The Bond Market: These Times (Maybe) A-Changin'

Investors tend to go with the status quo. If the market has been a certain way for a period of time the human tendency is to believe that the trend will continue until proven otherwise. The longer the trend the stronger the belief that things will remain the same. If a trend has been in place for almost two generations then the belief is that the status quo may go on forever.

A large proportion of Canadians are entering their retirement years and they are looking for the safety and security that fixed income investments such as bonds have historically provided. Pension funds are also mandated to have a substantial portion of their assets in fixed income to match future liabilities and to reduce portfolio volatility. The current extremely low interest rate environment is presenting large challenges for both individual and institutional investors looking for income, balance, and stability. The question for the future is whether rising interest rates may make the very investments that are meant to provide safety and lower volatility actually provide the opposite result.                 

The purpose of this article is not to attempt to call a top in bonds and a low in rates and there is certainly the potential that rates may move back lower in the coming months. The goal here is to highlight that the signs are there for a change in a very long term trend and investors should be prepared for what that may mean for their investment portfolios in the coming months and years. There are always opportunities and risks in the investment markets and this change in this trend in rates will potentially be of great importance.

The bull market in bonds and the corresponding move lower in interest rates have been in force since 1981. Central Banks of the world have been utilizing policies that have never been used before and this trend really accelerated after the credit crisis of 2008. By keeping overnight rates close to zero and buying bonds in the market, the Central Banks have held the level of interest rates at artificially low levels for an extended period. This has now been going on for so long that many investors now believe that interest rates will never rise. This does appear to be the mirror image of 35 years ago when most believed that rates of 15.00%+ could only go higher and rates would never go lower.

As was the case during the U.S. housing crisis last decade, things tend to remain with the status quo longer than one might think but then things tend to change very quickly. There is a likelihood that the world Central Bank policies of the past 15 years may actually result in interest rates going much higher than they otherwise would have in the next cycle due to high sovereign debt levels. The initial move may be quite pronounced and will almost certainly have large effects on many asset classes. 

In the coming months, we will focus articles on potential solutions for investors and how they may both benefit and protect from potential changes in investment markets especially with regards to interest rates. Fixed income should be an important part of portfolios and many Canadians may wish to review whether the bonds and income investments in their portfolios are structured in order to benefit in the future and to avoid the risks of higher rates. 

Quick Points

1. Fixed income investments make up an important part of portfolios as they add income, stability and balance.
2. Interest rates currently at historically low levels may be showing the initial signs of moving higher.
3. Due to high sovereign debt levels, the move higher in rates may be more pronounced over this cycle.
4. Investors may want to review the structure of their fixed income holdings to protect against higher interest rates while still maintaining exposure.
5. There are solutions to the fixed income challenge especially for individual investors and these ideas will be reviewed over the coming months.