Back to bond basics

By Canada Life Investment Management | April 24, 2023

2022 was the first time on record in Canada that bond markets posted a second consecutive year of negative returns. The shake-up has left some investors scratching their heads, but it’s important they understand the defensive role that the asset class continues to play in helping them reach their financial goals.

To help explain the ins and outs of fixed income, we asked Janet Salter, Vice-President and Portfolio Manager with Portfolio Solutions Group, for her thoughts as a veteran of both active and passive fixed income strategies.

“Interest rates and a bond’s sensitivity to interest rate changes are the two biggest drivers of bond prices,” she explained. Rising rates typically cause bond prices to fall and declining rates typically cause bond prices to rise. “The bulk of the public bond market’s prices are affected by changes in nominal interest rates,” she added. These nominal interest rates have two components – real interest rate and expected inflation.

So why did this rare downturn occur? “Usually, the income earned would help to mitigate the loss from the decline in prices but not this time around,” she said. With central banks raising rates quickly, income earned throughout the year couldn’t outpace the value bonds were losing. Salter explained that the speed and size of interest rate increases have the biggest impact on the severity of a downturn.

“Real interest rates are influenced by the potential output of the economy, productivity of the labour force, demographics, and monetary policy,” Salter explained. When the economy is doing well, interest rates tend to increase, which typically drives bond prices down.

But when the economic outlook sours, central banks usually lower overnight rates, rallying bond prices. “Over the last several decades, advanced economies have seen a decline in their level of potential output and productivity, causing real interest rates to fall,” she continued.

Duration measures how sensitive a bond’s price is to interest rate changes and is quoted in years. “The higher the duration the greater the impact that a change in interest rates will have on that bond’s price, all else being equal,” Salter added.

With rates and bond prices usually moving in opposite directions, it’s easy to appreciate the importance of this metric. Salter offered a simple example: “If a bond has a duration of five years and the interest rate on that bond declines by 1%, you can expect the price will increase by 5%.”

It’s not just the change in the bond’s price over time that makes up a bond’s total return. Returns also include regular interest payments, known as “coupon payments”, and any interest that has accrued since the last payment. These coupon payments are typically made on a schedule that’s set when the bond is issued. For public markets, this frequency is often semi-annual.

Investors might also be confused by the difference between returns and yield. Yield is simply the potential return of the bond. “If interest rates were to remain the same, an investor could expect to earn the bond’s yield as a return for that one-year period,” Salter said. “However, rates never remain static.”

A bond’s yield considers whether the bond is trading at a discount or a premium relative to what the issuer promised to pay at the bond’s maturity date, known as its par value (or face value). It also factors in the bond’s rate of coupon payments.

Bond yields look much different than a year ago. “On a broad Canadian index, the current yield is around 4%. We haven’t seen these levels of interest rates for over a decade,” she said. Salter added that this creates a cushion for the bond market that can help it weather a modest increase in longer-term rates. There’s also the upside that any lowering of rates could drive returns higher than that 4% yield figure suggests.

It’s typical for the traditional relationship between equities and bonds to break down during highly inflationary periods. Market reactions in 2022 were driven by rising inflation, heightened price uncertainty and an aggressive tightening of global monetary policies. “If some of these uncertainties in the markets are mitigated, it’s expected that the bond’s traditional role will resume.”

Going back to basics with clients can help avoid misunderstandings about the pivotal, defensive role that fixed income plays in portfolios. For more information on Canada Life™ funds with portfolios managed by Portfolio Solutions Group, such as Canada Life Target-Risk Asset Allocation Funds, talk to your Canada Life wealth wholesaling team today.

The views expressed in this commentary are those of this investment manager as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.

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