Financial advisors grapple with bonds turned upside down: “What’s the right allocation for negative real yields?”
The conventional wisdom in portfolio allocation is that clients of any age should hold some bonds. But with government bonds and top-tier corporates priced to produce negative real yields and with only modest rate increases in sight, the question has to be posed: “Why hold bonds at all?”
Asset-allocation strategies have been turned on their heads. Today, investors can buy stocks for income and bonds for capital gains. The risk in pursuing this strategy is that overpriced bond markets may correct severely.
That will not happen any time soon, says Edward Jong, vice president and head of fixed- income with TriDelta Investment Counsel Inc. in Toronto. “Bonds have price risk, of course, but government bonds are different from corporate bonds. As long as central banks keep on buying government bonds, the price does not matter.”
In a nutshell: bonds are on life support. If that support ends, Jong says, the market will crash. That support is still there, for the U.S. Federal Reserve Board’s Open Market Committee voted to leave overnight rates unchanged in its Sept. 21 statement. Canada, too, is on hold. The U.S. overnight rate remains at 60 basis points (bps), the same as Canada’s.
“The Fed did nothing on Sept. 21, but did lay the groundwork for a hike – perhaps at the December meeting,” says Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto.
Nevertheless, advisors are sticking with bonds. But they are doing so for reasons somewhat different from the old allocation rule: the percentage of fixed- income in a portfolio should match the investor’s age. (For 60-year old clients, 60% fixed-income, etc.) Now, the principle appears to be buying equities as insurance. The income from bonds is negligible and irrelevant.
You could call this strategy “going with the flow.” At the time of writing, 10-year U.S. treasuries were priced to yield 1.69% while Government of Canada 10-year bonds’ yield was 1.19%.
Yields are low, but that is not the point, says Dan Stronach, president of Stronach Financial Group Inc. in Toronto. “I continue to have high bond allocations for clients. Bonds stabilize portfolio risk, so I have moved clients to shorter-duration bonds with less price downside.”
Stronach’s strategy is buying portfolio stability and paying for it with yield. The trade-off is good, in the sense that the yield given up in moving to two-year term Canadas that pay 0.57% is 62 bps off the 10-year yield, but that spread is only $620 on $100,000 of face value. The short-term Canadas are an insurance premium, and it is worth paying, says Stronach: “Bonds remain the safety pin. To get stability in the portfolio, you have to use bonds. And the cost in foregone yield is just what has to be paid.”
For Caroline Nalbantoglu, president of CNal Financial Planning Inc. in Montreal, the rationale is liquidity: “I recommend an average of 40% fixed-income, although that varies with the client, of course. If the client is accumulating, building wealth in his or her portfolio, then he or she can take some risk. If the client is in the withdrawal phase, a lot of price risk usually is not bearable – so I suggest that the client have at least two years of laddered short bonds. That way, the client will not have to sell stock into a down equities market.”
Price risk on income stocks is genuine. In the first two months of 2016, BCE Inc. fell by 7% and a broader measure, BMO Canadian Dividend ETF (TSX: DZV), dropped by 16%. In comparison, the BMO Aggregate Bond Index (TSX: ZAG) rose by 2% in the same period. In other words, bonds are performing exactly as they should, although with much lower income returns. The problem of holding bonds for income becomes more severe when you put money into longer-term issues.
The 30-year Canadas were yielding 1.84% to maturity at the time of writing. With a 20-year duration, that bond packages a lot of risk in a low-yield box. The 30-year U.S. treasury had a 2.45% yield and a 21.5-year duration.
The pattern of investors buying bonds for capital gains as well as portfolio insurance is likely to prevail, says Jack Ablin, executive vice president and chief investment officer with BMO Harris Bank N.A. in Chicago: “The correlation that we see now is that bond prices will rise and rates drop in response to an equities pullback.”
Both stocks and bonds are expensive, Kresic says. The yield sacrifice in bonds of going shorter when the curve is flat is low. Short corporate bonds give added yield with little duration risk. For a retail account, he notes, corporate bonds can be held to maturity.
There also is the irony that some government bonds now are priced so high by the buying programs of central banks that these issues have become relatively illiquid. If the Bank of Japan wants to sell down its own negative-yield bonds, odds are only other central banks will buy those bonds.
Bottom-feeding nominal interest rates and negative real interest rates have created an unreal bond market that cannot last, Kresic says: “Borrowers become lenders because they get paid to borrow. They have to pay less than they borrowed. Creditors are then, in effect, debtors because they have to pay to lend. This bond market’s rules seem to have been written for an Alice in Wonderland world. Ironically, playing by those rules still pays.”
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