Fixed-income investing will continue to play a crucial role for investors, even as three decades of bond-market gains appear likely to come to an end, according to a recently released research paper by Toronto-based Russell Investments Canada Ltd.
The research paper by Shailesh Kshatriya, senior investment analyst and Greg Nott, chief investment officer, suggests that fixed-income investors shouldn’t agonize about the prospect of diminishing returns as yields rise, since fixed-income securities hold numerous advantages beyond the recent price gains, such as risk mitigation and portfolio diversification.
The research argues there are four key themes that will shape how investors think about and approach this asset class going forward and that the current low yields should not panic bond investors. The first theme is that rising yields need not imply negative returns.
“A bond’s total return includes both capital gains and income,” Kshatriya points out. “Although rising yields will hurt the capital return portion, investors should also consider the cumulative impact of coupon and maturity payments being reinvested at higher rates. As well, rising yields enhance the future income return on bonds.”
The second is that active bond managers have several tools at their disposal to mitigate the impact of rising yields. Thirdly, the paper argues that going beyond traditional fixed-income securities may be critical to enhancing overall portfolio returns. “Non-domestic exposure can offer significant income and return-enhancing opportunities relative to Canadian corporate bonds, which is where active management plays a critical role,” says Kshatriya.
Finally, the paper notes that rising yields may actually hold benefits for investors approaching or in retirement, “Investors don’t fully appreciate how higher yields can reduce the cost of liabilities in retirement,” says Nott. “As bond yields rise, the cost of funding future obligations, such as an annuity, decline as a result of an increase in the assumed rate of return. In other words, as your future assumed rate of return increases due to higher bond yields, less will be needed to fund future obligations.”
The paper also argues that the attributes that make bonds an attractive long-term holding have not changed, i.e., providing income and diversification. With equities remaining the largest contributor to risk in a portfolio, fixed income will continue to be a viable source to counter that volatility.