Stocks are riskier than bonds, which is why the potential returns are much higher.
But this foundational rule of investing seems to be unravelling a bit in the age of low and falling interest rates. The S&P/TSX Composite Index averaged an annual total return of 4.1 per cent for the five years to Aug. 31, while the FTSE Canada Universe Bond Index averaged 3.95 per cent. A premium of 0.15 per cent is not much compensation for the more jagged ups and downs of owning stocks versus bonds.
Over the past 10 years, stocks did markedly outperform. The S&P/TSX Composite averaged a total return of 7.33 per cent, while the FTSE Canada Universe Bond Index made 4.56 per cent. A performance premium of 2.77 per cent seems about right for holding stocks over bonds.
The past 12 months show just the opposite, though.
The S&P/TSX Composite registered a total return of 4.35 per cent, and the FTSE Canada Universe Bond Index made 9.55 per cent.
What’s happening here offers a lesson to bond skeptics – the investors who have scoffed at the idea of holding bonds because yields are low and any increase in rates would cause capital losses on paper. If interest rates are trending lower, as they have for the most part since the financial crisis, then bonds are unusually competitive against stocks.
Remember, bonds offer a total return that combines interest and changes in bond prices. Falling interest rates mean higher bond prices and higher total returns from bonds and bond funds. Rising rates would mean capital losses for bonds. But while we’ve had fleeting moments in recent years where rates were either rising or expected to rise, there has not been a year in the past five where the FTSE Canada Universe Bond Index lost money on a total return basis. The S&P/TSX Composite has lost money twice on the same basis in the past five years – a decline of 8.9 per cent in 2018 and 8.3 per cent in 2015.
Bond yields have been volatile this year as markets assess the risk that a slow-growth global economy could lapse into recession. In this type of uncertainty, bonds may continue to be surprisingly competitive to stocks. Ignore bonds at your own risk.
Rob Carrick