7 key questions about owning bonds today

Income – If you rely on stable, continuous payments or are planning for future expenses, you can build an investment strategy around the interest payments a fixed-income portfolio can generate.

We believe investment grade, intermediate-term bonds (as represented by the Bloomberg Canada Aggregate Bond Index) should be a core holding within a fixed-income portfolio. High-yield bonds (as represented by the Bloomberg Global High Yield Index) might provide more potential income, but because they tend to move in the same direction as stocks, that higher yield comes with higher risk.

Canadian investment-grade bonds offer a 3.6% yield (as of 8/27/2024), which, while low relative to rates in the 1980s or ’90s, is at the upper end of its past 10- year range. This yield is currently lower than the yield on cash as a result of the BoC's interest hiking cycle, however, the yield advantage of cash is narrowing with the BoC now normalizing policy by lowering rates. We would advise investors to complement short-term bonds and cash with longer-duration fixed income to avoid overexposure to reinvestment risk.*
 

Stability and the potential to preserve principal – When a bond matures, the investor typically receives back their original investment, absent any defaults. But historically, investment-grade bonds have been less volatile than stocks and generated positive total returns over the medium and long term. While past performance is not a guarantee of future results, Canadian investment-grade bonds have suffered two three-year periods of losses since 1980 (positive returns 95% of the time). By comparison, the S&P TSX has been positive 70% of the time over the same time frame.

2022 was challenging for bond investors. Canadian investment-grade bonds returned -11% in response to a surge in inflation and the BoC focus to tame it. Inflation has since moderated and we believe the BoC will continue to normalize policy over the coming years, which could be supportive to both equity and bond market returns.

Diversification – Bonds play an essential part in a diversified portfolio because they tend to rise when stocks decline, and vice versa. The fixed-income investments in a portfolio can help smooth out returns during times of volatility.

When economic growth slows, fixed income can become more attractive as a source of returns and liquidity. We saw this in 2020 and during past recessions. But stocks don’t have to be in a bear market for bonds to shine.

Looking at 69 MSCI Canada pullbacks of 5% or more that occurred during bull markets since 2000, investment-grade bonds generated positive returns 84% of the time as stocks fell.

By comparison, gold was positive 48% of the time, followed by the consumer staples sector (29%), the utilities sector (25%) and a basket of commodities (14%).

Cash can also help reduce portfolio risk. But because bonds offer diversification, adding them to a stock portfolio may generate better returns for a similar level of risk as adding cash.

The single best predictor of future returns of investment-grade individual bonds is their starting yield. The chart below shows the annual total return of the Canadian investment-grade bonds. Over five-year periods, it has tended to track investment-grade yields. High starting yields are likely to produce high returns, and low starting yields low returns.

While bond prices may fluctuate in the short term, this volatility doesn’t play a big role in long-term returns, which are primarily determined by the coupon and principal payments (absent defaults). The upside to the recent decline in bond prices is that yields are now more attractive, suggesting improved future returns for newly invested money.

Different fixed-income investments have their own unique drivers, of course. But the two most important determinants of performance are interest rates and credit quality.

Interest rates 
Interest rates determine the income that can be generated from a bond and affect its value as well. Bond prices typically fall when rates rise, and vice versa. The longer a bond’s maturity, the more sensitive its price is to interest rate changes. Duration (also expressed in years like maturity) estimates the sensitivity of prices to interest rate movements. When rates are rising, short-term bonds tend to outperform bonds with higher duration. But when rates are falling or stable, long-term bonds tend to do better because of their higher sensitivity to changes in rates and their typically higher yield.

Credit quality 
Bonds of lower credit quality tend to be more volatile than bonds of higher credit quality. But they also typically carry higher interest rates, which can mean more income for a portfolio. The difference in yields between higher-quality bonds (such as a government bond) and lower-quality bonds (e.g., BB corporates) is called a credit spread. When spreads narrow, credit risk is rewarded, and lower-quality bonds tend to outperform. However, the opposite happens when spreads widen, typically when the economy slows or contracts.

Your portfolio’s balance between equity and fixed income should be tailored to your risk and return profile. Your financial advisor can help you determine (or reassess) the portfolio objective that’s right for you.

Whether you invest in individual bonds or packaged bond products, we believe in diversifying a bond portfolio across the main fixed-income asset classes listed on the following page. Then you can work with your financial advisor to diversify across sectors, maturities, issuers and bond categories (government, provincial, corporate).

Investment-grade bonds are generally rated AAA, AA, A and BBB. With their focus on high quality and current income, these bonds should form the foundation of the bond portion of a portfolio. The diversification benefits relative to stocks and lower volatility relative to other fixed income asset classes typically results in lower yields relative to other bonds.

International bonds are higher quality bonds that may include exposure to foreign currencies. They add diversification because performance of international bonds may differ at times from that of Canadian bonds. Additionally, those with foreign currency tend to fluctuate more than Canadian investmentgrade bonds. For this reason, we generally recommend investors access international bonds through a diversified product such as an ETF of mutual fund that hedges currency exposure.

