Posted By By Alizay Fatema, Associate Portfolio Manager, BMO ETFs
(Sponsor Blog)
The latest economic data unveils a captivating narrative of a strong and resilient economy in both Canada and the U.S. The current inflation stickiness and robust job market numbers make a solid case for the central banks in both countries to keep interest rates higher for longer.
Towards the end of September 2023, markets basked in record-high yields. However, earlier this month, based on the current situation in the Middle East, bond yields fell owing to an increase in demand for safer assets and caused longer-term bond prices to surge. U.S. consumer prices remained elevated for the month of September and a pullback in demand for a treasury auction pushed longer-term yields higher again, resulting in 10-yr U.S Treasury yields touching their highest point since 2007. On the contrary, the recent CPI printed lower than expectations in Canada, yet the yields remain high as hot economic data continues to build pressure south of the border.
Source: Bloomberg
Given the current two-decade-high interest rates, yields on Aggregate Bond ETFs have surpassed 5%, making them an interesting avenue for fixed-income investors. Before we dive in further, let’s discuss some aggregate bond ETFs in detail along with their benefits.
Aggregate Bond ETFs as the Core of your Investment Strategy
Aggregate bond ETFs are exchange traded funds that aim to track performance of a diversified portfolio of bonds. These ETFs are referred to as core because it reflects their status as a foundational building block of a well-rounded investment portfolio. These ETFs can help investors achieve diversification, steady income & stability within their investment portfolios. BMO currently offers two Aggregate Bond ETFs:
- BMO Aggregate Bond Index ETF (ZAG) aims to replicate the performance of the FTSE Canada Universe Bond Index. This ETF primarily invests in a Canadian investment-grade fixed income securities consisting of Federal, Provincial and Corporate bonds, with a term to maturity greater than one year.
- BMO US Aggregate Bond Index ETF (ZUAG) tracks the performance of the Bloomberg US Aggregate Bond Index. It invests in U.S. investment-grade bonds such as U.S. treasury bonds, government-related bonds, corporate bonds, mortgage-backed pass-through securities, and asset backed securities with a term to maturity greater than one year. ZUAG is also offered as hedged to CAD (ZUAG.F) and in USD (ZUAG.U).
Source: BMO Asset Management.
These aggregate bond ETFs have proven to be an extremely viable investment solution owing to their key features:
- The Symphony of Diversification: Aggregate Bond ETFs provide exposure to a broad spectrum of bond market offering diversification across the curve, various sectors and segments, maturities, issuers, and credit qualities; making them resilient for any market environment.
For example, in the current high-interest rate environment, exposure to short duration bonds might provide some down-side protection. On the other hand, if central banks start cutting rates, then longer duration can provide some upside potential.
Aggregate Bond ETFs can also be considered an equity market hedge. Given the inverse correlation between equities and bonds, they can provide a cushion against market turbulence and can potentially outperform stocks during selloffs.
- Harnessing Cost Efficiency through Lower Fees: These ETFs are passively managed with the aim to track performance of the aforesaid indices. Their expense ratios are lower as compared to some actively managed funds, thereby reducing overall investment costs and improving net returns for investors. BMO is currently charging a Management Expense Ratio of 0.09% for both ZAG & ZUAG.
- Liquidity & Ease of Trading: Like all other ETFs, ZAG & ZUAG are traded on stock exchanges, enabling investors to easily buy and sell shares throughout the trading day, allowing them to see real-time prices. The bid-ask spreads on these products are lower in contrast with the underlying bonds which enhances their liquidity compared to traditional bonds, making them a cost-effective way to attain the exposure to the aggregate bond market.
- Navigating Risk Management through High Credit Quality: Aggregate Bond ETFs are perceived as a stable and safer investment option as they provide exposure to investment-grade bonds, which are considered to have lower risk as opposed to high-yield or junk bonds. In the current rising interest rate environment, the credit quality & relative stability of the investment grade bonds make them an appealing choice for investors seeking to minimize risk & preserve capital.
Combined with the key features mentioned above, these Aggregate Bond ETFs provide investors with a low-cost core in any investment portfolio. They distribute monthly interest payments, providing a steady stream of income. These ETFs emphasize on preservation of capital and provide transparency and visibility into the funds’ composition and their underlying assets.
Visualizing a Decade of Growth – 10-year Comparative Performance
Although past performance is not indicative of future returns, looking at the 10-year performance of the benchmarks of these Aggregate Bond ETFs, one can deduce that these ETFs can serve as a well-diversified vehicle ideal for any economic environment. Considering their risk and return objectives, if investors opt to stay invested in these ETFs for long-term, they can weather short-term fluctuations and capitalize on the power of compounding.
Source: Bloomberg
Positioning for Prosperity: Devising a Strategic Portfolio Stance using Aggregate Bond ETFs as the Core
ZAG and ZUAG can be used as the core of investment portfolios to add diversification to equity exposures. They can be used as core fixed-income investments and can be combined with other ETFs to complement their returns as market changes.
For instance, in the current high interest rate environment, combining these ETFs with an allocation to BMO USD Cash Management ETF (ZUCM), BMO Ultra Short-Term US Bond ETF (ZUS.U) or BMO Ultra Short-Term Bond ETF (ZST) a very attractive yield with limited duration and credit risk. If the goal is to get some inflation-protection, ZAG or ZUAG also can be combined with BMO Short-Term US TIPS Index ETF (ZTIP).
Source: BMO Asset Management.
If central banks decide to cut rates in 2024 or in case of a recession, exposure to longer-term federal bonds which are considered safe-haven assets can provide refuge from market volatility and uncertainty. So, combining ZAG or ZUAG with some allocation to BMO Long-Term US Treasury Bond Index ETF (ZTL) or BMO Long Federal Bond Index ETF (ZFL) may help stabilize the overall portfolio, over the long term.
Alizay Fatema is an associate at BMO ETF team, where she is responsible for assisting in fixed income trading and portfolio management. She focuses primarily on fixed-income segments such as sovereign, provincial, corporate – high yield & investment grade bonds as well as emerging markets debt. Over the past few years, Alizay has acquired experience in various areas of treasury and capital markets such as fixed income trading, ALM, FX sales, product development and product control. Prior to joining BMO, she worked with CIBC. Alizay holds a master’s degree from the University of London, majoring in accounting and finance and is a CFA charterholder.
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