One’s perception of interest rate trends depends very much on the time frame chosen. It is well known that long-term interest rates peaked in 1981 and then plummeted to about the 2-per-cent level over the next 40 years. Less well known is that this period represents just half of a longer-term cycle as interest rates had risen steadily from the 2-per-cent level in 1940 to the peak in 1981.
When one takes a very long-term perspective, going back to 1870, it paints a very different picture. (We had to use U.S. bond yields to be able to go back to 1870.) It suggests that the normal range for interest rates, specifically for 10-year government bond yields, is 2 per cent to 5 per cent.
Why a rout in government bonds is worrying
The period from 1967 to 2002 may have been merely an aberration. Under this long-term view, the current interest rate situation may represent a once-in-a-generation investment opportunity that could be of special benefit to retirees.
As of Thursday morning, the 10-year U.S. Treasury yield is 4.70 per cent while the yield on Government of Canada 10-year bonds is 4.14 per cent. Thus, yields are very close to the top end of the long-term range of 2 per cent to 5 per cent. There are two main scenarios for bond yields in the next few years.
In the first scenario, yields will continue to rise beyond 5 per cent. There are reasons to think this will not happen. The impact of COVID-19 was significant but it is now largely behind us; the inflationary spike of 2022 is already subsiding.
Moreover, current demographics are very different from the 1970s and 1980s. The populations in most developed countries are rapidly aging, a phenomenon which tends to result in lower rather than higher interest rates.
Finally, government policy on inflation targets points to lower bond yields. If Canada can achieve its stated inflation target of 2 per cent, bond yields are almost certain to fall.
In the second scenario then, longer-term bond yields will start to trend downward very soon. There are several ways for retirees to take advantage of this. The first is to invest more heavily in bonds, especially in longer-term provincial and federal government bonds.
An easy way to do this is to buy units in an exchange traded fund (ETF) that is dedicated to long-term bonds. If yields do in fact fall, it will result in double-digit returns for bond holders.
A second possible action is to buy an annuity. A 65-year-old male can now derive income for life of about $7,000 a year from a $100,000 purchase of a life annuity with a 10-year guarantee (slightly less for women). Because there is still a lingering inflation risk, it is generally not advisable to devote more than 30 per cent of one’s RRSP for the purchase of an annuity.
A third possibility is to buy into one of the new longevity products which are available in the marketplace – they are like annuities with a little more risk but also with a little more upside potential if investments do well.
While the opportunity may be substantial it is not without risk. If one buys bonds now and yields continue to climb, it will result in a capital loss. But doing nothing also entails some risk. It comes down to whether the future will resemble more the 118 years between 1870 and 2023 when bond yields were in the 2 per cent to 5 per cent range or the 35-year period when they were outside that range.
Frederick Vettese is former chief actuary of Morneau Shepell and author of the PERC retirement calculator (perc-pro.ca)