Current State of Government of Canada Bond Market
Bond yields are low. Really low.
Across the developed world, central banks have worked to lower short-term interest rates. In Canada and the United States, central banks are buying back long-term bonds. This drives up their prices and lowers their yields. They are doing this to help keep interest rates low in the long-term as well.
This allows individuals and companies to borrow for less cost so that they invest in creating or buying real assets (ie. homes for individuals, and business investment for businesses). This may be a good thing for people who want to borrow money to invest in those types of assets. But what about people who want to own bonds? The prospects for those investors aren’t great.
The blue line in the chart above shows the yield that an investor can expect from owning Canadian government bonds. For example, if an investor went out today and bought a 30 year Government of Canada bond, they can expect to get an annualized return of around 1.15% per year.
That’s a pretty low return.
Considering that inflation might be around 2%, it is reasonable to assume that the holder of long-term Canadian bonds may actually lose money over the long run after factoring in the cost of inflation.
Choices for long-term bond holders
Faced with the prospect of low bond yields for the foreseeable future, bond investors have several options available to them:
- Search for yield in other places – you can look for riskier investments that will provide higher yields. Last week I spoke with someone who let me know that he has a friend who is getting 11% annual returns investing in government infrastructure projects in Costa Rica. That may be the case, but what happens when you want to take a big chunk of that money out when you need to put a new roof on your house in retirement? Or, what happens if the bond defaults? Just remember, that risk and return go hand in hand. If you lower the quality of your bond investments, be prepared that they may be more volatile, or you may end up losing money
- Change your investment mix – a common stock and bond mix for a retiree is between 50% stocks and 60% stocks, with the balance in high-quality bonds. Rather than accepting low long-term returns for the bond portion of your portfolio, you may elect to increase your stock allocation. Again, as you accept more risk in the equity portion of your portfolio, you need to be prepared for higher volatility. There is no free lunch here either, unfortunately. Make sure that you stress test your plan in any case to make sure you are comfortable with the risks here.
- Lower their future return expectations for bonds – the days of a 60% global equity and 40% global bond portfolio generating the types of annualized returns that investors are used to seeing over the past couple of decades may be a thing of the past. Rather than reach for yield in other places simply adjust your financial planning expectations and stay the course.
Reasons to still hold bonds
To this point, we have been looking at bonds simply based on their ability to generate returns in your portfolio. But, there are several reasons to hold bonds beyond just their ability to generate high returns.
- Lower volatility – despite their lower returns, high-quality bonds should still provide diversification to a portfolio that also holds a large stock component
- Income – this kind-of builds on the point above, but the retirees main concern is generating a steady stream of income throughout their lifetime. Stocks alone aren’t suitable for this. They generate higher returns in the long run, but they are far more volatile. Bonds should still act as a ballast in your portfolio, providing income in the lean years where stocks are down.
- Re-balancing – again, this builds on the second point, but for retirees and accumulators alike, bonds can be used to re-balance your portfolio when stocks are doing poorly. So, when stocks go on sale, you can sell bonds to buy stocks.
- Sometimes you just need money – high-quality marketable bonds and bond funds provide you with an option to create cash quickly. If you have an unexpected spending need, you can sell your shares in a highly liquid bond fund and have cash in your hands within a few days at most. The same cannot be said for lower quality, less-liquid bonds, or GIC’s
High-quality government bonds may not generate the returns we have become used to over the past 30 years. But, there are still many good reasons to hold them for retirees and accumulators alike.
Please consult with your financial advisor, tax professionals, and legal professionals before making any decisions.