By James Parkyn
Most readers will be aware that Canada and the rest of the world have an inflation problem. You’ve no doubt noticed on your trips to the grocery store, your local restaurant, or Canadian Tire that prices are up for all sorts of things.
You also probably know that central banks are fighting inflation by increasing interest rates to cool down the economy. The other day, the Bank of Canada increased its benchmark rate by 0.5%, the largest one-time increase in over 20 years. It’s a safe bet the U.S. Federal Reserve will raise its rate at its next meeting in May. And both banks are expected to announce several more hikes in the months ahead.
What you may be less aware of is the extraordinary effect rising interest rates are having in the bond market. They’ve created a bear market like nothing we’ve seen since the mid-1990s.
You can be forgiven if you don’t follow twists and turns in the bond market. It’s usually quite staid compared to its flamboyant cousin, the stock market.
The stock market’s ups and downs are driven by investor emotions and that naturally draws the attention of the media and the public. By contrast, movements in bond prices are much more driven by boring, old math.
Bond yields—the current interest rate paid by bonds—move in the opposite direction to bond prices, meaning rising interest rates cause falling bond prices. This is because investors who wish to sell bonds have to accept lower prices since the purchasers of those bonds now expect to earn the new higher interest rates.
This effect has meant a steep decline in bond prices this year in response to higher rates. The FTSE Canada Universe Bond Index—the benchmark for bond ETFs held by many Canadians—is down 8.5% (excluding interest payments) year to date and 10.8% since hitting its high mark of the last 12 months in August 2021.
A decline of that size would be bad enough in the stock market; in the normally less volatile bond market it’s an epic debacle. In fact, there have only been two other bear markets on this scale in the Canadian bond market since 1980 – in 1980-81 and in 1994. The one in 1994, which also occurred in the U.S. was dubbed by our southern neighbors the Great Bond Massacre!
This year’s decline will be unsettling for investors, especially because the bond portion of their portfolios is supposed to be the “safe” bucket. However, there a couple of mitigating factors to keep in mind when thinking about this bear market.
The first point is that the decline in bond prices is more pronounced when you hold bonds with longer maturities. The longer a bond’s duration, measured in years, the more sensitive its price is to changes in interest rates.
Short-term bonds, as measured by FTSE Canada Short Term Bond Index, have lost 3.3% (again excluding interest payments) this year and 5.8% since hitting its high of the last twelve months in April 2021. This is still a significant drop, but a lot less severe than the one for longer dated bonds.
In our client portfolios, we prefer short-term bonds with maturities ranging from one to five years. The ETFs we use have a duration of roughly 2.7 years which compares to 7.9 years for the FTSE Canada Universe Bond Index.
Besides being less sensitive to interest rate increases, short-term bonds also provide better protection against rising interest rates in response to higher inflation and are less volatile than longer maturity bonds.
They offer better protection against rising interest rates because with shorter maturities, the portfolio turns over more rapidly, and the bonds can be reinvested at higher rates more quickly. In this context, it’s important to keep in mind that high inflation is a greater risk than rising interest rates because it eats into the value of your savings.
The second point to remember is that higher interest rates lead to better bond returns in the long run. Long-term investors, who have suffered through years of rock bottom interest rates, should want rates to rise, even if it means some capital losses in the short-term.
This is one clear case where short-term pain will produce long-term gain.