Why short-term bonds outshine cash in a falling rate environment

This article was produced in partnership with Franklin Templeton.

For years, longer-duration bonds were the go-to choice when rate cuts loomed on the horizon. The idea was simple: falling rates meant rising prices for long-term bonds, offering big gains. But in 2024, that playbook isn’t delivering the same results.

This time, the story is different. Short-term bonds are emerging as the unexpected winners, offering investors compelling yields with far less risk. With the Canadian yield curve still inverted, the traditional assumptions about bond performance are being turned on their heads.

“Many investors are surprised by how much value short-term bonds are offering right now,” says Alex Lee, Head of Canada ETF Product Strategy Franklin Templeton Canada, “It’s a clear example of why we can’t rely on old assumptions about the bond market term anymore.”

Sitting on cash, it’s tempting to stay put, waiting for clearer signals from the market. But waiting has its cost, cash sitting idle might miss out on opportunities to deliver stronger returns.

Short- and ultra-short-term bonds, offer an attractive middle ground—better returns than cash, without the long-term risk of traditional bonds. Franklin Canadian Ultra Short Term Bond Fund (FHIS) and the Franklin Canadian Short Term Bond Fund (FLSD) have already demonstrated their value in 2024.[1]

“Short-term bonds may be a first step for transitioning out of cash,” Lee explains. “With rates projected to fall, these instruments offer strong potential for total returns while keeping risk in check.”

Launched in September 2022, FHIS has been providing quiet stability, low volatility, and consistent returns. FHIS combines a short duration of less than one year with an attractive yield of 3.9%[2] (as of November 30, 2024). This balance gives potential to sidestep the big risks of rate movements while still outperforming its benchmark, the FTSE Canada 0-1 Year Universe Overall Bond Index.[3]

The barbell strategy: Stability meets opportunity

“FHIS is a great option for investors who want to put their cash to work without exposing themselves to significant interest rate risk,” says Lee. “It’s designed to deliver returns with minimal volatility, which is critical in this market.”

If FHIS is the cautious step out of cash, FLSD is its bolder sibling, designed for investors who want to address reinvestment risk as rates decline. 2022 was a brutal year for bond investors, and FLSD didn’t escape unscathed— Franklin Canadian Short Term Bond Fund recorded its first negative calendar-year return since its inception in 2003.[4] But that storm has passed, and FLSD is now well positioned for today’s environment.

With a yield of 4.2%[5] and an effective duration of just 3.0 years (as of November 30, 2024), FLSD offers more upside potential than ultra-short-term options like FHIS while avoiding the pitfalls of the broader bond universe, which comes with longer durations and lower yields.

“FLSD is about finding the balance,” says Lee. “It offers investors a way to capture higher yields without taking on the reinvestment risks that come with a steep drop in rates. I believe it’s a smart move in this environment.”

For those with long-term goals, there’s a way to have the best of both worlds. By pairing FHIS with the Franklin Canadian Core Plus Bond Fund (FLCP), investors can create a barbell strategy that balances immediate stability with longer-term growth potential. FHIS acts as the anchor, delivering consistent, low-risk returns. FLCP provides exposure to longer-term opportunities, with a competitive yield that outpaces the broader bond universe.[6]

“This combination is about flexibility,” Lee points out. “With FHIS offering short-term stability and FLCP capturing long-term opportunities, investors can create a portfolio that’s ready for whatever comes next.”

The bond market has been anything but predictable over the past two years. Rate hikes in 2022 left even seasoned investors scrambling, but today’s environment offers a chance to turn the page. Short-term bonds, once overlooked, are now proving their worth.

For investors looking to move out of cash, FHIS and FLSD provide compelling solutions to grow returns without taking on a lot of duration risk. And for those thinking beyond the short term, strategies like the barbell approach can open up new opportunities for both stability and growth.

“The bond market has changed dramatically since 2022,” says Lee. “The key now is to stay flexible and focus on segments that deliver both value and resilience. Short-term bonds are leading the way, and smart investors are taking notice.”

_{Important Legal Information}

_{This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.}

_{Commissions, management fees, brokerage fees and expenses may be associated with investments in ETFs. Please read the prospectus and ETF facts before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses, and other factors. Indicated rates of return are historical annual compounded total returns for the period indicated, including changes in unit value and reinvestment distributions, and do not take into account any charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.}

_{Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.}