For bonds’ sake

For bonds’ sake

by James Redpath, Curtis Elkington, Mawer Investment Management, via The Art of Boring Blog

Conversations about increasing interest rates and their impact on bond investments have recently spiked in Canada. Since bonds are traditionally viewed as an investment that provides a steady stream of income while acting as a safety net within an overall balanced portfolio, an environment of rising interest rates understandably causes unease: it can decrease the price of bonds and therefore can negatively impact performance.

While we share the same concern, we also think some of the prevailing discussions oversimplify the relationship between interest rates and bonds and require a bit more context. We may want to think twice about knee-jerk shunning of the asset class.

Right off the bat, what should be kept in mind is that the interest rate most commonly referred to in media articles is the overnight interest rate, which we will refer to here as simply ‘interest rate’. For anything longer than the overnight rate, we will use ‘yield’ and/or ‘yield curve’.

While the Bank of Canada controls the overnight interest rate (represented by the red dot in the graph below) and has some influence on the short end of the yield curve, medium to long-term yields are a different story. Medium and long-term yields tend to be driven by long-term factors outside of the Bank of Canada’s direct control, such as potential economic growth and inflation dynamics, supply and demand, and global influences.

Sources: Bloomberg and FactSet

Thus, pinning too much importance and conversation onto that red dot doesn’t provide a holistic picture since the Fund has a diverse maturity structure and exposure to multiple sectors—all of which can have different influences on performance. While shifts higher in the yield curve over the short-run will likely negatively impact a bond portfolio, over a longer time horizon, the effects might be surprisingly positive.

Why? Although it may seem counter-intuitive, if you have a long-term time horizon, an increase in bond yields is usually more beneficial than if yields remained lower as the performance of a bond fund is influenced by the level and slope of the yield curve over time. Another important factor is the pace yields rise relative to the time it takes to recover lost performance. While there could be short-term pain, maintaining a long-term horizon allows an investor to reinvest at a higher yield—which, over time, typically outweighs the negative short-term impact. Simply put, the higher yields are, the higher the income an investor receives when cash flows are re-invested.

Supporting research has corroborated this thinking. One standout report from PIMCO investigated how rising yield curves affected the long-term returns of the Barclays U.S. Aggregate Bond Index. The report tested multiple scenarios by shifting the yield curve higher either instantaneously, or gradually over time, and analyzed the bond index’s performance. An overarching theme that arose from these scenarios was that if an investor had a long time horizon, an increase in yields could actually be more beneficial for performance than if yields remained lower.

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