Three Fixed Income Strategies for Three Interest Rate Scenarios
With the end of the interest rate cycle in sight, what comes next for investors? Michael Oldrich, Inside Sales Representative, BMO Global Asset Management, sits down with Earl Davis, Head of Fixed Income & Money Markets, Active Fixed Income, and Matt Montemurro, Portfolio Manager, Exchange Traded Funds, who break out their crystal balls to discuss which scenarios are most likely, and recommend strategies for nearly any outcome.
November 2023
MO Thanks for speaking with me, Earl and Matt. As we know, the past couple of years have represented a paradigm shift in fixed income. Yields on short-term bonds are higher than they’ve been in over twenty years, prompting increasing client interest in these kinds of strategies. With the interest rate cycle likely nearing its end, however, the question shifts to what comes next. In that spirit, I’d like to outline three different scenarios and get your insights on their likelihood and what strategies Advisors may wish to consider for each.
Scenario #1: A mild recession.
MO How likely is this scenario?
ED This is the most likely scenario in my view—in fact, Canada may already be in a recession. I’d give it about a 60% chance of playing out.
MM Agreed. In this case, a technical recession will eventually lead to interest rate cuts, but they’ll likely be pushed out well into 2024.
MO Could you describe what the drivers for this scenario might be?
MM A meaningful pullback in growth. Job numbers continue to be strong, and while Canadian GDP is showing some signs of weakness, it’s not yet showing concrete indications of a technical recession. It typically takes 18-to-24 months for rate increases to work their way through the system, and we’re only now entering that time frame, the first hikes having occurred in March 2022. I expect we’ll see more cracks in the economy as we get closer to the two-year mark in March 2024.
MO What strategies would you suggest for this scenario?
MM In the case of a shallow recession, some normalization of the yield curve is likely as mid-to-long-term rates rise. The BMO Aggregate Bond ETF Fund is an all-weather, low-cost strategy that is well-suited to that kind of environment, with long government bond exposure to offset market volatility and provide downside protection against a slowdown in growth.
ED The BMO Core Plus Bond Fund is an actively managed strategy that is suitable for a range of different market environments. It includes a mixture of corporate, federal, and provincial bonds, and offers the potential for both yield and capital gains, both of which are likely to drive returns in this scenario.
Recommended strategies: BMO Aggregate Bond ETF Fund Fund & BMO Core Plus Bond Fund
Scenario #2: No recession, and interest rates remain higher for longer.
MO How likely is this scenario?
ED This is less likely than the mild recession scenario. Let’s say 30%.
MM I concur. No recession is less likely than a shallow recession but more likely than surprise rate cuts.
MO Could you describe what the drivers for this scenario might be?
MM A resilient economy buoyed by immigration. If growth continues at a decent clip, then markets will begin to adjust their interest rate expectations as cuts gets pushed further down the road. Regardless of which scenario occurs, I do think we’re entering a new paradigm in terms of rate expectations; for the last decade-plus, investors have come to expect rates in the 2-3% range, whereas the next period might see rates normalized in the 3-5% range. I suspect both the U.S. and Canadian economies would be able to withstand that shift.
MO What strategies would you suggest for this scenario?
MM If a recession fails to materialize, it’s likely that corporate credit will perform well—especially with spreads currently about 25-30 bps wider than the 10-year historical average, which tells me that the market is already pricing in some kind of downturn. In that scenario, the BMO Corporate Bond ETF Fund makes sense. It features a diversified portfolio of corporate bonds and has an average duration that is about a year and a half shorter than the BMO Aggregate Bond ETF Fund.
ED Let’s look at this scenario through the lens of yield. If a recession doesn’t happen, yield is likely to be the main driver of performance. This means that in an actively managed strategy like the BMO Core Plus Bond Fund, we’d be looking to optimize based on the highest point on the yield curve, which is currently the short end. There’s little need to extend duration in this scenario.
Recommended strategies: BMO Corporate Bond ETF Fund & BMO Core Plus Bond Fund
Scenario #3: A hard landing with aggressive interest rate cuts.
MO How likely is this scenario?
ED 10%. This is the least likely of the three scenarios.
MM This scenario would require a much quicker drop-off in growth than the others. That’s unlikely but still hypothetically possible.
MO Could you describe what the drivers for this scenario might be?
ED A sudden spike in unemployment. Major job losses would likely cause interest rates to be lowered across the board as central banks attempt to avoid a deep and painful recession.
MM It would have to be something significant and unexpected. Aside from unemployment, perhaps widespread defaults in the mortgage market could be a catalyst, but that’s unlikely to happen in the next six months.
MO What strategies would you suggest for this scenario?
MM The BMO Aggregate Bond ETF Fund would be a strong option as it provides exposure across the yield curve, including the kind of government bond and duration exposure that would be especially attractive amid volatility. For investors, looking to sit out the volatility all together, the flexibility granted by the BMO Ultra Short-Term Bond ETF Fund—which I discussed in depth in an article last month—would continue to make sense for clients.
ED In this scenario, the main driver of performance would be capital gains, so we’d position the BMO Core Plus Bond Fund with that in mind. In the event of a painful recession, our preference would be for a greater allocation to government bonds than usual and high-quality names on the corporate bond side. High Yield bonds should be avoided in this situation, because a deeper recession will likely cause default rates to rise.
Recommended strategies: BMO Aggregate Bond ETF Fund, BMO Ultra Short-Term Bond ETF Fund & BMO Core Plus Bond Fund
MO Thanks, Matt and Earl. One final question: what do you see as the main benefits of combining actively managed strategies (like the BMO Core Plus Bond Fund) with passive strategies (like the BMO Aggregate Bond ETF Fund and BMO Corporate Bond ETF Fund)?
MM I’ve spoken with many Advisors and clients about this very topic and what I always say is, when you’re building a portfolio, having both active and passive strategies gives you two separate levers to pull: low-cost, full-market exposure from the passive side with the agility of the active side. The combination of active and passive gives you a chance to navigate virtually any scenario—including the ones we’ve discussed—without having to be right 100% of the time, and that’s attractive in periods of uncertainty.
ED In my nearly 30-year career, I’ve never seen a time with a broader set of plausible interest rate outcomes, as the scenarios we’ve discussed highlight. An allocation to active fixed income—in addition to a significant allocation to passive—helps address that complexity and uncertainty. Active managers provide two major benefits: selecting credits that they believe will outperform, and exiting credits before the market turns on them, thus avoiding losses. That, in combination with a low-cost passive allocation, makes for a robust fixed income sleeve in client portfolios.
Please contact your BMO Global Asset Management wholesaler for any support and guidance.
1 Yield to Maturity (YTM): The total expected return from a bond when it is held until maturity – including all interest, coupon payments, and premium or discount adjustments. YTM is calculated gross of fees.
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