Behind Bond ETFs series with FTSE Russell and RBC iShares (2024)

An index is a portfolio of securities representative of a given market.

Most indices, especially in fixed income, grew out of capital market research desks and investment banks. Initially used as a representative measure of an investor choice set, these indices tracked market issuance and remain a reliable source of market information.

In addition to a baseline measurement of a market, indices provide transparency, rigor and stability in the investment process.

The FTSE Canada Universe Bond Index has been in the market since the 1980s and has continued to evolve with market issuance to remain representative.

Today, it is widely recognized and broadly used as the benchmark for Canadian fixed income.

The Universe Bond index is entirely rules driven to capture the issuance and behavior of the Canadian bond market.

The Universe Bond Index tracks fixed rate securities issued by the Government of Canada, government agencies, provinces and municipalities, as well as Canadian corporations.

Eligible securities include bonds with at least one year to maturity and all the way out the curve, and a minimum issue size requirement is considered to ensure liquidity.

The Universe Bond Index focuses on investment grade securities, which are bonds with an index rating of Triple B and above.

Index selection - referred to as rebalancing - scans for new securities daily to ensure that they are added to the Universe Bond Index on a timely basis.

This daily review process ensures that the index, as well as the products that track it, most closely represent the market reality.

With over 20 years of experience, iShares was the first asset manager to launch bond ETFs back in 2000 and remains the leading index ETF provider in the industry today.

XBB the iShares core Canadian Universe Bond Index ETF was the first fixed income fund launched globally.

The fund tracks the FTSE Canada Universe Bond index and has grown to become one of the largest bond ETFs in Canada, as it's an efficient vehicle for investors to access the Canadian bond market.

We see four key benefits for investors using bond ETFs.

First, is competitive performance. Many iShares bond ETFs have delivered strong performance over time relative to peers.

Second, low cost. As management fees may impact fund performance, it's important to consider fees in your investment decision making process. iShares bond ETFs can offer investors a low cost way to access fixed income markets.

Third, diversification. With bond ETFs, investors can access hundreds or sometimes thousands of individual bonds via a single ticker.

Finally, liquidity. Fixed income ETFs trade thousands of times throughout the day on exchange. While some individual bonds may not trade once in a single day.

There's nothing passive about indexing and in fixed income where bonds are traded over-the-counter, at times, the market can be illiquid and difficult to access.

In addition, indices include hundreds, if not thousands of individual bonds, all with different underlying characteristics. And the composition of the index is constantly changing.

As a result, it's impractical to hold every single bond that's included in the index.

At iShares, portfolio managers implement a stratified sampling process whereby we seek to deliver indexed risk and return characteristics by holding a subset of securities representative of the underlying index.

Portfolio managers first divide the index into cells with specific risk factors. These risk factors are the drivers of return for those individual bonds. For a corporate bond, those risk factors may include interest rate risk sector exposure and credit risk. Next, PMs will select the bonds across each cell, keeping in mind liquidity, transaction costs and overall efficiency of the exposure. The end result is a portfolio that delivers the same characteristics as the underlying index without owning every single security.

iShares has a long history of managing index funds, and through this sampling process, has consistently delivered tight tracking relative to benchmark.

XBB is a foundational tool for any Canadian fixed income portfolio. It represents the total Canadian bond market, just like a broad based stock market index.

Fixed income plays three primary roles in a portfolio. Capital preservation, income generation and equity diversification. Because of its high quality and intermediate duration, we believe XBB fits at the core of a balanced portfolio as its primary function is to deliver ballast against equity risk in the portfolio.

However, XBB can also be combined with other targeted exposures for investors to tailor their fixed income allocations to meet specific portfolio objectives.

Learn more at RBCiShares.com/bonds.

Target maturity Bond ETFs hold a portfolio of bonds that mature in the same calendar year. The ETF itself matures on a specified date in that maturity year. These ETFs have been designed to provide investors simplified easy access to fixed income in a very unique package.

They:

The FTSE Canada Target Maturity Corporate Bond Index series are designed to represent a liquid, high quality basket of Canadian corporate bonds that all mature or return the investment principle in a target year.

Securities are selected from the constituents of the FTSE Canada Universe Bond Index, which is the widely used measure of Canadian fixed income market, and means that eligible bonds have already gone through a round of rigorous due diligence in being selected for the universe.

In each maturity year, the Target Maturity Corporate Bond Index looks for Canadian corporate bonds with investment grade or BBB and above ratings.

