Strategy

Golden Opportunity for Fixed Income

Matt Montemurro
Portfolio Manager, Exchange Traded Funds
Feb. 14, 2023

Snapshot

Changing market dynamics have created a golden opportunity for fixed income investors to take advantage of higher yields, as we near the end of the central bank interest rate hiking cycle.

Details

Benefit

Increases in interest rates and the inversion of the yield curve have created an opportunity for fixed income investors to meet income needs, without having to take added credit or duration risk.

Trade Idea

Looking back at the past decade, we’ve experienced an unprecedented period of ultra low interest rates which has changed investor expectations regarding the fixed income allocation in their portfolios. It forced investors to move down in credit quality in search for yield. Traditionally fixed income was a way to generate income, while providing stability to portfolio returns. In a low interest rate environment, investors were forced to look at alternatives to meet their fundamental income needs. Investors were forced to take on additional risk, whether that be additional credit or more duration, if they wanted to meet these needs. Common alternatives included high yield and emerging market bonds, preferred shares, and greater allocation to equity within a portfolio. As we move into 2023, the paradigm has shifted where we are seeing short term yields in the range of 4%-5%.1 Investor income needs can, more easily, be met by taking on minimal additional credit and duration risk -- a completely new equation now. This creates a golden opportunity for fixed income investors. Take advantage of the inverted yield curve by locking in short term yields at 4-5%. The current environment allows you to build a more stable high quality bond portfolio, focusing on investment grade credit, while generating income, which seemed impossible, just a few years ago.

Tickers ZST/ZST.L, ZCS and ZQB are excellent ways to take advantage of attractive short-term yields while taking on quality investment grade credit exposure. For those looking to diversify away from Canadian fixed income exposure, the U.S. provides an excellent opportunity as it is a more diversified economy with a deeper and more blue-chip sector representation and issuer base. ZSU and ZUS.U, as these are well diversified exposure, with strong quality exposure and yield premiums over Canadian credit.

To complement the short corporate bond exposure, I would execute a barbell strategy and provide a risk offset to my portfolio by adding government long duration exposure. The period ahead is expected to see slowing of growth and adding long duration exposure will be helpful as a risk offset to equity market volatility. A barbell strategy is well positioned in the current environment. By using fixed income ETFs tactically, you can generate income with short term corporate bond yields use government long duration exposure as a risk mitigation and portfolio stabilization tool. 

Specifically, ZFL and ZTL / ZTL.F / ZTL.U, for U.S. government bond exposure are both well positioned for this purpose. If we see a global slowdown, U.S. treasuries tend to be a safe haven for investors, so pairing this with your short corporate bond exposure creates that barbell trade to lock in higher yields on the short end while having that portfolio protection.



1 Annualized Distribution Yield as of February 8, 2023: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. Source: BMO Global Asset Management.

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