Quarterly Fixed Income Strategy – Q1 2023
This report highlights our fixed income positioning strategies for the first quarter beginning January 1, 2023 (calendar year).Jan. 1, 2023
This report highlights our fixed income positioning strategies for the first quarter beginning January 1, 2023 (calendar year).
- The yield curve in Canada became more inverted, particularly on the short end of the curve. The Bank of Canada (BoC) continued to raise rates, as inflationary data remained resilient. The difference between the 10-2-year bond yields in Canada saw its biggest inversion since the early 1990s. An inversion in the yield curve tends to be a very reliable leading indicator to a recession, which we believe is almost a certainty. The more relevant question is whether a soft landing is possible. Contrary to the common belief that employment must weaken, we believe a strong labour market, combined with less spending, is one of the few paths to a soft landing and inflation being contained.
- Several months ago, the BoC seemed to have a much better handle on containing inflation, compared to the U.S. Federal Reserve (Fed). However, the Consumer Price Index (CPI) in the U.S. continues to trend lower, while the last three year-over-year readings for CPI in Canada have remained flat. Leading indicators all point towards ongoing deflationary forces, particularly in goods. Services will be more resilient, as people have been busy travelling and going out to restaurants, which we believe demand will dissipate in early 2023.
- The bad news is the inversion in the yield curve indicates recessionary forces. The good news is bonds exchanging hands at lower yields on the long end of the curve means investors believe inflation will eventually be contained; otherwise, they would demand higher yields to compensate them for taking on the term risk. Furthermore, the trend in real rates (bond yields – inflation) is becoming less negative.
- We believe the ongoing conflict in Ukraine will keep supplies in energy and food tight, which will lead to some structural inflation to persist. However, we believe tighter monetary conditions and continued supply-side healing will continue to cool inflation. As such, as we have been noting since last quarter, we believe both the BoC and the Fed will pause in its interest rate hikes in 2023. We also see concerns of an economic slowdown to eventually overtake those of inflation in mid-2023. Having said that, the question now becomes, does the Fed eventually cut rates at some point in 2023? Although Fed Chairman Powell has been adamant that rates will remain “restrictively high for some time,” the Overnight Index Swaps market isn’t buying the narrative.
- While we do believe a pause is very close, we don’t see interest rates being reversed lower this year, unless economic conditions significantly deteriorate. We view the recent rise in rates, though painful on asset markets, as a much needed recalibration, especially to the bond market. The era of zero interest rate policies (ZIRP) and quantitative easing is over, as we transition to back to a regime where growth was more moderated and bonds were actually meaningful. We continue to advocate for barbells, where we overweight investment-grate credit on the short end to better manage credit risk. This is also complemented with exposure to “risk-free” government bonds on the long end to position for a slower economy.
- While managing duration risk has been the primary focus for bond investors over the year, managing credit risk will become increasingly more important as we forge ahead to 2023. Higher rates will have a secondary effect on borrowers of credit as higher rates, will make refinancing more costly, placing pressure on lower credit issuers.
- We believe higher-quality investment-grade issuers will be better positioned than those of sub-investment grade. In the era of ZIRP, investors had to stretch for yield by dipping into areas, such as high yield bonds. As rates rise, investors can now get a much more attractive yield by staying in investment grade. Less demand in high yield would mean credit spreads will remain higher than the historical norms. The higher cost to now borrow via higher interest rates and higher spreads will lead to some defaults. This is further reason why we want to take our credit exposure on the short end of the curve and focus more on “risk-free” federal bonds on the long end.
- With yield-to-maturity on U.S. investment-grade corporate bonds reaching levels in more than a decade, we may see bonds begin to outcompete equities in the portfolios of investors. Similar to the post-Volcker era where bonds ruled, we may be seeing a similar setup occur this year in fixed income, albeit to a smaller degree.
- The US dollar enjoyed a notable run in 2022, with the Canadian dollar keeping pace early in the year before succumbing to the strength of the greenback. The Fed is likely closer than most central banks in reaching its neutral rate, which means it has less rate hikes than its peers. The European Central Bank (ECB) looks to be just starting its fight with inflation, while the Bank of Japan (BoJ) increased the bands on its yield curve control policy to 50bps. Even the BoC is arguably behind its U.S. counterpart at this point. As such, we believe investors may want to be hedging USD/CAD exposure, while unhedging exposure in both EUR/CAD and JPY/CAD.
|Ticker||ETF Name||Weight (%)||Duration*||Yield-to-Maturity||Mgmt. Fee||Exposure||Positioning|
|ZAG||BMO Aggregate Bond Index ETF||58.0%||7.39||4.02%||0.08%||Canada||Core|
|ZSU||BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF||25.0%||2.75||4.23%||0.25%||United States||Core|
|ZTL||BMO Long-Term US Treasury Bond Index ETF||4.0%||18.17||3.32%||0.20%||United States||Core|
|ZTIP.F||BMO Short-Term US TIPS Index ETF (Hedged Units)||5.0%||2.54||2.68%||0.15%||United States||Non-Traditional|
|ZPR||BMO Laddered Preferred Share Index ETF||5.0%||3.11||7.21%||0.45%||Canada||Non-Traditional|
|ZBI||BMO Canadian Bank Income Index ETF||3.0%||2,46||4.81%||0.25%||Canada||Non-Traditional|
Source: BMO Global Asset Management, Bloomberg, as of December 31, 2022.
**As of December 31, 2022. Please note yields will change from month to month based on market conditions.
The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.
Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.
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).
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.
Credit Risk: An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payment.
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