Welcome to this month’s edition of the ETF Insights newsletter.
This month’s issue includes something I have been getting a ton of requests to go over for the last month or so, and for a good reason.
Fixed income ETFs.
I will speak on bond ETFs and their potential for income in the upcoming rate environment and capital appreciation, depending on the bond you buy.
Let’s dig right into it.
The draw towards bond ETFs
There is a chance you’ve heard many investors state that there is a good chance bonds outperform stocks for the next while or that decreasing your equity allocation and boosting your allocation to bonds is a solid move to realize lower risk-adjusted returns in the future.
Why is everyone saying this? For the most part, it’s because bonds tend to become more attractive as rates decline.
You may think I’m crazy for saying this, so I should clarify one thing. Currently issued bonds, not newly issued bonds, tend to become more popular as rates decline.
The reasons for this boil down to the functionality of a bond.
Let me explain how they work in the simplest way possible, and there’s a good chance you get that lightbulb moment in your head by the end of this if you’re currently confused.
The basic concept of a bond
A bond has 3 key elements to it. It has a maturity date, a coupon, and a face value.
The maturity date is the date you will receive your face value back for your bond. If you purchase a $10,000 bond with a 5-year maturity, you’ll be paid your $10,000 back when it matures in 5 years.
What will you get in between that time? That would be the coupon. The coupon is a set interest rate relative to the face value of the bond. If the above bond has a coupon of 5%, you’ll be paid $500 every year for 5 years until it matures. And lastly the face value is the initial value of the bond, in this case the $10,000.
Bond liquidity
Many have the idea that once you buy a bond, you’re stuck with it until the maturity date. This just isn’t the case. Bonds trade much like stocks. In fact, the credit market is three times the size of the stock market.
Pricing deviations can occur because of the ability to buy and sell bonds on an open market. For the most part, this is where we get the capital gain (or capital loss) from the bonds we hold.
Let me explain how the pricing fluctuations work on bonds. Generally, after this, people really start to get a handle on how they work.
Bond pricing
Typically, when a company issues a bond, it will be at a competitive rate to other interest-bearing investments out there.
After all, if one could simply buy Government of Canada bonds or Federal Reserve Treasury Bills, which are about as guaranteed as it gets, over a corporate bond at the same rate of interest, it is an absolute no-brainer to buy the Government-issued debt.
Outside of this, bonds compete with each other in terms of pricing.
Let’s use a simple example. Let’s say we have the following bond:
Face Value: $10,000
Coupon: 5%
Maturity: 5 years
You buy this bond, and after a few years of owning it, interest rates start to rise, and you notice bonds from the same company now look like this:
Face Value: $10,000
Coupon: 6%
Maturity: 5 years
Rising interest rates have made the newly issued bond today much more attractive than the one you carry from two years ago. It makes little sense, outside of the smaller duration (you have 3 years left versus a brand new 5-year issue), to buy your bond over the new bond.
So what happens? Prices need to change.
Bond prices are inversely correlated to interest rates
As I mentioned, you will get your $10,000 face value back at maturity for the bond you purchased. However, over the period of the bond’s existence, it can be bought and sold on the public market.
In the situation above, interest rates have increased, and the demand for your bond will decrease, lowering its price on the open market and increasing its yield.
Don’t confuse yield and coupon here. Coupon is a set payment paid by the company to the bondholder.
Yield, however, is what the bond pays relative to its current market value.
In order to make your bond more attractive, if you want to sell, you will have to price it lower so the yield becomes more competitive relative to the newly issued bond.
Let’s say your bond is listed for $9000. With a $500 annual coupon, your bond yields 5.5%, closer to the newly issued bond of 6%. Considering the differences in maturity (generally, a shorter time to maturity equals less interest), and capital gains upon maturity, your bond will likely gather some interest from other investors.
I imagine you may be a bit confused as to the “capital gains upon maturity” part. Here is an easy explanation:
If someone ended up buying your bond in the situation above for $9000, they would not only earn the coupon payment, but a capital gain of $1000 when it matures, because they still get the $10,000 face value back at maturity. So, the yields don’t need to line up exactly to make the older bond attractive. There are other factors at play.