The target maturity Corporate bond indices seek diversification, while enhancing the available yield. To achieve this, the eligible bonds are ranked in yield order, with selection focused on higher yielding eligible instruments. The index mitigates concentration risk by only selecting two securities from the same issuer, capping issuer weight at 10% and limiting exposure to BBB-rated securities.

To further support the quality of selected instruments for longer dated baskets where high grade corporate issuance may be thinner, the index may supplement the selection with eligible provincial bonds, a common practice in institutional investment strategies.

To ensure the indices remain relevant and captures most current rates, the selection is reviewed as part of the semiannual rebalance.

Target Maturity Bond ETFs offer investors many benefits, including:

The defined maturity - with the ability to select a defined maturity date that provides an experience that is similar to holding an individual bond.

Flexibility - You can choose from several maturity dates to build a customized fixed income portfolio tailored to your specific preferences and investment goals.

Monthly Distributions - Interest income is distributed monthly, helping smooth cash flow and simplify your cash management.

And finally, tax effective income - Since bonds today are trading at a discount to par, the return is made up of both coupon interest as well as capital gains. For investors in taxable accounts, this can be a significant benefit.

Learn more at RBCishares.com/bonds.

The yield to maturity of a bond is the overall rate of interest being paid on that bond. It is based on current price of the security, its future coupon interest payments and the repayment of principal.

More precisely, it is the interest rate or the discount rate that make a bond's current price equal to the sum of its discounted future payments, both the coupons and the principal.

As long as the bond does not default, its yield to maturity is a good estimate of the return an investor would earn over the life of the investment from buying the bond and holding it to maturity. Why is it only an estimate? It is because the yield to maturity calculation is a compound interest calculation that implicitly assumes reinvestment of coupons at the original yield, which may not be achieved in the real world.

The risk free rate is driven primarily by the central bank, but credit spreads and term premiums are driven by market forces.

The composition of an index will determine how much influence each of these factors has on its yield to maturity.

This can make sense if it is likely that future interest rates will be lower than they are today.

With a few important exceptions like a target maturity index, a bond index does not mature. It's a perpetual portfolio. The yield to maturity of an index, therefore, is the weighted average of the yields of all the underlying bonds.

However, an index can't be held to maturity and it's also diversified, and so the bonds don't all mature at the same time.

First, the yield to maturity captures the aggregate interest, income and pull to par effect across the entire portfolio. That makes it a reasonable starting point for thinking about the range of possible returns.

At the same time, the change in the market value of the bonds is also a very important part of the total return when investing in a fixed income ETF. This is because there is no final maturity event when a fixed dollar amount is returned to the investor.

Bond prices move the opposite way as interest rates, so when yields go down, bond prices go up and vice versa. In general, longer dated bonds are more sensitive to changes in yields and maturity than shorter dated bonds.

Yield to maturity is a useful metric to use when selecting and comparing fixed income ETFs, but how to use it can vary depending on the objective that you're solving for.

If my primary objective is capital preservation or income generation, then a good place to start is short term ETFs generally ETFs that invest in bonds with five years or less to maturity. These ETFs and their underlying bonds are less sensitive to changes in interest rates.

I can use yield of maturity here to compare. For example, a short term multisector ETF like XSB with a short term corporate bond ETF like XSH. Since both are focused on short term bonds, the additional yield for XSH gives me a sense of the extra compensation I get for taking additional credit risk, and I can decide based on my objectives what makes more sense for the portfolio.

Alternatively, my primary goal might be to hold fixed income as a ballast in my portfolio, ideally maintaining value or even gaining value. Stocks go through a sell off. This typically means choosing bond ETFs with a significant government bond component.

In that context, I can use yield to maturity to evaluate term premiums.

Firstly, what does an all maturity ETF like XPB yield relative to a short term ETF like XSB?

And secondly, given those yields, is the right positioning to stay shorter and protect against yields rising, or own some longer term bonds and capture upside if yields fall? The level of yield to maturity is key to thinking about this.

For RBC iShares ETFs, the yield to maturity is available on our website and is updated daily.

One key thing to note is that the cash distribution yield of an ETF is generally not the same as its yield to maturity.

The cash distribution yield is primarily influenced by the coupon income that is received by the fund. Most ETFs are required to pay such income out to investors.

The yield to maturity also captures the pull to par effect, as bonds approach maturity. That component of yield to maturity generally will not be reflected in ETFs cash distributions. This means that the yield to maturity may be higher or lower than the cash distribution yield.

Learn more at RBCiShares.com/bonds.