A pain in the bond

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This article was published 21/05/2022 (1420 days ago), so information in it may no longer be current.

In general, it’s been hard being an investor recently.

But if you’re a conservative or balanced investor — holding a significant amount of fixed income in your investments — it’s been downright painful.

That’s because bonds—the asset class supposed to hold their value when stocks fall in value — have dropped too because inflation is running at its highest in decades.

In turn, the Bank of Canada has set out to raise its overnight rate — already hiking it 75 basis points this spring to 1 per cent.

The central bank is forecast to raise the benchmark lending rate another 150 to 200 basis points, possibly reaching three per cent within a year, according to many economists.

The trajectory is much the same for the U.S. Federal Reserve.

“This is a challenge because normally when you talk to clients about it, you have the conversation that fixed income should move opposite to equities,” says Evan Mancer, chief investment officer at Cardinal Capital Management Inc. in Winnipeg.

When a recession hits, for example, inflation often falls with a drop in economic demand, which leads to interest rates falling to boost economic activity.

If you hold bonds in your portfolio, their value increases to offset losses in your stock holdings, he adds.

“Conversely, when interest rates rise in a strong economy, that hurts bonds with their value in your portfolio falling, but stocks are “generally doing great,” Mancer says.

That’s not happening now.

Both assets are falling in value.

Of course, bull markets can’t go on forever.

While younger investors have not yet experienced an extended bear market in stocks — a 20 per cent or more retraction in prices — even fewer investors have experienced a bond bear market.

“It is difficult for people to see the worst bond returns they will have seen in their entire investment lifetime,” Steve Locke, chief investment officer for fixed income at Mackenzie Investments.

The S&P U.S. Aggregate Bond Index, which covers just about every fixed income investment traded in the U.S., was down almost eight per cent, year to date, by the end of April.

While not a 20 per cent drop, which constitutes a bear market at least for stocks, it’s still painful for an asset class that until recently yielded about one to two per cent annually.

“Lots of government bond funds are down about 11 per cent for the year,” says portfolio manager Grant White with Endeavour Wealth Management with IA Private Wealth in Winnipeg.

“And these are supposed to be the safest assets.”

Of course, it’s understandable borrowing costs must increase to fight inflation.

Or else, we face stagflation where inflation runs high amid declining economic activity.

Investors are already spooked, leading to a retreat in stock prices even though unemployment remains low and economic growth forecasts are generally positive.

More than anything, the current environment is confusing for investors, Mancer says.

“Talking about bonds can be challenging now because people will ask, ‘Rates are going up. Isn’t that a good thing for my portfolio?’”

It’s not, because the bonds you already own would be worth less if you tried to sell them in the market. The reason being: they are less attractive than similar, yet newer bonds with a higher coupon (interest payment).

In turn, these older bonds’ yields rise to adjust for their drop in value.

Conversely, when interest rates fall, bonds in your portfolio rise in value because they are worth more relative to new bonds issued with lower coupons.

In this instance, bond yields fall.

Notably, neither gains nor losses in bonds are realized unless you sell them. You can hold them to maturity. Yet in a rising rate environment, the income they generate for your portfolio may be significantly diminished by rising inflation.

All of this may be confusing. That’s one key reason to leave fixed income investing to professional managers, who have been worried about the current scenario for years.

A key strategy for them has been investing in bonds with durations (the length until bonds mature) of one to five years because shorter term bonds are less negatively affected by rising rates than long-term bonds (i.e. 10 years or more).

White adds alternative strategies also provide steady income in a rising rate environment.

“We like using market neutral funds,” he says about the strategy to provide a return whether bond and equity markets are up or down.

Other alternatives include private debt funds and even real estate funds.

“Not all income generating investments do poorly in a rising interest rate environment,” says Derek Jenkin, managing partner at Romspen Investment, a private commercial mortgage lender based in Toronto.

Romspen’s strategy, for example, is lending to commercial buildings at 10 to 12 per cent for short-term mortgages.

“We don’t have any interest rate sensitivity,” he says. “As a result, the Bank of Canada could increase rates tomorrow by 100 basis points, and we will still generate our 7.5 to 8.5 per cent yields, and our price won’t change.”

Its funds’ long-term returns average more than seven per cent — even through the pandemic, which initially crushed commercial real estate. Yet alternative funds like Romspen have high barriers to invest. You basically need a portfolio worth more than $1 million to get a seat at the table.

But it’s not all bad news for bond investors. Buying low (and eventually selling high) is not just a good idea for stock investing. It can work for bonds too, and this could be that moment as bond markets price in presumed forecast interest rate hikes.

“With this rapid adjustment in the bond market, we actually have some reasonably good yields to invest in today compared with anything we’ve seen in several years,” Locke says, adding five-year U.S. government bonds yields are nearing three per cent, and corporate bonds are even higher.

Still, more pain may come if inflation continues to climb. Then bond yields could move higher, and your fixed income holdings could fall even more.

Yet if inflation begins to fall, holding bonds may feel much better when a recession comes.

“Then the bond portion of the portfolio will play its traditional role of offsetting equity (losses),” Mancer says. “It’s not happening now, but we still think it will in the future.”