The Fixed Income Conundrum
Q2 | June 2018
June 29, 2018
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The Fixed Income Conundrum
Q2 | June 2018
Bond holdings have been a key component of Canadian investors’ portfolios for generations. Historically, bonds provided a steady and useful stream of income. In fact, through the 1980s, with interest rates well above 10%, bonds provided an income stream that seems lavish in hindsight.
However, since their peak in 1982, interest rates have been on a steady and unrelenting decline. More specifically, in September 1982 the yield on the 10-year Government of Canada bond touched 17%. Today, it yields 2.15% – before tax and inflation. The idea that bonds provide a useful source of income now seems an historic curiosity.
Another key attribute is safety – a bond represents a promise or contract by the issuing company to pay back your principal at maturity and to pay you a set rate of interest along the way. It typically is backed by a senior claim on the assets of the issuer. Because of this, a bond’s market value is not likely to fluctuate nearly as much as the same company’s stock. But along with the assurance of safety is the fact that there is no upside. Today’s remarkably low yields guarantee a low return in the future.
Those who follow Nexus’s many writings on this topic will know that we have been predicting the end of the bond bull market for many years. Yet, despite our prediction for higher interest rates, rates have remained frustratingly low. Bond returns have been good … until now, when suddenly they aren’t. A growing number of clients have noticed, and remarked on the fact, that returns on this safe and reliable asset class have turned negative. For the 12 months ended May 31, 2018 the FTSE TSX Universe Bond Index, the principal bond market index in Canada, provided a total return of -1.0%. (2) For the three years ended May 31, it provided a measly return of +1.6% per year. This has caused a number of investors to ask the reasonable question, why should I own bonds at all?
One response to this dilemma is to reduce one’s allocation to bonds and increase the allocation to stocks. Given the low expectation that Nexus and many others have for bond returns going forward, this is a tempting proposition. Without doubt, it is reasonable to expect stocks to provide a far superior return to bonds over the next 10 and 20 years. But, given the nature of bonds and stocks, this has always been the case.
Undoubtedly, some investors can sensibly increase their allocation to stocks and accept the greater volatility in their portfolio that comes with that. Many, however, cannot. Income requirements often demand more stability in a portfolio – the worst thing that can happen is to be selling stocks to pay the rent just after the market has tumbled. It may also be that an investor’s psyche (and stomach) is not strong enough to watch their portfolio lurch higher or lower from month-to-month. The luxury of a high equity weighting is suitable for a relative few.
For those that don’t have the luxury of choosing a high equity weighting, bonds may be a necessary evil. They continue to offer a critical attribute: safety and stability. A well-used (perhaps over-used) expression at Nexus is that they provide ballast in the boat as the equities in a portfolio bob up and down on choppy seas.
With the negative return over the last year, however, and the possibility of further negative returns as interest rates drift higher, can this be logical? How can we say that something with a negative return is useful for many investors? Part of the answer is the fact that the apparent negative return provides only the illusion of a loss. All bonds that we would purchase have a positive yield-to-maturity, and this is the return that an investor will earn if he or she owns it to maturity. The illusion of loss arises because the market price of existing bonds fluctuates. Recently, prices have moved lower as the general level of interest rates moved higher. A bond held to maturity will provide the return promised at purchase regardless of market prices along the way. It will be low, but positive.
A few investors have turned to alternative investment strategies as an antidote to the low return expectations for bonds. Strategies such as distressed credit funds, commercial mortgages, and levered long-short bond funds promise higher returns that are less tied to the predicted rise in interest rates. Unfortunately, these strategies are no panacea – they typically are much riskier and demand higher fees. They also are much less liquid than a traditional bond portfolio.
A more common alternative to bonds are GICs, or other savings products. One does not need to worry about the ebb and flow of bond prices since GICs are fixed contracts. And because there is no explicit commission or fee attached they may seem like an intelligent option. Indeed, for some, this may be a sensible approach. However, bonds have some considerable advantages over GICs.
As is the case with alternative credit strategies, GICs have considerably less liquidity than bonds. They often require tying your funds up for a fixed period of time in order to get a good rate. Should a need for cash arise, or should a great investment opportunity present itself, you may be out of luck. The only option is to wait until maturity. Bonds, such as those Nexus owns, can be sold almost instantaneously, and at almost no cost.
The more important reason to embrace bonds is more subtle. Bonds typically are negatively correlated with stocks. In layman’s terms, this means they often go up when stocks go down. Conceptually, the reason for this is straight forward: during a crisis, investors dump stocks and run to the safe stuff, which they bid up in price with the extra demand. So while a GIC provides stability in a portfolio by staying constant, bonds can be even better. They can actually increase in value when it is most needed – when stocks are in a swoon. They represent an attractive insurance policy.
The dynamic of negative correlation also answers a question asked by a few clients: “If you think interest rates are going modestly higher, why own bonds with maturities greater than one or two years?” The answer is that to take advantage of the negative correlation you need to have bonds with at least some “duration”. (3) Our goal is to try and balance the risk that comes from long-dated bonds with the usefulness that duration provides as insurance. This is an art, not a science. Our bond portfolios are considerably shorter than the principal Canadian bond index, but longer than some might expect, in order for us to have a little bit of “duration insurance.”
Our conclusion, therefore, is that bonds remain an important component in most Nexus client portfolios. Moreover, it’s also important to remember that we actually want higher interest rates. The unusually low rates that have been in place for years are bad for savers, who can’t earn enough to support themselves in retirement, and bad for society should borrowers act in economically dubious ways as the result of an artificially low cost of capital. The road to more normal rates will be bumpy, but it will be better for us all in the end.
Thankfully, the normalization process is underway. Since trading at 0.95% in September 2016, the 10-year Government of Canada bond has risen 120 basis points to its current level of 2.15%. We expect the trend to continue. But with our short duration portfolio, the pressure on capital values will be manageable and our maturing holdings and collected interest payments can be re-invested at progressively higher rates. All the while, these bonds will provide the ballast in the boat so crucial for most investment portfolios.
(1) Source: Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis.
(2) In other words, the modest interest payment was exceeded by the decline in price.
(3) Mathematically, a bond’s duration is the weighted average length of time over which an investor receives cash flows – both the interest payments and the final principal repayment. The longer the duration the more sensitive a bond’s value is to changes in interest rates.