3 Fixed-Income ETFs to Navigate Interest Rate Uncertainty
The past two years have seen a substantial capital flight into short-term funds as investors earned higher return for very little volatility. As interest rates peak both in the U.S. and Canada and central banks contemplate reducing the cost of borrowing, keeping exposure in short-term bond funds is likely to become less attractive.
In this trade idea, we’ve outlined three potential interest rate scenarios and BMO’s Exchange-Traded Funds (ETFs) that would benefit from each.
ETFs In Focus
- BMO Aggregate Bond Index ETF (Ticker: ZAG)
- BMO Ultra Short-Term Bond ETF (Ticker: ZST)
- BMO High Yield US Corporate Bond Index (Ticker: ZJK)
- BMO High Yield US Corporate Bond Hedged to CAD Index ETF (Ticker: ZHY)
Scenario 1 - Interest rates fall in line with expectations
Interest rates start falling this year as the market is predicting. In this scenario, investors can mitigate risk and improve returns by increasing duration1 and quality while transitioning to longer-dated bonds.
BMO ETF Solution
BMO Aggregate Bond Index ETF (ZAG) invests in a variety of debt securities primarily with a term to maturity greater than one year. Securities held in the Index are a broad measure of the Canadian investment-grade fixed income market consisting of federal, provincial and corporate bonds.
The ETF rallied in the last quarter of 2023 as it became clear that the Bank of Canada (BoC) was done hiking interest rates in the current cycle. With its low-risk profile, the fund suits investors who want to move their funds to longer-dated bonds to benefit from the potential price appreciation, while still maintaining the safety and stability of their portfolios. When interest rates decline bond prices tend to rise.
ZAG benefits
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Scenario 2 - Interest rates remain high – rates don’t decline as quickly as markets expect
If inflation proves stickier than the market expectations, both BoC and the U.S. Federal Reserve (the Fed) can keep interest rates higher for a longer period. An uptick in inflation in December, followed by strong retail sales, have made markets less convinced that interest rate cuts will be announced soon. In this potential scenario, it’s likely better to stay longer in short-term bonds and wait for the first rate cut. This strategy favours ETFs less sensitive to interest rate changes.
BMO ETF Solution
BMO Ultra Short-Term Bond ETF (ZST) has been designed to provide exposure to a diversified mix of short-term fixed income asset classes with a term to maturity of less than one year or reset dates within one year. The ETF invests in investment grade corporate bonds. It has the flexibility to add exposure to government bonds, high yield bonds, floating rate notes, and preferred shares.
ZST benefits
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Scenario 3 - Recession brings faster rate cuts
While most economists believe a soft landing is still the base-case scenario, key vulnerabilities in the Canadian economy, like a high ratio of mortgage debt maturing, may keep consumers under pressure and slow demand quickly, forcing the BoC to respond with aggressive rate cuts. In this scenario, taking on credit risk may be beneficial for clients. During recessions, the markets tend to avoid riskier assets, expecting higher defaults. This results in spreads to widen across the yield curve2. But as the economy and credit situation improves, spreads tighten, rewarding investors with the high-risk tolerance. The U.S. corporate bond market, known for its depth and diverse range of issuers compared to the Canadian market, is better positioned to reward high-risk investors.
The BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY) has been designed to replicate, to the extent possible, the performance of the Bloomberg U.S. High Yield Very Liquid Index net of expenses. The BMO High Yield US Corporate Bond Index ETF (ZJK) is the unhedged version.
ZHK/ZJK benefits
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Outlook
Implied Overnight Rate & Number of Hikes/Cuts
The overnight index swaps market (OIS) currently reflects implied expectations for the Bank of Canada to cut interest rates approximately three times in 2024.
1 Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).
2 Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.
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