Oct 15, 2020

Should You Still Be Bonding To Bonds?

In this Market Commentary, our team discusses the current state of bonds and whether it is still a reasonable investment considering the lower returns.

  • Expect lower bond returns for some time
  • The 60/40 portfolio is not dead
  • Understanding what you need is more important than ever
“Neither a borrower nor a lender be / For loan oft loses both itself and friend / And borrowing dulls the edge of husbandry.” 1

Do you recall this famous excerpt from Shakespeare’s Hamlet? Scholars have argued that in this speech, Polonius was advising his son to be careful with his money. But had Polonius lived today, he could have just as easily been referring to the headaches facing the modern-day bond manager in a low interest rate environment.

 

Bank rates will likely not rise in the foreseeable future

It is our opinion that the U.S. Federal Reserve (the Fed) and the Bank of Canada (BoC) will not be increasing their respective bank rates any time soon. And “any time soon” could extend to 2023 or beyond. We expect a post-COVID economy to return to the meandering upwards trend that we saw pre-COVID. Both central banks have expressed an objective of allowing the economy to “run hot” in order to solidify a return to 2%+ inflation. These are not scenarios that set the stage for increases in bank rates.

 

Fixed income returns expected to be lower

We have experienced two years of surprisingly strong fixed income returns (mid-to-high single digits). But remember, the fine print in a prospectus always states that past performance does not necessarily predict future performance. We saw 10-year government bond yields at 2.4% two years ago; these fell to 1.4% last year and have since dwindled to 0.6%. Falling bond yields mean rising bond prices which generate capital gains on top of the coupon (interest) paid by the bonds. Since we don’t expect yields to continue to fall at the same rate over the next year, investors can expect little in the way of capital gains and thus lower returns from their bond holdings. But all is not lost; with a steeper yield curve, reasonable credit spreads and some potential trading opportunities, fixed income returns should be higher than the 10-year government yield of 0.6%. That said, returns will likely be closer to lower than the mid-to-high single digits detailed above.

 

Consider adjusting your asset mix for current conditions

Lower returns can prompt the prudent investor to ask if bonds are still a reasonable investment at all. Indeed, there are many headlines asking if the traditional 60/40 (equities/fixed income) asset mix is dead. It is important to remember that one of the main purposes of fixed income investments is to provide stability and capital preservation for the overall portfolio. To this end, fixed income investments still have a low correlation to equity investments.

 

We also believe that a traditional 60/40 portfolio can and should drift based on the risk/return profile of stocks versus bonds. For instance, a mix of 65/35 might be prudent in an environment with better equity risk/return characteristics. This is the environment we believe we are in now.

 

A drift away from 60/40 does involve a change in the risk profile of the overall portfolio, and it’s important to understand the nature of this risk change. Many investors may be tempted to take on even more risk to try to earn a higher return. Examples of this may be to change the asset mix to significantly more equities, add riskier bonds (high yield or junk bonds), take on leverage or add other higher risk asset classes with higher fees and less liquidity. If you are tempted in this direction, remember that there is no such thing as a free lunch. Going out the risk curve offers the hope of higher returns along with the possibility of higher losses.

 

Re-examine your investment goals

Having a sound financial plan is essential to identify and quantify your investment goals. If investment goals can still be met with the same risk profile, then you may be better off to simply stay the course. Everybody likes unexpectedly higher returns. Nobody likes unexpectedly higher risk.

 

We continue to feel that an allocation to bonds is prudent. Even with sustained low short rates, there are opportunities for returns. A sound financial plan outlining investment goals will help provide good insight into your capacity for risk.

 

1 William Shakespeare, Hamlet, Act I, Scene III