2022 was the worst year for bond investors since 1990, the last time interest rates spiked significantly in a short period of time. Many investors may be tempted to sell their bond fund holdings after such a bad year, but that would likely not be prudent. The below article from TD Investment Management notes that yields on bond portfolios have risen as central bank and GIC rates have increased, so bond investors are now earning close to 5% interest compared with the 1-2% they would have expected a year ago, and will recover last year’s losses as the bonds in their fund return to their Par value as they get closer to maturity. Bonds or GICs continue to play an important defensive role in a well-diversified portfolio, offsetting the higher volatility of stocks and other equities.
CIBC chief economist Avery Schenfeld provides this 4-minute video summarizing his economic outlook. A recession is likely on the horizon but markets have already priced in some slowing. “We’re still hopeful that…two years of minimal economic growth as opposed to an outright deep recession is possible. The central banks are right now still in the process of finding out what interest rate it’s going to take in order to get us there.”
Today, the Bank of Canada surprised markets with a 100 basis point (1%) increase in its target overnight lending rate to 2.5%. (Press Release: Bank of Canada increases policy interest rate by 100 basis points, continues quantitative tightening – Bank of Canada).
Markets had been expecting another 0.75% increase based on the bank’s comments in May that it expected the neutral rate (neither stimulative nor restrictive to economic growth) to be about 2.5%, but that it would re-evaluate this target based on inflation and other statistics. Inflation has remained persistent in the face of ongoing supply chain disruptions, Chinese COVID lockdowns, and the war in Ukraine, and job vacancies remain at record highs without sufficient labour force to meet the demand surge after this year’s re-opening.
The Bank of Canada said this week that the neutral rate may need to go to 3-3.5% to balance demand to available supply, and the economy was strong enough to absorb the interest rate increases without causing a recession, so it wanted to ‘front load’ the rate increases to reduce inflation pressures immediately, and avoid even higher targets being needed in the long term. We should therefore expect a further rate increase at the bank’s next meeting September 9th, and at the next US Federal Reserve meeting July 26-27.
While the bank does not believe the higher rates will cause a recession, they do expect economic growth to slow. Still, their expectations are for reasonable growth rates of 3.5% this year, 1.75% in 2023, and 2.5% in 2024. Because inflation measures price changes from past levels, they expect about 8% inflation readings for the balance of the year, but a return to 3% by the end of 2023.
Bond markets had anticipated further rate increases so their yields and prices had already adjusted before the announcement. Top GIC rates are now over 4% for a 1-year term, and top daily interest deposit rates of 1.3% may see an increase in the coming days.
Video summary: Monetary Policy Report – July 2022 – Bank of Canada
Full Report: Monetary Policy Report – July 2022 (bankofcanada.ca)
With surging central bank rates and bond yields, GIC interest rates have also risen sharply this year, with top offers on 1-year terms now paying almost 4%, and 5-year terms over 4.5%. These are the highest GIC rates we’ve seen since before the 2008 Global Financial Crisis (Source: Cannex Financial Exchanges).
Bond yields spiked earlier this year on expectations that central banks would hike rates in response to building inflation pressures. The chart top right compares bond yields of all terms before the pandemic in blue, December 2021 in green, and June 2022 in red – quite the surge in a short time, especially in the shorter terms (Source: www.ustreasuryyieldcurve.com).
Top GIC rates are usually higher than government bond yields of the same term because of two risks: one is that you can’t redeem or sell a GIC before it matures, the other is that the bank issuing the GIC could fail. Investors control the locked-in risk by staggering GIC maturity dates and by maintaining some liquid cash deposits in case some cash is needed between maturity dates. They can also control the default risk by only working with institutions that are deposit-insured.
Because you can’t sell GICs before they mature, their reported current values are always based on the guaranteed principal plus any interest accrued, thereby masking the impact of rising market rates. You might be sad your interest rate is lower than currently available, but can be glad you won’t see any decline in value on your statement.
Because bonds can be sold in the market before they mature, their market values will drop when market yields increase. However, just like GICs, bonds will still mature at their full principal value, so investors who hold onto them after a decline will still earn the same yield they had expected when they bought them. In the graph below, we show a 5 year bond bought December 31 2021 at the then-current 1.27% yield, which would be worth about $106.50 with accumulated interest when it matures December 31 2026. By June 30 2022, market yields for a 4.5 year bond had risen to 3.00% implying about a 7% reduction in the value of the original bond to keep its yield aligned with the higher market yield. In the graph below you can see that as time passes and the maturity date gets closer, the market value of the original bond would gradually recover to 100% of its principal value, plus the investor would have all of the interest expected originally. The investor actually has an advantage since the interest payments can now be reinvested at higher rates than initially expected.
Once the market value has dropped in response to higher market yields, the effective return to maturity will be in line with the market yield, so there is no advantage to be had trading out after yields have already increased. In this case you would be sad that your market value has declined, but you might be glad that your yield to maturity is now much higher.
If market yields moderate again once inflation is back on target, bond prices should recover. If you are not keen on such fluctuations in the defensive sections of your portfolio, perhaps a series of GICs with staggered maturities would be a better fit.
Noah Blackstein, Portfolio manager at Dynamic Funds, interviewed on CNBC.
“The Market got ‘carried away’ with 75 basis point rate hike” says Dynamic Funds’ Noah Blackstein in this interview on CNBC.
Were you surprised by what the Fed did yesterday? Was this your expectation ahead of hearing Jay Powell say that 75 basis points was not on the table right now?
- The market got really carried away with 75 basis points; we’re still starting quantitative tightening with at least two 50 basis point hikes coming
- Re: move in Treasury yields and mortgage rates year-to-date: mortgage rates are up almost 70% year-to-date, there is no way that a 70% move in mortgage rates isn’t going to have an impact but real estate has a much longer lag than stocks
- “In the relative asset game, mortgages and housing have a much larger and more significant impact on the overall economy; dialing it back a little bit is not unwarranted and being a little more data dependent is certainly not unwarranted at all”
The markets have moved significantly over the last several days. You saw a nine hundred points plus move yesterday, and that was the third day in a row of gains for the markets. But it really just got us back to last Thursday. Have you been a buyer on the dips that we’ve seen the last several weeks?
- It’s been a very tough market for legitimate growth managers since the macro took over in November, the S&P 500 is still about 7% off of where it was on the March rally
- Looking at growth stocks today, relative valuation multiples (an area of primary focus for Noah) are at some of the lowest levels since 1980
Will look to take advantage of awful sentiment (worst Nasdaq start since 2001, worst month for Nasdaq since 2008, worst month for the S&P since the pandemic) and focus on the many catalysts for a move higher (passing peak inflation has been good for markets, and we probably passed peak inflation in March)