Transcript: Where’s the Yield? Fixed Income Investing Using ETFs

Transcript: Where’s the Yield? Fixed Income Investing Using ETFs

[Where's The Yield?]

[Fixed Income Investing Using ETFs]

>>Ammar: Hello, everyone. Thank you for taking the time to join us today. On behalf of CIBC Investor’s Edge, I would like to welcome everyone to our webinar. My name is Ammar and I will be your host for this event.

Now, just a few things to note before we get started. CIBC Investor Services Inc. does not provide investment or tax advice or recommendation. So, everything we share today is for education purpose only. We are recording today’s session and a link to the replay will be emailed to anyone that registered.

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Also, if you wish to view this full screen, you may do so by clicking on the expander arrows located on the top right-hand corner of your screen. And should you have any questions during the presentation, please take note you will have the opportunity to submit your question after the presentation.

[Speaker]

Our topic for today is fixed income using ETFs, where we will cover how fixed income ETFs work and why active management and fixed income remains popular. We are very excited to have Mark Noble join us once again as our speaker. Mark is Senior Vice President and Head of Sales Strategy for Horizons ETFs. Mark has worked with various teams at Horizons ETFs to build client educational tools and initiatives that help Canadians become better investors. With great pleasure, please join me in welcoming Mark Noble.

[ETFS 102 — Fixed Income ETFS]

[Horizons ETFS Management Canada Inc.]

>>Mark Noble: Great. Thanks so much Ammar. And thanks everyone for being on this with us. I’m really excited about this particular topic. It’s a passion of mine actually to talk about fixed income because let’s face it. Fixed income’s kind of boring, right? But, it’s not so boring when you see what it can do for your portfolio. So, we’re going to spend the next 45 minutes or so going over a couple key things here on fixed income ETF investing.

[Agenda]

Now just so everyone’s aware, we will go over some of the basics of fixed income, and we’ll go over some of the basics of ETFs. And the goal here is to talk really not so much about what to buy when it comes to fixed income investing, but really understanding fixed income investing and how it relates to ETFs.

So, we’ll go through some of the reasons why fixed income continues to be popular amongst investors globally, but particularly in Canada. And then we’ll talk about some of the things such as the impact of fees, how to use ETFs to get exposure, the advantages of active management, really talking about the difference between active and passive management of fixed income, which is a very important topic actually, much more so than it is on the stock side.

And then I’ll talk a little bit about the interest rates and some ETF strategies. We won’t bring up any particular ETFs. We’ll talk about some types of ETFs that maybe help you in a rising interest rate environment. ‘Cause certainly as we’ve seen over the last 18 months, we are now in a rising interest rate environment. So, that’s a very new dynamic for a lot of fixed income investors.

[A Demographic Shift]

Now, the most important thing to understand about fixed income is that there’s a demographic shift occurring in North America. That means that fixed income for all intents and purposes is becoming a much more important asset class for a lot of investors. This just can’t be ignored by the fact that our population in both Canada and the United States is getting older.

And there’s a lot of things we can change about investing in terms of time horizons and assets that come in and out of favor, but there are some hard rules in investing. And one of the hard rules of investing is that as you get older as an investor, you likely have to shift your portfolio to become more conservative.

And for a lot of investors, they’ve saved for retirement so that they can pay for retirement. And the best way to pay for retirement, is typically through income generating securities, most likely fixed income. So, regardless of what happens with interest rates and valuation of bonds and new asset classes such as bitcoin, you know, really, this isn’t going to change the fact that a higher and higher percentage of investors are going to need access to fixed income market to fund their retirement. And so, this means that we’re likely seeing a longer environment of lower than historical averages on fixed income and interest rates. And we’re likely seeing a lot more demand versus supply for fixed income instruments which all again highlights the need to be looking at different types of fixed income strategies and things like ETFs. But, as we get older, we need to shift our portfolio to a fixed income profile, and that’s underscored again by the need to have income and also, the need to reduce risk. Fixed income, after cash, is probably the less risky portion of your portfolio, and that’s why it needs to be some portion of your portfolio, usually from an academic sense, in fixed income to protect from big drawdowns in the market.

[The income challenge]

The problem is is that as we’ve seen all these increase in investors, particularly in that really important investor demographic are the baby boomers, who remain the largest swath of investors in the world, it’s done a number of things to fixed income that make it extremely challenging to be a fixed income investor.

If I could be so bold, I would say being a fixed income investor today sucks. Okay? It’s not easy. It was easy twenty years ago, when I could get 8-9% on a GIC, and that could really fund the income of my retirement. Once I got from point A, which was growing my portfolio, I could switch it to income, and I’d have a pretty good drawdown on my portfolio.

Today it’s risky just to try to generate even a 4% yield for your portfolio. And to give you some mathematical kind of context to that, if you want to have a $40,000 per year income as a retiree, if you’re using a 4% drawdown metric that means you need a $1 million portfolio. And so, it is very, very challenging being a fixed income investor because yields are so low.

And hence the name of our presentation today: Where’s the Yield? And we’re going to talk about maybe how to get to the 4% maybe in aggregate using ETFs, but it’s challenging. Rates are very low. The higher you go out to chase rates, the more and more risk you’re taking on. It’s the riskiest it’s ever been to be a fixed income investor in the last generation. You have rising interest rates. You have low yields.

And this has sort of created a perfect storm, where you could see losses in your fixed income portfolio. And for many investors, this is something they haven’t experienced for more than 30 years. So, there is a very big change in the market, where bonds are not quite the riskless assets they once were, and depending on your position both on the length of the bonds you hold and the type of yields they have, it could be a fairly risky proposition.

So, then of course I get a lot of investors saying, ‘well I don’t really care about bonds. I’m going to go to the equity market and buy dividend paying stocks.’ Well, you’ve probably noticed that yields on dividend stocks have also declined over the last few years, as more and more investors have piled into dividend paying equities. So, equities are very expensive. And the problem with equities is when they’re expensive is it means that the risk of them declining increases as well.

A key difference between fixed income and equities is that with fixed income, I don’t need to worry so much about gyrations in the marketplace. I’m more concerned about the person paying or the entity paying my income is going to be able to continue paying that income and I can hold it through a market cycle. I’m not really worried too much about the value of my income. I’m more talking about the equity market. Stocks can go up and down. Dividends can be cut. And so, it is a much more risky place to look for for income.

