Bond funds were the big winner in a gangbuster November for exchange-traded funds.
What’s happening here is that a lot of smart investors are jumping on an opportunity to get into a beaten down asset ahead of a bond rally that can legitimately be described as inevitable. The only question is on the timing.
Inflows of money into bond ETFs totalled $2.3-billion last month, numbers from National Bank Financial show. Equity funds took in $1.6-billion, a bit less than half going into Canadian equity funds and the rest more or less evenly split between U.S. and international funds.
There’s opportunity to buy stocks low, too. While the Canadian stock market has recovered to levels not far off the start of the year, both the S&P 500 and Nasdaq are still down by double-digit amounts. Based on some good days recently for the U.S. market, there’s been some chatter that this year’s bear market in stocks is over. But the risk of a recession must be considered, too. The year ahead may not be a stellar one for corporate profits.
Bonds shocked investors this year with brutal losses that can be summed up in the 10.2 per cent decline in the FTSE Canada Universe Bond Index for the first 11 months of the year. That’s a total return number - it includes bond price changes and interest.
Bonds are starting to recover, though. In November alone, the index jumped 2.8 per cent on sentiment that the Bank of Canada is just about done increasing rates to fight inflation. A resurgence of inflation would massacre bonds, but there’s a growing sense that we have turned the corner in containing the rising cost of living.
Three of the five most popular ETFs in November were aggregate bond funds: the Vanguard Canadian Aggregate Bond Index ETF (VAB-T), the Horizons Cdn Select Universe Bond ETF (HBB-T) and the BMO Aggregate Bond Index ETF (ZAG-T). These funds give you exposure to government and corporate bonds, and to bonds maturing in the short, medium and long term. They’re an ideal way to play a bond market rebound – you’re essentially buying the entire bond market in one cheap package and waiting for lower interest rates to do their work.
To quickly review bond market mechanics, rising rates depress the price of bonds and falling rates increase bond prices. In the bond market, they’re already starting to price in the rate increases ahead. Smart investors are taking note.
-- Rob Carrick, personal finance columnist
Also see:
After a terrible year for U.S. bonds, the outlook Is better
Eleven new ETFs launch on TSX as inflows to Canadian funds highest since March
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Stocks to ponder
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Ask Globe Investor
Question: I want to invest in a guaranteed investment certificate, but I noticed something odd when shopping for rates at my discount broker. The yields offered on one- to three-year GICs are all more than 5 per cent, but four- and five-year GICs pay less than 5 per cent. Shouldn’t I be getting paid more, not less, to lock my money up for a longer time period?
Answer: Normally, that would be the case. Because investing your capital for a longer term carries more risk, you would typically earn a premium for doing so. Graphically speaking, if you were to plot the yields of one- to five-year GICs, the line would slope gradually up and to the right.
But these are not normal times. Now, the line slopes downward, meaning the lowest yields are paid for longer maturity periods. This is what’s known as an inverted yield curve, and it’s especially pronounced in the bond market right now.
As of Friday, Government of Canada bonds maturing in one year were yielding 4.39 per cent. Three-year bonds were yielding 3.56 per cent, and five-year bonds just 3.05 per cent.
An inverted yield curve is often said to signal an economic slowdown. Indeed, this is precisely what the Bank of Canada has been trying to engineer by hiking its short-term policy interest rate – including a half-point increase this week – in an attempt to get inflation back under control.
What the bond and GIC markets are predicting, essentially, is that interest rates will fall as the economy slows and the central bank wrestles inflation to the ground. That’s why you’re getting a lower, not higher, yield if you lock in a GIC for four or five years compared with a one- to three-year GIC.
Does this mean four- and five-year GICs are a bad deal? Not necessarily. If interest rates do start to fall, as expected, locking in now at a rate of, say, 4.8 per cent might turn out to be a smart move. You’ll continue to collect 4.8 per cent for many years even as yields on new GICs fall. There are no guarantees that events will play out exactly as expected, however.
To control your risk, one of the best strategies is to build a ladder of GICs. For example, you could invest equal amounts of your money in GICs with maturities ranging from one to five years. When the one-year GIC matures, roll the proceeds into a new five-year GIC, and so on. By staggering your maturities, you’ll avoid having all of your GICs coming due at the same time, possibly when interest rates are very low.
--John Heinzl (E-mail your questions to jheinzl@globeandmail.com)
What’s up in the days ahead
The Contra Guys look at the investment case for Canadian small-cap Quarterhill. Plus, former bond fund manager Tom Czitron provides his outlook for what the fixed income market may bring in 2023.
Click here to see the Globe Investor earnings and economic news calendar.
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Compiled by Globe Investor Staff