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The changing bond market

The bond party is ending and may not return for many decades.

After enduring the inflationary 1970s, the worst single decade in the last hundred years, bond prices — what people will pay for a buck of interest — rose nearly every year from 1982 to 2012. That’s a 30-year run, about the longest in the last two hundred years. Investors who held strip bonds in that three decade period were able to increase their stake by as much as 500 per cent.

There was zero risk of default in federal bonds. The only risk was a sustained rise in interest rates. It did not happen for three decades.

Changing market

The risk of rising interest rates is at hand. The end of U.S. quantitative easing is in view.

If real interest rates that have been held down since 2008 by the U.S. Federal Reserve Board and the Bank of Canada playing follow the leader start to rise and gain perhaps three per cent, then on top of the Bank of Canada target inflation rate of two per cent, the real return would go up to five per cent.

Real yields have been negative for years. The implication is that existing bond prices would fall until their trifling interest coupons divided by market price equals five per cent.

It will be a bloodbath for anyone holding bonds with terms to maturity of seven years or longer.

Bond investments through bond mutual funds got to be hugely popular in the last decade. Stock market returns ossified and bonds, thrived.

Ordinary investors made heaps of money in short dated bonds in 2008 and 2009 as short rates collapsed. Then in 2011 it was longer government bonds that thrived. In 2012 corporate bonds took off turning in a return about three times the 2.1 per cent return of the broad Canadian bond market index, the DEX.

There were a lot of bond market casualties along the way. Life insurance companies’ share prices tumbled as Manulife Financial and Sun Life Financial charged less than expected bond interest against corporate earnings. Seeing their bond returns crumble, big insurance companies sold bonds into the market, further driving down their prices.

The smart guys who were not insurance companies bought and made handsome profits as rates continued to fall. That insurance companies sold at exactly the wrong moment was the result of their accounting, which looked mainly at falling interest rates and not at total bond returns of interest plus price, and partly because management suffered from interest rate myopia. They did not see what the future held.

The future

We can use a little perspective on what the Fed and the Bank of Canada have in store. When monetary policy was tightened in several episodes from 1981 to 2009, real average yields on 30-year government bonds rose 2.5 per cent. This will be a modest recovery, so bond research and management companies like Canso Investment Counsel Ltd. of Richmond Hill, Ontario figure the gain will be just one to two per cent.

The current yield of the DEX index, 1.6 per cent less the average management fee on Canadian bond mutual funds, 1.8 per cent, implies a negative real yield of 0.2 per cent.

Corporate investment grade bonds will do better and, Canso notes, still at levels comparable to levels following the 1981 interest-rate induced recession, the 1992 real estate crisis, the 1998 Long-Term Capital Management Crisis, and the post-2000 dot com collapse.

Just as stock investors rushed to bonds as equity markets froze in the last 10 years, the same investors are going to be looking to flee bonds when the end of quantitative easing happens. However, that process is already underway. The Fed has said it has stopped trying to drop long interest rates. As the recovery speeds up, the demand for loanable funds and anxiety over rising inflation will push up interest rates.

The market will speak and staying in government bonds as rates rise will be like trying to stop a freight train with a feather.

Abandoning bonds

Should one go forth and abandon bonds altogether? Not at all.

Though U.S. and Canada federal bonds are likely to be losers for the next year, there is still a strong case to be made for holding global bonds hedged to the Canadian dollar, Canadian investment grade corporate bonds, and even a dusting of high yield U.S. bonds.

The central banks of Canada and the U.S. will be raising interest rates within 12 to 18 months and capital markets will anticipate the moves well before. That case is clear.

But other countries are still dropping their interest rates. So a position in global bond mutual funds or global emerging markets bond exchange traded funds makes sense. I’d suggest not too heavy a weighting — say 10 per cent at most in these critters.

Buying corporate bonds is a complex task involving credit analysis and reading bond covenants. Bond fund managers can do it or a couple of corporate bond exchange traded funds will provide exposure with low fees.

Finally, high yield bonds, though equity-like in their dependence on corporate earnings growth, still offer a yield premium over investment grade bonds. The spreads on these things are approaching relatively low levels, so it’s best not to have more than 10 per cent of a bond portfolio in them.

Bonds remain portfolio stabilizers and investors are wise to keep a position in bonds for the times that stocks sag. The boom and bust cycle of stocks and bonds may be rotating in favour of a stock boom or, at least, a boomlet. For the down periods, a bond portfolio weighted with high grade corporate bonds in A to BBB+ space with maturities of no more than 10 years will provide safe harbours in stormy seas. †

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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