So, as an investor your options of finding yield are dramatically less than what they were, and this is partly what’s driven a huge growth in the ETF market globally to move towards fixed income investing because ETFs offer a range of opportunities and specialization for you to try to get exposure to the fixed income market.

Quickly going to go over Exchange Traded Funds. I’m going to assume most of you are somewhat familiar with exchange traded funds. Nevertheless, it always helps to go over what is an ETF and why are we talking about ETFs today?

ETFs are a type of technology. They’re a delivery mechanism for an investment strategy. And they’re not too dissimilar to a mutual fund in that they will offer a basket or portfolio of securities, so, in the case of today’s presentation, they offer a basket or portfolio of a fixed income security that you would be able to invest in to get diversified exposure to a certain segment of the fixed income market.

Like a mutual fund, the really important part about ETFs is that they’re called an open-ended investment fund. And what an open-ended investment fund means is that any new units purchased for the ETF, will have a value that’s reflective of the underlying holdings of the bonds that they hold. So, if the aggregate value of the bonds is $100, then the aggregate cumulative value of your ETF unit should be $100, assuming that’s per unit. And so that’s really important. That’s really the aha moment for mutual funds, when they were invented in the 1920s, is that they allowed investors to get diversification.

But not only did they get diversification by being able to hold a whole lot of securities at once. They also got the value of their units reflective of the value of the securities that they held. So, my unit was worth what was underneath. There was no discount or premium to it. And that’s really what ETFs do. And the difference between ETFs of course and mutual funds is that ETFs trade on the exchange like a stock. So, like a stock they have a ticker symbol. You can buy them throughout the day. And they are available for purchase pretty much at any point in the day's cycle as well as they are transparent generally speaking you have a pretty good sense of knowing what they hold.

So, we tend to say very colloquially that ETFs are like a mutual fund, but trade like a stock. And I tend to use, you know, there’s a lot of misinformation about ETFs and I do want to quickly address this, in that, people say they only invest in passive. They can be risky. Really ETFs itself is a benign technology. There’s nothing risky about it.

I like to use the example of the music industry, where if you were a Beatles fan 50 years ago and you bought Rubber Soul or Sergeant Pepper’s Lonely Hearts Club Band on record and scratched the heck out of it by playing it over and over again, that was great. And then maybe as you got older you got a cassette tape and you could listen to it in the car. CDs certainly came along and you could keep listening to it in the car without having the quality decline. And mp3s I could start listening to it on my computer. I could share it with friends. Then we have streaming today. A lot of people have gravitated toward Spotify, Apple Music.

The point is this technology continuously changes, but at its core the music doesn’t, right? What we want to listen to if we're a Beatles fan doesn’t change. Where we listen to it, the flexibility of when and where we listen to it changes.

That’s what ETFs has done. So, the tenets of fixed income investing have not changed with the advent of ETFs. ETFs have just given you more flexibility at how to get that exposure.

[How mutual funds work]

So, if you take one thing from our presentation today, it’s this is obviously me talking about the benefits of fixed income ETF investing, but I really want you to think about the fact that if you have a portfolio of fixed income, mutual funds, or individual bonds that work for you and are helping you meet your risk and return objectives, please don’t make the jump to ETFs because of the fact that it’s ETFs. You have the exposure to the fixed income you need. Okay? Very important to understand that.

Just in the same point. If you still like listening to the Beatles on the record, you know go for it man. Some people still think that’s great. They like listening to it on that mono-speaker. Go for it.

So, in terms of mutual funds, mutual funds very simply when you’re buying and selling, particularly through something like CIBC Investor’s Edge, is you’re putting through the order and at the end of the day the fund company gets your order. They use a system called FundServ. They go and they execute your mutual fund order. They go out and buy the bonds or stocks. Here we’re using the example of stock exchange. They go out and they buy the bonds, fill the units of the mutual fund, and you get the net asset value that is aggregate value of those bonds given to you as units at the end of the day. Pretty simple. It is a very simple, easy process.

[How ETFs work]

This is where people start to get a little bit tripped up with ETFs. Now remember the benefit of ETFs is that this trades on the exchange like a stock and that particularly for bonds I’m going to talk about some of the advantages that that allows for. But it’s not so simple that it can just be done at the end of the day because ETFs trade throughout the day.

So, what occurs is there’s a separate step that occurs here. Generally speaking, buyers and sellers of ETFs are selling to each other on the exchange. So, if you go onto your CIBC Investor’s Edge and you purchase an ETF, you’re most likely buying it from someone else who is on the exchange through their broker. And so, you’re buying and selling to each other.

Now the difference here is you can have circumstances where there’s more buyers or more sellers of an ETF than there are inventory trading between people. And that’s where this important ETF market maker comes in. This ETF market maker is basically large capital markets groups of the ETF desks, and they are of the large banks. They come into the market and they make sure that they can build new units of ETFs for you to buy.

I use the example of similar to like buying from Amazon. You go onto Amazon. There’s a flash sale of new sunglasses. Great. You get in. You take a look at it and you say, ‘aw, man. It’s already out of stock. But wait I can order it and get it in two to three weeks at the same price. That’s not so bad. I mean I can’t take them to the beach immediately, but I’ll wait for those sunglasses.’

With ETFs, the same process is occurring except it’s happening in a matter of seconds. So, if those units aren’t available on the exchange, these market makers come into the market and build those new units with an ETF provider so that they can enter the exchange and be sold.

So, it’s just a third buyer and seller in the marketplace. And most likely if you’re buying and selling ETFs, you’re most likely buying from other sellers that have inventory. But if you’re a large dollar investor, putting in maybe more than $1 million, maybe these market makers are coming in to fill that for you.

Generally speaking the price though isn’t really any different than what’s there. You can obviously see that on your quotes. But the price remains the same just like if it’s out of stock on Amazon. You still have a price that was reflective of what they were willing to get it for you for.

[Differences between bonds and equities]

Now what’s really important to understand is the difference between stocks- between bonds and equities in terms of how they trade, particularly when it comes to ETFs.

Now ETFs have become an extremely popular way for people to buy bonds, and it’s because of the way that bonds historically trade. Now bonds trade with what we call over-the-counter. And what over-the-counter means is that they don’t trade on the exchange like a stock. They don’t have a symbol that you can look up. There’s not constant offerings and inventory available by individual investors typically for bonds.

