Getting active bond exposure with ETFs

Navigating an uncertain fixed-income market

ETFs continue to make inroads into fixed-income mandates, based on their liquidity, low cost, and as an effective way to efficiently reposition portfolios. Of late, we have seen the emergence of active bond ETFs that have caused investors to take a fresh view of their portfolios.

The opportunity for active managers is fueled by interest-rate volatility and market reactions to central bank announcements, plus inflation and economic growth expectations. We have exited a long period of declining rates, and can now expect return differences across sectors and issues as bond markets adjust to the tightening regimes.

As well, since bonds trade over the counter, fixed income markets lack the transparency of exchange trading, increasing the potential of active management. The Canadian market is focused on investment-grade government and corporate bonds, so active managers can add value not just in traditional markets, but by adding high yield bonds, looking across geographies and investing in securitized debt.

At the same time, the traditional benefits of ETFs remain in place: diversification; transparency; and enhanced liquidity. Typically, active fixed-income ETFs have been at the forefront of lowering the cost of active investing. These ETFs then combine the benefits of ETFs with active exposures.

Placed alongside passive ETFs, these new active ETFs add value through investing outside of traditional benchmarks and finding pockets of undervalued bonds. How to best use active ETFs? We view active and passive as complimentary, where depending on an investor’s approach, active, passive, or a blend can be effective ways to build a portfolio.

The simplest decision tree puts the emphasis on passive for fee-conscious investors and active for investors looking for outperformance. Just as important is an investor’s level of conviction in the markets, or their confidence in their views. An uncertain investor will favour the use of active managers to make allocation decisions, where a high conviction investor will want to pick their own passive building blocks around yield curve, credit, and currency views.

Investors can build portfolios around their view of the economy, where an optimistic view will favour corporate bonds in anticipation of narrowing credit spreads. As well, views on the yield curve, where short-term bonds are most impacted by central bank policy and long term bonds move with the economic cycle and inflation, can dictate portfolio positioning using ETF building blocks.

The ETF’s exposure also counts, where a traditional, domestic investment-grade manager will not have the same active opportunities as a global, multi-sector manager, unless the domestic manager can invest outside of their benchmark. Security selection is less impactful on bonds than equities, so credit, curve, and sector decisions drive fixed income outperformance.

Looking at the past three years, confirmation comes from the returns by category, where the dispersion in Canadian Fixed Income at 1.6% annually, falls short of the dispersion in Global Fixed Income and High Yield Fixed Income, at 3.0% and 5.1% respectively.*

Within Canada, taking concentrated portfolio decisions can drive performance, where splitting the investment grade universe by credit and term significantly drives performance. As shown in the table below, the dispersion in the three-year return between short federal bonds, at 0.2% annually, and long corporate bonds, at 5.5%, has a 5.3% performance spread.

BMO ETFs recently launched three active fixed income ETFs to help build portfolios:

* BMO Core Plus Bond Fund (TSX: ZCPB)

* BMO Global Multi-Sector Bond Fund (TSX: ZMSB)

* BMO Global Strategic Bond Fund (TSX: ZGSB)

Adding active fixed income ETFs can add outperformance to portfolios, used wisely by adding off-benchmark investments, making curve and credit decisions, and investing in global sectors that are more developed than in Canada. Working together with passive fixed income ETFs, blended portfolios offer meaningful differentiation across interest rate curves and credit while keeping a focus on low cost.

* As of June 30, 2018. The returns are winsorized to remove top 10% and bottom 10% of funds. Returns based on all Series F funds within each specified Morningstar fund category.

Mark Raes is Head of Product, ETFs and Mutual Funds, BMO Global Asset Management Inc. This article first appeared in the Fall 2019 issue of Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.

Notes and Disclaimer

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp. and BMO’s specialized investment management firms. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

®BMO (M-bar roundel symbol) is a registered trade-mark of Bank of Montreal.