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exchange-traded funds: fixed income

Alfred Lee, a portfolio manager and investment strategist with BMO Asset Management Inc. in Toronto. ‘Now we are seeing ETFs that slice and dice the market in terms of getting your exposure to where you want to be on the yield curve.’Della Rollins/The Globe and Mail

For investors who seek fixed-income exchange-traded funds, fund providers have moved beyond those that track bond benchmarks to newer offerings that promise tactical or strategic outcomes.

"Before, when you looked at fixed-income ETFs, most of the products got you exposure to the entire fixed-income market," says Alfred Lee, a portfolio manager and investment strategist with BMO Asset Management Inc. in Toronto. "Now we are seeing ETFs that slice and dice the market in terms of getting your exposure to where you want to be on the yield curve." This can mean products with a mix of different credit quality debt, as higher risk can mean potentially higher yield.

Beyond low fees, which are the hallmark of exchange-traded funds, ETFs also make a great deal of sense in fixed income because they provide better liquidity and market visibility than the underlying debt markets they track. "With an ETF it takes an opaque market where there is no live bid and ask, converts it to some that is on exchanges and gives you not only price discovery but the amount traded in terms of volume."

Mr. Lee says the evolution of fixed-income ETFs mirrors the development in equities, where ETFs have gone beyond tracking stock indices to offering exposure to specific sectors and sophisticated strategies. "Now you can pinpoint where you want to be and can really control your risk and reward," he says.

Newer versions of fixed-income ETFs also allow average investors to participate in previously hard to access asset classes such as high-yield and emerging-market debt, he said. "With an ETF you can get that exposure efficiently and very cost effectively as well."

While the appeal of bonds and guaranteed investment certificates has lessened in today's low interest-rate environment, take up of fixed-income ETFs has swelled as investors seek to eke out better gains than they can get from individual fixed-income investments.

"We are seeing actually an escalation, an acceleration of adoption of fixed-income ETFs in portfolios despite the fact that yields in fixed income globally and even locally have not been at the most attractive levels," says Pat Chiefalo, managing director and head of iShares Canadian product at BlackRock Canada in Toronto.

Beyond cost advantages and transparency, by buying a huge basket of bonds, fixed-income ETFs mean investors don't have the worry of buying or selling individual bonds, having to keep them for a certain duration and the concern of the credit risk of specific bonds, Mr. Chiefalo says.

"It is certainly resonating well and I think that is why you are seeing the groundswell of adoption in these products."

That is borne out by global ETF investment numbers: In the first quarter, $44-billion (U.S.) went into fixed income, or more than 60 per cent of the $71-billion invested in all ETFs, according to a BlackRock report.

"That is a disproportionately higher percentage than I have seen in the past," Mr. Chiefalo says.

In Canada, fixed-income ETFs account for about 40 per cent of that market last quarter, but the country's market generally follows U.S. and international trends over time.

Mr. Chiefalo noted that institutional investors were more active as buyers of fixed-income ETFs and that spurs growth in the sector.

The most popular fixed-income funds offered by iShares are headed by the iShares Canadian Universe Bond Index ETF (XBB/TSX), with a little more than $2.1-billion in assets, and the iShares Canadian Corporate Bond Index ETF (XCB/TSX) with more than $1.5-billion in assets.

In the area of strategic ETFs, BlackRock last year launched a trio of funds under its iShares Strategic Fixed Income suite (XSI/XSC/XSE) that aim to generate income and deal with duration and interest-rate risk.

This month, the fixed-income ETF ranks got a bit more crowded with the launch of four actively managed fixed-income ETFs from Mackenzie Financial Corp.: MGB/MUB/MFT/MKB. Those four new funds, which trade on the Toronto Stock Exchange, are a reflection of the growing market demand for fixed income and the limitations of underlying bond markets.

"It is just getting harder to navigate bond markets in general," says Michael Cooke, senior vice-president and head of exchange-traded funds with Mackenzie Investments.

Because of falling interest rates, bond markets have been growing riskier since the 2008 financial crisis, Mr. Cooke says, and ETF bond funds are evolving to help investors cope. The timing couldn't be better, given Canada's aging population.

"Fixed-income allocations are likely only to trend higher for many Canadian investors as they age and become more income dependent and risk averse," he says. "They need solutions that will give them that core [fixed-income] exposure but help to manage the risks inherent and the risks that have become more pronounced in bond benchmarking in the last decade or so."

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