CONTRIBUTORS
Alex Lee, CFA, CAIA, MFin
Head of Canada ETF Product Strategy
Franklin Templeton Canada
The Bank of Canada (BoC) lowered its key interest rate by 125 basis points to 3.75% in 2024 as progress on inflation persisted throughout the year. Recent headline and core inflation measures sit within the BoC’s target range of 1% to 3%, paving the way for further potential rate cuts.
While some analysts anticipated rate reductions would boost the performance of longer-duration bonds, this expectation has faced challenges, as yield movements are not always parallel along the Yield Curve (YC).
Year-to-Date Shifts in the Canadian Sovereign Yield Curve (%)
Source: Bloomberg L.P., as of October 31, 2024.
For Canadian bond investors, short-term investment grade bonds continue to offer compelling yields for limited interest rate risk as the yield curve remains inverted. Year-to-date, short-term bonds overall have outperformed both mid- and long-term overall bonds within the FTSE Canada Universe Bond Index.
FTSE Canada Universe Bond Index YTD Return (%)
|
|
Short |
Mid |
Long |
Universe |
|
Overall |
4.70 |
3.57 |
0.53 |
3.21 |
|
All Government |
4.07 |
3.08 |
-0.28 |
2.50 |
|
All Corporate |
5.98 |
6.19 |
3.39 |
5.35 |
Source: Morningstar Research Inc., as of October 31, 2024.
1. Putting Cash to Work
With interest rates projected to decline further—based on the Overnight Index Swaps (OIS) market—it is prudent for investors holding cash to explore alternatives with stronger total return potential. Ultra-short-term and short-term bonds are ideal first steps for transitioning out of cash as rates fall.
In a previous blog post, I highlighted two effective solutions to deploy cash: Franklin Canadian Ultra Short Term Bond Fund (FHIS) and Franklin Canadian Short Term Bond Fund (FLSD). Recent data strengthens their appeal even further.
FHIS and FLSD: Outpacing Cash Instruments Year-to-Date
Source: Morningstar Research Inc., as of October 31, 2024. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. The performance of the indices does not include the deduction of expenses and does not represent the performance of any Franklin Templeton fund. It is not possible to invest directly in an index. The Morningstar CAD O/N Cash GR CAD index measures the performance of a synthetic asset carrying the average of the overnight bank lending bid/offer rates in the Canadian market. The rate changes daily and interest accrues based on the daily rate. It is market value weighted. The index does not incorporate Environmental, Social, or Governance (ESG) criteria.
FHIS: A step out of cash to step-up total returns.
Since its launch in September 2022, FHIS has adeptly navigated both rate hikes and cuts, delivering low volatility and minimal drawdowns while generating alpha against its benchmark, the FTSE Canada 0-1 Year Universe Overall Bond Index. With an attractive yield of 4.0% and a duration of less than one year (as of October 31, 2024), FHIS is ideal for investors seeking to minimize interest rate risk within their fixed-income portfolios.
FHIS Navigating Evolving Monetary Policy
Source: Morningstar Research Inc., as of October 31, 2024. Common Inception Date is Sept 12. 2022.
Performance vs Benchmark (%)
|
|
YTD |
1 month |
3 months |
6 months |
1 year |
2 years |
Common Inception |
|
FHIS |
4.94 |
0.31 |
1.46 |
3.23 |
6.24 |
5.57 |
5.34 |
|
Benchmark |
4.50 |
0.38 |
1.31 |
2.84 |
5.51 |
5.03 |
4.85 |
Source: Franklin Templeton, as of October 31, 2024. Benchmark is represented by the FTSE Canada 0-1 Year Universe Overall Bond Index. Common Inception date is September 12, 2022. Time periods greater than one year are annualized.
FLSD: Mitigating Reinvestment Risk as Rates Decline
The dramatic rise in interest rates during 2022 posed significant challenges for bond investors. The Series F version of FLSD, with a history dating back to December 2003, had its first-ever negative calendar year return in 2022.
Today, the environment has shifted significantly, with the BoC firmly entrenched in a rate-cutting cycle. As rates may continue to fall, reinvestment risk becomes a key consideration.
FLSD offers reduced interest rate risk compared to the broader bond universe while providing more upside potential than ultra-short-term options. It strikes a sweet spot for investors seeking to address reinvestment risk in today’s environment. As of October 31, 2024, FLSD offers an attractive yield of 4.4% with a duration of 3.0 years, compared to the bond universe yield of 3.7% and duration of 7.3 years.
