How to profit from a new bond bull

How to profit from a new bond bull

An iShares bond ETF with big potential


No one can predict when a new bull market will start. That can only be known in hindsight.

But it certainly feels as though we are seeing the beginning of a new bond bull after the roughest two years since the 1980s-early 1990s.

The FTSE Canadian bond indexes have been flashing green since November, posting the most impressive gains we’ve seen since the Bank of Canada began its tightening cycle back in early 2022. Since then, it has raised its overnight rate 10 times, from 0.25% in March 2022 to 5% today.

In the process, it created devastation in the bond market, which seemed to expect low interest rates would last forever. Dividend stocks also suffered, as did variable rate mortgage holders who were squeezed by higher payments every time the central bank moved.

As for the economy, rising rates have been bad news. Third-quarter GDP showed a drop of 1.1%, putting Canada on the brink of a recession (two consecutive quarters of negative growth). While economic growth has stalled, the unemployment rate has been inching higher, reaching 5.8% in October.

Looking for a bond rally

All that may be over – we hope. Bank of Canada Governor Tiff Macklem hasn’t ruled out more rate hikes if inflation doesn’t fall back to the target 2% level. And we’ve already had a false flag – it appeared for a brief time last January that rates would stabilize, sparking a bond rally that quickly fizzled.

But this time, it appears to be the real deal, and the performance of key bond indexes is encouraging. The FTSE Universe Bond Index gained 4.51% in November and 3.66 in December (to Dec. 27), pushing the year-to-date gain to 6.93%. At the end of October, the index was in negative territory for 2023.

The big difference between now and the 1980s-1990s is that interest rates are nowhere near as high today. In February 1991, the Bank of Canada rate touched a record 16%. When inflation numbers finally cooled, there was a lot more room to climb down.

With current rates at 5%, there is less flexibility for the central banks to cut if the economy needs a boost. But a gradual retreat of even one point over the next two years would be a welcome signal to the markets, the economy, and mortgage holders.

So how can you profit from this situation? Here is one option to consider.

iShares Core Canadian Long Term Bond Index ETF

iShares Core Canadian Long Term Bond Index ETF (TSX: XLB) invests in a portfolio of long-term Canada bonds with a maturity of more than 10 years. If you based your investment decisions solely on past performance history, you wouldn’t want to touch this one with a 10-foot pole. The fund lost 21.9% in 2022 and shows a 10-year average annual compound rate of return of only 3.07% to Dec. 31. But, as they say, past results are no guarantee of future returns. The 2023 gain was 9.34%.

The ETF was launched in November 2006 and has $1 billion in assets under management. The management expense ratio is 0.2%. Normally, I look at bond ETFs strictly from an income perspective. But right now, we’re faced with a rare capital gains opportunity. If interest rates start to decline this year, as the market expects, long-term bonds will be the major beneficiaries – just as they were the biggest losers when rates were rising.

As of Jan. 25, the majority of the holdings (55.88%) is in provincial bonds. Federal issues account for 18.56%. Just over 3% is in municipals, with the rest in corporate bonds. All the bonds are investment grade (rated BBB or higher). About 20% are rated AAA.

With bonds, the longer the term to maturity, the greater the capital gains potential. Conversely, the risk of loss is much higher. If the Bank of Canada begins raising rates again, the market price of this ETF will suffer. But if the Bank cuts, investors in this fund will enjoy some nice gains on top of the regular monthly distributions.

Distributions are made monthly and are currently $0.063 per unit. They are not guaranteed and could change at any time.

This ETF is for investors who are willing to take more risk with their fixed-income securities in exchange for capital gains potential. If rates start to rise again, the units should be sold. This is a rare opportunity for those looking to score some fixed-income capital gains while earning decent cash flow at the same time. As always, consult your advisor to be sure the ETF fits with your risk-tolerance profile and financial objectives.

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.

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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.