Trader Robert Moran works in his booth on the floor of the New York Stock Exchange, Aug. 7.Richard Drew/The Associated Press
For investors, this has turned into a long and hot summer, both figuratively and literally.
Within the last few weeks, the world was shaken by an assassination attempt on a former (and perhaps future) president of the United States. The sitting President withdrew from the election, and Vice-President Kamala Harris was swiftly installed as the Democratic candidate. The U.K. and France held historic elections resulting in leftist wins and, for now, chaotic situations.
The Israel-Gaza War is still threatening to escalate. This could result in a larger regional war and the closure of all shipping through the Suez Canal and Persian Gulf, which would negatively affect a world economy that is already showing weakness. Meanwhile, the war in Ukraine rages on.
As political risks and uncertainties escalate, investors justifiably become nervous and seek to protect their capital. As we saw over the past week, this has profound effects on capital markets and asset prices. It also provides opportunities in the fixed income side of portfolios.
The past week’s chaotic markets have been blamed in part on a weak U.S. jobs report that increased the chances of a recession in the minds of market players. Curiously, government bonds were relatively stable. Bond prices rallied as yields fell (they move inversely) but there was no “flight to quality” trade into longer-dated Treasuries and the U.S. dollar. A lot of the action was in shorter-term issues.
Corporate bond spreads widened initially, signifying investors wanted higher yields to account for the higher risks of the corporate sector versus the government. But they did not increase explosively as in other times of market volatility and economic crisis. Given the seeming return to normalcy, bond players appear to have it right so far.
So, is an increase in bond exposure a good idea for investors right now? My answer is an unequivocal affirmative for two main reasons.
One is that bonds are good value right now and will yield good returns. The three-month U.S. Treasury bill rate is between 5.25 per cent and 5.50 per cent. U.S. inflation in June was up 3 per cent from a year ago and I believe we are heading for the 1.5-per-cent and 2.0-per-cent range over the coming year.
I base this on a weakening economy. I am a dinosaur and still believe in many of the tenets of Milton Friedman’s brand of monetarist economics, including the quantity theory of money. Expanded money supply as defined as M2 accurately forecast the recent explosion of inflation, while the neo-Keynesian establishment assured us warnings of increasing inflation were histrionic. M2 growth later declined, signalling inflation would as well. That’s so far proven correct, and indicates further declines in inflation ahead.
The spread between short-term T-bills and current inflation is over two percentage points and more than three percentage points over inflation expectations for the coming year.
This isn’t the historical norm. T-bills, which have a maturity of one-year or less, should provide inflation protection and not much else. Even a 1-per-cent yield above inflation is generous in the long run.
That doesn’t mean investors should park their cash in short-term T-bills. Central banks across the globe are now in a period of easing that will soon include the U.S. Federal Reserve. This will push T-bill yields lower, probably more quickly than long-term bond yields. But prices for long-term bonds are more sensitive to interest-rate changes and on a total return basis will perform better.
The second major reason to gain more bond exposure? As insurance in the event of a bear market in equities or a geopolitical flare-up. An equities correction appears inevitable given the historically expensive stock market and the economic and political risk in today’s world. Panicking investors almost always flee to U.S. dollar assets and Treasuries.
For example, during the bear market that coincided with the great financial crisis of 2008, the S&P 500 eventually fell by just under 50 per cent, peak to trough. During that same period from mid 2007 to early 2009, long U.S. Treasuries returned 30 per cent with interest. As a result, a 70-30 stock bond portfolio would have lost 25 per cent over that period while a 50-50 portfolio would have lost only 10 per cent. Older investors should think seriously about this.
My latest recommendation: overweight long-term government bonds, and consider holding U.S. debt. Right now, U.S. government yields offer more than those in Canada, but this spread will come down as the Fed cuts rates. That means total returns will be better in U.S. debt than Canadian debt, and I think the U.S. dollar will remain strong against the loonie.
Although there are legitimate concerns about the fiscal positions of the Canadian provinces, the extra yield one gets from provincial versus federal debt justifies having exposure.
Meanwhile, corporate bonds, especially high yield, should be minimized as any flight to quality crisis usually results in large drops in prices even if interest rates are declining.
Investors who want exposure to long-term bonds and the U.S. dollar can purchase the iShares 20+ Year Treasury Bond ETF XTLT-T. It has an expense ratio of only 0.15 per cent.
The Bank of Montreal offers the BMO Long Provincial Bond Index ETF ZPL-T with a management expense ratio of 0.28 per cent. If an investor is nervous about provincial fiscal positions there is the BMO Long Federal Bond Index ETF ZFL-T with an expense ratio of 0.22 per cent.
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 of Canada’s main bond fund.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.