The Time is Still Now: Capitalizing on Falling Interest Rates with BMO Bond ETFs

As the Bank of Canada’s monetary easing accelerates, the environment is still attractive for seizing fixed income opportunities. 

The past few years have been a challenging period for fixed income investors. A decade of extremely low interest rates was followed by one of the most aggressive monetary tightening in decades to tame the surging inflation. This rapid cycle of rate increase since March 2022 led to record levels of money flowing into cash and money market Exchange Traded Funds (ETFs), currently sitting at just over $25 billion in Canada.¹

Money Market ETF Flow Trends

The environment of higher interest rates offered an easy outlet for investors to collect higher yields of about 5%² from money market products and targeting short end of the curve. This opportunity, however, is fading as the slowing rate of inflation prompts central banks to cut interest rates in Canada.

The Impact of Falling Interest Rates

As interest rates fall, the yields on money market instruments will also decrease. Anticipating the yield curve steepening, interest rate normalization over time pushes investors to consider longer-duration bonds and to look for other opportunities.

Falling rates also present an opportunity for capital appreciation. Bond prices move inversely to interest rates, meaning as interest rates decline, bond prices rise. With rates widely expected to continue coming down for a prolonged period, adding duration to your portfolio could be a strong driver of performance in the period ahead. 

More Rate Cuts on the Horizon

The latest inflation report showed that inflation fell below the Bank of Canada’s (BoC) 2% target rate. October’s jumbo rate cut was mostly due to the steady decline in headline inflation in the past few months. The BoC’s mild tone in forward guidance suggests rate cuts will more likely be 25 bps in size, unless growth or inflation fall even further. That is still a possibility, as BMO Economics calls on both gross domestic product (GDP) and the consumer price index (CPI) to be slightly lower than the BoC,³ so there is still a risk of another 50 bps cut. They maintain a forecast of five more 25 bps cuts, taking the overnight rate to 2.5% by June 2025, at the lower end of the Bank’s 2.25%‒3.25% range for neutral. Given the potential for future rates cuts, the time is still right to take advantage of opportunities in the fixed income market. 

Below we have highlighted our top ETF picks that offer solutions based on investors’ preference for duration and risk appetite: 

• BMO Aggregate Bond Index ETF (ticker: ZAG): A Core Fixed Income Solution

The BMO Aggregate Bond Index ETF (ticker: ZAG) is a core fixed income solution for many investors. With over 1,500 bonds⁵ and access to the full spectrum of the Canadian bond universe, including investment-grade government, provincial, and corporate bonds, the ETF offers broad diversification. ZAG is currently the largest fixed income ETF in Canada with $10 billion assets under management.⁴ With duration of about seven years, it can help position portfolios to benefit ahead of further interest rate normalization. The ETF has done much better since rates have started to move lower, returning about 12% over a one-year period and 3.3% year to date.⁶

• BMO Discount Bond Index ETF (Ticker: ZDB): Tax-Efficient Exposure

For investors looking for a more tax-efficient investment option, the BMO Discount Bond Index ETF (ticker: ZDB) provides exposure to bonds that pay coupon lower than their Yield to Maturity (YTM) and trading below their par value. It is a discount bond version of the Canadian aggregate index. The tax advantage of buying an ETF that has a basket of bonds trading at a discount is that a portion of the future return will come from capital gains which is treated more favorably than interest income.

• BMO Long Federal Bond Index ETF (Ticker: ZFL): A Duration Play

For those looking to extend duration, the BMO Federal Bond Index ETF (ticker: ZFL) can be an attractive option to add as a satellite position to pair with ZAG acting as a stable core. The ETF has seen significant inflows with over $300 million moving into the long end of the curve in September 2024.⁷ Investors are using ZFL to position themselves ahead of further rate cuts. Should the Canadian economy weaken further, government bonds in ZFL provide a defensive cash flow stream, offering stability to portfolios. The loosening financial conditions with potential for further rate cuts can also benefit spread products, so provincial and high-quality corporate bond indices should also be positioned to do well in this environment.

Bottom Line

If you prefer more control over your exposure to different points on the yield curve, BMO ETFs offer the largest Fixed Income product suite in Canada,⁸ helping investors to be more precise in their selection for their fixed income portfolios. 

BMO ETF options range from ultra-short bonds with duration under one year to long-provincial bonds with fourteen-year maturities.⁹ This flexibility allows investors to adjust their portfolios based on their views of the yield curve and interest rate movements. 

Fixed Income Matrix

As of September 30, 2024. The inception date for ZMMK is November 29, 2021. The inception date for ZAG is January 19, 2010. 

¹ NBF ETF Research, Bloomberg, as of September 30 2024.

² Based on gross yield of the BMO Money Market Fund ETF Series, as of May 13, 2024 (5.15%).

³ BMO Capital Markets Economic Research, October 23, 2024.

⁴ NBF ETF Research, September 30, 2024.

⁵ As of September 30, 2024.

⁶ Bloomberg, BMO Global Asset Management, as of September 30, 2024.

⁷ BMO Global Asset Management, as of September 30, 2024.

⁸ NBF ETF Research, September 30, 2024.

⁹ Bloomberg, BMO Global Asset Management, as of September 30, 2024, based on the BMO Long Provincial Bond Index ETF, which holds an average weighted duration (years) of 14.62.