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Five reasons not to abandon bonds
10/22/2018 2:21:39 AM
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By Fund Library News Wire  | Tuesday, February 27, 2018


 



By Todd Schlanger, Senior Investment Strategist, Investment Strategy Group, Vanguard Group, Inc.

On January 17, 2018, the Bank of Canada (BoC) raised its key overnight interest rate target to 1.25%, an increase of 25 basis points. The bank cited strong data, inflation at close to target, and an economy that is operating roughly at capacity. This was the third rate increase by the BoC since July of 2017.

The initial timing and pace of this monetary policy normalization came as somewhat of a surprise to a market that believed the BoC would postpone action while waiting to see what the U.S. Federal Reserve would do with its policy rate and with the long-anticipated unwinding of its balance sheet and monetary stimulus.

As you may be surprised to learn, our outlook is not one of doom and gloom for investors and the bond market. Here are five reasons why:

1. A tightening of monetary policy often reflects a healthier economy

The three rate hikes we have seen over the past few months reflect stronger economic growth. The BoC responded by taking action on monetary policy to reflect the normalization of economic conditions.

Ten years on from the global financial crisis, economic growth in Canada and the U.S. is humming along with near full employment and inflation in check. In this scenario, a natural course of action would be to remove monetary stimulus and gradually increase policy rates from their historically low levels, which is exactly what the BoC and Federal Reserve have done.

2. High quality bonds play a critical role as risk dampeners in portfolios

It's important to keep the potential bond losses we could see from rising interest rates in perspective. A bear market for fixed income is nothing like a bear market for equities. Bond losses rarely exceed 10%, while equities can decline by 50% or more.

3. Rising interest rates and low inflation could mean higher returns in the long run

There is a well-known inverse relationship between a bond’s price and interest rate movements. However, what is often overlooked is that if rates were to rise and bond prices were to fall in the short-term, they should be offset by higher yields over time.

As a general rule, if investors’ time horizons are longer than the maturity of their bond portfolios, they should want rates to rise because this should translate into higher nominal returns in the long run.

4. Bond prices reflect current interest rate expectations, so only surprises matter

For investors who may be considering shortening duration in anticipation of rising interest rates, it’s important to keep in mind that the market is currently expecting a gradual tightening of monetary policy. This means that bond prices are already pricing in a future path for interest rates and inflation over their maturities. In fact, short-term interest rates have and are expected to rise more than longer term yields, a scenario that is commonly known as a flattening of the yield curve.

Simply put, the markets are forward-looking, and investors use their expectations for future interest rates and inflation to determine the current value of bonds. Therefore, it would only be in unexpected scenarios when rates rise either faster and higher or lower and slower than expected that there would be an opportunity to profit from a duration strategy. In more expected scenarios, there would still be a term premium associated with investing in longer maturity bonds.

5. Rates are unlikely to rise in all markets at the same time, creating opportunities to diversify with greater global bond exposure

Our research has shown that global bonds can help diversify local market-specific risk factors in bond portfolios, assuming that the currency risk is hedged.1 In the case of interest rate risk, hedged global bonds tend to outperform the Canadian bond market in periods of rising interest rates due to the relatively low correlations of government bonds' yields across markets.2

Examples of this in today's market would be the U.S. and Canada increasing their overnight lending rates at a time when the two largest investment-grade bond markets outside North America, the euro area and Japan, have not done so due to generally lower growth and inflation. This may change if the European economy continues to perform well, but the point remains that monetary policy will ultimately reflect economic conditions that vary by country and each particular market over time.

Maintaining investment discipline

As stated earlier, our outlook for the bond market is not one of doom and gloom. In fact, the rising interest rates we have seen should be a positive sign for long-term investors because it means the economy is improving and returns are likely to be higher in nominal terms than if rates remained at lower levels.

Therefore, we believe that investors will have their best chance of investment success by remaining focused on their long-term goals, diversifying their bond portfolios, keeping costs low, and remaining disciplined through this period of monetary policy normalization. 

1. Going global with bonds: Considerations for Canadian investors, Phillips, Bosse, Walker, Maciulis, Kwon (January 2014).

2. Fearful of rising interest rates? Consider a more global bond portfolio, Phillips, Thomas (November 2013).

Todd Schlanger, CFA, is a senior investment strategist in Vanguard’s Investment Strategy Group (ISG) based in Toronto, Canada, where his responsibilities include research on the capital markets, portfolio construction and design, and investment market commentary.

Notes and Disclaimer

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “ Education & Commentary page of the Vanguard Group, Inc.’s website. Used with permission.

Important information

The views expressed in this material are based on the author's assessment as of the first publication date (January 2018), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement his views and opinions whether as a result of new information, changing circumstances, future events or otherwise.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation.

Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

While this information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of this information or any results from its use.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

 
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