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Running for fixed-income cover? Think again

Some large institutional investors have finally had enough with bonds and their paltry yields. Someone should tell average Canadians: They're still piling in to the asset class.

On Tuesday, Caisse de dépôt et placement du Québec and Boston-based fund manager GMO LLC said they were cutting down on their exposure to fixed-income investments. Their decision may mark a turning point in the long love affair with bonds.

Bond prices move in the opposite direction to yields. As yields have collapsed in recent years, bond prices have marched steadily higher, allowing Canadian bonds to outperform equities from the start of 2000 to the end of last year.

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But yields are now about as low as they can go. In countries perceived as havens, the payouts on 10-year government bonds plunged to new depths this year, as cautious central banks did their best to push down rates.

The yield on 10-year Government of Canada bonds dropped to 1.56 per cent at one point, the lowest level on record. The yield on U.S. Treasuries of the same vintage fell to 1.38 per cent, the lowest in at least 50 years. Neither had anything on Germany (1.13 per cent) or Switzerland (0.48 per cent).

Rates are a little higher now, but still low enough to make medium-term debt a bad investment if rates should rise by even a modest amount. Benoit Durocher, executive vice-president with Montreal asset manager Addenda Capital, figures that a rise of just one third of a percentage point in interest rates would wipe out the interest payments on the average Canadian bond, as measured by the Dex Universe index. At such levels, supposedly risk-free bonds offer lots of potential for losing money.

In search of higher yields, some investors have upped the risk ante, piling into junk bonds and accepting looser credit terms from issuers in general. Last month, convenience store giant Alimentation Couche-Tard Inc. sold out a $1-billion bond issue that paid the same interest rate as debt from the much more credit-worthy Bank of Nova Scotia, much to the disbelief of long-time bond fund managers.

Given the overheated market, it's understandable why Michael Sabia, chief executive of the Caisse, told the Financial Times on Tuesday that he is planning to lower his institution's $58.8-billion allocation to fixed-income investments by at least $7-billion next year. And why GMO, a highly regarded money manager, told the FT it has "given up" on long-dated sovereign debt.

But if big institutions are starting to pull out of fixed income investments, ordinary Canadians are continuing to pile in. As of the end of October, retail investors had poured a net $16.3-billion into bond funds so far in 2012 – almost three times as much as in the same period in 2011 – while redeeming a net $11.5-billion from equity funds, according to the Investment Funds Institute of Canada.

The Caisse hasn't always been the best proxy for smart money, but GMO has. Headed by the famed investor Jeremy Grantham, it shifted its portfolios to a high cash position in late 2007, just before the credit crisis mushroomed, and also managed to avoid being sucked in by the Internet bubble in the late 1990s.

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Now, GMO is holding 40 per cent of its assets in cash, according to the FT. Canadians thinking it's high time they added more bonds to their portfolios should think twice; there may be safer places to keep that money.

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