Fixed Income: Identifying Non-Traditional Exposures Amid Rising Rates
As family offices and investment counsellors contend with a complex interest rate environment, Laura Tase, Director, Institutional & Advisory, BMO ETFs, shares her thoughts on how you can complement traditional fixed income assets by including low correlation funds in your portfolios.Apr. 19, 2022
Seeking Non-Traditional Yield
In a low-but-rising interest rate environment, yield opportunities are few and far between. Exposure to longer duration bonds, which would normally provide a higher level of income, often become a liability due to their higher interest rate sensitivity. In addition, correlations between equity and fixed income tend to increase in times of heightened volatility, and as we know, markets have recently been contending with not one but many different headwinds, from high inflation to the Russia-Ukraine war. As a result, exploring non-traditional fixed income is a way for investors to diversify their portfolios and potentially capture better risk-adjusted returns in the future.
In this article, we identify four strategies that can complement a traditional core fixed income allocation: (See Appendix 1 – Correlations Matrix).
1. Canada Preferred Shares
Despite having both equity and fixed income characteristics, Canadian preferred shares have historically demonstrated low correlation to traditional holdings,1 which makes them a great portfolio diversifier. This asset class also offers the advantage of rate resets that can make portfolios more adaptable in a rising rate environment; the securities simply need to be “laddered” in the same way as GICs or bonds, such that a portion of the portfolio’s dividends are reset each year to reflect current rates. (i.e., by evenly dividing the portfolio by calendar years or term buckets.)
However, family offices and investment counsellors may find it inefficient to trade individual preferred shares given the notorious liquidity and inventory constraints. It can also be draining to take on the responsibility of laddering yourself, as the process requires a specific kind of expertise to stagger the rate resets and continually maintain the right balance of exposures.
Using an ETF to access preferred shares solves many of these problems. For instance, the BMO Laddered Preferred Share Index ETF (Ticker: ZPR) offers a laddered structure with a 5-year rate reset, with 20% of the portfolio turning over each year. This fund is one of the most actively traded preferred share ETFs in Canada, with a secondary market liquidity that allows it to trade at tight bid-offer spreads.2 If you already own individual preferred shares but are concerned about a lack of liquidity, you can swap your shares for units of ZPR (Appendix 2: ZPR Metrics).
2. US Preferred Shares
Although the core benefits are similar, US preferred shares do have unique characteristics compared to their Canadian counterparts: they provide higher dividends, more diversified credit exposure, and, in general, less volatility than their northern cousins. In fact, the majority of US preferrZHPeds are perpetual, issued at wider spreads and callable after 2 years, which makes them less sensitive to interest rate changes and hence more similar to a credit product.
Moreover, US preferreds tend to have low correlation to bonds, equities and cash. As with Canadian preferreds, they can be a difficult asset class to trade for Canadian investors; however, ETFs provide easy access to a basket of assets with enhanced liquidity. But what about currency considerations? We understand that investors have a wide range of views on the U.S. dollar (USD) and Canadian dollar (CAD), and that those perspectives are subject to change as market conditions evolve. So, to account for different strategies, the BMO US Preferred Share Index ETF is available in three versions: hedged to CAD (Ticker: ZHP), unhedged (Ticker: ZUP) and US dollar units (Ticker: ZUP.U).
The BMO US Preferred Share ETF employs a smart beta approach that aims for quality over quantity: It starts with the US preferred share universe and narrows down the investable universe with screens for liquidity, solvency and company-specific risks. By going beyond a traditional market capitalization filter, the portfolio is able to weed out yield traps and consolidate a basket of quality assets that generate a higher yield than the market. (Appendix 3: ZUP Metrics)
The screening methodology of these ETFs:
3. Canadian Bank Income
Investors looking for the diversification benefits of preferred shares combined with the defensive characteristics of high-quality bonds should consider the new BMO Canadian Bank Income Index ETF (Ticker: ZBI). This solution may be particularly attractive to institutional investors and municipalities who are limited by an issuer’s credit quality when building a fixed income portfolio.
ZBI consists of debt higher up in the capital structure of Canadian banks, along with subordinate issues such as preferred shares, institutional preferred shares and limited recourse capital notes (LRCNs). It provides access to every fixed income stream available from the big banks. Investors can therefore generate appreciable yields while also achieving the capital preservation that’s characteristic of bonds, all backed by the quality and soundness of Canada’s “big six.” The banks also tend to issue primarily on the short end, making this a short-duration offering, with the preferreds and LRCNs providing protection against rising rates with enhanced yields.
Bank Capital Structure Hierarchy (“Capital Stack”)
Chart illustrates capital instruments that banks employ and their hierarchy in the “capital stack,” which determines its priority in repayment, risk and thus expected return and yield.
|Ave Credit Rating:||A|
Source: BMO Global Asset Management, January 31, 2022.
4. Private Debt
Asset owners and large institutional investors look at private debt as a portfolio diversification tool, however this may not be achievable for many family offices and investment counsellors due to a lack of liquidity and acceptable benchmarks, the latter making it difficult to measure correlations.
Fortunately, there are liquid strategies that can be used as proxies for private credit. The BMO Floating Rate High Yield ETF (Ticker: ZFH), for example, provides exposure to U.S. high yield credit while minimizing duration sensitivity. It employs a unique approach that isolates duration and credit risk in order to better control and target a specific risk profile.
To minimize interest rate risk, ZFH currently invests in short-term Canadian Treasury-bills (T-Bills) with an approximate duration of 90-days. In a rising interest rate environment, this means the ETF can reset and invest at a higher rate as each T-Bill matures. For high-yield credit exposure, ZFH currently utilizes a derivative strategy via a credit default swap (CDS). The CDS allows investors to earn a coupon in exchange for taking on the credit risk (or risk of default) of the underlying issuers. The ETF will short CDX and invest the proceeds in 90-day T-Bills.
|The upshot: Exposure to a CDS provides investors with several benefits, including central clearing, liquidity, pricing transparency, counterparty assurance and regulatory oversight.|
ZFH: Holding Breakdowns
Source: Bloomberg, BMO Global Asset Management, as of April 13, 2022.
In a very challenging yield environment, fixed income diversification is one of the key tools that investors have to balance risk versus reward. Some of the asset classes that can provide this diversification are difficult to access and manage – making ETFs a critical tool to provide the liquidity, transparency and ease of trading that’s needed to navigate today’s market. By working collaboratively, we can assist you in determining which funds would be best suited for your portfolios.
Please contact your BMO ETF Specialist for more information. Our Portfolio Managers are also available to help with trading insights. They can also be reached at 1−877−741−7263.
1 Aye Soe and Phillip Brznenk, “Looking Under the Hood of Canadian Preferred Indices,” S&P Dow Jones Indices, April 2014.
2 Bloomberg, as of December 31, 2021; BMO Exchange Traded Funds, “BMO ETFs Quick Reference Guide: Largest and Most Liquid ETFs.”
Appendix 1: Correlations Matrix
Source: Bloomberg, March 10, 2012 to March 10, 2022.
Note: SOLUSPFH is ZUP, while STIP is ZTIP.
Appendix 2: ZPR Metrics
Source: Bloomberg, BMO Global Asset Management, as of March 11, 2022.
Appendix 3: ZUP Metrics
Source: Bloomberg, BMO Global Asset Management, as of March 11, 2022.
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