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Prudent Investor Update, November 21, 2018

Managed bonds in a rising rate environment

Bonds are a popular fixed income instrument for municipal governments and ONE Investment offers two professionally managed bond portfolios. We earlier highlighted the value of bonds in a low interest environment. We now look at current interest rate trends and explain strategies our bond portfolio managers use to address the changing environment.

Why We Invest in Bonds
 
  • Unlike stocks, the value of bonds comes from the stream of interest they pay, rather than by increased wealth creation. Over the long run, interest rates tend to reflect long-term economic growth and inflation.
  • Bond returns are comprised of two components:  interest and capital gains/losses.  
    • The steady stream of interest payments stabilizes bond returns; this is especially beneficial when the interest payment is above the rate of inflation.
    • When interest rates rise, bond values fall, which means a capital loss, and vice versa.  Although there may be defaults during periods of rising rates, the capital losses mentioned here are not due to any default.  Rather, they are a direct outcome of the impact of rising interest rates on the price of the bonds. Gradually over time, as interest rates rise, newly issued bonds have higher coupon payments and the capital losses have a lower impact on returns.
  • Because of their relatively stable returns, bonds provide diversification versus volatile equity investments.  The following chart shows that in years when stocks went down, bonds provided a return cushion.
Image of  chart showing Calendar Year Performance When Equity Returns Were Negative

What are Interest Rates Doing?
Image of chart showing Long-term Perspective on Interest Rates
 
 
 
  • This chart shows that the 40-year downtrend in interest rates, which started in the 1970s, has since generated fairly consistent capital gains. Following the post-war growth period of the 1950s and 1960s, a huge anomaly occurred when interest rates shot up in the 1970s due to the oil price shock, higher wage growth and other factors. They have been adjusting back down since then, and now reflect the lower economic growth resulting from slower population growth.
  • Forty years ago, investors experienced the best of both of these sources of returns:
    • Interest rates were high = sizeable coupon payment, and
    • Interest rates were falling = fairly steady capital gains over 30 years.
  • Now, we are at the other end of the spectrum.  Rates have been rising resulting in capital losses, combined with low coupons. This means that we can no longer use past bond returns to project future returns.
  • Interest rates appear to have bottomed in 2015 and have been rising with recent economic growth. However, consumers and governments are now so highly indebted that higher interest rates could cause serious economic hardship.  This may encourage the Bank of Canada to keep future rate hikes modest.
  • Bonds with longer maturities have greater price movement from a change in interest rates.  Therefore, interest rate changes have a smaller impact on short term bonds and the coupon is a larger factor in overall returns.
Impact on ONE Investment Bond and Universe Corporate Bond (UCB) Portfolios
 
  • Changes in market value are reflected separately in our statements from investment income, whether they are realized or not. Over the last two years or so, realized and unrealized capital losses have been roughly equal to the interest payments, causing total returns to be near zero.
  • In a managed bond portfolio, our manager, MFS Investment Management Canada Limited (MFS), is buying and selling bonds throughout the holding period and is picking those believed to be the most advantageous to hold, given the constraints imposed by the Legal List.
  • MFS is aiming to increase the term to maturity of the portfolio when it believes that interest rates have reached their peak. As well, it will reduce exposure to corporate bonds in the Universe Corporate Bond portfolio, as they will become riskier:  falling interest rates reflect economic weakness which means corporate bonds have a higher risk of default.
  • ONE Investment is confident that this approach is appropriate.
  • Some investors may feel attracted to cash (short-term money market) investments during rising rates. However, cash causes you to give up most of the interest payments earned through bonds. Unless interest rates move higher quickly and significantly, the cash strategy may not pay off.
  • As well, we tend to avoid trying to time market movements because it is notoriously difficult to do. Not only do you have to time your exit from bonds correctly, you also have to get back in at the right time.  Studies show that, on average over long periods of time, most investors are unable to do that correctly.


 













 

Contact

Eleonore Schneider
Program Manager

T 416.971.9856 x320
TF 1.877.426.6527
F 416.971.6191

 
Donna Herridge
Executive Director, MFOA/CHUMS

T 416.362.9001 x233