Canadians are searching for yield, and ETF investors are no different. Hence the proliferation, on both the active and the passive side, of funds (including ETFs) that convert interest income into tax-advantaged capital gains. Such income recharacterization was put under the axe in Finance Minister Jim Flaherty’s budget in March.
Nevertheless, the quest for yield remains alive. It could be with corporate bonds, high-yield debt (aka junk bonds) or even emerging-market debt.
One area investors seem to have avoided is global bond ETFs – with the exception of emerging-market bond ETFs, which, according to the Canadian ETF Association, accounted for 10% of fixed income flows in the past quarter.
In part, that’s been because of a dearth of product and also a lack of interest. Home bias is probably even bigger in the bond market than in the stock market. That said, one ETF expert dubbed 2012 “The Year of the International Bond ETF.”
This year may be an even bigger year, as Vanguard prepares to launch an international bond ETF in the U.S. while PIMCO is readying three ETFs based on its existing U.S. mutual funds.
Vanguard suggests that international bonds do diversify a domestic bond portfolio – provided they are currency-hedged. With the loonie close to par, that would make some U.S.-based ETFs attractive.
However, there are complications. Europe’s debt woes are worrisome, rarely being off the front pages. That leads to a second consideration: credit quality. It’s not enough to apply market capitalization to the bond market. As Rob Arnott has pointed out, countries with the most outstanding bonds may also be the highest credit risks. As a result, some bond ETFs are GDP-weighted, including PIMCO’s. Vanguard, however, defends market-capitalization as the best measure of risk and reward.
Once again, it pays to know your index.