Diversifying Portfolio Construction by Harnessing Non-Core Fixed Income
While credit allocations such as private debt present intriguing investment opportunities, they may pose operating challenges for Investment Counsellors and Multi-Family Office clients. Mark Webster, Director, Institutional & Advisory, BMO ETFs, shows how to construct a complementary and scalable non-traditional bond model that can mirror a similar exposure.
Many investment counselling firms have built a strong brand in equities, expressing a disciplined approach to stock picking, yet have limited capabilities in fixed income. In our broad discussions with Investment Counsellors, it is evident portfolio construction tilts heavily towards stocks, where firms have conviction and expertise. This was quite understandable when yields were perilously low. It now appears out of sync, however, in an environment where yields are more attractive and, at least in the Canadian economy, inflation has been more muted.
There are, of course, operational considerations to a firm’s asset mix. Equities are easily accessible and scalable, whereas bonds are difficult to trade and pose problems because individual issues may not always be bought as and when required.
We have written at length about how fixed Income ETFs can help provide scalability and to contain spread costs, noting that the funds tend to trade at fractional spreads to the underlying bond issues they hold. Natural liquidity across exchanges and market-maker inventories allows fixed income ETFs to trade between market participants without transacting the underlying securities. This allows Investment Counsellors and Multi-Family Offices to create a core fixed income model that can be replicated across a growing client base, minimizing reporting and Know Your Product (KYP) requirements that accompany expanding individual bond holdings.
Most of our discussion has dealt with BMO Exchange Traded Funds’ broad fixed income listings, encompassing Short, Mid and Long maturities across Federal, Provincial and Corporate bonds. Managers can express an active investment thesis using index ETFs, adapting their allocations as they see fit — and doing so more effectively than is possible in the cash bond market.
Reaching Beyond the Core
There is, however, a strong case to be made for considering ETFs for non-Core bond holdings, too. Private debt has become an intriguing opportunity for Investment Counsellors, but its underlying thesis may pose operation challenges. Unlike institutional investors with very long-term horizons – such as pensions, foundations and life insurers – Investment Counsellors and Multi-Family Offices have individual clients whose lives may be disrupted when life circumstances intervene. The most obvious are the “Three Ds,” — Death, Divorce and Dismissal. Each of these may trigger a liquidity event. Evergreen funds certainly provide liquidity to help address unforeseen financial needs, but these often have provisions which impede full redemption as and when needed.
Similar exposure can be achieved using publicly-listed debt instruments, providing a rich data set to model risk and return, but at lower cost and without operational constraints. Using ETFs and their three levels of liquidity, Investment Counsellors can combine different exposures to manage both investment quality and yield.
A simple model deploying the BMO High Yield US Corporate Bond Hedged to CAD Index ETF (Ticker: ZHY) and BMO Floating Rate High Yield ETF (Ticker: ZFH) to accent yield, and the BMO BBB Corporate Bond Index ETF (Ticker: ZBBB) as well as BMO Emerging Markets Bond Hedged to CAD Index ETF (Ticker: ZEF) to maintain credit quality, allows managers to construct a suitable portfolio for their clients.
The table below shows how these assets could be weighted to construct a scalable non-traditional bond model which has very favourable metrics — attractive yield, moderate duration and cost — to complement traditional bond holdings:*
Ticker |
Asset |
Year-to-Month1 |
Duration (Years) |
Investment-Grade |
MER (bps) |
Canadian Corporate BBB Bonds |
4.88% |
3.9 |
1 |
15 |
|
Emerging Market Bonds (Debt/GDP Weight) |
6.92% |
4.77 |
0.68 |
50 |
|
US High Yield Bonds |
7.89% |
3.25 |
0 |
55 |
|
Markit CDX (non-investment grade) |
8.02% |
0.1 |
0 |
40 |
|
Canadian Aggregate Universe Bonds |
4.15% |
7.2 |
1 |
8 |
|
Canadian Short Corporate Bonds |
4.74% |
2.76 |
1 |
10 |
|
25% Model2 |
Non-Core Bonds |
6.93% |
3.0 |
0.42 |
40 |
For illustrative purposes only. BMO GAM as of June 30, 2024.
The ease with which this simple model can be altered allows Investment Counsellors and Multi-Family Offices to shape exposures to meet their firms’ investment thesis.
Private debt is an attractive asset class, but it is unequivocally an alternative asset. This model, in contrast, can provide investment counsel and their investors with a low cost, transparent and liquid solution that provides higher yield and lower duration for fractional expense.
To learn more about BMO’s suite fixed income ETFs or receive other trading insights, reach out to your BMO ETF Specialist at their email address or via telephone at 1−877−741−7263.
1 Historical Performance Data:
Fund | Year-to-Date | 1-Year | 2-Year | 3-Year | 5-Year | 10-Year | Since Inception |
ZBBB-BMO BBB Corporate Bond Index ETF | 1.92% | 7.42% | 5.34% | 0.68% | – | – | 1.65% |
ZEF-BMO Emerging Markets Bond Hedged to CAD Index ETF | 2.04% | 8.71% | 4.84% | -2.96% | -0.80% | 1.19% | 3.33% |
ZHY-BMO High Yield US Corporate Bond Hedged to CAD Index ETF | 1.80% | 9.10% | 8.47% | 0.25% | 1.92% | 2.37% | 4.59% |
ZFH-BMO Floating Rate High Yield ETF | 5.04% | 12.53% | 13.97% | 6.35% | 4.35% | 4.86% | 4.89% |
ZAG-BMO Aggregate Bond Index ETF | -0.39% | 3.66% | 3.38% | -1.85% | -0.14% | 1.76% | 2.63% |
ZCS-BMO Short Corporate Bond Index ETF | 2.26% | 7.23% | 4.79% | 1.25% | 2.04% | 2.23% | 2.67% |
As of June 30, 2024. Past performance is not a guide to future performance. Performance is shown net of fees. Inception dates as follows: BMO BBB Corporate Bond Index ETF: February 5, 2020; BMO Emerging Markets Bond Hedged to CAD Index ETF: May 21, 2010; BMO High Yield US Corporate Bond Hedged to CAD Index ETF: October 20, 2009; BMO Floating Rate High Yield ETF: February 10, 2014; BMO Aggregate Bond Index ETF: January 19, 2010; BMO Short Corporate Bond Index ETF: October 20, 2009.
2 Assumes 25% allocation to ZBBB, ZEF, ZHY & ZFH.
For Institutional Client Use Only.
Disclaimer for Model:
* Simulated returns do not reflect the deduction of investment advisory fees, as such actual returns may be reduced by advisory fees and any other expenses it may incur in the management of an advisory account. The simulated performance information was simulated using the assumptions and portfolio characterizations that would be used to manage a proposed portfolio. Presentation of these simulated results does not, in any way, guarantee that future performance will achieve similar results.
Such model accounts used for these demonstration purposes may be managed in a manner the same as, or substantially similar to, that of a typical managed account; examples of, but not limited to, the differences in the management of actual institutional accounts may be due to size, number of securities contained, specific client guideline restrictions, or tax or other strategy limitations. BMO Asset Management Inc. has attempted to set the factors, model settings, and limitations for this presentation to best represent the most realistic or most common institutional account mandate for this strategy presentation.
Simulated performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between simulated performance results and the actual results achieved by any particular trading program.
One of the limitations of simulated performance results is that they are generally prepared with the benefit of hindsight. In addition, simulated trading does not involve financial risk, and no simulated trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results.
There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of simulated performance results, and all of which can adversely affect actual trading results. 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.
Disclaimers
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.
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