For the past 35 years, after interest rates peaked in the 18% range in the 1980s, bonds have enjoyed a bull market. This has been characterized by high real yields on fixed income investments along with capital gains from gradually falling interest rates. But now there are a number of reasons to believe that that 35-year bull market is coming to an end. Whether or not that is the case, you may want to consider a strategy of diversifying your bond portfolio to increase returns. Consider it an insurance policy.
Inflation hit double-digit highs in the 1980s. In an effort to bring inflation under control, central bankers in Canada and the U.S. ratcheted up short-term interest rates, while longer bonds followed. With inflation under control, rates edged downward over the years. When the global financial crisis struck in 2008, central bankers used low interest rates in an attempt to stimulate economic growth and bond yields continued to fall globally until very recently. Now, as signs of economic growth increase, interest rates may finally be on the rise.
Rising interest rates spell trouble for bonds, especially fast-rising rates. Since bond prices fall as rates rise, the decline in price can exceed the income earned on the bonds. Given that the starting yields are close to 35-year lows, it doesn’t take much of an increase in rates to offset the income received.
Certainly, central bankers have signaled that rates are moving higher. After dropping interest rates to 0%-0.25% in 2008, the U.S. central bank, the Federal Reserve, began increasing rates in December 2015, with the promise that rates would be increased gradually. The fed funds target rate is currently 0.75%-1%, with two more increases expected as the year goes on.
The Bank of Canada has shied away from increasing rates, leaving the overnight rate at 0.5% for the past 19 months. The Bank is in no hurry to increase rates, but is monitoring policies south of the border that will affect Canadian economic growth. Note that short rates aren’t the whole story. While the Bank of Canada has yet to move, the market has already driven a 10-year bond yield from under 1% percent to over 1.8%.
Of course, not everyone agrees the 35-year bull market in bonds is coming to an end. Naysayers point to Japan and the fact that it has endured low short-term rates for years. Demographics might make a return to inflation and higher interest rates unlikely. They also note economic indicators that suggest the recovery is not as fulsome as we might like. They point to excess capacity and governments with high — and growing — national debt.
None of us can predict interest rates with any real accuracy. Bull market or not, it is clear bond returns will not be as high in the future as they have been in the past. Now may be the time to include alternatives to traditional fixed-income instruments in bond portfolios. T.E. Wealth, for example, has considered a number of options in its portfolios. To diversify across the asset class, we have weighed the value of high-yield bonds, commercial mortgages, preferred shares, unconstrained bond funds and diversified growth funds, to name a few.
These alternative credit strategies have different risk profiles than traditional fixed-income securities, making it important to have a clear understanding of the risks and benefits before including them in your bond portfolio. Talk to your investment counsellor about these alternative strategies, and the opportunity they provide for enhanced returns.
Tessa Wilmott is a financial editor, writer and researcher. She was formerly editor-in-chief of Investment Executive, and has held various reporting and editing positions with the Financial Post, the Financial Times of Canada and the Toronto Sun.
This article was published in T.E. Wealth’s Strategies newsletter, May 2017 edition. Read the full edition here.