Bonds Behaving Badly

by: Dan Bortolotti

There are a couple of basic rules bond investors can depend on. The first is that bond prices fall when interest rates rise, and vice-versa. The second is that long-term bonds are vulnerable to larger price swings than short-term bonds - in other words, they are more sensitive to changes in interest rates.

If you understand these principles, the logical next step - at least for active investors - is to move to short-term bond funds if you expect interest rates to rise, since they're likely to outperform bonds with longer maturities during any period when yields move up.

With this in mind, imagine you could transport back in time to early July 2017 when the Bank of Canada's overnight rate stood at 0.50%. This key interest rate had been stuck at that level since mid-2015, and many economists and media commentators at the time were predicting rates would start ticking up. That suggested investors should move to short-term bonds (or even cash) to protect themselves from losses.

As it turned out, the forecasts were right on. The Bank of Canada went on to hike the overnight rate four times: in July and September 2017, and in January and July of this year. Thursday, the overnight rate sits at 1.5%.

So, how would investors have fared during the last year had they favoured short-term bonds over those with longer maturities? Here are the 12-month returns for three representative ETFs:

ETF Average term 12-month return
iShares Core Canadian Short-Term Bond ETF (XSB) 2.7 years 0.63%
iShares Core Canadian Universe Bond ETF (XBB) 10.3 years 1.82%
iShares Core Canadian Long-Term Bond ETF (XLB) 22.5 years 3.66%

Source: Morningstar, as of July 17, 2018

So much for expectations: despite four well-publicized rate increases, the bond ETFs with the longer average maturity significantly outperformed. What's going on here?

Different fates for different rates

The answer is that not all interest rates have been rising. The Bank of Canada's policy interest rate (also called the target for the overnight rate) gets all the headlines, but it may have actually had little effect on the bond market. The overnight rate applies to the shortest of short-term loans: it's what banks charge when they lend each other money for periods as brief as one day. It can affect the interest rate you get on savings accounts (although not necessarily), and what you pay on your line of credit or variable-rate mortgage, too. But if you hold an ETF full of bonds with maturities of three, five, 10 and 20-plus years, the Bank of Canada's rate policy may not even move the needle.

Indeed, the day before the first rate hike in July 2017, the yield on Government of Canada benchmark long-term bonds (30 years to maturity) was 2.26%. A year later, though the overnight rate has since tripled to 1.5%, long-term rates have actually fallen several basis points - which explains the comparatively handsome return enjoyed by funds such as XLB during the last 12 months.

Remember, too, that traditional bond index funds hold about 20% to 30% in corporate bonds, which adds another variable. The yield on 10-year Government of Canada bonds may not move in lockstep with the yield on 10-year corporates. The difference between these two figures (called the credit spread) can be affected by the mood in the economy, inflation expectations, and the default risk of the companies issuing the bonds. All of this makes it even harder to predict the effect of interest rate changes on the performance of a diversified bond fund.

Keep this in mind next time you hear someone say it doesn't make sense to buy bonds if the Bank of Canada has indicated it's likely to increase its key policy rate. First, the increase might not happen: remember the shock when the central bank cut the rate twice in 2015? ("Virtually no economists had been predicting a rate cut," the CBC reported after the first one.) More important, even if the central bank increases its key rate as expected, that doesn't necessarily mean your bond fund will fall in value.

When it comes to bonds, then, the advice is the same as it is for equities: stop trying to adjust your portfolio based on forecasts, because it's counterproductive. Instead, build a portfolio with an asset allocation appropriate for your risk tolerance and your time horizon and tune out the armchair economists.