The bond market itself is a constrained market tightly controlled usually, by a bunch of large bond dealers which would be in Canada. And we’re talking Canadian bonds, the large Canadian banks in the US, it would be the large US investment banks as well. And the funds of course, the mutual funds and ETFs that hold those bonds. Because they’re not listed on an exchange their price is not transparent.

You know, if I was to ask you right now what is the value of a BCE 5 Year bond, you may be doing some digging to find out, but it would be somewhat difficult to figure out. Now you could put it up on your screen, on your Investor’s Edge screen. But built into that price is a commission. So, the actual value of that bond is somewhat not known to you. Commissions have certainly come down a lot, so the price you would be paying is probably close to what its market value is, but you don’t know. Historically it’s not been transparent.

And so, the liquidity of bonds is also reliant on dealers’ available inventory. There’s far fewer bonds than there are equities. They’re more difficult to procure. And you have to go to a fewer amount of people to buy them, which also means it’s more difficult to transact them on a daily basis. If you try to sell a bond into the open market there’s less buyers typically than there would be for stocks, which creates obviously some pricing issues. You may not get the price that you were hoping for. With an equity you kind of know what the price is because there’s so much demand already built up there.

And then the last part is bond indices. We’re primarily weighted on outstanding debt, meaning that indexes of bonds that you look at to determine the value of a bond market are based on the outstanding debt. That is the companies with the most amount of debt are the largest holding in bond indices. Whereas the companies that are the largest purely in the terms of the market size are the largest holding in stock indices. So that’s a little bit different in terms of how people weight the universe of bonds from which to benchmark yourself.

[Canadians and fixed income ETFS]

Now what I want to highlight here is ETFs and what ETFs has done. If you go back two slides, you’ll recall that we were talking about the fact that ETFs trade on the exchange like a stock. Well what happens if I take a portfolio of bonds and I put them in an ETF? Well, they start to trade like a stock. And this has been a revolutionary moment for fixed income investors because what it’s done is taken inventory and liquidity of bonds out of the hands of this OTC market, and put it into the hands of the equity market trader.

So, a bond ETF trades like an equity. So, when I put bonds into an ETF, I’m actually creating the flexibility and liquidity of an equity and giving it that wrapper as an ETF. So, I’m effectively creating liquidity, transparency, and generally lower costs by putting it into that ETF wrapper.

Now there are some big differences of course between individual bonds and ETF. The big difference of course being that an individual bond I can hold to maturity. So, if I have an individual bond, that bond can be held to maturity and I can get that bond value when it matures. With an ETF though we can see that the ETF trades during the day and is reflective of the underlying market value of the bonds it holds.

But in Canada, because we’ve had a fairly small bond market and it’s been historically expensive to transact in, we’ve seen a lot of people gravitate towards fixed income. And there’s two big reasons for this. The number one reason is Canadians generally like bonds. We look at historical studies and I can tell you one thing about Canadian consumer standards. Number one, they like to pay a lot for cell phone contracts. Number two, they like to pay a lot for homes. And number three - I don’t know if you knew this, they like to pay a lot for bonds.

We are by nature a conservative group of investors, the most conservative in the world. I’ve looked at demographics from Australia, the United States they like to take a lot of risks but they’re about half the exposure to fixed income than we are in Canada. So, we already have a predisposition to wanting to buy bonds.

Of course, when we create an ETF solution as the industry where there’s generally transparency and lower cost, plus the diversification. We’ve seen the big gravitation towards fixed income ETFs. To the point that they account for nearly a third of ETFs assets in Canada, and in 2017 they accounted for 40% of sales. So even in a raging bull market, four out of every ten dollars that went into ETF market went into fixed income ETFs. So, it’s a huge portion of the ETF business in Canada. And most of this money is associated with indices.

[Difference between stock and bond indices — illustrative example]

So, as I mentioned earlier, the difference between stock and bond indices has to do with the fact that, you know, the bond indices are weigh-based on outstanding debt, whereas the stock indices are based on the large size of the companies.

So, if I take, and it’s going to be a little counterintuitive, but I’m going to start on the right side here, if I look at the S&P 500, I can see that Apple, Microsoft, Amazon, and Facebook are the largest holdings in that index. And that would probably stand to reason that those were somewhat the largest companies in the United States at that given snapshot of time, which was the end of last month.

If I go and then look at the other side of the table, I can see here that Anheuser-Busch represents a whole bunch of the first few lines as well as GE Capital. Well all that means is that Anheuser- Busch has a lot of outstanding debt. Now certainly that’s a huge beer company, that has the money to service that debt, and as a fixed income investor that’s my most important selection criteria. I want to make sure they can pay me back. But it doesn’t necessarily mean it’s, you know, the best debt to hold, right?

Whereas I have a pretty good sense with a stock index that Apple and Microsoft may be leading companies, right now, they are the largest US companies and they’re the largest US companies for a reason. They have seen exponential sales growth, you know, high amount of market capitalization, high levels of cash. I can’t say the same thing on the other side between a stock and a bond indices.

So when you buy a bond index ETF, it’s really important to understand that what you’re being weighing to, what you’re buying the most of is what has the most amount of outstanding debt, whether it’s a government bond or a corporate bond, that’s what you’re getting exposure to.

[The credit ladder]

Now if you’re going to circle one slide for the remainder of this presentation, this is the one I really want you to take home and understand.

There’s a lot of misinformation out in the capital markets industry and the financial service industry about yield. And of course, our title of our presentation is Where is the Yield? And all things being equal, I want to buy something that yields more, of course. Who doesn’t? I want something that pays me more on an annual basis.

But with higher yield comes higher risk. And I can say, and I’ve been doing this long enough now with a fair degree of certainty, that, that usually holds. There’s no free lunch in investing. If something yields an attractive yield, I can be almost certain that it comes with a higher level of risk than you may anticipate, even if it doesn’t seem so on the surface.

So, when we’re looking at the credit of the credit ladder and when I am trying referring to the credit ladder I’m really referring to the risk. And this is the likelihood of the securities having a big fall on their value due to either credit, being the ability of the people issuing the debt to pay you back or in the case of dividend stocks, covered call writing, those just declining in value because of the volatility associated with stock investing.

