Cash Rules: The 60/30/10 Portfolio ‘Paradigm’ Has Arrived
As expectations for rate cuts push further out, the very front end of the yield curve has become one of the most attractive investments around, offering competitive returns with very little risk. With ample liquidity, the BMO Ultra Short-Term Bond ETF Fund provides efficient access, tax efficiency and plenty of flexibility.
- Cash and short-term bonds have become a viable asset class in building out financial plans
- The Fund hugs the short end of the curve, is very liquid, and maximizes yield (currently 5.7%1)
- With ultra-short-term bonds currently trading at a discount, the Fund also offers a tax advantage compared to GICs and HISAs
The bond market has entered a new phase—or what you’ve referred to as a paradigm—of fundamentally higher interest rates that could persist for some time, requiring investors to be nimbler. Can you elaborate?
MM It’s meant to describe how higher interest rates across the yield curve, and more specifically the short- and ultra short-ends of the curve in particular, are changing market dynamics and investing habits. This summer we saw capitulation from the previous market model as longer-term rates continued to rise, which created a lot of volatility. We’re now starting to see equity volatility driven by the rates market. All of this amounts, in our view, to a new paradigm for fixed income. It is important in this environment to be liquid, particularly to rebalance if we expect to be in this kind of market for a prolonged period. No one has a crystal ball, and given persistent volatility, this is a time when you want to be able to get in and out of an exposure in a cost-efficient way, while still looking for return.
In our view, this is a time you don't want to lock into something like a GIC, where you perhaps receive a higher rate, but the client has no flexibility. Meanwhile, they could be earning a comparable return on a fully liquid investment like the BMO Ultra Short-Term Bond ETF Fund.2 What happens if we hit a recession? What happens if something fundamentally changes with interest rate policy and in six months that GIC is stuck on an island? In contrast, the BMO Ultra Short-Term Bond ETF Fund provides that same top-level yield, but gives you the flexibility to maintain nimbleness in the market and to reallocate whenever you need.
What does this mean for how Advisors and investors should be viewing their fixed income exposures?
MM There are new challenges for investors. Traditionally, fixed income served two purposes. One, to provide stability, and two, to provide income. For the past 10 to 15 years, we've ignored the income part because rates were so low, and simply used bonds as a volatility offset. Now, with new higher interest rates, investors can once again achieve a lot of their income needs through the fixed income part of their portfolio. That's why, given the current market, the inversion of the yield curve and the higher-for-longer narrative, something like the BMO Ultra Short-Term Bond ETF Fund makes a lot of sense. It hugs the ultra short-term end of the curve and can give you a 5.7% yield.1 Investors are basically getting paid to take very, very little credit and interest rate risk. So again, it's a very interesting paradigm and I think a huge opportunity for investors to take advantage. It’s a unique market that we believe will persist for the next 18 months to two years. It is not just going to be a flash in the pan if this higher-for-longer narrative is kept firm by the central banks.
Let’s examine more closely why a short-term allocation is appropriate right now and how an investment like the BMO Ultra Short-Term Bond ETF Fund delivers that exposure.
MM To rewind a bit, we've seen the entire curve elevate into a new normal, with the market saying: “Okay, we may not be going back to the 2% range we’ve become accustomed to.” That’s not necessarily a bad thing. In fact, it's probably a good thing in terms of long-term stability. It has caused, however, a lot of volatility as it has been a painful stretch for those with long-duration exposure. If you’ve been invested in short-term bonds in the BMO Ultra Short-Term Bond ETF Fund, which holds duration of less than one year, the opposite has been true. You’ve received a yield that has been comfortably over 5%. You didn’t have to worry about volatility because the fund hugs the short end of the curve, is very liquid, maximizes yield and, from a risk-return perspective, is extremely attractive. The federal, provincial and corporate bonds this fund has exposure to carry extremely low credit risk. And, our view is that these market dynamics will remain intact going forward.
