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CA-EN Institutional

What Do Fixed Income ETF Flows Foretell?

November 7, 2022
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There’s no question—with interest rates rising, inflation persisting, and volatility reigning, it’s been a challenging year for fixed income. In such an uncertain market environment, insights into investors’ mindsets are worth their weight in gold, as they offer a possible answer to the critical question—where are we heading?

Enter ETF flows.

An examination of the money that is being invested in—or taken out of—fixed income ETFs reveals certain trends, which teach us great deal about the market’s expectations. From macroeconomic outlook to potential investment opportunities—these insights and more can be found in the data, as long as you know where to look.

Trend #1: Weathering aggressive rate hikes with three key themes

ETF flows show that investors are actively positioning their portfolios to withstand aggressive interest rate hikes by the U.S. Federal Reserve and the Bank of Canada, and this impulse has expressed itself in three key themes. The first is a move to ultra short-term bonds, which has become one of the biggest inflows we’ve seen year-to-date in fixed income, picking up over the summer as central banks got more aggressive in their rate increase schedule. With a duration of less than one year, ultra-short bonds can function as a cash equivalent, helping investors both de-risk their portfolio by reducing their interest rate exposure and put cash aside as they wait for volatility to calm down in late 2022 or 2023. A second theme, which goes hand-in-hand with the first, is a general shortening of duration. With fixed income in negative numbers across the board, the only way many investors have been able to reduce their sensitivity to interest rates is by complementing a core mandate, like the BMO Aggregate Bond Index ETF (ZAG), with short-term corporate, federal, or provincial bonds, or the ultra short-term space as previously mentioned. Finally, during rate-hiking regimes, credit tends to outperform and provide some protection, and investors capitalizing on that tendency is the third theme evident in ETF flows. So far this year, we’ve seen credit spreads widen, which we can trace back to the risk-off sentiment that emerged in the wake of Russia’s invasion of Ukraine in February. But over the last quarter or so, we’ve started to see investors return to credit, enticed by corporate spreads that are wider than historical norms. Adding credit to a portfolio allows investors to not only shorten duration, but also take advantage of higher yields the likes of which we haven’t seen in a decade. In particular, investment grade credit has been of interest to investors, as High Yield credit has suffered from a market correction in August, a reduction in risk-on sentiment since Fed Chairman Jerome Powell’s speech at Jackson Hole, and August’s U.S. CPI numbers, which further spooked the market. Investment-grade credit offers investors a chance to move up the credit curve and make their portfolio more quality-based, which is attractive in an uncertain market environment.

Investment-grade credit offers investors a chance to move up the credit curve and make their portfolio more quality-based, which is attractive in an uncertain market environment.

Trend #2: Protecting against inflation with TIPS and infrastructure

Another trend we’ve seen in inflows is toward inflation-protected notes, or TIPS (Treasury Inflation-Protected Securities). TIPS are indexed to inflation to protect against declining purchasing power, and the BMO Short-Term US TIPS Index ETF (ZTIP) has been one of our fastest-growing ETFs since its launch in early 2021. Both BMO’s TIPS solutions and other TIPS products in the U.S. and Canada have seen significant inflows over the last 15-16 months as inflation has become a primary issue not only for investors but for the economy at large. In today’s market environment, the primary benefit of inflation-protected securities is to protect a portion of a portfolio from inflation-related surprises, like the one we saw in August. That month’s U.S. CPI print surprised on the upside, causing inflation break-evens to spike and investors to re-evaluate their expectations, including the widespread belief that we’d reached peak inflation. Going forward, the question is—when should investors remove their TIPS protection? August’s developments are an excellent example of why keeping that exposure is wise for the time being. We’re still in a volatile environment, and though one-year expected inflation has declined from 6% to below 2%, there is no guarantee that we won’t see more inflation-related surprises in the near term. Speaking of inflation protection, another trend we’ve seen is investors looking outside of traditional fixed income and towards infrastructure. Revenues of infrastructure companies are often tied to inflation, so a product like BMO Global Infrastructure Index ETF (ZGI) may offer a natural inflation hedge.

Trend #3: Finding opportunities in an inverted yield curve

In general, a prolonged inversion of the yield curve—which we’ve seen recently—is a sign of the market’s expectation of a recession, the reasoning being that central banks will need to lower interest rates in the future to stimulate economic growth. But are there also opportunities to be found? An inverted yield curve implies that longer-term rates have peaked. With that in mind, investors may be looking to add duration at these levels and discussing when it would be most prudent to do so. At this time, ETF flows indicate that few investors have actually acted on this trade—they may share my belief that there’s more volatility ahead. But the conversations are happening, and we expect this trend to emerge more forcefully as we approach the end of the year, especially for institutions that employ high-conviction strategies. Relatedly, with the yield curve inverted and a recession looming, we’re also seeing the beginnings of a rotation to Quality. As investors add duration, they may also be considering solutions like the BMO Long Federal Bond Index ETF (ZFL) or long U.S. Treasury exposures like the BMO Long-Term U.S. Treasury Bond Index ETF (ZTL), which can serve as a stabilizer in a portfolio. Investors are asking themselves, “when do we pull the trigger?”, and we’d expect this trade to pick up as the Fed and the Bank of Canada provide greater clarity on what to expect going forward.

We’re still in a volatile environment, and though one-year expected inflation has declined from 6% to below 2%, there is no guarantee that we won’t see more inflation-related surprises in the near term.

Trend #4: Looking backward to see forward

Current ETF flows tell us a great deal about the market’s mindset. But historical flows can also be valuable as a record of how markets have reacted to past situations—and how things may play out going forward. In past recessions, we’ve often seen a flight to Quality trade and greater interest in long duration, especially long federal bonds in Canada and long treasuries in the
U.S. From a credit perspective, we’ve seen investors looking to move up the credit curve and take some High Yield and BBB risk off the table; elevated yields give investors flexibility, as they’re able to meet their income needs with high-quality, investment grade credit. All of these historical impulses are in line with conversations being had and trends starting to emerge in recent ETF flows. Looking at the big picture, one important thing to keep in mind is that periods of higher interest rates tend to last longer than markets expect. Often, investors’ outlook is overly rosy, expecting central banks to quickly reverse course and cut rates as soon as they’re done raising them. But historically, the Fed and the Bank of Canada usually prefer to keep their policy stable for several meetings, and sometimes several quarters, which allows the economy to slow down a bit before revving back up again. For that reason, investors may consider waiting to add long duration to their portfolio. With yields as high as they are, it may be preferable to be late to that trade than to be too early.

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