The best Canadian bond ETF is the perfect choice for investors looking to earn monthly income, diversify their portfolio and reduce risk. Whether you are a conservative investor, nearing retirement, or already retired, the best Canadian bond ETF may be just what you’re looking for.
- What are Bonds?
- What Are Bond ETFs?
- Should You Invest in a Bond ETF?
- The Best Bond ETFs in Canada
- Comparing the Best Bond ETFs in Canada
- Common Canadian Bond ETF Comparisons
- Choosing the Best Canadian Bond ETF
- Thanks for Reading!
What are Bonds?
You may have heard the term bond before but never fully understood it. Essentially, bonds are debt securities issued by governments or businesses when they want to raise money. When people talk about “government debt,” for example, they are usually talking about bonds issued by the government to fund the services it provides.
Investors can purchase bonds, typically on the secondary market, and receive income in the form of coupons. These coupons are agreed to by the issuer of the bond and can be close to 1% for low-risk bonds like those issued by governments and upwards of 10% or more for high-risk bonds issued by struggling corporations.
Bonds are priced based on the credit rating of the issuer and reflect prevailing interest rates. Rising rates tend to reduce the price of bonds, while falling interest rates will increase the price of bonds. In today’s environment, where rates are at multi-decade highs, bond issuers need to offer higher interests rate to ensure their bond is attractive to investors.
What Are Bond ETFs?
Bond ETFs are exchange-traded funds issued by companies like Vanguard, Blackrock, and many others, that purchase many different types of bonds. Investors can then buy shares in the bond ETF and receive their share of coupons paid by the underlying bonds that the fund holds.
Bond ETF Pros
Bond ETFs in Canada make it easy to earn income from a diversified portfolio of bonds. Purchasing a bond ETF is also much less expensive than selecting individual bonds for purchase. That’s because individual bonds have much larger trading spreads than common stock.
Canadian Bond ETFs also often have very low management expense ratios. This is especially true for large bond ETFs that follow a broad-market index. Bond ETFs with higher MERs tend to be actively managed or follow niche indexes or strategies.
Bond ETF Cons
The main downside of investing in a bond ETF is that the fund can experience large fluctuations in price. A good example is the past few years, where rising interest rates drastically reduced bond prices, causing bond ETFs to fall in price.
Technically, individual bonds you purchase would also experience these price swings, but you could always hold bonds to maturity to avoid realizing a loss.
Should You Invest in a Bond ETF?
For a long time, the 60/40 portfolio was the standard investment portfolio recommended to Canadians. It was a portfolio of 60% common stock and 40% bonds. This provided adequate growth while also helping to reduce year-over-year volatility.
These days, most people agree that young Canadians can invest less of their money into bonds or bond ETFs. But as you get older and closer to retirement, bond ETFs start to make a lot more sense.
At the end of the day, whether you should invest in bond ETFs is a question of risk. For conservative investors, both young and old, bond ETFs could be an excellent choice to weather market volatility while also earning income from their portfolios.
The Best Bond ETFs in Canada
Canada’s best bond ETFs each have a combination of medium to high yield, low management expense ratios, and excellent credit quality. In this list, I share my top 5 Canadian bond ETFs. Each of these funds are traded on the Toronto Stock Exchange and invests primarily in Canadian bonds.
HBB ETF Review
The first Canadian bond ETF to consider is the Horizons Canadian Select Universe Bond ETF (HBB). Established in 2014, HBB seeks to replicate the Solactive Canadian Select Universe Bond Index.
HBB invests in Canadian bonds with a minimum credit rating of BBB and primarily invests in high-quality AAA, AA or A bonds. It boasts a distribution yield of 2.54% and an MER of just 0.10%.
What’s unique about HBB is that it uses a total return swap contract to track the performance of its index. This has some advantages, such as HBB does not distribute taxable income to its unit holders. This can be advantageous for investors holding HBB in a taxable account. However, it does incur a 0.15% fee to execute this swap strategy, which can reduce the overall return of the fund.
VAB ETF Review
One of the most popular Canadian bond ETFs is the Vanguard Canadian Aggregate Bond Index ETF (VAB). This fund was started in 2011 and has attracted nearly $4 billion in assets.
Vanguard’s VAB seeks to track the Bloomberg Global Aggregate Canadian Float Adjusted Bond Index. This means it uses a passive strategy to invest in investment-grade bonds from across Canada.
What’s made VAB so popular is its combination of low MER, reasonably high yield, and excellent credit quality. Like other Vanguard funds, VAB is always trying to reduce its expense, and because of that, it boasts an MER of just 0.09%—tied for the lowest on this list. Its distribution yield is also excellent for a diversified bond fund at 3.55%.
XBB ETF Review
The first bond ETF from iShares on this list is the iShares Core Canadian Universe Bond Index ETF (XBB). XBB has been around for 1 year longer than VAB and coincidentally has more assets at over $4,780 million.
XBB has a low management expense ratio of just 0.10% and has a very high credit quality, investing 39% of its assets in AAA-rated bonds.
However, XBB loses marks for distribution yield. Today XBB yields only 3.01%, making it middle-of-the-pack compared to other popular Canadian bond ETFs. Like BMO’s Aggregate Bond Index ETF (ZAG), XBB seeks to replicate the FTSE Canada Universe Bond Index.
XSB ETF Review
The iShares Core Canadian Short Term Bond Index ETF (XSB) is another excellent choice for the best Canadian bond ETF. It tracks the FTSE Canada Short Term Overall Bond Index, which means it primarily invests in short-duration bonds. Overall, its average maturity is just 3 years.
