Fixed-Income ETFs and Portfolio Positioning

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

David Stephenson, director, ETF strategy, CIBC Asset Management.  

How is the current economy impacting ETF flows, including the recent Bank of Canada rate cuts?  

To answer this question, it’s interesting to look back to March 2022 when the Bank of Canada began to increase interest rates from March 2022 to July 2023. This was one of the fastest tightening periods in history, as the central bank raised rates 10 times, from 0.25% to 5%.  

Beginning in June this year, the Bank of Canada began lowering rates three times to where we are today, at 4.25%, with further easing priced in at the October and December meetings. But there’s uncertainty as to how much and how deep.  

Over this time period, which covers 30 months, ETF flows have only seen two negative months. In fact, as of mid-September, the Canadian ETF industry has seen $44.7 billion in flows year-to-date, which would be the second-best annual flow ever on its own.  

So, the question heading into Q4 is if 2024 will exceed the record $57.1-billion net flow we saw in 2021 which looks promising.  

In regards to fixed income, there’s been about $15 billion in flows year-to-date. Total AUM was approximately $137 billion, or 30% of the ETF industry. Interestingly, AUM has more than doubled over the last five years, from $64 billion in August 2019.  

What has been notable as yields have come down across the yield curve, especially in the front end — for example, two- to five-years — flows have been fairly broad-based this year, unlike the last two years, where money market and high interest savings account ETFs were the notable standouts. Most fixed-income categories have seen positive net flows, with Canadian aggregate bonds and corporate bond flows leading the way, while only preferred shares have seen outflows.  

So, what are the considerations of active bond ETFs versus passive?  

Before buying a bond ETF, whether it’s active or indexed, investors should ask themselves, what are they allocating the fixed income for? Is it liquidity, to preserve capital, looking for higher yields, or to diversify and hedge equities? Once this is decided, it becomes a decision as to what is a reasonable output for this.  

The good news is there is an ETF to fit your goal. With almost 400 fixed-income ETFs listed on Canadian exchanges, there are actually more active fixed-income ETFs at 237 compared to 140 for index ETFs. Of the $136 billion in fixed-income ETFs, about $60 billion is in active exposures. So, what this says is many investors are adopting a blended approach between active and index fixed-income ETFs to help improve portfolio outcomes over time.  

Both index and active fixed-income ETFs offer diversified ways to access the bond market. Index fixed-income ETFs might provide a more cost-effective way to access individual markets because the portfolio manager doesn’t need to spend resources to assess various fixed-income factors. The goal is to replicate the index.  

Active management of a fixed-income portfolio may help achieve gains beyond the index returns, or better preserve capital, depending on the interest rate environment. For most investors, it comes down to their preference for cost and risk.  

What are the benefits and challenges of each? 

On the index side, an investor can buy the Canadian bond market in one trade for as low as six to seven basis points. The global bond market costs about 20 basis points. These are great exposures to anchor most investor portfolios.  

Investors and investment advisors also use index fixed-income ETFs to implement active decisions, to gain more precise exposures, to customize client portfolios, to hedge risk or even capture opportunities. For example, using a government bond ETF to hedge equity risk, a short-term duration ETF to lower overall duration, a target maturity bond ETF to meet a specific cash flow goal in a given year, or an emerging market debt ETF to capture higher yields.  

On the other hand, the global fixed-income market is approximately $140 trillion in size and is very diverse in terms of numbers of securities, which creates opportunities for active managers. There are different levers active managers can pull to add value and reduce risk, such as security selection and credit duration management to be responsive to opportunities as the cycle unfolds, such as adding duration exposure in a declining rate environment, or adding exposure to credit, like U.S. high yield or U.S. investment grade corporate credit as market opportunities present themselves. 

So, what are the opportunities for fixed-income ETFs in Canada?  

In terms of opportunities, I believe fixed-income ETFs will continue to grow as a category for three main reasons. Number one, investor demand for yield has been a secular trend which is still intact. Two, increased use of fixed-income ETFs from both current and new users, as well as increased portfolio applications. And third, product innovation will continue to drive flows, particularly in active fixed income.  

If I take each of these in turn. First, even though we are in an easing cycle, bond yields are still at levels not seen since 2008 and are unlikely to see the lows from early 2022. With further rate cuts and inflation coming back down to 2%, flows into fixed income can benefit from still decent yields, plus a better chance of capital appreciation.  

Bonds are returning to a more traditional role of diversification to riskier assets and offer choice and opportunities to generate income across exposures such as Canadian corporate bonds. A flexible income approach with a global perspective and wide opportunity set can generate yields of 6 to 7% today.  

Second, in terms of trends, it’s been interesting to see how investors’ use of ETFs has evolved and changed. ETFs provide liquid access to different corners of the fixed-income market, and as product choice has grown, investors use ETFs to pivot quickly, add exposures or shift portfolio sensitivities in only one or two trades.  

I also believe distribution channels are changing, with the growth of digital channels, and also believe we will see more usage of ETFs from institutional investors. For example, a recent interesting development has been proposed changes by OSFI that could benefit the insurance industry and increase their use of ETFs.  

In a nutshell, proposed changes to capital treatment of ETFs would make it easier for insurers to buy and hold ETFs, similar to direct underlying bonds. Previously, ETFs required a higher capital charge relative to individual bonds, which limited their use.  

And third, finally, product innovation will continue to attract investor flows, particularly in active fixed income. There’s been 55 new product launches so far in 2024 in fixed income. An interesting development over the last year to highlight has been fixed-income ETFs with a covered-call option writing overlay. These higher-yielding products are meant to complement other fixed-income exposures and generate cash flow.  

The fixed-income market has also evolved from index exposures to incorporate solutions as well. For example, a well-diversified, simple, one-stop fixed-income portfolio. Investment advisors can use them as the core of their clients’ fixed-income allocations and focus on the equity component, or add, tailor other exposures themselves for more precise exposures, or client customization.  

Another category that has gained momentum since the beginning of 2023 and into 2024 is target maturity bond solutions that combine the maturity precision of individual bonds with the diversification of a traditional fixed income. Essentially a bond-like experience in an ETF wrapper. So, whether a client’s short-term savings are, target maturity bond solutions make it simple to build a customized portfolio that aligns with their goals, or implement the bond ladder to manage interest rate risk.  

These are the type of solutions that will continue to drive fixed-income flows in the future. 

So, what risks should ETF investors watch through year-end and into 2025?  

Looking ahead, central bank policy in both the U.S. and Canada will continue to be top of investor minds. Canadian economic growth still needs a boost, and in fact, some market participants believe the Bank of Canada needs to lower rates faster and further to avoid a recession. CIBC, for example, believes the Bank of Canada will lower rates 200 basis points between now and the middle of next year to stimulate the economy and halt the upward climb in unemployment.  

The Canadian housing market and labour market are areas with concerns. Close to 60% of all mortgages are expected to be renewed over the next three years, with estimates seeing payments increase by more than 20 to 60%.  

In the U.S., the U.S. Federal Reserve aggressively lowered interest rates 50 basis points on September 18. It’s the first rate decrease since 2020, and the first 50-basis-point cut since 2008, bringing the target range to 4.75% to 5%.  

Geopolitical concerns are also top of mind, but have been overhanging the market over the last few years, such as U.S.-China relations, the Russia-Ukraine war, tensions in the Middle East, and North Korea. The U.S. elections will also impact markets in November, but some of these will be noise to long-term investors.  

The implication to most investors is to remain diversified and stick to your long-term strategic asset allocation plan. This is the best way to deliver on financial goals and is a time-tested strategy.