It’s been a long time coming, but we’re finally seeing signs of life in the bond markets.
The Bank of Canada has already cut rates twice this summer and analysts are expecting another quarter-point decline in September. The U.S. Federal Reserve Board has yet to move but the pressure is building as the American economy shows signs of slowing. Its next scheduled meeting is Sept. 17-18, and we may finally see some action then.
At this point, no one is expecting the rate cuts to be as fast and furious as the increases were in 2022-23. Then, the emphasis was on stopping inflation quickly before it got out of control, as in the late 1970s-early 1980s. Now, with inflation still lurking, central banks will be more cautious in cutting too much, too soon.
That means that consumer rates, such as on mortgages, are not going to fall as quickly as they rose. Anyone expecting a speedy return to 2 per cent mortgages will be disappointed.
Those who welcomed the return of the 5-per-cent GIC will also be unhappy. According to ratehub.ca, no GICs of one year or more are offering 5-per-cent returns. You can still get 5.15 per cent at Duca Credit Union for a six-month deposit, but don’t expect it to last long.
Meanwhile, there are some unusual things happening in the bond market. As of Aug. 16, the FTSE Universe Canadian Bond Index was showing a gain of 0.84 per cent for the month and a year-to-date advance of 2.84 per cent. The ETF equivalent, the iShares Core Canadian Universe Bond Index ETF (XBB-T) was ahead 2.7 per cent for the year at that point.
But here’s a surprise. The FTSE Short Term Bond Index was up 3.61 per cent for the year, while the iShares Core Canadian Short Term Bond Index ETF (XSB-T) had gained 3.51 per cent. The FTSE Long Term Index was up 0.97 per cent for the year while the iShares Core Canadian Long Term Bond Index (XLB-T) was up 0.67 per cent.
Normally long-term bonds outperform short-term issues when rates are falling. We aren’t seeing that happen yet. The reason: we’ve had an inverted yield curve for more than a year, meaning short-term yields are higher than those of long-term bonds. Yields and prices move in opposite directions so in this case short bond yields had farther to fall than long ones when rates started to decline.
That is not a normal situation, and I don’t expect it to continue for long. I continue to like XLB for income and growth potential. Here’s an update from my Income Investor newsletter. Prices to Aug. 16.
iShares Core Canadian Long Term Bond Index
- Ticker: XLB-T
- Type: Exchange-traded fund
- Current price: $19.79
- Originally recommended: Dec. 7, 2023 at $19.30
- Annual payout: 75.8 cents
- Yield: 3.8 per cent (forward)
- Risk rating: High
- Website: www.ishares.ca
The security: This ETF invests in a portfolio of long-term Canada bonds with a maturity of more than 10 years.
Performance: The units are showing a year-to-date gain of only 0.64 per cent but have gradually been trending higher recently.
Key metrics: The ETF was launched in November 2006 and has $1.2 billion in assets under management. The management expense ratio is 0.2 per cent.
Portfolio: The majority of the holdings (57.22 per cent) is in provincial bonds. Federal issues account for 17.3 per cent. Just over 3 per cent is in municipals, with the rest in corporate bonds. All the bonds are investment grade (rated BBB or higher). About 17 per cent are rated AAA.
Risks: With bonds, the longer the term to maturity, the greater the capital gains potential when rates fall. Conversely, the risk of loss is much higher when they rise. If central banks begin raising rates again, the market price of this ETF will suffer. But right now it appears the Fed and BoC will cut, and as the yield curve normalizes, investors in this fund should enjoy some nice capital gains on top of the regular monthly distributions.
There is also a concern that long bond returns may suffer if the U.S. issues a large amount of new long-term debt to pay for tax cuts or expenditures. Several bond houses like PIMCO have warned that could limit returns on long term bonds. This is certainly a possibility, which is why I give this recommendation a high risk rating.
Distribution policy: Payments are made monthly and are currently $0.063 per unit. Distributions are not guaranteed and could change at any time.
Summing up: This is an opportunity to score some fixed income capital gains while earning decent cash flow at the same time.
Action now: Buy.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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