Bonds getting hammered is a pretty unusual occurrence. It seems that we are exiting a 30-year bull market on bonds. So what’s going on in the market to cause this to happen? And what are governments doing to counteract global inflation? Today on ThinkSmart Senior Financial Advisors Rob McClelland and Mike Connon examine what is happening in the markets worldwide to cause these typically stable investments to behave so poorly.
Transcription
Rob (00:00):
Hello, this is Rob and Mike from The McClelland Financial Group of Assante Capital Management, and this is Think Smart with TMFG.
Rob (00:11):
Today on Think Smart with TMFG, Mike and I will be discussing why are bonds getting hammered? Mike, this has been a big surprise for a lot of investors. And you and I have talked about this. Normally, when the stock market is down, bonds do quite well and they are there as the defense. And sometimes they even do a little more than defense. Maybe they provide a little bit of offense. This time, the bonds are down, not quite as much as the stocks, but they’re down 10 to 15% pretty much across the board.
Mike (00:49):
This is the first time we’ve ever seen this in our career, isn’t it?
Rob (00:52):
It really is. It goes back, we haven’t seen anything like this since the ’80s.
Mike (00:59):
Yeah.
Rob (00:59):
And so we started in the early ’90s. That’s over 30 years. And so this one is very different. I think what’s going on isn’t dramatically different, but it’s certainly new for us in our career.
Mike (01:14):
Yeah. We lived through, believe it or not it’s been a 30-year bull market in bonds. When you think of bull markets, you always think of equities going up by 25 and 30%. But the reality is we’ve been in an actual 30-year bull market with bonds. We’ve seen very few corrections on the bond market over that period in time.
Rob (01:33):
I was reading an interesting article this morning that was talking about we’re going to regret that we didn’t do more when interest rates were at ridiculous low levels and we’re going to regret that we didn’t build more infrastructure or people are going to regret that they didn’t buy things because interest rates were ridiculously low.
Rob (01:53):
But let’s start doing a deeper dive to what has happened. We’re seeing inflation in the economy and the inflation is the highest… The recent number that came out in Canada, we were 7.7%. The US is over 8% inflation. Those are numbers we haven’t seen since the ’80s. And the reason is, we’ve talked about this on numerous podcasts that we’ve got supply chain issues, we’ve got a war going on in the Ukraine, and we’ve got a very tight labor market. You put those three factors together and you’ve got high inflation and it’s global inflation. It’s literally all over the world. Everyone’s feeling it, especially in the price of food and especially in the price of anything oil related, oil and gas.
Rob (02:42):
So what happens when you see this high inflation, the only way governments can start to knock that inflation down to their target rate of two or 3% is by raising interest rates. So interest rates have already gone up. They’ve gone up in North America, they’ve gone up around the world. And the expectation is, is they may continue to go up even higher because inflation is not slowing down. So what happens in a bond portfolio is rather different.
Rob (03:16):
So let’s say you’ve got 100 bonds in your portfolio and the average maturity is about five years, which means those bonds will come due on average within the next five years. Some might be seven years, some might be three, but the average is five. And let’s say before this inflation number picked up, those bonds were only giving you one and a half percent a year for the next five years. So interest rates were really low and suddenly interest rates have gone up now. And those bonds, because they were only giving you one and a half percent have gone down in value. So, Mike, how does that work? Why did the bonds drop 10 to 15%? Because interest rates went up.
Mike (04:00):
Well, let’s think this way. If all of a sudden interest rates went up very significantly and it’s not only what the government’s raise interest rates by. It is what the government is expected to raise interest rates by. Let’s say, you bought that bond last year at one and a half percent. And all of a sudden this year I can buy the same term bond for three and a half percent, right? So I can get 2% more a year. And let’s say you had a six-year bond. So there’s five years left. So for those five years, I can just buy a bond now and get 2% more a year for five years or 10% more return off just the coupon on that bond.
Mike (04:41):
So for me to buy your bond, why would I bother buying your bond right now? Right? If a year’s paying one and a half percent, why don’t I just buy the new one that’s paying three and a half percent? So the only way you can make that bond attractive for me to buy is if I say, okay, let’s make this even. You’re going to get 10% more yield over the next five years. So what I’ll do is I’ll lower my price by 10%. And that will give you the equivalent return by owning my bond that you bought last year to me buying a brand new bond.
Rob (05:08):
So in other words, my bond is no longer worth $100. It’s only worth 10% less or $90.
