After taking a massive beating, the bond market looks attractive again. Many analysts think it’s time to move back in. But be careful, says a Morningstar specialist.
Presently, the dominant narrative “is that inflation and rate increases will peter out in the course of 2023,” recalls Anil Passi, Director of Global Corporates at DBRS Morningstar. “If you agree with that, then everything is good.”
“We’re seeing a turning point; at their present levels, bonds are looking very attractive again,” says Paul Sandhu, CEO and CIO of Marrett Asset Management. Since Sandhu manages a bond fund, some could claim that his perspective is biased.
But he’s not alone in rooting for bonds. “We see many managers of equity funds propose a “hold” position, but on the bond side, the signal is a strong buy,” says Marc Johnston, Director of investments and retirement at Groupe Cloutier Investments.
Historic Beating
Investors had good reason to be wary of bonds. By mid-October, year-to-date, the FTSE Universe Canadian Bond Index had shed 17%, while the S&P/TSX had fallen only by 12%, and the Morningstar Canada Domestic Index by 10.93%. It was worse in the U.S. By the end of October, long-maturity Treasuries had fallen by 34% while funds tracking the bond market had dropped by about 16%; in that time, the S&P 500 index had shed 21% and the Morningstar US Market Index by 20.15%. “On paper, bondholders have seen their returns fall into the red, something we haven’t seen in 40 years,” points out Martin Lefebvre, Chief Investment Officer at National Bank Investments.
This is an unusual historical moment: the correlation to Canadian equities was greater than 1.0 when it should normally be below 1.0. This is not unheard of during the past 100 years, but for the past two decades, the correlation between stocks and bonds has been consistently negative, and investors have largely been able to rely on their bond investments to protect them in the event of a decline in equities. Not in 2022: bonds dropped even more than stocks.
Now, the interest rate context is bringing bonds back to their basic role. “Expected returns are more attractive and bonds are more likely to play their role as an asset with a lower correlation to equities,” says Lefebvre.
Observers are not crying victory over the possibility of a recession, but optimism is in the air, with Nobel laureate Paul Krugman claiming that “a soft landing is looking increasingly plausible” after inflation numbers for October were lower than expected.
Waiting for the Turning Point
However, even barring a soft landing doesn’t dampen Sandhu’s optimism for bonds. If the Fed rate rises to 5%, he says, “we will likely have a hard landing and, at that point, rates could start to go down.”
That turning point when rates level off and even start to back down is what portfolio managers are keenly attentive to. “That point will be extremely profitable for bonds,” says Fred Demers, Director and Investment Strategist at BMO Global Asset Management, “In their transition to 2023, central banks will become more measured in their assertions and deeds”.
Presently, Sandhu and other portfolio managers are mostly positioned in short, less than two-year duration issues. When the turning point becomes imminent, “we would go full throttle and add aggressively to duration,” he asserts. And even if central banks hike rates higher than the expected mark of 5%, it would still not be catastrophic. “You might be wrong for a few months, but you would still win in the long run,” he adds.
Don’t Discount Inflation Yet
The present crucial variable in the bond equation remains inflation and how an investor times his purchases in relation to it. “If inflation and rising rates are around longer, you should stick to short-term issues and keep rolling them,” Passi advises.
Indeed, concerns arise here and there that inflation might be more embedded than what most observers think, notably that a wage inflation spiral could take hold in Europe, even in North America. The present teacher strike in Ontario is a warning sign that such events could multiply. Also, oil prices could rise again above the $100/barrel mark, propelled by a combination of factors: China’s reopening, the ending of strategic reserve releases, the spillover of price caps on Russian oil, and OPEC supply restraints.
However, such concerns don’t cancel the present attractiveness of bonds. “If you’re of the view that inflation is embedded for longer, then you should hold out longer,” Passi points out, “If not, it’s a good time to go into bonds. But I think it’s early; I would still keep my powder dry.”
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