1. Should I even care about bonds?

That is what we hear from many of our clients. Indeed, fixed income securities like bonds will – for the most part – generate lower returns than stocks during bullish markets. However, bonds are an essential part of portfolios. Bonds provide more predictable returns over time, and add a layer of protection which usually helps to smooth out returns in a portfolio. However, this year has been a particularly negative environment for bonds. Since January, the broad bond universe (or index) is down more than 12% in Canada, and 10% in the U.S. (globally, some emerging market indices have fared even worse). That may not sound like a lot compared to stocks (some indices have been hit nearly -30% over the same period), but investment grade bonds are “supposed” to protect portfolios during difficult market environments as a flight to quality. This year, fixed income is one of the main reasons why conservative portfolios are feeling the market correction more than usual.

 

2. What are bonds anyway?

A bond is a fixed-income instrument where investors lend money to a borrower – ex. a company or a government – generally in exchange for a fixed rate of return over a specified period of time. The bond will most often offer semi-annual or annual interest payments known as coupons. When the bond matures, the original amount borrowed (par value) is repaid to the lender. Here is an illustration of a basic 5-year, $1,000 par value bond, with 3% annual coupon payments:

 

3. How do bonds protect a portfolio?

Traditionally, when stock prices fall, “risk-free” assets like government bonds will increase in value, and this is why Balanced portfolios are diversified between these two main asset classes. This is the first time in 30 years that both stocks and bonds declined by more than 10% concurrently.

Harry Markowitz won a Nobel Prize for developing Modern Portfolio Theory (MPT), a ground breaking investment strategy based on the idea that investors should optimize their portfolios from both a return as well as from a risk standpoint. The idea behind MPT was that investors should diversify their portfolio to optimize the amount of return they would generate for a desired level of risk. To do so, they should diversify their portfolio between risk assets (ex. a diversified stock portfolio) and risk-free assets (ex. government bonds).

 

4. Bonds have not been protecting portfolios right now. Why?

Bonds are highly dependent on Interest Rates – which in-turn are influenced by inflation.

When interest rates rise, bond prices will fall. This is a counterintuitive, but crucial relationship to grasp. If a bond is yielding 3%, but interest rates on comparable new bonds increases to 5%, the price of the original bond must fall as it has become less attractive relative to other investments with the same risk profile. Once the price falls, a new investor who purchases the bond would earn return from two sources: the coupon payments, and the eventual repayment of a par value that is higher than the price they paid for the bond.

When we have inflation like we have seen in recent months, there are two things to remember:

1) Central banks will attempt to tame inflation by raising interest rates and making it more expensive to access capital. These higher rates put downward pressure on bond prices as they adjust to the new market conditions.

2) Higher inflation also decreases the real return (ie. the return after adjusting for inflation) on bonds, making them less attractive investments (thus decreasing prices) so long as inflation persists.

 

5. How and when does this end?

While it is impossible to predict the exact path of inflation from here, it stands to reason that as issues relating to the supply chain begin to ease, and as higher rates cause a slowdown of economic activity, inflation will begin to slow. In fact, we are seeing a number of indications that this trend is further along than many would expect. For example, many commodities (lumber, iron ore, copper, wheat, and others) are now trading well below their recent highs. Shipping rates and port congestion readings are on their way down, oil prices have pulled back from highs, and wage inflation has started to ease. All of these are leading indicators that are only captured in inflation readings (ex. CPI, PCE, etc.) on a delayed basis.

As this occurs, it will allow central banks to then begin responding to slowing economic growth by pausing interest rate increases, and potentially even lowering rates in the not too distant future. At that point in time, and potentially even ahead of it as the market begins to anticipate these changes, bonds are likely to start performing relatively well – potentially even buoying overall portfolio performance more than usual as a result of the higher interest rates being paid on fixed income today.

 

Bottom line: Should I sell or buy bonds now?

Bonds remain an excellent way to navigate uncertain times for the markets, as even when they experience volatility like we’ve seen recently, the future cash flows and repayment of the par value remains unchanged. In the short-term, things could continue to be volatile as the market comes to terms with the most likely path forward on inflation. However, extrapolating a few months of anomaly into saying “this time is different” remains a dangerous proposition. We believe the outlook on fixed income returns has actually improved, and that bonds should remain a key part of a Balanced asset allocation in combination with equities and alternatives. For more information on this outlook, please consult our previous blog: 3 Reasons Timing the Market Is Futile.

 

Thanks for reading.

Di Iorio Wealth Management

 

 

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