Well, at the bottom is government debt. Government debt is effectively risk-free debt. There is some interest rate risk which we’ll highlight later, but government debt from a credit perspective is about as safe as it gets. There’s pretty much no safer instrument than the US Treasury bond. It’s effectively cash in terms of its risk profile. And lo and behold it doesn’t yield a whole lot.

So, if I look at a five-year Canadian government bond, that yields to me about 2.1%. So, my risk-free rate as a Canadian fixed income investor is about a 2.1% yield. That’s really not a lot, and that’s locked in for five years if I was to hold that to maturity. So, when you think why GICs and high interest savings accounts pay sort of less than 1%, that’s because your risk- free rate over a five-year period is 2.1%. So, there’s not a lot of risk associated with that.

Now I can move up on the credit risk a little bit and I can look at corporate bonds. Corporate bonds are bonds issued by investment grade companies. So, these are companies that are rated BBB and above. BBB is jargon, we’ll highlight it later on in the presentation, but when someone says BBB they mean investment grade. And investment grade means that, that corporation has been deemed by independent credit agencies to have a lot of credit-worthiness to pay back their bond issuance. Well those tend to trade just a little bit higher risk than government debt and they tend to offer maybe let’s say 50 basis points, 0.5% better yield than what you would see with government debt.

Above that we’ve got preferred shares. Now preferred shares are interesting because you don’t have the same access to capital as corporate bonds, meaning that if I buy a preferred share that pays me a dividend and if that company for whatever reason runs into financial impairment, it’s going to pay its bondholders before it pays you. But generally speaking the credit-worthiness of the preferred shares tends to be in line with investment grade.

Most preferred share issuers in Canada are considered investment grade on the bond side, but they’re rated differently than the preferred shares. Again though, higher yield over corporate bonds. They yields about 1.5% more, and that comes with a higher degree of risk. If you held preferred shares in 2015, you lost 20%. You don’t see those kinds of drawdowns in corporate bonds.

And then we get to where this area of senior loans and high yield bonds, and this is where I get my hackles raised up a bit over missed information is because there’s a lot of products selling out there in the marketplace, people telling about 4 or 5% yields, and usually they’re being backstopped by this type of debt, which is great debt for a number of reasons and provides diversification, but it’s not investment grade. You’re getting paid 5% plus because the underlying companies have been deemed non-investment grade. There’s a higher risk of default. Currently, it’s about 5%. But during the 2008 crisis, believe me, it was a lot higher.

And so, these companies have a much higher level of impairment that it could occur if they miss some sales targets, if something happens like energy producers for example. The price in oil declines. This could have a huge issue in their ability to pay you back. So as a result there is a high yield associated with them, but they’re certainly not safer than government debt and corporate bonds, and so, you’re being paid a higher yield to take on that debt.

It’s similar to if you go in to take out a mortgage. We know that people that are higher risk for mortgage payback have to pay a higher risk. The bank wants to ensure that the lender can meet its obligations and this is worth their time from a financial perspective.

It’s the same thing with debt issuance. If I’m a high yield bond provider and I go to market and I’m going to be lent to by banks, they’ll want to make sure that they’re getting a higher yield because there’s a higher risk associated with default.

Dividend paying stocks and covered call writing tend to end up in a lot of fixed income products as well. They’re technically not fixed income, but I do see them show up. These obviously pay a yield, but these are a stock risk. And as we saw last week you can lose 7-9% in Canadian dividend paying stocks. The Canadian equity market which yields about 2.8% lost 9% last week. And you can have that happen on a short-term basis.

So, when you move from dividend paying stocks to covered call writing, covered call writing is writing option to generate income, selling the future obligation for someone to be able to buy that stock if it rises in value at the current level. You’re giving away your upside. Now you’re making an attractive income doing that, but you’re still taking on stock risk. If those stocks decline 20% you’re going to lose 20% minus the premium you paid on the covered calls. So covered calls and dividend paying stocks are full on stock risk.

Senior loans/high yield bonds. Senior loans have a number of names. They’re called senior loans, bank loans. Those are noninvestment grade debt and there is a credit risk associated with them.

[Types of fixed income ETFS]

All of this is highlighted again in the definitions here. I’m not going to go through it again. It’s just available for you. If you didn’t take notes feel free to go back to that slide and there’s a better explanation of what I was talking about.

[Credit spreads over the past 5 years - Higher yield = Higher risk]

And this gets shown in what we call the credit spread. So, I highlighted again that the Canadian five-year bond is at 2.1. The Canadian ten-year bond is about 2.5%. And so, it would be down towards the bottom here, and that’s really your risk-free rate of return. Well each of these different areas here, the HSPC, are different indices of bonds designed based on their rating.

So, at the top end of this rating here, we can see that on this one here we have AAA. So, AAA would be your top rated corporate companies in the world. They are near the bottom. Their yield is only slightly higher than it would be to own a government bond.

But as we move to BB which is noninvestment grade that’s the highest tier of noninvestment grade we can see this is the blue line up here and you’re yielding above 6% right now. Well there’s a reason for that. So, you can see now mathematically what I was talking about in that the higher risk you are on a bond, the higher that the yield that exists there.

So, one takeaway from this presentation is: as you move towards your journey of becoming a fixed income ETF investor, the yield is something you want to look at. And you should automatically have a spider sense in place where if something is yielding a lot more than a GIC or is yielding a lot more than what you’re seeing with a government bond ETF product, you need to ask yourself: what is it holding? If it’s yielding — we can see right now above 5-6%, then it’s probably comprised of a lot of high yield bonds.

Preferred shares would be the one exception. I don’t have them on here. They’re yielding about 4%. I mean that’s paid as a tax efficient dividend, so, and it has an interest rate component built into it so that those yields tend to rise as interest rate rises. That’s a little bit harder to map on here. But again, you’re probably looking at higher credit risks than you would be in corporate bonds, but maybe that’s an interesting risk-reward tradeoff for people right now.

But overall the higher the yield, the higher the risk, and that’s how it gets mathematically expressed in the marketplace.

[The costly impact of higher management fees]

So, that’s the credit risk. The credit risk is the single most important risk when you’re looking at fixed income. Obviously as a fixed income investor you want to know that you’re going to get paid back. You notice I haven’t even talked about ETFs really a whole lot here, but ETFs obviously have tranches available where they offer exposure to this whole range of fixed income categories.

