Turning idle cash into opportunity with active short-term bond ETFs
As policy rates fall, it's time to put your cash to work. Explore why short-term bond ETFs could be a smart option, providing liquid access to higher yields while mitigating interest rate risk.
Key highlights
- With peak interest rates likely behind us, yields on investments such as GICs, money market funds, and HISAs have been declining.
- Investing in short-term investment-grade bonds can offer compelling yields relative to cash-like securities while also offering the potential to see a higher total return if rates continue to fall.
- In today’s uncertain market environment, opting for an actively managed short-term bond strategy can be an important way to mitigate risk and take advantage of opportunities.
Over the last few years, cash has become an essential component of many investors’ portfolios, offering stability in an otherwise volatile market environment. In 2022, for example, investors who maintained an allocation to cash-like securities, such as guaranteed investment certificates (GICs), High-Interest Savings Account (HISA) exchange-traded funds (ETFs), and money market funds, found them to be an invaluable anchor within their portfolios. As both equity and fixed-income markets suffered double-digit declines, these investments helped preserve capital and buffer against market volatility.
Rising yields have caused cash balances to surge
For investors seeking retirement income, the benefit of allocating to cash became even more pronounced. As interest rates soared, with the overnight rate in Canada reaching a peak of 5% amid one of the fastest rate-hiking cycles in history, GICs and cash-like securities began to deliver attractive yields that had been elusive for much of the preceding decade. This shift allowed investors to earn competitive returns while maintaining a low-risk profile, helping to explain the deluge of assets that have flowed into these types of securities over the last several years.
With the peak in yields likely behind us, the investment landscape now poses a potential risk to those who continue to hold these types of securities. As inflation has stabilized, the Bank of Canada (BoC) has shifted its approach and began lowering rates in June 2024. At its most recent meeting in mid-March, the BoC trimmed rates by an additional 25 basis points, bringing the policy rate down to 2.75% and dragging GIC rates further down as well.
GIC rates have been falling in tandem with the BoC’s policy rate
Interest rate (%)
This situation presents a dilemma for investors who, faced with a softening economic outlook and high market valuations, see few compelling opportunities. As their cash or maturing GICs come due, investors could find themselves unable to access the higher yields they’ve become accustomed to but may be unsure of where else to invest these funds.
Short-term bond ETFs balance yield and risk
An allocation to a short-term bond ETF offers several advantages over cash in this context. First, these ETFs could potentially provide a yield premium over HISA ETFs, money market funds, and GICs. Additionally, unlike GICs, short-term bond ETFs don’t face any of the same liquidity constraints. This means that investors can access their money whenever needed, offering greater flexibility to navigate a changing market landscape.
Finally, if interest rates continue to trend downward, short-term bond ETFs could outperform these cash-like securities due to the inverse relationship between bond prices and yields. While falling rates can drag down the yield for GICs and high-interest savings rates, they create potential for higher total returns for bonds. This is highlighted by bonds’ historical performance relative to GICs, where they’ve generally outperformed over most periods, the last few years having been a rare exception.
Bonds have historically outperformed GICs
Relative outperformance of 3-year annualized returns of FTSE Canada Universe Bond Index vs. Bank of Canada 3-year GIC rates (%)
Why investors should consider active fixed income
To take full advantage of an allocation to short-term bonds, investors might consider an active ETF, which offers unique advantages in today’s uncertain market environment.
Active ETFs have the potential to generate higher yields than the index due to their flexibility in selecting which bonds to purchase. This allows portfolio managers to target securities with higher yields, leveraging opportunities while managing risk through credit research.
This also means that active ETFs don’t have to hold every security in the index. Instead, these funds have the discretion to select only those securities that are expected to enhance the portfolio’s risk/reward profile. This approach contrasts with passive fixed-income ETFs, which typically own thousands of bond issues and follow an underlying index. These indexes are designed to reflect issuer needs, meaning issuers with the most debt make up a larger portion of the holdings. On the other hand, active fixed-income ETFs focus on the investor, allowing the portfolio to be optimized with the goal of improving the overall client investment experience.
Active ETFs also benefit from the ability to be nimble, an essential trait in an uncertain market environment. By carefully evaluating the evolving investment landscape, portfolio management teams can take advantage of opportunities within the bond market while maintaining a vigilant focus on risk management. These advantages are reflected in the ability of active short-term fixed-income ETFs to outperform passive ETFs over the last 10 years.
Active short-term bond funds have outperformed over the past 10 years
Active Canadian short-term fixed-income funds that beat the top passive ETF in the category (%)
The case for transitioning out of cash
While the future direction of interest rates remains uncertain, yields on GICs and cash-like securities have already started to reflect the lower rate environment. These assets have provided essential stability in recent years; however, as we look forward, active short-term bond ETFs present the potential for not only higher yields but also enhanced total returns, making them an attractive option to add diversification to your fixed-income portfolio.
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