Volatility in bond markets has not been this high since the mid-1990s, as traders try to make sense of uncertain economic growth prospects and the outlook for inflation in these unprecedented times.
This dramatic increase in market volatility may have younger bond managers perplexed, since many started their careers in a very different environment. Retail investors are undoubtedly stressed out, too, over what to do with fixed income in their own portfolios after encountering steep losses so far this year.
A look back on how bond fund managers used to ply their trade may provide some valuable insight.
Back in the 1980s and 1990s, many managers built their entire careers on duration management – essentially, investing in bonds of certain terms depending on their interest rate outlook. Successfully anticipating a rise or fall in interest rates was the most important skill a market player could have in fulfilling their goal of outperforming a benchmark bond index.
Here’s an illustration: A portfolio duration one year longer than the benchmark index during a one-percentage-point fall in interest rates would result in the portfolio outperforming the benchmark by about 1 per cent. That would handily beat the performance of most competitors.
Conversely, a manager could outperform the benchmark in a period of rising rates and falling prices (they always move inversely) if they had shortened their average term and duration. The longer the duration of the bond, the more it will move in price. For instance, the price of a bond with a two-year duration will fall less than 2 per cent if yields quickly rise by one percentage point; a bond with duration of 30 years will fall well over 10 per cent if yields rise by the same one percentage point.
Canadian portfolios in that era tended to mimic the characteristics of the benchmark. Less intrepid bond managers kept their portfolios close to the index. (There was a saying at the time: “You only get fired for underperformance, not average performance.”)
Given the historically large and relatively quick changes in interest rates, interest rate anticipation and duration management may yet again be in fashion. However, interest rate prediction is easier said than done. Even back in the 1980s and 1990s, many bond managers underperformed dramatically.
During the early 2000s, many investment firms gave up on interest rate anticipation. As rates became less volatile, there were less significant moves to take advantage of. Managers would place a bet in one direction only to have it eventually reverse, resulting in underperformance.
The result was that bond managers became very conservative and many realized they could outperform their benchmarks simply by overweighting corporate bonds, which have higher yields than Government of Canada issues. Benchmark indexes had relatively low corporate weights so it was fairly easy to underweight Government of Canada issues. Barring a major default or credit event in the portfolio by one or more issuers, outperformance over a significant time period was all but assured.
Another strategy employed by bond managers was to eliminate issues with average terms of less than two years, unless they were higher yielding investment grade corporate bonds, since shorter issues tend to yield far less most of the times.
What we’re seeing right now is quite different. We have an inverted yield curve where shorter-term bonds are offering greater yields than those further out the curve. Late last month, for instance, we saw two-year government bonds yielding 3.19 per cent and 10 years only 2.84 per cent.
That means the two-year/10-year spread was inverted 35 basis points. (There are 100 basis points in a percentage point.) That’s unusual, and many market analysts see this as a harbinger of recession. However, this inversion probably has more to do with the market being more optimistic about lower inflation and rates in the long term than the near term.
Typically, when interest rates on two to five year bonds are trading at similar levels, or slightly above the yields of longer term issues, bonds tend to do quite well over the next year. Yes, inversions can be profitable for bondholders who have the intestinal fortitude to buy when others are in a state of panic and pessimism.
The market seems to be saying rates will not rise significantly, and may even fall. Given rates are still below current headline inflation, the market seems to be pricing in a drop in inflation. This isn’t unexpected given current demand suppression – when consumers and businesses stop buying goods and services – and general economic weakness.
Given the rise in spreads between corporate and government issues, it may be a good time to hunker down in bonds. The current ICE BofA U.S. Corporate Index Option Adjusted Spread is about two percentage points over Treasury issues, up from a bit more than one percentage point in the fall of 2021. This spread was as high as five percentage points during the height of the pandemic panic. Those who bought when most were frantically selling profited handsomely.
My suggestion to investors right now: Diversify your credit risk by using corporate bond ETFs instead of buying individual issues. This strategy is inherently less risky and avoids the high management expense ratios of actively managed mutual funds. It will yield positive and relatively steady returns during volatile times.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.