Whither the Bond Markets – A Year Later

• Q1 2022 was the worst quarter for bonds since the bull market in bonds began in 1982.

• Yet the increase in yields only took rates back to 2018 levels; 10-year bond yields continue to be at historically low levels.

• Bond yields are expected to be volatile, as there is significant uncertainty – not just tightening monetary policy with its impact on yields and the dramatic and potentially persistent increase in headline inflation – but also the impact of the war in Ukraine on both.

• Diversification is your best friend in investing; being exposed to a single asset class carries undue risk in the face of volatility and uncertainty.

Bonds declined early in the quarter, as markets anticipated that the Bank of Canada and the Federal Reserve would introduce interest hikes due to the 40-year highs in headline inflation. (1) Just as the bond markets appeared to stabilize in February, yields climbed again as Russia invaded Ukraine, sending oil and other commodity prices soaring. (2)

Recent headline inflation numbers have caused an increase in short-term inflation expectations. As shown in Figure 1, the percentage of businesses that expect the annual rate of inflation to exceed 3% over the next two years has risen from 2% at the start of the pandemic (Q1 2020) to 70% as of the end of Q1 2022. By contrast, long-term inflation expectations appear well anchored to the 2% inflation-control target of the Bank of Canada (see Figure 3). Despite the benign long-term inflation outlook, when short-term inflation expectations rise, so do bond yields, which cause bond prices to move lower. (2) As a result, by the end of Q1 2022, the Canadian Universe Bond Index had declined 7.19% on the year.

Figure 1: Short-Term Inflation Expectations (Next 2-Years)

Source: Business Outlook Survey, Over the next two years, what do you expect the annual rate of inflation to be, based on the consumer price index? (% of firms).

While the size and speed of the bond market decline in Q1 was unusual, a negative quarter of performance for the bond market does not fall outside of our expected range of possibilities.

As we wrote back in Q1 2021 “Whither the Bond Markets” when the bond market took its first significant tumble since 1994, a 40-year bull market in bonds (albeit with occasional retreats) allowed bond investors to become complacent and ignore the fact that bonds also carry risk; bonds can and do lose money from time to time.

Now that investors have once again been reminded of the risks inherent in bond investing, it’s important to put the recent bond market decline in perspective.

Firstly, the increase in yields only took rates back to 2018 levels; 10-year bond yields continue to be at historically low levels as shown in Figure 2.

Figure 2: Government of Canada 10-Year Bond Yields

Source: BOC

Secondly, economists expect that inflation will peak within the next two to three years.  As shown in Figure 3, the consensus economic forecast for CPI inflation is just 2.1% two to three years out and 2% six to ten years out.

With inflation expected to peak soon, there is a greater chance that central banks will become more dovish, as there would be less need to raise interest rates if inflation begins to trend lower. (3) If central banks start to sound more dovish because inflation begins trending lower, then long-term bonds will likely begin to appreciate in price (4) in anticipation of fewer interest rate hikes and slower economic growth.  This would benefit investors that own long-term bonds, by increasing the value of their bond investments.

Figure 3: Medium to Long-Term Inflation Expectations

Source: Consensus Economics Inc. Prior to April 2014, forecasts were semi-annual (semi-annual values are shown for the two appropriate quarters in the graph above). Since then, they are available quarterly.
* Year-over-year percentage change
** Yield spread between conventional (selected long-term government of Canada benchmark bond yields) and benchmark real return bonds. The differential is calculated using the appropriate compound interest formula.

Thirdly, the biggest increases in rates may have already taken place as the bond market moved in anticipation of central bank moves.  While central banks have moved off their “lower for longer” interest rate policy and are prepared to raise interest rates further if inflation continues to be a challenge, the rise in bond yields (or decline in bond prices) means that investors will be receiving more income from their bond funds in the coming years.  This could lead to positive returns if the interest rate increases by central banks have already been priced in.

And fourthly, there are still plenty of economic, labour market/underemployment (5) and income inequality challenges confronting governments to keep a lid on rates rising too rapidly.  Central banks will need to balance the risk of inflation against the risk of recession and exacerbating societal problems.

For these reasons, we believe that investors should “stay the course” with their bond fund investments and reiterate that the best investment defense is a diversified portfolio based on a sound investment policy that has considered your investment objectives, your time horizon for investing, and your tolerance for risk. And importantly investors need to understand not just their emotional comfort or discomfort with risk but also their objective capacity to take on risk based on the size of their capital pool and the timeline for requiring the capital

Astute investors build portfolios that factor in both their assets and their liabilities and ensure that the two are aligned. Practically, what does this mean? It means that unless you have an immediate need for your capital, an efficient portfolio will have an exposure to equities as an offset to volatility and uncertainty in the bond markets, and vice versa.

(1)     Headline inflation is the total inflation in an economy. Headline inflation includes inflation in a basket of goods that includes commodities like food and energy. It is different from core inflation, which excludes food and energy prices.
(2)     The amount of return a bond earns over time is known as its yield. A bond’s yield is its annual interest rate (coupon) divided by its current market price.  There is an inverse relationship between a bond’s price and its yield.  When yields rise, bond prices fall and visa versa.
(3)     Central bankers are described as “dovish” when they favor economic growth and employment over-tightening interest rates. The opposite is “hawkish” when Central bankers support raising interest rates to fight inflation.
(4)     There is an opposite relationship between a bond’s price and its yield.  When bond prices fall, its yield rises and visa versa.
(5)     Underemployment can be thought of as the unmet need for paid employment. For example, a person may be unable to find full-time work, but manages to find part-time work. There is still an unmet need for more hours of work, even though this person is no longer counted as unemployed