How to help investors avoid interest-rate risk

Fixed income investors are facing a period of sustained uncertainty and choosing the most suitable – and effective – investment vehicles will be central to a portfolio’s success

How to help investors avoid interest-rate risk

The Bank of Canada’s stance has changed radically over the past six months — and things could change yet again. Fixed income investors are facing a period of sustained uncertainty and choosing the most suitable – and effective – investment vehicles will be central to a portfolio’s success.

In Canada’s ETF market, fixed-income investors have many options when it comes to targeting the short end of the yield curve. They also have a healthy selection of strategies that concentrate exclusively on corporate issues, including the BMO Corporate Bond Index ETF, which trades on the TSX under the ticker ZCB.

ZCB tracks the Bloomberg Barclays Canadian Corporate Index. The index consists of Canadian investment-grade, fixed-rate, corporate bonds that must have greater than one year to maturity and greater than $150 million outstanding and issued by a diversified number of sectors including industrials, utilities and financial issuers.

“Although we have seen central banks tighten monetary policy in recent years, it looks as if that tightening cycle is at least taking a pause for the time being,” said Alfred Lee, Director, Portfolio Manager, Exchange Traded Funds at BMO Asset Management. “With less concerns of rising rates, investors could become less inclined to overcrowd the short-end of the curve. A more accommodative policy from the central bank could mean that the credit environment remains positive, meaning that investors may continue to keep their exposure to corporate bonds.”

The dramatic improvement in corporate credit has occurred amid a year-to-date pickup in the economy. And while moderating concerns about interest rates has allowed outperformance on the long end of the curve, uncertainty around the Bank of Canada’s stance can create concern.

“Also, given we are late in the economic cycle, we have seen many investors move out of areas such as high yield bonds and into investment grade areas. ZCB allows for investors to efficiently access, investment grade corporate bonds across the entire yield curve in a cost efficient manner.”

“I think a lot of that negativity has already been priced into the market; economists on the Street think the five-year could go as low as 1.5%, and right now we’re at 1.55%,” he said, pointing to the recent harsh winter as a possible reason behind depressed economic activity and market expectations. “As we head into spring and summer, we could potentially get positive economic surprises that push interest rates back up, so investing in corporate bonds across the entire term, can prove to be a more prudent way of getting exposure to corporate bonds right now, given the uncertainty of interest rates going forward.”

ZCB comes at a price of 15 basis points, whereas the iShares Canadian Corporate Bond Index ETF (XCB) — which tracks the performance of the FTSE Canada All Corporate Bond Index — is offered at 40 basis points.

Another benefit of ZCB is that it trades at a higher NAV. “Although ZCB at times may seem that it has a wider bid-offer spread, investors should look at it from a basis point perspective as the spread is really due to ZCB being at a higher NAV,” he said. “

ZCB outperformed the broad-based FTSE Canada Universe Bond Index by 0.28% over the 12-month period up to December 31, 2018. But the fund’s low cost and performance aren’t the only things that retail investors benefit from. The fund was also launched at a higher NAV; this is desirable for institutional investors, which tend to pay their commissions on a per-share basis.

“Generally, a higher-NAV product attracts institutions,” Lee said, explaining that a higher NAV means fewer shares executed. “The more institutional investors use a product, the more it improves secondary-market liquidity for the ETF, which benefits retail clients who want to get in and out of that product.”

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