A friend of mine manages a few billion dollars of bonds in his day job as the chief investment officer of a financial services firm, but doesn't own a single bond of any type in his personal portfolio. He considers fixed-income investing to be a mug's game in today's environment of ultralow – and sometimes negative -- interest rates.
So should you follow in his footsteps and (with apologies to poets everywhere) slip the surly bonds of, um, bonds? It's a contentious issue right now. Financial planners, as well as some colleagues of mine, will tell you that a hefty helping of bonds is a vital cushion against possible stock market catastrophe. The point, they say, isn't to make money from bonds but to ensure that your wealth won't be devastated if stocks plunge.
Their argument possesses a certain logic, but then so does the macro evidence that we're now in a period of low, low rates that may last a long while. The danger – at least to my eye – has been that people with large exposure to the bond market in non-tax-protected accounts may suffer through several years of returns that won't keep pace with inflation. It's difficult to predict if the slow erosion of their buying power will be any worse than the damage inflicted by an abrupt stock market fall.
I was fascinated therefore to see a fresh paper from three British researchers that argues strongly against the notion of a fixed-income buffer for reasons very different than my own. The title of their piece – "Why it doesn't make sense to hold bonds" – sums up the authors' take on the issue.
Balazs Csullag and Jon Danielsson of the Systemic Risk Centre at the London School of Economics and Robert Macrae, an independent money manager, write that a crisis in bonds is now far more likely than most investors recognize. "Under almost any likely inflation scenario, including central banks merely hitting their target inflation rates, bondholders suffer large losses," they say.
Bonds have been a fantastic investment since 1982, they acknowledge. But that's because of a couple of hard-to-repeat factors – falling inflation in the decades after 1982, and very, very high bond yields back in the early 1980s. The combination created huge returns for bond investors in the 1990s and onwards, as falling inflation and plunging interest rates made earlier, higher-yielding bonds more attractive.
Today's situation could not be more different. Inflation has already been hammered to the ground, while bond yields are comically low. The combination of low inflation and low yields makes bonds a risky investment if either inflation or rates head upward.
Investors who buy long-dated bonds today could suffer a fate similar to the people who purchased 30-year U.S. government bonds in 1945 and held them to maturity. Those loyal bond buyers lost 49 per cent of their purchasing power, according to the researchers. This was not a unique situation, they add. Buyers of the long U.S. bond lost up to 45 per cent between 1975 and 1982.
Mr. Csullag, Mr. Danielsson and Mr. Macrae don't believe that low interest rates are here to stay. They say inflation, and interest rates, are likely to start moving up, maybe not right away, but at some point in the coming years. Bond investors will feel the pain because bond prices move in the opposite direction to rates. This inverse relationship is particularly strong in the case of long-dated bonds that mature decades in the future.
"Perhaps bond investors clearly understand these dangers and are set to sell bonds in vast quantities at the first whiff of higher inflation," they write. "In that case, we should anticipate a very large bond crash, so large that it potentially exceeds anything we have seen over the past few decades."
Their paper makes scary reading. It reminds us that even supposedly secure assets like bonds can hide large risks. One practical take away? If you do want to buy bonds in this environment, stick to ones that mature sooner rather than later.
Three big numbers to note
7.5% Rise per share in S&P 500 dividends in the year through April 30, according to the Wall Street Journal.
23.8% Probability of the Bank of Canada cutting interest rates by October, according to overnight index swaps. That compares to a 7.3 per cent probability seen as of June 23.
-16.9% The three-day decline in Intertain Group. - the top decliner in the TSX composite since the Brexit vote. The company faces concerns about its efforts to be acquired and relocate to the U.K.
Frederic Bastien, an analyst from Raymond James who covers industrial securities, joined our Jennifer Dowty in a live chat about his top stock picks. He notes that given the recent market selloff, all commercial real estate companies, including Colliers, are presently trading at steep discounts to their historical trading ranges. He also believes investors will do well owning Canam, Brookfield Infrastructure and SNC-Lavalin. Read the full archive here.
How markets got Brexit so wrong
It's not just how wildly the markets were off in the runup to the Brexit referendum. It's why that matters heading into the U.S. presidential election. JPMorgan Chase & Co. has taken an interesting look at how investors may have misjudged the "anti-establishment" sentiment before the surprising results of the referendum last Thursday, when voters shocked the markets in deciding that Britain should bolt from the European Union.
A new report from CIBC World Markets has detailed the top 20 S&P/TSX composite index stocks with the most exposure to the British pound. Concordia Heathcare tops the eclectic list.
The Italian connection
The S&P/TSX composite is well-positioned to weather the European storm with gold prices rising quickly and oil prices stable, despite a strengthening U.S. dollar. If there's going to be a problem for Canadian investors, it will be bank stocks. Scott Barlow explains why we have the Italians to thank for that.
A different type of safe
Amid the fallout from the British referendum, Europe's largest asset manager pointed to Brazil and Russia for buying opportunities as political chaos has eroded traditional views on safe havens for investors.
Flight to safety
Profitable companies with stable earnings and lower price volatility will likely be in high demand given the turbulence from the Brexit vote. Craig McGee finds 20 Canadian stocks that fit the bill.
"Little more than a sideshow"
HSBC Holdings Plc's head of fixed-income research said investors shouldn't be concerned with the results of the UK vote or even the possibility of a Donald Trump presidency. Instead, a prolonged period of low and negative rates will haunt.
Gordon Pape examines four factors which will likely to keep the U.S. Federal Resource Board from hiking rates this year. He said the impact of that stability will be important for your income investments.
Simplicity is key
In his "Me and my money" feature, Larry McDonald profiles a veteran investor and popular blogger who says he's comfortable with the fluctuations of the market.
Cash now, gold later
Investors who like precious metals, but hate the grimy, risky business of actually digging them up, are turning to an alternative source: streaming companies. If precious metals prices go up, streamers will do exceptionally well. But there are downsides too, writes our Ian McGugan.
What's up in the days ahead
Tim Kiladze will take a look at an uncomfortable question for frightened Canadian investors: Can the wicked rally in defensive stocks such as utilities, telcos and consumer staples, really last? For those investors looking to boost their international exposure without leaving Canada's borders, Ryan Modesto of 5i Research takes a look at four stocks that accomplish exactly that. Meanwhile, Jennifer Dowty outlines the investment case for Chorus Aviation.
And we'll be firing up the barbecue ourselves on Friday in celebration of Canada's birthday. So no newsletter to end off the week, but we'll be back Tuesday with more stock tips and insight to help you navigate the investing world.
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Compiled by Darcy Keith and David Leeder