This is why, as the heading suggests, bonds are inversely correlated to interest rates.
When interest rates rise, bond prices will fall. When interest rates fall, bond prices will rise.
You probably have a better idea now as to why bonds are looking attractive
Unless you’ve been living under a rock, you’ll likely know that interest rates have started coming down and have the potential to come down further and faster in the future.
In this situation, bond ETFs should benefit from an increase in value due to rates dropping. Remember, rates go down, bonds go up.
To drive this point home, I’ve added a chart below of ZAG, a large-scale Bank of Montreal bond ETF.
The black line is the Bank of Canada overnight rate, while the orange line is the price of ZAG. You’ll notice that when rates were dropped in 2015, bonds went on a run upward, and when rates were raised in late 2017, bonds went through about 2 years of flat prices.
From here, you’ll notice that the sharp decline in rates in 2020 fueled bond prices a bit, and the sharp rate hikes in 2020 caused a significant drawdown in bonds. In fact, it was one of the worst years on record for bonds ever.
Fast forward to 2024, and we can see that bond prices are starting to rise again as rates decline.
The one thing you’ll notice from this chart is that prices tend to lead rate cuts/hikes, meaning pricing changes happen before policy rate changes. Which, for the most part, is correct.
The bond market is traded by human investors trying to predict and time the market like anyone else.
If people believe rates will start to decline, bond prices will rise before this. This is why we see bond prices do so poorly in 2021/2022, despite rates being low. Many investors knew at some point, they were going to go up much higher.
And in the case of 2024, because policy rate predictions have been so complicated and up in the air, changes in prices are not leading the rate declines as much as usual.
The longer the date to maturity, the more pricing fluctuations you will see
One final thing before I move on to some bond ETFs for members to look at is the length of maturity of the bond and its relation to pricing volatility.
The longer the maturity, the more volatile a bond will be. The price of a bond with a 20-year maturity will fluctuate significantly more on policy rate changes than a bond with a 5-year maturity.
I won’t go too deep into why this is, but it is primarily due to the time value of money. Cash flows from longer-term bonds are a long time down the line, and the values of those cash flows change much more with policy rate changes.
I’ve dropped a chart below that should give you a good idea as to the overall pricing volatility. Vanguard’s long-term corporate bond ETF has put up nearly 2.5X the returns since May of this year than the Vanguard short-term bond ETF.
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On the contrary, I want to give you an idea of what happens in the opposite situation. When we underwent the fastest increase in interest rates in history, Vanguard’s long-term bond ETF lost a whopping 33% in less than a year, while the short-term bond ETF lost just 8%.
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33% is a monumental loss in the bond market in this amount of time. It truly did shake the market.
But, I hope these two examples highlighted the difference in volatility relative to interest rates.
With all that said, which bonds should you target with rates falling?
It seems like a no brainer to stack up a portfolio of long-term bonds at this point, as there is little doubt they will benefit the most from falling rates.
Although this may be true from a pure capital appreciation standpoint, there is a fallacy among investors that bonds are inherently safe. Yes, in terms of your principle, buying high quality bonds is pretty much a guarantee you’ll get it back.
However, with bond ETFs, you’re simply buying a basket of bonds. There is no “maturity” date on the ETF in which you’ll get your initial capital back.
Let’s use a quick example. Say you bought a $10,000 5-year bond on Jan 1st, 2020. On Jan 1st, 2025, you’ll receive $10,000.
However, if you bought $10,000 of Vanguard’s long-term bond ETF on Jan 1st, 2020, you’re currently sitting on an investment worth $8000~.
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This won’t magically jump to $10,000 on Jan 1st, 2025. Bond ETFs don’t work the same way as individual bonds.
Although there are individual bonds inside of the portfolio that are maturing and the fund is receiving its principal back, you are not buying an individual bond with your investment into an ETF, you’re buying thousands of them.
This is why it is imperative that you know your risk tolerance
A portfolio of long-term bonds has the highest likelihood of bringing in the largest total returns during a falling rate environment. However, this strategy would be utilized amongst those with the highest tolerance for risk in their fixed-income portfolios.
