As yields rise and prices fall, what's a bond investor to do?

Consider laddered portfolios, shorter maturities and floating-rate products.

Andrew Hepburn 20 February, 2018 | 6:00PM

Bonds are selling off. What's an investor to do?

For decades, interest rates have been on a steady decline, making bonds a great place for investors to park their money. Falling yields cause bond prices to rise, resulting in capital gains for investors.

Those bullish days appear to be over. Take the benchmark U.S. 10-year bond, for example. In early July 2016, it traded at a yield of 1.37% amid fears of deflation and talk of negative interest rates by central banks. Less than two years later, the U.S. 10-year now stands at 2.90%, a sharp climb even from last September, when it traded at 2.20%.

There are some key factors driving the upward pressure on bond yields, and therefore the downward pressure on bond prices. On the fiscal-policy side, the massive tax cuts recently passed by the U.S. Congress mean that future budget deficits will be very large. This will require a significant amount of new bond issuance by the U.S. Treasury. More bond supply, all else being equal, equals lower bond prices and higher yields.

Monetary policy is also playing a role: the U.S. Federal Reserve, which accumulated large amounts of bonds during its quantitative-easing programs, has begun the slow process of reducing its balance sheet. Having been supportive of the bond market for years, the Fed is now somewhat of a headwind.

Added into the bearish mix are signs that U.S. inflation is finally on the rise. For years since the financial crisis, core inflation measures consistently undershot the central bank's target of 2%. Wage pressures, in particular, failed to materialize. But recent data suggests inflation is accelerating. Indeed, according to the U.S. Department of Labor's latest monthly report, wages grew 2.9% year over year, suggesting that a tight jobs market is finally resulting in higher earnings. Inflation tends to go hand in hand with higher interest rates, giving the bond market another reason to send yields higher.

Benjamin Reitzes, Canadian rates and macro strategist at BMO Capital Markets, doesn't expect an upward spike in rates, but he believes that the direction of rates will be consistently higher. He cites good global growth and an expectation that the Bank of Canada is likely to keep raising rates. Reitzes notes, however, that in his view, "the high of this cycle will be lower than the high of the last cycle."

Daniel Straus, vice-president at National Bank's ETFs and financial-products division, also does not foresee a large jump in bond yields. "Despite recent stock-market pullbacks, there remains a consensus that the economic backdrop of growth and productivity is strong, which sets the stage for continued central-bank tightening, albeit at a slow pace.

In other words, rates might inch higher slowly, rather than spike to significantly high levels on a short time scale, he says. Straus believes the main factor driving bond yields at the moment is "increasingly hawkish, though cautious" central-bank policies around the world.

For Ben Homsy, a portfolio manager at Leith Wheeler Investment Counsel in Vancouver, long-term bonds are now close to fair value. "We've been expecting a move higher in bond yields for some time," he explains. Homsy argues that "what we're seeing now is a natural evolution in the global economic cycle," with "some signs inflationary pressures are building."

Homsy believes bonds still have a role to play for investors, providing "some reasonable level of return" plus an element of diversification. He adds that laddered bond portfolios mitigate the risk of rising rates.

BMO's chief investment strategist, Brian Belski, believes the conventional view that higher rates are bad for stocks is misguided. In a report dated Feb. 1, Belski and his colleagues argued that, generally speaking, rising rates actually coincide with higher equity prices. This makes intuitive sense, they say, because rates tend to increase in environments of strong economic growth. According to their report, in a rising-rate scenario, investors should focus on stocks with low debt burdens and strong levels of free cash flow.

There is one piece of information in the BMO report that should give bullish equity investors reason not to get too carried away. Namely, five of the six interest-rate cycles (for the U.S. 10-year bond) examined by the strategists since 1990 coincided with double-digit annualized gains for the S&P 500. These ranged from 11.2% to 23%.

The one exception was from September 1993 to December 1994. During that period, the S&P 500's annualized gain was a paltry 0.1%. This may have some bearing on today's markets, since 1994 famously experienced a bond-market crash that left major hedge funds and Wall Street trading desks nursing serious losses. Fast forward to 2018, and a curious feature of the early February rout in equities is the sense that, in part, it was caused by the incessant rise in bond yields.

Of course, the fixed-income market is directly affected by higher interest rates, with long-term bonds being the most sensitive to changes in yields. Perhaps not surprisingly, investors seem to be shying away from these types of securities. Straus of National Bank points out that investors have been pouring money into shorter-term bond ETFs and floating-rate products lately.

For his part, Leith Wheeler's Homsy sees opportunities in one- to two-year Canadian bonds. While the market is pricing in 62 basis points of tightening from the Bank of Canada this year, Homsy suggests this might be too aggressive an expectation. In essence, he says that it's easier to contemplate events (such as a housing correction or an unfavourable outcome from NAFTA negotiations) that would lead the central bank to tighten less than forecast, rather than more.

In the near term, it's quite possible that yields may retrace a bit. Speculators, according to U.S. government data, are now betting heavily against 10-year bonds. This raises the prospect of a short-covering rally, which would send interest rates lower. Yet unless economic data begin to consistently disappoint, or inflation fails to stabilize, investors will have to get used to the new reality of higher interest rates. Perhaps it's too soon to officially declare the bond-market bull well and truly departed. For the time being, however, it's nowhere to be seen.

About Author

Andrew Hepburn

Andrew Hepburn  Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, RateHub.ca and Canadian MoneySaver.