Bonds are an integral part of every Canadian’s portfolio for good reason. Bonds carry the “promise” of fixed income with regular stable cash flows. But with interest rates hovering at all-time lows, the pressure to make every cent count has never been greater. Creating such exposure smartly can make all the difference in the returns.
A portfolio for the average Canadian probably contains fixed income securities, otherwise known as bonds. Bonds are particularly attractive to those investors at or near retirement as they look to replace their regular and stable salary with a similar certain stream of interest income.
Unfortunately purchasing bonds in Canada is not as easy or as cost effective as purchasing stocks. Unlike equities which trade on an open stock market exchange with fully transparent bid and ask prices, bonds in Canada have to be purchased through a ‘dealer network’ which effectively removes all the efficiency and transparency of a fully functional liquid market.
This is where it gets unpleasant for the retail investor. Compared to gigantic financial institutions who invest billions of dollars with pooled assets, it is extremely challenging for the retail investor to purchase a bond with the similar efficacy as these large behemoth financial institutions.
The only thing that might be worse than purchasing bonds through Canada’s dealer network is purchasing a bond mutual fund. The average expense ratio on a Canadian bond mutual fund is close to 1.75%. In an interest rate environment where long term yields are hovering around 3.5%, that’s like sharing my hamburger with a stranger and him taking half of it in one bite. I don’t think so!
So how can the retail investor get the fixed income exposure with a handsome seniority and a tight bid ask spread? The average investor should consider Bond ETF’s to create the fixed income exposure in their portfolios.
ETF’s are managed by big financial institutions, and trade on any number of stock exchanges just like your favorite stock. The benefits to the average investor are numerous.
A bond ETF, is basically a bunch of different bonds bundled up in a portfolio and traded in the stock market. Unlike the individual bonds themselves, there is substantially more liquidity in bond ETFs, which makes for a tighter bid ask spread. Basically, investors can easily exit their position at any time without the cost of large transaction fees.
This advantage alone is all retail investors should need to convince themselves that bond ETFs are the most efficient way to gain exposure to the fixed income market. In addition, these Bond ETFs have huge amounts of assets under management and have superior purchasing power. For example, total assets under management for the major Canadian Bond ETFs is in excess of 2 trillion dollars. Guess what – that gives these ETF companies huge leverage in negotiating with the best bond issuers. Not only are they able to trade in and out of bonds at much better spreads than you or I could ever get, but they also have access to the best issuers.
While the stock market is far from perfect, investors should always have the ability to buy and sell a security that is somewhat close to the current market price, In the bond market, this is not the case as the spread between the bid and ask is in the order of magnitude several times much larger. For the retail investor purchasing individual bonds is not only unfavorable but often hazardous. By leveraging economies of scale and keeping the system whole, bond ETFs minimize transaction costs and ensure Canadian investors get better value on their dollar.