Persistent inflation has changed perceptions of how much and how quickly interest rates will rise. The bond market is not taking this development well.
As of late February, the FTSE Canada Universe Bond Index was down 5.1 per cent for the year through Feb. 23. What makes the year-to-date decline for bonds especially unpleasant is that it follows a 2.5-per-cent drop last year. To be clear, we’re talking about total returns here – declines in bond prices and interest together.
Bond prices have been falling in anticipation of a reversal of the interest-rate cuts put in place in early 2020 to support the economy as the pandemic took hold. The first in what could be a long series of rate hikes is widely expected to happen next Wednesday. The Bank of Canada is expected to raise its overnight rate by 0.25 of a percentage point, though a more attention-grabbing increase of 0.5 of a point is possible. With inflation at a 30-year high of 5.1 per cent and not yet losing momentum, the central bank may need a tougher stance on rates than was previously imagined.
This means more pain for bonds, which are in your portfolio in the first place because of their supposed safety. Bonds do offer a hedge against plunging stock markets or recession. But for now, they’re a pain point.
Bond market data for the year to date highlights the benefit of sticking to short-term bonds in a rising rate world. The FTSE Canada Short Term Overall Bond Index was down about 1.4 per cent for the year to date, an uninspiring result that nevertheless beats the broader bond market index by a lot.
You can avoid seeing any price fluctuations at all for the fixed-income side of your portfolio if you substitute guaranteed investment certificates for bonds or bond funds. One online broker recently offered third-party GICs with an average yield of as much as 2.5 per cent for terms of one through five years. The yield you get these days from a short-term bond ETF would be around 1.9 per cent, while a broad market ETF holding short- and longer-term bonds would yield about 2.4 per cent.
Be cautious about responding to disappointing results from bonds by allocating more money to stocks. This approach has produced good results in the bull market of the past two years, but stocks are looking choppy these days. If you think the 5.1-per-cent year-to-date decline for bonds looks bad, check out the last big stock market decline. In the span of about four weeks in early 2020, the S&P/TSX Composite Index fell about 37 per cent.
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