Summer 2022

Building Active Bond Strategies with Passive ETFs

With bond markets still a challenge, Daniel Stanley, Director, Institutional & Advisory, BMO ETFs talks investors through executing active strategies using index exposures that can be dialed up — or down.

Jul. 20, 2022

Completing your investment toolkit

What aspects of portfolio construction come to mind when you see the term ETFs? Some investors, including portfolio managers in charge of large institutional books, continue to believe that ETFs are only passive investments that provide access to a broad asset class. The reality is quite different.

Today, fixed income ETFs are often used by active managers to execute their larger bond portfolios. The fact is fixed income ETFs can 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 active 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. 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.

Let’s start with duration. Ever since the Bank of Canada and U.S. Federal Reserve began raising interest rates earlier this year, there’s been downward pressure on the value of long-duration government bonds. If you wanted to quickly reduce your duration, you could sell long bond exposure in a single trade using BMO Long Federal Bond Index ETF (Ticker: ZFL), saving the effort and expense that would be involved in selling those bonds directly, likely at a fractional spread. You could also then allocate more to the BMO Short Federal Bond Index ETF (Ticker: ZFS) as a means of building up your exposure on the nearer-end of the curve. This combination, of selling long duration and buying short duration, would allow you to slide down the yield curve in two simple trades.

It’s 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 you see a recession as imminent, you’d likely 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.

How do you execute this trade? Do you source pricing for each of the 20 or so underlying bonds with a market maker? Or do you simply add exposure to 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 revealing the shift in positioning. By contrast, any investor — from a retail trader with $100K to a pension fund manager with $100M — can painlessly and anonymously add or trim their exposure to the corresponding ETF.

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

Adding extra liquidity to your portfolios

One of the advantages of executing bond portfolios with ETFs as opposed to individual bonds is increased liquidity. When problems arise in the bond market, like they did in March of 2020, what you find is that even though the underlying bonds can stop trading, the ETFs of those bonds still trade because they’re listed on the stock exchange. In effect, the bond ETF provides price discovery and acts like a market clearing mechanism during times of stress. It’s like a pressure release valve. 

For example, if you’re an active manager who manages a balanced portfolio, and you’re only holding individual bonds, and those bonds stop trading, you can’t rebalance from bonds to equities when the markets are falling. But if you use bond ETFs, and the markets drop, and cash bonds stop trading, what we saw in March of 2020, there’s still a market for bond ETFs. 

In fact, we had a massive client come in and sell $200 million of the BMO Aggregate Bond Index ETF (Ticker: ZAG) at the height of the panic, when most of the underlying bonds weren’t trading. It was a wonderful example of a massive trade that you could execute 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 you need a strong relationship with a bond dealer — and, frankly, vast AUM — 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

Impact to bond prices

New yield*

Payback period

Ticker

YTM

Duration

Rate Movement

Bond Price Movement

Yield Movement

Recovery Time (years)

ZAG

4.02%

7.38

0.50%

3.7%

4.52%

0.82

ZCB

4.87%

5.81

0.50%

2.9%

5.37%

0.54

ZSB

3.79%

2.74

0.50%

1.4%

4.29%

0.32

ZCS

4.68%

2.8

0.50%

1.4%

5.18%

0.27

ZQB

4.58%

3.36

0.50%

1.7%

5.08%

0.33

ZBBB

4.99%

4.03

0.50%

2.0%

5.49%

0.37

ZCDB

4.75%

3.55

0.50%

1.8%

5.25%

0.34

ZSU

4.23%

2.73

0.50%

1.4%

4.73%

0.29

ZSDB

3.99%

2.76

0.50%

1.4%

4.49%

0.31

*That which is earned on a prospective basis figures as at July 192022.

Note: Rate movement should reflect what the market has priced for a change.
Source: BMO Global Asset Management, as of July 192022.

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.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/​or elimination.

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