Understand what you own and why you own it
Try this. When you get stuck on the crossword, or a Sudoku, or the NYT Spelling Bee - stop. Put it down. Take a break.
When you come back, as little as ten or fifteen minutes later, you almost always make immediate progress, or even finish quickly.
Funny how that works. The answer was actually just… there.
During that break you’re not solving anything. You’re just no longer staring at the wrong assumption. It’s freeing.
A similar thing happens when you look away from yet another disappointing fixed income statement. Put it down. Take a break. When you come back, the assumption is easy to spot: interest rate risk somehow became your default investment - a single, dominant return driver that hasn’t produced for a long time now, and isn’t poised to.
It becomes fairly obvious that investments like investment grade credit and secured mortgages - differentiated return drivers - can improve the portfolio’s risk metrics and return expectations.
Problem solved.
What you actually own
The FTSE Canada Universe Bond Index is Canada’s main bond benchmark. It tracks investment-grade, Canadian-dollar bonds from two sources: government (federal, provincial, municipal) and corporations. Government bonds make up about 75% of the index. Bonds need a minimum issue size of $100 million and pay fixed, semi-annual coupons. Every bond that meets the index guidelines is included, with no judgment about whether it is attractive. Its inclusion and weighting are mechanical.
The same mechanical dynamic is playing out in the bigger, adjacent US market. Investment-grade bonds tied to AI infrastructure - the hyperscalers building the data centers - went from under 2% of total issuance in 2024 to nearly 8% in 2025. In July 2026 alone, hyperscaler-related deals made up almost a quarter of all US investment-grade supply. Passive funds don't get a choice. If a bond meets the index rules, it's bought - however concentrated it may be. It's not yet the overarching theme that it is in the equity market. But as a share of new issuance, it's moving quickly in that direction. It may be the single largest factor driving credit markets today.
The vast majority of bond funds closely track the index - owning all the securities in the broad index, or essentially the same exposure delivered somewhat more efficiently. They often state an intention to deliver the index return plus 50-100 basis points, achieved through small overweights or underweights around the edges.
Most index and index-like managers would be quite happy to return -1.5% if the index lost 2.5%. Their relative performance and variable compensation rely on that modest outperformance, whether the return is positive or negative.
Some managers openly call themselves index-like. For the rest, the month-to-month and year-to-year track record will show if they are too.
That matters because an index fund, including many of the popular Canadian bond funds and the bank funds, leaves you with the same rate-dominant problem that has underperformed. Switching from one to another doesn’t solve anything.
Why that’s a problem
When you go into a shoe store, you ignore the shoes that don’t fit and the ugly ones. In the produce aisle, you don’t buy everything - you pick what looks good today and leave out what’s rotten or overpriced.
If you don’t have a sharp fashion sense, or you’re no cook, you still don’t buy everything. So why would you, or your advisor, do that with your fixed income allocation? Not understanding the nuances of fixed income is no better a reason to buy all of it than it is anywhere else in your life.
Returns for the index, and the funds that track it, have been poor for a long time. That captures an enormous amount of the money sitting in “fixed income” today, and the outlook isn’t much better.
Why interest rate risk stopped working
The performance of the index, and the funds that replicate it, is dominated by interest rate risk. For decades, that risk came with an extraordinary tailwind: high starting yields followed by a long, almost uninterrupted decline in interest rates. That tailwind is gone.
In the 1980s and 90s, bond yields were into the double digits. That income was a large cushion. Even when rates moved against a portfolio, coupon payments were big enough to absorb the hit and still deliver a positive return most years. Interest rate risk was there the whole time - the high income just covered it up.
Today, Canadian bond yields sit around 3-3.75%. That’s higher than the 2020-21 lows near 1-1.5%, but nowhere close to the historical norm. The cushion is thin. A rate move that used to get absorbed by coupon income now immediately impacts your return. 2022 is recent proof. The broad bond index had one of its worst years on record, almost entirely because rates spiked. Coupon income wasn’t close to enough to cover the loss.
Why bonds are supposed to help
Every portfolio likely needs some exposure to interest rates - often called duration risk. In the right circumstances, duration can provide return, and it can appreciate to offset falling stock prices. That is the textbook case for holding bonds.
But that “right circumstances” part matters more than it used to. The hedge works best when the central bank has room, and reason, to cut rates - which is what happened in 2008 and 2020. Today the Bank of Canada’s overnight rate is 2.25%, with the bank itself flagging that inflation expectations remain elevated. There’s less room to cut than in past cycles, and less appetite to cut fast while inflation is still a concern. If the next downturn happens while inflation is still sticky, stocks and bonds can fall together - the pattern we saw in 2022.
The real problem
Interest rate risk is too often mistaken as synonymous with fixed income, when it’s only one - albeit important - risk factor. Fixed income returns can come from several sources. Interest rates are one. Credit spreads - the additional yield paid by companies over government bonds - are another. Mortgages and asset-backed securities add still different sources of income. They don’t behave the same, and that’s the point.
Today you can limit your duration risk the way you choose your shoes or your lettuce. You substitute comfortable, attractive footwear and in-season corn - in the form of investment grade credit, mortgages and asset-backed securities - to round out your sources of return and limit the duration risk that hasn’t produced - and doesn’t look poised to.
For example, some investment grade credit funds now carry little to no interest rate risk at all - a natural complement or substitute for a traditional bond fund.
Once upon a time, and sadly still too often today, we were led to duration risk that was called broad fixed income, presented as the go-to solution. The broad fixed income premise still stands. But we now know to be careful to include much more than duration risk alone. The good news: newer fixed income solutions have developed, including many with long enough track records to analyze and gain real comfort in.
Not all fixed income is created equal, and it’s no longer a check-box exercise. Ignorance is also no longer an excuse, since the coverage of the space and the product offerings have outgrown that.
Conscientiously, perhaps with an advisor, select the distinct sources of income and protection that an optimized fixed income allocation requires. That likely includes the interest rate exposure of your choosing, but now you know that that’s just one of the steps.
Put the statement down, take the break, come back and look again. Find the right fit. Avoid the rotten lettuce. The assumption you were relying on wasn’t diversified fixed income, it was misplaced duration risk. The solution isn’t to ignore or abandon fixed income. It’s an opportunity to build it properly.
Kevin Foley is Managing Director, Institutional Accounts at YTM Capital, a Canadian asset manager specializing in credit and mortgage funds. He spent two decades trading and managing fixed income at a major Canadian bank and serves on several Canadian foundation boards and investment [email protected]
