Although investing in government bonds has long been considered a way to get a return free of risk, that’s not the case now. Today, these bonds offer little return and are one of the riskiest asset classes. And while corporate bonds are a better bet, they also carry more risk than in the past.
Another problem with holding bonds these days is that when interest rates rise from their current historically low level, as they inevitably will, the prices for the bonds your clients own at that time will tumble. This does not, however, mean you should abandon fixed-income. Clients need the security of having a portion of their portfolio in investments that have a specified value at maturity — and even the safest of equities don’t provide that guarantee.
What this all means, though, is that you will need to pay more attention to the fixed-income portion of your clients’ portfolios, and you will need to find good bond-fund portfolio managers or develop your own skill in picking the right bond issues and the right time to buy them.
The timing part is going to be difficult because no one knows when interest rates will rise. It depends, first, on the U.S. and Europe coming up with credible plans to eliminate their deficits and pay down their mountains of debt and, second, on resumption of healthy economic growth.
Interest rates may fall before they start rising again. According to J.P. Morgan Chase & Co., the worldwide central bank interest rate, weighted to gross domestic product — which means it gives more clout to the U.S. Federal Reserve Board rate than to Switzerland’s National Bank’s rate, for example — will fall to 1.7% by June from 2.16% in September 2011.
But Canada may buck this trend. Our economy is relatively solid and our banks are quite secure, so our interest rates may not fall further and could rise ahead of others as the recovery begins to pick up steam.
So, although investors in the U.S. and Europe won’t have to worry about seeing the value of bonds they hold fall for a considerably time, Canadian investors could see that happen sooner and need to be prepared.
Canadian interest rates may rise during 2012 and 2013 — although, says Tom Czitron, a bond specialist with Barometer Capital Inc. in Toronto: “They won’t rise to normalized levels of 1.5% [in the] short [term] to 4.5% [in the] long [term], given the output gap that persists in much of the western world.”
Bank of Nova Scotia’s economics department in Toronto also foresees gradual increases in rates: three-month T-bills reaching 1.1% by the end of this year and 2.3% a year later vs the current 0.9%; five-year Government of Canada bonds moving to 2.75% from 1.6% over the next two years; and 10-year Canadas rising to 3.3% from 2.2%.
Czitron suggests, to protect against losses, shopping for provincial bonds such as 10-year Government of Ontario bonds that yield 90 basis points over Canadas of a similar term — or about 3% to maturity — and investment-grade corporates in the A to BBB+ rating range that pay as much as 250 bps over Canadas of similar terms. “Those yields will cover the small losses that could come from an interest rate rise,” he says. “You get good security and, unless rates rise a great deal, you keep a positive return.”
Long bonds are much riskier. They normally protect against inflation because they pay higher interest than shorter-term bonds, but their time risk is high. For example, a 30-year Canada with a 2.63% yield to maturity has a duration of 19 years, so a 1% change in interest rates would produce a 19% drop in the bond’s price. (Note that Scotiabank foresees 30-year Canadas’ rates at 3.8% at the end of 2013 vs the current 2.75%.)
A Deutsche Bank AG study of long-term bond returns indicates that when sovereign yields return to the historical mean (200 bps to 300 bps higher), investors in 30-year U.S. Treasury bonds that have recently paid 2.85% a year to maturity or 30-year Canadas (2.46%) will have to accept annualized losses of 2% a year for the next 10 years.
Thus, staying with U.S. Treasuries and the almost parallel-priced Canadas for the next decade is a sure-fire way to book losses. Much safer places are at the short to middle range of the yield curve for government debt and in corporate debt that is less sensitive to rates than to business conditions.
With short- and medium-term bonds, your clients will not be locked into losses for many years, while corporate bond yields remain in their customary range and offer the potential for appreciation if the issuer’s credit rating improves.
Bonds of financial services companies offer good investment opportunities. The value of financial services firms’ bonds have been hammered because of fears of rising provisions for bad loans, writeoffs of European sovereign debt and the difficulty for the banks in growing their loan portfolios in slow-growth periods. Yet, Canadian financials are in good shape, so it won’t take much to turn them around. And, in the meantime, yields are particularly good. IE