After a banner year of returns in the broad bond market, it may be tempting to invest in a broad market index vehicle in 2021. However, while these vehicles may look attractive in the rear view mirror, the combination of low yield and high duration means that investors should expect lower returns and higher volatility going forward.
The risk of low yield in a low interest rate environment
Bond investors have benefited from the trend of falling interest rates for the better part of a quarter-century, padding overall returns by pushing bond prices up in addition to the interest income received from bond coupon payments. “Yields down, prices up” is a popular maxim to remind investors about the inverse relationship between interest rates and bond prices. The onset of the COVID-19 pandemic pushed yields down even further, and while that contributed to the substantial return that accrued to investors in 2020, it also amplified the risk in the marketplace going forward via low yields and higher durations.
Having a low-yield bond portfolio means that, over the long term, investors risk having a low-return profile, and in the short term, they risk having more periods of negative returns as there is less coupon yield to protect against negative price volatility as interest rates change.
A bond’s price sensitivity to changes in interest rates is what describes a bond’s interest rate risk. In the investment industry, interest rate risk is referred to as “duration” and measured in units of “years” – the practical impact of duration is an equal per cent change in bond price (up or down) for every unit of duration, based on a 100 basis points (“bps”) (100bps is equal to 1%) shift in the government yield curve. This means that with a duration of 8 years an investor can expect their investment value to adjust by 8% for every 100bps movement in interest rates.
For investors holding an index investment vehicle right now that owns the broad bond market in Canada, the interest rate risk is considerable. And while in the past there were higher bond market yields to buffer an investor’s total return against price volatility, with yields hovering at around 1% to 1-¼ %, an 8-year duration investment would only need interest rates to increase ~15bps for the price decline in that vehicle to wipe out a full year worth of interest income.
What can investors do?
Two ways to increase yield in a bond portfolio are to extend the term to maturity or move further out the corporate quality spectrum.
But, remember that bonds with long maturities have the longest durations so they are most sensitive to interest rate changes and thus are more volatile. Bonds further out the credit quality spectrum have a higher risk of default, which also makes them more volatile.
Chasing yield is risky, especially if you are not familiar with how to assess risk. You might end up with price volatility you can barely stomach. The yields are higher for a reason — because you are taking on more risk.
Given all this uncertainty, it’s probably wise to seek out an active manager who can carefully increase the yield of a portfolio and will be better equipped to evaluate the relative merits of which higher-yielding names to buy – those with longer maturities, those with lower credit quality or both.
A corporate bond (“credit”) manager can reduce the risk associated with buying bonds further down the credit quality spectrum by conducting due diligence on companies to determine the probability of default and the potential loss under the worst-case scenario. A key differentiating feature of bonds as opposed to stocks is their placement in a company’s capital structure. When a company defaults on its debt, in almost all cases stockholders experience a total loss of their investment. Bondholders on the other hand have a better chance of recovering at least some portion of their investment; they may still have to accept a certain amount of capital loss, although that loss can be mitigated depending on the bond’s placement in the capital structure and its covenants.
Fundamental bottom-up credit managers also have unique expertise in analysing specific credits and are better suited to find inefficiencies in the bond market or spot bonds that are mispriced to determine whether the incremental yield is worth the risk for the price being sought. This includes conducting due diligence on a company, reviewing its financials, the bond’s placement in the capital structure and its covenants. This is a better way to control for and manage risks, rather than simply relying on rating agencies’ assessments of risk via their credit ratings.
Tax is also an important consideration for investors, especially in the current environment of record government deficits and questions surrounding whether taxes will have to be increased to eventually repay the additional debt burden. The interest income investors receive from bonds outside of registered investment accounts or TFSAs is fully taxable in Canada. However, in some cases investors can realize capital gains as a part of the overall yield from a bond. For example, a bond that has a coupon of 4% may have a yield-to-maturity of 5% if the bond is trading at a discount. In that case, if the bond matures at its par value, 4% of the return will be interest income and 1% of the return will be a capital gain. This is another way a credit manager can add value – by carefully investing in attractive bonds trading at a discount, which ultimately improves yield and tax efficiency.
All of these decisions should be made in consultation with an Investment Professional or Portfolio Manager, to ensure all investments are suitable and in keeping with the investor’s goals and needs.