man wearing a mask / FG Trade

Bond yields are supposed to drop as interest rates decline. But recently, data have shown otherwise. For the year to Nov. 30, the iShares Core Canadian Universe Bond Index ETF posted a 8.06% return. That’s 339 basis points over the return of the iShares S&P/TSX 60 Index ETF (which turned in a 4.67% total return for the same period) and with a great deal less risk. The reason? Old bonds with relatively high interest rates gained value as new bonds with lower rates hit the market.

Getting a good return for taking little risk seems against the rules. However, in a world of negative nominal interest rates on senior sovereign debt from Germany, France, parts of Scandinavia, the Netherlands and Switzerland, Canadian bonds with positive interest rates offer old-fashioned value during a time of peril.

Business conditions have languished as the Covid-19 pandemic has forced companies to close, shrivelled people’s income, reduced demand for oil and energy products, and hammered banks’ earnings. Quantitative easing (QE) has produced bond outperformance relative to stocks.

All of this seems to be the way of the immediate future.

“The Bank of Canada will keep providing monetary stimulus to support the economy through the recovery,” Tiff Macklem, governor of the Bank of Canada, said on Oct. 29. The recovery depends on how fast various vaccines get into the bloodstreams of Canadians. BoC guidance states that the overnight rate will remain at 0.25% until at least 2023.

Meanwhile, the U.S. outlook is clouded by political issues. For now, the U.S. target rate and the BoC overnight rate are both at 0.25%. Inflation is running higher than these policy rates. In October, the inflation rate in the U.S. (1.2%) and in Canada (0.7%) resulted in lenders paying borrowers to take their money.

How long can financial fears depress interest rates and reward bond investments? Josh Nye, senior economist with Royal Bank of Canada in Toronto, says central banks won’t abandon QE and the policy of flattening the interest rate curve for quite some time.

“The BoC is sensitive to high household debt loads,” Nye says. That creates a policy bias against raising interest rates and pushing families who are unable to pay higher borrowing costs into financial distress.

Sentiment against raising rates and steepening the yield curve reflects a desire to suppress volatility in equities markets. James Orlando, senior economist with Toronto-Dominion Bank, says interest rate management is now about stress control via injections of liquidity into markets. “Our view is that we are at the lower bound,” he says. “Our view is that rates will go up.”

The pressure on monetary authorities to keep the economy humming has turned cheap money into life support. The Government of Canada plans to borrow $703 billion in fiscal 2020-21, which is $427 billion more than issuance in 2019-20.

Higher debt serviced by higher taxes impedes economic growth and future choices. Global currency markets used to penalize nations for inflation and/or currency mismanagement, but nowadays, one country’s red ink is matched by another’s. For example, nearly three-quarters of European sovereign bonds traded on TradeWeb had negative yields as of Oct. 31 — a record high. Government spending in excess of tax collections is not just tolerated — it is expected.

Chris Kresic, head of fixed income and asset allocation at Jarislowsky Fraser Ltd. in Toronto, predicts rates on the 10-year Government of Canada bond could rise to 1.15% by July 2021 from 0.67% on Nov. 30 on good news about containment of the virus.

Kresic predicts the rate on 10-year U.S. Treasury bonds, anchored at 0.84% as of Nov. 30, could rise to 1.30% by July 2021. Those rises would steepen the yield curve and increase the reward for clients going long.

In the face of rising rates, investors would be well advised to go short as rates rise, and then overweight corporate bonds for yield, Kresic says. The best performers could be energy companies’ bonds that have been beaten down by environmental concerns. A recovery could raise those companies’ cash flow and ratings.

The big “if” in these projections is Covid-19. If the pandemic stabilizes or ends, the ensuing business recovery may lead to more borrowing and higher rates. That would drive down bond prices. But as a countervailing pressure, money made in the equities markets will probably rebalance into bonds.

In all of this, there is no political risk premium. We have no reason to think that the U.S. will not maintain its obligations, pay interest, redeem maturing Treasury issues and remain the bedrock of global finance.

If things get worse and new bonds are issued with even lower yields, today’s minus numbers could look attractive. High risk inherent in the tentative Covid-19 recovery, uncertainties before President Trump’s title acquires an “ex-” and any vaccine failures could make stocks plummet, which would push money back into bonds and cause fixed-income returns to rise.

If the recovery runs smoothly, though, stocks will soar and take some of the money currently held in fixed income off the table.