Getting active with fixed-income ETFs

The growing allure of active fixed-income management

While the Canadian ETF industry continues to grow by leaps and bounds, the fastest-growing segment, by far, has been fixed-income – registering 37% growth over the last 10 years1. Although index ETFs still dominate the category, the latest trends reveal a growing demand for active management2. According to a recent report by National Bank of Canada, actively managed, fixed-income ETFs now account for 42% of the total number of fixed-income ETFs, or roughly 24% of fixed-income assets3.

The report also states the rising number of new active fixed-income ETFs tend to outperform their benchmarks more often, especially during volatile times or in rising-rate environments4. The report’s authors reviewed the relative performance of actively managed fixed-income ETFs over one-, two-, three-, four- and five-years periods, ended July 31, 2018, and found that a greater number of active funds outperform their benchmarks than underperform5.

So how can an active fixed-income manager potentially deliver better returns versus a passive bond ETF? Let’s take a look a look at three key advantages delivered by active management.

Active Advantage #1: Managing Interest-Rate Risk

One key risk that bond investors face is interest-rate risk. A change in interest rates has an opposite impact on bond prices. As interest rates rise, bond prices will decline, and vice versa. Thus, the risk is that rising interest rates will make bonds less valuable.

Another key concept you’ll often hear is “duration,” which measures the price sensitivity of a bond portfolio to a change in interest rates. Measured in years, duration tells us how a 1% change in rates will impact a bond portfolio. The higher a portfolio’s duration, the more sensitive it will be to changing interest rates.

For a bond portfolio with an average duration of 7 years, a 1% rise in interest rates will result in a 7% drop in value (and vice versa; if rates fall 1%, the portfolio would increase in value by 7%.) Thus, in a rising-rate environment, the higher the duration, the higher the risk in your portfolio.

Keep in mind that, in 2018 alone, the Bank of Canada raised rates three times6, while in the U.S., the Federal Reserve hiked rates five times since the summer of 20177. See Figure 1 for an overview of recent rate hikes. These rising rates negatively impacted North American bond investors holding long-duration portfolios.

While index bond ETFs must match the holdings and duration of their respective benchmarks, active managers are able to adjust their portfolio’s duration. In a rising-rate environment, as we saw in late 2017 and 2018, many active managers were able to limit interest-rate risk – and protect capital – by keeping the portfolio duration shorter than the broad benchmark. Furthermore, if interest rates begin to decline, an active manager can add value by increasing duration longer than the broad benchmark. Duration flexibility allows an active manager to manage interest-rate risk and add value in both rising- and declining-rate environments.

Active Advantage #2: Exploit bond market inefficiencies

Active bond managers can exploit inefficiencies in volatile markets by finding mispriced bonds or by investing in so-called “fallen angels,” which are typically high-rated bonds that get downgraded by a credit rating agency. A downgrade often results in a selloff of the bond. Fallen angels are often attractive to active managers if they believe the bond’s downgrade resulted from a temporary setback and that the issuer will recover and in time receive a credit upgrade.

Active Advantage #3: International Exposure

If interest rates are more attractive (higher) in international markets (outside Canada), an active manager has the ability to purchase these bonds to enhance the yield in your bond portfolio.

With ongoing volatility and uncertainty about the trajectory of interest rates, active fixed-income ETFs should remain an attractive option owning the market’s overall duration. When it comes to managing interestrate risk, we believe you’re better off having an active manager with duration flexibility.

1. “A Close Look at Actively Managed Fixed Income ETFs,” National Bank of Canada; Aug. 21, 2018.
2. Ibid.
3. Ibid.
4. Ibid.
5. Ibid.
6. “Policy Interest Rate,” Bank of Canada.
7. “Fed Funds Rate History with Its Highs, Lows and Chart,” thebalance.com; March 15, 2019.

Mark Brisley is Managing Director and Head of Dynamic Funds, one of Canada’s largest asset management companies. With over 25 years of industry experience, Mark is responsible for the firm’s strategic execution, day-to-day business operations, and business development. This article previously appeared in the Spring 2019 issue of Your Guide to ETF Investing, published by BrightsRoberts Inc. Used with permission.

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