Our H1 2022 Fixed Income Outlook takes a detailed dive on the differences between the latest wave of COVID-19 and those that came before it, the way society and businesses have adapted over the last two years, the outlook for growth and inflation, monetary policy and much more.
2022 Edition: Bonds, what are they good for?
The pandemic has been a constant source of disruption, not just in financial markets, but to the everyday lives of virtually everybody across the world. As we enter the third year of this public health crisis, however, there appears to be growing optimism that the months ahead could represent a return to a more “normal” environment, one in which concerns over infection ebb (thanks to increased resistance across populations brought about by vaccination and prior illness) and restrictions on activity are rolled back.
While a move toward the end stages of the pandemic and the resulting, improved, clarity over the outlook — notwithstanding the recent rise in geopolitical uncertainty — are unambiguously positive developments for the world, there are some implications of these changes that have proven less than ideal for financial markets.
The most notable is that the more sanguine expectations have resulted in a material shift in the approach to policy setting by central banks. The easing in pandemic-related risks to the outlook, combined with generally constructive macroeconomic fundamentals, has resulted in monetary policymakers eschewing their previous “abundance of caution” in favour of stepping up to address rising issues that are seen as providing longer-term risks to economic growth and price stability.
Specifically, the combination of the surprising resiliency of the consumer and business demand through the pandemic and the ongoing supply-side difficulties have resulted in persistent and broadening price pressures, with gauges of inflation worldwide perking up to multi-decade highs.
Inflated inflation readings
(consumer price index, year-over-year percent change)
Data to January 2022; shaded regions represent periods of US recession; source: Bloomberg, Guardian Capital
While moderate increases in prices are viewed as a normal and good force — so much so that central banks spent the better part of the pre-pandemic decade trying, and failing, to engineer it — the destructive impact of inflation on purchasing power and demand becomes evident when it runs too high for too long. Moreover, efforts to rein in excessive price pressures once they are present can involve the economy being forced to take particularly bitter medicine, which may end up being worse for growth than the disease itself.
The heightened risks of sustained elevated price pressures have, therefore, spurred a rise in inflation expectations and increasingly aggressive rhetoric from central bankers, which in turn has driven a significant repricing of market interest rate expectations over the last few months. As a result, market interest rates have risen fairly sharply to levels last seen before the pandemic hit — and given the inverse relationship between interest rates and bond prices, the rise in market yields has been undeniably bad for holders of fixed income securities for whom recent performance has been among its worst in the last three decades.
Market interest rates movin’ on up
(10-year government bond yield, percent)
Data to February 28, 2022; shaded region represents period of US recession; source: Bloomberg, Guardian Capital
The rising-rate environment has proven to be a headwind for equities as well — the value of a stock is derived from the cash flows that the underlying company can generate, both now and in the future; higher interest rates reduce the present value of those future cash flows. As a result, those companies that are valued predominantly based on their future prospects have been impacted more by the up-move in the rates market, which has driven a rotation in the market where the “growth” oriented areas of the market that had previously flourished over the last year have underperformed their peers.
The increased correlation in movements in stocks and bonds — prices for both asset classes moving together, in this case, lower — in recent months diminishes the diversification benefits of a balanced portfolio which, combined with the general weakness in bonds that appears likely to persist as market interest rates edge higher, still raises the question as to why bother holding bonds at all. Why place bets on a losing proposition?
For one, bonds still offer tremendous diversification benefits for a stock portfolio by virtue of their comparatively lower degree of volatility — the presence of bonds, even if perfectly correlated with stocks, would still effectively halve portfolio volatility in a traditional 60/40 portfolio.
Relatively Lower Volatility Matters Most
(expected standard deviation of portfolio returns, annualized rate)
Stocks=S&P/TSX Total Return Index; Bonds=ICE BofA Canada Government Total Return Index. Based on annualized performance over the 30 years ended December 31, 2021; source: Bloomberg, Guardian Capital
Secondly, it may be the case that correlations have increased of late, but the diversification benefits are most notable when things take a significant turn for the worse.
For example, while the S&P/TSX Composite Index¹ plunged almost 40% at the onset of the pandemic crisis from February 19 to March 23, 2020, the ICE BofA Canada Government Index² was actually up 3% over that span (and the broad Canadian Bond universe was down a marginal 1%, as represented by FTSE Canada Universe Bond Index³).
The ability of bonds to offer this “disaster insurance” for equity exposure in portfolios, helps to mitigate large and unexpected declines, clearly provides investors’ value — all while also receiving income.
Bonds Provide a Buffer Against Stock Declines
(portfolio total return; percent, rolling 12-month basis)
Stocks=S&P/TSX Total Return Index; Bonds=ICE BAML Canadian Government Bond Total Return Index. Data to February 28, 2022; shaded regions represent periods of US recession; source: Bloomberg, Guardian Capital
Finally, rising interest rates only really impact those looking to trade their fixed income holdings. For investors intent on holding bonds until maturity, there is no real impact (the par value and coupons are fixed). Further, rising interest rates actually serve to benefit these investors since they are able to reinvest the proceeds from maturing bonds at higher coupon rates, which could result in higher cash flows on future bond purchases.
In other words, while performance of the fixed income portion of balanced portfolios may disappoint over the near-term should positive economic forecasts come to fruition, it may be best for those with a long time horizon to think of them as an equivalent to the vaccines that have factored so heavily into improving the outlook for the coming months: they may provide a bit of short-term discomfort, and there is the temptation to just forge ahead without them, but it could be in the best interests of investors’ long-term well-being to have them to keep portfolios healthy for years to come.
Equity market corrections are part and parcel of even the strongest bull markets, but investors rarely completely give up on stocks simply because their near-term prospects turn negative. The benefits of buying stocks at a discount are obvious — and everyone loves to buy things on sale.
While the market environment may be such that bonds are currently “on sale”, none of the benefits of income, diversification or capital protection have disappeared completely. As such, fixed income securities remain, as ever, an important long-term component of client portfolios.
 The S&P/TSX Composite Index is the benchmark Canadian index, representing roughly 70% of the total market capitalization on the Toronto Stock Exchange (TSX) with about 250 companies included in it.
 The ICE BofA (Bank of America) Canada Government Index tracks the performance of CAD-denominated sovereign debt publicly issued by the Canadian government in its domestic market.
 The FTSE Canada Universe Bond Index is the broadest and most widely used measure of performance of marketable government and corporate bonds outstanding in the Canadian market.
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The opinions expressed are as of the date of publication and are subject to change without notice. Assumptions, opinions and estimates are provided for illustrative purposes only and are subject to significant limitations. Reliance upon this information is at the sole discretion of the reader. This document includes information concerning financial markets that was developed at a particular point in time. This information is subject to change at any time, without notice, and without update. This commentary may also include forward looking statements concerning anticipated results, circumstances, and expectations regarding future events. Forward-looking statements require assumptions to be made and are, therefore, subject to inherent risks and uncertainties. There is significant risk that predictions and other forward-looking statements will not prove to be accurate. Investing involves risk. Equity markets are volatile and will increase and decrease in response to economic, political, regulatory and other developments. The risks and potential rewards are usually greater for small companies and companies located in emerging markets. Bond markets and fixed-income securities are sensitive to interest rate movements. Inflation, credit and default risks are all associated with fixed income securities. Diversification may not protect against market risk and loss of principal may result. Index returns are for information purposes only and do not represent actual strategy or fund performance. Index performance returns do not reflect the impact of management fees, transaction costs or expenses. Certain information contained in this document has been obtained from external parties which we believe to be reliable, however we cannot guarantee its accuracy.
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