The Canadian bond market is like a flimsy bridge between two shores. On one side, the U.S. Federal Reserve Board is expected to raise rates in mid-December by, perhaps, 25 basis points (bps). On the other side, the Bank of Canada (BoC) is committed to holding steady or even lowering rates by 25 bps in 2017.
In the middle, financial advisors face a high risk of having their fixed-income recommendations go wrong. What to do?
Playing government bonds has become precarious: Brexit has resulted in a drastic drop of the value of the pound sterling, Italy’s banks are tottering and other countries may leave the European Union. That instability could make the Fed postpone or moderate rate rises in 2017.
In Canada, poor export numbers could persuade the BoC to cut rates, as Governor Stephen Poloz mused on Oct. 19 that it might do.
Predicting that the bond bull is finished is hazardous, but duration – the measure of price risk in bonds – is very high. The duration of the Bank of America global government bond index rose to an all-time high of 8.23 years in 2016. In the bond world, that’s massive. (The index was introduced in 1997.)
Long bonds have been very profitable. BlackRock iShares 20+ Year Treasury Bond ETF, which holds U.S. treasuries, reported a 13.8% return for the 12 months ended Sept. 30. That’s more than three times the return of the BlackRock iShares US Treasury Bond ETF for the same period. Going long has paid handsomely for investors. But that party is ending.
Interest rates have a long way to rise and very little room to drop. The bond bull, which has been running for three decades, is long in the tooth, even allowing for the fact that bond cycles tend to be much longer than stock cycles. Just in this century, 30-year U.S. treasuries have produced a 7.8% annualized return, compared with 4.3% for the S&P 500 composite index (both in U.S. dollars).
Strategically, bond portfolio managers are in a tough place: with inflation knocking on the door in the U.S., the trend to lower rates is slight and the probability of higher rates is strong. U.S. consumer prices edged up by 1.5% on an annualized basis in September, the latest month for which data is available, compared with 1.3% on an annualized basis year-to-date.
Canada’s inflation numbers are the mirror reverse of the U.S.’s, with Canada’s consumer price index up by 1.1% in August, also the latest month for which data is available, from 1.6% year-to-date.
The risk for investors in government bonds is getting caught in the pinch. The dilemma is more than just a rate squeeze.
The risk also is structural, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. Corporate bonds, which can mitigate the squeeze for investors willing to sacrifice duration risk for rate boosts on lower-quality issues, are not what they were a decade or two ago.
The difference in payout for investments in government bonds vs corporate bonds depends on the composition of bond indices. There are more BBB-rated bonds in the corporate index; thus, the spread on rates is exaggerated by the decline in quality. Today, BBBs comprise 35% of the market. In the 1980s, they comprised just 5%, Kresic notes.
Also, there is less liquidity in the marketplace for corporates, so the trading risk adds to the duration and default risks.
The payoff for avoiding sovereign bonds is substantial. For example, a 10-year Province of British Columbia bond paying 2.3% and recently priced at $103.00 to yield 1.96% to maturity adds 73 bps vs the yield of a 10-year Government of Canada bond paying 1.5% and due June 1, 2026, that was recently priced at $102.48 to yield 1.23% to maturity. Note that default risk on provincials is trivial.
As well, going out 30 years, the yield on a Province of Ontario bond due June 2, 2048, and recently priced at $99.50 to yield 2.82% is 91 bps over the Canada bond of similar duration that yields 1.91% to maturity.
A quasi-government issue, the Highway 407 International Inc. 3.83% issue due May 11, 2046, and recently priced at $107.66 to yield 3.32% adds 141 bps for this issue, which has an A rating from DBRS Ltd.
Among conventional investment-grade corporate issues, a Brookfield Asset Management Inc. 4.82% issue due Jan. 28, 2026, pays 3.48% to maturity – a 225 bps boost. Rated A (low) by DBRS, this bond is a play with modest risk for a hefty payout boost.
“Buying corporate bonds makes sense, especially when you can double the yield from government bonds and avoid the worst of duration risk if and when rates rise,” says Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C. “The problem, of course, is that bonds can be hard to sell. You may lose some of the yield pickup on liquidity, so [corporate] bonds work best if they are held to maturity.”
Given the expectation that the Fed will raise rates in December and at least once in 2017, duration risk suggests potential losses on U.S. bond investments.
That will be compensated by a good chance for the greenback to rise against the loonie, given the low probability of BoC rate rises any time soon. Short bonds and one- to five-year ladders are a defensive strategy in both markets.
Bonds still make sense in portfolios, even if the bridge is precarious.
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