For the better part of the last decade, a continuous downward trajectory of interest rates, coupled with a Zero Interest Rate Policy (ZRIP) — a policy wherein nominal interest rates or real interest rates are close to zero — has ingrained a sense of comfort and complacency in investors' minds.
This familiarity has manifested in a heavy tilt towards long-duration bonds, perceived to offer both safety and a decent yield. However, the events of 2022 provided a sobering reality check that has extended into 2023 as bond prices continue to fall.
The Bank of Canada's recent decision to maintain its overnight rate at 5% fell short recently as inflation continues to rear its head, with a notable 0.7 percentage point surge in September. A significant portion of this rise can be attributed to the annual increase in gasoline prices. This could prompt further hikes until inflation resumes a downtrend.
South of the border, the narrative follows a similar tune. The U.S. Federal Reserve, while keeping interest rates stable for now, has adopted a notably hawkish stance. The anticipated policy path indicates a firm hand, with the possibility of the benchmark overnight interest rate peaking in the 5.50%-5.75% range this year and a commitment to tighter monetary policy through 2024.
Against such a backdrop, the emerging "higher rates for longer" environment could spell disaster for long-duration bonds. While predicting the exact ebb and flow of interest rates can be a fool's errand, a proactive reassessment of one's risk appetite is prudent.
It's in this climate that ultra-short-term bond ETFs present themselves as a viable solution for those seeking a balance between managing interest rate risk and ensuring reasonable returns. Let's look at the merits of such ETFs and some examples to consider.
Understanding Ultra-Short-Term Bond ETFs
Ultra-short-term bond ETFs are designed to offer investors exposure to fixed-income instruments that have relatively short maturities. At their core, these ETFs invest in bonds that typically mature anywhere from a few months up to a year, although certain funds might stretch to slightly longer durations.
Usually, these ETFs will hold a portfolio of high-quality, liquid fixed income such as government Treasury bills, investment-grade corporate bonds, and commercial paper, which can be diversified across different issuers and geographies.
However, unlike individual bonds that might not always be easy to trade, these ETFs are traded on stock exchanges. This feature allows investors to buy or sell shares with the same ease as stocks during market hours and at market prices, providing a liquidity level often desired by investors.
Also unlike individual bonds are the different distribution schedules of these ETFs. Whereas bonds usually payout semi-annually (or upon maturity, as with Treasury Bills), most ultra-short-term bond ETFs pay monthly distributions, which can be beneficial for income.
Benefits and Use Cases
The principal aim of these ETFs is capital preservation. The short maturities of the bonds within these ETFs make them less sensitive to interest rate fluctuations, minimizing the potential for significant capital loss. The high credit quality also helps to minimize default risk.
A secondary objective is income generation. While the yield might not be as high as that of longer-duration bonds, ultra-short-term bond ETFs still provide investors with a steady income stream through their dividend distributions.
Interestingly, the dynamics can shift favorably for these ETFs during certain market anomalies, such as an inverted yield curve. An inverted yield curve occurs when short-term interest rates surpass long-term rates and has historically preceded many recessions.
Under normal circumstances, investors expect higher yields for longer-duration bonds to compensate for the increased risk of holding a bond over a more extended period. However, when the yield curve inverts, ultra-short-term bonds can offer higher yields than long-term bonds.
Finally, these ETFs offer flexibility. They're a boon for investors looking for short-term parking spots for their funds without compromising on liquidity. They stand as a middle ground, offering higher yields than money market funds or savings accounts but with comparable flexibility.
An Example from Franklin Templeton
The Franklin Bissett Ultra Short Bond Fund (FHIS) is a great example of a professionally managed ultra-short-term bond ETF available to Canadian retail investors.
This ETF currently has an effective duration of 0.43 years, implying a low sensitivity to interest rate changes. Think of it as the "average wait time" for the returns on the bond. With a shorter duration like this, the fund's value is less prone to big swings if interest rates were to change.
When we talk about the yield to maturity of 5.62%, it gives us an insight into the returns. For bond ETFs, the YTM approximates the return an investor can anticipate if the ETF's underlying bonds are held until maturity.
In simpler terms, it's like saying, "If everything goes as expected and we hold onto the bonds in this ETF until they're due, we might see about a 5.62% return annually."
Now, let's touch on the ETF's average credit quality of 'A'. In the world of bonds, this is a reassuring sign. It's like a credit score for individuals. An 'A' rating suggests that the bonds inside FHIS are from issuers that are financially stable and reliable.
The makeup of the FHIS is pretty diverse. The majority, about 59.31%, is invested in corporate bonds, meaning bonds from various companies. Then we have a sprinkle of federal bonds and provincial bonds, at 4.25% and 1.76% respectively, which are bonds issued by the Canadian government.
Not to forget, the fund keeps a robust 34.67% in cash and equivalents, ensuring there's ample liquidity. Think of this as a safety cushion or rainy-day fund, allowing for quick moves and a safety net against unforeseen market events.
Lastly, there's the management expense ratio at 0.18%, which is highly competitive as active management in the fixed-income space goes. For a $10,000 investment, that works out to around $18 in annual fees.
This content was originally published by our partners at the Canadian ETF Marketplace.