Two Canadian Bond ETFs offering low fees and high-quality holdings

Even for our conservative investors, we caution against investing in bonds. Today’s rising interest rates make bonds unattractive, and further increases would push down their future value. But, if you need stable income and want to hold bonds, these two Canadian bond ETFs offer lower fees and high-quality holdings. Each is a buy.

For a recent article on other Canadian bond ETFs we recommend, read Most of Canada’s best stocks are in these two ETFs. And for our overall view on the best way to profit in the expanding field of exchange-traded funds, read When you invest in ETFs, keep it simple.

What types of bonds are held within Canadian Bond ETFs?

Canadian Bond ETFs typically hold government bonds (federal, provincial, municipal), corporate bonds (investment-grade and high-yield), real return bonds (inflation-linked), mortgage-backed securities, and occasionally foreign bonds, with portfolios varying based on the ETF’s specific investment strategy and objectives.

What are the risks associated with investing in Canadian Bond ETFs?

Interest rate risk, credit risk, inflation risk, liquidity risk, and reinvestment risk are the primary risks associated with Canadian Bond ETFs.

• Interest rate risk: When interest rates rise, bond prices typically fall, with longer-duration bonds experiencing more significant price declines.
• Credit risk: The possibility that bond issuers may default on interest or principal payments, particularly relevant for corporate bond ETFs and high-yield ETFs.
• Inflation risk: Inflation can erode the purchasing power of fixed bond interest payments, making your investment worth less in real terms.
• Liquidity risk: Some bonds within the ETF may be difficult to sell quickly without price concessions during market stress.
• Reinvestment risk: When interest rates fall, proceeds from maturing bonds may need to be reinvested at lower rates.
• Market risk: General market volatility can affect bond prices regardless of their underlying fundamentals.
• Currency risk: If the ETF holds foreign bonds without currency hedging, exchange rate fluctuations can impact returns.
• Premium/discount risk: Bond ETFs sometimes trade at prices above (premium) or below (discount) their net asset value.
• Management risk: The ETF manager’s decisions regarding duration, credit quality, and sector allocation directly impact performance.

How does the duration of a bond ETF affect its sensitivity to interest rate changes?

A bond ETF with a longer duration will experience greater price sensitivity to interest rate changes, with prices typically falling when rates rise and increasing when rates fall.

What is the yield-to-maturity of a Canadian Bond ETF?

The yield-to-maturity of a Canadian Bond ETF varies by fund but typically ranges between 3% to 5% currently, representing the estimated total return if all bonds in the portfolio are held until maturity.

ISHARES CORE CANADIAN SHORT-TERM BOND INDEX ETF (Toronto symbol XSB; buy or sell through brokers) mirrors the FTSE TMX Canada Short-Term Bond Index. You pay a low MER of just 0.10%.

That FTSE index tracks investment-grade government and corporate bonds with one- to five-year terms. The ETF holds 533 bonds; the average term to maturity is 3.08 years.

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The bonds are 67.4% government and 32.6% corporate. Issuers of the corporate bonds include TD Bank, Hydro One, Intact Financial, Hydro Quebec, Bank of Nova Scotia, Enbridge, CP Rail and other high-quality companies.

The fund offers investors a 2.2% yield, which reflects the number of its bonds paying above-market interest rates. As a result, they trade above their face value, although when they mature, holders only get their face value. That means the ETF’s portfolio will incur predictable capital losses, which could partially offset your high yield.

When looking for the long-term return of this fund, you should study its yield to maturity. That ratio weighs the series of capital losses or gains the fund will experience as its bonds mature. Here the yield to maturity is 4.63%. So for this ETF, that’s effectively the yield you will get. Note, it’s higher than the current 2.1% interest yield, and also higher than the 4.16% you’d earn by investing in, say, a one-year treasury bill.

If you want to invest in a bond fund, the iShares Core Canadian Short-Term Bond Index ETF is a buy.

ISHARES CORE CANADIAN UNIVERSE BOND INDEX ETF (Toronto symbol XBB; buy or sell through brokers) mirrors the FTSE Canada Universe Bond Index.

The portfolio’s 1,451 bonds have an average term to maturity of 10.01 years. You pay a low 0.10% MER. The bonds in the Canadian Universe Bond Index are 73.9% government and 26.1% corporate. The iShares Core Canadian Universe Bond Index ETF’s bond issuers are similar to those of the Short-Term Bond Index Fund.

This ETF yields 3.0% versus the Short-Term Bond fund’s 2.2%. Its yield to maturity is 4.59%—4 basis points above the Short-Term Bond fund’s. That reflects the added volatility this ETF exposes you to (long-term bonds move up and down more on interest rate changes than do short-term bonds).

The iShares Core Canadian Universe Bond Index ETF is a buy for investors prepared to accept that risk.

How interested are you in Canadian bond ETFs given current interest rates and the outlook?

This article was originally published in 2013 and is regularly updated.