by Steven Visscher, Mawer Investment Management
Bonds canāt go higher. Bonds are too expensive. Inflation is inevitable and will punish bond investors.
These are the comments we are hearing from many of our clients.
We understand where this negativity is coming from. To some extent, we feel the same way. Interest rates have been in a long-term decline, both in Canada and elsewhere. This has boosted historical bond returns. And since rates canāt go much lower, this additional boost to returns will likely dissipate on a go-forward basis. So in our opinion, bonds do have limited upside potential. As a result, we have been actively reducing bonds in client portfolios, and now hold one of the lowest bond weights in our balanced portfolios in our firmās history.
This begs the question ā why bother owning bonds at all? If weāre not enthusiastic about future bond returns, why are they still a significant component in our balanced portfolios? The simple answer is because we donāt hold bonds strictly for return potential ā they also provide valuable downside protection. Did you know that in the last 20 years, the Mawer Canadian Bond Fund has only lost money in two of those years? And that the very worst year in those 20 years, 1994, was a return of -5.48%? So, bonds have done their job.
And to be intellectually honest, we donāt know whatās going to happen in the future. Our view of the world economy is that we are in the midst of a slow and gradual recovery and inflation and interest rates will eventually rise. So, equities should outperform bonds if this environment unfolds. But we might be wrong. The U.S. might not resolve its fiscal cliff dilemma. Europe may not solve its debt problems. China might slow down. So while it is not our base case, we still believe there is the potential for a deflationary scenario to develop. And deflation, characterized by slowing consumption and falling prices, would likely cause serious losses to equity markets. Suddenly, the stability and returns of bonds, even at todayās low yields, would seem very attractive.
So thatās why weāre not recommending that clients abandon bonds. Weāve adjusted our allocation to bonds in light of the scenarios we think are most likely to occur, and weāve wisely adjusted the types of bonds we own in light of what weāre seeing, but we still believe they play a critical role in client portfolios. Building resilience is not about preparing for the expected ā itās about preparing for the unexpected.
Steven Visscher
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