Fixed-income ETF momentum set to continue

Compelling yields and market uncertainty have led fixed income ETFs to dominate inflows in the Canadian market, making them the preferred investment choice as investors take defensive positions.

Listen to the full podcast on AdvisorToGo, powered by CIBC.

Fixed income ETFs led first-half flows, accounting for $11.2 billion compared to $6.5 billion for equity ETFs, according to National Bank Financial.

“The reason for this is pretty clear,” said David Stephenson, director of ETF strategy for CIBC Asset Management. “After 10 Bank of Canada rate increases since March 2022, yields are the highest we have seen in decades.”

Stephenson noted the appeal for investors has been particularly strong in short-term assets, which now offer yields above 4%.

Notably, he said investors are favouring money market, cash and ultra-short-term ETFs, which made up over 50% of fixed income flows. This cautious positioning aligns with the deeply inverted yield curve, where high-interest savings account ETFs offer 5%-plus yields with minimal risk exposure, he said.

This could begin to change as the economy “moves to a firmer footing” and investors look to extend duration at the end of the tightening cycle, Stephenson said. Canadians are currently sitting on a lot of cash and there are signs of a shift in position: long-term bonds have seen more than $2 billion in flows year to date through July 31.

While cash is attractive at current yields, Stephenson said investors should consider the opportunity cost of holding too much, particularly as the long-term cost of being out of the market increases over time.

“If the reasons for holding cash is market timing or worrying about short-term events or uncertainty, when you have a long-term time horizon, history shows it’s best to stay invested,” he said.

While cash has been the story of the Canadian ETF market for more than a year, equity flows have also reflected a thirst for yield.

“Yield–oriented strategies such as dividend and covered–call strategies have done well this year, which I expect to continue,” he said. “Another interesting development so far in 2023 has been investors diversifying into global and international equities,” where valuations are more attractive than for North American stocks.

The search for yield is reflected in new products as well, with enhanced yield and covered calls featuring prominently in the 112 new ETFs launched this year, Stephenson said. Investors in the decumulation stage who are looking for cash flow have been especially interested in these products.

“Yield has been a long-term secular theme in the Canadian market, and there are plenty of options now given the repricing in the bond market, dividend yields on equities in general, as well as enhanced-yield covered-call ETFs that can be in the low double-digit range,” he said.

Stephenson said he expects fixed income ETFs will continue to grow over the longer term as well.

Fixed income currently accounts for approximately 30% of total ETF assets under management, having doubled in the past five years from $52 billion to $110 billion, he said.

Active fixed income strategies are particularly well-positioned for growth, Stephenson said, allowing managers to dynamically adjust duration and credit positioning in response to market opportunities. Additionally, one-stop fixed income portfolio solutions offer convenience and flexibility, enabling investors to navigate changing market environments.

Stephenson also noted that the fixed income ETF landscape has evolved significantly, providing precise exposures to various regions, sectors, credits, yields and maturities.

“The convenience of ETFs and different portfolio applications bode well for future growth,” he said. “Fixed income innovation will continue to evolve and grow as well.”