While interest rates were rising, bonds and the funds that invest in them were a drag on income portfolios.
Sure, they kept making regular payments (or distributions in the case of funds). But their market value eroded every time the Bank of Canada raised interest rates.
In 2021, the iShares Core Canadian Universe Bond Index ETF (XBB-T) lost 2.65 per cent. The next year was even worse, with the fund dropping 11.78 per cent. That’s almost unheard of in an ETF of this type.
The comeback began when the central bank pushed the pause button on rate hikes in 2023. The ETF gained 6.61 per cent that year. Now that rates are falling – three BoC cuts so far this year and more expected – XBB is on a pace to match and perhaps exceed last year’s gain. To Sept. 26, it was showing a year-to-date gain of 3.63 per cent. Most of that gain has occurred in the last three months.
But the bond market recovery we’re experiencing is uneven. Short-term bonds are outperforming long-term issues in some cases, leaving investors puzzled. This isn’t the way it’s supposed to work when rates are falling.
The reason for this unusual situation is the inverted yield curve we experienced earlier this year, with short-term rates higher than long-term ones. That meant short-term rates had farther to fall when rates began to decline, boosting their capital gains potential.
That situation is now ending. Long-term U.S. Treasury rates are now close to or slightly above short-term rates. As of Sept. 26, 10-year Treasuries were paying 3.79 per cent compared with 3.6 per cent for two-year issues. We’re seeing a similar situation in Canada.
For a closer look at how this is playing out in the ETF world, let’s revisit three of our bond exchange-traded funds recommendations and see how they are performing. Prices are as of Sept. 27.
iShares Core Canadian Universe Bond Index ETF
- Ticker: XBB-T
- Current price: $28.63
- Originally recommended: Dec. 15, 2004 at $29.49
- Annual payout: 93.6 cents (forward 12 months)
- Yield: 3.3 per cent
- Risk: Moderate
- Website: www.ishares.ca
Comments: This ETF tracks the broad Canadian bond market. It covers government and corporate issues with maturities of a few months to more than 20 years. The fund has $8-billion in assets and an MER of 0.1 per cent.
As mentioned above, this ETF is in recovery mode after down years in 2021-22. The credit quality is very high, with all the holdings rated investment grade. Federal bonds make up 40.22 per cent of the total assets with provincials accounting for 33.16 per cent. High-rated corporate issues make up most of the rest of the portfolio.
Because this fund covers the entire bond market, it’s not being adversely affected by the unevenness of the recovery, making it a good choice for your portfolio.
iShares 0-5 Years TIPS Bond Index ETF
- Ticker: XSTP-T
- Current price: $41.44
- Originally recommended: Sept. 29, 2022 at $39.44
- Annual payout: $1.21678 (2023)
- Yield: 2.9 per cent
- Risk: Medium risk
- Website: www.ishares.ca
Comments: This is a short-term ETF that invests in a Canadian-dollar-hedged portfolio of inflation-protected bonds, known as TIPS, issued by the U.S. Treasury. The fund is designed to protect your money while providing a modest rate of return. Investors have also benefitted from the weakness of the Canadian dollar against the greenback.
We have a 5.5-per-cent capital gain since the ETF was recommended in September, 2022, and the fund is showing a year-to-date gain of 6.9 per cent. But that return reflects the past, not the future, and the exchange rate differential is responsible for part of the gain. The U.S.-dollar version of this fund is up only 4.65 per cent year to-date. As the yield curve continues to revert to normal and inflation drops, the return on this fund will decline.
Another drawback from the point of view of income investors is the unevenness of the distributions. Some months they are very healthy, but some months the payments are zero. There’s no predictability.
For example, we received big distributions of 21.9 cents per unit in May and 26.6 cents per unit in June. But the July payout fell to 13.9 cents and August’s was 9.7 cents. If you’re looking for dependable cash flow, this is not your fund. It’s either a feast or a famine with this ETF when it comes to distributions.
This fund is not well positioned for the new environment of falling rates and reduced inflation, so I would not add to positions or open new ones. If you own units, hold for as long as they keep generating above-average gains but be ready to switch to a different option unless you’re willing to live with a much lower return.
iShares Core Canadian Long Term Bond Index ETF
- Ticker: XLB-T
- Current price: $19.90
- Originally recommended: Dec. 7, 2023 at $19.30
- Annual payout: 74.4 cents (forward)
- Yield: 3.7 per cent
- Risk rating: High
- Website: www.ishares.ca
Comments: This ETF invests in a portfolio of long-term Canada bonds with a maturity of more than 10 years. The ETF was launched in November, 2006, and has $1.2-billion in assets under management. The management expense ratio is 0.2 per cent.
Long-term bonds have greater profit potential when interest rates fall, but we haven’t seen the full effect of that yet. The fund gained 9.34 per cent in 2023 but is up only 0.94 per cent so far in 2024. That’s because the inverted yield curve we experienced pushed short-term rates higher than long-term ones. When rates began to drop, short-term bond funds benefitted more as a result.
The balance is shifting, however, and I expect a better performance from this fund going forward.
The majority of the holdings (56.44 per cent) is in provincial bonds. Federal issues account for 18.64 per cent. Just under 3 per cent is in municipals, with the rest in corporate bonds. All the bonds are investment grade (rated triple-B or higher). About 19 per cent are rated triple-A.
Distributions are made monthly and are currently 6.2 cents per unit. Distributions are not guaranteed and could change at any time, but historically they have shown reasonable consistency.
Bottom line: The bond market recovery is uneven and not as predictable as we would normally expect. This is particularly true of ETFs and mutual funds. Do your research before making any commitment.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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