Paving the way for a resurgence in bonds

After years of having their value proposition dictated to by the zero interest rate policies (ZIRP) of global central banks, bonds are finally positioned to potentially provide meaningful returns to investors. Admittedly, the asset class has been a tepid source of income since the Global Financial Crisis, and it hasn’t been a reliable store of value in the post-COVID era. However, when it comes to generating income and preserving capital, the value proposition of bonds has been restored to an extent we haven’t seen in over a decade.

If you believe in central banks, you can believe in bonds

Though not obvious, central bankers have laid the groundwork for what should be a generational bond turnaround. Inflation has surged, central banks have pursued an aggressive strategy to defeat it and bonds have been the primary victims. While painful, inflation and the associated rise in rates needed to combat it are cyclically regenerative for bonds. To see why, investors need to turn back the clock to the early 1980s—the last time price increases were a major headwind. With inflation in the double digits (maxing out at almost 13% year over year), investors demanded higher yields to compensate for declining real returns in bonds. But as inflationary pressures subsided in the years thereafter, yields followed suit, setting the stage for an environment that was conducive to bond investing for nearly 40 years.

Gone are the days of rock-bottom yields 

Since the Global Financial Crisis, central banks made it a priority to prop up economic growth and ease financial market turbulence through ultra-low interest rates. While income generation in this environment was minimal (10-year Government of Canada bonds averaged about 1.85% from 2010-2019), this was tolerated, as the gravitational pull to zero yields offered sufficient opportunities to generate meaningful all-in returns. The ZIRP thesis for investing in bonds is gone (for now), and having suffered the pain of this recalibration, investors now have a new, very compelling rationale for investing in bonds—income generation and capital preservation. If investors can somehow keep their short-term whims in check, higher rates will lead to meaningful rewards for bondholders over the long run.

When inflation is kept at bay, bondholders reap the benefits 
Relationship between CPI and 10-year Government of Canada bonds

Line chart depicting CPI and 10-year government bond yields. As inflationary pressures subside, bond yields come down, setting the stage for an enviornment conducive to bond investing.

Source: Manulife Investment Management, Federal Reserve Economic Data as of October 4, 2022.

A recalibrated value proposition  

Having been weakened by central bank ZIRP for years, bonds are on the verge of becoming a more powerful tool in an investor’s arsenal. Why?

Well for starters, investors buy bonds for two main reasons: income generation and capital preservation. ZIRP gave investors no choice but to opt for unconventional fixed-income strategies to bridge the yield gap. For this reason, bonds were suppressed from an income-generating standpoint. But this part of the value proposition is finally on the mend.

·  Income generation – To see how the playing field has changed, investors need to look no further than 10-year Government of Canada bonds. Precisely two years ago, these issues were yielding less than 50 basis points (bps)—their lowest yield on record. At the time of writing, they’re yielding close to 350 bps. Add to the mix much more attractive corporate debt spreads, and there’s no doubt that investors are getting more bang for their buck in fixed income today.

·  Capital preservation – So if yields didn’t cut it for all these years, what kept investors from liquidating their bonds outright? The answer to this question is simple: capital preservation. Bonds are structured in such a way that investors are entitled to a steady stream of interest and a repayment of their entire principal at maturity. As long as market volatility remains the norm in investing, this part of the value proposition should remain intact. Bonds provide added diversification and downside protection against riskier asset classes such as stocks.

Investors may find it hard to pass up on current yields 
10-year Government of Canada bonds over the last decade 

Line chart depicting the path of 10-year Government of Canada bonds over time. Yields on 10-year government bonds in Canada are at a 10-year high.

Source: Manulife Investment Management, Federal Reserve Economic Data as of October 4, 2022.

Finding the sweet spot for bonds involves overcoming some hurdles

Let’s not hide from reality—bond prices tend to go down as interest rates go up. But as we’ve seen on more occasions than one, rising interest rates can also hurt stock valuations, as investors leveraging once-cheap financing exit the market, and businesses relying on cheap capital have to re-think their financing options.

Thankfully, active managers can cushion the blow of rising interest rates by managing exposures across asset categories or maturities. Not all bonds are created equal, and some issues are more sensitive to interest-rate fluctuations than others. Short-term bonds, for example, are more likely to be more directly influenced by changes to central bank key policy-rate decisions. Longer-dated bonds, on the other hand, are more anchored to broader market expectations and tend to be less influenced by short-term central bank policy.

Take the spread between 2- and 10-year Government of Canada bonds as an example. As inflation trends upwards, the term spread (or slope of the yield curve) has gone negative (that is, 2-year Government of Canada bonds are yielding more than 10-year ones) and the yield gap has widened considerably. What this suggests is that shorter-term bonds are more likely to be impacted by hawkish central bank policies than their longer-term equivalents. Because interest-rate and inflation expectations are already baked into the prices of longer-term bonds, active managers can mitigate the impact of rising rates by actively managing curve exposure. 

Long-term bonds are more anchored to inflation and growth
Consumer Price Index vs Government of Canada bonds term spreads 

Line chart illustrating the 10-year, 2-year spread versus Canada CPI. Long term bonds are more anchored to broad market expectations and less influenced by short term bank policy.

Source: Manulife Investment Management, Statistics Canada as of October 6, 2022.

Bonds' time to shine is here 

Bonds have had to make their way through some pretty tough moments. But everything has its time, and we believe the time for bonds to shine is here.

Yield back-up is bolstering the case for bonds

Yields on corporate and government bonds are at levels unseen since 2009, and fixed income as an asset class hasn’t been this compelling in years. Investment-grade corporates, for instance, were yielding low-single digits in 2020 and are now yielding mid-single digits. Not only is this favorable from an income standpoint, it’s also an opportunity to invest in quality bonds that are trading at deep discounts to par.

Easing inflationary pressures will be a tailwind 

Quantitative tightening will surely be a headwind for inflation, both south of the border and in Canada. A slowdown in economic growth, falling oil prices, housing market declines, and improvements on the supply chain front could also bring inflation down to more manageable levels by 2023. This would undeniably be an attractive scenario for bonds.

Recessions generally bode well for bonds 

As evidenced by the inverted yield curve, markets are expecting sluggish growth ahead. In such environments, investors tend to look at bonds to help curb adverse economic impacts. Even if they aren’t risk free, bonds offer a steady stream of interest income and are generally relied upon for their downside protection.

Are the stars aligned for a bond turnaround? 

Bond markets are on the cusp of a structural shift. To fully appreciate this, you have to look beyond short-term uncertainties and see the bigger picture. Will central banks steer clear of a hard landing? How will geopolitical risks in Europe pan out? Whatever the source of uncertainty, the world is transitioning into an era, at least in the short to medium term, of higher interest rates, a change that should bear fruit for bonds as an asset class.

The comfort of knowing bonds will contractually mature at par (barring default) and offer the yields investors have long been clamoring for is reassuring. While nobody can predict what lies ahead, one thing is certain: bonds haven’t been this compelling in years. For an asset class as bruised and battered as bonds, we’re of the belief that it’s hard to ignore the value proposition bonds offer at this stage.

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Roshan Thiru, CFA

Roshan Thiru, CFA, 

Head, Canadian Fixed Income

Manulife Investment Management

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