In April, the bond market did the unexpected: in spite of months of forecasts that interest rates would drop, they rose; as a result, bondholders, who believed that rates would drop, wound up in a bath of red ink.

Not surprisingly, some financial advisors are disillusioned with current bond returns and the early forecasts that bond prices will rise this year. “Clients who want income can just as well consider dividends when interest rates are low and yet still rising,” says Caroline Nalbantoglu, a certified financial planner with PWL Advisors Inc. in Montreal. “With bond yields threatening to rise and bond prices correspondingly threatening to fall, I can accept some risk on dividend stocks.”

The business cycle is alive and well. Business is booming and the Bank of Canada is trying to restrain inflation by the usual means of raising interest rates; on April 25, it raised its key lending rate to 4% from 3.75%. In the U.S., the Federal Reserve Board also raised its overnight money rate to 5% as of early May from 1% in June 2004.

As a result, bond buyers — who had been lulled into thinking that the Fed and the Bank of Canada would overshoot their marks — have been bleeding. The SC Universe Bond Total Return index, the benchmark for the Canadian market, lost 0.43% from Jan. 2 to April 14 — about 10% of the expected coupon return and a big number in the security-hugging domestic bond market.

“We thought the interest rate drop would happen in the third or fourth quarter last year,” says Randy LeClair, vice president and global bond portfolio manager at AIC Ltd. in Burlington, Ont. “But there have been extraordinary events for Canada. Oil and commodity prices are at 25-year highs and there is talk of the U.S. being involved in an invasion of Iran.” In sum, price inflation is running and war commands a risk premium.

There is also a new awareness that inflation is here to stay and that the Bank of Canada will be in no hurry to cut rates. That recognition shows up in what has happened to long-bond yields. In mid-April, the yield on the 5.75% Canada due June 1, 2033 shot up to 4.48%. That move, which anticipates further interest rate increases, was a huge rise over the 4.33% the bond yielded at the beginning of April. The almost horizontal yield curve had indicated no expectation of rising inflation rates, so the new boost in long-bond yields indicates a dramatic change in expectations.

As such, the time for individual investors and advisors to begin thinking that long bonds may be worth the risk has arrived. “The argument that we are out of the flattening phase of the business cycle [when low inflation expectations drop the long end of the yield curve] is starting to look more compelling,” says Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver.

A steepening yield curve implies that investors will begin to be paid for the risks they take in going long. And bond-market analysts are rejigging their expectations for the moment when the Bank of Canada begins to unwind its rate rises.

“We are getting to the point where we will have a peak in yields,” says LeClair, who believes that inflationary expectations are now exerting more pressure than pension funds’ demand for scarce long bonds — a force that had kept prices up and yields down.

Now, more powerful forces are about to exert themselves, he says: “Negative returns in the bond market are usually followed by some very large positive returns. The tightening phases on long-term bonds last an average of 12 months and we are somewhere in the seven- to nine-month range of this tightening phase.” As well, LeClair is one of many who believe that the Fed’s practice of raising short-term interest rates — which it has done at 16 consecutive meetings since June 2004 for a total of 400 basis points — is drawing to an end.

“We are now pricing in overnight money at 5.25% by September,” says Richard Gluck, a principal at Trilogy Advisors LP in New York. Gluck, who manages CI Global Bond Fund, says this implies one more raise from the current 5% rate. He’s also calling for the Fed to hold interest rates steady. His reasoning is not only that it is time to see an end to the tightening cycle, but that there is no need for money markets to raise rates to get cash. “Companies are awash in money and inflation is under control in the U.S.” In short, he says, there is a time of interest- rate stability to come.

@page_break@Bond managers have also revised their predictions for Bank of Canada rate lowerings.

“I can see the Bank of Canada stop raising rates at its meetings later this year, but I don’t see it dropping rates before early 2007 at the earliest,” says Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “Basing predictions on the timing of cycles is nonsense that presupposes a degree of cyclicality and causality that do not exist. What it will take for the Bank of Canada to cut rates will be a weakening of the economy, and that is not in sight.”

The trends to higher long rates and the likelihood that short rates won’t come down any time in 2006 implies that individual investors and financial advisors should stock up on shorter maturities that are under seven years, Czitron says: “The long end of the curve is likely to keep on rising as conservative portfolio managers from mutual funds to pension funds decide to reduce risks and shorten terms. What’s more, foreign investors and hedge funds will recognize that it’s time to cut their risks too.” In his view, shortening terms and losses on long bonds will tend to reduce total returns to a coupon level of 4.5%, at most, for the remainder of the year.

“In the absence of certainty, you have to go back to a basic asset-allocation model that is suitable for the client,” says Derek Moran, a registered financial planner who heads the Kelowna, B.C., office of Vancouver-based Macdonald Shymko & Co. “People are complacent about risk after a good run in equity markets. Today’s market sentiment is greed. But when that turns to fear, bonds will shine even if they have generated small short-term losses. So there is still a place for bonds in an investor’s portfolio, even if there is a carrying cost of low or negative returns in the short run.” IE



Andrew Allentuck is the author of Bonds For Canadians, published by John Wiley & Sons Canada, Ltd. in 2006.