So, you can buy high yield bond ETFs. You can buy corporate bond ETFs. You can buy government bond ETFs. You can buy ETFs that are actively managed and hold all those asset classes where a manager is holding them based on their risk-return outlooks. They maybe move higher to higher yield in a market like last year where no one’s concerned about credit risk.

Well if no one’s concerned about credit risk they’re going to move towards high yield bonds. But maybe as we move into an environment where we get worried about earnings, worried about stock valuations, they want to reduce risk, and they move more towards government bonds. So, all of those ETF options are available for you.

Knowing what your portfolio is, and this isn’t offering advice, it’s just a blanket statement, but generally speaking, if you have a fixed income portfolio, tentative investing is diversification. So, diversification applies to stocks. It also applies to bonds. Most likely a well-diversified portfolio of fixed income will have exposure to government bonds, corporate bonds, high yield bonds, and maybe even something like preferred shares. And I think that if you’re missing all of those asset classes then maybe you can ask yourself why you don’t have exposure to them because they do behave differently in different cycles of the market in the credit cycle.

Now the second really important thing to understand is fees. And fees have a much bigger impact in fixed income market than they do in other areas like equity.

So, if I take for example US equities last year, I made double digit returns. So, if I paid 1% to get that exposure, I’m probably not complaining too much. If I was in fixed income though, I would have been averaging let's say 2-3% per year, roughly similar to what the yield is. Maybe there is some upside on the price as interest rates decline. But it’s a much lower return asset class, which means that the higher the fee you pay, the much larger proportion of your total return you’re removing from the equation. That should be fairly simple.

And of course, as yields have come in, as interest rates have declined and yields have come in, then the higher these fees take up an even bigger proportion of the amount of money that you’re paying to get exposure to. So, I’m just going to highlight what the costly impact of these management fees are.

But if we look here in this slide here, I have two funds. I have one paying about 0.5%, and another fund that’s 1.6%. Now up, just accumulation cycle, there’s no drawdown on the portfolio here, if I assumed at 4% per annum return, which is sort of the target return I see on most fixed income portfolios, and nothing really bad happened, all things being equal there would be a difference of about $14,000 or 14% on the initial investment, a difference in return just from fees alone.

So, remember you can’t control what the market’s going to do for you. You can’t control where interest rates are going to go or fixed income pricing is going to go, but you can control how much you’re going to pay to access it. No one pats you on the back for paying a higher fee to generate lower returns. And so, if we look at that here we can see that it makes a big difference in a low interest rate environment to be keeping fees low.

And on average ETF fees on the fixed income side are amongst the lowest, much lower than any other type of asset class — oh sorry, any other type of product class. You can get fixed income exposure to the investment grade Canadian bond universe now for eight basis points. That’s extremely low, and that means that if that yields about 3%, well then you’re getting 2.92% of net return of fees. Where if you’re paying 1-1.5% through an expensive other product, you’re losing more than half your return to fees. It becomes even more. Sorry, go down here.

[Fees have a greater impact in drawdown phase]

It becomes even more costly when we look at what happens in the drawdown phase. Of course, people as they move towards the drawdown phase or the retirement portion of their portfolio, well then they start to move towards more fixed income because for obvious reasons you’re withdrawing money.

Well every time you withdraw money you reduce the amount of principal in your portfolio and the ability for it to compound and grow. We call this longevity risk. And if you are paying high fees again for fixed income exposure, well now we see this working against you I mean in a much more profound way.

So, take the same example again, but now I take the assumption that I am taking $10,000 out to fund my retirement, well I’m having less money now and that principal is being eaten away at fees. So now my difference is $33,000. And the really important thing is that at the end of ten years, my portfolio and the lower fee fixed income portfolio is $83,000. I’ve got quite a few more years to go where I’ve spent about half my portfolio already with the other one.

So, this is really important to understand. All things being equal, and I know there's a lot of things to determine if all things be equal but all things be equal, you should be intuitively moving towards a lower cost investment product when it comes to fixed income, particularly in a low rate environment.

[U.S. Treasury/10-Year, 1962-2017]

Now the next risk I’m going to talk about is the one that, you know, a lot of people tend to be surprised by and are not aware of. And that’s interest rate risk. Memories of investors are long, but they’re not 40 years long. You tend to be more recent, thinking of the last four or five years when it comes to your returns. And a lot of people don’t realize that over the last 40 years and this is coming up on 40 years now we’ve been in a bond bull market. And there’s an argument that it somewhat came to an end at the beginning of last year.

Time will tell if that’s the case. But what this chart is showing you is that if I’ve held US treasuries over the last 37 years, I’ve basically had nothing but positive returns. There’s been some bumps along the way with the financial crisis. In 1994 there was a rise in interest rates.

But bonds have inverse relationships to interest rates. So as interest rates increase, the value of the bond declines. As interest rates decrease, the value of the bond increases. So, your total return ends up still being positive. But as interest rates have declined it’s actually dramatically increased the risk of being a bond investor.

So, if I take something like a US treasury, which from a credit risk perspective has almost no risk, it still has a lot of interest rate risk because of how low interest rates are and the fact is that now that they’re rising keep in mind that the US feds expect to raise rates three more times this year.

Canada is also on track potentially to raise rates three more times. That’s not a certainty. That’s just what the market’s priced in. There always can be surprises, but that’s what the anticipation is. Rates increased so the value of your bond is declining. As the value of your bond declines, you hope that from a total return perspective, the yield that you earn will offset the losses in the price of the bond.

We’re talking about two different things price of the bond, interest rate. As the interest rate goes up I hope that the interest rate that’s earned on the bond will offset the loss in the price of the bond. And in the past that certainly was the case. But as we’re going to see on this next slide, that may not be the case anymore.

[The risk of owning bonds — Simple explanation]

In fact, last year and particularly over the last couple of months, You've seen losses in bond portfolios, and fairly noticeable ones, and that’s because of the rise in interest rates. So, there is a mathematical equation applied to bonds called duration. And duration basically posits that, well duration is what we’re talking about, but as a duration calculation, duration is effectively the amount of time until your bond is going to pay out all of its distribution.

