In an article December last year, I wrote about government bonds: “They’ll be times when you wonder why you own them. That is, until they show up to save the day.”
Well, today is one of those times when you have every right to wonder. The world is in turmoil. Stocks have been weak. Your portfolio needs diversifiers to kick in. And so far, bonds have done nothing. Even I am disappointed, as I have them in my Founders Fund.
Before analyzing the letdown, let’s start with some basics.
Why bonds
When you own a bond, you’re lending to a government or corporation. In return for tying up your money and taking the risk that you won’t get paid back, you receive a rate of interest, as measured by the bond’s yield.
There are three components to a bond yield – real yield, inflation adjustment and credit spread. The first two are connected. The yield has to more than offset what you expect inflation to be over the term of the loan so that you get a positive real (after-inflation) yield. In other words, when you get your money back, you’ll have more buying power than when you lent it.
The credit spread, or extra yield, compensates you for the risk that the borrower defaults on the loan.
Credit spreads vary widely, depending on the quality of the issuer. Government of Canada bonds and U.S. Treasuries offer little or no extra yield because they’re strong countries that have the ability to tax.
For corporate bonds, spreads range from small premiums for high-quality issuers such as utilities, banks and mega-tech firms (half to one per cent) to double digit percentages for less established and/or more cyclical borrowers where the chance of default is considerably higher.
When adding the components together, bonds provide steady income and portfolio protection during economic slowdowns or crises.
How much protection
The mix between income and protection, however, varies depending on the quality of the issuer and term of the bond. There’s no free lunch. To get more of one, you get less of the other.
On one end of the spectrum are Government bonds which offer a modest income but plenty of protection. When interest rates fall to stimulate a failing economy, these bonds react immediately.
On this note, I need to review something that confuses many people. When interest rates drop, existing bonds go up in price (and vice versa). Consider a simple example. If you buy a bond that yields 5 per cent and rates subsequently drop to 4 per cent, you’ve got a more valuable piece of paper. The price adjusts up until it too yields 4 per cent, which is the going rate.
How much the price rises depends on the term of the loan. The longer the bond, the more sensitive it is to changes in interest rates and the more protection it provides when rates fall.
If government bonds are at one end of the income-versus-protection trade-off, riskier bonds are at the other. High yield bonds, which woo investors with their annual income, offer substantially more income but provide little or no insurance. They trade more like stocks than government bonds.
Where’s my diversification
Now, back to the letdown. When bonds disappoint at crunch time, it’s usually because they’re too short term and have too much credit risk. They don’t benefit enough from interest rate declines to offset expanding credit spreads.
But that hasn’t been the case this time. Credit spreads on corporate and provincial bonds have increased surprisingly little considering the turmoil. Bond investors appear to be looking beyond the current headlines and assuming the world economy is still on solid footing.
Rather, what has held bond returns back is an increase to the inflation component. The linkage between higher oil prices and inflation expectations is unequivocal.
What next
Right now, there is a tug of war going on in the bond market. Those concerned about inflation are gaining ground, but the question is, will the issues at the other end of the rope win out over time? Will reckless fiscal management and an unstable geopolitical landscape cause an economic slowdown, such that interest rates need to come down substantially to stimulate growth?
The strategies that have worked so far include holding cash, market neutral funds and resource stocks. If the outlook deteriorates further, however, longer-term, high-quality bonds are likely to be an important diversifier. Real yields will come down and more than offset any changes to credit spreads and inflation expectations.
Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.