This month’s interest rate cut by the Bank of Canada has income investors taking a fresh look at bonds.
One reader wrote to say: “I’m 70 years old. Within the fixed income component of my RRSP, I have been investing in 1-2-3-year GICs since interest rates started climbing. I did this rather than holding on to my usual mix of go-to PHN bond funds (Total Return; High-Yield; Short Term) that you recommended many years ago.”
“Many pundits suggest that interest rates will now continue to fall. If we assume this is correct, is it reasonable to assume that the value of bonds/bond funds will increase accordingly? With this rationale in mind, would it be appropriate to start increasing one’s exposure to bond funds again, like the PHN funds mentioned above?” – Brian B.
One of the basic principles of bond investing is that when yields drop, prices rise, and vice versa. It’s as predictable as the sun rising and setting.
We saw the downside of this in 2022-23. While the Bank of Canada was raising rates, bond yields climbed, while prices dropped. The result was the worst bond market in 40 years.
Logically, it would seem we should now be on the cusp of a reversal in this cycle. However, we aren’t seeing much evidence yet. As of June 14, the FTSE Canada Universe Bond Index was up only 0.88 per cent year-to-date. The Long-Term Bond Index, which should be the main beneficiary of a declining interest rate cycle, was off 0.94 per cent so far this year.
What’s missing from this picture? Momentum. The rate hikes of 2022-23 came at a rapid-fire pace. Almost every meeting of the Bank of Canada and the U.S. Federal Reserve Board ended with the announcement of at least a 0.25-per-cent rate increase. It didn’t take long for investors to realize that the trend wasn’t going to end soon, and bond prices plunged. In 2022, the iShares long-term bond ETF was down 21.9 per cent. A loss of that magnitude is almost unheard of in a bond fund.
So, where are we now? There’s been one quarter-point cut in Canada. Will there be more this year? Governor Tiff Macklem says “maybe.” If inflation remains contained, it’s a possibility but the BoC will decide on a meeting-to-meeting basis. No binding promises there.
Meantime, the U.S. situation looks even less hopeful. The latest employment figures were much stronger than expected and the American economy is performing well. The recent market sell-off reflected investors’ concerns that the much-anticipated rate cuts are still several months away.
The Bank of Canada is faced with a dilemma. Housing costs are a major factor in the current inflation picture. Reducing rates further would help lower the costs for homeowners and renters. But if the gap between U.S. and Canadian rates widens, it will result in higher inflation as the cost of imported goods rises. Talk about a rock and a hard place!
This leaves fixed-income investors in a quandary. GIC rates are already starting to edge down. Ratehub.ca is not showing any five-year rates at 5 per cent. A few months ago, there were several. Nor are there any three-year GICs at that level. You can still earn 5 per cent for one year, but that may not last much longer.
Bond ETFs are still struggling. The actively managed PHN (Phillips, Hager & North) mutual funds that our reader mentioned look like the better choice right now. The Total Return Bond Fund was showing a six-month increase of 2 per cent as of May 31. The PHN High Yield Bond Fund posted an impressive gain of 7.4 per cent in the same period. That fund only lost 4.8 per cent in 2022, outperforming the overall bond market by a wide margin. The PHN fund was temporarily re-opened to new investors on June 10, 2024.
Most Canadian high-yield bond funds invest primarily in U.S. securities because our market is so small. The PHN fund is a rare exception, with 91 per cent Canadian content.
In contrast, there is no problem finding U.S. high-yield bond funds and ETFs. But their recent performance record is weak. One example is the iShares U.S. High Yield Bond Index ETF (CAD-hedged, XHY-T), which trades under the symbol XHY. It’s only up 1.92 per cent year-to-date. The companion short-term bond fund has a gain of 1.75 per cent in the same period, with less risk.
The bottom line is that bond funds will look better if interest rates start dropping on a steady basis. But the timing is questionable. In the interim, here’s what I suggest for income-oriented investors who want to minimize risk.
- Create a laddered GIC portfolio out to three years to take advantage of the high rates still available. Do not agree to automatic reinvestments as each tranche matures as rates will likely he lower then.
- Buy units in the PHN High Yield Fund.
- Start building small positions in the iShares Universe Bond ETF (XBB-T) or the company’s long-term fund (XLB-T) for more aggressive investors. The payoff is coming, we just don’t know precisely when.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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