Many investors, especially those new to investing in the stock market, don't even bother putting bonds in their portfolios, using perilous logic to rationalize their thought process.
Even with the ability to purchase a bond ETF and thus broad exposure in a single click, they don't. Their thinking goes something like this.
"If stocks outperform bonds over the long term, then why wouldn't I have a portfolio full of stocks instead?"
After all, isn't the whole point of investing to end up with the most amount of money? Yes, but there are a few things wrong with this line of thinking.
As Warren Buffett likes to say, the first rule of investing is to not lose money. An excellent way to lose a lot of money is to aggressively buy stocks no matter what underlying economic fundamentals say.
Even "safer" investments, such as blue-chip dividend stocks, are volatile. Some investors can't handle the volatility of an all-stock portfolio, and they'll inevitably sell at the worst time.
Canadian bond ETFs and the impact of rising rates and inflation
We always hear that bonds have an inverse relationship with interest rates, which is true. As rates rise, bond prices tend to fall.
This is because as new bonds are issued in a higher rate environment, they will have a higher coupon rate, as companies need to issue bonds at competitive prices. So their prices must drop for the previous bonds to stay competitive and yield the same.
So, many will look to avoid bonds during periods of high inflation. This is because not only do real returns shrink with bonds during high inflationary environments (especially with long-term bonds compared to short-term bonds), but it is common practice for policymakers to raise rates during high inflation to cool the economy like we're witnessing now.
However, if interest rates are at their peaks, this only means one thing, bonds will go up in price as interest rates fall. Again, the price of a bond has an inverse relationship to interest rates. As rates go down, newly issued bonds at that time will have lower coupon rates, and be less attractive than bonds issued right now.
So, you could make a strong case for adding bonds to a portfolio right now, and many are.
What is the downside of bond ETF?
The downside of a bond ETF versus simply buying individual bonds is that the portfolio is constantly rolling through many bonds that may have been issued at a lower interest rate. A prime example is that you can often find new bonds in this environment yielding 5%+, while most of the funds on this list yield less than 3%.
Why? Well, they have many bonds purchased in a lower-rate environment and have yet to come to maturity. When they do, new bonds at higher rates will replace them and boost yields. It just takes a little longer than buying a single bond.
Will bonds and bond ETFs provide strong returns?
Nowadays, we must think of bonds not as an asset that will provide strong real returns (real meaning after inflation) but as somewhat of a safety net. However, depending on the situation with interest rates, they could certainly drive strong returns moving forward.
Past performance of bonds, especially when we look at timelines before the financial crisis in 2008, are likely never to be repeated, though. Countries are now forced to run on ultra-low interest rate environments, and we are unlikely ever to see large coupons or high-quality, high-yielding bonds again.
There is also the issue that income taxes are not friendly to bonds. Unlike capital gains on a stock or dividends from a Canadian corporation, a bond has no tax benefits. It is taxed at 100% of your nominal tax rate.
However, this doesn't mean you shouldn't own high-quality, investment-grade bonds inside a portfolio to take advantage of the current environment. You may just want to consider tax-sheltering them.
This is why Canadian bond ETFs are perfect for retirees
Mixing bonds into the portfolio is especially important as you approach retirement. The last thing you want is for your portfolio of 100% equities to implode 40% right before you hang up the proverbial skates.
Although the diversification of your portfolio via bonds will undoubtedly impact the potential of capital gains, it will provide you with some downside protection if the stock market crashes.
Many ignore asset allocation until it's too late, harming a portfolio. As you get older and approach retirement, most investors will look to reduce their risk tolerance. And to do this, many of them head to the bond market. And with the addition of these bond funds, it's effortless to buy bonds these days.
A few decades ago, a regular investor couldn't build a diversified bond portfolio. They were forced to buy individual bonds at their local brokerage, which cost a lot in commissions and was generally inefficient.
Compare that to today with the emergence of Canadian ETFs, where anyone with an online brokerage account and a mouse can buy diverse bond ETFs that hold hundreds of different kinds of bonds for a small ongoing fee. We've quickly reached the point where there's almost too much choice in the bond ETF market.
In this article, we will help you cut through the noise and provide you with five of the best Canadian bond ETFs to add to your portfolio today.
So what are the best Canadian bond ETFs to buy today?
