Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life.

For today’s Soundbites, we get a fixed income primer from Janet Salter, vice president and portfolio manager with Canada Life’s Portfolio Solutions Group. She offers ideas on how to explain earnings, yields, and expected returns to clients who are new to bonds. And we started by asking why simple explanations are probably the best.

Janet Salter (JS): A lot of people think that bonds are simple, but they’re actually very complex investment instruments. 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 the negative returns and then they’re very fearful of what happened. And 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.

How to explain market drivers.

JS: Interest rates and a bond’s sensitivity to interest rate changes are the biggest two drivers of bond prices. Bond prices and interest rates have an inverse relationship. That is, as interest rates rise, bond prices fall, and vice versa. The bulk of the public bond market prices are affected by changes in nominal interest rates — made-up of expected real interest rates and expected inflation. 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.

Explaining real interest rates.

JS: Real interest rates are influenced by the potential output of the economy, productivity of the labour force, demographics, and monetary policy. When the economy is doing well, interest rates have a tendency to increase, and bond prices will decline. But if the economy is expected to decline, interest rates will fall, and bond prices will rally. Over the last several decades, advanced economies have seen a decline in their level of potential output and productivity, causing real interest rates to fall with it. This decline in real interest rates fueled the great bond bull market.

Explaining recent performance.

JS: 2021 and 2022 were unusual markets. This was the first time on record in Canada that the bond market posted two consecutive negative years. In 2020, central banks around the world dropped their overnight interest rates to help stimulate the economy and stabilize the financial markets. After several years of low interest rates, bond yields were too low to provide enough cushion when interest rates did move higher. As the pandemic restrictions were loosening, pent-up demand was released, and the economic recovery unfolded. But supply chain issues remained in place. The forward-looking bond market started to reverse the bond price rally seen in 2020 in reaction to the new economic environment. In 2022, Russia invaded Ukraine, spiking both food and energy prices, putting further upward pressure on inflation expectation, and driving down bond prices. Globally, central banks aggressively increased overnight rates, and that didn’t help the negative tone in the bond market.

Expected bond earnings.

JS: A bond or a fixed income portfolio’s yield is a good measure of what you can expect to earn over the next year if interest rates don’t change. On a broad Canadian index, the current yield is around 4%. 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.

The allure of corporate bonds.

JS: Corporate bonds are great assets for those investors that want additional yield but are willing to take on additional risks. Canadian investment grade bonds remain above the 10-year average for spreads, and at the top of a two-year range, pre-Covid. A benefit of the increase in Government of Canada interest rates are that corporate bond yields are now at levels that we haven’t seen since mid-2009. The trick to corporate bonds is to ensure that the yield pickup is enough to compensate you for the additional credit risk you’re taking on.

And finally, what clients need to understand about fixed-income investments.

JS: Bond investors should keep interest-rate risk, credit risk, geopolitical risk, and economic risk in mind, and remember that while market forecasters may be OK at predicting the direction of the economy or potential capital market events, no one can predict the timing of these movements. A disciplined investment approach to investing is always the best path forward.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Janet Salter of Canada Life’s Portfolio Solutions Group.

Visit us at InvestmentExecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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