As I’ve mentioned, in many cases, bond prices lead interest rates. The bond market does a lot of predicting, and there is a chance if rates don’t go the way the bond market expects them to, long-term bonds will face significant volatility in price.
For this reason, if you’re looking to add fixed income into your portfolio, figure out your overall risk tolerance in this situation and build out a bond portfolio that makes sense for you. If that is 100% long-term bonds, go for it.
However, if it means buying a bond ETF that is equally spread out across all maturity lengths to mitigate pricing volatility, that is perfectly fine, also.
The good news? This would have been an incredibly difficult thing to navigate with individual bonds in the pre-bond ETF era. However, now it can be done in a couple clicks of a button.
For the final chunk of this newsletter, we’ll dig into some bond ETFs you can look at today.
If you’re looking to add fixed income to your portfolio, here are some solid options
BMO Aggregate Bond ETF (ZAG.TO)
Expense Ratio: 0.09%
Yield: 3.42%
This is arguably one of the most popular bond ETFs in the country, and for good reason. It contains some of the highest-quality bonds in Canada. It also does not include any short-term bonds.
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73% of the portfolio is intermediate bonds, meaning maturities of 1-10 years; the remaining 27% is maturities of 10 years or longer.
As I mentioned, the longer the maturity of the bond, the higher the likelihood it will react positively in price to interest rate declines. This is exactly why we’ve witnessed a fund like ZAG earn over 13% over the last year or so.
This is a relatively risk-averse fund, with over 75% allocated to government bonds and 25% to corporate bonds. This higher allocation to government bonds means it will yield less than a corporate bond ETF of the same maturity profile.
I view it as a great all-around option for someone who simply wants to hold fixed income in their portfolio but also benefit to a small degree from the price appreciation of mid to long-term bonds and the higher yields of those maturities.
BMO Long Corporate Bond ETF (ZLC.TO)
Expense Ratio: 0.33%
Yield: 4.77%
This is likely the highest volatility bond ETF you’ll see me mention here, but is also the one that will benefit the most from falling interest rates. In fact, it’s already benefitting heavily.
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Because you read the write-up above highlighting how bonds work, you know that longer-term bond prices are more sensitive to interest rates. This bond fund is purely long-term corporate bonds. For this reason, we can see it is up over 21% over the last year.
21% for a fixed-income fund would be considered a monumental move.
This fund holds 100% bonds from Canadian corporations, which are less safe than government bonds. However, there are a lot of high-quality corporations in this fund, such as Rogers, Enbridge, Suncor, TransCanada, Pembina Pipe, and CN Rail. There is little risk they cannot pay debtholders back at maturity.
This fund is going to be for those who are comfortable with a bit of added volatility in order to achieve the highest levels of returns from falling interest rates. I like the fund for those with a higher risk tolerance.
BMO Mid Corporate Bond ETF (ZCM.TO)
Expense Ratio: 0.33%
Yield: 3.84%
If you haven’t noticed by now, I prefer BMO for pretty much all fixed-income options in Canada regarding ETFs. They have one of the best varieties of funds, enabling investors to pick and choose what type of exposure they want when it comes to fixed income.
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I would say this fund would be appropriate for those who want a bit of upside potential from falling rates but don’t want the heavy volatility that comes with buying long-term bonds. This fund holds Canadian corporate bonds that are anywhere from 7-10 years in length.
With it being intermediate bonds, you’ll get a higher yield and a bit more pricing volatility. As mentioned, perfect for the “middle of the pack” investors in terms of risk tolerance.
An all in one fund
For those who simply want to add a mix of fixed income into their portfolios but don’t really want to go through the effort of figuring out which individual bond funds to buy, “all-in-one” funds certainly provide a one-click solution to someone’s needs.
Fixed income all-in-one funds typically are classified by having “GRO” or “BAL” in their names.
For example, XBAL, VBAL, and ZBAL are the 60/40 equity/fixed income funds offered by the major fund managers, while XGRO, VGRO, and ZGRO are the 80/20 funds.
