It seems that investors can’t get enough of bonds these days. Recent figures released by the Investment Funds Institute of Canada show that net sales of fixed-income funds in Canada tripled in 2012. On the one hand, this apparent insatiable demand for bonds is understandable – investors spooked by the financial crisis and heightened market volatility are seeking lower risk options and the baby boomer bulge is heading into retirement, a stage when investing for income and capital preservation typically trumps investing for growth. But, on the other hand, the current returns from bonds (and those for the foreseeable future) are so low that the incredible appetite for bonds defies logic.
Looking for yield, investors have been heading lower and lower down the credit risk scale to eke out a higher return from a perceived “safe” asset class. So much so that in the United States two major mutual fund companies, T. Rowe Price and Vanguard, stopped taking new money into funds that invest in “junk” or below investment grade bonds because of difficulties finding opportunities to invest the money at a reasonable risk/return trade-off. Some have been speculating that bonds are the next big bubble. More likely, we are seeing the end of the great bull bond market that began in 1981.
Is the bond party over?
As the chart below illustrates, for the 30 years from 1980 to 2010, investors enjoyed historically high returns from bonds even when inflation was factored in. But the preceding 30 years show a bear market for bonds where returns barely kept up with inflation. Pessimism about bonds at the time was rampant and commentators from Wall Street deemed bonds a “bad” investment in a 1981 New York Times article. That “bad” investment had an incredible run over the next three decades. Yet, with the yield on a 10-year Government of Canada bond at 1.80% as of December 31, 2012 and the annual rate of inflation registering at 0.80% at the end of November 2012, it’s hard to not conclude that the bond party is mostly over.
Bond returns through the decades
|Rate of Inflation||Return Net of
Source: 2012 Andex Chart ©Morningstar
Still, bonds will remain a key part of an investor’s portfolio, valued for providing income flows (albeit lower ones) and for lessening the impact of equity volatility. Returns from bonds of 5% or more per year (net of inflation) are not expected to be repeated any time soon. In the low interest rate environment, what’s most important is how the bond portion of your portfolio is managed so that it is able to play this crucial role in your overall investment plan.
Managing interest rate sensitivity
One of the levers for effectively managing a bond portfolio is duration, which is the weighted average of the term-to-maturity of the bonds held and indicates the portfolio’s sensitivity to interest rates. A shorter duration means less sensitivity to changes in the level of interest rates. If rates rise, there will be a more limited depreciation in the value of bonds held and an earlier turnover of assets to take advantage of the rising rates. Currently the DEX Universe Bond index has a duration of seven years, which is roughly the period over which an investor will realize the current yield of 2.2%. To illustrate how returns could vary over that period, a 1% increase in interest rates would result in a 7% decline in the value of the index. Conversely, if interest rates decline by 1%, the value of the index would increase by 7%. Shortening the duration within bond portfolios is a strategy that we are pursuing to reduce sensitivity to future changes in interest rates.
Finding ways to responsibly enhance yield
Another lever available to managers is increasing yield. But, of course, higher yield comes with increased risk. Today, in our low interest rate environment, everyone is searching for higher yields and the demand for riskier emerging market debt and high-yield bonds is at an all time high. In the U.S., investors have poured a record $350 billion into junk bonds in 2012. Given such high demand, the risk premium historically associated with emerging market and junk grade corporate debt is weakening, leaving investors with more risk in their portfolio for less return. While steering clear of junk bonds, we have been taking advantage of opportunities to tweak yield through higher quality corporate debt that offers a respectable return premium for the additional risk involved.
Over the short term, we expect to see increased volatility in bond returns but these short-term fluctuations will make little difference to your overall return if bonds are held for the duration.
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