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As interest rates remain lower for longer, bonds are not to be feared

There is scope for interest rates to rise over time – but not as much as people expect. Therefore, investing in bonds should not be seen as a money-losing proposition


Date: October 8,2014

As investors brace for an increase in interest rates next year, many may be reducing, or even eliminating, the government and corporate bonds in their portfolios.

But as speculation intensifies as to exactly when the U.S. Federal Reserve will finally tighten monetary policy after years of low rates, investors may be wise to question mainstream thinking.

Most investors are making two incorrect assumptions about rates, says David Wolf, a portfolio manager at Fidelity Investments who co-manages the company’s Canadian Asset Allocation Fund.

Their first is that interest rates will rise by next summer and their second is that rates will rise by a substantial amount.

People have in fact been expecting a rise in lending rates ever since the economy bottomed in 2009, Mr. Wolf points out.

“The likelihood of rising rates in the next 12 to 18 months is lower than people commonly believe,” he says.

“Making the assumption that rates will rise is really dangerous and expensive. If you avoided the bond market entirely this year, you have actually cost yourself quite a bit of money.”

How much money? U.S. Treasury Bonds have returned about 3.5 per cent this year and investment grade U.S. corporate bonds have gained about 6 per cent.

While those returns aren’t stellar, they are significant next to the negative returns (after inflation) that investors may experience from holding cash, whether in the form of bank deposits or money market funds. This is one reason that fixed-income managers like Mr. Wolf urge investors not to fear bonds today.

“We are playing defence with bonds rather than cash,” he says.

The Federal Reserve could begin hiking its key lending rate in the next six months, or 18 months. In either case, the increases will be lower than we have seen in other cycles, he argues.

Rates have traditionally averaged between 4 per cent and 5 per cent in the past 40 years. Today, they are more likely to settle close to 3 per cent.

Mr. Wolf’s perspective comes from years as both a money manager and a policy advisor. Between 2009 and 2013 he was an advisor to the Governor of the Bank of Canada and secretary to the Governing Council of the Bank of Canada, a role in which he oversaw analysis supporting the monetary policy decision process.

A short time after Mr. Wolf gave his outlook on rates, in an interview with Globe Advisor and in a Fidelity quarterly report entitled “Don’t fear the bond market,” Bank of Canada senior deputy governor Carolyn Wilkins expressed similar sentiments.

The Canadian central bank’s target rate for the future will range between 3 per cent and 4 per cent, down from between 4.5 per cent and 5.5 per cent before the global financial crisis, she said in a speech in Toronto on Sept 22.

Important structural forces are weighing on interest rates and will likely do so for some time, Mr. Wolf says.

Canada and the United States have aging populations. With the baby boomers leaving the work force, there will be slower growth of the labour market than in the past. That trend will mean reduced economic growth, which is an anchor for interest rates.

Compounding the effect, baby boomers will begin shifting to more conservative investing styles as they retire, buying more bonds and pushing prices up in the process. (Higher bond prices produce lower bond yields.)

That means that while interest rates will certainly continue to rise and fall over the course of the business cycle, they will do so in a smaller range than North American investors are accustomed to, he says.

In addition, low rates may eventually become self-reinforcing. That’s because low rates encourage households and governments to assume high debt. When rates rise, the cost of that debt becomes more expensive and has a dampening effect on the whole economy. The result is a stagnant economy trapped in a high-debt, low-rate environment, which has been Japan’s story for the past two decades, Mr. Wolf says.

“Yes, there is scope for interest rates to rise over time, but not as much as people expect,” he says. “This means that investing in bonds is not the obvious money-losing proposition that many have assumed.”

The market’s guessing game on rates will only intensify in the New Year.

On Sept. 17, the Federal Reserve repeated its commitment to keep interest rates near zero for a “considerable time.” But Chair Janet Yellen said the definition of that phrase will be “highly conditional” on the Fed’s assessment of the economy. At the same time, Fed officials increased their median estimate for the federal funds rate at the end of 2015 by one quarter of a percentage to 1.375 per cent.

Investors shouldn’t waste too much time trying to decipher arcane Fed speak, but instead should have a clear strategy in mind for bond allocations. Mr. Wolf says he has maintained “substantial allocations” to bonds in Fidelity’s multi-asset funds.

“It has been a mistake and will continue to be a mistake to position portfolios on the assumption that rates will rise soon and rise fast,” he says.

He recommends investors adjust return expectations and consider the level of risk they are incurring to get the highest rates. So many investors have piled into riskier bonds – such as high-yield corporate bonds and emerging markets sovereign debt – that prices have risen and rates have fallen, reducing returns but not the risks.

“You are not being nearly as handsomely compensated for the risk that remains in these instruments as you would have been two to five years ago,” Mr. Wolf says.

In recent months, Fidelity has been trimming its exposure to these bonds. But Mr. Wolf still likes top-rated government bonds, especially U.S. Treasuries, which he says still have room to rally. Longer duration government bonds are one of the few things likely to go up if there is any shock in the market, he adds.

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