- Year-to-date, Canadian bond performance has been firmly negative.
- The worst of it is likely over and things should improve with time.
- Our active fixed income exposure has added value to client portfolios.
Inflation continues to trend higher across the globe. As a result, central banks like the Bank of Canada and the U.S. Federal Reserve have begun the process of raising interest rates and quantitative tightening in an effort to bring rising prices under control.
At the same time, bonds have sold off materially – the FTSE Canada Universe Bond Index (a proxy for Canadian bonds) is down over 10% year-to-date – as the market absorbs recent central bank actions as well as the additional rate hikes and tightening that is expected to occur throughout 2022. Eight-to-10 rate hikes are now priced in for both Canadian and U.S. bonds. At the time of writing, expectations for key interest rates in Canada and the U.S. by the end of the year are 2.9% and 2.8% respectively.
Mismatched expectations led to the worst quarter for bonds since 1994
Unfortunately, as bond yields have risen, investing in fixed income has not been rewarding year-to-date. The three-month performance of Canadian bonds as of March 31, 2022 (-6.97%) was the worst since 1994 and the second worst since 1980.
Generally speaking, fixed income investments have provided steady, positive returns for a very long time. The recent decline represents a discrepancy between what investors have come to expect (prolonged, steady, positive returns) versus the reality of the current situation. This is particularly true after the outsized gains realized in 2020, when central banks provided extraordinary policy support by reducing interest rates to all-time lows and introduced asset purchasing programs that were even larger than those implemented during the Global Financial Crisis (2007-2009).
Softening the blow and looking for opportunities with tactical asset allocation
Despite the poor recent performance, we still believe fixed income investments are essential for clients investing in multi-asset portfolios. Historically, fixed income returns have shown low correlations to broad equity market performance. We must keep in mind instances when the fixed income portion of a portfolio proved its worth, providing insulation from equity market drawdowns. For example, when global equity markets declined 44.1% between June 2007 and February 2009, Canadian fixed income rose 10.3%.1 Similarly, between March 2000 and November 2002, global equities fell 37.4% and Canadian fixed income rose 23.0%.1 In fact, there has only been seven quarters in the last 20 years (80 quarters) when Canadian equities and fixed income have both experienced a negative return.2
With that being said, we actively manage the fixed income portion of our clients’ portfolios and, appreciating the risk that bond yields could increase and that bond prices could fall as the extraordinary monetary policy support from 2020 was unwound, we proactively positioned our fixed income exposures to preserve capital.
Across our client portfolios, our defensive tactical positioning within fixed income has added value by reducing interest rate risk (duration). Within the MD Bond Fund and the MDPIM Bond Pool, having a dynamic, but short duration bias, was the key driver in preserving capital and outperforming the benchmark over the period.
In addition, we expanded exposure to other non-traditional strategies to help bolster total return potential while carefully managing risk. We achieved this through increased investment in higher yielding corporate bonds and real-return bonds to hedge against inflation risk.
There may be further bumps in the road ahead but given the number of rate hikes that are now priced into the market, we believe the worst of the bond sell-off may be over. More importantly, we are now seeing more attractive opportunities for fixed income markets.
The worst of it is likely over…
The shape of the yield curve – which is quite flat right now (there is little difference between the yield of shorter-term bonds versus longer-term bonds) – is, in part, implying that the current high inflation is caused more by global supply constraints than by demand. This situation may be alleviated in time as COVID cases decrease and lockdowns in large Chinese cities ease.
Additionally, a great deal of monetary tightening is already priced in, we don’t believe there will be a material increase in bond yields beyond what we’ve already seen unless persistently high, longer-term inflation materializes.
It is also important to note that the number of rate hikes ahead is also limited by what the economy can shoulder. Given broader secular trends that have been reducing interest rates over the last few decades – the current lack of productive capacity, increased use of technology and an aging population – there is likely a lid on bond yields, particularly in Canada.
… And things should improve
There is good news! The forward-looking performance assumption for fixed income just got better. Bond yields are an excellent predictor of future returns and, with bond yields having fallen to their all-time lows in 2020 due to pandemic response monetary policy, the forward-looking return was extraordinarily low.
The recent increase in bond yields means that, over time, holding now higher yielding bonds is assumed to provide higher carry in the future. We believe this additional carry will translate to higher returns and more value-add to our client portfolios.
In the meantime, we will continue to manage our bond exposure with a focus on capital preservation, reducing volatility, and, when appropriate, enhancing income. If you have any questions about recent market events, portfolio positioning or the impact to you, please contact your MD Advisor*.
1 Bloomberg and 1832 Asset Management. Global equity returns are represented by the MSCI World Index, in Canadian dollars, and Canadian fixed income is represented by the FTSE Canada Universe Bond Index.
2 Morningstar and 1832 Asset Management, as of March 31, 2022. Canadian equity returns are represented by the S&P/TSX Composite Index and Canadian fixed income returns are represented by the FTSE Canada Universe Bond Index.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.