Guides

Quarterly Fixed Income Strategy – Q4 2022

This report highlights our fixed income positioning strategies for the fourth quarter beginning October 1, 2022 (calendar year).

Oct. 1, 2022

This report highlights our fixed income positioning strategies for the fourth quarter beginning October 1, 2022 (calendar year).

Duration

  • The yield curve has taken a dramatic shift in both Canada and the U.S. year-to-date. Every point on the Canadian yield curve is now higher than 3.5% and is inverted beyond the one-year mark. While an inversion of the yield curve tends to be an ominous signal and indicates a pending recession, it may come as a sign of relief on this occasion. Lower yields further out in the curve indicate market expectations that inflation will be eventually be contained in Canada. While the last Consumer Price Index (CPI) print in Canada came in ahead of expectations, we view it as a positive that inflation continues to trend in the right direction. Furthermore, we believe many of the components in the CPI calculation are extremely lagged and not representative of the current environment.
  • The U.S. yield curve has been flatter, relative to Canada, with all points beyond 3-months now above 4%, as its inflation numbers have been higher. In combination with its strong labour market, it is anticipated that the U.S. Federal Reserve (Fed) is further behind the curve, compared to the Bank of Canada.
  • We do see encouraging signs that supply chains are improving, which we believe will lead to lower inflation on the Consumer Goods front. In addition, as we have suggested for many quarters, we believe demand would outstrip supply as the world reopens, and areas like travel and hospitality would be in strong demand, as people look to make up for lost time due to the pandemic. We anticipate this post-COVID-19 revenge buying” to eventually cool, especially with central banks quickly ratcheting up interest rates and creating economic uncertainty.
  • With interest rates usually taking 18-24 months to take effect on the economy, and due to the stickiness of the CPI calculation, we believe central banks will overshoot in raising rates. We do anticipate at least a pause in rate hikes in the spring of 2023. Having said that, we still favour overweighting the short end of the curve in the current environment. For one, the flat yield curve offers no compensation for taking on the term risk of longer-dated bonds. The correlation of bonds with equities has also increased, limiting the benefit of long bonds. We do, however, still maintain a barbell in fixed income, as we believe the U.S. yield curve will eventually also invert. The recent Bank of England bailout of its long bonds also suggests that some countries may have a limit in terms of how much long-bond yields can rise.

Credit

  • Credit spreads still remain much wider than historical averages, which suggests corporate bonds (both investment-grade and sub-investment-grade) to be undervalued. We don’t believe current spread levels to be unsustainable; however, we do believe the natural resting tights for credit spreads in high yield to be wider going forward. Higher interest rates will mean lower growth, which will benefit bonds with stronger balance sheets (investment-grade), and make refinancing more difficult for high-yield issuers. From a risk-adjusted perspective, we continue to favour investment-grade bonds.
  • Preferred share spreads were also trading wider, due to the asset class being lower in the capital hierarchy, compared to corporate bonds. Furthermore, recent extensions of bank-issued preferred shares created some uncertainty, as it casted doubt that all outstanding bank preferred shares would be redeemed in favour of newer structures, such as Limited Recourse Capital Notes (LRCNs) and institutional preferred shares. We view the extension as a positive, as many of them had wide reset spreads, which keeps the remaining universe more robust. We do believe that these extensions may have been special situations, where banks were not willing to shrink their risk-weighted assets.

Currency

  • The US dollar continues to be king in today’s environment. With inflation still running high, the Fed is anticipated to have further hikes on hand. The recently revised expected terminal value from the Fed’s dot-plots” created a massive tailwind for the U.S. currency, which means they are now exporting inflation and may force Canada to move rates beyond what is deemed necessary in order to defend the loonie to help offset inflation. We do believe Canada will move rates slightly more than the terminal value that is priced in, which eventually will cause some relief for the Canadian dollar.


Model Portfolio**

TickerETF NameWeight (%)Duration*Yield-to-MaturityMgmt. FeeExposurePositioning
ZAGBMO Aggregate Bond Index ETF58.0%7.394.02%0.08%CanadaCore
ZSUBMO Short-Term U.S. IG Corporate Bond Hedged to CAD Index ETF25.0%2.754.23%0.25%United StatesCore
ZTLBMO Long-Term US Treasury Bond Index ETF4.0%18.173.32%0.20%United StatesCore
ZTIP.FBMO Short-Term US TIPS Index ETF (Hedged Units)5.0%2.542.68%0.15%United StatesNon-Traditional
ZPRBMO Laddered Preferred Share Index ETF5.0%3.117.21%0.45%CanadaNon-Traditional
ZBIBMO Canadian Bank Income Index ETF3.0%2.464.81%0.25%CanadaNon-Traditional
Portfolio100.0%6.064.16%0.15%



Credit Summary**


Term Summary**

Source: BMO Global Asset Management, Bloomberg.

* https://www.federalreservehistory.org/essays/great-inflation.
**As of September 30, 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.


Q4 2022 BMO ETF Portfolio Strategy Report >



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