the given index.”
As of Oct. 31, ZCS was showing a year-to-date gain of 1.1% while XSB showed
a small gain of 0.25%. We should not expect these numbers to improve much
beyond that in the next few months given the current bond market
One final thought. RBC offers a series of bond funds that hold their
positions until maturity. They are called
RBC Target Maturity Corporate Bond Index ETFs, and they are available for the years from 2017 to 2023. As of Oct. 31,
all of the funds out to 2022 were showing small year-to-date gains. These
might be a better choice for our reader.
Gordon Pape is one of Canada’s best-known personal finance commentators and
investment experts. He is the publisher of
The Internet Wealth Builder and The Income Investornewsletters, which are available through the Building Wealth website.
For more information on subscriptions to Gordon Pape’s newsletters,
check the Building Wealth website.
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