The yield-duration sweet spot

There’s a sweet spot along the yield curve for bonds, offering higher yield when adjusted for the risk of holding longer maturities. By identifying that yield-duration target and tilting their portfolios accordingly, ETF and mutual fund managers can materially enhance returns in their bond mandates.

Though it’s a moving target, the sweet spot can also serve as a guidepost for how advisors and their clients can effectively position fixed-income holdings.

“Yield per unit of risk is a good approach,’ said Ashish Dewan, senior investment strategist with Toronto-based Vanguard Investments Canada Inc. “This approach has provided a yield cushion that has helped steady returns against broad market volatility.”

A year and a half ago, when the yield curve was inverted, short-term maturities were the most attractive on a risk-adjusted basis, said Darcy Briggs, a senior vice-president and portfolio manager with the Canadian fixed-income team of Franklin Templeton Canada in Calgary.

But with the yield curve having reverted to a normal trajectory, Briggs added, the sweet spot is now in what bond managers call the “belly” of the curve, the middle ground between short- and long-term maturities.

“That sweet spot will move around,” said Briggs. “But on average, like over a full cycle, the belly of the yield curve offers some of the better risk-adjusted returns.”

One yield-curve measure employed by bond managers is the difference between the two-year yield and the normally higher 10-year yield. Recently, this gauge of steepness was about 73 basis points in favour of the longer end. Briggs said this falls within the 50 to 150 basis-point range of a normal yield curve, though currently less than the median level of 100.

There’s no specific range of maturities that constitutes the belly of the curve, but depending on the portfolio manager it’s generally considered to be anywhere from three to seven years.

For the fixed-income team at CI Global Asset Management, the best risk-return tradeoff is currently in that range. That provides a healthy stream of income while mitigating the price sensitivity of longer-dated bonds.

“The long end carries too much risk in this environment. The belly gives you more bang for your buck,” said portfolio manager Grant Connor, who has the lead role in domestic rate strategy for the CI GAM team.

Connor and his colleague Fernanda Fenton, who is responsible for managing rates exposure in developed and emerging markets, consider the five-year area of the curve to be the current sweet spot.

This part of the curve, they believe, offers enough duration to benefit from any central bank easing, while avoiding the elevated volatility and downside risk of the long end of the curve, which remains vulnerable to fiscal concerns, inflation persistence and geopolitics.

Bond yields are attractive

Regardless of the next move in interest rates by the U.S. Federal Reserve or the Bank of Canada, bond yields look attractive, bond watchers say. Vanguard’s Dewan noted that recent real, after-inflation yields have exceeded 2%, particularly at the 10-year level.

“That is something we haven’t seen in a while. So it increases the return potential,” he said. As well, Dewan added, higher quality bonds are well equipped to be portfolio hedges in the event of falling stock markets.

Citing factors such as tariff-related economic weakness and the plight of homeowners facing mortgage renewals at much higher rates than several years ago, the Franklin team believes that the Bank of Canada will be compelled to make more cuts in its trend-setting policy rate. For that reason, said Briggs, the yield on 10-year Government of Canada bonds, which was at 3.4% in early August, looks attractive.

If the Bank of Canada rate fell to 2%, 75 basis points lower than its current level, that would suggest a 10-year yield falling to 3%, according to Briggs. This would result in capital gains, since bond prices move in the opposite direction of market interest rates.

“That would represent a high, single-digit return on the Canada 10-year,” Briggs said.

Looking ahead over the next six to 12 months, the CI managers believe the five-year part of the yield curve is expected to remain the anchor for risk-efficient positioning. But central bank cuts might present an opportunity to extend duration, especially if the yield curve steepens as long-bond rates remain high. “Unless tariffs or [rate] cuts change the outlook, five years still makes the most sense over the next six months,” Connor said.

U.S. “uncertainty”

In the context of an overall fixed-income portfolio, the sweet spot is only one element of portfolio construction to consider. Dewan recommends diversification into international bonds outside North America, citing differences in central bank policies and “uncertainty around U.S. policy, which is a big risk for many investors right now.”

The sweet spot will also vary depending on the investment objectives and risk tolerance of the individual investor. In a more conservative portfolio, said Dewan, longer-term investors should consider holding mostly fixed-income securities with an emphasis on short-term corporate credits. Risk-tolerant investors with a longer-term horizon, he added, can take on more duration risk by holding longer-dated securities.

“Active duration management is essential,” said CI’s Fenton. That means dialing risk up or down and rotating into parts of the yield curve that provide the best risk-adjusted rewards.

For example, CI Global Unconstrained Bond Fund has gone from having very short-term positioning in 2021–2022 to a recent duration of 5.5 to six years, now that there’s a normal, upward sloping yield curve.

Active management can also pay off in terms of being able to overweight corporate credits versus market benchmarks, said Briggs. Franklin Canadian Core Plus Bond Fund, for instance, maintains a large overweighting in high-quality corporate securities, while holding far less in federal bonds than the fund’s market benchmark, the FTSE Canada Universe Bond Index.

By accepting somewhat higher credit risk, actively managed ETFs can generate higher yields with less duration risk. “If you structure your portfolio to be more geared towards corporate debt, you should generate higher returns and better risk-adjusted returns, because you just don’t have the interest-rate volatility,” said Briggs.