So, it’s basically the lifetime of the bond. The longer you have a duration of bond, the more interest rate risk it has because rates increase over time. You’re locked into a bond that’s going to pay below market interest rates over time. So, from a market price perspective, the value of bonds declines as interest rates go up.

Now in 1990 if I had had that ten-year Canadian bond I would have been earning a yield of about 10.5%. Now that certainly sounds nice and high, but that was the standard going rate 27 years ago or 28 years ago now for getting exposure to ten-year Canadian bonds.

Now if I saw a 1% rise in interest rates, for each 1% rise in interest rates, a bond is anticipated to lose 1% for each year duration. So, if I have a bond with a ten year duration, then for each 1% rise in interest rates I would expect mathematically to lose 10%.

OK. So, we have a duration of ten years here. And interest rates go up 1%. Well, I’ve been earning 10.5%, so, it’s really unfortunate I lose 10% in the price of my bond, but that 10.5% yield still means that I have a slight positive return. I haven’t lost any money. so even in a dramatic increase of rates of 1%, I’m still net positive, mainly flat but it’s not terrible for my portfolio.

If I take the same example for today or at the end of December, this same bond was yielding above 1.5%. Now, but my duration is the same. It’s still a ten-year bond. So, if I lose, if I see a 1% rise in interest rates, I’m going to lose 10%. But I’m only offsetting that with a 1.5% yield. And so, my total return is now a loss of 8.5%.

So, what is the take-home message here? The take-home message here is that duration interest rate sensitivity is a huge risk for fixed income investors right now.

And so, when we've seen a big movement towards a number of ETFs that are called floating rate or short-duration ETFs and what's important for you to understand is, you know, you can't really get these through the mutual fund complex where they offer funds that are designed to just reduce duration typically as an active management whether management may be doing that for you.

But you can implicitly buy or explicitly buy ETFs now that give you shorter duration, that is, duration that's less than five years or duration that's less than one year, where you can eliminate this interest rate risk for the foreseeable future until rates maybe reach more of a normalization stage. But there's a lot of risk being invested even in high, low-credit risk areas of the marketplace because of this interest rate risk.

[Buying and selling fixed income ETFS]

Now, we're going to talk a little bit about buying and selling fixed income ETFs. And now, just as a highlight to our last slide, three key things to remember: number one, credit risk, understand the credit risk of what you're holding; number two, know the costs, try to reduce cost; number three, understand the interest rate risk.

So, when you're looking at a fixed income ETF, look at what the duration is. Understand that for each year of duration, that ETF would be subject to lose one percent roughly for every one percent rise in interest rates or, you know, or 50 basis points or .5 for every 50-basis point rise in interest rates; so, very important metric to look at right now.

[Intraday liquidity]

Now, when it comes to buying and selling fixed income ETFs, as I've highlighted, you can buy and sell them throughout the day. I think for most fixed income investors, we have a longer term time horizon. That's not a huge value-add the way it would be with something like equities but it's still good to know that I can try to optimize my pricing throughout the day.

[Market makers: A pillar of the ETF eco-system]

[Determining bid-offer spread]

But in terms of the market makers, what I want to highlight here is that fixed income ETFs tend to be slightly more expensive on what we call the bid-ask spread versus equities. And that goes back to the fact that these ETFs are going into the OTC market to buy bonds. And this is a much less liquid market, less inventory than exist for equities.

So, it's not a hard and fast rule but typically, you would expect to see a slightly higher bid-ask spread — that's the difference between the bid at price and ask price of a bond ETF because of the cost for the market makers to go on create new units.

Now, when a market maker goes into create new units of the ETF, they're only taking roughly the same commission regardless of whether it's equities, preferred shares, fixed income or, you know, some other commodity features, asset class, a lot of what goes into their pricing is here below. There the underlying securities, liquidity, exchange taxes and fees, ticketing charges, creation or redemption fees that may exist, those certainly do exist, some things like high-yield bond ETFs.

So, all of that gets built into the price. So, what you will find is that when you're looking at an ETF, I would anticipate to have a slightly higher bid-ask spread with fixed income than I would with an equity like a TSX 60 ETF for example. And not always the case on somebody's extremely large fixed income ETFs, they trade almost as liquid now as equity ETFs and that's because of how much available inventories is available.

But generally speaking, if you see a fixed income ETF trading 3 or 4 cents wide which on a $10 now would be like 30 or 40 basis points, you know, that's probably in the range of what you will expect for some of these asset classes because fixed income, again, is a much less liquid asset class to be transacting in.

So, ETFs have improved the liquidity of being a fixed income investor, there's no doubt about that. But they're still limited by liquidity of the fixed income market relative to stocks and that does reflect itself in the price.

[Indexing: Not a one-size-fits-all-solution]

One other thing to look at when buying and selling ETFs, fixed income ETFs, is understanding that indexing is not a one-size-fits-all solution. So, in other presentations that I do, I go through the benefits of indexing and we're not going to get into that today.

But what I will say is if you look into the bottom here, indexing is typically not as effective for preferred shares, corporate bonds, high-yield bonds, senior loans, municipal bonds. In other words, all of these fixed income asset classes we're likely trying to get a hold of.

So, a lot of the product launches in the fixed income market in Canada have actually been actively managed products, meaning there's a portfolio manager there trying to generate better returns than an index strategy. And the reason that is because a lot of these managers have access to preferred pricing. Again, it's over-the-counter market, they get better pricing that in index product may be able to do so. They also get what we would call, you know, not forced to buy and sell.

So, sometimes an issuer may, you know, flood the market with kind of a lousy bond that they somehow managed to get subscribed to and, you know, a lot of managers wouldn't want to buy that. But in an index, because indexes have to follow methodology, are required to buy that.

But so, they're forced to buy and sell bonds and sometimes they're forced to buy bonds in expensive market and they're forced to sell them in a market sell-off; that can be very dilutive to the returns of an index ETF, where an active manager isn't forced to as much.

They're still forced to if their investors are pulling out of the fund, but they have some tools at their disposal to allow them to create some meaningful performance in fixed income. And by meaningful, you know, usually 25, maybe 50 basis points above performance. But in a market where most fixed income is yielding three to four percent, that's actually quite a bit of, you know, additive value.

Now, I'm not just, you know, talking randomly about this.

[What is an "active ETF"?]

I am going to offer you a proof point on why this is.