The conventional wisdom around the traditional 60-40 stocks-to-bonds portfolio mix came under scrutiny when yields were near zero. With rates now significantly higher, how should Advisors construct the bond side of that equation?
MM The narrative prior to, say, 2022 was that investors needed to take 10% of their fixed income and put it into alternative or private investments because yields were so low. This new paradigm is a different environment. We have historically high yields—we haven't seen front-end yields this high since the early 2000s. What we are saying now is: how should that 40% fixed income sleeve be constructed? One combination is the BMO Aggregate Bond ETF Fund—which should serve as that core, full-term exposure of 30% of the overall portfolio—with the BMO Ultra Short-Term Bond ETF Fund for that last 10%. That's the ‘60-30-10’ that we view as a solid portfolio construction. The last 10% is essentially cash, but still generating a healthy yield. In our view, cash basically becomes an asset class when it is earning 5% for almost no risk. If you had said three or four years ago that cash yields would be where they are now, investors would take that and run—it was not so long ago we could only find 5% on High-Yield debt. Again, the paradigm has changed.
Why is it important for investors to have a core exposure in an aggregate bond allocation? Why shouldn’t they just ignore duration and take the 5% yield at little-to-no risk?
MM Well, let’s review what’s in the BMO Aggregate Bond ETF Fund. It contains the entirety of the Canadian bond universe, so you're getting a little bit of everything, which in itself helps diversify the overall fixed income position. And, if you're a long-term investor, that duration exposure over the long term is advantageous. For example, when we do hit a slowdown in growth and when a recession arrives, longer duration bonds are going to be an attractive investment. That is why these two funds complement each other well from a long-term strategic view.
GICs are offering some of their best returns in years, but there are drawbacks such as tax considerations. What are they and how do they contrast with an investment in the BMO Ultra Short-Term Bond ETF Fund?
MM Flexibility is key during a volatile market. And if you are getting the same yield from the BMO Ultra Short-Term Bond ETF Fund that you’re getting from a GIC, why lock yourself into a six-, 12- or 18-month term? Things are changing so quickly that, in our view, those kind of lockup periods are very detrimental to GIC investors. Second, if an investor is laddering out with GICs, or investing in notes that mature at different times, those yields are going to move up and down quickly based on the policy of the Bank of Canada compared to the BMO Ultra Short-Term Bond ETF Fund, which will deliver a smoother return profile over time. That can be helpful for investors in terms of income planning.
For taxable investors, the BMO Ultra Short-Term Bond ETF Fund offers tax efficiency compared to standard GIC. Last year was a tough one for bonds, with many trading at a discount. When those bonds ultimately rebound, more of an investor’s return will be derived in capital gains versus interest income. So, for taxable investors, using something like the BMO Ultra Short-Term Bond ETF Fund can lead to a 75 to 100 basis-points after-tax outperformance compared with a GIC.
Lastly, we like to ask BMO Portfolio Managers about their reading or listening habits as they relate to markets, investing or the world at large. Are there any books or podcasts you’ve recently come across that you’ve found informative or enlightening?
MM I would say Malcolm Gladwell’s Revisionist History podcast always puts a unique lens on historical events, which opens my mind into what's happening in the current environment and why things are happening. The podcast tends to view things differently.
For more information on the funds referenced above or additional fixed income strategies, please contact your BMO Global Asset Management wholesaler.
1 The weighted average yield-to-maturity of the fund’s underlying ETF (Series F) as of Oct. 27, 2023. 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.
2 The BMO Ultra Short-Term Bond ETF Fund invests in the BMO Ultra Short-Term Bond ETF, designed to provide exposure to a diversified mix of short-term fixed income asset classes with a term to maturity of less than one year or reset dates within one year. The Fund invests in investment grade corporate bonds, and has the ability to add exposure to government bonds, high yield bonds, floating rate notes, and preferred shares. The portfolio is rebalanced based on the portfolio manager’s fundamental analysis, relative strength indicators, and risk adjusted yield expectations.
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