investment risk / gremlin

This article appears in the April 2021 issue of Investment ExecutiveSubscribe to the print edition, read the digital edition or read the articles online.

The bond market is gloomy: the first quarter was among the worst for U.S. treasuries and bonds in several years.

Here in Canada, the broad bond index — as represented by the iShares Core Canadian Universe Bond Index ETF — fell by 5.24% for the year to March 31.

But when looking at different types of bonds, the path to doom is not so clear.

Investment-grade corporate debt has lost less value than government debt. The iShares Canadian Corporate Bond ETF was down by a more modest 3.82% for the year to March 31. Meanwhile, the iShares U.S. High Yield Bond Index ETF was up by 0.34% over the same period and BlackRock Corporate High Yield Fund was up by 2.89%.

Fixed income is supposed to be a refuge from equities risk, but we’re in a risk-on bond market.

With central banks holding policy rates low, most of these moves are market-made. The Bank of Canada has announced it will dial down quantitative easing. The implication: if the BoC just treads water, markets will have to run stimulus-free. That alone will allow rates to rise, and the bears will say they were right.

Without governments buying bonds, bond prices will fall and interest rates will rise. Investment-grade corporate debt will follow. Spreads for junk bonds, which are historically low compared with investment-grade, are likely to widen if interest rates rise. Companies paying rising interest rates will have to unburden balance sheets by selling bonds and selling or paying other obligations, such as bank loans.

Ahead of this process, investors are leaving the safety of government bonds and accepting the risks inherent in junk bonds. That makes bonds less of a hedge against equities prices. Risk-off government bonds and senior corporates are losers in this market. Risk-on junk is in good shape.

That leaves the question of where to hedge and how much to pay for it.

James Orlando, senior economist with Toronto-Dominion Bank, noted in a March 24 bulletin that the main exception to the market recovery has been in the prices and returns of long-dated U.S. and Canada government bonds. Returns have slumped in expectation of rising yields. But investors have not rushed in to buy cheaper bonds.

The dilemma now for bond investors is how much fixed income is worth having. In the face of double-digit monthly gains for favoured tech stocks, committing money to a bond portfolio yielding less than inflation seems foolish. Bonds are life preservers: dead weight until they are needed; then precious.

For now, the idea of prepaying for a portfolio rescue seems of no importance.

“The CAPE [cyclically adjusted price/earnings index] has been overvalued for five years,” said Chris Kresic, head of fixed income and asset allocation at Jarislowsky Fraser Ltd. in Toronto. In other words, a stock price reset is in the cards. But when it happens and how long bondholders will have to wait to smile are unknowns.

Bonds with subinvestment-grade ratings present a compromise between equities-like risk (and returns) and bond risk with lower returns. Bonds — even if unrated or dubious — still have legally enforceable covenants and promises of payment. A share of stock gives the investor no rights other than to vote for directors — and Canadian non-voting shares do not even offer that.

We are now in a period in which investors are eager to accept equities-like risk and default risk on low-rated bonds.

Charles Marleau, president and portfolio manager with Palos Management Inc. in Montreal, offered a caution: “Junk is driven by credit spreads, not interest rates. A lot of junk is energy-related, and as oil prices have risen, junk has gotten new life.”

Ten-year Government of Canada bonds can get back to 2%, but not more, Marleau predicted. While 2% may still mean a negative real return, it is a hedge that will be seen as wise if markets take another hit similar to October 1987, the collapse of 2008 or even March 2020.

Equities risk is a sleeping tiger.