[Active management: Bonds vs. equities]

So, if I look at active management bonds versus equities, this was a study done by PIMCO — I've no affiliation with PIMCO but they're one of the largest fixed income managers in the world — they did a quantitative study using Morningstar data where they found that on equities, we do see that the mass majority of equities, less than 50 percent, regardless of the categories or time horizons, tend to underperform the benchmark equity indices.

So, in this case, I could make the case that indexing as a default strategy for equities probably makes a lot of sense. If I looked on fixed income though, we see almost the opposite.

Example, with the vast majority of active fixed income funds — and this includes, you know, this is mutual funds; again, remember this isn't just about ETFs — maybe you have a great actively managed low-cost mutual fund — they are outperforming the index.

So, some really important questions to ask yourself, if my fixed income, if I'm in preferred shares, if I'm in senior loans or high-yield bonds, is there value to me looking at an active manager versus an index product. I don't have an answer for you but the statistics suggest that there's probably some value in using an active manager versus using an index strategy.

[Fixed income jargon]

Now, we're going to take a look at the CIBC Investor's Edge platform in about two minutes. But before we do that, I just quickly want to go through some of the fixed income jargon that you'll see when you're doing your due diligence on ETFs.

So, one of the nice things with ETFS is all these information is available on issuer websites. So, there's, you know, about 28 ETF providers in Canada and they all provide this on the fixed income ETFs that they offer fixed income ETFs.

Now, the big one obviously is Current Yield. Current Yield is the yield that you would receive over the previous month versus the price. It's similar to what a dividend yield is. So, a current yield is 4 percent, it means that based on the last distribution, if I was to annualize that over the next 12 months, I would anticipate to earn a four percent yield based on price. Now, as price goes up, that yield declines and vice versa but it's a good proxy of how much that product is yielding right now.

Twelve-month Trailing Yield is yield you would have received over the previous 12 months, that's told you what it did in the past.

Yield to Maturity is one of the ones that's really not understood very well. Some people viewed this as the most important metric — that's a big debate. But yield to maturity is the total return anticipated on a bond if the bond is held until it matures. So, this would be, you know, this is extremely important metric if you're in an individual bond. It's a little bit trickier if I'm in an ETF where an ETF doesn't have, you know, ETFs can buy and sell the bonds before they mature. So, it's not as hard and fast a rule but it does give you some sense of what the long-term yield that would be expected for this portfolio would be.

Coupon is the actual underlying legal obligation payment by the bond that's being offered, so that's the fixed income rate paid out by the bond. Coupon is relatively meaningless if you're an ETF investor just because you're concerned about the yield. The coupons could be, you know, could have been a bond that issued a high coupon ten years ago and now, you know, but the yield is still low because the price has come up to reflect the value of the coupon.

Credit Quality, extremely important. That's looking at whether you're buying investment grade or non-investment grade.

And Duration, extremely important. That's looking at the interest rate's sensitivity. So, you know, the three that you really want to be looking at when you're looking at a product are current yield, credit quality and duration of the ETF.

[Before you trade: Key considerations for fixed income]

So, before you trade, key considerations, you know, I find it would help if you're really into fixed income ETF investing maybe printing this off.

Questions you want to ask: What are the yield metrics? Is it an index strategy, is actively managed, what is the credit risk? What is the interest rate risk — big risk right now, are there liquidity concerns, is this an esoteric asset class of fixed income? am I buying a merging market corporate bonds? They may be yielding a lot but that may be a very difficult ETF to purchase in a sell-off because they have to be transacting bonds in foreign markets that aren't open when they're transacting them. So, there's liquidity issues there. Do I understand what it holds?

No, there's no reason to outsmart yourself as an investor, asking questions assuming you don't know is really a good way to become a better investor? If something doesn't make sense to you, if you don't know how it's generating yield, ask why before buying. Again, if it's too good to be true — most likely it is — there's cases where there's some really interesting opportunities in fixed-income, but, you know, if you don't understand what it holds, make sure you understand.

You know, I highlight this with preferred shares. Preferred shares are (an) extremely attractive asset class right now because they have interest rate protection built in, they're yielding 4 percent. But the underlying structure of some of those products is extremely complex. They have reset structures on a five-year basis that can be somewhat difficult to understand.

[CIBC Investor's Edge]

Now, when we're looking at CIBC's Investor's Edge, you know, well, a place that I would start in — I have no affiliation with CIBC so, take this for what it is as objective, but, you know, going through their website and their — sorry — their platform is they actually have a great place to start which is on their Screening tools.

So, if you go into the ETF Center under Quotes and Research and you click the Screener, they have actually built the Screener already to look at Canada's fixed income ETFs.

This is a wonderful tool, okay? And the reason I really like it is, look at this, it's answering almost all of those questions I had in the previous slide and I can look at them all in one spot. So, I can see, you know, the year-to-date return, I can see what the distribution yield is — that's the current yield — I can see what the fee is on the ETF and I can see what the credit quality is.

And so, this is really awesome because if I could see here on the active floating rate bond from Horizons, I can see that's yielding about 2.8 percent and it has fairly high credit quality and a 40 basis point yield. That's actually floating-rate bond product so its yield rises with interest rates so that's why it would have a slightly positive return in a rising interest rate environment.

But if I go down, you know, below and I look at, you know, RBC Target 2018 corporate bond, RQF, I can also see that's got a fairly attractive 4 percent yield with an A rating. And I don't know anything about this ETF in particular, but for me that's an interesting risk-reward trade off. I'd like to know more about that ETF and that information is available.

So, before you start your due diligence process, you know, again, can't offer advice but as someone new to this system, at CIBC, I would definitely be going to this slide first to get a nice snapshot of the Canadian fixed income market.

The other great tool that they have here is a Compare ETFs. So, if we're talking about building a diversified portfolio of fixed income, let's look at comparing some of these ETF. So, I've put of some of the ETFs that we offer at our shop here and I can put them side by side. And what I can see is, you know, I can see different risk-return metrics here.

So, I have the Horizons Canadian corporate bond ETF where I can see that, you know, it has a yield of about 3.15 percent and it's investment grade but it has a relatively long duration. So, maybe I need factor that in. Where if I look at HFR, for example, I can see that it's yielding quite a bit less but it has a lot less duration so similar investment grade but less duration.

