Investing in fixed income can be a challenge for beginner investors or those without substantial investments. One particular challenge is the minimum purchase amounts for most bonds, for most brokers this amount is $5,000 per security. Unfortunately, this makes it difficult for many investors to build a diversified portfolio of fixed income securities.
In the past, most individuals would attempt to overcome this by purchasing either a bond mutual fund or by purchasing a balanced fund, containing both the equity and fixed income portions of their portfolio. The downside to these types of funds is the limited control individuals have over their fixed income strategies or asset allocations.
Fixed income Exchange Traded Funds (ETFs) are a solution available to all investors. Typically, these funds have lower management expense ratios (MERs) and have no minimum purchase amount. These trade similarly to stocks and can be bought and sold readily and in whatever amount is appropriate for you at the time. This allows you to customize the weighting of fixed income investments in your portfolio, and choose exactly what fixed income strategies you want to employ.
Government Bond ETFs
The lowest risk ETFs are the government bond ETFs. These include funds such as the iShares DEX All Government Bond Fund (TSX:XGB) among others. These funds invest strictly in government bonds, typically both Federal and Provincial government obligations. The majority of government bond funds are index based, meaning they track a specified index and there no active management. This helps ensure low fees, typically in the range of 0.15-0.35% for these types of investments.
These investments are ideal for individuals with low risk tolerance and are willing to sacrifice some yield for the protection of having only government backed securities in their fixed income portfolio.
Corporate Bond ETFs
In addition to the government bond ETFs, there are numerous products that focus on corporate securities. One such example is the Horizons Corporate Bond ETF (TSX:HAB). Instead of focusing on government securities, these funds take on the additional risk of investing in corporate bonds in exchange for increased returns.
Corporate ETFs generally come in two flavours, actively managed funds or index driven. Funds that employ active management incur more expenses managing the fund, and therefore carry higher management expense ratios. Despite this active management, several studies show limited, if any, benefit of active fund management. Accordingly, it may be more appropriate to look for a passive fund, that simply tracks an index such as the DEX All Corporate Bond Index. This may be especially true with fixed income ETFs, where the benefit of active management is muted in the current interest rate environment, and lower fees should be a primary objective of today’s fixed income investor.
There are also a number of funds that combine corporate and government bonds, one such example being the Claymore Advantaged Canadian Bond ETF (TSX:CAB).
More on Investing
As with most fixed income investments, rising interest rates will negatively impact your return through capital declines in your portfolio. This is increased when fixed income investments have long maturity dates. One innovative product that has been developed by a number of ETF firms is the laddered ETF. These come in both government and corporate flavours, and essentially weight their portfolio to mature equally over five or ten years. This ensures there is always debt to be rolled over at current market interest rates, limiting investor exposure to capital losses during periods of rising rates. While some return is sacrificed in these funds, they do offer a lesser risk option for those considering a fixed income ETF.
Unique and Exotic Fixed Income ETFs
There is a number of unique and exotic fixed income ETFs in the market, allowing intermediate or advanced investors to gain exposure to specific markets or types of securities. These would include funds such as convertible debenture funds, preferred share funds, floating rate funds and inverse return funds. While this is beyond the scope of an introductory discussion of fixed income ETFs, those with experience investing in fixed income may want to explore some of these products further.
For investors looking for alternatives to high fee fixed income mutual funds, or for those that have been hesitant to invest directly in bonds, fixed income ETFs offer a liquid, low cost and flexible solution. It is important that all investors have a balanced portfolio that they understand, and the accessibility of fixed income ETFs assist individual investors in accomplishing that goal.
Note: In no way does this article endorse any particular fund mentioned. These are provided for information purposes only, and all investors are advised to research specific fund selections in detail. If you are unsure, please consult a qualified advisor.
Geoffrey is a corporate finance expert with several years of experience in trading and managing fixed income foreign exchange and options.
He recently began writing to share some of his perspectives on finance with the public.