This series of articles, “Solving your investment problems,” will explore advisors’ and investors’ key concerns and suggest some of the best solutions for each one.
Part 4: Thinking outside of the core box: Satellite fixed income
The problem: How to get higher yields and/or greater diversification from bonds.
One solution to consider: Satellite fixed income
In Canada, when it comes to fixed income investments, many investors stick to North American offerings. However, investment-grade North American bonds (those perceived to have very low risk) have seen a decrease in yields for many years now. The current US 10-year treasury rate is only 1.58%, (as of May 25, 2021), which is not very exciting and far below expected inflation.
When you consider that some North American bond returns were as high as 8% in 1990, this is a huge shift in the fixed income field.
Bonds are still an important diversifier to equities and North American bonds still have a role to play in investors’ portfolios. That said, for investors looking to use bonds as a safe way to provide income in their retirement, or to provide a safe way of growing their savings, traditional bonds fall short. Fixed income investments that bring higher yields and/or greater diversification than North American bonds are known as satellite fixed income. Let’s take a look at some satellite fixed income options and how they might complement a portfolio.
Emerging market debt
For diversification and income reasons, investing in emerging market bonds makes excellent sense. It’s always wise to avoid too much investment in any one region, so emerging markets will help diversify your portfolio geographically.
Another advantage is that these countries are typically classified as having higher risk. The risk is still fairly low, as you would want to focus mostly on government-backed debt, but they are not triple-A rated bonds. The payback for taking on this extra risk is a higher yield (typically at around 5%), which is considerably more than investment-grade bonds are delivering.
Buying ETFs of emerging markets bonds will help to spread the risk across numerous different countries and governments. If a country’s credit rating dips, then its price usually falls. A good investment manager will balance the ETF’s portfolio to accommodate the extra risk. There are several events that could cause a country’s credit rating to change, including:
- Gross domestic product changes
- A trade war
- A military conflict
- Civil unrest
- A local epidemic
For example, Canada’s triple-A rating was downgraded by Fitch Ratings in June 2020 because of the impact on its gross domestic product of government spending to offset the economic impact of COVID-19.
Two ways to invest in emerging market bonds
US dollar emerging market bonds: There are funds that only invest in bonds that are listed in US dollars and traded in the US. A big advantage of this kind of product is that they typically contain a lot of holdings (bonds from different issuers), so they provide great diversification.
Using a US-listed emerging market bond fund will likely expose you to paying withholding tax in both the US and the bond’s country of origin, which can reduce your overall returns. This risk can be mitigated by investing in Canadian-listed ETFs for emerging market bonds.
Non-US, local currency emerging market bonds: This kind of fund invests in emerging market bonds and buys them in the country of origin. There are several advantages to this strategy. Firstly, there is no issue with US withholding tax (unless you invest in a US-listed ETF), which can bring a positive impact to returns. Secondly, this type of fund brings a unique diversification in the currencies a portfolio holds.
The main downside is that these ETFs might not hold as many holdings or have quite as many countries represented, so you trade potentially higher returns for somewhat lower diversification.
High yield bonds
Also known as junk bonds, these are bonds that pay higher interest rates than investment-grade bonds. Issuers of these kinds of bonds are typically start-ups or companies with high debt ratios. Either way, they represent a higher risk and so pay a higher interest rate – this can be as much as three percentage points more than investment-grade bonds.
Buying high yield bonds through an ETF will spread the risk and is a much safer way of tapping into this higher yield potential than by buying individual junk bonds (which we don’t recommend unless you’ve done your homework on the issuer and the details of the issue).
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are treasury bonds that are issued by the US government. They are indexed to inflation, so they protect investors from a potential drop in their money’s buying power. They do this by adjusting the principal of the bonds relative to changes in the Consumer Price Index (CPI). When the bonds mature, investors receive the largest amount of either the adjusted principal or the original principal (investors never receive less than their originally invested principal).
TIPS pay out a fixed coupon rate. The dollar amount paid is the coupon rate multiplied by the current principal amount, which itself is adjusted for inflation. The dollar amounts paid as interest are also therefore adjusted for inflation. You also receive a principal adjustment payment if the CPI goes up.
TIPS are great for helping to protect your investments from high inflation and provide added diversification.
Developed ex-North America bonds
Investing in bonds from developed countries overseas can bring added diversification to most portfolios, especially those with a bias towards US and Canadian fixed income. You can buy ETFs that hedge the foreign currency back to the Canadian dollar, which reduces your currency fluctuation risks.
Mackenzie’s satellite fixed income ETF options
Mackenzie offers several satellite fixed income ETFs that aim to bring higher yields and/or greater diversification than treasury bonds. Here is a selection:
Emerging market bonds: The Mackenzie Emerging Markets Bond Index ETF (QEBH) and the Mackenzie Emerging Markets Local Currency Bond Index ETF (QEBL) both provide exposure to the higher yields and diversification from emerging market debts. QEBL is the only emerging market local currency bond index fund in Canada, delivers substantial currency diversification and avoids the need to pay withholding tax twice.
High yield bonds: The Mackenzie US High Yield Bond Index ETF provides an estimated yield of around 5% and exposure to hundreds of predominantly US fixed income holdings.
Treasury Inflation-Protected Securities: The Mackenzie US TIPS Index ETF (CAD-Hedged) aims to provide protection against inflation, particularly important when inflation is forecast to rise.
Developed ex-North America bonds: The Mackenzie Developed ex-North America Aggregate Bond Index ETF provides diversification with bonds from developed countries outside of North America and is hedged to the Canadian dollar to minimize the risk of currency fluctuations.
In case you missed them:
Find out more about integrating satellite fixed income ETFs into your portfolios. For advisors, speak with your Mackenzie sales team; for investors, talk to your financial advisor.