Extending Duration (and Hedging Against a Market Downswing) with Aggregate Bonds

Bonds: A Comeback Story

Needless to say, it’s been an interesting couple of years for bonds.

Since yields bottomed out in the early days of the pandemic, they’ve rebounded significantly — though given market volatility and uncertainty around monetary policy, it hasn’t been in a straight line. Driven by higher interest rates than we’ve seen in decades, short-term bonds now offer very attractive yields, with both the U.S. 2-Year Treasury Note and the Canada 2-Year Bond topping 4.5%.¹ But it’s the long end of the curve that offers another benefit: diversification.

Inflation and Fixed Income Markets

A close examination of the macroeconomic picture reveals an environment that is favourable for bonds. As the Consumer Price Index (CPI) has started to trend in the right direction, rate hikes by both the U.S. Federal Reserve (Fed) and Bank of Canada (BoC) have slowed, with the Fed following through in June on what some analysts have dubbed a ​“hawkish pause” — keeping interest rates unchanged while maintaining a relatively hawkish tone in its commentary. The chart below shows that real interest rates, as calculated by subtracting year-over-year CPI from the U.S. 1-Year Treasury yield, are finally positive for the first time since 2019. This is a significant sign that inflation is on the mend, and is a positive bellwether for fixed income markets.

Additionally, real-time inflation, which is calculated daily by the firm Truflation based on millions of data points, also appears to be slowing, as shown in the graph below.

Rising prices in goods have largely abated and supply chains are normalizing. Inflation in services has been more resilient but also shows signs of easing. This provides additional justification for the Fed’s pause.

Hedging Against an Equities Sell-Off With Aggregate Bonds

So, with the inflation picture improving, where are the risks for investors? If inflation continues to move in the right direction, this may allow the economy to avoid the ​‘hard landing’ that markets had feared. Although inflation and the cost of money have risen, the labour market has remained resilient, helping to delay the onset of a potential recession. This is, generally speaking, good news. However, further rate hikes have the potential to expose systemic risks, which could prompt an equity market sell-off.

One strategy to sidestep such a scenario is to extend duration in your client’s bond holdings. This can help provide protection and act as a hedge against a stock market downturn. For clients not comfortable allocating a portion of their portfolio to long bonds, an aggregate exposure can be an attractive alternative.

Full exposure to the yield curve can often help manage unexpected volatility. Our expectation is that markets will remain volatile for the foreseeable future, and that recovery won’t be a straight line. Having exposure to the full bond market can be helpful in constructing client portfolios that can withstand such periods of uncertainty.

Low-cost core beta solutions like the BMO Aggregate Bond Index ETF (ZAG) and the BMO US Aggregate Bond Index ETF (ZUAG) offer the flexibility to be more precise and tactical around the periphery of a client’s portfolio. If a portfolio has a set allocation to fees, minimizing the cost of its core frees up funds to consider a wider range of satellite solutions. Both ZAG and ZUAG provide high-quality fixed income exposures that enable investors to take advantage of credit spreads without being forced to go extremely overweight bonds in case of a market sell-off — and at an attractive MER of only nine basis points.³

The Advantages of ETFs

There are several advantages to using bond ETFs for the fixed income allocation of your client portfolios compared to individual bond trading. They include cost effectiveness, greater liquidity, better tactical flexibility, and the ability to precisely target duration and exposure to meet your client’s investment objectives. ETFs also feature tighter spreads relative to individual bonds purchased through a retail advisory desk. As the largest bond ETF provider in Canada,⁴ BMO GAM offers asset managers the benefits of institutional pricing.

For more information on BMO’s fixed income solutions, reach out to your regional Institutional BMO ETF Specialist.

¹ As of June 27, 2023.

² BMO Global Asset Management, as of June 16, 2023. Yield to Maturity (YTM) is the discount rate that equates the present value of a bond’s cash flows with its market price (including accrued interest). The measure does not include fees and expenses. Annualized Distribution Yield: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. Duration: A measure of sensitivity of bond prices to changes in interest rates. For example, a 5-year duration means the bond will decrease in value by 5% if interest rates rise 1% and increase in value by 5% if interest rates fall 1%. Generally, the higher the duration the more volatile the bond’s price will be when interest rates change.

³ As ZUAG is less than one year old, the actual Management Expense Ratio (MER) will not be known until the fund financial statements for the current fiscal year are published. The estimated MER is an estimate only of expected fund costs until the completion of a full fiscal year and is not guaranteed.

⁴ Measured by AUM, as of March 31, 2023.