Views from the Desk

Managing Risk through Short Duration

Jul. 11, 2022
  • During times of economic uncertainty, fixed income is used in a portfolio to provide stability and counter the volatility from the equity side of a portfolio. Year-to-date, equity markets have struggled, with the S&P/TSX Composite Index and the S&P 500 Composite delivering a total return of -8.9% and -17.4% respectively so far. Bonds, unfortunately, have done little to soften the blow. The FTSE/TMX Canada Bond Universe is down -12.1%, only adding to portfolio losses.
  • It has been a challenging year for investors, as most assets have struggled in the face of inflation. With the consumer price index (CPI y/​y) in Canada and the U.S. at 7.7% and 8.6% respectively, central banks have had to act aggressively by raising rates and through quantitative tightening (QT) to counter inflation levels not seen since the Great Inflation of the 1980s.
  • The yield curve has flattened significantly as a result with the 2-, 10- and 30-year yields all being within 20bps. Consequently, fixed income investors are not being compensated for taking on term risk. In addition, with the rapid rise in yields on the short end of the curve, investors can position themselves on the short end, with yield to maturity (YTM) levels not seen in years.
  • Signs of slowing inflation are starting to emerge. For example, commodity prices have cooled in the last month, supply is starting to build in housing, and the secondary market for some luxury goods has fallen substantially. However, with lockdowns hopefully a thing of the past, demand will likely outstrip supply, leaving inflation persistent for at least another 6 months. Also, should China continue with its Zero-COVID policies, inflation could be resilient, leaving central banks to maintain its hawkish stance.
  • Though long-end yields can continue to fall, investors may be better served by managing interest rate risk through short-duration fixed income. Further upside surprises in inflation could cause the long end to move higher again, particularly with job numbers continuing to come in strong. As a result, we view the risk and reward of short-term fixed income to be more attractive and an appropriate landing spot for investors.

A Very Flat Yield Curve

A Very Flat Yield Curve
Source: Bloomberg. As of December 31, 2021, and July 82022

Trade Opportunity:

  • Fixed income ETFs allow investors to efficiently target the short end of the curve. Whereas for the past several years, yields on the front end were insignificant, investors can now collect a much more attractive yield by targeting short-term fixed income exclusively.
BMO Short Term Bond Index ETFZSB3.66%2.76
BMO Short Corporate Bond Index ETFZCS4.53%2.79
BMO Short Provincial Bond Index ETFZPS3.43%2.98
BMO Short Federal Bond Index ETFZFS3.17%2.65
BMO Canadian Bank Income Index ETFZBI4.81%2.46

Source: BMO Global Asset Management, Bloomberg and FTSE/​Russell, July 42022.

  • While fears of inflation have grown in recent months, the long end of the curve has started to move lower. Overnight index swaps are also now starting to price in a Fed rate cut by June of 2023. However, a stagflationary environment could see a recession with longer-term yields moving back higher.
  • Investors that do want long-term bond exposure, or to make an early call on falling inflation or potential equity market hedging, may want to consider using a barbell approach. As discussed in our BMO ETFs: Views from the Desk Podcast this week, that strategy could include an 80% allocation to the BMO Short Corporate Bond Index ETF (ZCS) alongside a 20% allocation to the BMO Long Federal Bond Index ETF (ZFL). ZCS would allow investors to maximize yield on the short end, while ZFL would allow investors to target a potential risk-aversion and/​or recessionary trade.

Calculation is weighted average of underlying securities in portfolio.

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