Bonds on the Rise

by Scott Ronalds

It might surprise you to hear that bonds are up 13% over the past year (ending September 30). Even better, our Income Fund is up nearly 15%. To understand this welcome turnaround, a little recent history is helpful.

A rocky road post-pandemic

Bonds had a rough stretch coming out of the pandemic. Yields sat at rock-bottom levels throughout 2021 after central banks around the world aggressively cut interest rates to support ailing economies. Investors had soured on the asset class and the bond market turned in its first negative year since 2013, falling nearly 3% (as measured by the Morningstar Canada Core Bond Index).

Then, in the spring of 2022, central banks began raising interest rates to combat soaring inflation and overheated parts of the economy. The Bank of Canada increased its key policy rate from 0.25% in March to 4.25% by year-end. Bond yields rose across the maturity spectrum. The 10-year Government of Canada yield, for example, climbed from 1.5% to over 3.5%. These moves were massive in bond terms, and the market fell nearly 12% in the year, one of its worst showings in memory. It’s important to remember that when interest rates rise, bond prices typically fall (and vice versa).

But it was an extraordinary time in history. The global economy was essentially shut down for the first time, only to be supercharged by ultra-low rates. Inflation reached levels many Canadians have never seen, and central bankers were subsequently prompted to hike interest rates at a swift pace.

Stabilization and recovery

These rate increases began to slow last year, however, and bonds regained their footing. The market was up 6% in 2023, with all the gain coming late in the year (the index was up 8% in the fourth quarter) as consensus started to build that the rate hiking cycle was nearing its end.

The asset class has been solid this year too, up 4.1% so far, albeit all the gain has come in the third quarter, when the market was up 4.6%. This strong recent return, when added to the heady figure from Q4 2023, accounts for the stellar 12-month number.

The Bank of Canada cut its policy rate in June for the first time in over four years and has implemented two more cuts since (bringing it down from 5.0% to 4.25%). Bond yields have fallen commensurately. The Bank has indicated that more cuts are likely if the economy cools further and inflation continues to trend down towards its target of 2%. The U.S. Federal Reserve has indicated the same, although nothing is written in stone.

Outlook

This environment of easing interest rates bodes well for future returns. Indeed, over the medium term (five years), we expect bonds to return 4-6% per year.

With short-term rates declining, investors are earning less on money market holdings and GICs. If the fixed income portion of your portfolio is heavily weighted in these securities in lieu of bonds, it’s a good time to consider rebalancing. In our Founders Fund, we’ve increased our bond weighting in recent quarters with the improving fundamentals. Our weighting has risen from a low of 25% in early 2022 to its current level of 33%, which is just under our long-term target of 35%.

Despite the rough stretch, bonds are earning their keep again and balanced investors can feel good about the diversification and income benefits they provide.

Management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The indicated rates of return are the historical annual total returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns.

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