Bond ETFs climb as rates fall

Three ETFs that stand to benefit

Since their arrival over two decades ago, bond ETFs have become a popular way for individual investors to gain exposure to the fixed-income market. Before that, investors could buy individual bond issues; however, this was not always feasible because of the high minimum investments, low liquidity, and lack of diversification. Fixed-income mutual funds were another option that alleviated some of these issues, but at that time, these were primarily active funds that came with sales charges as well as management expense ratios (MERs) in the 1% to 2% range. Fixed-income ETFs solved these problems by packaging bonds into low-MER funds that could be bought and sold just like stocks.

As rates increased dramatically over the past two years, fixed-income products performed very poorly. This is because bond prices move inversely with the direction of interest rates. For fixed-income products, the most common metric used to measure sensitivity to changes in rates is called “duration.”

There are a few different ways to interpret duration, but the important thing to know is that the higher the duration, the more the price of a bond will fluctuate with changes in rates. In general, long-term bonds have a higher duration than short-term bonds. So, in a rising rate environment, long-term bond funds are expected to underperform short-term bond funds. As the accompanying table shows, this is exactly what has happened to Canadian bond funds across the duration spectrum.

Over the past few months, inflation has cooled, and signs have emerged that the economy is slowing down. Many investors and market participants believe that interest rates have peaked. In fact, yields at the long end of the curve have already come down off their highs and many expect that the Bank of Canada will begin cutting the overnight rate as early as March 2024. Declining rates would be welcome news for fixed-income investors after the losses they have endured. Depending on an investor’s risk tolerance, here as three ETFs that stand to benefit from such a scenario.

iShares Core Canadian Short Term Corporate Bond Index (TSX: XSH) debuted in 2011 and is in the Canadian Short Term Fixed Income category. XSH seeks to replicate the performance of the FTSE Canada Universe + Maple Short Term Corporate Bond Index, which consists of investment-grade corporate bonds with maturities of between 1 and 5 years. It includes bonds issued by Canadian issuers as well as Maple Bonds, which are bonds issued in the Canadian market by foreign issuers. The duration is 2.6 years, and the trailing 12-month (TTM) yield is 3.2%. After losing 4.5% in 2022, XSH finished 2023 up 6.6%, gaining over 4% in the final two months of the year. The fund has an MER of 0.1% and is rated Low-risk.

BMO Aggregate Bond Index ETF (TSX: ZAG) is in the Canadian Fixed Income fund category, and was launched in 2010. It is designed to replicate the performance of the FTSE Canada Universe Bond Index. The index is a broad measure of the Canadian investment grade fixed-income market consisting of federal, provincial, and corporate bonds. The duration is just over 7 years, and the TTM yield is 3.5%. ZAG lost 11.8% in 2022 and was on track for another poor performance in 2023, down 1.1% through Oct 31. But a strong November and December propelled this fund to a gain of 6.7% for the year. The fund is rated Low-risk and has an MER of just 0.09%.

Vanguard Canadian Long-Term Bond Index ETF (TSX: VLB) debuted in 2017 and is in the Canadian Long Term Fixed Income category. This ETF seeks to track the Bloomberg Barclays Global Aggregate Canadian 10+ Year Float Adjusted Bond Index, a market-capitalization-weighted index of investment-grade government and corporate fixed-income securities issued in Canada with maturities of at least 10 years. The duration of VLB is close to 15 years, and it has yielded 3.7% on a TTM basis. 2022 was particularly painful for this fund, which fell 21.8%. It looked like more losses were in store for 2023 until it shot up 15% in the final two months, finishing the year with a gain of 9.2%. VLB has an MER of 0.17% and a risk rating of Low to Medium.

Brian Bridger, CFA, FRM, is Senior Vice President, Analytics & Data, at Fundata Canada Inc. and is a member of the Canadian Investment Funds Standards Committee.

Notes and Disclaimers

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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