Mike (05:16):
Yeah. And that’s essentially what we’ve seen.
Rob (05:18):
In other words, you don’t care whether you buy the new bond or my bond at a 10% discount.
Mike (05:25):
Yeah. The one thing interesting about the bond market is it’s not like the stock market. It’s very easy to figure out. Sometimes it’s hard to say, why is Tesla worth this much? Why has this changed? Like we don’t have a clue sometimes on that. The bonds are pretty easy to explain. You can’t tell where interest rates are going. So you don’t know what’s going to happen in the future exactly. But it’s very easy to explain the price of a bond. It’s just math.
Rob (05:49):
So does the bond always move with interest rates or does it move also about… Is there a role that expectations of higher rates play a role?
Mike (05:58):
Expectations are definitely in there. So it’s not only, you hear the Fed saying they’re going to raise rates by, you hear between two and 2.75% over the next couple years. So people realize that’s going to be built into the price. So they know, if I’m only getting… When you’re talking low rates on bonds, if your expectation is next year you’re going to be able to buy a bond for, we talk from one and half to 3%, if you expect to buy a bond for 5% in a year, your bond is going to be worth even less. It’s paying one and a half percent. I’ll wait the year for the 5% bond.
Rob (06:30):
Interesting. So we’ve seen a couple of clients, not many, a couple of clients buy GICs in the last week. And I looked at it and thought, I just don’t understand that the GIC’s paying 4%, inflation’s 7.7%. Why would I buy a GIC paying 4% when inflation’s 7.7%?
Mike (06:56):
And plus there’s no liquidity in GICs. Remember there’s a price for liquidity. You can cash out a bond. If you don’t like the bond you’re in, you can cash and change positions, change term, change the quality, change a bunch of things to control the bonds. GICs have no liquidity whatsoever. You’re locked in for those five years. So if it’s at 3% and inflation goes up to 10 or 12%, you’re stuck watching your money disappear over that full five years with nothing you can do about it.
Rob (07:23):
You were in the GIC world for a number of years before you joined The McClelland Financial Group.
Mike (07:29):
Yep.
Rob (07:29):
People used to love GICs. Why have they fallen out of love with GICs?
Mike (07:34):
Well, when I started, I started in 1990, I think it was ’92 working for a deposit broker, which basically is a service that took care of all the GICs. So you could spread GICs amongst different financial institutions. And at that time we were keeping within the CDIC limits of $60,000. It’s now $100,000, but back then it was $60,000 and we’d find the best rates going. And when I started, I remember there was still the signs in the windows that had all double-digit rates return on GICs, 12% GICs. When I was working, then they were usually around 8% rate of return. But at that time, an 8% rate of return, if you have a five-year GIC at, well, if you start getting one at eight, 9%, your money grows very significantly. So they were good investments at that time.
Mike (08:24):
When we look back, the stock market actually did a little bit better over that period of time. But the GICs seemed like a pretty ideally safe place to keep your money and have sustainable growth. The problem is, with time interest rates continue to go down. And basically we’re in a situation in the last few years where GICs paid practically nothing.
Rob (08:43):
I think the other problem is they struggle to keep up with inflation.
Mike (08:47):
Yeah. There’s also, there was a big spread between GICs. When interest rates are high, there’s a big spread between the one year and the five-year GIC. There was probably about a 3% premium for going into longer term GICs. Later what we’ve seen is, at a few points in the last couple years I’ve looked in there, is under half percent difference between a one year and a five-year GIC. It just wasn’t that expectation of future higher interest rates.
Rob (09:14):
So if I’m looking at my statement and I see my bonds are down in value, 10 to 15%, is that going to get better? Is it going to recover?
Mike (09:26):
It can. One thing to look at is everyone’s assuming that government’s going to continue to do everything they said and continue to raise interest rates by all the threats they put out there. We see a few issues with that. Number one, if this starts to work and the interest rates start to take hold and starts to lower down that inflation rate and the stock market continues to struggle, the government isn’t going to send us into a hard recession. They want, they always talk about soft landings and that means they’re going to try to control. You may have a recession, but you’re going to have a light recession that’s very recoverable. You’re not going to have a deadly recession. So at that point, they may ease off on raise interest rates as much as they said. And as we talked about before, the change in the bond prices is based on expectations on what they said, not actually what they did. It’s what everyone thinks they’re going to do. So if all of a sudden they don’t do what they said, you’d see the bond returns pop up again.