- iShares Core Canadian Short-Term Bond Index ETF
- iShares Canadian Hybrid Corporate Bond ETF
- iShares Core Canadian Bond Universe ETF
- BMO Aggregate Bond Index ETF
- Vanguard Canadian Short Term Corporate Bond Index ETF
iShares Core Canadian Short-Term Bond Index ETF (TSE:XSB)
The one way to help fight inflation and interest rate risk when it comes to bonds is to stick to short-term options. The longer the bond's maturity date, the more impacted it is by inflation and changes in policy rates.
This makes complete sense, as with a short-term bond ETF, the weighted average maturity of each bond inside the fund is shorter. With a shorter maturity date, the bond fund or the individual investor can roll that capital back into a new bond with a higher coupon rate as rates rise.
So, this is what makes XSB a healthy option right now. Please make no mistake; this bond fund will still suffer in a rising rate environment. However, if we look at the past couple of years and especially in late 2021 and 2022, it has outperformed funds made up of intermediate and long-term funds by significant margins.
XSB contains a blend of corporate (32% of the portfolio) and government (66% of the portfolio) bonds, with the bulk of the portfolio containing bonds that mature within five years. It does have a tiny portion of the portfolio, around 3%, of bonds with 7-10 year maturities. But for the most part, this is a pure-play fund on short-term bonds. In terms of fees, you'll only pay $1 per $1000 invested annually to own it. This is a very fair price to pay for convenience. It has one of the lowest MER on the list.
As we've mentioned, the upside to short-term bonds is the ability to fight inflation better than one with longer maturity. However, corporations and governments aren't willing to pay you as much to hold these bonds. As a result, XSB only yields around 2.3%. This is ultimately a tradeoff you have to weigh yourself, as long-term bonds provide a higher yield but expose you to more interest rate and inflation risk.
Keep in mind, because these types of bonds were not as severely impacted via the rapid rise in policy rates, they likely have the least amount of upside pricing wise in the event rates start to come down.
iShares Canadian Hybrid Corporate Bond ETF (TSX:XHB)
One issue many investors have with bond ETFs is they usually prioritize safety over yield. Some people are more comfortable taking risks with their bonds in exchange for more income.
If that sounds like you, you'll want to check out the iShares Canadian Hybrid Corporate Bond ETF (TSX:XHB). It is an ETF that aims to invest in bonds of companies that have a BBB credit rating or lower.
Before you run for the hills thinking this is a high-risk bond ETF, you must understand that many outstanding companies have BBB credit ratings, such as Ford, Parkland Corporation, Pembina Pipeline, Keyera, Suncor Energy, and Superior Plus. All of which are inside this fund.
The bond ETF has assets under management of $209M, which is relatively small compared to the other funds on this list, likely due to its higher-risk nature. Investors tend to head to government and provincial bonds when the markets get volatile, not corporate.
This is very likely why despite bonds being deemed a relatively "safe" investment, XHB witnessed a 26.5% drawdown during the March 2020 market crash.
The portfolio – consisting of over 500 different types of bonds – is an exciting mix of household names and risky bonds added to increase the yield. The ETF also increases its yield by holding bonds that don't mature until 2070 or 2080. However, a bond's typical maturity inside the portfolio is anywhere from 1-10 years. So, this is primarily an intermediate-length bond fund. At the time of writing, it contains a 70/30 mix of intermediate to long term bonds.
Because corporate bonds tend to yield higher, this is the highest-yielding bond fund on the list in the low 4% range. That might not seem like a lot, but it's 33-50% higher than the most popular bond ETFs. That alone should be enough to get some high-yield seekers interested.
There's just one big problem with this unique product. Like with many specialty ETFs (like Canadian REIT ETFs), the management fee is a little high. Expenses will run you 0.5%, which means you'll pay $5 per $1000 invested.
iShares Core Canadian Universe Bond Index ETF (TSX:XBB)
Next is Canada's oldest bond ETF, the iShares Core Canadian Bond Universe ETF (TSX:XBB), a behemoth fund Blackrock offers.
It has over $5.1 billion in net assets, with over 1,540 different bonds in the portfolio. The vast majority of these are government bonds issued either by the federal government or various provincial governments, but some corporate bonds are mixed in. At the time of writing, the mix is around 73% government and 27% corporate.
This ETF's significant advantage over some of its peers is its meager management expense ratio. You're paying a mere 0.1% or $1 per $1000 invested to own this bond fund. Considering it gives you single-click exposure to thousands of bonds in North America, 89% of which are rated A or better, this is a small price to pay.
