By Daniel Stanley, Director, Institutional & Advisory, BMO ETFs

With bond markets still a challenge, Daniel Stanley, Director, Institutional & Advisory, BMO ETFs talks investors through the benefits of executing active strategies with passive index exposures.

Perception arbitrage: From outdated views to new realities

History has a habit of rendering the popular truths of one generation obsolete in the next. Case in point: one widely held belief that’s rapidly fading is the idea that ETFs merely offer passive access to a broad asset class. The current reality is quite different.

Today, fixed income ETFs are often used by institutional portfolio managers to execute their larger bond portfolios. Index construction is more targeted and creative than a generation, or even a decade, earlier. The fact is fixed income ETFs can now provide precise exposures along the Yield Curve, segmented by term and by credit quality. Managers can express their active investment objectives using precisely defined baskets tilted towards their desired exposures.

Nowhere in the portfolio is this truer than in fixed income, where the bond market can be segmented into ever more precise segments to allow for greater portfolio customization.

Today, fixed income ETF are often used by institutional portfolio managers to execute their larger bond portfolios.

Executing quickly within the bond universe

At BMO ETFs, all our major bond strategies are divided by their investment horizon and by their credit quality. You can invest in short, medium and long-term exposures for both corporate and government securities, and the latter can be further divided into federal and provincials.

Consider duration as a prime example. Since the Bank of Canada and U.S. Federal Reserve began raising interest rates earlier this year, there has been downward pressure on the value of long-duration government bonds. If you wanted to quickly change your duration, a single trade out and a complementary trade in would pivot from one point on the yield to another. Two trades could tilt from Short Corporate (ZCS) to Long Federal (ZFL), potentially at a tighter spread than could be accomplished with cash bonds.

It is also been important to consider how quickly you can adjust credit quality when market conditions evolve—as has happened repeatedly in 2022. For example, if a recession is viewed as imminent, you may want to upgrade the credit quality of your bonds from investment grade to government, but with a yield component that’s still relatively attractive. This may put you in the mid provincial bond space, where the payouts are more substantial than with federals.

What is the optimal process for executing this trade? Rather than pricing each of the 20 or so underlying bonds individually, efficiencies can be found by relying on precise, single-ticket exposures such as the BMO Mid Provincial Bond Index ETF (Ticker: ZMP). Buying the bonds directly can be costly and time-consuming, and that information would leak to the street in drips thus revealing the shift in positioning. By contrast, an ETF allows active portfolio managers to painlessly add or trim their exposure to achieve a tactical objective.

If broad beta is the hammer in your investment toolkit, smart beta is everything else.

Adding extra liquidity to your portfolios

Another advantage of executing bond portfolios this way is the increased liquidity. When problems arise in the bond market, as they did in March of 2020, liquidity challenges in the underlying bonds are unlikely to impact the ETF holder. The bond ETF is akin to a pressure release valve—it provides price discovery and acts like a market clearing mechanism during times of stress.

For example, in a falling market, an active manager who manages a balanced portfolio may be unable to rebalance from bonds to equities. But with ETFs there’s a secondary pool of investors to close the bid-ask spread, and the market continues functioning even if cash bonds stop trading.

In fact, we had a massive client sell $203 million of the BMO Aggregate Bond Index ETF (Ticker: ZAG) at the height of the panic, when most of the underlying bonds had ceased trading. It was a classic example of a massive trade that can be executed during times of huge stress in the market. The key is that ETFs actually provide liquidity at three levels:

  1. Natural liquidity – matching Sellers & Buyer across exchanges: units traded across Exchanges do so at tighter spreads because the units have already been constructed, so there is no trading in the underlying securities.
  2. ETF inventory: Market Makers hold inventory to fill excess Sell or Buy orders which cannot be filled through natural liquidity. Again, these trades are at tighter spreads because there is no trading in the underlying securities.
  3. Creation or redemption of ETF units. When the demand or supply for units exceeds order demand, units will be created or redeemed, just as they would in a pooled or mutual fund.

It’s also worth remembering that cash bonds trade over the counter, which means a strong relationship with a bond dealer—and, frankly, vast AUM—is required in order to receive optimal execution. ETFs, however, are much more accessible and transparent, they trade freely, and you can easily adapt the exposure to your tactical views.

To learn more about bond ETFs as a means to optimizing your portfolios, reach out to your BMO Institutional ETF Specialist.

Appendix

* That which is earned on a prospective basis (e&oe).
Figures as at September 9, 2022.
Note: Rate movement should reflect what the market has priced for a change.
Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.

Disclosures:

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

The viewpoints expressed by the authors represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. The statistics in this update are based on information believed to be reliable but not guaranteed.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

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