Safe and Predictable No More: Can’t be Passive in Bonds Any More

Bonds have a reputation as a safe and predictable investment vehicle primarily because in most investor’s experience, they’ve given wonderful returns with low risk. For the past 35 years, interest rates have declined from as high as 18 and 19 per cent in the early 1980s to close to zero today, resulting in bond prices appreciating dramatically over the last three and a half decades. But when investing looking forward, not backward, is critical. And we don’t like what lies ahead.

Although the Bank of Canada’s recent decision to cut interest rates resulted in higher bond prices, providing more capital appreciation to bond investors, our bond outlook and concern for investors remains unchanged. Looking forward, rates are more likely to stay flat and then go up from here, not down further, hurting bond prices and ultimately resulting in negative returns. Even if interest rates stayed flat, the real return, after inflation, of bonds looks like a big fat zero over the next 10 years. What’s more worrisome is that these low returns will likely come with a greater level of price volatility, or risk. So in fact what we think of as safe and predictable will be riskier with no return.

When I launched Claymore’s Laddered Bond ETFs seven years ago, I did it because I believed passive investing and laddering bonds was the best strategy for investors at the time, and it paid off well over the past few years.

Moving forward, I think we can and have to do more. In this new regime, investors will have to be more tactical. Investors will have to protect themselves by moving away from bonds and into cash when interest rates start to rise or credit spreads start to widen.

Focus on the Trend

Monitor price momentum for signals of fundamentally changing bond markets. Movement in high yield bonds will reflect what’s happening to credit spreads. Ten-year government bonds will respond to even subtle changes in interest rates. Flat to positive price trends are a signal for you to continue holding your bonds for the long-term. Negative price trends, on the other hand, are a signal for you to become defensive and move into cash. Cash is the ultimate protective asset – zero interest rate risk and zero credit risk. When interest rates fall, prices of government bonds and high grade corporate bonds do well; when rates rise, they will do poorly. When credit spreads tighten, high yield bond prices do well; when spreads widen, they will do poorly. We believe moving average trends and momentum signals can indicate changes in the market and help investors navigate around them.

Find the Right Nimble and Active Strategy

Choose bond portfolio strategies that are active and nimble, and equally importantly, be fee sensitive. It’s important to find an approach that provides flexibility, meaning the manager can go heavily into cash or move out of bonds entirely if the environment warrants it. Some managers are just too big and they will have no choice but to stay in long bonds. These types of managers will be no better than passive funds, so avoid them. Fees on bonds still matter, especially in this low interest rate environment, so no matter what, keep fees reasonable.

A New Fund for a New Regime

We created the Purpose Total Return Bond Fund for one reason: to create a product that ensures a total return that’s positive through different market cycles. If we see protracted rising rates or credit spreads widening, we will act to protect against losses.

The Purpose Total Return Bond Fund uses four types of investments: high yield bonds, investment grade bonds, government bonds and cash – with cash being used as a defensive asset.

As we see it, there are only two factors that matter when you are making decisions on strategy in bonds: direction of interest rates and credit spreads. We monitor interest rate and credit spread exposure, and then use bond price momentum indicators to tell us when to be aggressive or defensive. If moving average indicators on government or investment grade corporate bonds are positive, we want to be long and take advantage of conditions for both income and capital appreciation. But if they go negative, we go into cash. Same with high yield bonds; if prices are trending positively, we want to be long, but when prices start to turn negative, we go into cash. When things go negative, cash is our best ally in our defense against losses.

As we enter this new era of potentially rising interest rates, investing with bonds has changed. We’re no longer in an environment where bonds are the low risk, high return way to diversify a portfolio. Today, the key is to be tactical and active, and when needed, hold the line against losses to create absolute positive returns over time.

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