This ETF has provided a solid total return over the long term due to persistently falling interest rates. However, once inflation started to rear its ugly head in late 2021 and 2022; its performance started to suffer.
However, during the multi-month correction in the stock markets in late 2021 and early 2022, XBB lost around 6%. This is a far cry from the double-digit losses from most US markets and even 20%+ losses suffered by the NASDAQ. So, this highlights some of the volatility reduction these funds provide.
Lower interest rates have slowly eroded the iShares Core Bond ETF's payout over the years, but this fund still pays a high 2% yield. As the fund continues to add new corporate and government bonds into the portfolio, the yield should start to rise.
BMO Aggregate Bond Index ETF (TSX:ZAG)
At first glance, the BMO Aggregate Bond ETF (TSX:ZAG) might seem like a carbon copy of the iShares Core Canadian Bond Universe ETF.
They both offer exposure to many high-quality Canadian bonds at a low price. ZAG has an ever-so-slightly lower management fee (0.09% compared to 0.1% for XBB), but that's not enough of a difference to matter. Additionally, they both track the FTSE Canada Universe Bond Index. So, what makes this ETF better?
ZAG invests in other BMO bond ETFs and other securities to gain exposure to more bonds for holders. As a result, the two options have a 0.4% difference in yield.
Remember, the iShares bond ETF pays a nearly 3% yield. BMO's flagship bond ETF does quite a bit better, offering investors a payout in the 3.4% range. That might not seem like much, but it still represents more cash in your pocket today.
The critical thing to note here is the maximum drawdown, which was only 17.5% during the market crash of 2020. Considering many major indexes fell more than double this, it shows the impact of holdings bonds in a portfolio.
The fund is also the largest on this list, with a whopping $6.1B in assets under management, and is one of the most popular Canadian ETFs today.
Vanguard Canadian Short Term Corporate Bond Index ETF (TSE:VSC)
In our recent update, I've added another short-term bond fund to the list and a Vanguard product, as I really do like the company's funds.
VSC seeks to track, to the extent reasonably possible and before fees and expenses, the performance of a broad Canadian credit bond index with a short-term dollar-weighted average maturity. It invests primarily in public, investment-grade non-government fixed-income securities issued in Canada.
It has just over $1B in assets under management at the time of writing and is almost a corporate pure-play, with 90% of the fund being corporate bonds that mature in 1-5 years. A few longer maturity bonds here mature in 7-10, but it is currently less than 10% of the portfolio.
To spruce the yield a bit, the fund has 31% of its bonds rated BBB. However, the bulk of the portfolio (nearly 65%) is rated A or AA. You'll see many of the significant Canadian companies inside this portfolio, including all the major banks, along with the pipelines. But, it also sprinkles some American companies inside, like Apple and Bank of America. Many of these companies have virtually zero default risk.
In terms of management fees, you'll only pay $1.10 per $1000 annually to hold it, and at the time of writing, it currently yields in the high 2% range. Much like any other fund on this list, performance has struggled over the long term. However, as mentioned at the top of the article, there is some potential for upside if rates start to trend downwards.
Which Canadian Bond ETF is right for you?
Ultimately, it comes down to whether you want income or stability.
If you're interested in maximizing the income collected from the boring part of your portfolio, choose the iShares Canadian Hybrid Bond ETF.
Just remember that this fund has the chance to perform poorly if there were to be more volatility in the markets. During high volatility, investors tend to gravitate towards government bonds, not corporate ones.
If stability is your chief concern, the iShares Canadian Bond Universe ETF or the BMO Canadian Aggregate Bond ETF are good choices. ZAG is my favorite because it offers a slightly higher yield, but I wouldn't fault an incredibly nervous investor for choosing XBB and its somewhat better safety instead.
And, if you're looking for bonds that will be the least exposed to rising rates and inflation, the short-term bond index is a solid option.
No matter what Canadian bond ETF you choose, the real benefit of owning these comes when the next recession hits. While the rest of the market was imploding in 08-09 and March of 2020 due to COVID, Canadian bonds were doing fine.
During COVID, XBB and ZAG shares fell from 12-16%. Although this is still a big dip, it's a far cry from the 40% collapse of the TSX Index.
That's the kind of stability we're looking for.