Stop mistaking interest rate risk, or the index, for diversified fixed income
Today, Canadian bond yields sit around 3-3.75%. That’s higher than the 2020-21 lows near 1-1.5%, but nowhere close to the historical norm. The cushion is thin. A rate move that used to get absorbed by coupon income now immediately impacts your return. 2022 is recent proof. The broad bond index had one of its worst years on record, almost entirely because rates spiked. Coupon income wasn’t close to enough to cover the loss.
Why bonds are supposed to help
Every portfolio likely needs some exposure to interest rates – often called duration risk. In the right circumstances, duration can provide return, and it can appreciate to offset falling stock prices. That is the textbook case for holding bonds.
But that “right circumstances” part matters more than it used to. The hedge works best when the central bank has room, and reason, to cut rates – which is what happened in 2008 and 2020. Today the Bank of Canada’s overnight rate is 2.25%, with the bank itself flagging that inflation expectations remain elevated. There’s less room to cut than in past cycles, and less appetite to cut fast while inflation is still a concern. If the next downturn happens while inflation is still sticky, stocks and bonds can fall together – the pattern we saw in 2022.
The real problem
Interest rate risk is too often mistaken as synonymous with fixed income, when it’s only one – albeit important – risk factor. Fixed income returns can come from several sources. Interest rates are one. Credit spreads – the additional yield paid by companies over government bonds – are another. Mortgages and asset-backed securities add still different sources of income. They don’t behave the same, and that’s the point.
Today you can limit your duration risk the way you choose your shoes or your lettuce. You substitute comfortable, attractive footwear and in-season corn – in the form of investment grade credit, mortgages and asset-backed securities – to round out your sources of return and limit the duration risk that hasn’t produced – and doesn’t look poised to.
