It’s a very difficult time for your clients to be invested in bonds. That’s because current yields on government debt remain well below historical averages and the outlook is for rising interest rates, which will result in losses on the value of the bonds in your clients’ portfolios unless they’re held to maturity.
Long-term interest rates began rising this past May, when the U.S. Federal Reserve Board began talking about tapering off quantitative easing (QE) – the moniker used to explain the Fed’s program of US$85 billion in monthly purchases of U.S. Treasury bonds. In turn, 10-year U.S. bond interest rates closed 2013 at 3.03% vs 1.76% a year prior; 30-year rates closed at 3.97% vs 2.95% over the same period.
Canadian rates have followed suit, with the 10-year Government of Canada interest rates rising to 2.78% from 1.8% year-over-year and the 30-year rate climbing to 3.24% from 2.36%.
Analysts expect further increases in long-term rates, but nothing dramatic because short-term rates remain low – and that’s not expected to change.
“We’re assuming that tapering will begin in March 2014 and be completed by the end of 2014,” says Paul Ferley, assistant chief economist with Royal Bank of Canada in Toronto. Although tapering will put some upward pressure on bond yields, Ferley expects U.S. inflation to be subdued – at around 2% a year.
Moreover, the Fed will seek to avoid driving up interest rates, Ferley adds: “The Fed wants to limit pressure on bonds that developed in the [autumn], when the bellwether 10-year rate rose by 90 basis points [bps]. For Canada, the direction of rates will be similar.”
The Bank of Canada’s (BoC) interest rate policy tends to mirror the Fed’s, so what happens on Wall Street and the Fed’s open market committee will determine what the BoC does, says Camilla Sutton, chief currency strategist with Bank of Nova Scotia in Toronto, adding that she doesn’t expect major short-term rate rises in either country.
“If rates rise too much,” adds Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto, “then the economy will slow down. A sustainable rise would require more inflation, which does not seem to be the case. There’s still excess capacity. There’s still deleveraging. There’s still some deflationary pressure. We still have high government debt levels. There’s every reason to think that interest rates, even as they rise, will remain at low levels.”
Scotiabank’s economics department is forecasting central bank overnight rates to remain at 0.25% in the U.S. and at 1% in Canada through at least the third quarter of 2014. Other forecasters believe that the BoC won’t raise its overnight rate until 2015 and that the Fed won’t make a similar move before 2016.
That’s the economic side of interest rates. But prospects for large interest rate gains also are subdued on a flow-of-funds basis as well.
Governments around the globe have used various forms of monetary easing, including QE programs, to pump money into markets, thus reducing the need for corporations to offer higher rates when issuing bonds – and that will continue for as long as easy money policies prevail.
For portfolio managers, the problem is finding the point at which the reward for investing is sufficient to compensate for duration (eventually higher interest rates) and credit (possibility of default) risks.
“Our solution is to shorten bond duration below the current 6.6 years on the DEX universe bond index to 5.6 years,” says Beste Alpargun, portfolio manager with Seamark Asset Management Ltd. in Halifax.
Bonds are not primed to provide large returns in the current market, but they are portfolio stabilizers, Alpargun adds: “There is now a stigma attached to bonds because, in the past, people thought they could not lose money. But the current reality is that bonds will accrue paper losses unless they’re held to maturity. Institutions can match their bonds’ maturities to their obligations, but private clients need to understand the risks of holding government bonds. Today, therefore, the contest is to get better than government bond returns without giving up too much security.”
Next: Bond yields by category
Bond yields by category
In order to generate satisfactory returns with reasonable risk, it’s useful to examine bond yields by category. Case in point: provincial bonds currently offer a 70- to 100-bps yield boost over federal bonds. For example, an Ontario 10-year 2.85% issue due June 2, 2012, was recently priced at $94.96 to yield 3.48% to maturity, as compared to a 1.5% Government of Canada bond due June 1, 2023, that was recently priced at $90.08 to yield 2.69% to maturity – meaning the Ontario issue carries a yield boost of 79 bps.
Going down the liquidity scale, a Prince Edward Island issue with an 8.5% coupon due Dec. 15, 2023, was recently priced at $140.14 to yield 3.67% to maturity – a pickup of 98 bps over a 10-year federal bond.
In addition, the P.E.I. issue totalled only $60 million, so this bond would be more difficult to trade than the Ontario issue, which totalled $10.85 billion and trades actively. Toronto-based credit-rating agency DBRS Ltd. rates Ontario as AA-low and P.E.I. as A-low, but Ontario is a big issuer and P.E.I. is the equivalent of a small-capitalization equities play.
“You get what you pay for,” says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto and co-manager of TriDelta High Income Balanced Fund. “It’s lack of liquidity more than a rating notch that pushes up the yield on the P.E.I. issue. It’s unlikely that any dealer has the P.E.I. issue in inventory – or wants it, unless it’s a big position of $2 million or more. And if you own 10% of the P.E.I. issue, you could have a problem selling it. The Ontario bond is a trader while the P.E.I. issue is a keeper.”
For clients who want to set up their portfolios with bonds to backstop their stocks, you should mention the need to take on credit-sensitive corporate bonds. Provincial issues carry A or better ratings while corporate bonds’ ratings range from AAA for chartered banks’ covered bonds secured against specific assets to the lower end of investment-grade BBs and out to Bs (which indicate cyclical risk) and Cs (which suggest severe challenges to the ability to pay interest and redeem principal on time).
Liquidity can be an issue for corporate issues as well. For example, an A-rated Canadian Utilities Ltd. issue due November 2022 was recently priced to yield 3.67%, a 100-bps spread over a federal issue of similar term. And of that 100-bps point spread, no more than 20 bps can be attributed to default risk, says James Hymas, president of Hymas Investment Management Inc., a specialty fixed-income investment firm in Toronto. As the credit rating declines, he adds, default risk rises, but the largest premium remains the illiquidity premium.
In structuring a bond portfolio, you also should manage duration, which is the sensitivity of the bond portfolio to interest rate changes. The DEX universe bond index’s duration currently is 6.6 years, which means that a rise of one percentage point in rates would cause a 6.6% drop in the market price of the portfolio. That duration goes along with an average term to maturity of about 7.5 years.
The other factor worth considering is minimizing the loss of purchasing power to inflation through holdings of inflation-indexed bonds. Inflation is expected to remain in the low single digits in both the U.S. and Canada, so Government of Canada real-return bonds and U.S. Treasury inflation-protected T-bills are unlikely to do as well as they did in previous periods, when inflation was higher. Indeed, for the 11 months ended Nov. 30, 2013, inflation-protected Canadas declined by 13.1% compared to conventional Canadas, which dropped by 1.2%.
In the end, the fixed-income components of a client’s portfolio should reflect the client’s need for liquidity, inflation protection and income, says Hymas. Canadas and provincial bonds offer liquidity; investment-grade corporate bonds provide a yield increase; and high-yield bonds provide an equities-like boost to bond returns.
However, as Caroline Nalbantoglu, president of Montreal-based CNal Financial Planning Inc., notes, some of your clients may be purists who believe in holding federal bonds as the bedrock of fixed-income portfolios because of these issues’ absolute guarantee of payment – with provincials and high-grade corporates adding return, at the cost of diminishing liquidity.
The argument is that below investment grade, your clients are in a quasi-equities space in which the value of their holdings could plunge.
What bonds are yielding
A closer look at yield rates for some of the top-rated bonds in the market:
Government of Canada
Province of Ontario
Source: Bloomberg LP
Investment Executive Chart
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