BMO ZAG: A Steady Hand in the Fixed-Income Core Amid Rate Uncertainty

The BMO Aggregate Bond ETF (ZAG.TO) has long been a staple in Canadian investors' portfolios, offering broad exposure to the domestic bond market through its passive replication of the FTSE Canada Universe Bond Index. As central banks globally navigate shifting interest rate expectations, the question arises: Is ZAG still a reliable core holding for fixed-income investors? Let's dissect its composition, risks, and performance to find out.

Portfolio Construction: A Government-Focused Core

ZAG's portfolio is overwhelmingly tilted toward Canadian government bonds (75.18% as of March 2025), with a smaller slice allocated to Canadian corporate debt (23.92%). This allocation aligns with its mandate to mirror the FTSE index, which emphasizes investment-grade, liquid securities. The fund's geographic focus—99.9% of assets in North America—limits currency risk but also geographic diversification.

The ETF's average duration of 6.1 years as of June 2025 underscores its sensitivity to interest rate shifts. Duration measures how much a bond's price will change given a shift in rates. A 1% increase in rates would, all else equal, reduce the ETF's net asset value (NAV) by approximately 6.1%. While this exposure can amplify losses in rising-rate environments, it also positions ZAG to outperform in periods of declining rates or stable yields.

Cost Efficiency and Performance: A Low-Friction Option

With a management expense ratio (MER) of just 0.09%, ZAG is one of Canada's cheapest broad bond ETFs. This low cost advantage is critical for core holdings, where compounding fees can erode returns over time.

Historical performance reveals ZAG's stability and vulnerability:
- 2024 was a tough year, with a -11.6% return as higher rates punished long-duration bonds.
- Early 2025 saw a rebound, gaining 6.4% through April as rate hike expectations eased.
- Over the past decade, it delivered a 4.54% annualized return, slightly trailing its Bloomberg Global Aggregate CAD Hedged benchmark but outperforming peers like the iShares Core Canadian Universe Bond ETF (XBB.TO).

Interest Rate Risk: Navigating the Uncertain Landscape

The Bank of Canada's pause on rate hikes since early 2024 has fueled speculation about whether rates will rise again or decline. For ZAG, this uncertainty is both a risk and an opportunity.

Key Considerations:
1. Duration Management:
ZAG's 6.1-year duration is moderate for an aggregate bond fund, but investors seeking shorter-term exposure might look to alternatives like the iShares 1-5 Year Laddered Bond ETF (XLB.TO), which has a duration of ~2.5 years.

1. Yield Environment:
   ZAG's dividend yield—while not explicitly disclosed in recent reports—is likely anchored to the prevailing short-term rates. Quarterly distributions of $0.04/unit (as of June 2025) suggest a trailing yield around 1.6% based on its current price. This is modest but stable, reflecting the low-yield environment for government bonds.

2. Inflation and Policy Shifts:
   The ETF's heavy government bond weighting insulates it from credit risk but exposes it to inflation-linked policy decisions. If the Bank of Canada cuts rates to combat a slowdown, ZAG could rally. Conversely, an unexpected rate hike could cause short-term pain.

Investment Thesis: A Core Holding, With Caveats

ZAG remains a strong core fixed-income option for Canadian investors due to its diversification, low cost, and broad market coverage. Its government-bond focus aligns with the safety-seeking mindset of many investors, and its inclusion in “lazy portfolios” (e.g., balanced equity/bond allocations) speaks to its reliability.

However, its duration risk demands attention. Investors should:
- Pair it with shorter-term bonds to mitigate rate sensitivity.
- Monitor rate expectations: If the market begins pricing in cuts, ZAG could shine.
- Consider inflation-protected securities (e.g., the iShares Canadian Real Return Bond ETF XRB.TO) for added protection against rising prices.

Final Verdict

ZAG is not a perfect solution for every fixed-income investor, but its role as a low-cost, broadly diversified bond fund remains intact. For those willing to accept moderate duration risk in exchange for stability and broad exposure, ZAG remains a solid core holding. Just be sure to pair it with other strategies to hedge against the inevitable twists and turns of the rate cycle.