This strategy has some upsides. Mainly the bond ETF lost a lot less value than its peers. In 2022 while other ETFs lost over 10%, XSB lost only 4%. That’s because bonds with a short maturity lose less value than bonds with a long maturity when interest rates rise.
The main downside for XSB is that because it has such a short maturity, it pays a low yield at just 2.48%. However, this has to be weighed against its overall strategy. In a rising rate environment, XSB will likely outperform bond ETFs that have longer maturities.
ZAG ETF Review
The BMO Aggregate Bond Index ETF (ZAG) is a top contender for the best Canadian bond ETF. It also has the largest assets under management at $6,279 million.
The Bank of Montreal’s ZAG has a high dividend yield of 3.56% and a low MER of 0.09%. That gives it both the highest distribution yield and lowest MER on this list.
It also has an excellent credit rating, having 89% of its assets invested in bonds with a rating of A or better. Its largest issuer is the federal government at 37% of assets, followed by Canada’s provincial governments at 34%.
Comparing the Best Bond ETFs in Canada
Canadian Bond ETF Fundamentals
Each of the best Canadian bond ETFs have an MER of around 0.10%. They also pay monthly distributions, making them ideal investments for those looking for cash flow.
The main difference between these bond ETFs is their yield. XSB has the lowest yield due to its short-term focus. You can see that its average maturity is just 3 years, while the other best bond ETFs in Canada have a maturity of around 7 years or more. XBB’s yield is probably the most disappointing, given it has an average maturity of 10 years.
Canadian Bond ETF Performance
Each bond ETF has performed poorly in the rising rate environment that took place in 2022 and that may continue this year in 2023. HBB was the worst performer, but only by a hair. That’s a good sign that its swap-based strategy is doing a good job replicating its index.
XSB has benefited from its short-term focus over the past two years, losing just 4.1% and 1.0%, respectively. However, in a falling interest rate environment, expect HBB, VAB, SBB and XAG to overperform due to their large portfolios of longer-maturity bonds.
Canadian Bond ETF Issuer
Each of the best bond ETFs in Canada primarily invests in federal and provincial bonds. XSB is the largest investor in federal bonds out of the five ETFs, with VAB having the most corporate bonds under management.
Canadian Bond ETF Credit Quality
Each bond ETF received full marks for credit quality. Each fund holds mostly AAA, AA or A-rated bonds, with only 10% or less allocated to BBB-rated bonds.
Canadian Bond ETF Maturity
VAB, XBB, and ZAG all have a similar distribution of bond maturity. Most of their bonds mature within the next 5 years, while equal amounts of bonds are due to mature within 10 years and subsequently within 30 years.
XSB stands out for having by far the lowest maturity. 99.5% of its bonds mature within 5 years. Breaking that down further, we can see that 29% of its bonds mature within 2 years, a further 28.6% mature within 3 years, and a further 42% mature within 5 years.
Common Canadian Bond ETF Comparisons
VAB vs ZAG
VAB vs ZAG is a tough decision. Both funds are excellent choices for the best Canadian bond ETF. Both VAB and ZAG share an MER of 0.09%, making them competitive on cost. They also both have a distribution yield of around 3.55%. These attributes have helped them attract over $10 billion in assets.
Over the past 5 years, their performance has been nearly identical, so the deciding factor probably comes down to personal preference. Investors already holding Vanguard ETFs will likely choose VAB for their Canadian bond ETF. While investors with an existing relationship with BMO will select BMO.
XBB vs XSB
XBB vs XSB comes down to whether you want a shorter or longer maturity fund. Like the other best bond ETFs in Canada, XBB has a maturity of 10 years. Contrast this with XSB, which has a maturity of just 3 years. If you want a lower-risk portfolio or expect rates to rise even more in 2023, XSB may be the better choice.
However, if you want an ETF that’s diversified into longer maturity bonds and want a higher distribution yield, XBB is the superior choice.
HBB vs VAB
When comparing HBB vs VAB, it’s clear that both ETFs have some attractive qualities. If you’re looking for a standard bond ETF that is low-cost and pays good income, VAB is the superior choice. But if you’re an investor looking to purchase their ETF in a taxable account, HBB may be more advantageous. That’s because HBB does not pay any taxable income. And since income from bonds is taxed as regular income, that can make HBB much more attractive in a taxable account.
Choosing the Best Canadian Bond ETF
Each of the best bond ETFs in Canada are competitive on price, having management expense ratios of around 0.10%. They are also both competitive on credit quality, with each fund primarily investing in government-issued bonds with ratings of A or higher.
The deciding factor may come down to the overall strategy of the bond ETF. For Canadians looking for a shorter-term bond ETF, iShares Core Canadian Short Term Bond Index ETF is the clear winner. It’s inexpensive, has an adequate distribution yield, and has an average maturity of just 3 years.
Of all the longer-maturity funds, the best Canadian bond ETF is VAB or ZAG. Both funds have comparable management expense ratios, distribution yields, credit quality, and average maturity. They even have almost identical performance over the past 5 years. Any investor looking for a Canadian bond ETF would do well in either of these two popular ETFs.
Thanks for Reading!
I hope you enjoyed my analysis of the best Canadian bond ETF. If you’re interested in learning about other great ETFs, check out my review of the best preferred share ETFs, the best dividend ETFs, and the best REIT ETFs for Canadians.