So, you can put all these ETFs against each other. The middle one is yielding a fantastic six percent but I can see that it's a high-yield bond ETF; I know I'm taking more credit risk. Use this compare screen not only to look at different fixed income ETFs in different parts of the fixed income market but even potentially look at, you know, the fixed income ETFs that are similar to each other to see if there's the one that's right for you.

[Disclaimer]

And with that I'll wrap it up and we can move to questions and I'm sure there's quite a few and I'll try to get to as many as I can.

>>Ammar: Thank you Mark. That was a very insightful presentation.

[Q&A]

We would like to answer questions from the audience. So, if you have them ready, you can type them into the Q&A panel. It's located on the right-hand side of your screen.

So, while we wait for questions to come in, I just like to remind everybody what Mark covered is that our Investor's Edge clients have access to ETF Center on our website. And after logging into your Investor's Edge account you just have to click on Quotes and Research and below that you will see the link for ETF Center.

And as Mark already highlighted in the ETF Center, we have great research tools available such as a Screener which you can compare four ETFs side by side. But in addition, there are also resources such as analyst reports and videos. So, be sure to check that out.

Now, I will pass it back to you, Mark, to answer some of the questions that are coming.

>>Mark Noble: Perfect. I see the first question here is, "Any thoughts on mortgage-backed securities?"

Mortgage-backed securities is one area that you probably wouldn't find the ETF market covering right now. So, that is a constrained asset class, where you're probably looking at mutual fund or hedge fund opportunities there, really unfortunately not a lot in the ETF place. I'm not going to offer any thoughts in terms of the value of that to say that obviously they yield more but that comes with some serious liquidity issues which is why it's probably serviced by the mutual fund market. Someone asked about how they had a ladder bond portfolio but it contains only Canadian bonds.

>>Question: How can you add international exposure?

>>Mark Noble: Well, when we're to add international exposure if you have got Canadian bonds, is to look at the ETF market. So, the ETF market in Canada has both foreign and US bond products available as well as I would highlight, high-yield bond ETFs in Canada are primarily composed of US issuers. So, the name of the ETF — and again, using the ETF Screener will really help you here — the name of the ETF will have built into it, what it's investing in. So, it will implicitly say US corporate bonds ETFs.

The only exception there would be something like high-yield bonds which are actually US. But most of the ETFs will highlight whether they have international, emerging market or bond portfolios.

>>Question: How do I know the ETF issuer has actually purchased the underlying securities and these securities are actually secure in ETF product?

>>Mark Noble: Well, it was a little bit of an unfortunate question. You don't. But understand this, the ETF companies do their best to try to hold as many of the bonds as possible. But it's a wonderful question because one thing that is done in the ETF world is something called stratified sampling where they're trying to hold the smaller amount of bonds that are higher correlated to the index.

Now, the investment objective of the ETF is to return the other underlying — to get the return of the underlying index or strategy that it's highlighting. And one way you could determine if you're doing a good job is to look at the underlying index and compare the returns of the ETF. If it's way off, then they're likely engaging in some sampling and they're likely not meeting their investment objectives.

But I will say this — this goes to every ETF provider — they do take every meaningful option to try to hold as many of the underlying as possible to replicate the returns as stated. Now, for you to know exactly what the ETF holds you can go to the ETF websites and you can see the top holdings. Usually, most of the providers have the top holdings available and you can see that, you know, as advertised they're holding these securities of the fixed income that they say that they would hold.

>>Question: Where would you find the management cost information for each ETF?

>>Mark Noble: Well, the first answer to that is you can go right on to CIBC and they provide that information for you. In fact, they go one step further; they don't just provide you the management fee, they provide you the management expense ratio which is the total cost. But that's also available on all of the ETF provider websites as well.

>>Question: Are ETFs as liquid as equities?

>>Mark Noble: I love this question. Okay. No. No, they are more liquid than individual bonds potentially, depending on the size of the bond. But remember, the ETF liquidity is related to the underlying liquidity of what you're holding. So, I would say it's fair to say that ETFs will improve the liquidity of your fixed-income portfolio versus holding an individual bond. But bonds, by nature, will always be less liquid than equities.

The only exemption to this may be some of the large Treasury bond ETFs where Treasuries is obviously a multitrillion-dollar market, those are probably as liquid as equities. But as a stand-alone rule you should expect these are less liquid than equities. So in a sell off, there would be more difficulty in selling off the underlying holdings and you would expect that there may be some difficulty in the pricing on those. Very important to understand, wonderful question.

>>Question: In this environment, should we invest in bonds?

>>Mark Noble: Well, that really it depends on where you want to be as an investor, what your goals are, but I will say this, you probably should always own bonds. I get this question a lot from investors, "Should I own equities or get rid of my bond exposure?" The answer is, it actually, bonds are an extremely important risk protection — I think this probably our last question with given time — but bonds provide a huge amount of diversification from equities.

So, if you have a massive sell-off like we saw last week where Treasuries were the number one performing asset class while the market was down 5 to the 8 percent, or the financial crisis, where the markets are down 40 percent, bonds are positive, it's one of the only true sources of diversification you have. So, regardless of your age — obviously, the younger you are, you probably want to have less bond exposure but all investors should have exposure to bonds because of the diversification benefits they offer the portfolio.

So, it has nothing to do with the income, it has to do with the diversification. If there's a severe market correction, bonds are one of the only historical asset classes that provide positive returns. And now, I'm talking about investment-grade bonds, treasuries in particular, offering you positive returns and what is otherwise pretty much market carnage. So, for diversification reasons you probably want to consider having some allocation of bonds.

>>Ammar: Thanks again, Mark. It looks like that's all the time we have. One final question I just wanted to answer.

[Thank You]

There's a few questions about PowerPoint slides. If you actually go to Investor's Edge's website and go to the Contact us and Email and we could provide the slides to you. Mark, that was a very informative presentation and I'm sure our audience is a lot more comfortable with fixed income ETFs as a result. So, thank you for a great presentation.

>>Mark Noble: My pleasure.

>>Ammar: A reminder to the audience that if you wish to listen to this webinar again, a link will be emailed to anyone that registered. I would like to thank the audience; we really appreciate you being here. Should you have any questions, comments, please visit our website or get in touch with us by phone, chat or email. Thank you for joining us today. We will see you next time.

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