be over (or at least close to over as we approach the zero bound).
A 5 year Canada bond yields about 1% at the moment, so it is a
pretty good bet that a portfolio of Canada bonds with maturities
near 5 years will average about that return if held to maturity. With
inflation running at about 1.6%, the return in real terms is long
This begs the question – if we can’t rely on the “40%” fixed
income portion of our portfolio to provide any decent return,
should we continue to hold it? Fixed Income used to be
simple. Bonds had a coupon and a maturity date. That gave
them certain reliable characteristics. Over the past decade,
government bonds have an average correlation of -0.20 to
equities, meaning they will rise in value when equities fall.
Today, what gets classified as fixed income often doesn’t
pass the classic tests. Coupon rates are not fixed, maturity
dates are not guarantees, and pools of debt in a fund often
have the ability to use all sorts of instruments including
private securities and derivatives in an effort to replicate the
fixed income portion of portfolios, while still generating a
competitive level of return.
Portfolio construction is not just about return. Government
and investment grade bonds tend to do well when equities
do not, thus providing some ballast for when equities lag or
drop. While we still believe this to be true, we feel seeking
actual returns from “the 40” is reasonable, provided the risks of
doing so are understood.
This paper is our attempt to examine alternatives – many of which
are new to the investment landscape - while maintaining diversification and avoiding some of the potential pitfalls that are inherent
to seeking returns.
Bond Markets – How Did We Get to 2017?
• For centuries, long term rates were range-bound between 2%
and 6%. The inflationary 70’s caused that upward bound to be
shattered, and the deflationary 00-10’s have caused the bottom
bound to be tested.
• Central Bank actions have been unprecedented
• Current government bond rates provide negative to minimal
real returns, challenging investors.
The mid-sixties to the early eighties represented an unprecedented
period for bond markets. A confluence of social and military spending, demographics and monetary system changes, among other
reasons set the stage for rising inflation. These factors led long term
bond yields to definitively break above 6%, a cap that had held not
just for decades, but for over two centuries. These centuries were
also characterized by a floor on rates of around 2.0%, despite
numerous wars and severe business cycles, including the great
Starting in late 1970s, a period of “tight money” was initiated;
Higher central bank rates to combat the rampant inflation. Although
this sparked a recession, yields finally peaked in 1981, and since
then investors have enjoyed a 35 year run of declining yields.
Whereas in the 1890s and 1930s deflationary shocks resulted in
severe downturns in industrial production, the monetary tools
employed by central banks since 2008 staved off a prolonged
decline in GDP. What might have been a severe depression has
instead become a long period of tepid growth, as the unprecedented
expansion of the monetary base globally has so far helped markets
avoid a deflationary bout as seen in the past.
Cutting interest rates to all-time lows, the use of unconventional
policies such as direct bond and asset buying by central banks and
experimentation with negative interest rate policy, the bailing out
of financial institutions and European sovereigns avoided a crisis,
but ensured the continuation of these policies. Finally, last summer
global yields plummeted to new lows amidst “Brexit” news and we
have broken definitively below that 2% yield floor that had held
through the centuries.
For investors, this has translated into a multi-decade run of solid
returns from their fixed income portfolios. Canadian long bonds
have provided a total return of 8.74% annually from 1960 through
2016, only slightly trailing the 9.49% return on the S&P/TSX
Composite Index. Interestingly, since 1980, Canadian long bonds
have actually outperformed equity markets, not only over the
period, but in each decade since the change in central bank policies
in the late 1970s.
The decline in yields has not been simply an inflationary phenomenon. Real yield (the return after inflation) has also fallen. The chart
that follows graphs the yield of what was then the benchmark long
bond in Canada, the 10.25% due March 15, 2021, in comparison to
the Canada Real Return Bond (RRB) 4.25% due December 1, 2021.
RRBs pay a rate of return that is adjusted for inflation – as CPI
increases year over year, so does the principal, ensuring that inves-