Hello, 

Here is the last section of this fixed income commentary. In the past few weeks the market has rallied however we have seen the biggest impact for balanced investors on the fixed income side and especially in the rise of long-term interest rates.

As the first chart shows, the yield curves in Canada and the United States have really changed over the past year. In January 2020 (the red dotted lines), the difference between the 90-day versus 30-year rates was minimal.

A few months later, in August 2020 (the blue dotted line) we notice two things. First, rates have really gone down for all maturities, from 90 days to 30 years, rates are lower. The other important thing is that the curve is now upward sloping, meaning that the 90-day rates are lower than the 30-year rates.

Today (the red line) we notice that this slope has increased. The 90-day to 2-year rates are pretty much unchanged but for later maturities we see a significant increase in rates. This partly explains why the Bank of Canada and the Fed are consistently buying more long-term bonds. Due to the fact that they have much less direct control over long-term rates than they do rates of maturities of 1 year or less.

Recall that when rates go up, the price of bonds goes down. It is therefore normal that since the beginning of the winter months, in terms of yield, fixed income has been declining. In contrast, in March 2020, fixed income had been an important component of our outperformance. We must realize that despite the current under-performance, the yield to maturity that we expected from bonds has not changed. Only the trajectory of this yield has changed. In other words, if we had bought a 10-year bond, paying 2.5%, we would still make $ 125 on the $ 100 originally invested. However the trajectory has changed, as shown in the graph below which illustrated a rise or fall in rates on this trajectory.

In red, we see what happens with lowering rates on a 10-year bond. Lower rates increases the price but at maturity you still receive your principal of $100 plus the $25 over the years as interest. The only way to profit from rising prices is to sell the bond before maturity. At this point, you have to buy back a bond at current rates. Remember in our example, rates are lower which explains the rise in the price of the bond.

In blue, we see the reverse (also a reflection of our current situation). That is, the rise in rates causes the price of the bond to fall. Theoretically, we have paper loss. By keeping the bond until maturity, we collect our principal and the interest promised at the bonds purchase.

Which brings me to the management of your portfolios. We have always believed the risk we primarily need to control when it comes to bonds is credit risk. If not, worst case is that an issuer goes bankrupt and is unable to repay our capital. Interest rate risk, the other big risk when it comes to fixed income, we have always controlled by buying maturities laddered annually over 10 years. Principally, the direction of interest rates seems as certain to me as a prediction of the weather for the next month. Secondly, this approach allows us to take advantage of a rate hike and lessens the impact of a rate cut on yield.

Let's see how and why.

Let’s envision a portfolio of 10 bonds, with a maturity every year. When the bond in year one matures, we reinvest in year 10, by buying a 10 yr bond. When the 1-year bond reaches maturity, 9 more bonds remain. Each will mature between 1 and 9 years (recall that when the first bond matures, the portfolio has existed for a year, so the bond with a 2 year maturity is now a 1 year bond)

Next, let’s assume that on day 1, our hypothetical bond portfolio was paying 2% on average and rates increase by 0.25% each year. The result is that our average yield increases slowly but surely as we renew our maturities with higher yielding bonds. So that, in year 8 of our example, we renew at a rate of 4%. In addition, over a decade, the average return rose from 2% to 3.375%, which is, proportionally, a significant increase.

Alternately, a drop in rates looks good to us because it increases the price of our existing bonds. Slowly but surely, however, this drop in rates is lowering our average yield. In our same example, but with a rate cut of -0.25% per year, in ten years the same starting portfolio would go from an average return of 2% to just 0.625% of average return.

In short, the rate hike is currently forcing us to make difficult performance comparisons but in the long term we will benefit greatly. In addition, a more normal yield curve is characteristic of a healthier economy, another positive indicator for a long-term investor. In closing, a rate hike is certainly negative for some stock market sectors but will also help clean up companies that are over-indebted and that were taking advantage of the respite offered by very low rates. On the other hand, the kind of businesses we favor will win out.

As usual, we are available to discuss further and please feel free to circulate these memos to your friends and family if you think they might benefit.

Warmest regards,