Bonds had an extremely tough year in 2022. In fact, some commentators believe it was the worst year ever for US bond investors; the Total Bond Index, for example, lost more than 13% in value over the year. These investments, which are usually perceived as being boringly safe, were anything but.
That’s changing, however, and there are good reasons to be enthusiastic about bonds once again. We take a look at how bonds and bond ETFs work, the ways that bond ETFs can deliver investment returns and how bond ETFs could fit into your investment portfolio.
How do bonds work?
Bonds are basically a kind of loan that governments or companies issue, in return for cash from investors. They’re issued for a certain amount of money over a specified timeframe (ending with the maturity date) at an agreed rate of interest. At the end of the redemption period, you’ll (normally) receive all of your investment back, plus interest is paid out to you until the loan is repaid.
That redemption period can be a few months or even less, right up to 30 years or even more. Typically, the higher the perceived risk, the higher the interest offered; so, for example, government bonds will usually offer lower rates than corporate bonds. Companies in stronger financial positions will typically pay lower interest rates than those with weaker finances, given that they’re perceived to be a lower risk. Also, theoretically at least, the longer the redemption period, the higher the interest rate.
Yield is the amount of money received as a percentage of the investment made. With bonds, this can be a combination of the interest paid out, plus capital gains or losses if the bonds are sold before the redemption period is up. The market value of a bond can change over time, especially when interest rates fluctuate considerably, as they did in 2022.
In that year, the Bank of Canada increased its policy interest rate from 0.25% to 4.5% and the US Federal Reserve increased its federal funds rate from around 0% to 4.25%-4.5%. As a result, many long-term bonds were offering interest rates that were far below rates available elsewhere. This led to their market values dropping considerably. When higher-interest options are available, investors will only be willing to pay a lower price for a bond with low interest, so as to maintain an attractive yield rate.
Investors will often sell long-term bonds if they feel they could get better returns elsewhere, however, they might have to accept a considerable drop in value to sell them. If you’re willing to hold onto a bond until its redemption date, you will still (typically) get your whole investment back, but you could have missed out on your money earning much higher levels of interest over that time.
Here’s an example:
Bond 1 was issued two years ago at 3% interest, and you invested $100 in it. For this example, let’s assume the bond will last forever (no redemption date).
If Bond 2 were issued now, with interest rates so much higher, it would offer a 6% interest rate for that $100 investment. Bond 2 is identical to Bond 1 except for the interest rate.
Once Bond 2 is released, the market would move; for Bond 1 to yield 6%, it would require a price of $50, substantially lower than the issue price of $100.
How do bond ETFs work?
A bond ETF (bond exchange-traded fund) is a collection of different bonds held in one fund. It allows you to diversify the bonds you own, so as to reduce the risk from being too concentrated in one type or region of bond. They could be comprised of corporate bonds, government bonds, or a mix of the two.
When you invest in individual bonds, it’s more difficult to get the kind of diversification that reduces risk in your portfolio. Another disadvantage of individual bonds is that, once one reaches its maturity date, you have to buy another bond to replace it. Also, issuers often have the right to pay the bond off early (known as calling it in), if they feel they could get better terms elsewhere. This would abruptly turn your bond investment into cash.
With bond ETFs, the ETF’s money managers understand this and will sell bonds they feel might be called in, so as to maintain a balance of yield over a longer period within the ETF. With bond ETFs, you don’t have to worry about your investment suddenly being turned into cash, making it a more reliable, ongoing investment.
Why are bond ETFs so attractive now? What changed?
Usually with bonds, the longer the time period involved, the higher the interest rate. However, because central bank interest rates shot up so quickly in 2022, short-term bonds began offering significantly higher interest than existing long-term bonds. This has caused many long-term bonds to be sold off below their initial value. However, those bonds will eventually be redeemed at their original value, so there is also an opportunity to earn additional returns from those bonds in the form of capital gains.
Many bonds began 2023 trading at a discount, which could make them one of the most attractive investment assets of the year. An important bond statistic to be aware of is its weighted average yield to maturity (YTM). This is the estimated annual yield until the redemption date. In early 2023, because of these steep discounts, some bond ETFs had a yield to maturity of over 11%.
It’s important to remember, though, that the higher the yield, the higher the risk within the bond asset class.
The types of bond ETFs
Bond ETFs can be active funds, which is where the fund managers follow a specific investing style or philosophy. One example of this is the Mackenzie Unconstrained Bond ETF (MUB); the fund’s managers are able to tactically adjust the fund’s holdings to take advantage of opportunities and adapt to changing market conditions. As at January 31, 2023, its weighted average yield to maturity was 6.36%1.
Bond ETFs can also be index funds, where they’re designed to replicate a specific bond index.
For example, the Mackenzie US High Yield Bond Index ETF (QHY) is designed to replicate the Solactive USD High Yield Corporates Total Market Index, which mirrors the performance of high yield-rated corporate bonds issued in US dollars. As at January 31, 2023, its weighted average yield to maturity was 7.88%2.
Within those categories of bond ETFs, there can also be region specific, high-quality or high-yield, and short-, medium- or long-term bonds.
How do bond ETFs fit into a portfolio?
Bonds would typically make up the 40% part of a 60:40 portfolio ratio of equities to bonds. That ratio could also be higher for retirees who need their investments to provide consistent income. However, bonds have seen a drop in value for two years in a row, plus their yields were very low, so some investors bought more equities and reduced the bond portion of their portfolio to 30% or even 20%.
Given the opportunities currently available with bonds, it makes sense to rebalance portfolios back to the 60:40 ratio. Bond ETFs are back in the position of providing a safe cushion in the case of equities falling and can provide more substantial regular income. Also, bond ETFs make it really easy to help the fixed income portion of your portfolio have immediate, broad diversification.
Talk to your advisor to discuss ways to add bond ETFs to your portfolio and take advantage of the unique opportunity that bonds currently offer.
1. Performance for Mackenzie Unconstrained Bond ETF for the period ended February 28, 2023 is as follows: -2.8% (1 year), -0.3% (3 years), 1.3% (5 years) and 2.6% (since inception - April 2016).
2. Performance for Mackenzie US High Yield Bond Index ETF for the period ended February 28, 2023 is as follows: -5.0% (1 year), 0.3% (3 years), 1.3% (5 years) and 0.9% (since inception - January 2018).
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