by Alan Friedman
Last year the bond market and investors took a beating; but as is the case with most obstacles and challenges, they can also present an opportunity.
As for last year, because they are germane to the rest of this story, there are two points I want to make before we file 2022 away in the history books and concentrate on the here and now:
- Interest rates affect the price you pay for government bonds. And you can see how that played out in 2022, on the chart below.
- What happened last year was, in large part, the result of the U.S. Federal Reserve aggressively raising interest rates — by 5% —in an effort to fight inflation. And they were joined by other central banks around the world — including our own, Bank of Canada — which accounts for the significant repricing in Canadian Government long-term bonds as well.
So here we are, halfway through 2023. There's a lot to talk about in regards to where the bond market's at now, and what it means for investors.
To make sure we do this important topic justice, in this blog I’ll focus on long-term bonds and a potential opportunity, and we’ll write more later.
The good news for investors is, the potential of earning attractive returns from income securities is real — especially with long-term bonds, and here’s why:
If the rate hikes that have already been implemented push the economy into a recession, it is likely that central bankers will cut rates at some point within the next 12 to 24 months. And investors could potentially benefit financially by owning long-term bonds when interest rates drop.
The thing about long-term bonds versus short-term bonds is, all else being equal, the price of bonds with a longer term to maturity are more sensitive to changes in interest rates. It’s called “duration risk,” and it was on full display last year when interest rates in both the U.S. and Canada were being hiked — as you can see in these charts.
2022 Bond Market Volatility - The Year Interest Rate Risk was Realized
What took investors by surprise last year is this: the very asset class that’s meant to provide stability in a diversified portfolio — and offset our exposure to volatility in equities — did the opposite, and fared just as badly itself. So as we can see from the charts, things don’t always turn out as advertised.
Conversely, if and when interest rates go down, the value of those bonds will rise, resulting in capital appreciation — and this is where we see the opportunity.
An effective way to gain exposure to long-term bonds is through ETFs. Should rates go down, the price of the ETF units will go up, because the prices of the underlying bonds go up.
This would be a lucrative strategy, particularly now, when it’s anticipated that the Federal Reserve will cut interest rates — as Gary Shilling writes recently in his investing newsletter, “Gary Shilling’s Insight.”
“Finally,” Shilling says, “the rally in Treasury bonds may be anticipating eventual credit ease by the Fed but, as noted earlier, the central bank is likely to wait longer than normal in this cycle before reversing gears to be sure that inflation is killed, and killed dead. In any event, in the next six to 12 months, the yield on the 30-year Treasury bond may drop from the current 3.7%to 2% as its price jumps 38.4% for a total return, including interest, of 40.2%.”
Obviously, much is still unknown and it remains to be seen what the central bank will do; and a lot depends on inflation and whether or not we’ve seen the end of that. But the outlook is definitely brighter.
All that said, as with any investment, we believe there are other considerations to keep in mind, when investing in long-term bonds. Don’t lose sight of the fact that interest rates may still go up and the value of your long-term bonds may go down in the short term.
And that said, it would likely only be temporary, and should we be right and rates come down in the future, the move upward in the market value of these bonds would make them a worthy investment.
The appetite for investing in bonds is improving. Nothing is ever guaranteed, but I think it’s fair to say you can feel somewhat more comfortable about your bond allocations. The best thing, always, is to speak with your advisor.
While I’m certainly not suggesting that taking the time to assess and reevaluate will eliminate any future uncertainty, it will make us much better equipped to deal with it, and improve our chances of success. And for investors, that’s money in the bank.
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Alan Friedman is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Alan Friedman do not necessarily reflect those of CIBC World Markets Inc. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client please contact your Investment Advisor. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
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