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The June 5 interest rate cut by the Bank of Canada has income investors taking a fresh look at bonds.
Reader Brian B. wrote to say: “I’m 70 years old. Within the fixed income component of my RRSP, I have been investing in 1-2-3-year GICs since interest rates started climbing. I did this rather than holding on to my usual mix of go-to PH&N bond funds (Total Return, High-Yield, Short Term) that you recommended many years ago.
“Many pundits suggest that interest rates will now continue to fall. If we assume this is correct, is it reasonable to assume that the value of bonds/bond funds will increase accordingly? With this rationale in mind, would it be appropriate to start increasing one’s exposure to bond funds again, like the PHN funds mentioned above?”
One of the basic principles of bond investing is that when yields drop, prices rise, and vice versa. It’s as predictable as the sun rising and setting.
We saw the downside of this in 2022-23. While the Bank of Canada was raising rates, bond yields climbed, while prices dropped. The result was the worst bond market in 40 years.
Logically, it would seem we should now be on the cusp of a reversal in this cycle. However, we aren’t seeing much evidence yet. As of June 14, the FTSE Canada Universe Bond Index was up only 0.88% year-to-date. The Long-Term Bond Index, which should be the main beneficiary of a declining interest rate cycle, was off 0.94% so far this year.
What’s missing from this picture? Momentum. The rate hikes of 2022-23 came at a rapid-fire pace. Almost every meeting of the Bank of Canada and the U.S. Federal Reserve Board ended with the announcement of at least a 0.25% rate increase. It didn’t take long for investors to realize that the trend wasn’t going to end soon, and bond prices plunged. In 2022, the iShares long-term bond ETF was down 21.9%. A loss of that magnitude is almost unheard of in a bond fund.
So, where are we now? There’s been one quarter-point cut in Canada. Will there be more this year? Governor Tiff Macklem says “maybe.” If inflation remains contained, it’s a possibility but the BoC will decide on a meeting-to-meeting basis. No binding promises there.
Meantime, the U.S. situation looks even less hopeful. The latest employment figures were much stronger than expected, and the American economy is performing well. The recent market selloff reflected investors’ concerns that the much-anticipated rate cuts are still several months away.
The Bank of Canada is faced with a dilemma. Housing costs are a major factor in the current inflation picture. Reducing rates further would help lower the costs for homeowners and renters. But if the gap between U.S. and Canadian rates widens, it will result in higher inflation as the cost of imported goods rises. Talk about a rock and a hard place!
This leaves fixed-income investors in a quandary. GIC rates are already starting to edge down. Ratehub.ca is not showing any five-year rates at 5%. A few months ago, there were several. Nor are there any three-year GICs at that level. You can still earn 5% for one year, but that may not last much longer.
Bond ETFs are still struggling. The actively managed PHN (Phillips, Hager & North) mutual funds that our reader mentioned look like the better choice right now. The PH&N Total Return Bond Fund was showing a 12-month gain of 3.0% as of June 30. The PH&N High Yield Bond Fund posted an impressive gain of 10.9% in the same period. That fund lost only 4.8% in 2022, outperforming the overall bond market by a wide margin.
However, the High Yield Fund is “soft-capped.” That means current unitholders may add to their holdings, but newcomers can’t buy in.
Most Canadian high yield bond funds invest primarily in U.S. securities because our market is so small. The PH&N fund is a rare exception, with 91% Canadian content.
In contrast, there is no problem finding U.S. high-yield bond funds and ETFs. But their recent performance record is weak. One example is the iShares U.S. High Yield Bond Index ETF (CAD-hedged) (TSX: XHY). It’s only up 1.9% year-to-date. The companion short-term bond fund has a gain of 1.5% in the same period, with less risk.
The bottom line is that bond funds will look better if interest rates start dropping on a steady basis. But the timing is questionable. In the interim, here’s what I suggest for income-oriented investors who want to minimize risk.
If you have a money question, send it to gordonpape@hotmail.com and write Fund Library Question in the subject line. Sorry, I can’t guarantee a personal response, but I’ll answer as many questions as possible here.
Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder and The Income Investor newsletters, which are available through the Building Wealth website.
Follow Gordon Pape on X at X.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney.
Notes and Disclaimer
Content © 2024 by Gordon Pape Enterprises. All rights reserved. Reprinted with permission. The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting, or tax advice. Always seek advice from your own financial advisor before making investment decisions.
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