Canadians like to spend a lot of money on three things, according to Horizons ETFs vice-president Mark Noble: Housing, cellphone plans and fixed-income ETFs.
Culturally, Canadians are more conservative-leaning in their investing and in 2018, weighted 33 per cent of their ETF portfolios toward fixed income, according to a National Bank of Canada report. In comparison, U.S. investors are putting 18 per cent of their ETF portfolios in bonds. According to BMO, fixed-income ETFs have generated $5.4 billion in net new assets this year, while investors have placed just $1.9 billion in those that are equities-based.
When it comes to bond ETFs, investors have a wide array of options, both in duration and in sector, but recent trends suggest they might not always realize what they’re buying into, Noble said — and it’s leading to negative returns.
“I would say that the financial literacy on fixed-income is poorer versus equities among both professional advisors and investors,” Noble said. “What I say to people is look at the yield. If the yield seems too good to be true, then like with everything else in investing, it probably is.”
Several of Horizons’ fixed-income ETFs have seen their prices dip this year, but are still netting slight returns for investors when incorporating interest and dividends. Horizons’ broad-based ETF, which acts as an index to the sector as whole, has netted investors 1.08 per cent year-to date. Those invested in the firm’s ETF focused on senior loans have seen 0.29 per cent returns. Horizons’ high-yield ETF has lost 1.62 per cent.
For years, fixed income has been considered a safe investment for Canadians as interest rates remained low or declined. With multiple rate hikes over 2018 alone, however, that’s no longer the case.
Generally, for every one per cent rise in interest rates, a bond investment loses about that amount per year of duration — a measure of how long it will take to receive a bond’s cash flow.
That’s problematic, when yields for these investments typically sit between two to three per cent, he said.
As investors look for safe havens amid a global equity selloff, they’re struggling to find them in fixed income.
“Game of Thrones came out in 2011 and since 2011, there’s been a view that interest rates would rise and they really didn’t since the last two years,” Noble said. “Well, everyone’s yelling, ‘Winter is coming’ in Game of Thrones and it finally arrived last season and it’s the same thing for fixed income. Winter has arrived and here are rising interest rates.”
Winter has arrived
Horizons ETFs vice-president Mark Noble
“Remember eight years ago when we told you this could create negative return in your fixed income portfolio? Now it’s actually happening.”
While interest rate risk is the key concern for government bond buyers, those looking at corporate bonds must consider credit risk as well. Often times, Noble said, investors “trade one risk for another.”
That’s how he describes the flow of investors deciding to go into senior loans, a type of fixed-income investment that normally excels in an environment of rising interest rates because its yield rises as rates are hiked. But interest rate hikes stalled this month and there’s now more concern about corporate credit.
“I feel for fixed-income investors because it feels like they’re making this shift at what seems like an inopportune time to trade interest rate risk for credit risk,” Noble said.
Even when their strategies seemed sound, Noble said, Canadians are still seeing losses. Before interest rates began to rise, inflows were heading toward broad-based ETFs such as Horizons’ Canadian Select Universe Bond or BMO’s Aggregate Bond Index ETF. Issuances of these ETFs were in longer duration and left investors, who just wanted simple exposure to fixed income, open to high-interest-rate risk.
Investors may not necessarily know what they’re buying. I think a lot of investors assume the yield curve moves up in a parallel manner, which it hasn’t.
BMO Asset Management portfolio manager Alfred Lee
To combat rising interest rates, BMO Asset Management portfolio manager Alfred Lee said, investors have been placing funds into short-term ETFs, which are one- to five-year investments that are sold a year before maturity. That move is unsound, Lee said, considering the short end of the yield curve has flattened while the long end is outperforming.
“Investors may not necessarily know what they’re buying in recent times,” Lee said. “I think a lot of investors assume the yield curve moves up in a parallel manner, which it hasn’t.”
Because investors have had to deal with rising rates, many were invested in laddered preferred shares, Lee said, because the dividend they pay adjusts to where the five-year government bond yield is sitting. But with rate hikes slowing, returns cratered in October as investors sold off, Lee said, and year-to-date losses exceed 10 per cent.
Now, Lee has suggested that investors look to ultrashort-term fixed-income ETFs, which are often held for less than a year and are sold at maturity and have seen a 1.89 per cent return year-to-date. That move, however, again places them at the mercy of credit risk.
“You’ve got nowhere to hide right now,” Noble said.