International high-yield bonds are lower quality global bonds that may include exposure to foreign currencies. Like international investment grade bonds, they add diversification to the Income category, as Canadian bonds won't always outperform non-Canadian bonds. While they provide higher income due to having higher risk, those with foreign currency exposure tend to fluctuate in value even more. They also tend to underperform international investmentgrade bonds in poor credit environments.

Cash is the lowest risk and most liquid investment. It is a distinct asset class within fixed income, providing stability and serving as a source for future investment. But don’t confuse this type of cash with spending cash or emergency cash. It is meant to protect principal and will generally have a very low yield, meaning it can lose purchasing power over time due to inflation.

Beyond the asset class level

• Maturity – One long-term strategy is to build a bond “ladder” by investing across maturities. Laddering helps manage risk and doesn’t depend on rising or falling interest rates for success. It can also help smooth wide swings in your income and principal. But keep in mind that bond laddering doesn’t ensure a profit or protect against loss. This table shows our general maturity guidance.

Your bond’s coupon payments don’t change when interest rates rise. But bond prices fall as new bonds are issued with a higher interest rate.

While rising rates have challenged fixed-income returns the past several years, investors with a longer-term time horizon can benefit from higher yields. Maturing shortterm bonds can be reinvested into newly issued bonds with higher coupons to provide more income.

The following example illustrates this concept. This hypothetical fixed-income investment initially declined because of a 2% rise in yields in year one. After 10 years, though, it ended up higher when compared to a scenario where rates stayed unchanged.

This example illustrates that bond investors can benefit in the long term from rising rates, but only if they stay invested as appropriate relative to their investment goals, time horizon and risk tolerance.

Around the world, interest rates have trended downward since the early 1980s. But after record lows in 2020, long-term yields have risen to the upper end of their range over the past two decades. With meaningful progress made on inflation and global central banks cutting rates to normalize monetary policy, we would expect limited upward pressure on yields from current levels. But many of the factors that caused interest rates to fall over the past 40 years are still with us, albeit to a lesser extent.

Demographics – Over time, population growth among developed countries has slowed and even stagnated in some cases. In the U.S., population growth has averaged less than 1% per year over the past two decades. While Canadian population growth has been strong in recent years due to strong immigration, government plans to reduce the share of temporary residents as a percent of the population over the next several years will likely slow domestic population growth in the years ahead. As the population becomes older and more workers exit the labour force, the potential growth rate for consumer spending and economic growth declines, exerting downward pressure on yields. Also, the rise in life expectancy means people need to save more for longer retirements, which increases the supply of savings and demand for bonds.

Deflationary forces – Disruptive technologies, globalization and transparent prices (the so-called “Amazon effect”) have helped keep a lid on inflation in the past 20 years. While the days of below 2% inflation seem distant at the moment, central banks around the world have acted and are now easing policy as inflation has moderated. We have seen supply chain bottlenecks clear and demand normalization. At the same time, technology and the potential productivity gains are likely to continue to exert downward pressure on prices.

Low overseas yields – While yields have risen around the world over the last few years, U.S. and Canadian interest rates remain higher than in most developed countries. For example, the 10-year yield on a Japanese government bond was still below 1% at the end of August 2024. For this reason, foreign demand for U.S. and Canadian government bonds will likely remain strong, acting as an anchor against another significant rise in domestic rates.

The 10-year Government of Canada (GoC) yield climbed to a 16-year high at over 4% in October 2023. While yields have since pulled back, they remain elevated relative to levels seen over the past two decades.

Based on our expectation for falling inflation, additional BoC rate cuts, and below-trend economic growth, we see an opportunity to slightly extend duration relative to the Bloomberg Canada Aggregate benchmark. Domestic inflation has continued to moderate and with signs of economic weakness we believe the BoC will continue to ease monetary policy over the coming years, which could lead to lower yields and better performance in longer-term investment-grade bonds.

At an asset class level, we recommend investors underweight international bonds in favour of U.S. small- and mid-cap stocks. While our view for lower inflation and central bank rate cuts would be supportive to both stock and bond returns, we believe the opportunity is greater in stocks therefore recommending an overweight in U.S. small- and mid-cap stocks and underweight in international bonds.

As the 10-year GoC yield hovers between 3% and 4%, we think the risk-reward for bonds becomes more attractive from an interest rate perspective. We expect the BoC to continue to normalize policy over the coming years which could lead to lower yields and support returns in Canadian investment-grade bonds. Therefore, we recommend a neutral allocation to Canadian investment-grade bonds.

The higher yields suggest improved forward bond returns and the potential to put some cash to work. We would advise investors to avoid over-allocating to short-term fixed income and maintain balance across maturities in their fixed income portfolio.

We believe opportunities are balanced among investment-grade and lower quality bonds, recommending a neutral allocation to global high yield bonds. Over the past year, international high-yield has been the best performing fixed-income asset class, as resilient global economies have supported lower quality issuers.