Is bailing on bonds the right thing to do?
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What a year 2022 has been so far for markets. For the most part, the double-digit pullback in stock markets around the world dominated headlines. However, the story in fixed income appears to be much more newsworthy. This year's negative double-digit returns are historically unique and a poignant challenge for the most conservative investors.
Most investors typically view their fixed income investments as something that won't fluctuate in value and will provide income for their portfolio. Unfortunately, this isn’t always the case (like we have witnessed this year).
How can a bond price go up or down?
There are various factors that influence a bond's value with the most prevalent being interest rates. For a basic bond, the interest payments (coupons) remain the same throughout the life of the bond and when this coupon is equal to market interest rates, a bond is priced at par (usually $100).
When interest rates rise however, newly issued bonds at higher coupons will look more attractive. As a result, previously issued bond prices will decrease and trade below par (under $100). The opposite is true when rates decline.
For illustrative purposes only
With interest rates increasing this year, and by extension bond prices falling, it is clear to see why conservative investors have felt compelled to rethink their investment in bonds and want to reallocate those funds elsewhere, like cash or Guaranteed Investment Certificates (GICs). Many have sold investments, fearing continued negative returns and are unsure of what to expect moving forward as we face the real prospect of a recession.
A helpful resource
To help get a better understanding of how bonds work, why we have experienced negative returns, and why investors should consider remaining invested in fixed income, TD Asset Management Inc. (TDAM) has recently authored an article titled Bailing on Bonds - Why now is not the time to turn your back on bonds In addition to the article providing a better understanding of how bonds function, it digs deeper and gives investors clearer insight into why now is not the time to abandon fixed income within portfolios.
Why are bonds in the red?
So why are bonds in the negative this year? The short answer is higher interest rates. Because inflation remains well beyond central bank targets, central banks have aimed to slow the economy through raising interest rates, which in turn, pulled down bond values. This situation is sort of a double-edged sword for investors.
High inflation is a headwind to fixed income since it typically leads to raising interest rates (falling bond values), but it leads to a high correlation between stocks and bonds which weakens their diversification advantage in balanced portfolios. To boot, inflation also erodes the purchasing power of fixed income cash flows.
Why not to bail on bonds now
Aside from not turning your back on bonds now, TDAM feels that there are also several compelling reasons why investors should view them in a more favourable light.
- High and attractive levels of income - Despite this year's plunge in fixed income returns, the asset class still holds value within a diversified portfolio. With aggregate bond yields currently nearing 5%, this is an impressive source of income for conservative investors. Much higher than dividends or fixed income yields over the past decade.
- Fixed income outperforms in recessions and market crises - Rising rates slow the economy and can potentially lead to a recession. This may sound like bad news, but for bond investors, it presents an opportunity. Historically, bonds have outperformed in times of market struggle as yields tend to fall as inflation and growth decline during a recession. Falling yields and a flight to safe assets (away from more riskier assets like stocks) supports fixed income returns.
- Tax advantages - Fixed income yield is a mix of coupons paid to the investor and the bond price moving to par (flat) as it reaches maturity. As a result, part of the fixed income returns one can expect is capital gains and not entirely income (unlike deposit-based investments) and as a result, fixed income can be a tax advantaged way to invest for conservative investors since some of the returns are taxed more favourably compared to deposit based investments.
- Active management - Active managers do not just invest in a broad index but are selective in the fixed income positions they take. Views on overall interest rate risk (duration), the distribution of that risk, the credit exposure (corporate vs. government), and foreign exchange moves can all add incremental performance and income to an active fixed income fund.
For the full article click here and be sure to visit our insights page for more thought leadership from the great minds at TDAM.
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