Written by: Tony Dong

This week’s focus is on bonds – you know, the asset most of you don’t have in your portfolio. I’m basically a boomer, so I own a bunch. Man, did it hurt in 2022.

But brighter times for bonds may be on the horizon, especially for 2023. In particular, I’d like to draw your attention in particular to long-term bonds issued by the Canadian Federal Government. 

The tl;dr is – for Canadian investors, there are few assets right now that rival their upside potential and crash protection, at least in my opinion. Let’s dive into it.

Rate hikes are paused…for now

With the Bank of Canada officially holding its policy rate steady at 4.5%, fixed-income investors may enjoy significant tailwinds moving forwards. Let’s break down the reasons why:

1. Interest rate stability: After a period of rate hikes, pausing the policy interest rate can lead to a more stable interest rate environment. This stability can make it easier for investors to make informed decisions, as they no longer have to worry about the uncertainty of further rate hikes in the near term.
2. Bond prices: When interest rates rise, bond yields rise, and bond prices tend to fall. This inverse relationship is because new bonds issued with higher yields make existing bonds with lower yields less attractive to investors. With yields at historical highs, bonds prices now have more room to run.
3. Portfolio diversification: With a more stable interest rate environment, investors may be more inclined to allocate a portion of their portfolios to long-term government bond ETFs. These investments can provide diversification benefits, as they often have a low correlation with other asset classes, such as equities, and can help to reduce overall portfolio risk.

The power of long-term Federal bonds

The BMO Long Federal Bond Index ETF (ZFL) offers Canadian investors the most liquid way of investing in longer duration Federal government issued bonds. With a weighted average duration of 16.63 years, this ETF is highly sensitive to interest rate movements. Investors betting on lower rates in the future can expect a 16.63% return if rates fell by just 1%.

In addition, the ETF only holds AAA rated bonds, which have historically experienced significant “flight to safety” effects. For instance, contrast the performance of ZFL versus the more popular BMO Aggregate Bond Index ETF (ZAG), which has an allocation to provincial and investment-grade corporate bonds during the March 2020 COVID-19 crash.

ZFL held its value much better. In addition, the ETF traded at a far lower discount to its net asset value, or NAV versus ZAG owing to the higher liquidity of Federal government bonds. At the trough of the crash, ZFL only hit a -2.05% discount to NAV, while ZAG tanked by -11.30%. Minimizing this risk is critical if you need to sell a bond ETF to rebalance during a crash.

To end this – if you’re a young investor with a time horizon of 20+ years, I think there’s no reason to fear the long duration of these assets. The math of bond ETFs makes it so if you hold for the average duration of these ETFs, you will see a positive expected return. In my opinion, they make for more sustainable hedges against equity risk than things like VIX futures or put options due to the lack of decay.