Strategy

ZBI: Over 5% Yield to Maturity1 from Income Securities from Canadian Banks

Looking for a new fixed income solution? Consider ZBI: BMO Canadian Bank Income Index ETF.

Sep. 12, 2022

Details:

  • Canadian banks have gathered a lot of interest in recent months with the BMO Equal Weight Banks Index ETF (ticker: ZEB) attracting over $500 million in net inflows year-to-date.2 Investor interest in the banks has picked up, due to bank share prices experiencing headwinds as concerns of a recession grow. The recent slide in share prices has led the valuations of the Big Six” banks to trade at a current price-to-earnings (P/E) ratio of 9.2x, which is a -30% discount to the 13.1x current P/E ratio of the S&P/TSX Composite Index.3
  • We are constructive on the equities side of the Big Six” Canadian banks and consider the current discounts to be an opportunity for long-term investors, as we outlined in our recent trade idea, Canadian Banks: A Potential Bargain. However, investors interested in Canadian banks, but who want to move up the capital structure, may want to consider the BMO Canadian Bank Income Index ETF (ticker: ZBI). This ETF invests in funding instruments, such as bonds, preferred shares and limited recourse capital notes (LRCNs) issued exclusively by Canadian banks. All of these issues have a higher priority than equities in the capital hierarchy of banks.
  • ZBI is 60% invested in bonds issued by Canadian banks. This portion of the portfolio provides defence, given bonds are of high priority in the capital structure. The remaining 40% of the portfolio is invested in preferred shares: institutional preferred shares and limited recourse capital notes (LRCNs). This component allows the portfolio to generate more yield and also provide protection against rising interest rates, as hybrid instruments all have resettable features that allow the issues to adjust to the prevailing 5-year Government of Canada yield, if extended.
  • Virtually all bonds issued by Canadian banks are on the short end of the curve. The shorter duration nature of bank-issued bonds also provides further protection against rising rates. Currently, ZBI has a yield of over 5.0% and a duration of 2.6.4 This ETF offers an efficient solution to complement fixed income holdings in order to generate an attractive yield, while staying on the front end of the curve, and also staying in a portfolio whose underlying instruments are currently rated investment-grade. 

A comparison of short-term Canadian fixed income ETF exposures:

ETFTickerYield to Maturity

Duration

BMO Canadian Bank Income Index ETFZBI

5.27%

2.60
BMO Short Federal Bond Index ETFZFS3.60%2.65
BMO Short Provincial Bond Index ETFZPS3.79%2.97
BMO Short Corporate Bond Index ETFZCS4.89%2.72
BMO Short-Term Discount Bond ETFZSDB4.23%2.70
BMO Short-Term Bond Index ETFZSB4.05%2.73
BMO Ultra Short-Term Bond ETFZST3.87%0.44

Source: BMO Global Asset Management, Bloomberg, as of September 82022.

Trade opportunity:

  • The recent widening of credit spreads has led many bonds and preferred shares to trade at a discount. It can be argued that, given their conservative management and large capitalization, banks offer an advantage over other industries within Canada from a credit standpoint. In addition, there are significant barriers to entry for banks in Canada, which along with being independently regulated by the Office of the Superintendent of Financial Institutions (OSFI), has resulted in strong solvency historically. 
  • Rising interest rates year-to-date, have also led duration-sensitive instruments like bonds to trade at a discount to par. However, given we hold all securities in the portfolio until maturity, bonds will not only generate a higher yield (given the recent rise in interest rates), but investors can also potentially take advantage of the discount-to-par value. The preferred share side of the portfolio also offers opportunity. While preferred shares may not always realize their par value, given the maturity date can be extended, bank-issued preferred shares are a unique situation, as outstanding issues are being called back by banks and replaced with newer instruments. 

Breakdown of average discount to par by asset class in ZBI

Asset ClassDiscount to Par
Preferred Shares-7.1%
Limited Recourse Capital Notes (LRCN)-10.2%
Institutional Preferred Shares-10.7%
Bonds-4.9%
Non-Viable Contingent Capital (NVCC)-5.6%

Source: BMO Global Asset Management, Bloomberg, as of September 82022.

  • ZBI provides investors with a convenient and efficient way to access funding instruments issued by the Canadian banks. This allows investors to generate yield by going one level further down in the capital structure, in an industry that has had a strong record of being well capitalized. Furthermore, with the holdings in the portfolio trading at a discount to par, the fund also offers the potential for additional returns when instruments mature or are redeemed by the issuers.



1 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.
2
BMO Global Asset Management, as of September 8, 2022.
3 Ibid.
4 Ibid.

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