How to Talk to Your Clients About Fixed Income

Interest rates are winding back the clocks and returning investors to another time. We look back at the evolving fixed income landscape to compare the past to the present and discuss where this paradigm shift could lead markets in 2024.

Past: The Fall of Rates and Fixed Income

MM For well over a decade—between the Great Financial Crisis and 2022—many investors came to think of the low-interest rate environment as the norm. However, monetary conditions were kept accommodative through two central bank mechanisms: a move toward zero-interest rate policy (ZIRP) and quantitative easing (QE). It was a challenging market for yield-oriented investors, which is very different from what we are seeing today. At the time, fixed income was failing to provide income, and as a result, investors had to take on a lot more duration (and credit) risk to get yield. In today’s market, we are setting up for a revival of fixed income, where the risk-free rate is 5%,¹ and investors can generate even more yield on the short end of the curve. The lifting of the accommodative policies we have grown accustomed to in the recent decade has revealed a rate environment more consistent with historical norms.

ED I agree. Individuals generally own fixed income for two reasons. The first is for yield, the income they receive from the bond coupon, and the second is capital gains, which has historically worked as a counterweight to equities. For example, let’s say there is an equity sell-off. In the past, fixed income would often rally in this scenario, providing a capital gain—a rise to offset the fall, or capital loss, in stocks. When interest rates fell in 2009, this underlying thesis changed. To get yield, you had to take on additional risks through either high yield or private credit. Fixed income investors had to move down the credit curve or potentially take on more illiquidity in order to deliver a higher return for clients—a dynamic that persisted until the later stages of the pandemic. But now everything has changed.

Present: Putting the “Income” Back in “Fixed Income”

MM Now, interest rates have gone back up, and we’re entering a time when fixed income is making a comeback. This paradigm shift has led to even short-term bonds generating a healthy yield, and we are seeing what could be argued as the true normal. Fixed income is doing its job once again regarding both portfolio construction and as a standalone investment in this real environment.

ED It truly is—it’s almost historic by some measures how much yields have risen in the past two years. I would argue, however, that the short-term pain from the recent fixed income losses is now turning into an opportunity for long-term gains. We are presently seeing the highest expected returns for owning 10-year bonds since 2007.² This is great from a pensioner’s perspective or anyone who is looking for income. Here’s why: if you were to hold the bond to maturity, it would mature at par and you would accumulate the yield over time. And while you could still see a capital loss if you have to sell prior to its maturity, you now have more protection through the higher yield to cushion performance, which you can achieve without moving too far down the yield curve in terms of duration.

MM That’s right. With the way the yield curve is structured right now, being inverted, people aren’t getting compensated for taking on term risk—and what we are seeing is crowding on the short end. People are turning to short corporates, cash and cash-like solutions. There are a couple of reasons for this. For one, the bond and equity markets were highly correlated in 2022, which had investors hugging the front end (as long bonds did not provide the ballast to equities, given the removal of QE led to a rise in yields across the curve). And two, the risk-free rate is sitting at 5.5% in the U.S³ and 5% in Canada.¹ Many people don’t see the benefit of taking on risk right now—particularly with the current geopolitical landscape and interest rate volatility.

In our view, the opportunities lie in short-term credit and investment grade credit overall. Look at areas like high yield, which I believe was the asset class that benefited the most from cheap funding via ZIRP. Investment grade credit is now the sweet spot, as issuers have balance sheets that are more durable and will have an easier time refinancing at current interest rate levels. One way for investors to gain access is the BMO Ultra Short-Term Bond ETF Fund, which provides exposure to a diversified portfolio of primarily investment grade corporate bonds, all with a term to maturity of less than one year. This fund could potentially be used as a “cash-plus” fund. While slightly more volatile than a money market fund, we hold bonds until maturity, where they all end up at par value, regardless of where interest rates move.

ED To Alfred’s point, today’s peak yield is probably on your one-year bond. Historically, an investor would receive a term risk premium, which means earning a higher coupon the longer the period of time the money was invested for or lent. We haven’t seen this in a long time. And with the inverted yield curve, we aren’t seeing this presently. That said, the curve is starting to steepen. We are seeing a return to more normal risk premia in the U.S.—the longer the bond, the higher the yield—but until we see that in Canada, we expect people to remain invested in shorter-duration bonds.

