This year was looking good for bonds, but inflation has turned the tide.
Unless inflation backs off even further, we could very well see a third straight year of declines for bond funds. As of Friday, the benchmark FTSE Canada Universe Bond Index was down almost 2 per cent on a year-to-date basis.
Investors hold bonds for two reasons: reliable interest income and hedging against nastiness in the stock market. Stocks have slipped lately, but bonds have been worse. They’re providing diversification in reverse right now by adding extra volatility and risk.
Some quick thoughts on limiting the damage from bonds: emphasize short-term bonds and bond funds, which means maturity in five years or less; supplement with guaranteed investment certificates in cases where liquidity is not an issue; and consider high-interest savings account exchange-traded funds and investment savings accounts packaged like mutual funds. Floating-rate bond funds are also worth a look if you think rates will rise further or hold steady for a while.
One lesson of recent months is that dividend stocks are no substitute for bonds. High rates have left a long menu of blue-chip dividend payers bruised and beaten. Yields are high for these stocks, but that’s because of big price declines.
If you’re of a mind to buy low as bonds slump, you could add more money to the broadly diversified bond ETFs that account for the fixed-income portion of so many retail investor portfolios. The weighted average yield to maturity for these funds in early October was roughly 5 per cent after fees. If rates plateau and then ease off even a little, rising bond prices will combine with interest payments to produce a nice total return.
As tempting as GICs are right now, they pay the advertised rate and nothing more. You forfeit any opportunity to benefit from falling rates, although it has to be noted that you also avoid any further damage if rates rise again.
There is still ample time for bonds to rebound at least a little in 2023. But a “higher for longer” narrative on interest rates is gaining currency right now, and that’s bad for bonds and the balanced portfolios that hold them.
Rob Carrick