The Active ETF Advantage: Discount Bonds
By Peter Tomiuk
Vice President, ETF Distribution
Dynamic Funds
Last year we saw tremendous volatility in fixed-income markets around the world. The resulting drawdowns – not seen in decades – created havoc for investors as fixed income is generally expected to help mitigate portfolio risk. Prior to this, bond markets had the luxury of longstanding tailwinds: rates trended downwards, and the economy consistently gained strength after the Great Recession of 2008, albeit with occasional hiccups along the way.
In the world since COVID-19, we have seen inflation rocket up and central banks around the world combatting this by raising rates. In addition, fears of a recession have increased, and the combination of these events have created headwinds for fixed income, thereby increasing the need for strategic active management to manage these challenges.
Not All ETFs Are Created Equal
While passive ETFs may make sense in certain market environments, fixed income, for the most part, is not one of them. For starters, there are significant issues with how fixed-income indexes are created. Oftentimes, they’re weighted according to the amount of debt an issuer holds – the more debt, the higher the weighting in that index.
Passive Fixed Income ETFs can’t adjust their duration or credit exposure to respond to micro- or macroeconomic events taking place within markets.
Unlike equities, fixed-income securities trade over the counter, which can present serious liquidity issues. Many passive fixed-income ETFs have a difficult time in replicating their respective benchmark because many of those bonds may not be available for trade. The difficulties in replicating benchmarks can result in tracking error because a passive ETF manager literally cannot buy all the bonds in the index they’re replicating.
And finally, passive ETFs can’t adjust their duration or credit exposure to respond to micro- or macroeconomic events taking place within markets.
Given the more complex economic realities of today’s fixed-income markets, investors can no longer dismiss the significant flaws that exist in many passive mandates. That’s why we believe that active management is absolutely necessary in today’s fixed-income environment.
Active Opportunity: Discount Bonds
As active fixed-income managers, we know that volatility creates opportunity. Case in point, the rapid rise in interest rates, especially in Canada and the U.S., has meant that bonds that were once trading at premiums are now trading at a discount. This is significant – especially for bondholders in taxable accounts, as a significant portion of the bonds’ return will be accounted for as capital gains, which are taxed at a lower rate than interest income.
The rapid rise in interest rates, especially in Canada and the U.S., has meant that bonds that were once trading at premiums are now trading at a discount.
Additionally, discount bondholders stand to profit more in a falling interest-rate environment (versus premium-priced bonds), while their lower acquisition cost provides an added measure of downside protection, especially in cases where an issuer might be in financial distress.
The number of ETFs that are able to take advantage of opportunities in discount bonds is extremely limited. As stated previously, passive ETFs don’t have the investment flexibility to capitalize on changing market conditions.
DXDB provides interest income and the potential for tax-efficient capital gains by investing in bonds that are trading below the average price of their benchmark. As a core component of a bond portfolio, the ETF invests primarily in investment-grade, discount bonds with a term to maturity of between three to seven years, taking advantage of opportunities in the belly (short to mid-term range) of the curve.
Key Benefits
STEADY MONTHLY INCOME STREAM
DXDB will provide investors a stable monthly income stream offering a fixed monthly distribution with an initial yield of 4.5%*.
TAX-AWARE MANDATE
Relative to its benchmark, DXDB’s potential return profile contains more capital gains, which are taxed more efficiently than interest income.
ENHANCED FLEXIBILITY
Unlike passive ETFs, credit selection is the cornerstone of this strategy. Portfolio managers have the flexibility to express a view on sector exposure or select bonds outside of DXDB’s benchmark to maximize opportunities.
POSITIVE BOND CONVEXITY
Discount bonds have the potential to rally more than premium-priced bonds in certain scenarios.
EXPERIENCED MANAGEMENT TEAM
DXDB’s investment team possesses broad fixed-income experience across the whole capital structure -- coupled with a diversified product base that supports capital deployment towards the best risk-adjusted returns.
* The yield is calculated based on a fixed, but not guaranteed, monthly distribution of 7.5 cents/unit and a net asset value per unit (NAVPU) of $20 as of inception date. Monthly distribution yields may fluctuate as the month-end NAVPU changes. An ETF’s distribution yield should not be confused with its performance or rate of return.
Disclaimer:
Commissions, trailing commissions, management fees and expenses may be associated with mutual fund investments, including ETFs. Please read the prospectus before investing. Mutual funds and ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Views expressed regarding a particular investment, economy, industry or market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management LP. These views are not to be relied upon as investment advice nor should they be considered a recommendation to buy or sell. These views are subject to change at any time based upon markets and other conditions, and we disclaim any responsibility to update such views. To the extent this document contains information or data obtained from third party sources, it is believed to be accurate and reliable as of the date of publication, but 1832 Asset Management L.P. does not guarantee its accuracy or reliability. Nothing in this document is or should be relied upon as a promise or representation as to the future.
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