FLSD: Has Delivered Yield Without Longer Duration Risk
|
|
FLSD |
Short Overall (Benchmark) |
Bond Universe |
|
YTM |
4.36% |
3.39% |
3.68% |
|
Duration (Years) |
2.96 |
2.68 |
7.25 |
|
Average Credit Quality |
A |
AA |
AA |
Source: Franklin Templeton., as of October 31, 2024. Short Overall Index is represented by the FTSE Canada Short Term Overall Bond Index. The Bond Universe is represented by FTSE Canada Universe Bond Index.
Performance vs Benchmark (%)
|
|
YTD |
1 month |
3 months |
6 months |
1 year |
2 years |
3 years |
5 years |
Common Inception |
|
FLSD |
5.71 |
-0.11 |
1.65 |
5.03 |
9.33 |
6.2 |
2.48 |
2.49 |
2.57 |
|
Benchmark |
4.70 |
-0.3 |
1.52 |
4.78 |
8.16 |
5.24 |
2.01 |
1.92 |
1.98 |
Source: Franklin Templeton, as of October 31, 2024. Benchmark is represented by the FTSE Canada Short Term Overall Bond Index. Common Inception date is July 8, 2019. Time periods greater than one year are annualized.
2. Optimizing Fixed Income: The Power of the Barbell Strategy
For clients with longer-term objectives, combining FHIS with the Franklin Canadian Core Plus Bond Fund (FLCP) offers a strategic balance of stability and growth potential.
FHIS has delivered stability and consistency with minimal risk, while FLCP offers opportunities to capitalize on long-term fixed-income trends, maintaining a competitive yield in combination compared to the Bond Universe today.
|
|
FHIS |
FLCP |
Bond Universe |
|
YTM |
4.03% |
4.50% |
3.68% |
|
Duration (Years) |
0.85 |
7.43 |
7.25 |
|
Average Credit Quality |
A |
A |
AA |
Source: Franklin Templeton., as of October 31, 2024. Bond Universe is represented by FTSE Canada Universe Bond Index.
Performance vs Benchmark (%)
|
|
YTD |
1 month |
3 months |
6 months |
1 year |
2 years |
3 years |
5 years |
Since Inception |
|
FLCP |
3.92 |
-1.01 |
1.24 |
6.63 |
12.50 |
6.25 |
0.00 |
0.87 |
1.16 |
|
Benchmark |
3.21 |
-1.01 |
1.20 |
6.62 |
11.34 |
5.52 |
-0.09 |
0.46 |
0.74 |
Source: Franklin Templeton, as of October 31, 2024. Benchmark is represented by the Canada Universe Bond Index. Common inception date is July 8, 2019. Time periods greater than one year are annualized.
Final Thoughts:
The fixed-income landscape has transformed since 2022 when aggressive rate hikes left few places to hide for investors. Today, conditions are more favourable, presenting attractive opportunities in specific segments of the bond market.
For investors concerned about volatility in their core bond allocations, incorporating FHIS may help reduce drawdowns.
Glossary
Average Credit Quality: The credit rating of a bond is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. The average credit quality of a fund reflects the holdings of the underlying issues, based on the size of each holding. Usually, we quote the average credit quality as per Standard & Poor’s or Moody’s credit rating agencies.
Average Duration: Also known as ‘effective’ or ‘Macaulay’ duration it is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. It’s an indication of an issue’s coupon relative to its maturity. Rising interest rates mean falling bond prices; declining interest rates mean rising bond prices. The bigger the duration number, the greater the interest-rate risk (or reward for bond prices). The weighted average duration of a fund reflects the effective duration of the underlying issues, based on the size of each holding. This value differs with ‘Modified Duration’ which is modified for the market (dirty) price of an issue.
Average Weighted Maturity: An estimate of the number of terms to maturity, taking the possibility of early payments into account, for the underlying holdings. The calculation uses the weighted average time to the receipt of all future cash flows for all holdings. Also known as ‘average life’ for fixed-term products. The weighted average maturity of a fund reflects the maturity of the underlying issues, based on the size of each holding.
Yield to Maturity: Yield to Maturity (‘YTM’) also known as the ‘Gross Redemption Yield’ or ‘Redemption Yield’. The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a long-term bond yield expressed as an annual rate. The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity. It is also assumed that all coupons are reinvested at the same rate.
IMPORTANT LEGAL INFORMATION
Alex Lee’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinion, and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
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