Here’s a switch: The bond market is a bigger worry than the stock market right now.
We all understand that stocks are volatile, but we’ve lost perspective on bonds after a 30-year bull market. Now, the bond market is acting up. Two-and-a-half months of sharp volatility have reminded investors that their bond holdings are not immune from losses.
For some perspective on how to manage bonds and bond funds in current market conditions, let’s check in with James Price, director of fixed income at Macquarie Private Wealth. Here’s an edited transcript of a conversation we had this week.
What guidance do you have for investors in deciding how much of their portfolios to have in bonds?
One factor is how conservative investors are in their portfolios, which is usually a function of their age. Another factor that is largely ignored is the level of the bond market, or how expensive the bond market is on a risk-return basis. Bond geeks such as myself talk about duration all the time and duration is quite simply the price sensitivity to a change in interest rates.
What is duration telling us?
We’re at levels right now that are historically high, though not as high as two months ago. There’s more risk priced into the bond market than there has been for decades.
How vulnerable are investors to duration risk or, in other words, to rising interest rates?
When I’m looking at retail client portfolios, I find people are taking more duration risk than they think they’re taking.
Just to be clear about the furor in the bond market – the risk is that bonds will fall in price, not that they will default on interest payments or repayment of capital on maturity.
We’re talking about losing capital as a result of your bonds dropping in price.
Widely held bond funds are down from 1.5 to 2 per cent year to date. Is it possible we could see losses for the year in the high single digits?
Yes. If we get back to that duration measure, a 10-year Government of Canada bond has a duration around nine and change, which suggests that with a 1-per-cent hike in yields, you’re going to lose 9 per cent of the value of your bond. The benchmark for bonds [the DEX Universe Bond Index] – has a duration around six.
So what’s the maximum duration you should have in your portfolio?
I don’t like being longer than the benchmark on average.
Can you translate your view on bonds into some suggestions for investors?
I view this bond correction as long overdue, but we’re of the view that rates are not going to spiral higher any time soon. So right now, we’re telling people to sit tight. Certainly, don’t panic and start selling off here. A lot of times we’re looking too hard for an answer – do we need to sell something, do we need to buy something? A lot of times, doing nothing is the right answer.
What if I have new money to put into bonds?
We’re still being relatively conservative in that we don’t want to take too much interest-rate risk and buy “long” bonds [with maturities far in the future]. What we’re actually telling people to do is take increased credit risk rather than interest-rate risk.
That suggests using corporate bonds instead of government bonds. How much extra risk is there in that?
What we’re seeing in the corporate world right now are balance sheets that are in very good shape. Corporations are healthy, profitability is quite good. In those situations, defaults tend to be very low.
What’s the better way for someone with a portfolio of $100,000 or more to own bonds – individually or through funds?
I’ve always been a proponent of owning bonds specifically, and most of that is fee driven. Bond fund managers have had a tailwind at their backs for 30 years, so they have been posting good returns. But a lot of times, those good return numbers are masking fees we shouldn’t be paying in a world where the benchmark index pays you 2.5 per cent.
Bond exchange-traded funds have comparatively low fees and they’ve been hugely popular lately – what’s your view on them?
I think they’re great for small clients – portfolios of less than $100,000. ETFs offer great liquidity, you get great pricing and you get low fees, all of which are big bonuses in the bond world. What you give up is a defined maturity date, which is the fixed part of fixed income – you know, barring a default, what you’re going to get back and when you’re going to get it.
How should I divide my bond holdings between government and corporate bonds?
This comes with the caveat that every client is different. But in our main fixed income portfolio, we’re right now 80 per cent in corporate bonds and 20 per cent provincial and Government of Canada bonds. We’re very light on government bonds.
Where do high yield bonds fit in?
I’m happy with putting 25 per cent of a fixed income allocation into high yield. But when we move into the high-yield space, we view it as a hybrid of fixed income and equities. It’s a cross-over. If you’re looking at a 60-40 equity-to-bond ratio and we want to put in a quarter of the bonds in high yield, we might take 5 per cent from both the bond and the equity side.
It’s not hard to find people who say high yield bonds are over-valued today – should investors be concerned?
If we see corporate financing rates go higher, then we’re probably going to see high-yield bond yields go higher, and we don’t want to be there when it happens.
Does that mean people should be thinking about an exit strategy for high-yield bonds?
At the moment, no. That stems from our view that rates are going to stay low for a very long time.
What about emerging market bonds?
Liquidity particularly comes into play there. When money leaves emerging markets, it leaves fast. And that leaves somebody holding the bag.
What do you think about using a bond ladder (structuring your bond holdings so you have money maturing every year)?
It’s a fantastic strategy. It’s low cost, it’s simple and it generally achieves what you want to achieve, which is protection against rising rates. It’s almost like having a floating rate portfolio. But today, you’re starting off at a very high price, low yield point.
How long should the ladder be?
One to five years is a very conservative way to approach a ladder; one to 10 years would be pretty standard. At the moment, we’re actually building three- to eight-year ladders. There’s not a whole lot of yield in the one- to two-year range, so we cut those out. This is, of course, done after you interview the client and say, you’re not going to need money in the next two years, are you? We cut out the last bit of the ladder because we think the duration is a bit too long.
Investors put billions of dollars into bond funds in the past couple of years – do you think the typical portfolio has too much in bonds right now?
It’s disputable, but the rush to bonds following the equity crash in 2008 was a rebalancing out of equities and into bonds. If I had to take a guess, I’d say we’re a little bit overweight on bonds at the expense of equities.
I’ve heard from readers who say they’ve sold all their bonds. How sensible is that?
I’ll always say the balanced approach is the best way to go. To say you’re all in or all out is a little short-sighted.
If we have another global financial crisis, will money flow into government bonds as the one safe refuge?
That’s where liquidity becomes a huge issue again. Money would flow to the most liquid instrument and that would be government bonds. Another crisis hits, I’m pretty sure bond prices go higher and equities drop.
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