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David Stephenson, Director, ETF Strategy and Development, CIBC Asset Management.
It’s been a very challenging year for fixed income investors. What fixed income ETF strategies are best suited in this environment?
First of all, to provide some context, 2022 is shaping up to be one of the most challenging years ever for fixed income investors. If you look back since 1980, the worst calendar year return for Canadian bonds was negative 4.3% in 1994. Year to date through October 21st, the Canadian bond market, as measured by the FTSE Canada Universe Bond Index, was down 15.1%, more than three times as much. In short, many investors have never experienced these types of returns in their fixed income portfolios, and in 2022, bonds have not served as a ballast in portfolios, as equity markets have declined as well.
If I use the period 2000 to 2022 year to date as an example, the S&P/TSX Composite Index had six negative calendar years. In each of those years, bonds had positive returns, including the dot-com bubble burst in 2002 and the Great Financial Crisis in 2008. This hasn’t been the case in 2022. In terms of ETF strategies best suited to this environment, it can be best characterized as a flight to safety by investors, which have been flocking to high-interest savings account ETFs and ultra-short duration ETFs. The only areas within fixed income that have been positive year to date in terms of returns are high-interest savings accounts and money market ETFs, floating rate notes and short-term TIPS. That’s it.
Interestingly, despite market returns, we’ve seen about 9 billion in fixed income flows year to date through September 30th, with approximately half of that into high-interest savings account ETFs. With inflation in Canada at 40 year highs, the Bank of Canada has undergone one of the steepest and fastest tightening cycles ever conducted, raising rates from 0.25% to 3.25% since March with further increases priced in before year end at the October and December meetings.
This has led to a huge repricing in fixed income markets as yields across the bond market are up significantly since the beginning of the year. In this environment, there has been a lot of repositioning within the short end of the curve. Investors have also incorporated inflation protection into their portfolios. A good example is floating rate notes, coupons adjust with short term rates, which are up over 300 basis points year to date, and are less sensitive to interest rate increases.
Another strategy well suited for this type of market environment is unconstrained fixed income. These strategies have a wide investment opportunity set and flexible mandates and can capture opportunities as they arise across different sectors, whether that is U.S. investment grade corporate bonds, emerging market debt, or even U.S. high yield bonds. Finally, one ticket fixed income portfolio solutions can serve investors well and help navigate current markets. These products are designed to deliver specific client outcomes and are core bond allocations. The focus is on risk adjusted returns and flexibility to take advantage of tactical opportunities as they arise. Investors can use them as core fixed income holdings or a core satellite approach, where other ETFs can be used to express market views as well, depending on their risk profile.
So where are we seeing demand? Although investor demand has been concentrated and cash in ultra-short duration ETFs, there is a silver lining here for investors. The sell off in fixed income in rising yields has created opportunities for investors. For many years, investors referred to TINA, or there is no alternative, to equities given low yields. As a result, investors looking to achieve certain yield targets had to take on a fair amount of risk, whether it was equity or credit risk.
You can now find rates of more than 4% across several areas of fixed income. In the U.S., for example, many investment grade corporate bonds are yielding close to 6%. We are now seeing some of the highest yields in the fixed income market in 15 years before the Great Financial Crisis in 2008. With investors being overweight cash, this has helped preserve capital for future buying opportunities and portfolio repositioning. With over 300 fixed income ETFs to choose from in Canada, there are many different ways to slice and dice the market to express the view on duration, credit and yield.