Q: I’d like to invest 50% of my RRSP money in a fixed income ETF. How do they differ, and which ones are worth considering? What are the pros and cons of fixed income ETFs? I am retired and want a very conservative fixed income component in my RRSP, even though I don’t need that money for several years.
A: Bond ETFs have many positive qualities, but simplicity isn’t one of them, unfortunately. This is especially true for people who are used to buying individual bonds or GICs, which are much easier to understand. So if you’re trying to select the right bond ETF from among the dozens of choices available, Laurice, here are some suggestions for weighing your decision.
Start by considering whether you want to use an active or passive strategy. With an active bond ETF, the manager tries to anticipate changes in interest rates and adjusts the portfolio accordingly, moving between shorter and longer maturities. She will also shift between government and corporate bonds to try to improve performance.
A passive bond ETF simply tracks an index and makes no attempt to forecast the future. Some bond indexes hold hundreds of bonds of all maturities. Others are designed to mimic the popular “laddering” strategy, with roughly equal amounts in, for example, bonds with maturities of one to five years.
Active bond ETFs offer the potential of higher returns and protection from losses during periods when interest rise. But in practice, the majority of active funds fail to outperform their benchmarks over the long-term, partly due to their higher fees. The ones that do earn higher returns often do so simply by taking more risk—which leads to our next consideration.
Bonds are supposed to be the safe part of a balanced portfolio, but all fixed income ETFs carry potential for losses, so it’s important to understand the risks in your bond fund. There are a few key characteristics to consider.
The first is the ETFs average maturity (or term). In general, bonds that mature in, say, two or three years carry less risk than those that lock up your money for 10 or 20 years. Short-term bonds are less volatile than long-term bonds, so if you want your fixed income to be nice and stable, look for an ETF that holds bonds with maturities of five years or less. If you’re willing to tolerate a little more volatility in exchange for higher yield, choose a broad-market bond ETF (they often carry the word “Universe” or “Aggregate” in their names) to get a mix of short, intermediate and long bonds.
The second key characteristic is credit quality, or the risk that the bond will default. This is close to zero for federal government bonds but much greater for high-yield (“junk”) bonds issued by distressed companies. Laurice, since you say you want a “very conservative” ETF, you should consider one that holds only investment-grade bonds, which are issued by governments and blue-chip companies with an extremely low likelihood of default. They will pay a lower yield than their junky counterparts, but bonds are not the place to take big risks in a retirement portfolio.
You also asked about the pros and cons of fixed income ETFs, presumably as compared with individual bonds or GICs. There are a few trade-offs to consider.
Bond ETFs have many advantages over individual bonds, including low cost (trading individual bonds incurs relatively large commissions) and instant diversification. Bond ETFs are also very liquid and easy to buy and sell in small amounts, which comes in handy when rebalancing your portfolio.
The downside of bond ETFs is they can be challenging to understand. If you buy an individual bond with a yield of 3% and a term of five years, you know exactly what your return will be if you hold it to maturity. A bond ETF has no maturity date, so your rate of return is less predictable. You can always look up the ETF’s “yield to maturity,” which is the most reliable estimate of its future return. But this number assumes that interest will remain unchanged—which of course never happens. If the YTM is 3%, for example, and interest rates rise over the next 12 months, your annual return is likely to be lower than that. If rates fall, you’ll stand to earn a return higher than 3% on that ETF.
So, Laurice, bond ETFs are an excellent choice for RRSPs. Just make sure you take the time to get familiar with them before you buy.
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