If you look at the Bank of Canada’s policy rate over the past couple of years, the direction has been clear. The first 25 basis point, or 0.25%, cut came on September 4, 2024, bringing the rate down to 4.25%. That was followed by a series of additional 0.50% and 0.25% cuts.
After a brief pause from April to July 2025, easing resumed again in September and October 2025, eventually pushing the policy rate down to 2.25%. Since then, the Bank has held steady, including pauses in December 2025 and again in early 2026.
But zoom out, and the broader trend is unmistakable. Rates have moved materially lower from their peak. If you’re a homeowner with a variable-rate mortgage, that likely feels like relief. Lower borrowing costs mean smaller interest payments.
If you’re an investor, though, you might be wondering how to reposition your portfolio. My answer is simple. Don’t. Interest rates go up. Interest rates go down. Economies expand. Economies contract. Inflation rises and falls.
If you’re building a diversified, long-term portfolio, these cycles are part of the process. Trying to tactically trade every policy shift often creates more harm than benefit.
That said, for more active investors, falling rates do have implications. In particular, they affect fixed income exchange-traded funds (ETFs) in different ways depending on what those ETFs actually hold. Here’s how I think about it.
Potential winners from a rate-cutting cycle
One ETF that may see tailwinds during a rate-cutting cycle is the BMO Long Federal Bond Index ETF (TSX:ZFL).
This fund tracks an index of Government of Canada bonds with maturities of 10 years or longer. While that sounds straightforward, the key number to focus on is duration. ZFL currently has a weighted average duration of about 16.9 years.
Duration measures how sensitive a bond portfolio is to changes in interest rates. The higher the duration, the more the price will move when rates change.
When interest rates rise, newly issued bonds come to market with higher coupons. Older bonds that were issued at lower rates become less attractive by comparison. In order to compete, their prices must fall so that their yield, which is the coupon divided by the bond’s market price, adjusts upward to match prevailing rates.
When interest rates fall, older bonds with higher coupons become more valuable. Investors bid up their prices because their fixed payments now look attractive relative to newly issued bonds at lower rates. The longer the duration, the more pronounced this price movement tends to be.
You can see this clearly in ZFL’s history. In 2022, when rates rose rapidly in response to post-pandemic inflation, ZFL fell 24.1% in a single calendar year. But if the Bank of Canada continues cutting to support a slowing economy, the opposite dynamic could play out.
Potential losers from a rate-cutting cycle
On the flip side, some ETFs become less attractive as rates fall. A good example is the BMO Money Market Fund (TSX:ZMMK).
ZMMK holds very short-term, high-quality fixed income instruments. These include treasury bills, bankers’ acceptances, and commercial paper, all with maturities under 365 days and an average maturity of less than 90 days.
This structure makes ZMMK a popular option for parking cash while earning some yield, without locking funds into a guaranteed investment certificate (GIC). It is not insured like a GIC, but its price tends to be very stable compared to traditional bond ETFs.
The trade-off is that its yield closely tracks the prevailing short-term interest rate environment. Money market ETFs typically yield around the Bank of Canada’s policy rate, sometimes slightly higher due to exposure to high-quality corporate paper.
When the policy rate was above 4%, ZMMK’s yield was over 4% as well. Today, it is posting an annualized distribution yield of about 2.4%. If rate cuts continue, that yield will likely fall further.
As a result, some investors may rotate out of money market ETFs and into higher-yielding assets such as dividend stocks or real estate investment trusts in search of income.
