Bonds’ bullish run near an end

Rising interest rates has seen Canadian bond indexes drop 1.28 per cent for September

For more than 30 years bonds have been a safe haven for conservative investors. Through the stock market crashes of 1987, 1990, 2000 and 2008, bonds offered a refuge from the storm.

The stock market may have lost half its value in 2008, but an all-bond portfolio gained a respectable 6.2 per cent that year. It’s been that way ever since interest rates began to steadily drop following the inflationary run-up in the late 1970s and early 1980s that culminated when government bond yields topped 15 per cent.

Since then, it has been downhill for bond yields, which meant that prices have risen steadily. Yields and prices have an inverse relationship; a rising bond price equates to a reduced yield.

Consider a bond with a par value of $1,000 and a 5-per-cent yield, meaning it pays $50 annually. If the price of that bond increases to $1,250, the payment stays the same at $50, but at the higher price the yield drops to 4 per cent ($50 divided by $1,250). There has been an occasional blip along the way but, that is essentially what has been happening since 1982. It’s been one of the longest bond bull markets in history.

How strong has it been? According to the volatility meter on the Steadyhand Funds website, an all-bond portfolio would have experienced only three losing years between 1980 and 2016. The worst of those was a 3.8-per-cent drop in 1994. You couldn’t invest much more safely than that.

But now the long run finally seems to be over. Many central banks are raising interest rates after years of accommodation while the world recovered from the Great Recession. The Bank of Canada has implemented two hikes since midyear and another is expected before we usher in 2018.

Interest rate increases aren’t the only sign that the days of easy money are over. The U.S. Federal Reserve Board is starting to unwind its quantitative easing program and other central banks are moving the same way.

A look at Canadian bond indexes tells the story. The FTSE TMX Canada Universe Bond Index hit a peak for the year in early June and has been declining steadily ever since. As of the close of trading on Sept. 25, the index was off 1.28 per cent for September and the year-todate gain had slipped to a mere 0.53 per cent.

The sub-indexes tell an even more discouraging story. The Canada Short Term Overall Bond Index was down 0.39 per cent for the year to Sept. 25. Short-term bonds are viewed as a safety zone in a declining bond market, but that is not the case right now.

Ironically, long-term bonds, which are normally the first victims of a bond bear market, are actually ahead by 2.24 per cent year to date, despite being down more than 2 per cent for September.

This is standing conventional bond wisdom on its head and indicates we are seeing a flattening yield curve, where short-term yields are rising faster than long-term ones.

Historically, that’s a bad sign — a flat or inverted yield curve is often seen as a precursor to a recession.

So what are investors who want to reduce equity exposure supposed to do in this situation?

Until now, bond mutual funds or ETFs were an obvious choice. But no longer. The average Canadian fixed income fund lost 1.4 per cent in the three months to the end of August. Supposedly safe short-term bond funds were down about half a point in that period. Some financial experts believe that bonds are even more risky than stocks in the current environment.

You could always keep your money in cash. Some high-interest savings accounts look very attractive right now. For example, EQ Bank is paying 2.3 per cent on deposit accounts and your money is protected by deposit insurance up to $100,000. But that return is not guaranteed. The bank could cut its rate at any time.

Although interest rates have moved higher, financial institutions have not rushed to raise GIC rates. The best I could find right now is 2.85 per cent for five years. Who wants to lock up their money for that long when rates are rising?

In an effort to address this conundrum some financial companies are stepping up with new ideas. One of these is the new First Asset Enhanced Short Duration Bond ETF. It invests in an unusual portfolio that is divided between short duration high-yield securities and investment grade corporate bonds.

Managers Barry Allen and Paul Sandhu are aiming to generate positive returns over any rolling 12-month period, regardless of where interest rates are moving. Investors receive a monthly distribution of $0.03 a unit ($0.36 a year).

The yield, based on a recent price of $10.01, is 3.6 per cent. That’s exceptionally high for a short-term bond fund and it is not guaranteed, although the managers believe it is sustainable. This is a totally different approach for bond ETFs. Whether it will succeed remains to be seen — the fund was only launched in mid-September. However, the hedge fund on which it is based, the Marret Enhanced Tactical Fixed Income Fund, has performed well since its launch in 2014.

This fund is just the latest example of the financial engineering that is being applied to the rapidly growing ETF market. The bond bull is dead? Fine — we’ll come up with new ways to invest in fixed-income securities. We’ll see if investors buy in.

One final note: because FSB is a new fund, it is very thinly traded. Often the daily volume is less than 10,000 units. If you want to take a position, enter a limit order (an instruction not to pay more than a certain amount) and be patient. It may take a few days to get a fill.

And remember, this is a brand-new fund. There are no guarantees it will meet its performance targets. Gordon Pape’s website is www.BuildingWealth.ca