A fixed-income primer: how to explain bonds to the uninitiated

Advisors should be ready to address client questions about their fixed-income investments, especially after periods of market turbulence, says Janet Salter, vice-president and portfolio manager with Portfolio Solutions Group, a division of Canada Life Investment Management Ltd.

“After market volatility sometimes, we know that questions are coming in from investors like, ‘Am I going to get a positive return again?’ People see negative returns and then they’re very fearful of what happened,” she said. “So, it’s good for advisors to explain bond basics to their investors and to recap how bond returns and prices are affected by economic factors in the marketplace.”

Salter said that investors may not realize the true complexity of bonds, with properties that are sometimes counterintuitive.

“People don’t understand. They think [a bond is] like a stock,” she said. “A stock goes up and down. And bonds do that too, but that’s not your return. It’s completely separate.”

On the latest episode of the Soundbites podcast, Salter offered a primer on how to address client questions about fixed income. Here’s how she broke down some of the key concepts:

Bond pricing

Interest rates and a bond’s sensitivity to rate changes are the two biggest drivers of bond prices, she said. Notably, as interest rates rise, bond prices fall, and vice versa.

“The bulk of public bond market prices are affected by changes in nominal interest rates,” she said. “Nominal interest rates are made up of two components: expected real interest rates and expected inflation.”

She added that factors like supply and demand fundamentals, term structure premiums and liquidity constraints can add a discount or premium to bond interest rates. As a rule of thumb, she said, the higher the uncertainty in the economy and inflation outlook, or the change in supply and demand fundamentals, or liquidity of the bond will call for a premium to compensate investors for that uncertainty.

Bond returns

The total return of a bond is made up of the change in the price of the bond, accrued interest and any coupon payment received during the investment time horizon.

A measurement of the bond’s potential return is its yield, which takes into consideration the coupon rate and whether the bond price is trading at a discount or premium to its par value.

“If interest rates don’t move, you can expect to earn the bond yield as return for that one-year period,” she said. “However, interest rates never remain static.”

On real interest rates

Real rates are influenced by the potential output of the economy, productivity of the labour force, demographics and monetary policy, she said.

“When the economy is doing well, interest rates have a tendency to increase, and bond prices will decline,” she said. “But if the economy is expected to decline, interest rates will fall, and bond prices will rally.”

She also noted that over the last several decades, a decline in real interest rates fuelled the great bond bull market.

Duration

Duration is a measurement of how sensitive a bond price is to changes in interest rates, and it’s quoted in years.

“The higher the duration, the greater the impact that a change in interest rate will have on that bond price, all else equal,” she said. “For example, if a bond has a duration of five years and the interest rate on that bond declines by 1%, it’s expected that that price will increase by 5%, keeping in mind that price and interest rates move in opposite direction.”

Salter said 2021 and 2022 marked the first time on record in Canada that the bond market posted two consecutive negative years.

“Usually, the income earned would have helped to mitigate the loss from the decline in the prices,” she said. “But not this time around.”

She said the speed and magnitude of interest-rate increases have the biggest impact on the severity of a downturn.

“The faster the interest rate increases, the harder it is for income to mitigate the capital loss in the bond,” she explained. “Also, the income earned can only offset so much of the price decline before you move into negative territory.”

Expected bond earnings

Salter said bond yields are particularly strong at the moment.

“On a broad Canadian index, the current yield is around 4%. We haven’t seen these levels in yields for over a decade,” she said. “With this yield cushion, the bond market can weather a modest increase in longer-term interest rates. As well, if we see longer-term interest rates fall from these current levels, you could see a higher return than the yield suggests.”

Bonds as ballast

Salter pointed out that in 2022, market reactions were driven by rising inflation, heightened price uncertainty and aggressive tightening of global monetary policies. This led the traditional relationship between equities and bonds to break down.

“If the market landscape is favourable for bonds, it’s expected that bonds will once again play that traditional role of diversifier and safe-haven asset in a risk-off environment,” she said.

The bottom line for investors, she said, is to remain open to questions from clients, and help them understand why their fixed-income investments are acting as they are.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.