Fixed income investors face an interesting investment problem: Where do we go from here? Although bond prices are high and fixed income returns have been notable as of late, yields have come down in a material way — a signal that future returns will almost certainly be lower than they have been in recent months.
Uncertainty and accommodation driving fixed income returns
Bond prices have risen for a few reasons. Most recently, investors have driven up the price of bonds because many are seeking safe haven investments over concerns that the coronavirus outbreak will affect global growth. Even before that, however, investors were already concerned about weaker-than-expected growth prospects for the global economy.
Central banks around the world have lowered interest rates and have taken extraordinary measures to ease monetary policy. The search for higher-yielding instruments has driven up bond prices in many markets. As interest rates decrease, bond prices generally go up and, consequently, the yield on those bonds declines. If interest rates climb, yields will likely go back up as bond prices fall (To determine a bond's yield, we divide the bond's coupon payment by its price, i.e. if a bond pays a $50 coupon and its face value is $1000, the bond's yield would be 5%).
A blockbuster year for bond fund returns... that likely won't be repeated
As yields have fallen, the near-term rate of return earned by bond portfolios has increased. In January alone, the MD Bond Fund had a one-month return of 2.92% — an extraordinary result, the kind of return we might expect over a good year. For the past 12-months, that same fund delivered a whopping 7.66% return (Feb. 1st, 2019 through Jan. 31, 2020).
This was great news for investors but it's not the kind of performance we expect to see going forward.
A bond's starting yield is often a reasonable proxy for what we can and should expect over time for the performance of a bond. The starting yield is a good proxy because it incorporates the bond's coupon payment, the bond's price, and its price at maturity.
Fixed income still plays a part in a properly diversified portfolio
So if future results are unlikely to be as robust as the previous 12 months, are investors still well-advised to keep up their allocations to fixed income? The answer is an unequivocal yes.
The benefit of fixed income investments in portfolio construction is that the asset class is negatively correlated with other assets like equities. They act as a balance, so to speak, against equity market volatility.
A mix of bonds and equities will be far less volatile than a portfolio invested in equities alone. Achieving your investment goals while minimizing risk is the name of the game — why take on risk if it's unnecessary to reach your goals? Reducing volatility in a portfolio can also guard against investor temptations to pull out of markets at inopportune times. For investors with a shorter amount of time to invest, bond funds are an important component to preserve capital and provide timing flexibility.
How we manage risk and improve returns
There are a number of actions we've taken to improve the probability of investment success in a low-yield environment.
Partially due to bond yields having fallen, duration in the Canadian bond market has risen. Duration measures the sensitivity of a bond's price to changes in interest rates. The longer a bond's duration, the more sensitive its price will be to moving interest rates.
We have proactively taken measures to manage our interest rate risk exposure. One of those efforts has been to manage duration. By the end of 2019, our duration was modestly below the benchmark. Today we are getting even more aggressive in reducing our duration. We do this by actively selling a portion of our exposure to longer term bonds (which typically have longer duration), and buying bonds which have a shorter term to maturity.
The second decision we've made, has been to diversify bond holdings outside of Canada – something we introduced back in 2015. By doing this, we've reduced our exposure to changes in domestic interest rates and the domestic bond market.
Our overall aim is to enhance income but still maintain our focus on capital preservation. Our proactive, opportunistic mandates are designed to provide additional yield, capital preservation and volatility reduction, and the mandates have worked as intended.
This combination of duration management and international diversification has enhanced performance outcomes and has provided us with opportunities for better volatility management overall.
Past returns, future growth, and the importance of staying diversified
The reaction in the bond market last year — reactions in response to monetary policy and recession fears — were profound and unlikely to be repeated. If interest rates continue to fall from where they are today, we are still going to get a positive return in the short-term, but there's not a lot of room left for bond yields to go lower.
Interest rates are low, which means that future returns from fixed income are going to be lower in the future than what we've recently realized. That said, it is important to recognize that fixed income is an incredibly important part of a well-balanced portfolio. To make sure that our investors are well positioned to meet their objectives, we've proactively gone out to look for additional yield, but we've done so in a way that still preserves capital while keeping volatility low.
For more information about interest rates, fixed income or your portfolio, please contact your MD Advisor.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).