Many investors, especially ones new to investing in the stock market, don’t even bother to put bonds in their portfolios, using some perilous logic to rationalize their thought process.
Even with the ability to purchase a bond ETF and thus wide exposure in a single click, they don't. Their thinking goes a little something like this.
"If stocks outperform bonds over the long-term, then why wouldn’t I have a portfolio stuffed 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.
Firstly, as Warren Buffett likes to say, the first rule of investing is to not lose money. A good 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 have significant volatility. Some investors just 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 absolutely 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 in order for the previous bonds to stay competitive and yield the same, their prices must drop.
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 periods of high inflation to cool the economy.
However, this doesn't necessarily mean an investor should avoid bonds altogether. It just means they need to be careful in choosing which bonds we add to our portfolios.
Will bonds and bond ETFs provide strong returns?
In this day and age, I think it's important we think of bonds not as an asset that will provide strong real returns (real meaning after inflation) but somewhat of a safety net.
Past performance of bonds, especially when we look to timelines before the financial crisis in 2008, are likely to never be repeated. Countries are now forced to run on ultra-low interest rate environments, and it is unlikely we ever see large coupons or yields on bonds again.
There is also the issue that income taxes are not friendly to bonds. That is because unlike capital gains on a stock or dividends from a Canadian corporation, there are no tax benefits to a bond. 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 of a portfolio. You may just want to consider tax-sheltering them. Overall, the decision to buy bonds shouldn't be in hopes of large returns. It should be to reduce portfolio volatility.
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 made up of 100% equities to implode 40% right before you hang up the proverbial skates. Although the diversification of your portfolio via bonds will certainly impact the potential of capital gains, it will provide you with some downside protection in the event the stock market crashes.
Many ignore asset allocation until it's too late, which can be detrimental to 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 incredibly easy to buy bonds these days.
Just a couple of decades ago, it was impossible for a regular investor to build a diversified bond portfolio. They were forced to buy individual bonds at their local brokerage, something that cost a lot in commissions and was just 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 tiny ongoing fee. In fact, we’ve quickly gotten to the point where there’s almost too much choice in the bond ETF market.
In this article, we're going to help you cut through the noise and provide you with 4 of the best Canadian bond ETFs to look 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
iShares Core Canadian Short-Term Bond Index ETF (TSE:XSB)
The one way to help fight inflation when it comes to bonds is to stick to short-term options. The longer the date to maturity of the bond, the more impacted it is by inflation.
This makes complete sense, as with a short-term bond, it is much closer to its maturity date. 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 strong option right now. Make no mistake about it, this bond fund will still suffer in a rising rate environment. However, if we look to 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 both corporate (31% of the portfolio) and government (69% of the portfolio) bonds, with the bulk of the portfolio containing bonds that mature within 5 years. It does have a very small 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.
The upside to short-term bonds as we've mentioned 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%. This is ultimately a tradeoff you have to weigh yourself, as long-term bonds do provide a higher yield but are ultimately exposing you to more interest rate and inflation risk.
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 a little bit more risk with their bonds in exchange for more income.
If that sounds like you, then 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, it's important to 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 of this fund.
The bond ETF has assets under management of $393M, which is relatively small compared to the other funds on this list, likely due to its higher risk nature. When the markets get volatile, investors tend to head to government and provincial bonds, 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 – which consists of over 510 individual bonds – is an interesting mix of household names and risky bonds added in to really increase the yield. The ETF also increases its yield by holding bonds that don’t mature until 2070 or 2080. However the typical maturity of a bond inside of the portfolio however is anywhere from 1-10 years. So, this is mostly an intermediate-length bond fund.
Because corporate bonds tend to yield higher, this is the highest yielding bond fund on the list in the high 3% range. That might not seem like a lot, but it’s a full 33-50% higher than the most popular bond ETFs. That alone should be enough to get some investors interested.
There’s just one big problem with this unique product. Like with a lot of specialty ETFs (like say 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 Bond Universe ETF (TSX:XBB)
Next up is Canada’s oldest bond ETF, the iShares Core Canadian Bond Universe ETF (TSX:XBB), a behemoth fund offered by Blackrock.
It has net assets of more than $4.5 billion, with more than 1,430 different bonds in the portfolio. The vast majority of these are government bonds, issued either by the federal government or various provincial governments, but there are also some corporate bonds mixed in as well. At the time of writing, the mix is around 73% government and 27% corporate.
One big advantage this ETF has over some of its peers is its ridiculously low management fee. 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, 87% of which are rated A or better, this is a small price to pay.
Thanks to persistently falling interest rates, this ETF has provided a solid total return over the long term. However, once inflation started to rear its ugly head in late 2021 and 2022 its performance started to suffer, as we will inevitably be heading into an environment where policymakers raise rates.
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.
If you reinvested your monthly distribution into more shares, a $10,000 investment made in this unsexy bond ETF would be worth just over $13,000 over the last 10 years. That works out to a 2.38% annual return. Considering the average inflation rate in Canada over the last ten years was 1.87%, you've managed to post a very small positive real return, all while getting some downside protection.
Lower interest rates have slowly eroded the iShares Core Bond ETF’s payout over the years, but this security still pays a high 2% yield. That compares rather nicely with other fixed-income options, like GICs.
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 cheap 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. To add to this, they both track the FTSE Canada Universe Bond Index. So, what makes this ETF better?
Well, ZAG invests in other BMO bond ETFs and invests in other securities to potentially gain exposure to more bonds for holders. As a result, there is about a 0.5% difference in yield between the two options.
Remember, the iShares bond ETF pays a 2.71% yield. BMO’s flagship bond ETF does quite a bit better, offering investors a payout in the 3.21% range. That might not seem like much, but it still represents more cash in your pocket, today.
The key thing to note here is the maximum drawdown, which was only 16% 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.
For a bond ETF, the BMO fund has delivered solid returns over the last decade. Total return has been 2.40% annually over the last decade, marginally outpacing inflation.
One last feature of note is this: like the other ETFs on this list, the BMO flagship bond ETF will likely see its yield continue to fall a little bit as existing bonds are replaced with new ones with a lower interest rate.
Which Canadian Bond ETF is right for you?
Ultimately, it comes down to whether you’re looking for income or stability.
If you’re interested in maximizing the income collected from the boring part of your portfolio, then 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 times of high volatility, investors tend to gravitate towards government bonds and not corporate bonds.
If stability is your chief concern, either 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 especially nervous investor for choosing XBB and its slightly 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 in owning these comes when the next recession hits. While the rest of the market was imploding in both 08-09 and March of 2020 due to COVID, Canadian bonds were doing just fine.
In fact, during COVID, XBB and ZAG shares fell anywhere 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.