MARKET COMMENTARY

Bond Logic

Declining bond yields have been a defining feature of the investment landscape for the past 40 years. We look at the role of bonds and picking performance in today’s world.

08.03.2020 - Giles Marshall, Vice President, Portfolio Manager,

What’s been the defining feature of the investment landscape of the past 40 years? The answer is arguably the secular decline in bond yields. The chart below shows the yield on the Government of Canada 10-year bond over the 40-year period, March 31, 1980 to March 31, 2020.

The downward slope in yields was advantageous to bond prices, provided a strong tailwind for equity prices, and much-needed support during times of heightened volatility such as the Gulf War, Asian Financial Crisis, Global Financial Crisis (GFC) and, most recently, the pandemic-induced correction.

Of all the unpredictable consequences of the 2008-2009 GFC, the continued decline in bond yields surprised many, given the range of monetary policy initiatives deployed by central banks worldwide. The aggressive loosening policies prompted widespread expectations that inflation would be unleashed. But over the 10-year period to March 31, 2020 the FTSE TMX Canada Universe Bond Index delivered a solid total return of 4.46% annualized.[1] Given the pandemic’s economic impact, central banks have again loosened monetary policy. Only this time, it’s to an extent unthinkable just a few months ago. With the Government of Canada 10-Year bond yielding a meagre 0.53% at May 31 and negative bond yields prevailing across much of Europe and in Japan, where do we go from here and what role can bonds play in a portfolio?

Bonds traditionally provide capital preservation benefits, a reliable source of income and a cushioning effect when equities are volatile. We see them continuing to play this role in the near term. Inflation expectations remain muted and bond prices are likely to remain rangebound. However, given the monetary stimulus already in the system and the possibility of more to come, combined with a likely rollback of globalization, shorter and less efficient global supply chains and aging populations in most developed markets, the potential for higher inflation beyond the near term is a threat. Looking shorter-term, as the economy begins to open, we expect the yield curve will revert to its normal upward slope, prompting bond prices at the longer end of the curve to drop.

Based on these factors, we retain an overall duration exposure (i.e., interest rate sensitivity) below that of the FTSE TMX Canada Universe Bond Index while emphasizing investment grade corporate bonds, which provide a superior yield to government bonds.

With such low yields, the long bond bull market is surely in its final throes. But, short of inflation accelerating rapidly, which seems unlikely at this point, we believe bonds will continue to play a role in a balanced portfolio. In time, as inflation expectations rise, we’ll decrease our bond position and increase equity exposure to hedge against inflation risk.

 

 

Footnotes:

1. Source: FactSet, as at March 31, 2020.
2. Organization for Economic Co-operation and Development, Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for Canada [IRLTLT01CAM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01CAM156N, May 18, 2020.

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