Dan Bortolotti, CFP, CIM, is a portfolio manager and financial planner at PWL Capital in Toronto. He is the author of Reboot Your Portfolio: 9 Steps to Successful Investing with ETFs.
In case you’ve missed it, we’re in a bear market for bonds. A surprising, frustrating, and confusing bear market that most investors have never experienced before.
In 2021, the FTSE Canada Universe Bond Index, a benchmark for the broad Canadian bond market, posted a loss of 2.5 per cent. A modest decline, but we were just getting started. This year is shaping up to be much worse, with the index already down over 10 per cent. To put that in context, the index’s data go back to 1980, and it has never posted an annual loss of more than 4.3 per cent (that was in 1994, when yields spiked from about 6 per cent to over 9 per cent). Even long-term bonds, which are more volatile than the overall market, have never had a calendar year with a double-digit loss in Canada, with data going back to 1948.
In this ugly bond market, investors may be tempted to dump their bonds and not look back. With higher inflation and rising interest rates on the horizon, the thinking goes, it’s just going to get worse. Maybe. But panic-selling bonds is just as short-sighted as bailing on stocks after a crash.
For investors who want to keep a balanced portfolio, here are a few ideas to consider before pulling the chute on bonds:
Bond funds are a long-term holding.
Bonds are often portrayed as short-term investments, appropriate for those who need their money in just a few years. That might be true if you’re holding an individual bond with a short maturity. But if you’re using a bond ETF or mutual fund, then you need to have a long-term focus and be prepared for volatility along the way.
Consider the BMO Aggregate Bond Index ETF, or ZAG, the largest fixed income ETF in Canada and a proxy for the overall market. Bonds in this fund have an average maturity of more than 10 years, so your investment horizon should be at least that long. ETFs like this are not suitable for providing next year’s living expenses, or saving for a down payment. For those short-term goals, cash and GICs are more appropriate investments.
More important than maturity, however, is a bond fund’s duration, which measures its sensitivity to interest rate changes. The higher the duration, the more volatile the fund. A bond fund with a duration of five years can be expected to fall in price by 5 per cent if interest rates rise by one percentage point.
ZAG and other funds like it have a duration between seven and eight years. Given that the fund’s yield has climbed from about 1.2 per cent in December, 2020, to about 3.3 per cent today, it shouldn’t be surprising that its unit price has fallen almost 16 per cent over that period.
Interest rate hikes have a silver lining.
If you’re a dividend investor, when a stock’s price declines, its yield goes up. As an investor, you probably think that’s a good thing. If you’re planning to hold the stock for the long term, you might even purchase more shares when the yield goes up.
This principle should hold true for bonds, too, but few investors ever apply that same logic. Don’t lose sight of the reason bond prices have cratered: it’s because their yields have moved much higher, and therefore, the expected return must also be higher. Rising rates cause short-term pain, but long-term gain. Think of it like this: if you were willing to buy bonds in late 2020, when funds like ZAG were yielding about 1.2 per cent, why would you avoid them now, when that figure is more than two-and-a-half times higher?
Granted, bonds are likely to recover more slowly than dividend stocks following a sharp decline. But unless the bonds default – which is highly unlikely for investment-grade bonds – they will always recover eventually. Higher interest rates accelerate that recovery: every dollar you use to buy more units of your bond fund has a higher expected return than at any time in the last decade. As of late April, ETFs such as ZAG were sporting a yield to maturity (the best predictor of future bond performance) of more than 3.3 per cent for the first time since May, 2010.
The central bank doesn’t control bond yields.
One of the most common misunderstandings about bonds is that their yields are determined by government policy. The Bank of Canada raised its benchmark rate by 50 basis points in mid April, and it has signalled that more increases are coming. Isn’t that almost guaranteed to cause more losses in bond funds?
Not necessarily. The central bank directly controls the overnight rate, the shortest of short-term rates, which impacts your variable mortgage and your line of credit. But the Bank of Canada has much less influence on the yield of five-, 10- and 20-year bonds.
Bond yields are driven not only by current short-term rates, but also expectations of future rates, inflation and investor sentiment. In most cases, these longer-term yields move more gradually than short-term rates, and in some cases they even move in the opposite direction.
We don’t have to look back very far for an example. The Bank of Canada raised the overnight rate five times between July, 2017, and October, 2018. These increases were largely expected and had been signalled by the bank. Yet over that 16-month period, the FTSE Canada Universe Bond Index actually eked out a small gain. That’s because while short-term rates spiked, longer-term bonds saw their yields move more modestly, sometimes downward. (For the record, the index then went on to return 6.9 per cent in 2019 and 8.7 per cent in 2020.)
Bonds are still a safety net when stocks crash.
Many investors take for granted that rates will keep climbing and bond prices will plummet further – and that’s certainly a possibility. But we need to be humble enough to recognize that such forecasts are frequently wrong. There are plausible scenarios that could cause interest rates to level off or decline in the near future.
The most obvious include a recession or market crash. Whether it’s the central bank pushing down short-term rates to stimulate the economy again, or jittery investors selling stocks and fleeing to safety, it’s easy to imagine events that would be favorable for bonds.
There’s no perfect hedge against a stock market downturn, but high-quality bonds remain the most reliable. That’s why they have always been part of balanced portfolios. Some investors have the experience, time horizon, and stomach lining to manage an all-stock portfolio, which can easily lose half its value in a matter of months. But most of us need to temper that volatility by including bonds, even if those bonds carry significant risks of their own.
So how should investors navigate the great bond bear market? By focusing on the long-term, rebalancing our portfolios, remembering the importance of diversification and avoiding the impulse to bail after short-term losses. In other words, the same way we weather difficult periods for stocks.