There are three things driving demand in the one-year area: peak yield central bank policy and volatility. To start, investors want yield right now. There is also uncertainty about when interest rate hikes will stop. Thankfully, we are getting more clarity there, and I believe we are closer to the end than the beginning of central bank policy. The third thing is significant: interest rate volatility. Although the 10-year yields are getting more attractive, we are not at a level to begin extending duration yet. We need a period of calm in the market before investors should start to optimize and maximize the yield generated over time by extending out duration. So, you may ask, what’s the level at which I should start extending duration?

Canada Historical 10-Year Bond Prices

Source: Bloomberg, from January 1, 1988 to November 2, 2023.

Let us use history as a guide. The yield for a 10-year bond was 3.83%, as of November 2, 2023. The average yield since 2000 is 4.52%. Once you reach that level, it starts getting to a compelling buying level, and when it goes above it, you should consider moving from the one-year to the longer-duration bonds (10-year plus).

Future: Fixed Income Outlook

AL Where we end up depends on inflation’s course. If the worst of it is behind us, it would pave the way for central bankers to be less hawkish. But they will need clear signs that inflation has receded before we see rate cuts—as central banks feel it’s safer to over-tighten than to let embers of inflation remain. If inflation retreats, a lot of the rate volatility will subside. Interest rate cuts currently priced into the market will potentially be squeezed out as the year progresses. Right now, the massive rate cuts the market anticipates do not necessarily make sense unless we see massive disinflationary pressure. The return to a more normal rate environment may see fixed income out-compete equities. Remember, yields are reaching levels we haven’t seen in a long time and will probably last 10 to 15 years. Even though long-term annualized returns are expected to be in the, say, 9% range for equities, from a risk-adjusted level, people may look to overweight fixed income.

ED We anticipate that rates will stay higher for longer. At the same time, we are close to buying longer-dated bonds—and I’ll explain why. Anecdotally, this is the first time in North American bonds where, if the year were to end today, we would have had three consecutive down years in fixed income. It would therefore be reasonable to expect that we could see a rally next year. But investors are understandably nervous because of the recent interest rate volatility, which is why we look to a quantitative measure known as the margin of safety—a metric that can provide comfort to investors in chaotic markets.

Essentially, if interest rates jumped 100 basis points overnight, how long would it take to make that loss back by holding your portfolio? The table below illustrates what would happen, as indicated by the “Payback Period,” if one were to stay invested.

Using the BMO Core Plus Bond Fund as an example: if interest rates were to suddenly rise 100 bps, that would cause bond prices to decline by -6.1% and the yield-to-maturity (YTM) to rise to 6.4% from 5.40%. In one year, that would result in a total return of 0%, and it would take one year to make back that loss.

The BMO Mortgage and Short-Term Income Fund tells a different story. In the same example, a sudden 100 bps increase would prompt bond prices to decline only 2.5% and YTM to reach 6.5%, resulting in a positive return of 3.8%. Additionally, it would only take four months to recover the lost return caused by the instantaneous rate shock. This is the benefit of higher-yielding, shorter-term bonds.

The Payback Period figure is what we refer to as the margin of safety. In 2021, the margin of safety for the BMO Core Plus Bond Fund was 2.6 years. When that number comes down to under one year is when we feel increasingly comfortable because it indicates the relative ease with which we’d be able to earn back lost returns. A Payback Period of under one year, then, is the catalyst to extend duration that we are looking out for, as it would allow a manager to withstand a 100-bps shock and still likely earn a positive return. As yields go higher, the payback period decreases—and, after several challenging years for fixed income investors, that level of protection is compelling.

Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.

For illustrative purposes. Table figures and calculations assume a parallel yield curve shift and no change to credit spreads. Yield-to-maturity (YTM) and Duration (years) is as of October 24, 2023. Total Return and Payback Period are calculated using compound returns.

¹ Carolyn Rogers (Advocis), “Financial stability in a world of higher interest rates,” Bank of Canada, November 9, 2023.

² Garfield Reynolds, Ruth Carson and James Hirai, “Treasury 10-Year Yield Breaches 5% for First Time Since 2007,” Bloomberg, October 23, 2023.

³ The Federal Reserve, “Implementation Note Issued September 20, 2023,” September 20, 2023.