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While interest rates were rising, bonds and the funds that invest in them were a drag on income portfolios.
Sure, they kept making regular payments (or distributions in the case of funds). But their market value eroded every time the Bank of Canada raised interest rates.
In 2021, the iShares Core Canadian Universe Bond Index ETF (TSX: XBB) lost 2.65%. The next year was even worse, with the fund dropping 11.78%. That’s almost unheard of in an ETF of this type.
The comeback began when the central bank pushed the pause button on rate hikes in 2023. The ETF gained 6.61% that year. Now that rates are falling – three BoC cuts so far this year and more expected – XBB is on a pace to match and perhaps exceed last year’s gain. To Sept. 26, it was showing a year-to-date gain of 3.63%. Most of that gain has occurred in the last three months.
But the bond market recovery we’re experiencing is uneven. Short-term bonds are outperforming long-term issues in some cases, leaving investors puzzled. This isn’t the way it’s supposed to work when rates are falling.
The reason for this unusual situation is the inverted yield curve we experienced earlier this year, with short-term rates higher than long term ones. That meant short-term rates had farther to fall when rates began to decline, boosting their capital gains potential.
That situation is now ending. Long-term U.S. Treasury rates are now close to or slightly above short term rates. As of Sept. 26, 10-year Treasuries were paying 3.79% compared with 3.60% for two-year issues. We’re seeing a similar situation in Canada.
For a closer look at how this is playing out in the ETF world, let’s have a closer look at three bond exchange-traded funds and see how they are performing. Prices are as of Sept. 27.
iShares Core Canadian Universe Bond Index ETF (TSX: XBB). This ETF tracks the broad Canadian bond market. It covers government and corporate issues with maturities of a few months to more than 20 years. The fund has $8 billion in assets and an MER of 0.1%.
As mentioned above, this ETF is in recovery mode after down years in 2021-22. The credit quality is very high, with all the holdings rated investment grade. Federal bonds make up 40.22% of the total assets with provincials accounting for 33.16%. High-rated corporate issues make up most of the rest of the portfolio.
Because this fund covers the entire bond market, it’s not being adversely affected by the unevenness of the recovery, making it a good choice for fixed-income portfolios.
iShares 0-5 Years TIPS Bond Index ETF (TSX: XSTP). This is a short-term ETF that invests in a Canadian dollar hedged portfolio of inflation-protected bonds, known as TIPS, issued by the United States Treasury. The fund is designed to protect your money while providing a modest rate of return. Investors have also benefitted from the weakness of the Canadian dollar against the greenback.
The fund is showing a year-to-date gain of 6.9%. But that return reflects the past, not the future, and the exchange rate differential is responsible for part of the gain. The U.S. dollar version of this fund is up only 4.65% year to date. As the yield curve continues to revert to normal and inflation drops, the return on this fund will decline.
Another drawback from the point of view of income investors is the unevenness of the distributions. Some months they are very healthy, but some months the payments are zero. There’s no predictability.
For example, there were big distributions of $0.219 per unit in May and $0.266 per unit in June. But the July payout fell to $0.139 and August’s was $0.097. If you’re looking for dependable cash flow, this is not your fund. It’s either a feast or a famine with this ETF when it comes to distributions.
This fund is not well positioned for the new environment of falling rates and reduced inflation, so I would not add to positions or open new ones. If you own units, hold for as long as they keep generating above-average gains but be ready to switch to a different option unless you’re willing to live with a much lower return.
iShares Core Canadian Long Term Bond Index ETF (TSX: XLB). This ETF invests in a portfolio of long-term Canada bonds with a maturity of more than 10 years. The ETF was launched in November 2006 and has $1.2 billion in assets under management. The management expense ratio is 0.2%.
Long-term bonds have greater profit potential when interest rates fall, but we haven’t seen the full effect of that yet. The fund gained 9.34% in 2023 but is up only 0.94% so far in 2024. That’s because the inverted yield curve we experienced pushed short-term rates higher than long-term ones. When rates began to drop, short-term bond funds benefitted more as a result.
The balance is shifting, however, and I expect a better performance from this fund going forward.
The majority of the holdings (56.44%) is in provincial bonds. Federal issues account for 18.64%. Just under 3% is in municipals, with the rest in corporate bonds. All the bonds are investment grade (rated BBB or higher). About 19% are rated AAA.
Distributions are made monthly and are currently $0.062 per unit. Distributions are not guaranteed and could change at any time, but historically they have shown reasonable consistency.
The bond market recovery is uneven and not as predictable as we would normally expect. This is particularly true of ETFs and mutual funds. Do your research before making any commitment. And consult with your advisor to ensure investments you are considering meet your financial objectives and risk tolerance.
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 Investor newsletters, which are available through the Building Wealth website.
Follow Gordon Pape on X at X.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney.
Notes and Disclaimer
Content © 2024 by Gordon Pape Enterprises. All rights reserved. Reprinted with permission. The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned carry risk of loss, and 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. Always seek advice from your own financial advisor before making investment decisions.
Image: iStock.com/Jirapong Manustrong
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