It’s Time to Prioritize the Exploration of New Bond Strategies

Filling the gap for fixed income 

While markets have certainly endured a challenging fixed income (FI) environment for several years, conditions are ripe for increasing volatility and a potential structural shift that could have larger implications for bonds. With yields at historically low levels, and as inflation continues to be a pressing concern, traditional FI strategies counselling firms and family offices have used may no longer be the optimal solution going forward. 

In August, CPI was 4.1% in Canada and 5.3% in the U.S.,¹ with Canadian inflation continuing to tick higher and fueling further worries. Much of the inflation appears to be supply driven, and there is an expectation that businesses plan to pass these increased costs to customers, leading to speculation interest rates may rise and pose issues for bondholders.

Adding to limited FI inventory and liquidity constraints on individual issuances, rising inflation makes laddering bonds, a popular strategy for multi-family offices and investment counsellors, even more complicated, as it essentially erodes yield. Meanwhile, traditional portfolios are also not a strong alternative, as long duration positioning provides a portfolio hedge but may not be attractive in a rising rate environment. This has been exacerbated by the Federal Open Market Committee’s (FOMC) recent announcement that tapering will begin in 2022.

Under these circumstances, family offices and investment counsellors require FI strategies that are not only easily accessible, but are capable of combatting inflation and generating above-average yields.

Rising inflation in the U.S. and Canada

US INFLATION

As of: 8/31/21

CPI YoY: 5.30%

2yr BE: 2.54%

5yr BE: 2.51%

10yr BE: 2.34%

CAN INFLATION

As of: 8/31/21

CPI YoY: 4.10%

5yr BE: 1.99%

10yr BE: 1.73%

Definitions:

CPI YoY: The Consumer Price Index is a measure of price movements by the comparison between the retail prices of a representative shopping basket of goods and services.

Inflation Breakevens: Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.

Source: BMO Global Asset Management, as of August 31, 2021.

Why fixed income ETFs are increasing in popularity

Enter FI ETFs, which offer a diversified set of exposures in an easy-to-access vehicle, many of which provide a hedge against increasing rates. In fact, FI is actually the fastest growing segment of the Canadian ETF market with 20% annual growth in recent years² – offering enhanced liquidity, price transparency, trade anonymity, lower costs, and access to a broad range of markets and sectors. They provide family offices and counselling firms with better execution, and the opportunity to easily adapt the fixed income exposures in their portfolios as conditions change. 

When creating the BMO ETF shelf, we recognized the limitations asset allocators faced when seeking tactical solutions to manage their exposures dynamically. Our suite of ETFs provided carefully segmented and precise exposures to manage duration, credit exposure and term, across geographies, helping asset allocators to manage volatility and to improve yield.

Yield + Protection: 4 BMO ETF solutions to consider

Given the current economic outlook, we recommend the following FI ETF solutions to enhance institutional portfolios and mitigate risk:

BMO Short-Term US TIPS Index ETF (ticker: ZTIP): As a direct inflation hedge, this strategy is beneficial because markets have generally agreed (whether inflation is transitory or not) that some measure of protection will be useful, particularly over the medium term. Typically, treasury inflation-protected securities (TIPS) are long duration, but when we launched the ETF early this year, we anticipated what direction rates were headed, implementing time to maturity of zero to five years. TIPS help investors because the principal value adjusts in line with CPI, making these an effective tool to maintain buying power in an inflationary period.

BMO Floating Rate High Yield ETF (ticker: ZFH): While this carries additional credit risk as a high yield bond strategy, it has low liquidity risk, and ultra-low duration of 0.21.³ Exposure to Floating Rate and High Yield issuers earns an attractive yield spread over a Core bond portfolio, minimizing the impact inflation can have on traditional bond holdings. 

BMO also offers alternative ETF strategies that would benefit from a rising rate environment, including:

BMO US Preferred Share Index ETF (ticker: ZUP): As an alternative to U.S. high yield bonds, this ETF provides exposure to U.S. preferred (preferreds) shares, increasing credit quality while still generating above-average yield. While U.S. preferreds are perpetual in nature, they are characterized by wider spreads and are callable after two years, allowing them to perform well as interest rates trend higher. As rates rise, credit spreads typically tighten, which means outstanding preferreds can be called and refinanced at a lower rate (see below for interest rate scenario analysis). In addition, the steeper yield curve and strengthening economy should be supportive of the issuers in this universe, particularly the banks. Given the low correlation to traditional assets, ZUP can be an attractive complement to core FI and/​or Canadian preferred share holdings.

Source: Bloomberg

Source: Bloomberg, BMO Global Asset Management (10 Year, ending April 30, 2021 - using weekly data).

BMO Laddered Preferred Share Index ETF (ticker: ZPR): With investors seeking ways to offset duration risk as the Fed begins its tapering process, Canadian preferred strategies will also play a critical role for institutional portfolios. The five-year rate reset ladder tends to perform best in a rising rate environment, with robust tax-efficient yield. In addition, demand for yield-oriented assets such as Canadian preferreds remains strong, and is expected to continue to outstrip supply.

To learn more about our full suite of fixed income ETFs, or other ideas to optimize your portfolios, please contact your BMO ETF Specialist.

¹ Bloomberg, August 2021.

² Fixed income assets currently only make up 2.5% of the Canadian bond market, but with about 20% annual growth in recent years. Size of Canadian Bond Market Source: Bloomberg Finance L.P., as at August 10, 2021. Total assets under management (AUM) of Fixed Income ETF Assets in Canada Source: Morningstar Direct, as at June 30, 2021. Growth rate of Fixed Income ETF assets was 25% from December 31, 2018 to December 31 2019 and 21% from December 31, 2019 to December 31, 2020 based on total net asset data from Morningstar and funds classified as ​‘Fixed Income’ within the Global Broad Category Group.

³ Bloomberg, BMO Global Asset Management, as of October 19, 2021.