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After their worst showing in about 40 years, bonds have charged out of the starting gate to begin 2023. The question is, will it continue?

As of the close on Jan. 27, the FTSE Canada Universe Bond Index was showing a year-to-date gain of 3.29 per cent. That’s a big advance for a bond index in less than a month.

All classes of bonds were ahead, with long-term issues the leaders by a wide margin with the Universe Long Bond Index ahead by 5.88 per cent. Federal long-term bonds were up 6.46 per cent, an astonishing move. Long-term bonds are viewed as high risk, as they are most sensitive to interest rate moves.

Even real return bonds, which are designed to combat the effects of inflation, are showing a year-to-date gain of 2.14 per cent after a disastrous 2022. Short-term bonds are ahead 1.43 per cent.

The strong performance so far this year suggests traders believe central bank rate hikes are approaching the end and the Bank of Canada confirmed on Wednesday it is pausing to assess the situation. We’ll see what the U.S. Federal Reserve does later this week.

The key to whether this recovery will continue lies in the hands of the central banks. If both the BoC and, especially, the Fed pause to see the impact the large raises in the past year, expect the bond rally to continue. On the other hand, if inflation continues to stay high, it will push the central banks to start raising rates again. Bad news for bonds.

My feeling is the worst of the bond debacle is behind us and it’s time to begin to rebuild your fixed income positions. That doesn’t mean there is no further downside risk. But I think it’s limited, especially with recession concerns increasing. Central banks will be wary of continuing to raise rates if the economy is in decline.

The most effective way to invest in bonds is to buy carefully chosen individual issues, preferably trading below par. But you need a broker who is experienced in bond trading and charges a reasonable commission. Make sure to clarify how much you’re paying in advance.

Most retail investors use mutual funds or exchange-traded funds for the fixed-income portion of their portfolio. Here are two bond ETFs that have been recommended in the past by my Income Investor newsletter.

iShares Core Canadian Universe Bond Index ETF

  • Ticker: XBB-T
  • Current price: $28.09
  • Annual payout: 79.8 cents (trailing 12 months)
  • Yield: 2.8 per cent
  • Risk Rating: Moderate

Comments: This fund tracks the broad Canadian bond market, including government and corporate issues. So, what you’re seeing is a reflection of what is actually happening across the entire bond spectrum in this country.

The fund lost 11.78 per cent in 2022, the worst year in its history by far (it was launched in November 2000). But in the first three weeks of this year, it gained just over 4 per cent. Assets under management total $4.7 billion.

The credit quality of the portfolio is very high. Almost all the holdings are rated BBB or higher. Of that, 72 per cent are rated AA or AAA. The company assigns it a risk rating of low.

I wouldn’t go that far, given the current environment. I think you should regard this ETF as moderate risk until it’s clear that inflation is under control. That said, it’s time to start gradually rebuilding bond positions and this is a good place to begin.

iShares Core Canadian Short Term Bond Index ETF

  • Ticker: XSB-T
  • Current price: $25.94
  • Annual payout: 59.243 cents (trailing 12 months)
  • Yield: 2.3 per cent
  • Risk: Low

Comments: Short-term bond funds are normally less exposed to interest rate movements, either up or down. But these are not normal times. The yield curve is inverted, which means short-term bond yields will fall faster than long-terms yields as we revert to normal. That leads to the assumption that short term bond ETFs have a greater price gain potential than usual.

This fund lost 4.13 per cent last year, on the heels of a 1.04-per-cent loss in 2021. It’s rare to see a short-term fund lose any money, much less two years in a row. I don’t expect it to happen a third time.

This ETF has gained 1.72 per cent year-to-date. The MER is 0.1 per cent, and 99 per cent of the portfolio is rated BBB or higher.

Conservative investors should choose XSB. If you want exposure to the entire bond market, go with XBB.

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