Fixed income exposure through ETFs

By Darren Matte

After witnessing market volatility in the fourth quarter of 2018, many investors turned to fixed income to find peace of mind. As central banks paused their interest rate hikes, the markets were able to stabilize.

Moving forward, fixed income remains an important component of investors’ portfolios. One thing fund manager Horizons ETFs has noticed is that investors are increasingly turning to ETFs to gain exposure to fixed income instruments. By offering efficient exposure to a diversified set of fixed-income products, ETFs could be the way many investors incorporate fixed income in their portfolios moving forward.

Fixed income globally and domestically
The hiatus in rate increases was predicated by a slowdown in global growth, says Jane-Marie Rocca, vice-president and senior portfolio manager in fixed income at Fiera Capital, which sub advises some of Horizons’ fixed income ETFs.

“Tariffs created a lot of uncertainty, and in the fourth quarter of 2018, that uncertainty caused central banks to pause increases,” Rocca says. “Domestically, rate increases also paused, as there was a fear of a recession. I still think it is too early to say that, but the pause made for a more positive tone in the first quarter of 2019.”

In addition to allowing the market to regroup, Rocca says, the lack of rate hikes also helped the liquidity of fixed-income products. “Interest rates were coming off lows – in Canada, the 10-year treasury bond yield is 1.75%, but it was as low as 1.53%,” she says. “Markets tend to go one way or another, but now they are stabilizing; even the riskier assets began to stabilize in the first quarter of 2019.”

Rocca believes rates aren’t likely to go up again in the immediate future. She says the central banks are looking to stimulate growth and aren’t as worried about inflation rising.

“We probably won’t see rates go lower or hit the lows they were at,” she says. “Canada does have issues in household debt, and keeping rates low allows Canadians to handle that debt, knowing that their mortgages aren’t going to increase significantly. With rates remaining the same, it could get growth going again and allow provincial and corporate spreads to do well and add to their positions.”

If the current environment persists, Rocca notes that it will allow the capital in fixed-income investments to remain and the income to continue. “There is a nice balance right now for fixed income,” she says. “Growth is slowing, but I hope that by stopping rate increases, it will help with stability.”

Now, Rocca sees plenty of opportunities in fixed income, especially for active managers. “Active managers can take advantage of trends in terms of duration in the portfolio or in corporate credit by adding to their exposure,” she says. “Fixed income has always been a vital part of investors’ portfolios and can potentially add positive performance now, as long as rates stay at this level. There is

a potential advantage to having it in portfolios. Going into 2019, investors were scared by the volatility in the markets and moved money into fixed income for peace of mind.”

Fixed income and ETFs
Increasingly, opportunities for investing in fixed income are arriving in the form of ETFs, which are seeing more inflows and greater investor demand. “The vast majority of fixed-income ETF flows in 2019 are going into the sector of fixed income known as the Canadian aggregate bond fixed income category, which comprises broad investment strategies that own both high-investment-grade government and corporate bonds,” says Mark Noble, senior vice-president of ETF strategy at Horizons ETFs.

One example is the Horizons Active Canadian Bond ETF (HAD), an actively managed strategy that seeks long-term returns primarily through maximized interest income and moderate capital appreciation. HAD invests primarily in a portfolio of high-quality Canadian fixed-income securities denominated in Canadian dollars, including government and corporate bonds. Sub advised by Fiera Capital, HAD was honoured with the 2018 Lipper Award in the Canadian fixed income category.*

While interest rate risk isn’t the same as it was a year ago, HAD’s ability to shorten or lengthen duration has given it the opportunity to potentially outperform index-tracking ETFs.

“The management team of HAD has tightened the duration to about a year less than the broad benchmark,” Noble says. “In the latter half of 2018, it had tactically gone longer duration, which turned out to be a good call, and now the team is positioning for a potential pullback on the longer end of the curve.”

When looking at fixed-income ETFs, Noble says one of the main benefits is that they apply equity characteristics to bonds. This results in ETFs’ prices being more transparent, and the trading spread can end up being less than with individual bonds.

“We often refer to bond ETFs proving a ‘lit’ market for bonds,” Noble says, “since they provide pricing transparency and an important source of liquidity for investors looking to get bond exposure.”

For advisors, using ETFs to provide clients with fixed-income exposure offers the advantages of cost efficiency and flexibility. “In general, an ETF is going to be a much more liquid and a lower-cost option with which to transact bonds,” Noble says. “Additionally, and potentially more importantly, advisors can efficiently match their fixed-income needs with ETFs. If they want less interest rate risk, they can buy a shorter-duration bond ETF; if they want a higher yield, they can buy a high-yield strategy. They can also tactically allocate in and out of bond strategies based on their own outlook. This flexibility really allows advisors to tailor their client’s fixed-income exposure to their unique income needs.”

Much like Rocca, Noble believes the current trends in fixed income will continue moving forward. “For this year, almost half the inflows have gone into fixed income,” he says. “I expect this trend will likely continue until there is more confidence amongst retail investors in the global

equity markets. Because it remains a huge source of asset flows, I would expect there will continue to be a deluge of fixed-income and income-focused products coming to market.”

*Horizons Active CLDN Bond ETF (HAD) was awarded the 2018 Lipper Fund Award in the Canadian Fixed Income category, for the three and five-year periods ending July 31, 2018, out of a total of 12 ETFs and 10 ETFs respectively, and the Horizons Active Floating Rate Bond ETF (HFR) was awarded the 2018 Lipper Fund Award in the Canadian Short-Term Fixed Income category for the three-year period ending July 31, 2018 out of a total of 21 ETFs. The Thomson Reuters Lipper Fund Awards, granted annually, highlight funds that have excelled in delivering consistently strong risk-adjusted performance relative to their peers. The Lipper Fund Awards are based on the Lipper Ratings for Consistent Return, which is a risk-adjusted performance measure calculated over 36-, 60- and 120-month periods. The highest 20% of funds in each category are named Lipper Leaders for Consistent Return and receive a score of 5, the next 20% receive a score of 4, the middle 20% are scored 3, the next 20% are scored 2 and the lowest 20% are scored 1. The highest Lipper Leader for Consistent Return in each category wins the Lipper Fund Award. Lipper Leader ratings change monthly. For more information, see lipperfundawards.com. Although Thomson Reuters Lipper makes reasonable efforts to ensure the accuracy and reliability of the data contained herein, the accuracy is not guaranteed by Lipper. Performance for the HAD fund for the period ended July 31, 2018, is as follows: 3.64% (1 year), 1.40% (3 year), 3.17% (5 year), and 2.46% (since inception on October 10, 2012). Performance for the HFR fund for the period ended July 31, 2018, is as follows: 1.76% (1 year), 1.88% (3 year), 1.84% (5 year), and 2.28% (since inception on December 10, 2010). The corresponding Lipper Leader total return ratings for HAD for the same periods are as follows: 4 (3 years), 4 (5 years). The corresponding Lipper Leader Ratings for HFR for the same period are as follows: 5 (3 years), 5 (5 years).