Fear of global instability sustained the recent long-bond buying frenzy for four years. But the sun now is beginning to set on the record-busting run of government-bond returns in the U.S. and Canada. So, the issue now is: when will market forces take over and how far can they push up rates, trashing prices of existing bonds in the process?

Interest rates on U.S. treasury bonds and Government of Canada bonds have been below the rate of inflation since the U.S. Federal Reserve Board (the Fed) and the Bank of Canada forced overnight interest rates down to virtually zero in 2009. However, an increasing number of forecasts say that Canadian and U.S. government bonds should start producing positive real returns later this year or next. That means the prices of existing bonds will tumble. Thus, you need to be aware of when this may happen, by how much rates may rise and what to do for your clients when they do.

Regarding long-bond prices, they will begin to drop gradually in 2014, with the largest move in the second half of that year, says Dawn Desjardins, assistant chief economist with Royal Bank of Canada in Toronto: “We see inflation moving up and the Bank of Canada removing stimulus [i.e., policies that hold down interest rates] by the end of the year.”

The reason for the forecast is that the big negatives on the Canadian economy will be gone by then, she says: “China will be recovering its growth and, in fact, is already doing so; European problems are being resolved; and the U.S. fiscal cliff is being managed.” Add in the present pickup in U.S. housing construction, she adds, and the case for continued intervention by central banks weakens.

How much rates will rise is essential to managing portfolio risk. Normalization of returns implies about a 4.5% interest rate on future 10-year Government of Canada bonds, which now pay about 1.9%, notes John Carswell, president of bond research and management firm Canso Investment Counsel Ltd. in Richmond Hill, Ont. For long bonds, the consequences of a reversion to market-driven rates would be devastating, he adds.

“A return to conventional monetary policy would see real yields rise to at least a 2% level and probably to an average of 3%,” Carswell says. “Tack on the Bank of Canada inflation target of 2% and this puts the yield of the DEX long-term bond index at 4% to 5%, up from its current yield of 3.3%.”

The current duration of 14.0 years in the DEX long-term bond index, he adds, suggests long-bond prices would drop by as much as 15%-20%. In the U.S., normalization implies a rise in interest rates to 4% for 10 years and 5.5% for 30 years.

Moves to higher interest rates will follow the cessation of quantitative easing by the Fed and allow market forces to set rates. The normalization process is likely to move quickly once it starts, Carswell notes. Canada would move in tandem with the U.S., as it almost always does. The process, he suggests, could begin in the second half of 2013.

When interest rates do begin to rise, institutional bond sales will accelerate the rate of decline of current bonds’ prices. Canadian life insurance companies have hedged their actuarial risk on bonds, which is the difference between the interest they expect and what they get, by buying more bonds when yields were dropping and prices are rising.

When interest rates do begin to rise, the insurers will be selling into dropping yields, accelerating the price decline, Carswell explains. The consequence for your retail clients holding long bonds is likely to be magnified losses.

The problem you are likely to face at that point is balancing the duration risk of government bonds with the potential downside when interest rates rise. The DEX universe bond index has an average duration of 7.0 years, the longest of all major bond markets. The reason is twofold: the existence of the long-bond market – which is absent in many emerging markets and in many European countries – and the relative calm of the Canadian market. That can make potential losses in Canadian government bonds higher than in other bond markets.

The predicted sell-off of government bonds will gain strength from more confident equities markets, notes Rémi Roger, vice president and head of fixed-income for Seamark Asset Management Ltd. in Halifax. “Investors will sell bonds to buy more risky assets,” he says, with the proviso that, over the long term, the growing proportion of older investors in Canada and the U.S. will continue to maintain a substantial market for fixed-income.

The question, therefore, comes down to how long today’s low interest rates will last. Upward pressure is in place, says James Hymas, president of Toronto-based Hymas Investment Management Inc. and an expert in preferred shares. “Current interest rates are unsustainable, as is the U.S. deficit,” he says. “Negative real yields on government bonds in the U.S. and in Canada, and the risks intrinsic in investing in the still growing U.S. deficit by way of holding U.S. T-bonds, imply that investors will demand higher interest rates.”

There is as yet no rush to sell bonds, he suggests, but when the rush does start and yields start to drop, the long end of the yield curve will rise swiftly.

The meek and the wise will shorten the average term of their bond holdings. As Carswell warns: “The long end of the [yield] curve is a dangerous place for an individual to live while waiting for the inevitable return of interest rates to their historical norms. Current yields do not pay the individual investor for the risk of being long on the yield curve.”

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