Those looking for protection have only found themselves trading one kind of risk for another
The traditional safety offered by fixed-income investments hasn’t materialized so far for Canadian ETF investors.
Historically, Canadians have tended to be conservative in their investments. Aside from having a home bias in their portfolios, they’ve also weighted 33% of their ETF portfolios toward fixed income this year, according to a National Bank of Canada report. In comparison, US investors have placed just 18% of their ETF portfolios in bonds, reported the Financial Post.
Figures from BMO also point to a Canadian appetite for fixed-income ETFs, which have gathered $5.4 billion in net new assets this year compared to just $1.9 billion in equity-based ETFs.
But according to Mark Noble, this tendency to bet on bonds may be harmful, especially for those who aren’t aware of what they’re getting into. “I would say that the financial literacy on fixed-income is poorer versus equities among both professional advisors and investors,” he told the Post.
While fixed income has worked as a safe investment in the years of low or declining interest rates, that’s not the case anymore as rate hikes enter the picture. For bond investments, 1% rise in interest rates generally equates to a loss of roughly the same amount per year of duration. When yields are sitting between 2% and 3%, Noble said, it’s a problem.
“Remember eight years ago when we told you this could create negative return in your fixed income portfolio? Now it’s actually happening,” he said.
Some investors have decided to sidestep that danger by going into senior loans, a type of fixed-income investment whose yield rises as rates are hiked. But with the Bank of Canada’s decision to stall interest rate hikes this month, there’s a growing concern about corporate credit risk and how senior loans will perform.
That’s not the first time bond investors pursuing seemingly sound strategies have been caught wrong-footed. Before interest rates started to rise, investors were putting money in broad-based bond ETFs. But issuances of those ETFs were longer-duration, so they left investors who were just looking for simple fixed-income exposure open to high-interest-rate risk.
But according to BMO Asset Management portfolio manager Alfred Lee, the current trend of placing bets on short-term ETFs — one- to five-year investments that are sold a year before maturity — is still unsound. His reason: the short end of the yield curve has flattened, while the long end is outperforming.
“I think a lot of investors assume the yield curve moves up in a parallel manner, which it hasn’t,” Lee told the Post.
Many bond investors have also gone into laddered preferred shares, whose dividend payouts adjust based on the five-year government bond yield. But as rate hikes slowed, investors sold off, causing cratered returns in October as well as year-to-date losses exceeding 10%.
And while Lee advises investors to consider ultrashort-term fixed-income ETFs, which have seen a 1.89% year-to-date return, he warns that those investments still come with considerable credit risk.
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