On Wednesday October 25, 2023, the Bank of Canada (BoC) made its stance clear by keeping its policy interest rate firmly at 5%. However, despite not adding another 25-basis point hike, the BoC did make it clear that quantitative tightening (QT) would continue.
In their decision, the BoC noted that while the Canadian economy paints a mixed picture, it’s evident that previous rate increases are having their desired effect – mitigating inflationary pressures.
Notably, Canadian consumption is seeing subdued dynamics, especially in housing and durable goods. On the inflation front, although volatile of late, the Bank projects it to stabilize around 2% by 2025.
These economic insights had significant implications for investors upon release, impacting numerous ETFs both favorably and adversely. Here’s a look at which types of ETFs are reaping benefits and which ones are bracing for challenges in the wake of this announcement.
Loser: Long bond ETFs
Long bond ETFs haven’t had the best run recently. In fact, they rank among the least favored assets in 2023, a trend set in motion by a bearish market spell in 2022. The primary culprit behind this downtrend? A string of aggressive policy moves by the Bank of Canada.
From June 2022 to the present day, the BoC steadily increased the policy interest rate, propelling it from a moderate 1.50% to a substantial 5% through a series of eight rate hikes. Such a swift and significant rise in rates tends to be detrimental to long-duration assets like bonds, and here's why.
Bond prices and interest rates move inversely. When rates surge, bond prices drop, and the longer the duration of the bond, the more sensitive it is to this rate movement. Therefore, long bonds feel the most acute pain during rate hikes.
The recent October 25 meeting, even without a rate increase, delivered another blow to long bonds. By day's end, their prices had plummeted yet again. ETFs like the BMO (TSX:BMO) Long Federal Bond Index ETF (TSX:ZFL)(ZFL) and the iShares Core Canadian Long Term Bond Index ETF (TSX:XLB) (XLB) fell by 1.90% and 1.56% respectively.
This decline can be attributed to the BoC's decision to persist with its QT strategy. For those less familiar, QT involves the central bank reducing its bond holdings, which effectively reduces the money supply in the economy. This action exerts upward pressure on bond yields (and hence downward pressure on prices) as the bank sells more bonds into the market.
Moreover, the Bank's sentiment surrounding inflation only added to the apprehension in bond markets. The BoC openly expressed concerns about the sluggish progress towards achieving price stability and highlighted the lingering inflationary threats.
The mere hint that the Bank is poised to further increase the policy rate if deemed necessary was enough to set off alarms for bondholders. The bond market's reaction was unequivocally bearish, understandably viewing the potential of more hikes on the horizon as a dark cloud looming.
Winner: High interest ETFs
While long bond ETFs might have faced challenges, another category emerged victorious in the wake of the BoC's announcements: high interest ETFs.
Investors with holdings in these types of funds, which primarily focus on high interest-bearing deposit accounts at financial institutions, must've heaved a sigh of relief. The Bank's decision to maintain the rate means that these ETFs' almost risk-free yield of over 5% remains intact, at least for the foreseeable future.
For those unfamiliar, here's a brief overview of how these high interest ETF products function: Their Net Asset Value (NAV) exhibits a consistent upward trend, accumulating steadily over the course of a month. When monthly interest gets paid out to investors, the NAV resets, usually dropping back to a baseline, often around the $50 mark.
What makes these ETFs particularly attractive is their direct correlation with prevailing interest rates. As rates go up, so does the yield on these ETFs, making rate hikes a boon for them. Conversely, a rate cut would mean a reduction in their yield.
Apart from this, they come with the added advantages of liquidity (unlike the somewhat rigid term structures of products like GICs) and generally low expense ratios, making them cost-effective.
Take, for instance, the High Interest Savings Account Fund (NLB:HISA) from Evolve ETFs, listed on Cboe Canada. It's currently paying out an impressive 5.46% gross yield.
Such enticing, near-risk-free yields present a strong case for these products. With returns being so competitive, investors might find little incentive to venture into riskier territories like equities or REITs.
Finally, high interest ETFs like HISA also serve as ideal instruments for those seeking consistent income streams or those prioritizing the safety of their principal. Think of scenarios like saving up for a down payment on a property in the next year or two; these ETFs fit the bill perfectly.
This content was originally published by our partners at the Canadian ETF Marketplace.