Canadian bond investors had a rough go in 2022. After holding through years of low yields, many Canadians were overweight long and intermediate duration bonds in their portfolios. So when interest rates were hiked sharply in 2022, they certainly felt the impact.
By the end of 2022, the popular BMO (TSX:BMO) Aggregate Bond Index ETF (ZAG) fell by 11.60%, a consequence of its weighted average duration of 7.41 years. All else being equal, a 1% increase in rates would cause ZAG to lose 7.41% in net asset value, or NAV. In comparison, the S&P/TSX 60 index fell just -6.36%.
Despite the bond bear market, some Canadian ETF providers still launched new and innovative bond ETFs. Namely, RBC (TSX:RY) iShares launched a suite of "Target (NYSE:TGT) Maturity" corporate bond ETFs. This approach is being used in the U.S. and I am pleased to see it arriving in the Canadian ETF market. Let's take a look.
The weakness of regular bond ETFs
New investors unfamiliar with the jargon and mechanics of fixed income investing often conflate bond ETFs with individual bond issues. The two have a critical distinction, namely in terms of maturity.
With an individual bond, an investor who holds the bond to maturity is guaranteed the par value of the bond, assuming the issuer does not default. Therefore, even if the bond's market price dips as a result of rising rates, the bond investor can hold the bond to maturity to avoid locking in a loss.
Not so with bond ETFs. While they have significant advantages over individual bonds (namely, greater liquidity and more transparent pricing), they have a constant maturity. A bond ETF must always buy and sell bonds to maintain its target maturity.
For example, consider the iShares 1-10 Year Laddered Government Bond Index ETF (CLG), which holds a ladder of Canadian government bonds ranging from less than one year to 10 years in maturity. At all times, CLG will try to target an average maturity of 4.81 years and an effective duration of 4.41 years.
Reducing bond duration is generally a good idea as investors age as it minimizes interest rate risk. The problem is that by holding a regular bond ETF, investors are exposed to the same interest rate risk throughout the years while their risk tolerance and time horizon decreases.
Where the new RBC bond ETFs can help
The usual solution is to swap bond ETFs for shorter duration ones, but that can be a hassle and, in some cases, incur capital gains tax. The RBC Target Maturity corporate bond ETFs solve this by "maturing" much like individual bond issues do.
Each RBC Target Maturity corporate bond ETF tracks a unique FTSE Maturity Corporate Bond Index that holds a portfolio of corporate bonds maturing in the same calendar year. For example, the RBC Target 2025 Corporate Bond Index ETF (RQN) tracks the FTSE Canada 2025 Maturity Corporate Bond Index.
Along the way, RQN will payout regular interest income. Unlike individual bonds though, the income will be paid on a monthly basis as opposed to semi-annually, which is beneficial for income investors. In 2025, RQN will liquidate and payout its final NAV to holders. The ETF charges a 0.28% expense ratio.
The weakness of RBC's new bond ETF lineup lies in the limitation of corporate bonds. These bonds have lower credit ratings than government issuers and thus have more market risk. During a crash, corporate bonds can lose value. However, they are still investment-grade and provide a more attractive yield.
Overall, I think the new RBC Target Maturity corporate bond ETFs can be a great way for investors to diversify their fixed-income allocation further. Pairing one of these bond ETFs with a government bond ETF like CLG can be a great way to balance out market versus interest rate risk.
This content was originally published by our partners at the Canadian ETF Marketplace.