investment outlook / vectormine

This article appears in the February 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

The common refrain about bond funds and ETFs is that they lose money when interest rates go up — as seen dramatically in 2022.

Toronto-based Vanguard Investments Canada Inc.makes an opposing argument, which comes down to whether the investor holds the investment over the short or long term.

“Even during periods of rising rates, total returns from bonds can increase if your investment horizon is longer than your bond’s portfolio duration,” said Ashish Dewan, a portfolio consultant with Vanguard Canada, in a new research paper. “That’s because higher yields on reinvested cash flow outweigh the market price decline.”

For that reason, the paper said, investors who are willing and able to assume risk and have a longer time horizon “should almost always prefer bond ETFs and funds over GICs due to their substantial diversification benefits and superior total returns over the long term.”

Understandably, investors generally didn’t share that view in 2022, a dismal year for bonds. The Investment Funds Institute of Canada reported $13.8 billion in net redemptions of bond mutual funds last year, a sharp reversal from net sales of $14.5 billion a year earlier. IFIC reported sales of bond ETFs remained positive in 2022, at $9.3 billion, down from $12.4 billion in 2021.

Meanwhile, according to the Bank of Canada, personal fixed-term deposits at chartered banks totalled $529.5 billion in the year to Nov. 30, 2022, up by 47.9% from a year earlier.

Unlike the equities and bond markets, GICs yielded positive returns, as they always do, and new purchasers benefited from higher rates. Five-year GIC rates at many issuers now exceed 4%, and the products have full Canada Deposit Insurance Corp. (CDIC) protection against capital loss for amounts up to $100,000. Savers can easily get around the CDIC insurance limit by opening accounts at different deposit-takers or by holding multiple accounts at the same institution.

By contrast, investors can look back on 2022 as a major disappointment for their bond funds and ETFs, given the normal expectation that these funds should provide diversification against falling equities markets.

Instead, the broad Canadian investment-grade universe, even after interest payouts, lost almost 12% last year. Long-term bonds with maturities of more than 10 years fared worse, down by nearly 22%. Short-term bonds, with less interest-rate risk because of their maturities of one to five years, lost about 4%.

The Vanguard paper states that since 1976, stocks and bonds have had simultaneous losses over a one-year span in only 0.6% of instances. Therefore, such a rare occurrence shouldn’t guide future asset-allocation decisions.

In the wake of last year’s losses, the outlook in 2023 for bonds is much brighter, according to the Vanguard paper: “Ironically, the worse returns get, the better bonds should look in the future.”

The firm’s investment thesis is that as the Bank of Canada continues to raise its trend-setting policy rate, inflation should gradually abate and the Canadian economy is likely to slow:“The beginning of a recession is usually accompanied by a flight to quality with bond prices going up and yields going down, particularly on the longer end of the maturity spectrum.”

Based on its latest forecast at the end of the third quarter, Vanguard projects 10-year average returns of 3.3%–4.3% for the aggregate Canadian bond market and 3.2%–4.2% for global ex-Canada bonds after hedging currency exposure back to the Canadian dollar.

Although these projected returns are lower than what some investors have obtained in recent months by purchasing GICs, bond fund and ETF investors have the advantage of liquidity.

With the exception of redeemable deposits, which have lower rates, GICs require a fixed holding period. As the Vanguard paper noted, GICs can be suitable investments for clients who require principal protection, do not have immediate liquidity needs and have a shorter-term objective, such as saving for an upcoming automobile purchase or a down payment on a home.

“If you’re able to take on a bit of risk, if you have the appropriate time horizon, we believe a bond ETF will serve you better over time from a wealth accumulation perspective,” said Sal D’Angelo, head of product with Vanguard Canada. He noted that ETF sales in this asset class have picked up in the fourth quarter, with some clients now taking advantage of higher yields and a better outlook.

D’Angelo said a natural starting point in bonds for a Canadian investor is a broad domestic fund. If a client has a shorter-term horizon or goal, a better choice would be a short-term bond fund with a duration in the one-to five-year range.

For greater diversification, consider a bond fund that invests outside Canada as part of the mix. Monetary policies don’t always move in the same direction at the same time, D’Angelo said:“So there’s definitely diversification by buying global bonds and having different countries, because you have that interest-rate diversification.”

However, hedging back to Canadian dollars is critically important when investing globally in bonds, D’Angelo said: “If you’re not hedged, you’re exposed to various currencies. And that adds a lot of volatility to an asset class that should act as your ballast.”