We anticipate that Canadian growth will remain sub-par and, consequently, that the Bank of Canada will not raise interest rates before mid-2014. In the United States, we expect the Fed will begin to taper its government bond purchases later this year, possibly as soon as September. It is important to recognize, however, that tapering is a different decision than raising interest rates, and we do not expect the Fed to raise rates before 2015. We do anticipate that economic growth in America will accelerate over the balance of this year as the effects of spending cuts and tax increases diminish. More rapid growth may cause speculation of earlier Fed rate increases, thereby leading to higher bond yields and lower prices. We also acknowledge that the headline risks of upcoming U.S. budgetary negotiations may result in increased volatility in the bond market. However, we suspect most market participants will experience a sense of déjà  vu and, therefore, the impact of the political debate will be more muted than last year.

In the short to medium term, we anticipate that bond yields may move somewhat higher. The yields of long term U.S. Treasuries, for example, appear headed at least to the psychological 4.00% level from their current 3.70%. We also believe that Canadian bond yields will follow the direction of the U.S. bond market. Accordingly, we are maintaining portfolio durations that are substantially shorter than their benchmarks.

Bond Yields Normalizing

What should investors do if yields are expected to rise further? First, they should maintain perspective about the potential impact of higher rates. Rising yields are very unlikely to cause bond market selloffs of the sort that occur with some regularity in stock markets. So far this year, the yield on 10-year Canada bonds has risen about 75 basis points and the DEX Universe Bond index has declined only 1.49%. The higher income earned on bonds helps to offset price declines. As well, the fact that they mature means that bond values tend to move toward par, thereby reducing their volatility. Earlier this year, we stress-tested some of our Universe-mandate portfolios. We assumed that the Bank of Canada kept rates level for a year and then raised them 100 basis points in the second year. In the stress test, we assumed that yields across all maturities rose by 100 basis points as a result. Even in this fairly harsh scenario, we found that the portfolios would produce a small, positive return for the two year period.

A second thing for investors to consider is the rationale for holding bonds in their long term investment strategy. While we do not believe that bonds currently should be tactically over-weighted in portfolios, they continue to make tremendous sense from a long-term perspective. The diversification benefits of including fixed income in the asset mix are significant. In the chart below, the “Steady Eddy” nature of bond returns is apparent. Equity returns generally experience higher highs, but importantly, also lower lows. Having bonds in the mix makes it easier for investors to sleep at night. The chart also illustrates that investment returns vary considerably from year to year. Put another way, the world is an uncertain place and it is difficult to predict yearly asset returns in advance. Maintaining diversification, therefore, is the prudent course of action.

Historically, Bonds vs Stocks

From a sector perspective, we continue to favour corporates and will look to add selectively to the holdings. Our credit analysis will pay particular attention to the impact of the recent rate increases and the potential for disappointing economic growth in coming quarters.

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