Mike (10:22):
And we have this in the back of our mind, I think a lot of us know the real problem is the housing that if you raise interest rates by what they have threatened to raise them by, you’re going to create a massive housing crisis. Because remember interest rates eventually follow through to mortgage rates and everyone’s borrowed a ton of money on houses. People have been going up 80, 90%, find houses way over their affordability level based on very low interest rates. When those mortgages come up for renewal, if all of a sudden interest rates are 3% higher and they had an interest rate based on one and a half percent, now they’re going at four and a half or 5%, the housing market’s going to take a terrible crash.
Rob (11:03):
I saw an interesting comparison between if you were looking to buy a house a year ago versus today. And so housing prices are up 10 to 15% and interest rates have gone up almost 200%. So when you put the two together, if you were looking at taking out a mortgage, your payments are 40% higher than they were a year ago, because the house costs more and the interest rate costs more. Therefore, your payments have gone up by 40%. So if you were getting away with $3,000 a month, now you’re 40% higher than that. Now you’re $4,200 a month. That’s a game changer. And if it keeps going higher, a lot of homeowners are going to be in trouble.
Mike (11:57):
It’s funny. I read a lot of articles, but the one thing I haven’t seen anyone bring up is no one brings up the fact that along with a recession comes unemployment. We haven’t seen unemployment. Unemployment’s been basically a factor of people that don’t want to work in the last couple years, because we’ve had a market that needs employees. So if anyone wants to work, they can work. Unemployment’s a very serious situation. And when you talk about how much people borrow in houses, all of a sudden, if you throw that recessionary component of unemployment on top of it, and if you look at how far mortgages have gone and how much people have paid, have an 800,000, $1 million mortgages on their house, all of a sudden the interest rates go up. And look, I don’t know what unemployment maximum is. I think it’s only… I don’t think it’s a lot of money.
Rob (12:44):
Not with high inflation, it’s not a lot of money.
Mike (12:47):
Because unemployment maxes out and I don’t know if it’s $30,000 or 20,000, I don’t even know where it maxes out, but it’s nowhere enough to cover anyone’s mortgage payment who’s bought a house in the last five years.
Rob (12:58):
I think we’ve already started to see some small cracks in employment. We’ve started to see some companies do some layoffs. I saw that Wealthsimple announced a layoff of 12% of their workforce. I saw that Tesla’s doing a little bit of a layoff, even though they’re selling products left right and center. And so you’ve started to see a few little things that were not in the economy two or three years ago.
Mike (13:26):
Yeah. Companies are very forethinking. They make these adjustments, which is great. We sat down in a meeting today and we know things are going to change for us. And we are not doing layoffs or anything like that, but we look at little expenses we can cut. I mean, you have to. The only way to be physically responsible in a company is, when you see changes happen in the economy, you have to make some adjustments inside your business.
Rob (13:51):
So I want to go back to, what should we do? We’ve got bonds in our clients’ portfolios. 30% of the portfolio might be in bonds, 40%. Should we continue holding onto those bonds, or should we move it to cash and wait for the bond market to settle down?
Mike (14:10):
Well, think of it. Now, the bonds are paying more than they did before. So if you have a bond now, you’ll get a better interest rate than you did previously. So they are a better holding than cash in this position. If the government does not raise interest rates as much as they plan to and you enter a recession, you’ll see the bond rates and the bond returns jump, because-
Rob (14:32):
Sure.
Mike (14:33):
Yeah. So I think we’ve been in through the bad part. It’s like selling the stock market at the bottom. You don’t want to do that when the stock market takes a dive, why would you sell the bond market when it takes a dive?
Rob (14:42):
I think today, our current global bond portfolios, I think it’s generating about four and a quarter percent for the next five years. So that’s a reasonable rate and it’s good enough that you probably don’t want to dump it.
Rob (14:58):
That brings us to the end of another week. This is Rob and Mike with Think Smart from The McClelland Financial Group of Assante Capital Management, reminding you to live the life that makes you happy.
Assante Capital Management (15:33):
You’ve been listening to The McClelland Financial Group of Assante Capital Management Limited. Assante Capital Management Limited is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. Insurance products and services are provided through Assante Estate And Insurance Services Incorporated. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources. However, no warranty can be made as to its accuracy or completeness. Before acting on any of the previous information. Please make sure to see a professional advisor for individual financial advice based on your personal circumstances. The opinions expressed are those of the authors and not necessarily those of Assante Estate Management Limited.
