A now familiar but concerning trend has persisted this year for bond prices, which move in the opposite direction of interest rates: every month since March, one or both of the Bank of Canada and the U.S. Federal Reserve have announced increases in their trendsetting rates.
The common goal of central banks in Canada, the U.S. and elsewhere is to bring down inflation by slowing economic growth while avoiding a deep recession and massive job losses. In doing so, bondholders — including the millions of retail investors who obtain their exposure through mutual funds and ETFs — have become collateral damage.
“The key for investors is not so much what the Fed does on a given day, [but] rather the read on the expected longer-term trajectory for financial conditions, inflation and the health of the economy,” said Myles Zyblock, chief investment strategist with Toronto-based Dynamic Funds, in an Oct. 31 market commentary. “At this stage, inflation has remained stubbornly high, leaving the Fed with little wiggle room to take their foot off the brakes.”
With its fourth consecutive 0.75% increase on Nov. 2, the U.S. Fed — whose influence is felt globally — hiked the target range for its federal funds rate to 3.75%–4%. After six rate increases so far this year, the rate is up a whopping 375 basis points since the zero–0.25% target in January.
Similarly, the Bank of Canada’s bellwether overnight rate rose for a sixth time this year to 3.75% on Oct. 26, up 350 basis points since January. It was scant consolation to mortgage holders, other debtors and bond investors that the latest 50-basis-point hike was less than had been widely expected.
Since bonds’ cash payouts are generally fixed amounts, the steep rate increases have made existing issues less attractive, driving down prices. The longer-dated the maturities — or the longer the duration, a more precise measure of rate sensitivity — the greater the losses.
In the year to Oct. 31, the total loss sustained by Canadian long-term bonds — which have maturities longer than 10 years — was about 23%. By comparison, the investment grade universe as a whole lost about 13%. Meanwhile, short-term bonds, which have maturities of one to five years, lost less than 5%. (These negative returns are after interest income.)
For investors looking to make new investments in bonds, the positive aspect of this year’s losses is that yields have become increasingly attractive. In early November, the yield to maturity was about 4.5% for the Canadian investment-grade universe and 5% for its U.S. counterpart.
As rates moved higher and higher, market pundits continued to ponder when rates might begin to level off if not decline. But in making their latest tightening moves, U.S. Fed chairman Jerome Powell and Bank of Canada governor Tiff Macklem were both adamant that more rate increases are still to come. This will continue to exert downward pressure on bond prices.
Among the prominent bond watchers who are inclined to take central bankers at their word is Sonal Desai, chief investment officer of Franklin Templeton’s fixed income group based in San Mateo, Calif.
Desai said the Fed’s latest rate hike confirms her long-standing view that the policy rate will go higher than markets anticipate and stay higher for longer, and that investors should not expect rate cuts in 2023.
The Fed funds rate “is headed toward 5.5%, and markets still need to absorb this across the yield curve,” she said. Before fixed income markets recover, “we will first continue to face bouts of volatility like we have seen in the past few months on the back of each new data point, as the yield curve adjusts to this scenario of a more hawkish Fed.”
Amid uncertainty over when rate relief may arrive, recommendations from market strategists will vary depending on their expectations for economic growth and inflation.
BMO Asset Management Inc.’s fall ETF forums for financial advisors brought together experts from several investment firms who discussed their picks for recession, rebound and “wild card” scenarios.
Jin Yan, director and portfolio strategist with CIBC’s capital markets division, recommended long-duration bonds in the event of a recession. “Typically in a recession, you get rates coming down,” she told the Oct. 13 forum attendees in Richmond Hill, Ont. “So you want to have that exposure to securities that are more sensitive to falling rates.”
In a rebound scenario, CIBC Capital Markets favours short-and mid-term corporate bonds because, in an economic recovery, their rates should fall by more than the long end of the market. When yield spreads narrow over government issues, prices of corporate bonds go up.
An economic recovery would also be positive for high-yield bonds, which are more speculative in nature. “They really benefit from the narrower credit spreads,” said Yan, as investors become more confident in the economy.
Alfred Lee, director, portfolio manager and investment strategist with BMO ETFs, suggested U.S. Treasury Inflation Protected Securities (TIPS) as a “wild card” applicable to either recession or recovery.
As a hedge against inflation uncertainty, Lee cited the BMO Short-Term US TIPS Index ETF, which in early November had a weighted average yield to maturity of 4% with a duration of 2.5 years. “Even though I think inflation is going down, we’re going to have some structural inflation due to what’s going on in Russia and Ukraine,” he said.
With markets expecting that interest rates will continue to rise in the short term, safer alternatives include money market mutual funds, which generally yield more than 3%, and high-interest savings ETFs, which have yields exceeding 4%. GICs are available at still higher rates, but require longer holding periods.
For investors who want to be able to sell at any time and are willing to accept day to-day price fluctuation and some credit risk, floating-rate funds and those holding “ultra-short” maturities are modestly higher yielding alternatives with low duration risk.
“Most advisors, I think, are at a spot right now,” said Ahmed Farooq, senior vice-president and head of retail ETF distribution with Franklin Templeton Canada, “where if they’ve moved into cash and cash-type equivalents, they’ve asked: ‘Is there any way I can enhance that a little more than what I have today?’”