Whither the Bond Markets

• Q1 2021 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 pre-pandemic levels; rates continue to be at historically low levels

• Looking forward, bond yields are expected to fluctuate within a reasonably narrow range, at least for the foreseeable future

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

By the end of March 2021, bond markets, and by extension bond investors, had experienced their worst quarter in over forty years …. the bull market in bonds that began in 1982 seemed to come to an unceremonious end!

The swift and abrupt rise in yields was the result of a combination of events – the Biden election, the rollout of the vaccination campaigns in the US and UK and their significance for economies finally reopening, and the massive fiscal stimulus programs. While these events are inherently positive, they caused the market to worry that it might translate into runaway inflation. And the two most significant negative influences on bond prices are an increase in interest rates and a rise inflation – both of which erode the market value of bonds.

But let’s put the increase in perspective – firstly, it followed one of the BEST years for bond markets – bond returns in 2020 were in the high single digits which is well above the norm.

On a year over year basis, bond portfolios at the end of March 2021 were still higher than they were at the end of March 2020!

And, secondly, the increase in yields merely brought interest rates back in line with where they had been pre-pandemic – which were and continue to be historically low!

And, thirdly, real yields (after deducting inflation) continue to be negative!

The reality is that central banks have committed to a “lower for longer” interest rate policy. They are prepared to maintain this policy as long as levels of employment continue to be a challenge. And that is certainly the case for those at the low end of the wage scale.

They also believe that any rise in inflation will be transitory, resulting from the short-term aftereffects of the economic collapse in 2020.

So, the outlook for bonds for the foreseeable future is that they will be range bound – in other words, that they will fluctuate within a narrow range; that there are still enough economic, labour market and income inequality challenges confronting governments to keep a lid on rates breaking significantly above the upper bound of the range.

The bond hiccup in Q1 however did offer an important portfolio lesson. The hiccup reminded us that diversification is your friend in investing; and that diversification is imperative for a strong portfolio foundation. Owning a single asset class creates short and long term risk for an investor.

A 40 year bull market in bonds (albeit with occasional retreats) allowed bond investors to be complacent and ignore that fact that bonds also carry risk; that bonds can and do lose money. The first quarter hammered home the lesson that the best defense for dealing with market turmoil and uncertainty is a diversified portfolio that holds both bonds and stocks.

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.