Top bonds in Horizons Active Canadian Municipal Bond ETF, as of Dec. 31, 2022, are the province of Ontario, and the cities of Montreal, Boucherville, Que. and Repentigny, Que.Ryan Remiorz/The Canadian Press
Sign up for the Globe Advisor weekly newsletter for professional financial advisors on our newsletter sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know.
With central banks raising interest rates, a less familiar fixed-income investment that also provides an effective way to diversify fixed-income portfolios and boost returns is becoming more attractive.
Municipal bonds, also known as muni bonds, are issued by mid- to large-sized cities across Canada and the U.S., which use the funds to pay for infrastructure projects like bridges, roads and ports. They also offer investors an attractive yield higher than Government of Canada bonds anywhere from 100 to 180 basis points, depending on the duration, says Philippe Ouellette, senior portfolio manager, fixed income at Fiera Capital Corp. in Rosemere, Que.
Many retail investors don’t know much about the municipal bond market even though it’s worth about $40-billion in Canada and about $4-trillion in the U.S., according to the Securities Industry and Financial Markets Association. There’s a group of about 10 top institutional investors that focus on the sector in Canada, Mr. Ouellette adds.
Rising interest rates in North America in the past year have caused bond prices to fall sharply but pushed up bond yields to some of the highest levels in about a decade.
In Canada, municipal bond yields reached a high of about 5.25 per cent in October, and now have eased to about 4 per cent, says David Kletz, lead portfolio manager at Forstrong Global Asset Management Inc. in Toronto.
“The path of yields on municipal bonds has basically been the same as the path of yields on other types of [fixed-income] instruments,” he says.
Prior to the pandemic, bond yields were quite depressed; they then spiked in 2022 as inflation increased and the Bank of Canada, along with central banks around the world, began raising interest rates from their record lows.
Yields on U.S. municipal bonds reached a tax-equivalent yield of 7.1 per cent, the highest level in a decade in late October, according to a report from J.P. Morgan Private Bank. The actual yield of U.S. municipal bonds rose to 4 per cent. Yet, in the U.S., municipal bonds are tax-exempt, so the tax-equivalent yield is the higher yield that a taxable bond would need to reach to equal that of a tax-exempt municipal bond, the report states. They have fallen now to about 3.15 per cent.
Mr. Ouellette, whose fixed-income team manages Horizons Active Canadian Municipal Bond ETF HMP-T, along with other Horizons ETFs Management (Canada) Inc. fixed-income exchange-traded funds (ETFs), says there are several good reasons to add municipal bonds to a portfolio, mainly via a diversified ETF. (Horizons Active Canadian Municipal Bond ETF has about $35-million in assets under management and a management expense ratio of 0.35 per cent. Its current estimated annualized yield is 3.39 per cent.)
To attract investors, municipal bonds offer a yield that’s higher than federal and provincial bonds and close to that of A-rated corporate bonds, he says.
“When you look at the alternatives, like [guaranteed investment certificates (GICs)], equities and other asset classes, we can say to our clients – fixed income is back,” he says.
The actively managed ETF has a lower risk profile compared to corporate bonds, especially as they may come under pressure if the economy falters, he adds, noting most municipal bonds have an A rating.
Not all are rated
However, not all municipal bonds are rated because many municipalities aren’t willing to foot the approximately $75,000 bill of having their bonds rated by a major debt rating agency. Fiera has its own independent rating system for municipal bonds, and because the fund is actively managed, it also means it’s diversified by issuer and bond duration, Mr. Ouelette explains.
The ETF “without any corporate risk is yielding better than a short-term [bond] index,” he notes.
It also offers more liquidity than a single bond or a non-liquid GIC, which can offer a comparable rate of return, he adds. The fund also invests a portion in provincial bonds to ensure liquidity.
The fund’s top bonds, as of Dec. 31, 2022, are the province of Ontario, and the cities of Montreal, Boucherville, Que. and Repentigny, Que.
While many municipal bonds aren’t rated, that doesn’t mean they are riskier bonds, Mr. Kletz says.
One of their main sources of revenue is “property taxes, which don’t really go up and down too much with the economy, it tends to be actually a pretty stable source of revenue,” he says.
Liquidity, credit risk and tax exemption
However, Forstrong Global Asset Management doesn’t invest in municipal bonds as they represent a “tiny proportion of the bond market and [they’re] very, very small in terms of net issuance,” Mr. Kletz says. The main purchasers are big institutions that are long-term buy-and-hold investors, which means these bonds aren’t very liquid or traded easily.
“You can get a pretty similar yield buying provincials with a much better liquidity profile,” he adds.
In addition, they’re a tough buy for the average investor as they aren’t all rated bonds, and most people aren’t able to do the kind of credit analysis Fiera does for the Horizons ETF, he says.
While the U.S. market for municipal bonds is huge, the tax-exemption feature doesn’t apply to Canadian investors, which makes those bonds less appealing as the yield isn’t as attractive, Mr. Kletz adds.
“So, for a Canadian citizen who doesn’t benefit from the tax exemption, it really kind of begs the question – why would you buy it, if you could get a corporate bond with similar credit quality at a higher yield?”
But some positive selling points are that these are high-quality bonds, “so you’re not taking on a whole lot more credit risk and you do get, generally speaking, a bit of a higher yield,” he admits.
“I would just view [municipal bonds] as a stable source of cash flow, not something where you’re going to make a ton of profit on or anything like that,” Mr. Kletz says.
For more from Globe Advisor, visit our homepage.