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Bonds, the unloved ones!


Richard Morin

Update :
Update :
December 3, 2021

The omicron variant of Covid-19 has caused major jolts in the stock market and we can expect this volatility to continue until we know more about this variant, the measures that will eventually have to be put in place to counter it and the impact on economic activity. The stock markets will therefore be under close surveillance in the coming weeks.

That said, the stock market is only half the story. The bond market sends us signals that are just as important - if not more important - to our portfolio management and financial plan than the stock market. And the messages coming from the bond market often seem to contradict those coming from the stock market. To fully understand this, we need to remember two basic concepts:

  1. The value of a bond is inversely related to the level of interest rates[1]
  2. Interest rates are directly linked to inflation expectations[2].

For these reasons, bonds tend to fall when inflation expectations rise. On the other hand, they provide protection against economic downturns, which are usually accompanied by a decline in the rate of inflation or even deflation.

Note that it is inflation expectations that drive interest rates up rather than inflation itself. This explains why the interest rate (called the "yield to maturity") on Government of Canada bonds is only about 1.5%, while inflation over the past year has been 4.7%. It would appear that investors in the bond market have not seen inflation coming[3] or do not anticipate that it will be sustainable.

Even if the surge in inflation were to be sustained, it is not entirely out of the question that the yield to maturity on bonds would remain at current levels. This is what happened in the 1940s. Yields on 10-year Treasury bonds remained below 2.5% for an entire decade while average annual inflation was 5.6% (see chart).

Graph Interest rate on 10-year bonds

As discussed in our last quarterly letter, there are likely factors that explain why demand for government bonds remains high and why, as a result, rates remain low despite rising inflation.

One thing is certain, however, such low bond rates indicate that, despite the apparent optimism in the stock market, investors are keeping a lid on buying a healthy dose of bonds. It's kind of like always buying an insurance policy on your house; it would be very unwise not to!

Like the homeowner who renews his or her insurance policy even when premiums increase, Archer always maintains the bond (and equity) target set out in each client's investment policy. We systematically rebalance portfolios when they deviate from that target. For example, we sold bonds to buy stocks for our clients during the February 2020 stock market lows and sold some of those stocks back after the rally.

Experience over the past 100 years has shown that this highly disciplined approach offers the best long-term returns.

1] This is normal. A $100 bond that pays an annual interest "coupon" of $3 has a (current) yield of 3%. If interest rates in the market suddenly drop to 2%, a potential buyer looking for a 2% yield will be willing to offer significantly more than $100 for that bond. The new price of the bond will depend on its duration. In our example, the price of a typical 10-year bond with a duration of 8 would rise from $100 to about $108, an 8% gain on top of the 3% coupon for the year.

2] Since inflation erodes the value of capital (i.e. its purchasing power), the investor will demand a higher interest rate to compensate.

3] The market has partially adjusted, however, as the yield to maturity on bonds has risen from 0.5% to 1.5% since last year.