October 15, 2021
The last forty years have delivered strong returns for bonds and now, “the times they are a-changin’.” The strong returns of the past now come at the price of low returns in the future, so low that we expect bonds won’t keep pace with inflation. This is the result of a long term decline in bond yields and the fact that these ultra-low yields today influence future return. The chart below illustrates the relationship between bond yield and total return. As yields fell so followed the total return.
Four decades of falling yield and return
Compounding the issue, when bond yields inevitably rise, we expect bonds to experience periods of negative returns. We experienced such a decline in the first quarter of 2021 when the Canadian core bond index, made up of investment grade bonds, fell 5.0%**. More recently we have seen negative returns as inflation rises and central banks begin to reduce the level of stimulus.
Think of bonds as insurance
The purpose of holding core bonds in a portfolio has been to generate income and provide stability. With today’s low levels of income, the reason to hold bonds is for the protection they provide during periods of significant equity decline. This protection from bonds is similar to buying insurance on a home. We expect to pay for home insurance and only benefit if there is unforeseen damage. Now investors are paying more for the protection of bonds in the form of lower portfolio returns.
An active approach is critical
At CC&L Private Capital, we are focused on positioning client portfolios for success. This includes uncovering opportunities in the capital market that generate better outcomes. Over the last ten years we have moved away from traditional sources of return and reduced allocations to core bonds. In their place we have added private market direct investments in:
- Real estate
- Private loans
We have also added public market strategies to our investment platform including:
- High yield bonds
- Market neutral hedge
Overall these strategies improve portfolio income and expected return. They also more broadly diversify portfolio risk, which allows us to reduce the protection that comes with core bonds while not meaningfully increasing overall risk. As such, these strategies are a good solution for many investor portfolios.
For those that hold core bonds, active management has never been more important. It’s vital to have a manager that incorporates macro-economic views and deep credit research. Both are essential if you are going to generate above-market returns while managing risk. Using their broad set of tools, our experienced team of portfolio managers and analysts are able to uncover opportunities despite the ultra-low yield environment.
Consider your objectives
Changes to a portfolios asset allocation should not be made lightly. It’s important to consider how changes to a portfolio’s asset allocation may affect its ability to meet one’s desired objectives. We work closely with our clients to develop a plan that incorporates historical risk and forecasts for asset class returns, and marries these inputs with clients’ financial situations. This process allows clients to pre-experience their wealth under different allocation scenarios and ensure the strategy is best suited to meet their desired outcome. For some, reducing core bonds is warranted. Others may choose to maintain their asset mix because they have enough capital to meet their future goals. Of course another option is to make lifestyle decisions like save more or spend less over time. Whatever the preference, we can quantify the long-term outcome to wealth and likelihood of meeting specific objectives. We have dedicated significant resources to this planning so that our clients can feel confident they are well positioned to meet their personal version of financial success.